Note to Subscribers: The June 13, 2009 issue of Taxing Lessons discussed 132 T.C. No. 17 – Countryside – Federally Authorized Tax Practitioner Privilege, in which the tax court found for the taxpayer in regard to privileged communications. While the decision stands, for research purposes it’s useful to know that in a recent ruling on a similar case (Valero Energy Corp. v. United States), the Seventh Circuit Court of Appeals reached a different conclusion than the judges in this case.
What’s the tax effect of income received from a partnership in which a partner holds legal title but is not a beneficial owner?
Taxpayer Says: He is not the beneficial owner of the partnership interest and is not subject to tax on the partnership income attributable to the partnership interest.
Internal Revenue Service Says: Taxpayer had beneficial ownership rights in the partnership and owes tax on the income reported on Schedule K-1.
From Internal Revenue Code Section 702(a): A partner must take into account his distributive share of each item of partnership income, gain, loss, deduction, and credit when determining his individual income tax.
From Federal Tax Regulation 1.702-1(a): Each partner is taxed on his distributive share of partnership income regardless of whether the income is actually distributed.
From Ragghianti v. Commissioner, 71 T.C. 346, 349 (1978), affd. without published opinion 652 F.2d 65 (9th Cir. 1981): Beneficial ownership, not legal title, determines ownership for Federal income tax purposes.
From Hang v. Commissioner, 95 T.C. 74, 80 (1990): Beneficial ownership is determined by actual command over the property or enjoyment of its economic benefits.
From Grigoraci v. Commissioner, T.C. Memo. 2002-202: The determination of the beneficial ownership of a partnership interest is made at the partner level.
THE CAUSE OF THE DISPUTE
A partnership is a pass-through entity, meaning the partnership itself is generally not subject to federal income tax. Instead, as a partner, you pay tax on partnership activities, even if no distributions of income or other items are actually made from the partnership to you. You will receive Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., showing how much of these items were allocated to you based on your ownership percentage.
Because preparers of a partnership tax return and the accompanying Schedules K-1 may not have accurate information regarding the true economic relationship between a partnership and its partners, conflicts can arise over whether the person receiving Schedule K-1 is the proper owner of the partnership interest and is therefore liable for any tax due on the items shown on the schedule.
Relevant factors in determining beneficial ownership include receipt of economic benefits from the partnership interest, control over the disposition of the partnership interest, obligations and risks with respect to the partnership interest, and the manner in which the parties treat the partnership interest.
In this case, the taxpayer, who lived in Canada, received Schedules K-1 over a period of four years from a limited partnership. The partnership owned real estate in New York, and the taxpayer legally owned an interest in the partnership, which was part of a family investment management company. The taxpayer’s sister managed the real estate investments and had authority to conduct transactions for the company.
During family disputes over management of the company, the taxpayer discovered the real estate partnership had issued distribution checks payable to him, in care of his mother. His sister endorsed the checks using their mother’s name and cashed them.
The taxpayer sued. A Canadian court held that he had a beneficial ownership interest in the partnership, that he was the owner of the distributions, and that they should be repaid to him. The family business appealed the decision. At this point, the taxpayer attempted to transfer legal title of his partnership interest to other family members, but the partnership refused to allow him to do so because of the appeal.
The initial ruling was overturned on appeal, though the issue of beneficial ownership was not addressed by the appellate court. In addition, the taxpayer was informed the statute of limitations precluded a suit against his sister to recover the distributions.
The taxpayer says he did not receive any benefit from the distributions. He also had no control over the disposition of his partnership interest, and so is not liable for federal income tax related to his legal ownership of the partnership interest.
The IRS says the lower court was the only one that made a decision on the issue of beneficial ownership. Since the court decided the taxpayer was a beneficial owner, he owes tax on his share of the partnership income.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.