We all know that some of the most difficult, emotional disputes can arise when the owners of a closely-held corporation, limited liability company (LLC), partnership or limited liability partnership (LLP), limited partnership or limited liability limited partnership (LLLP) part ways. These business disputes between the owners of a closely-held entity can arise at formation, or during operations, or when one or more of the owners desire to leave or exit the entity. Business disputes of this kind may also arise in estate and trust administration when there is a family business involved. These disputes may also arise in a family law or divorce setting as well, between husband and wife or other family members.
One of the issues often overlooked is the “negative capital account.” For example, in a Tennessee state case, Dermon-Warner Properties, LLC v. Warner, 2017 WL 6502887 (Tenn. Ct. App. 12/19/2017), a 2-member LLC established to manage commercial and residential properties and consisting of 2 members, Dave Derman Co. and Steve Warner, each owning 50%, faced a situation where Mr. Warner withdrew from the LLC as a member on December 31, 2010. At the time, he had a negative capital account of $399,657. He did not pay back to the LLC this negative balance when he withdrew. In September, 2011, he gets his K-1 from the LLC. It describes how he now had “income” to report in the amount of this negative capital account balance. On February 8, 2012, the company sent a written demand to Mr. Warner demanding that he either pay the negative capital account balance or dispute the claim and provide documentation supporting the position. When Mr. Warner did not do either, the company sued him, asserting claims for unjust enrichment and breach of the operating agreement. After discovery, the company pursued summary judgment.
In pursuing summary judgment, the company admitted that the provisions of the operating agreement did not expressly require withdrawing members to reimburse the company for a capital account deficit, but asserted that it was only “logical and equitable” for such an obligation to exist because had there been a positive capital account balance at the time of withdrawal, the company would have been expressly required to pay that out to a withdrawing member. The trial court agreed. The issue became what was the effect, if any, of the K-1 that had been issued on the obligation. Mr. Warner claimed that the K-1 itself, in stating that “income” was produced in the amount of the negative capital account amounted to an admission that the deficit had been forgiven, giving rise to an affirmative defense including equitable estoppel and set-off. Mr. Warner looked to rely on cases involving IRS Form 1099-Cs issued with respect to the reporting of cancelled income for debtors. Noting that under a minority view, the filing of a Form 1099-C is prima facie evidence of a discharge which then forces the creditor to prove that the form was filed by mistake or pursuant to other IRS requirements, while a majority view conclude that issuance does not bar a creditor from collecting payment, the Tennessee court noted the “inherent differences that exist between” the Schedule K-1 and 1099-C. The LLC’s CPA testified that the K-1 reflected a zero balance in Mr. Warner’s capital account “for tax accounting purposes” only, and that there was nothing on the K-1 itself to indicate that the item was being “discharged” as there is on the Form 1099-C. For these reasons, the court refused to conclude that the mere issuance of the K-1 indicates that the LLC in any way forgave Mr. Warner’s debt. The court also rejected Mr. Warner’s equitable estoppel defense.
The Dermon-Warner Properties case is a reminder to all practitioners how important it is to expressly deal with the possibility of capital account deficits and withdrawal in the agreements, further distinguishing between the different manner in which capital accounts are maintained (i.e., tax, book, 704(b), GAAP, other).
Still another recent case reminds practitioners that 704(b) capital account maintenance rules and the regulations issued with respect thereto can become the subject of litigation. In Clark Raymond & Co. PLLC v. Commissioner, T.C. Memo 2022-105 (10/13/22), the Tax Court had occasion to consider whether an accounting firm, Clark Raymond & Co, PLLC (CRC), a TEFRA partnership, had properly handled distributions and allocations of ordinary income to its entity partners, including Clark, PLLC (which was a partner of CRC for the years 2011-2013) and whose shareholders were a CPA, Mr. Clark and his wife, with Mr. Clark being employed as an accountant in the accounting firm and his wife employed as the firm administrator. At some point, Rachelle A. Benbow, PS (Benbow PS) purchased a 25% interest in CRC from Clark, PLLC for approximately $580,000 in 2006, and was admitted as a partner. The purchase price had been calculated by taking 12 months of gross receipts and the net value of the firm tangible assets. The agreement between Benbow PS and Clark PLLC reflected that Benbow PS purchased an indirect interest in 25% of CRC’s tangible assets and 25% of CRC’s “book of business” when it purchased a 25% partnership interest in CRC. CRC credited Benbow PS’s capital account with an initial balance of $580,000. John E. Town, CPA, Inc., P.S. (“Town PS”) later came along and purchased a 25% interest from Clark PLLC in 2009 and was admitted to CRC as a partner in 2009. Again this was a seller-financed purchase, by Clark PLLC. CRC set Town PS’s initial capital account balance at $639,000, the amount of the agreed upon purchase (a purchase price of $872,996 reduced by a discount for the amount of revenue generated by Mr. Towne’s book of business in the prior year, of $234,046, for a final purchase price of $639,000 (and did not adjust the balance upward to reflect the value of the book of business). Yet another entity, Chris Newman CPA, PLLC (Newman PLLC) became a partner in December 2012 and remained a partner until May 1, 2013, making a $200,000 cash contribution to CRC using funds it obtained through a bank loan, supported by personal guarantees. CRC set Newman PLLCs initial capital account balance at $200,000. CRC employed Mr. Newman as an accountant from 2009 until May 1, 2013. As with most of these partnerships, the operating agreement for the firm contained sophisticated partnership tax provisions, including rules governing capital contributions and capital account maintenance for each partner. In fact, the 2013 LLC agreement expressly stated that “a separate Capital Account will be maintained for each Member throughout the term of the Company in accordance with the rules of Regulation Section 1.704-1(b)(2)(iv).” From there the agreement explicitly stated that each capital account would be increased by the FMV of contributions, by allocations of “net profit” and by any items of income, and gain specially allocated to the partner, and decreased by the FMV of distributions, by allocations of expenditures, and by items of deduction and loss specifically allocated to the partner. The 2013 LLC Agreement also stated that maintenance of capital accounts under the agreement is intended to comply with the requirements concerning substantial economic performance under Section 704(b) and that the agreement shall not be construed as creating a DRO (deficit restoration obligation) or otherwise personally obligating any Member to make a capital contribution. When disputes arose concerning two of the employed accountants leaving the firm (Mr. Newman and Mr. Town), a lawsuit was brought. That lawsuit was settled. The value of the clients that the accountants were able to retain was determined to be $742,569, broken down into $318,144 allocable to Mr. Newmann’s entity and $424,425 allocable to Mr. Town’s entity. CRC made certain adjustments to the capital accounts after the withdrawal of these two entity firms. While CRC chose to decrease the two entity capital accounts, to account for property distributions reported to each of the partner entities, it then decreased one of the entity capital accounts further, by $150,000 and increased one of remaining partner entities (Clark PLLC) by $150,000, treating that increase as a capital contribution. Meanwhile CRC did not adjust the entity partners who were withdrawing to reflect the allocations of any inherent gain in the property distributions before decreasing the partners’ capital accounts in the amounts of the distributions.
While realizing ordinary income of $563,118 in 2013, CRC then made allocations of the same to each of the entity partners. However, the IRS came in and found that the allocation of ordinary income had no substantial economic effect, and was not consistent year to year.
At trial, the Tax Court found that CRC’s method for valuing client-based intangibles upon the withdrawal of two of the entity firms comports with the definition of “fair market value” in Regs. Section 1.704-1(b)(2)(Iv)(h)(1). The petitioner was found to have met its burden of proving that there was a distribution of clients, and that based on the evidence presented, CRC did, in fact, distribute client-based intangible assets of $318,144 to Newman PLLC, and $424,426 to Town PS when certain clients left CRC and engaged NT PLLC following Newman PLLCs and Town PS’s withdrawals. No argument was made that the amounts were not properly agreed upon (i.e., giving rise to a loss).
The fact that the 2013 LLC Agreement did not make express provision for goodwill to be contributed by a partner and included in his capital account but this omission did not mean that client-based intangibles do not exist, and cannot be transferred. The fact that CRC failed to reflect intangibles values in partners’ capital accounts was not dispositive.
The Tax Court then took a close look at whether there was a lack of substantial economic effect in the 2013 allocations. The taxpayer argued that the two entity firm’s capital accounts were driven negative by subtracting the value of the clients distributed to them, which then triggered the QIO provisions and required that CRC allocate income to these two entity firms in amounts sufficient to restore the capital account balances to zero. CRC then argued that the income allocations have “substantial economic effect” because they were consistent with the economic arrangements of the partners in the 2013 LLC Agreement.
While the allocation was found to have met the alternate test, these were found to be lacking in economic effect. This is because the 2013 LLC agreement, while it contained all of the so-called boiler-plate 704(b) regulations, the special allocation of income in this case could not be accepted because CRC did NOT actually maintain the capital accounts of its partners in accordance with the 2013 LLC Agreement and Regs. Section 1.704-1(b)(2)(iv). The IRS asserted persuasively that CRC had failed to do so, because before distributing those assets, CRC did not increase the partners’ capital accounts by the value of the unrealized gain inherent in the client-based intangible assets. See Regs. 1.704-1(b)(2)(iv)(e)(1). That being said, the Tax Court found that an analysis of the partners’ interest in the partnership reveals that although Clark PLLC was the largest percentage owner of CRC’s membership units, the partners agreed to income allocations (including a QIO) that are most indicative of how they agreed to share the economic benefits and burdens of the partnership, particularly in light of the unanticipated distribution of client-based intangibles to the two entity firms.
In many of these disputes, client representation needs to be handled by legal practitioners who can combine the necessary tax and business entity expertise to assist the owners in working through these issues. Mr. Tufts aims to provide an owner with the expertise he or she or it may need to work through the issues that can arise in a business dispute of this kind.
