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TAX MATTERS

Accounting firm’s distributions of clients or, alternatively,
distributed clients are that CRC failed to establish the value of
intangible assets the distributed clients. The FPAA also
found that the allocations of income
But related income allocations did lacked substantial economic effect and
not have substantial economic reallocated the income: $538,118 to
effect because the partnership Clark, $20,000 to Newman, and $5,000
did not properly maintain capital to Town. CRC timely filed a petition in
accounts, the Tax Court held. Tax Court.
Holding: The Tax Court rejected
By Charles Keith Kebodeaux, J.D., the IRS’s determinations in the FPAA
LL.M. disregarding CRC’s client distributions
704(b) and to liquidate in accordance and reallocating its ordinary income.
The Tax Court addressed the proper with the capital account balances. In lieu It held the client distributions were
treatment of an accounting firm’s of a deficit restoration agreement, the distributions of client-based intangibles
distributions of “client-based” intangible agreement contained a qualified income that should be valued under the terms of
assets, the capital accounting rules of offset provision. A qualified income CRC’s LLC agreement.
Regs. Sec. 1.704-1(b)(2)(iv), and the offset is activated by a negative capital The Tax Court also held, however,
tests for substantial economic effect of account balance and requires allocation that CRC failed to properly maintain
partnership allocations. Finding that the of all income and gain to partners with capital accounts under Regs. Sec. 1.704-
taxpayer failed to properly maintain and negative capital balances to bring the 1(b)(2)(iv); therefore, its allocations
adjust capital accounts for unrealized balances to zero. The agreement also of its 2013 income lacked substantial
gain in the client-based intangible assets contained provisions that permitted a economic effect and the income must be
it distributed to two withdrawing part- “distribution” of clients to withdrawing reallocated in accordance with the part-
ners, the court held that allocations of partners. ners’ interests in the partnership under
firm income in the year of the distribu- CRC’s 2013 partnership return Sec. 704(b) and Regs. Sec. 1.704-1(b)(3).
tions did not have substantial economic treated the clients as a distribution Finally, it held that because Town and
effect and would not be respected. of property to Town and Newman at Newman had negative capital accounts
Facts: Clark Raymond & Co. PLLC a value prescribed by the operating at the end of the tax year, under CRC’s
(CRC) was an accounting firm that in agreement. Because the distributions qualified income offset, ordinary income
2013 had three members (partners): drove their capital accounts negative, the must be allocated first to them in an
Clark PLLC (Clark); John E. Town, qualified income offset was triggered, amount necessary to bring each partner’s
CPA, Inc., P.S. (Town); and Chris and all the partnership’s 2013 taxable capital account up to zero.
Newman CPA, PLLC (Newman). income was allocated to them, with none The Tax Court stated, citing the
After negotiations for a buyout of Clark allocated to Clark. Supreme Court in Newark Morning
stalled, Town and Newman withdrew Issues: CRC was subject to the audit Ledger Co., 507 U.S. 546 (1993), that a
from CRC in May 2013, and a number regime of the Tax Equity and Fiscal Re- “client-based intangible” asset, such as a
of CRC clients chose to become clients sponsibility Act (TEFRA), P.L. 97-248 customer list, is an intangible asset that
of their new firm. Civil litigation ensued (codified at Secs. 6221–6234), and Town may be capable of valuation, distribution,
as a result of their departure, which and Newman each filed a Form 8082, and sale to third parties. The court held
ended with a settlement agreement that Notice of Inconsistent Treatment or Ad- that the CRC’s clients or client list was
acknowledged the latest limited liability ministrative Adjustment Request (AAR), a client-based intangible asset that was
company (LLC) agreement the partners contesting the income allocations. The owned and could be distributed by CRC.
had executed in January 2013 and settled IRS then audited CRC’s 2013 partner- Therefore, it rejected the IRS’s argument IMAGES BY ILLUSTRATOR DE LA MONDE/GETTY IMAGES
all claims regarding Town’s and New- ship return and issued a Notice of Final that CRC’s client distributions should
man’s departure from the LLC. Partnership Administrative Adjustment be disregarded.
The CRC LLC agreement required (FPAA) disregarding the client distri- Regarding the value of the client
the firm to maintain capital accounts in butions and reallocating the ordinary distributions, the Tax Court observed
accordance with regulations under Sec. income. It determined there were no that neither CRC nor the IRS argued

32 | Journal of Accountancy February 2023