Walter Mack Jr. was a partner in a New York partnership in 2011. The partnership filed the form 1065 U.S. Return of Partnership Income and gave related Schedules K-1 to each partner for their share of the profits.
Mr. Mack did not report his share of the income ($479,743) as shown on his Schedule K-1 because he did not receive that amount of money. He only received $75,000 because the partnership had problems and needed the rest of the money to pay expenses (which it paid and claimed on the partnership income tax return).
Mr. Mack asked the accountants for the law firm if he had to report the entire amount of income shown on his Schedule K-1. The answer was, “Yes, that is taxable income you are required to report on your individual income tax return, even though the distributions to you were much less ...”
He prepared his own income tax return and only reported $75,000 as his share of the law firm partnership income for 2011.
About a year after he filed his return, IRS issued a notice of deficiency and IRS also assessed an accuracy-related penalty of $28,060 (for a substantial understatement of income tax).
The matter went to U.S. Tax Court after Mr. Mack petitioned it in March 2014. In May 2015, the IRS filed a motion for Summary Judgment (meaning there was no dispute about the facts, just the application of tax law). In December 2016 the Tax Court issued the decision that he failed to correctly report his taxable income in 2011. The Court also found the accuracy-related penalty applied.
Many partners also may have not understood the basic partnership tax law provisions. A partner is taxable on his or her share of the taxable income of the partnership. The distributions to the partner are not what is taxable. The distributions might be more or less than the taxable income on the Schedule K-1.
This is another instance where the matter should have been settled without going to Tax Court. As an attorney who asked if he was taxable on the income shown on the Schedule K-1 and ignored the answer, the special penalty does seem to apply.
It also is an example of how important it is for all partners to understand the partnership financial records, reports and tax returns. Surprises of this sort are not enjoyable at all.
Did you hear? “There is a gigantic difference between earning a great deal of money and being rich,” by Marlene Dietrich.
John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.
