Mr. Tufts understands that shareholders (of closely-held S corporations), partners (of partnerships, joint ventures and LLPs) or limited or general partners (of limited partnerships or LLLPs) or members or managing members (of LLCs) may come to doubt that they have received accurate and correct information on the K-1 that they have received from management and its tax return preparer.  Far too many tax return preparers of IRS Forms 1120S or Form 1065 prepare K-1s without appropriate regard to the terms of the parties true economic relationship, as intended, or as set forth in the governing shareholder, partnership or operating agreement.  If you or your tax advisor are concerned about the information appearing anywhere on a K-1 that you have received, now is the time to act.  The IRS has enacted a K-1 matching program and further provides for the scanning of these forms, to enable them to more efficiently tag items and look for inconsistencies or mismatches.  If you do not take prompt action with regard to an erroneous K-1, you may not have an opportunity to challenge any adjustment made of your return in the future.  A duty of consistency may apply.  A proper filing of IRS Form 8082 may need to be made, to note an inconsistent position being maintained.  See, e.g., Latitude Co. v. Reese, 2022 U.S. Dist. LEXIS 209447 (N.D. Ind. 2022)(disallowing suit seeking issuance of revised Schedule K-1 given that Form 8082 was not filed, but could have been, to protect business owner’s contention that K-1 was in error).

In November, 2015, President Obama signed into law the Bipartisan Budget Act of 2015, which eliminates TEFRA and replaces it with a more streamlined approach to the audits of partnerships at the Federal tax level.  Practitioners will want to closely examine the new law.  This new law changes how adjustments are to be made to the partnership tax return.  The new law looks to make the prior year tax adjustments, but with any underpayment then impacting the partnership entity in the current year. The concept of a TMP has been replaced by a simplied partnership representative. Many agreements will need to be revised, to reflect the changes in the audit provisions.

An administrative adjustment request (AAR), using IRS Form 8082, may also need to be filed, seeking permission from the IRS to make amendments to previously filed, but erroneous partnership tax returns.   In these settings, careful attention must be given to the terms of the governing shareholders? agreement and bylaws, organizational documents, partnership or operating agreements, plus any and all side agreements and understandings.  Special procedures and filing obligations may exist under the Federal tax law.

Business disputes may arise, and often times, parties are encouraged to pursue mediation or arbitration or other alternative dispute resolution techniques so that the complex tax issues and erroneous K-1s may be addressed in an efficient manner.   We have found that many times confusion can arise over whether the person receiving K-1 forms is the proper owner and therefore, recipient of the K-1, in whole or part.  Promises or just the circumstances or dealings between the parties may give rise to claims that another person had become an owner, whether beneficial or otherwise.  Eventually, courts may have to weigh in and resolve the matter.  See, e.g., Garvey v. Lemle, 2005 Mass. Super. LEXIS 336 (Sup.Ct. Mass. 2005)(after 11 day trial, court discusses how the K-1s issued were never meant to be the final determinant for identifying the shareholders, but instead, as temporary place holders until the parties could reach agreement as to what additional investments had been made, what payments were loans, and what payments were intended to be equity, but then again, after 13 years, the parties never reached agreement as to a different identity or percentage).

Careful negotiations and deliberations that must go into resolution of disputes involving erroneous K-1s.  Often times, the IRS Form 8082 cannot be filed without giving due regard to more than just tax concerns.  Much will depend on the parties, the quality of their tax advisor, and the terms set forth in the governing documents.  We try and encourage the parties in these situations to look to resolve matters early on, by taking an approach similar to the one pursued in Wolgin v. Kennington Ltd., Inc., 84 A.F.T.R.2d 99-6855 (E.D.Pa. 1999).  In these matters, the parties can work with a mediator and coordinate resolution of disputes over how to make proper allocations of each partner or member’s distributive share, consistent with the parties’ agreement and Federal tax law.

Practitioners and taxpayers alike must also understand how to approach squeeze-out mergers, conversions, and other techniques or strategies that can threaten any individual, non-managing member or partner.  If an effort is made to compel any such member or partner to accept things, without regard to a proper adherence to the underlying agreements and Federal tax law, such efforts may be challenged.  In the past, under TEFRA, a partner or member might find that they have the right to take an inconsistent position to a position taken by the majority interest holders, and even if the IRS concurs with the majority’s position, elect to pursue an administrative adjustment or result favoring his or her position.  For e.g., Harbor Cove Marina v. Commissioner, 123 T.C. No. 4 (2004); see also, Tufts, “It Ain’t Over ‘Til It’s Over; When Partnership Tax Vessels Make Ill-Advised Journeys and Wind-Up at Harbor Cove,” 6 J. of Bus. Ent. No. 5, at 26 (Sept./Oct. 2004)(author tells the story of an unhappy voyage taken by a partnership tax vehicle that could not rid itself of an unwanted 10% limited partner interpleaded a pay-out of cash that was handed to him, and filed IRS Form 8082 when the limited partnership did not dissolve in accordance with the terms of the limited partnership agreement by selling its assets and liquidating).

VALUATION AND OPERATING AGREEMENT COMPLIANCE ISSUES

—1.704-1(b)(2)(iv)(h)

Under this section, practitioners will note that for purposes of the capital account maintenance rules, the fair market value assigned to property contributed to a partnership (LLC taxed as such for federal tax law purposes) is to be regarded as correct, provided that (1) such value is reasonably agreed to among the partners in arm’s length negotiation; and (2) the parties have sufficiently adverse interests.  This provision goes on to say that if these conditions are NOT satisfied, then a determination must then be made as to whether the value assigned to such property is overstated or understated by more than an insignificant amount.  If it is, then the capital account maintenance rules under the 704(b) regulations will have been violated.  This might then result in a breach of the underlying operating agreement if the terms state that “capital accounts” are to be maintained in accordance with the Treasury Regulations under Section 704, or in accordance with 1.704-1(b)(2)(iv).  For any CPA working with LLCs, he/she/it are well advised to review the operating agreement, carefully, so as to determine how they are to keep the books, and all capital accounts, not just those on a “tax” basis, but also, on a “book” basis, or even in accordance with GAAP, or all of the above, and strictly comply with the agreement terms, and if the capital account maintenance rules of 1.704-1(b)(2)(iv) are incorporated by reference, ensure that the capital account rules set forth in great details are strictly complied with.  See, e.g., Clark Raymond Co., PLLC v. Commissioner, T.C. Memo 2022-105 (required adherence to 704(b) regulations in agreement resulted in adjustment based on fair market value of client-based intangibles kept by departing accounting firm).

It is not at all clear whether there was any mandated use of the 704(b) regulations in the operating agreement at issue in the Ryan and Wages case, but practitioners ought not let down their guard, as adherence to these rules may not just be academic, but rather, one actually mandated by state law and the terms of the operating agreement.

FRONT-END COMPLIANCE IN DRAFTING LLC OPERATING AGREEMENTS BEFORE FORMATION

Practitioners will best serve their clients by working closely with CPAs on the front end of any transaction, in the selection of how capital accounts are to be maintained, and decide, before simply using some “form” agreement, whether or not that form, and presumably, reference to compliance with the 704(b) regulations makes sense for the parties.  Certainly, in those states like Florida, where the operating agreement may be entered into, prior to, or at the time of formation, it again emphasizes the need to have these issues addressed before title is taken in the name of the LLC for property contributed, so that a determination can be made whether the process of valuation will comply with 1.704-1(b)(2)(iv), inclusive of 1.704-1(b)(2)(iv)(h), and from there, whether the book and tax capital account maintenance will then seek to properly address the issues arising under 704(c), and applicable regulations, in terms of the approaches to be taken there, e.g., 1.704-3 (contributed property).

704(B) REGULATION METHODOLOGY WHEN ADDRESSING CONTRIBUTIONS OF PROPERTY UNDER SECTION 704(C)

As practitioners know, Section 704(c) and applicable regulations is a section of the Federal tax law intended to prevent the shifting of tax consequences among partners with respect to precontribution gain or loss, by and through which a partnership (LLC) is required to allocate income, gain, loss, and deductions with respect to property contributed by a partner so as to take into account any variation between the adjusted tax basis of the property and its fair market value at the time of contribution.  Any allocations must be made using a reasonable method that is consistent with these stated purposes.  Even when operating agreements do not mandate that capital accounts be maintained in accordance with 1.704-1(b)(2)(iv) for purposes of the so-called safe harbor provisions, Section 704(c) and the applicable regulations thereunder nevertheless mandate adherence to these valuation concepts (i.e., using a book capital account based on the same principles, that is to say, “a book capital account that reflects the FMV of property at the time of contribution that is subsequently adjusted for cost recovery and other events that affect basis of the property).

PARTNERSHIP AND K-1 ISSUES MUST BE ADDRESSED SOONER THAN LATER

Mr. Tufts is in a position to advise on, provide testimony about, and otherwise counsel or represent parties in these disputes.  It is easy to assume that “no one understands that stuff” and how it seemingly may feel that it is full speed ahead, anything goes.  However, this is an attitude that can be one that leads many practitioners and CPAs and their clients down the wrong road fast.  This is because many operating and partnership agreements are driven by references to the tax law, applicable treasury regulations, thereby incorporating these complex tax laws and rules into the agreements reached by the parties.  Courts will be quick to hold the parties to what was agreed upon, and not hesitate, when it feels it needs the assistance, to reach out to experts who may then advise as to these complex regulations and rules, when incorporated into everyday agreements.  This is, as was evident in the Wolgin case, and many others, the only thing a court can do, in attempting to effectuate the parties’ stated intent in addressing any dispute.

Thus, practitioners and their clients must be wary of those who suggest that it just doesn’t matter, or that the IRS, much less anyone else on this planet, really understands partnership tax provisions like those under the 704(b) regulations.  That may be missing the point, when practitioners have already drafted the agreement to mandate, by incorporation by reference, that the capital accounts be maintained in accordance with the rules set forth in the regulations.  That then means that the issue has become an issue of state law.  Thus, partners or members on the receiving end of a reporting (e.g., K-1) that does not accurately reflect the maintenance of capital accounts arguably cannot sit back and accept the same, or do nothing, even as to valuations of, or the proper keeping of the capital accounts on a “book” basis under these situations.  Schedules K-1 must be prepared and reflect tax capital accounts.  Business owners will find it prudent to get on top of the issue immediately, and bring forth these matters as soon as possible, first, to the attention of the CPA, and the Company, to make sure they are aware of the issue or concern, and then, if the issue is not resolved, to their satisfaction, fully consider whether it is prudent (or required) that he/she/it file inconsistently, contrary to the K-1 they have received.

Mr. Tufts is sensitive to the extraordinarly complex issues and practical concerns that arise when disputes arise, and how dispute resolution techniques, if permitted, or otherwise how to address these issues, with proper adherence to the applicable audit procedures, the Federal tax laws, and underlying agreements.  If advice or consultation is needed with respect to these issues, please do not hesistate to contact us.