Sometimes our biggest problems are self-created. In Taryn L. Dodd v. Commissioner, T.C. Memo. 2021-118 (Oct. 5, 2021) (Judge Lauber), the taxpayer was attempting to repudiate a tax liability she had self-reported but had not paid. Her multi-year slog through Collection Due Process (CDP) involved three trips to the Tax Court. Only in the third trip do we learn this basic lesson about passthrough entities: a partner must report as income her distributive share of partnership income, whether or not that share is actually received. So now Ms. Dodd not only has her 2013 liability to pay off, she also has all the additions to tax and interest that continues to accrue.
We also learn a second lesson, a lesson about the structure of CDP. The difference between Appeals Officers (AOs) and Settlement Officers (SOs) is more than just the title. Each has different subject matter competencies but only SO's conduct CDP hearings, which are generally all about collection issues. Sometimes, however, taxpayers can raise substantive tax issues, creating a CDP mashup. When a taxpayer uses CDP to contest the merits of a liability, the lesson here is to be sure to ask the SO to confer with an AO. Otherwise you get stuck like Ms. Dodd. Details below the fold.
Law: The Concept of Distributive Share
In my 20 years of teaching tax I have successfully avoided having to teach partnership taxation. My tax law specialty is procedure and collection. I confess to still being confused by inside and outside basis!
Fortunately, today’s lesson involves a fundamental concept of partnership taxation that even I can understand: the concept of the distributive share. Here’s how that works.
Partnerships earn income. They are legal entities with the capacity to sue and be sued and with the capacity, as entities, to earn income. They figure out their taxable income just like an individual, although they also get some special rules. §703(a).
But partnerships don’t pay tax on the income they earn. §701. Instead, a partnership assigns its income to each of its partners, generally in proportion to each partner’s ownership interest in the partnership. Thus we say that partnerships “pass through” their partnership income by allocating to each partner an appropriate “distributive share.” A partner must then report and pay tax on that distributive share, whether the partnership actually distributes that share to the partner (in the form of cash or otherwise) or instead holds onto the income and uses it for the benefit of the partnership. That rule dates back at least to the Revenue Act of 1918’s statutory command that “there shall be included in computing the net income of each partner his distributive share, whether distributed or not, of the net income of the partnership for the taxable year.” §218(a), 405 Stat. 1057 at 1070. You now find that rule in Treas. Reg. 1.702-1(a).
Thus the concept of “distributive share” focuses on what proportion of the partnership’s income each partner is responsible for. It’s not about what income the partner actually receives. As the Supreme Court has said: “Few principles of partnership taxation are more firmly established than that, no matter the reason for nondistribution, each partner must pay taxes on his distributive share.” United States v. Basye, 410 U.S. 441, 454 (1973).
Law: The Structure of CDP Distinguishes AOs from SOs
I think of tax administration as consisting of two big boxes. One is the box encompassing the determination of tax liabilities. The other is the box encompassing the collection of tax liabilities so determined. Here’s a graphic I find helpful (and have shared before):
You can see that once a taxpayer is in the Collection box, the only ways to get back into the Determination box are: (1) through the statutory CDP process in §6320 and §6330; (2) the statutory Spousal Relief process in §6015; or (3) the administrative audit reconsideration process (which Congress will at some point cut and paste into the Tax Code, proudly declaring another “reform”). This is just a rough graphic and I am sure there are many details one could add. But I think it is a useful one.
Congress did not add the CDP or the current Spousal Relief pathways until 1998 (before 1998 only what is now 6015(b) relief was available). Before 1998, the Office of Appeals had responsibility mostly over decisions made in the Determination box, by the Exam function, decisions about tax liabilities made before assessment. As a result, Appeals Officers (AOs) were all experienced Revenue Agents, bringing years of tax determination expertise to help ensure that Exam employees made the correct determinations. Yes, I know the Collection Appeals Program (CAP), started in 1996, but I am not clear on how that was worked in Appeals. Perhaps someone could comment on that? Did Appeals start hiring experienced Revenue Officers at that point?
Regardless, when Congress created the CDP process in 1998, that gave the Office of Appeals a big new job: reviewing decisions made in the Collection box. For a description of how CDP works, see Lesson From the Tax Court: The CDP Butterfly, TaxProf Blog (July 6, 2021). The Office of Appeals now needed to bulk up its expertise in tax collection. That meant Appeals hired experienced Revenue Officers, giving them the title Settlement Officers (SOs) to distinguish them from the traditional Appeals Officers.
This setup creates some awkwardness when taxpayers seek to use CDP as a pathway back into the tax determination box. That's what I call the CDP mashup, when determination box issues get mixed in with collection box issues. When a taxpayer has not had a prior opportunity to dispute the tax liability being collected, they are allowed to use the CDP hearing as a way to get a new tax determination. §6330(c)(2)(B). And if they don’t like the answer they get from Appeals, the Tax Court will review that tax determination de novo, just as it does when reviewing a proposed deficiency. Goza v. Commissioner, 114 T.C. 176 (2000).
The problem is that SOs may not always have the depth of expertise needed to address a taxpayer’s plausible argument regarding the merits of the liability. See Lesson From The Tax Court: The Proper Role Of Delay In CDP, TaxProf Blog (Sept. 30, 2019). Today’s taxpayer, Ms. Dodd, had just such a plausible argument regarding the merits of her liability. Or at least it was plausible until she (eventually) supplied the relevant information about all the relevant facts and someone in Appeals who know what they were doing actually reviewed the information. Let’s take a look.
In 2013, Ms. Dodd was the office manager for the law firm of Braude & Margulies (now named Braude Law Group) She was also the managing partner of Cadillac Investment Partners, LLC, (Cadillac) in which she held a 33.5% share. Her boss, Mr. Braude, held the remaining 66.5% interest. Cadillac was in the business of buying, leasing, and selling realty and had elected to be taxed as a partnership.
On its 2013 partnership tax return, Cadillac reported, inter alia, a net §1231 gain of $3.2m from the sale of commercial property that it had sold for some $4m. As a partnership, it did not need to pay any taxes on that gain. Instead, as required, it sent a Schedule K-1 to each of its two partners, telling them their respective distributive shares of income, deductions, losses, etc. Ms. Dodd’s distributive share was 35.5%, which made her responsible for just over $1m of that net §1231 gain.
The same CPA who prepared Cadillac’s 2013 return also prepared Ms. Dodd’s 2013 return. Consistent with the partnership return, Ms. Dodd reported all the distributive shares from the partnership, including the $1m. Of the resulting self-reported tax liability, however, she left $170,000 unpaid. It remained unpaid through 2014 and 2015. In 2016 the IRS finally grabbed her state tax refund through its State Income Tax Levy Program. IRM 18.104.22.168 (10-20-2016). That grab released the CDP butterfly which she timely caught.
Ms. Dodd wanted to use her CDP hearing to dispute the liability she had reported in 2013. She claimed that she should not have reported the $1m income because she never received that money. She alleged that “the sale proceeds were immediately...used to pay off the bank credit line of the law firm that I worked for.” Apparently she was under the impression that if she had not touched the money, it was not income to her. She offered nothing more.
The SO assigned to her case erroneously noted she had not contested her liability. In Tax Court the IRS Chief Counsel attorney caught the SO's error and the Court remanded so the SO could properly consider the liability issue. But Ms. Dodd was no more articulate the second time around and also got stuck with the same SO, who was no more receptive. The SO merely told Ms. Dodd to submit an amended return and when she did not the SO immediately green-lighted continued collection.
Again Judge Lauber sent the case back to Appeals. He thought Ms. Dodd had a plausible story that required the SO to do more to consider her challenge to the underlying liability. The SO should have explained exactly how to file an amended return and what information was needed to make the liability determination, such as whether Cadillac had in fact realized any gain or, if it had, what amount was properly allocated to her interest in the partnership.
On the second remand, Ms. Dodd got a new SO, one who knew enough to ask for help from an AO who had experience in partnership tax. Remember, SOs know collection box stuff and don’t necessarily know even basic determination box stuff. Just like me! This time, the AO told Ms. Dodd exactly what information she needed to give. She gave all the information requested (or almost all of it). The AO basically then said “nice try, but your CPA properly reported the $1m. Ya gotta pay.”
Lesson 1: The Partnership Tax Lesson
Once Ms. Dodd submitted all the relevant information, it became quite clear that she was responsible for the $1m distributive share of Cadillac’s net §1231 gain, regardless of how it was used. The information she provided confirmed she held a 35.5% partnership interest and confirmed that Cadillac indeed had a $3.2m gain that someone (i.e. the partners) needed to account for as their taxable income.
Ms. Dodd’s basic complaint seems to be that her boss, Mr. Braude, had diverted the money realized from the sale of Cadillac's property to pay off debt of Mr. Braude’s law firm. As Judge Lauber points out, however, that claim creates a state law issue, not a federal tax issue: “To the extent petitioner is contending that the sales proceeds were applied incorrectly—to Mr. Braude’s benefit and her detriment—she is advancing a State law argument that we lack jurisdiction to consider.”
Bottom line: regardless of how the partnership used its income, Ms. Dodd was responsible for the taxes on 35.5% of it because that was her distributive share, even if it was not actually distributed.
Lesson 2: The CDP Lesson – Get an AO!
Keith Fogg has blogged on the CDP aspect of this case here, and here. As did I here.
Keith's blogs point out that the failure in the first two administrative hearings lay both with Ms. Dodd and the first SO. Ms. Dodd repeatedly failed to submit information to help the SO understand the issue. But perhaps more importantly, the SO had neither the experience to resolve the substantive tax issue nor, apparently, the desire to ask for help from an AO. Only on the second remand did the new SO partner with an AO to make the proper tax determination.
I like this insight from Keith: “That an SO would have difficulty determining the correctness of partnership items comes as no surprise, but the failure on the first two tries to line up someone to help with that aspect of these case seems like a failure of the system.”
That insight, folks, leads to our second lesson: learn the difference between SO’s and AO’s. Remember that SO’s are generally experts in collection box matters but not in substantive tax determination matters. That means if you have a client who is trying to contest a liability as part of a CDP hearing, you may want to proactively ask the SO to partner with an AO to help get your client the best quality review.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each week to TaxProf Blog for a new Lesson From The Tax Court.