A recent Tax Court case provides an important reminder of an issue that can be overlooked. A partnership is a very different tax animal than a corporation. A corporation pays its own tax on its taxable income and its shareholders do not pay any tax except to the extent that the corporation makes dividend distributions to them. Such is not the case with partnerships. Partnerships do not pay any income tax. Instead, their partners each include their share of the partnership’s taxable income on their own tax returns and must pay any additional income tax that results.
In Les Hicks v. Commissioner, (May 7, 2009), the taxpayer was a member of a limited liability company that was treated as a partnership for income tax purposes. His share of the company’s taxable income was $54,819 but he did not receive any cash distributions from the company. He did not include this amount on his 1040 for that year. He argued in court that he should not have to pay tax since he did not receive any distribution. The court told him that the law is clear that he did have to pay tax and upheld the tax assessment and the assessment of the 20% accuracy penalty.
There is nothing new or unique about this case as this has always been the law. It does however, provide an important reminder. If you ever invest as a partner in a partnership that you do not control, you should insist that the partnership agreement contain a provision that requires the partnership to make cash distributions each year of an amount at least sufficient to enable the partners to pay their taxes on their shares of the partnership’s taxable income. These provisions are called “tax distribution clauses” and while they are very important, they can also be very complex and can cause unintended consequences if they are not properly drafted. This is an area where you need competent legal advice.