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Taxpayer must report share of partnership income even though he was unaware there was income

Lamas-Richie, TC Memo 2016-63TC Memo 2016-63

The Tax Court has concluded that a gossip blogger was liable for tax on his distributive share of partnership income that was not actually distributed to him and of which he was not aware until IRS began examining his return for the year at issue. However, the Court declined to impose accuracy-related penalties because the overall facts of the case showed that he acted in good faith.

Background. A partnership is not subject to Federal income tax. Instead, the partners are liable for tax in their separate or individual capacities. (Code Sec. 701) Each partner is required to take into account his or her “distributive share” of the partnership’s income, gain, loss, deductions and credits, regardless of whether any actual distribution of cash or other property is made. (Code Sec. 702(a); Reg. § 1.702-1(a)) A partner’s distributive share is determined by the governing partnership agreement (Code Sec. 704(a)) and is includible in the partner’s income in the tax year of the partnership ending within or with the tax year of the partner. (Code Sec. 706(a))

Facts. Nik Lamas-Richie started a gossip blog in 2007 that eventually became “thedirty.com.” As the blog gained more viewers, it attracted the attention of investors including James Grdina, who approached Lamas-Richie and suggested the formation of a partnership that would take over the website and supply capital to help it expand. The partnership was called “Dirty World,” and it began operations in September 2007. Mr. Grdina provided capital by causing Intrigue Investment Co. (Intrigue) to lend the partnership $650,000. Mr. Grdina and Intrigue together owned a 59% interest in the partnership; Lamas-Richie received a 41% limited partnership interest.

Lamas-Richie operated the website much as he had before, essentially functioning as its editor. He entered into an employment contract with iNetwork Group, LLC, another venture owned by Mr. Grdina, to compensate him for his services. This contract was apparently oral. For 2011 iNetwork furnished Lamas-Richie a Form W-2, Wage and Tax Statement, reporting that it had paid him wages of $74,500 for that year.

On Apr. 14, 2012, Lamas-Richie and his wife timely filed a joint Federal income tax return for 2011 which was prepared by a professional and competent tax return preparer. The return reported his wages of $74,500 from iNetwork, but did not include a Schedule E, Supplemental Income and Loss, and it did not otherwise report any income or loss stemming from his 41% limited partnership interest in Dirty World.

Then, on Sept. 17, 2012, Dirty World filed Form 1065, U.S. Return of Partnership Income, which was prepared by an accounting firm and signed by Mr. Grdina. The return reported for calendar year 2011 ordinary business income of $61,992 from operation of the website, consisting mainly of advertising revenue. The Form 1065 included a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., for Lamas-Richie reporting a distributive share equal to $25,417 (41% of $61,992) and no distributions made to him. Lamas-Richie did not receive a copy of this Schedule K-1 and was not aware of the contents of Dirty World’s Form 1065 until IRS began its examination of his 2011 return. IRS ultimately determined a tax deficiency of $7,097 and an accuracy-related penalty of $1,419.

Tax Court decision. The Tax Court concluded that, regardless of whether Lamas-Richie in fact received a distribution or was even aware of the existence of such income at the time it was earned, his distributive share of Dirty World’s business income was taxable to him in 2011. It was undisputed that he had a 41% interest in Dirty World during 2011, and there was no indication that the amount that the partnership reported as business income was incorrect. And, although Lamas-Richie claimed that Dirty World had losses for prior years, he failed to introduce any evidence that would establish the amount of such losses or the existence of any loss carryforward to 2011.

However, the Court declined to impose an accuracy-related penalty under Code Sec. 6662(d)(1)(A) with respect to the unreported partnership income. Although the Lamas-Richies’ understatement of income tax was substantial, in that it exceeded $5,000, the Court found that they acted in good faith and made a genuine effort to correctly ascertain their 2011 tax liability. Notably, Lamas-Richie viewed himself as an employee of Dirty World and properly reported wages he received for services, he hadn’t received a Schedule K-1 at the time they filed their return, he credibly testified that Dirty World had not previously earned income that he would have been required to report, the couple supplied their return preparer with all relevant tax-related documents, and they reasonably relied on the preparer’s assurance that the return was correct.

References: For partner’s distributive shares of partnership income, see FTC 2d/FIN ¶  B-1900  et seq.; United States Tax Reporter ¶  7014  ; TaxDesk ¶  584,000  ; TG ¶  2152  .