Tax Accounting
The Tax Court held that the taxpayers could not report the portion of a sale of a partnership interest that was attributable to unrealized receivables using the installment method.
Background
Lori Mingo joined PricewaterhouseCoopers LLP (PwC) sometime before tax year 2002. Mingo was a partner in PwC’s management consulting and technology services business (consulting business) until tax year 2002, when PwC sold its consulting business to IBM.
As an initial step in the transaction, PwCC LP (PwCC), a partnership, was formed in April or May 2002. As part of the transaction, PwC transferred its consulting business to PwCC. Among the assets PwC transferred to PwCC were its consulting business’s uncollected accounts receivable for services it had previously rendered (unrealized receivables). PwC then transferred to each of the 417 consulting partners an interest in PwCC and cash in exchange for the partner’s interest in PwC. Mingo received a partnership interest in PwCC and cash from PwC in exchange for her partnership interest in PwC.
On Oct. 31, 2002, PwCC was sold to IBM. The value of Mingo’s partnership interest in PwCC as of Oct. 1, 2002, was $832,090, of which $126,240 was attributable to her interest in partnership unrealized receivables. Mingo received a convertible promissory note (note) for $832,090 in exchange for her interest in PwCC. The $126,240 attributable to her interest in partnership unrealized receivables was included in that face value.
On their joint federal income tax return and on an attached Form 6252, Installment Sale Income, Mingo and her husband reported the sale of her interest in PwCC as an installment sale. They listed the selling price, gross profit, and contract price as $832,090. The Mingos did not recognize any income relating to the note other than interest income on their 2002 federal income tax return.
The Mingos did not convert any portion of the note during tax years 2002, 2003, 2004, 2005, and 2006 and did not report any income other than interest income from the note for any of those years. During 2007, the Mingos converted the entirety of the note in a series of transactions. On Feb. 26, 2007, the Mingos converted a portion of the note into shares of IBM stock worth $929,765. On Oct. 1, 2007, they converted the remainder of the note into shares of IBM stock worth $283,494.
In connection with the conversion of the note, the Mingos reported on their Schedule D, Capital Gains and Losses, for 2007 the full amount of the value of the stock received in both exchanges as gain. They also claimed a loss of $217,402 for “debt converted to stock.” This loss amount was equal to the value of the stock received for the portion of the note related to the unrealized receivables.
The IRS audited the Mingos’ return and disagreed with their treatment of the transactions. It determined that they could not report the amount received from the sale of the unrealized receivables on the installment method. It further determined that the Mingos’ reporting of the sale constituted an establishment of an accounting method under Sec. 446 for which a change of accounting method adjustment under Sec. 481 was required and accordingly issued a notice of deficiency for $126,240 of ordinary income (the amount of Lori Mingo’s share of the unrealized receivables) for 2003. It also issued a notice of deficiency for 2007, increasing long-term capital gain in that year by disallowing the loss for the debt-to-equity conversion and decreasing it for the $126,240 of income it had determined should have been included in 2003. The Mingos challenged the IRS’s determinations in Tax Court.
The Tax Court’s Decision
The Tax Court held that the Mingos could not report the income attributable to the sale of the unrealized receivables under the installment method and should have reported it as ordinary income in 2003 as a Sec. 481(a) adjustment. In addition, it held that the Mingos were not entitled to the loss they claimed on the conversion of the promissory note into stock in 2007.
With regard to the use of the installment method for the unrealized receivables, the court found that Lori Mingo had engaged in a barter exchange of a property interest (a portion of the note) in exchange for the right to collect unpaid amounts in satisfaction of services her partnership had previously rendered (the unrealized receivables). Therefore, Mingo should have reported the proceeds of this transaction as ordinary income in the year of the conversion. Citing Sorensen, 22 T.C. 321 (1954), the court found that a taxpayer cannot use the installment method (Sec. 453) to defer compensation income. The court stated, “Nothing in section 453 or its associated legislative history suggests that Congress intended to allow taxpayers to escape the basic principles of revenue recognition by deferring compensation for services under the installment method.”
The Tax Court also found that the IRS had correctly determined that the Mingos had established a method of accounting with respect to the unrealized receivables because the timing of their inclusion in income was a material item, and they had established a pattern of consistent treatment for this item through their tax returns for 2003 through 2007. In addition, the court found the IRS had also correctly determined that this treatment did not clearly reflect income and thus the IRS had not abused its discretion in making a change in the Mingos’ accounting method and a Sec. 481 adjustment. Thus, it sustained the IRS’s deficiency determination for 2003.
For the loss claimed in 2007, the Mingos made a curious argument. They contended that had they been liable to pay tax on the income from the unrealized receivables in 2002, they would have had to sell stock in that amount to pay the tax owed. Had they sold that portion of the stock, it would not have had the opportunity to appreciate over the life of the note, and therefore they should not be liable to pay tax on the amount of appreciation allocable to that portion of the note. However, the Tax Court noted that while it might have been an economic necessity for the Mingos to sell the stock, no authority required them to do so. In addition, if they had sold the stock related to the unrealized receivables, they would not have had the gain they realized from its appreciation. Therefore, the court found that the combination of the increase in the basis of the note due to the inclusion of the income for the portion of the note attributable to the unrealized receivables in income in 2003 and the disallowance of the loss claimed in 2007 from its conversion resulted in the correct amount of income for the Mingos in 2007.
Reflections
This case highlights the need for practitioners, when deciding how to report the sale of a partnership interest, to make sure that they have all the necessary information about the partnership interest and whether part of it is attributable to unrealized receivables or inventory that will give rise to ordinary income. While the IRS conceded that the taxpayers were not liable for an accuracy-related penalty in this case, taxpayers in similar situations might not be so fortunate.
Mingo, T.C. Memo 2013-149
