Payments to Taxpayer Held to Be Compensation, Not Distributions

Gross Income

The Eleventh Circuit, affirming the Tax Court, held that payments made to a taxpayer by limited partnerships that he controlled but did not own an interest in were compensation reportable on Schedule C, not partnership distributions.

Background

Martin Plotkin controlled a limited partnership, Autumn Years LP, which owned a 99% limited partnership interest in Rolla Health Care Associates LP (RHCA), a Missouri limited partnership that owned and operated a nursing home in Rolla, Mo. Although Plotkin controlled Autumn Years, he did not own a direct interest in the entity. Instead, his children, his ex-wife, and several other entities owned or controlled by Plotkin were the owners. However, neither his ex-wife nor his three children were aware that they were members of the partnership. Plotkin never drafted financial statements, filed partnership tax returns, or observed other partnership formalities with respect to Autumn Years.

Autumn Years received payments from RHCA and a number of other entities that Plotkin owned or controlled. Plotkin treated the funds deposited into Autumn Years’s bank accounts as his own, writing numerous checks for personal expenses. During the years in question, he did not have any bank or other financial accounts in his name.

In 1995, RHCA sold the Rolla nursing home. Plotkin, through RHCA, used a portion of the sales proceeds to pay off the mortgage on a home that he built for an old girlfriend. Plotkin also used the sale as an opportunity to transfer money to his then-girlfriend, Barbara Nemec, by having a brokerage set up and owned by Nemec sell the nursing home on a commission basis. After receiving the commission from the sale, the brokerage business bought a home in Florida that it shortly afterward transferred to Nemec. Plotkin and Nemec took up residence in the home.

Plotkin’s Criminal Tax Conviction

In 1999, a district court convicted Plotkin of three counts of willfully making and subscribing false income tax returns. The district court found that, during 1991, 1992, and 1993, Plotkin received and failed to report substantial income from the Rolla nursing home. Plotkin argued at trial that the funds used to pay his personal expenses were partnership distributions to Autumn Years’s limited partners. The district court rejected this argument, explaining that Autumn Years was a sham and had not been treated as a true partnership. Specifically, the district court found that no partnership formalities were observed and the purported distributions were not made in accordance with the partnership agreement or the law of partnerships.

Plotkin’s Tax Court Case

In 2008, the IRS issued a notice of deficiency to Plotkin for the years 1991 through 1995. In the notice, the IRS determined, among other things, that Plotkin had received and failed to report a substantial amount of self-employment income on Schedule C, Profit or Loss From Business. The IRS included in the Schedule C income funds transferred to Autumn Years and Quixoti Corp. (another corporation owned by Plotkin). Plotkin challenged the deficiency in Tax Court, again arguing that these payments should not be included in his income because they were partnership distributions. The court held that the IRS had properly included the payments in income because Plotkin was not a partner in Autumn Years or RHCA and the payments were made in return for his work carrying on the business of RHCA and related entities (Plotkin, T.C. Memo. 2011-260).

Plotkin’s Appeal

Plotkin appealed the Tax Court’s decision to the Eleventh Circuit. In the appeal, Plotkin argued that because the district court found that Autumn Years was a sham in his criminal case, the 99% limited partnership interest Autumn Years had in RHCA should be imputed to him. Accordingly, the money Plotkin received from RHCA’s payments to the accounts of Autumn Years and Quixoti were not Schedule C income to him, but rather, were distributions made by RHCA to him as a limited partner. Because partnership distributions would be taxable only to the extent they exceeded his basis in his interest in RHCA, Plotkin contended that the IRS erred in treating the distributions as unreported Schedule C personal income.

The Eleventh Circuit’s Decision

The Eleventh Circuit held that the funds Plotkin received from RHCA through Autumn Years were compensation for his work for RHCA and thus were Schedule C income, not partnership distributions.

The court stated that while that Autumn Years may have been a sham partnership given that the partners were unaware of their membership and no partnership formalities were observed, it made no difference because there was no authority for Plotkin’s claim that he should be considered the owner of Autumn Years’s interest in RHCA if it was a sham. The court also noted that Plotkin could have made himself a partner of RHCA, but instead chose to assign the partnership interest he could have had to Autumn Years. Therefore, Plotkin was bound to accept the tax consequences of his affirmative choice of organization, which gave him no partnership interest in RHCA or Autumn Years.

The court then explained that even if Plotkin was a partner, payments to him from RHCA would not automatically be considered partnership distributions. Under Sec. 707(a), where a partner performs services for a partnership “other than in his capacity as a member of such partnership,” those services are treated as though they were rendered by a nonpartner. Therefore, to demonstrate that the IRS’s conclusion that the payments were compensation was arbitrary or erroneous, Plotkin had to affirmatively show that the payments were distributions made pursuant to a partnership agreement.

The court found Plotkin had failed to do this. In particular, Plotkin did not allege or prove that his work for RHCA’s business was performed pursuant to RHCA’s partnership agreement or that the payments made by RHCA or Quixoti were made in accordance with RHCA’s partnership agreement. Therefore, the court concluded that the Tax Court did not err in finding that payments were compensation that Plotkin should have reported on Schedule C.

Reflections

In this case, the taxpayer tried to have his cake and eat it, too. However, since he worked hard to avoid being a partner in Autumn Years or RHCA, the court would not let him claim the benefit of the partnership rules to avoid tax. Other than being an interesting example of the Byzantine structures taxpayers create to evade taxes, this case also illustrates an important point for practitioners and taxpayers who are members of a partnership. While it may be beneficial to treat a payment to a member for services performed outside his or her capacity as a partner as a distribution, it is not proper and may be challenged by the IRS.

Plotkin, No. 12-10620 (11th Cir. 11/27/12)