Donald W. & Kathryn W. Wallis, Petitioner

T .C . Memo . 2009-24 3 UNITED STATES TAX COUR T DONALD W . AND KATHRYN W . WALLIS, Petitioners v . COMMISSIONER OF 'INTERNAL REVENUE, Responden t Docket'No 8818-08 .

Filed Odtober' 27, 20-09 .

Donald W . Wallis , for petitioner .

William F . Barry IV , for respondent .

MEMORANDUM OPINION

JACOBS, Judge : The parties submitted'this case full y stipulated pursuant to .Rule 122 . Respondent determined a deficiency„in petitioners' Federal income tax of $33,414 and a penalty under section 6662(a) of $6,684 for 2005 . The issues for determination are : (1) The characterization (capital gain or ordinary income) of "Schedule C Benefits" totaling $80,000 tha t

SERVED OCT 2 7 2009

Donald W . Wallis (,petitioner) received from Holland & Knight , LLP, a Florida limited partnership`engaged in the practiceo f (hereinafter " referred to ,as, Holland & .Knight or th e law firm) , connection with his withdrawal as apartner ; .(2) the characterization (capital gain or'return of-basis) of $32,721 .

that petitioner received from `Holland & .Knight-for his capita l account ; and (3) whether petitioners are liable for-the section .

6662 ( a) accuracy -related penalty .

,Petitioners did not include in . income, either as .capita l gain or ordinary income," any of the approximately $112,72 1 petitioner received . from-Holland, &,Knight in'-2005 (the . $80,'00 0 Schedule C Benefits and'the .$32,721 :for petitioner's capital , account) . Petitioners row acree that the $80, .000 petitione r received : from Holland & .,Knight in,2005 designated as Schedul e .parties disagree as tothe characterization of . the Schedule C e Benefits . Petitioners contend the 'Schedule C Benefits' were long- term capital gain income, .whereas respondent contends thes e amounts were ordinary`incom e The statutory notice of deficienc y issued to petitioner s February 19, 2008, did not includ e an adjustment relating to th e $32,721 petitioner received from & Knight in .2005 for hi s capital account . As la result of information discovered durin g the discovery and stipulation processes, . respondent filed an --3 :- Amendment .to Answer, .requesting an increased deficiency on the basis that all or most of the $32,721 petitioner received from Holland & Knight-in 2005 for his capital account should have bee n ,reported as, long-term capital gain . Petitioners contend that all .

of the $32,721 is a return of petitioner's"basis in Holland & Knight .ahd therefore is-not taxable .

Unless otherwise . indicated, all section references .,are .to°=' the Internal Revenue Code (Code) in effect for 2005, all'Rule references are-to the Tax Court Rules of Practice and . Procedure and all dollar amounts .are`°rounded to the nearest dollar.

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, Background We adopt as findings of fact all statements contained in the stipulation of facts and supplemental stipulation of facts . The stipulation,of facts, supplemental stipulation of .facts, an d exhibits-attached thereto are incorporated . herein by this .:

reference . Petitioners 'resided in Florida when-they filed-their petition . -Kathryn W ., Wallisis .a party .hereto as a consequence of filing ,,a joint . return with Donald W . Wallis .

Petitioner-has-been a practicing,tax lawyer for approximately 35 years and .is°a member,of the bar of this Court .

On August 1, 1989, petitioner joined Holland & Knight as ,a Clas s C partner .in its Jacksonville, Florida, office . . Upon joining th e law firm, petitioner_and"Holland & Knight entered into .a Memorandum of Agreement which governed their relationship .

At all relevant, times-Holland & Knight had-three classes o f partners ., Al) Class .A Class A partners . arenot expected to spen d full time in the . .practice of law and are not required to contribute to the capital of the firm .

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(2) Class B Class B partners are expected to spend full time in .the practice of law .and in the discharge of other responsibilities on behalf of the firm ., They are the principal partners in the firm. There are two categories of Class B partners ; namely, :Class'B (Capital)_ partners and Class B (noncapital) partners . Class B (Capital) partners are the equity partners, whereas, Class B (noncapital)partners have no equit y or ownership, interest :in the law firm .

(3), Class C Class C partners are affiliated with the law- firm on a nonownership basis-,and are not required to contribute to the firm's capital . As a general rule, the professional experience of aeClass C .!partner .exceeds,that of an-associate .

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Class C partners may receive financial data generally available to partners, sign checks, attend partnership meetings as nonvoting participants,-and represent to others that they ar e partners .

In addition, the managing partner, of the,-law firm can besto w the honorary title "partner' emeritus" on certain former partners of the law firm= A .partner emeritus has no rights or obligations as a partner in the . law firm .

On January 1, :1991, petitioner, became a Class B (Capital) partner . Petitioner and Holland & , .,Knight did not enter into a new bilateral agreement . . Instead, petitioner's new .partnership status was governed by the Holland & Knight Partnership Agreement (hereinafter referred to as the Partnership Agreement) .

As a Class B (Capital) partner, petitioner received 50 "Schedule C Units" each year .' Each Schedule ,C Unit .'ha`da stated value of-$300,' so that the units yearly awarded .to"each ClassB (Capital) partner, including petitioner, had 'an aggregate value of $15,000 . The granting : of Schedule'C Units,each year was a benefitxor .entitle m'ent awarded to 'each Class ;B (Capital) partner.

per capita .

The .amount and the award of=the Schedule C Unit .

benefits were determined without regard to the profits of ; the -law firm . Further, the dollar value of Schedule C Units-was .noti«, reserved or otherwise .set aside-by the=law,firm . If a partner voluntarily -'left 'the `law firm,.-he generally forfeited -the valu e of his Schedule C Units . The .-awarding of, Schedule C .Units was- discontinued,in 2002 .

Paragraph 27 .01'of the-Partnership Agreement provided that ' upon attaining age 68 , a Class B (Capital) partner was entitle d 'The .. term :"Schedule C Unit" has`no meaning or significance outside the context of the Partnership Agreement . .

partnership , con-sisting of the sum of (1) `the, amoun t (as disclosed in-'the firm' s books :=and records) as ;of the .fisca l year in 4 :which "he reached age ; 68, ,-and,, (2 ) ; -.the ,valu e Schedule C -Units .p Payment of this suml :was to- begin ,3 month s after; the =first da,y of, the fiscal-year following-=the partner' s 68th birthday .

While--a Class B (Capital) partner, petitioner made all-_ required =contr butions :;; t.o, the capital` of„-Holland &` Knight .

Petitioner's : capital,,oblig .ation fluctuated as,theamount of hi s annual distributive share of„the law ifirm's profits .fluctuated r The law ;A,'firm :prepared,-and provided, .peti-tioner,with ;; an annual .

statement reflecting the amount of :h s,"capital contribution :

obligation .

.Petitioner,,also,, :received quarterly ,statements .

reflecting deposits made to ;;, wit-hdrawals--made from, .,,,interes t accrued on, . .and the current balance of, his capital account .

As .of January .1, :

:.2003, petitioner ceased to be<a Clas s ,{C . partner .- As part of that .' conversion , petitioner and .Holland &' Knigh t entered into a Class .C Partner.-Agreement which modified-°th e Partnership . Agreement as it ., affected ,the 'rights „an d 2Pursuant to : the Partnership Agreement, Class= .B (Capital ) partners were required to contribute, capital to',-- arid maintain a capital :account, with, . Holland & -Knight ,in ., an,,'amount determined b y its managing partner -. >, ; .

-`7 responsibilities of petitioner .vis-a-vis'Holland"&,Knight .

Attached to the`ClassC Partner Agreement was"a`schedule, dated March 7, 2003, showing petitioner's capital-account balance to b e $98, 162 .

On March 19 :, 2003, petitioner withdrew as'a--Class C .partner , ,,and he ceased `performing- services for the law_ firm . Upon hi s withdrawal petitioner : received a document from the law firm entitled . "Wi'thdrawal' Benefits Analysis" (the benefits due schedule) showing the amounts owed him byHolland=& Knight and the dates payments were to,bemade ; : The benefits due schedule reflected petitioner's partnership interest to be $338,162, of which $98,162 was designated as Schedule"B .Regular Capital and $240,000,as Schedule C Withdrawal Benefits :3 The document scheduled the amounts to'be"paid to :petitioner into 12 payments of approximately $28,18 :0 each, of which approximately $8,180 was deemed'a distributionof-capital and $20,000 as a'Schedule C Unit ' payment .

From,1991 until the date petitioner withdrew from Holland & Knight, petitioner annually received from"the .law firm a Schedule K-1 (Form 1065),,,Partner's Share of Income, Deductions, Credits, .etc ., on which was reported petitioner's capital` contributions .

3Sec . 6(a) of the Class C Partner Agreement definedthe . value of'petitioner'-s capital account and Schedule C Units as the amount "reflected on ;Schedule No . '1„to the?:Class C Partner Agreement .

- 8 ' during''the year, .. petitioner';s-dist-ributive'(cid:127)share of „th e firm's pr.ofits, : .petitioner' sshare of' . the , l:aw ., firm' s tax-exempt - income, and the amount . .of petitioner's=withdrawals and .

; distributions . Copies of the Schedules K-1 were submitted .bylthe ' law firm to the Internal Revenue Service .

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Petitioner's .Schedules-K-1, ;reported :the followin g information :

(1) petitioner' .s contributions, to'Holland ; ;& Knightfrom1991 , through 2003'totaled $111,756 ; .

(2) petitioner's .shareof the .taxable income of Holland & .Knight from 1991 to 2003,totaled,_$2,780, 3 94 4 :(-3) peti tioner ' s share of the tax - exempt income ofnHolland Knight from-199i ;; to 2003 totaled $42.2 ; (4),distributions .petitioner received from .,Holland' .& Knight : , from .., 1991 to 2003 ,:totaled- $ 2,^892, 173 ..

On the--basis of1th- ese Schedules, K-1, respondent - determined.,that p (1) . petitioner received $111,357 of distributions in excess of-= , the amount of,his . :share of Holland & Knight's taxable and tax' = exempt income, and :(2) petitioner's basis in-Holland & Knight as .

.:

.'Our, review of petitioner's Schedules .K-1 indicates that petitione,r's share of the taxable income of Holland & Knight fro m 1991 to 2003 totaled $2,779,764 . $2, 780, .3914 amount ( as determined by respo ndent ) of .that amount is,more beneficial to petitioner since it .'provide s him with additional . basis to offset ;athe payments ,Xreceived,in ; respect of his capital account .

Nonetheless , we use-th e .. because the use , I of March_19,` . 2003, ,(the 'date he withdrew from the law' firm) wa s $399 .

The Schedule K-1 for 2002 reports petitioner's capital account 'at the end of that year-to be $10,758, which , is the same amount-as reported on the Schedule K-1-for 2003 as petitioner' s capital account for the beginning of' .that year .

After his withdrawal from Holland & Knight, petitioner's financial relationship with the law firm was governed by the law' firm's Partnership Agreement and Class C Partner Agreement .

Section 6 of .the Class C Partner Agreement governed the payments to be made to petitioner with respect to his capita l account and his Schedule (cid:127) C Benefits . Section 6(b) of th e Partnership' Agreement provided that with respect to the paymen t of petitioner's capital account :

Until the first payment of the Capital . Amount has been made ., WALLIS shall earn, and 'Holland & Knight 'shall pay ; interest on the Capital Amount (to the same extent payable to Class B. (Capital) partners) in`accordance'with`the- policy established by the Managing Partner pursuant to the Partnership-Agreement Except in 'the event of his earlier ' -death, disability, expulsion . or withdrawal from the firm, in which event payment of-his Capital Account will be made' ,.in accordance with procedures identical to those applicabl e to Class B (Capital) partners pursuant .to `paragraph 27 .`05 of. the Partnership Agreement, WALLIS .hereby waives any right to receive payment of his Capital Account until after December 31, .2003 . After December 31, 2003,,WALLIS shall be . entitled to withdraw 'theF" Capital Amount at any time, on at least thirty (30) [sic] advance writtennotice to Holland & Knight . The Ca.pital,Amount shall be paid .in twelve equal quarterly installments', with the first installment being payable on the first day of the calendar quarter immediately following the date of the notice provided in the preceding sentence .

Section 6 (c) of the- Partnership Agreement .,,provided that " with respect to'the payment of the value of petitioner's- Schedule C :Units . :

Payment of: the Schedule C ° amount ,shall . be . made' by Holland . & . Knight to WALLIS, or to his estate, onhis'death, . :hi s disability, or his expulsion or . wi :thdrawal_from Holland,,&, Knight and otherwise in accordance with the procedure s identical to those applicable to Class_B ( .Capital)' .partner s pursuant to paragraph 27 .05 of the Partnership Agreement .

'Paragraph 27 .'05 of the Partnership Agreement provided fo r the following payments to be made to a partner who withdrew fro m the partnership : Subject to certain limi ations`,one-twelfth o the total due the retiring partner was to be made . withi n months after. the partner's withdrawal and one-twelfth . every ; ,months thereafter until the full sum is paid . ` Paragraph 27 .0 4 of the Partnership Agreement stated that "Payment,will no t additionally be made'for goodwill, trad e and retainer value, work in progress, accounts . receivabl e accruals, or,,other,tangible or .intangible assets : of the :_firm .

`Paragraph 27, .03 . of the Partnership Agreement atated that "Fo r the purp5oses of the foregoing computation [the paytent :of, . a withdrawing .partner's interest],>the Pursuant to the aforementioned provisions, Holland & Knigh t made payments to petitioner'and,recorded them .in a secon d withdrawal benefits analysi s (the benefits paid schedule .), as follows :

Payment Date Capita l June 19, 2003 Sept . 19 ; 2003 Dec . 19, 2003 Mara 19,"2004 June 19, 2004 Sept . 19, 2004 Dec .` 19, 2004 Mar . °19, 2005 June 19, 2005 Sept . 19,`2005 Dec . 19, 2005 Mar . 19, 2006 ;*, $8,18 0 -8 18 0 8,18 0 8,18 0 8,18 0 8,18 0 8,18 0 8, 1'8 0 8,18 0 8,18 0 8,180 , 8,180 18 0 $20,000 20,000 20,000 20, 000' 20,000 20, 000 20, 000 20r' 000; 20, 000 20,000' `20, 000 20 ;000 ($8,180) (8, 180) (1,044) -0 ..

-0 -0-1 Pay . to Donald Walli s $20,00 0 20,00 0 27, 13 6 28, 18 0 28, 18 0 28, 18 0 28, 18 0 28, 18 0 28,18 0 28 ;18 0 28, 18 0 28,18 0 Petit ioner .received the"payments set-`forth in the column "Pay to Donald Wallis""on .or" .about the date stated in the column labeled "Payment Date" . After March"19,-"20,03, petitioner performed no,services forthe law firm and received only those payments described-in the benefits paid schedule .

In 2005 petitioner received payment for his Schedule'C Units totaling`$80 ;000 . ''Because the"Schedule C .Units were forfeitable, Holland and Knight did not treat the award of th e Schedule 'C Units as income inthe year they were awarded .

.. Instead , Holland &` Knight considered the-Schedule C amounts as ` additional compensation to the recipient partner in the year th e amount was paid .

2005 Holland -& Knight issued to petitioner , and: .file d with respondent , a° Form 1099 7MISC, :Miscellaneous .' Income , reporting $80 ;0.00 as nonemployeecompensation, the amount i t considered as payment for petitioner's Schedule ,C Units .

Holland. :&,Knight deducted this amount as nonemploye e compensation in 2005 . 5 -,Hol'l'and & Knight paid petitioner $32, 721 with respec t his capital account in 2005 . Holland & Knight ; did not deduct,.

this+amount as nonemployee compensation in 2005 .

.Petitioners did not include in income any of the-payment s described in the benefits due schedule or th :e,benefitstpaid .

; schedule . On September 10, 2007, respondent .sentpetitioners a CP'2000 .,notice stating that petitioners' Form1040,~U .S .

IndividualnIncome Tax Return, for year 2005 .didnot .match the, income and payment information that respondent hadon .f le and ; 'proposing several,Rchangesto petitioners' ;taxes . Petitioner, replied that he disagreed with respondent's proposed . .changes'l stating, :

'I did, :indeed, receive during the tax, year . in questio n ° payments .totaling the amount reported to the IRS by Hollan d 5In 2003 Holland & ,Knight issued and filed a .,Form ,. 1099 - MI :SC , reporting $60,000 of nonemployee compensation, the amount Hollan d & Knight, considered to be payments% during 20 .03 for petitioner's Schedule-C Units . Holland & Knight issued a Form 1099-MISC i n 2004 reporting $ ;80„000 of nonemployee compensation and; a' Form ' . 1099-MISC in 2006 reporting $20,000 of nonemployee compensation representing payments for petitioner's Schedule C Units, for'those years .

& Knight, LLPI.' However-,- .the reporting of these payments by- Holland & Knight, LLP on Form 1099-MISC and the characterization of these payments as "non-employee compensation " were inaccurate . ..Instead, these payments are accurately characterized as, andshould have been reported as, cash distributions by a partnership to a withdrawing partner"in'complete liquidation of-his partnership . interest . Under the circumstances, none of these payments constituted income, and none of these payments is required to be included in income on`my tax return for the tax year in question .

As stated supra P(cid:127) . 2, petitioners now concede that the y should have reported on their tax return for 2005 the $80,00 0 petitioner received for his Schedule C Units and the $32,721 petitioner received with respect to his capital account .

However, as stated supra p . 2, petitioners contend the $80,000 should be characterized and taxed as long-term capital gain , whereas respondent contends the $80 ,000 should be . characterize d 'Additionally, petitioners and respondent disagree as to the amount of petitioner's basis in Holland & Knight . Petitioner s contend that petitioner's basis'in'Holland"&'Knight' as of Marc h 19, 2003, was $98 ,162, whic h amount of petitioner's partnership capital account in both th e attached to th e Class C Partner' Agreement, see supra p .

7,' and the benefits due schedule, see supra p . 7 . In contrast , respondent 'maintain's that petitioner's 'capital account balance in the law firm was°$10,758 as of January 1, 2003, and tha t 14 - approximately, $ 399 . See supra pp . 8-9 .

Discussio n Characterization of the Amount Paid for the Schedule C Units 6 ,.Payments made by a partnership in liquidation of th e interest of a retired partner are governed by section 736 , which divides such payments into three categories ; namely : (1) (cid:127) Those representing the recipient's distributive share o f partnership income, sec . 736(a)(1) ; (2) those deemed to b e guaranteed payments, sec . 73 .6(a)(2) ; and (3) those in"exchang e for the partner's interest in partnership property,, sec .

.736(b) If the payments are considered to represent a distributive share of partnership income or . deemed to b e guaranteed payments, then the amount of the payment's received i s taxed to . the recipient as ordinary income . On the other hand , 6Petitioners - assert respondent bears (cid:127) the -burden : of ..proo f with respect to this issue . We need not, and do not, addres s petitioners 'x,assertion ;, because our conclusion with = respect t o this issue does not turn on who bears the burden of proof .

' .Neither party asserts that the transaction giving rise to the payment, to petitioner constituted a sale or exchange of a n interest-in a partnership within the purview .of sec . 741 .

For purposes of sec . 736(b ), if capital is not a material,, income-producing .-factor for the partnership and the retiring partner was a general partner , interest in,partnership property do not include .(A),unrealized receivables or (B) goodwill, except to the extent that the . partnership agreement provides for a payment with respect to goodwill . 'Sec . 736(b)(2) .

. payments in exchange for a n I fthe,payments are considered,,to be',in°exchange for partnership , property, then the mbuntreceived in excess--of the adjuste d basis of ..the withdrawing .partner's,partnership interest . is . taxe d as , capital°' gain . We,,find - and hold . that, ; the payments fo r petitioner's Schedule C Units are guaranteed payments .

The . .record . revea-1s that .*each~ ;partner received the sam e number (50) of'Schedule C Units each-.year, for services . rendered .

to .(cid:127) th, e -law . firm regardless of the size of, the partner' s pa--rtnership _in.terest `in Holland & . Knight and without regard t o treated as- :part-s:of .. the partners' . respective shares . o f partnership income : or partnership property and were-no t reflected'in .the-partners' respective capital . accounts ., Further,`the law'.,firm did-,not .establish .a-reserve or any othe r accountto ;reflect the value,o-f the .xSchedule C Units . Finally,, the . Partnership Agreement .states that a .partner would receive ; . ; the value o-f.his Schedule,-C Units within 3Rmonths after the .

first day . of ; the fiscal year following=the partner's~68t h birthday .

IIt . appears to us !that, .,Holland -¢ &Knight' s creation of the . F Schedule° . -CUnits,program was, a ., means . by° :which the law firm provided . ' retirement benefits .to its equity partners , since afte r December 31, 1991, , the law firm had no reti-rement plan as such .

The va--lue .,of .,the 'Schedule C Units provided the measurement for' , the retirement amounts to be"paid to each of the :-law firm ' equity partners, and the source of payment of : those .amounts was, the future revenues-of the law "firm .

We,have :,previously held that retirement payments paid, to a :

wi't-hdrawing :partner as part of the liquidation of, his partnership interest under section 736 are guaranteed payments .

Sloan v :: .: Commissioner , T .C . Memo . 1981-641 . Tn' Sloan , . :we,"had,-to determine-the proper characterization of payments"to'a'retirin g doctor/partner after the medical partnership'dissolved .

The partnership agreement that governed the three partners-- ,provided that if one .of the partners retired, he would-be, paid .

(1)-the= .£equity in his :capital account, and (2)a sum,(the , additional amount) equal to one-twelfth of the gross .annual ; .

income=during .the 12 months next preceding the date of his , withdrawal :<4The retiring partner had the option to elect-t o receive the additional amount either in a lump sum or :overma,, .period of 12 months or less . The partnership agreement furthe r provided that the partner had to completely retir& ;fromTthe, practicetof'medicine to be eligible for the " additional amount .

9The historical note to para . 32 of the Partnership Agreement` states that the law firm discontinued its retirement plan as of Jan . 1, 1992 .

Because o partnership ultimately diss .olved, ..with one partner opting t o retire and(cid:127)the two other partners opting to establish a ne w three former partners entered into a partnership termination agreement, which provided that in addition ,to dividing the partnership-assets the retiring partne r would receive $2,000 a month as retirement pay over a period o f 18 months .

We determined that-(1) a liquidation of the retirin g partner's='. interest had occurred, . and (2) the $2,000'-a-mont h payments were guaranteed payments pursuant to section 736(a)(2) .

conclusion in ',Sloan is consistent with the Rev . Rul . 75- 154, 175-1 C . . B . 186 ,' the Commissioner determined that periodi c payments made insatisfaction of a partnership liability to a previously retired partner, .in addition`to amounts previousl y paid to the retired . partner for his interest in partnership property, were guaranteed payments because they were determine d without regard to the income of-the partnership .

We are also mindful that section 1 .707-1(c) ., Income Ta x Regs , provides : . .} Payments made by 'a partnership to a partner for services or for 'the use` of "capital` are'considered-'as made to a person ,who is not a partner,'to the extent such payments . are . determined without regard ° o `the "income` of ,the partnershi p However, a partner must include such payments as ordinar y income ` fo°r his taxable `, year within or- with which ends th e partnership taxable year in .which the partnership deducted such payments as paid-or accrued under its method,"of . accounting .

Petitioners contend that the payments for petitioner's Schedule C Units were made in exchange for his interest i n Holland & Knight and therefore the payments should be considere d as a distribution as that term is used in section 736 (b)(1) .

Petitioners base their position on paragraph 27 :01 of the Partnership Agreement, which states that with respect to a r withdrawn Class B (Capital) partner the value of the partner' .s . :

interest in the firm is the sum of his capital account and hi s Schedule C amount . Continuing, petitioners maintain that sectio n 1 .736-1-(b)(1), Income Tax Regs . , provides that "Generally, . th e valuation placed by the partners upon a partner's interest"i n partnership property in an arm's length agreement will be regarded as correct ." Finally, petitioners posit that since the valuation set forth in the Partnership Agreement reflects the "valuation placed by the partners" in Holland & Knight, th e valuation of petitioner ' s partnership interes t must be regarde d s as'correct and therefore the payments are for partnershi p property . We do not subscribe to petitioners' contention .

Paragraph 27 .01 of the Partnership Agreement does not defin e petitioner's Schedule .C .Units as partnership :property .

.Moreover, section736{makes clear that payments for a partner's interest in .

a partnership, may be made up of distributions for partnershi p property as well as guaranteed payments . In this'regard, section 1 .-736-1-(a)(2)., :Income ;Tax R .e .gs ., provides, in part, that the .

amounts paid t .o a ;withdrawing, partner' may represent several items and'the payments mustbe allocated between payments . for the valu e of the withdrawing ;partner's interest in assets, except unrealized ; receivables 'and, : generally ., goodwill, sec . 736(b), and ; other . payments=, sec . 7.36 (a) :As-provided-in the Partnershi p Agreement,,' Holland & Knight allocate.d .,t.he, payments toypetitioner ; -between petitioner's capital, :.account ':and-,the value of hi s Schedule C Unit s

II .-

'Characterizat=ion of .. P .eti.tioner' s . °2005= .Capital Accoun t Distribution Respondent included an, adjustment to petitioner's 200 5 income, for the .$32,721 .capital,account distribution for the firs t time in his Amended Answer . Consequently, respondent concede s that he bears . the . burden o.f .proof with respect to thi s adjustment . See Rule 142(x)(1) ; Achiro V . Commissioner , 77 T .C .

881, 889 Beck Chem . . Corp . v . Commissioner ; 27 T .C .

840,'856 (1957) . That the parties submitted this case full y stipulated under Rule 122 does-notaffect which party has th e burden of proof "or the effect of a ,failure of proof . See Rul e 122(b) ; Borchers` v . Commissioner , 95 .T .C . 82, 91 (1990), affd .

943 F .2d 22 (8th Cir .m 1991) .

Both parties .agree that petitioner' s capital accoun t payments are distributions of- partnership ,property to- a withdrawing partner ahd`J are gove.rned ,,by-,the 736(b) .''Section 731(a)(1), governing the recognition°of,gain .or, losson'partnership distributions, provides,-in part, .,that gain=- is-not recognized to the recipient .partner except .to . the :. extent r, " of any money distributed in excess of the adjusted basis . of the- ,partner's'`interest in the partnership immediately ;before :th e distribution . In this regard, a liquidating partner generally does"-not recognize-gain on liquidating payments paid over a period of,time until the aggregate amount of the',payments exceed s the .partner's basis in the partnership interest .'0 ' Section°705 .(a) provides, in part, that a partner's adjuste d basis"in a partnership is the basis of the interest determined under section 7,22 (relating to contributions to a partnership) o r section 742 (relating to transfers of partnership interests) increased by the sum of the partner's distributive share of' income (taxable and tax exempt) of the partnership for the p taxable year and prior taxable years (as determined pursuant to section 703(a)) and decreased by distributions by the'partnershi p as provided`in section 733 .

Section 722 provides that the basis of an interest in a F. tl t partnership acquired by a contribution of property, including money, to the partnership shall be the amount of any money an d "However, if the payments are fixed in amount the partner ;.

may elect to prorate his adjusted basis among the payments and recognize .gain or loss on receipt of each payment. See sec . 1^ .736-1(b)(6), Income Tax Regs . _ ,°= the adjusted " basis of other proper ty''to th'e contributing partne r at the time ofcontribution . iricreased`by the amount of any gain recognized-under'section 721'(b)'to the contributing partner a t the'time of contribution .

Both respondent -and,petitioners rely on their respective calculation`s of petitioner'rs-,capital-account in Holland & Knight in deterrrm niing ppetitioner' s basisa in the law firm . But th e parties-differas Ito th e amount~of petitioner's capita l account 'l- Wekmust ."resolve this-°dispute using only the fact s that were stipulated .

' Resporident 'contends, that the $32, 721 capital account paymen t petitioner.-shou-ldhave°been"(cid:127)reported as long-term capita l gain .

2 ; petitioner' Schedule s K-l for,4years-1991 through=2003 . Relyin g on the'capitaa account :

information provided in Item J on th e SchedulestK-1 reporte d by Holland & . Knight, respondent'calculate d that petitioner made rta(cid:127) totallcapital`=contribution of $111,756 t o the law firm, that `his distribut ive-share - ;of Holland & Knight's income from 1991-2003 aggregated $2,780,394, that his share o f income "As a'partner in "a ser.vi`ce partnership , the amount of petitioner ' s capital - account and the amount of petitioner ' s basis in,Holland .& Knight in general should ° be the same .

12Und`er respondent's position, petitioner would have exhausted his $399 basis in his capital account in 2003 .

that :he,received distributions totaling $2,892,173 from 19 .9 1 through 2003 . Thus, respondent concluded that petitioner"-s-- capital account when he left Holland & Knight in 2003 (cid:127)was $399 .,. .

Incontrast, petitioner maintains that his basis in Hollan d & Knight on- .January 1, 2005 , was in excess of the $32,721 h received . To support their position, petitioners rely , on : severa l schedules created by Holland & Knight in the regular course ; its business .

The first schedule , attached to the Class C Partner Agreement , shows the value of petitioner s .capital account to be $98 , 162 on the date petitioner ceased to be a Clas s B ;(Capital ) : partner, and became a Class C nonequity partner . In addition,, the benefits due schedule , discussed supra p .,7, .showed that petitioner's capital account on March 19 , 2003 , theRdate o f petitioner's ; withdrawal from the law firm, was,$98 ,162 . . Further, the benefits paid,schedule, discussed supra p . .11, showed that petitioner's capital account was $98,162 before the distribution s began,,a`nd .that as of March 19, 2005 (the date, of the firs t distribution in .2005), petitioner's capital account was approximately .$40,900 .

.

We are therefore confronted by two sets of capital account ., :

calculations both created by Holland & Knight in the regular course of its business . On the one hand, the Schedules K- 1 relied upon by respondent were reported by the law firm t o ,,respondent in compliance with the tax reporting requirements of 23 - section 6031 . On the,other` . .hand, the . .sche :dules relied upon by petitioner(cid:127)were created by Holland ;& . Knight to track petitioner' s capital account-and, L, ultimately .-to determine the law firm's payments to .=petitioner in,liquidationof his .. interest in the partnership . 'Holland & Knight had . an interest in accurately calculating thez=amounts that'- .were entered on both the Schedule s K-1? .(to`compl-y with the"r`eporting,requirements of the Code) an d the schedules provided to .petitiorier (to-ensure that petitioner was given the&proper amount forhis interest in the partnership) .

the burden°ofx .proof .with : respect t o establishing (1) ; petitioner' s .?basis in his partnership . property , and (2-), the , payments . in liquidation`,, of his capital account exceeded that-basis . Petitionerestablished,a reasonable basis for us . to determine that-'his 2005' capitalaccount .payments did not exceed'-his basis inh°is`partnership property . Respondent did not addsess~-pe_titione-r's evidence onbrief and has not given . us any reason .t:o :, believe ,his calculation is more reliable than that .

of petitioner-. = Consequently ;,;,,on,-the ::basis . of . . the record before- us,- -W⁶ conclude that there was no preponderance of evidence to support-respondent's .position'and that . respondent, failed to carry his burden 'of,-establishing,'that the payments . in liquidation of petitione'r'-s'partnership property exceeded his basis . Hence, we' find in . favor (cid:127)o-f= .petitioner with . respect'to this issue .

IN F; ~,-I IINEV* i _L⁷ III .z Section 6662(a) Accuracy-Related Penalt y Section 6662(a) imposes a 20-percent penalty on the portion ; of an . underpayment of tax attributable to, inter,alia , substantial understatement of income tax, as provided in section, 6662(b)((cid:127)2-),- .or negligence or disregard of rules or,regulations, as'provided in section 6662(b)(1) . An understatement i:s .equal,to the .excess of the amount of tax required to be .shown in .the=tax . ;,, return :over-the amount of tax shown in the return . Sec . , 6662 (d) ;:(2) (A) . The understatement for an individual . .is substantial if it exceeds the greater of 10 percent,-,of then .tax required,to,~be shown or $5,000 . Sec . 6662(d)(1)(A)-. -Negligence is the lack .of due care or failure to do what a reasonable and ;-,, ordinarily°p.rudent person would do under the circumstances . . , Jean Baptist e v . Commissioner , T .C . Memo . 1999-96 .

.Section 7491(c) provides that the Commissioner has .the, burden : of . production with respect to penalties and must come forward'with'sufficient evidence indicating it is appropriate-to impose penalties .

Higbee v . Commissioner , .11.6-T .C . 438,-446 (2001)_ . Once the Commissioner has met his burden of production,, the burden of proof remains on the taxpayer, including, the burden- of proving-'that the penalties are inappropriate because of reasonable cause or substantial authority .

. Id .

. at 446-447. . 'With respect to the payments for petitioner's ScheduleC Units,_ - 25 , respondent's burden of p ;rolductionis mdt by petitioners ' concession that they,fai=led 'to report these payment s Sect:ron 6662(cid:127)(a) penaltiesKare(cid:127)-inapplicable to the extent the taxpayer had reasonable cause-and acted in good faith . Sec .

6664(c)(1) . "Circumstances that may indicate reasonable caus e and . good faith' include °an'honest-`misunderstanding of fact or law that 'is ; reasonable 'in lightof all of the facts an d circumstances including the experience, knowledge, and education of the . taxpayer . Sec .-1 .6664"4(b),(1), Income Tax Regs .

Generally, the~ nost important ' factor is the extent of th e taxpay_er's efforts'to' assess =the proper tax liability .

Id .

An honest misunderstanding of-factor`law that is reasonable in th e light of the taxpayer's experience,"knowledge, and education may indicate reasonable 'cause and"good faith .

Halby v . Commissioner , T .C .(cid:127) .Memo .'2009-204 : ;(cid:127) Remy v : Commissioner ; T .C . Memo . 1997-72 .

Respondent determined"that petitioners are liable for a section 6662 ( x) accuracy - related . pen-alty for 2005 with respect to their-failure to : report the- amounts received for petitioner's Schedule CUrits and capital account . .

. Petitioners assert that their failure-to,reportthe`$80 ,0 00-of payments for petitioner's Schedule C-Units in 200 5 . was''-reasonable because Holland & Knight incorrectly reported the`se . payments as nonemployee compensation on Form 1099 - MISC instead of reporting it as a distribution o n Schedule Petitioners- maintain that -,it was reasonable for them to not report the $80,000 on their 2005 Federal income ;..tax .

return since -they "could not possibly report the receipt of th e payments ., both correctly and also in a manner that was consistent with the reporting by Holland & Knight . We find this-argument ; unpersuasive .

Preliminarily, we note petitioners' argumen .tr is,, circulars , In any event, the Code provides a mechanism whereby , a ;partner may report, an item of .income inconsistently with the manner in which the partnership reports the item on its own return,=soalongas- ~ .the partner provides a statement reporting ,that i nconsisten t treatment to the Secretary . See sec . 6 .222(b)(1)(B) ;`sec .

3016222,(b),-1(a), Proced . & Admin . Regs .13 The, Schedule K-1 instructions require the partner to file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request ; { (AAR), .in order to notify the Commissioner of the . inconsistent treatment . A ;partner is subject to the section 6662(a) accuracy- related penalty if he fails to comply with this requirement. See sec .1, 6222 (d) ; Blonien v . Commissioner , 118 T .C . 541,550 n- .5 (2002) . Petitioner, as a tax attorney of long standing, shoul d familiar with this mechanism . To simply not report .the income is n'ot,-seasonable and does not show good faith . We ;therefore findthe .section 6662(a) accuracy related penalty is applicable , "Petitioners do not argue they received information fro m Holland &`Knight inconsistent with the partnership-return .- Therefore sec . sec. 6222(b)(2) does not apply .

I 2.7 - with respect to petitioner's failure to report the $80,000 of payments for petitioners' Schedule C Units .

With respect to petitioner's capital account payments, .respondent did not establish that a deficiency exists . Hence, the section 6662(a) penalty is not, applicable with respect t o .those payments. .

o reflect the foregoing, Decision will be entered for respondent in the amounts set forth in the notice of deficiency .