KO’d By the K-1 | USTaxAid

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KO’d By the K-1

Written by Diane Kennedy, CPA on October 23, 2021

A partnership (or an LLC) is a great asset protection device. It’s not often we see it in play, though, in such a dramatic way. In the Tax Court case of Dodd, we saw a major conflict playing out.

Taryn Dodd was 1/3 owner of Cadillac Investment Partners. She worked as an office manager at a law firm. The managing partner, her boss, was 2/3 owner. The partnership owned real estate, including the office building housing the law firm. In 2013, the partnership sold real property valued at approximately $4 million. The net income was $3.2 million. Her K-1 showed 1/3 of that income. That meant she owed tax on the amount.

Sounds good, right? The problem was she didn’t get any of the money. Instead the managing partner, her boss and majority partner of Cadillac Investment Partners transferred the money to his law firm. They used it to pay off a debt that the law firm had.

Taryn wasn’t a partner in the law firm, so she received nothing but a K-1. And now she owed tax on the amount.

The IRS said “tough” and told her she owed the tax. She appealed to Tax Court, and lost.

She owes the tax. 

K-1s are Asset Protection

In the past, we’ve used limited partnerships as a way to protect assets. If you can’t control the partnership because you’re a limited partner, you have no liability for decisions made in the partnership. And if someone is going to sue you and try to take your ownership away, you (or your remaining partners) could hit the new hostile takeover partner with a K-1. The K-1 would show income but there wouldn’t be any cash to go along with it. That meant the partner had to pay tax on income he didn’t get with cash he didn’t receive.

A couple of things have happened since the strategy was the hot way to protect assets. First, we now have the LLC that has charging order protection. That means you get the protection of assets held by the LLC without having to go through the K-1 income no cash strategy, or even threatening it.

If you become a partner in an LLC or partnership, make sure you have outside counsel review the agreement. One thing you’ll want is an agreement that you get at least a minimum payment of cash when there is income on your K-1. I suspect that the lawyer drafted the agreement himself and she just blindly signed it.

In this case, she’ll have taxable income, but it’ll be interesting to see what happens to the lawyer, legally. 

Talk to your lawyer and your CPA before you start any business. If you skip this important step, you could end up with a very important lesson.

Can we help? Tax Consultation with Diane 

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