T.C. Memo. 2009-243

UNITED STATES TAX COURT

DONALD W. AND KATHRYN W. WALLIS, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 8818-08. Filed October 27, 2009.

Donald W. Wallis, for petitioner.

William F. Barry IV, for respondent.

MEMORANDUM OPINION

JACOBS, Judge: The parties submitted this case fully

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 that
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Donald W. Wallis (petitioner) received from Holland & Knight,

LLP, a Florida limited partnership engaged in the practice of law

(hereinafter referred to as Holland & Knight or the law firm), in

connection with his withdrawal as a partner; (2) the

characterization (capital gain or return of basis) of $32,721

that petitioner received from Holland & Knight for his capital

account; and (3) whether petitioners are liable for the section

6662(a) accuracy-related penalty. 

Petitioners did not include in income, either as capital

gain or ordinary income, any of the approximately $112,721

petitioner received from Holland & Knight in 2005 (the $80,000 of

Schedule C Benefits and the $32,721 for petitioner’s capital

account). Petitioners now agree that the $80,000 petitioner

received from Holland & Knight in 2005 designated as Schedule C

Benefits should have been included in income. However, the

parties disagree as to the characterization of the Schedule C

Benefits. Petitioners contend the Schedule C Benefits were longterm capital gain income, whereas respondent contends these

amounts were ordinary income.

The statutory notice of deficiency issued to petitioners on

February 19, 2008, did not include an adjustment relating to the

$32,721 petitioner received from Holland & Knight in 2005 for his

capital account. As a result of information discovered during

the discovery and stipulation processes, respondent filed an
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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 been

reported as long-term capital gain. Petitioners contend that all

of the $32,721 is a return of petitioner’s basis in Holland &

Knight and 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.

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, and

exhibits attached thereto are incorporated herein by this

reference. Petitioners resided in Florida when they filed their

petition. Kathryn W. Wallis is 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 Class

C partner in its Jacksonville, Florida, office. Upon joining the

law firm, petitioner and Holland & Knight entered into a

Memorandum of Agreement which governed their relationship.
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At all relevant times, Holland & Knight had three classes of

partners.

(1) Class A Class A partners are not expected to spend

full time in the practice of law and are not required to

contribute to the capital of the firm.

(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 equity

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 a Class C partner exceeds that of an associate.

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 are

partners.

In addition, the managing partner of the law firm can bestow

the honorary title “partner emeritus” on certain former
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1The term “Schedule C Unit” has no meaning or significance

outside the context of the Partnership Agreement. 

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.1 Each Schedule C Unit had a stated

value of $300, so that the units yearly awarded to each Class B

(Capital) partner, including petitioner, had an aggregate value

of $15,000. The granting of Schedule C Units each year was a

benefit or entitlement 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 not

reserved or otherwise set aside by the law firm. If a partner

voluntarily left the law firm, he generally forfeited the value

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 entitled
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2Pursuant to the Partnership Agreement, Class B (Capital)

partners were required to contribute capital to, and maintain a

capital account with, Holland & Knight in an amount determined by

its managing partner.

to receive the value of his interest in the partnership,

consisting of the sum of (1) the amount of his capital account

(as disclosed in the firm’s books and records) as of the fiscal

year in which he reached age 68, and (2) the value of his

Schedule C Units. Payment of this sum was to begin 3 months

after the first day of the fiscal year following the partner’s

68th birthday.

While a Class B (Capital) partner, petitioner made all

required contributions to the capital of Holland & Knight.2

Petitioner’s capital obligation fluctuated as the amount of his

annual distributive share of the law firm’s profits fluctuated. 

The law firm prepared, and provided petitioner with, an annual

statement reflecting the amount of his capital contribution

obligation. Petitioner also received quarterly statements

reflecting deposits made to, withdrawals made from, interest

accrued on, and the current balance of, his capital account.

As of January 1, 2003, petitioner ceased to be a Class B

(Capital) partner, and his status reverted to Class C partner. 

As part of that conversion, petitioner and Holland & Knight

entered into a Class C Partner Agreement which modified the

Partnership Agreement as it affected the rights and
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3Sec. 6(a) of the Class C Partner Agreement defined the

value of petitioner’s capital account and Schedule C Units as the

amount reflected on Schedule No. 1 to the Class C Partner

Agreement.

responsibilities of petitioner vis-a-vis Holland & Knight. 

Attached to the Class C Partner Agreement was a schedule, dated

March 7, 2003, showing petitioner’s capital account balance to be

$98,162. 

On March 19, 2003, petitioner withdrew as a Class C partner,

and he ceased performing services for the law firm. Upon his

withdrawal petitioner received a document from the law firm

entitled “Withdrawal Benefits Analysis” (the benefits due

schedule) showing the amounts owed him by Holland & Knight and

the dates payments were to be made. 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 $28,180 each, of which approximately $8,180 was

deemed a distribution of 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
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4Our review of petitioner’s Schedules K-1 indicates that

petitioner’s share of the taxable income of Holland & Knight from

1991 to 2003 totaled $2,779,764. Nonetheless, we use the

$2,780,394 amount (as determined by respondent) because the use

of that amount is more beneficial to petitioner since it provides

him with additional basis to offset the payments received in

respect of his capital account.

during the year, petitioner’s distributive share of the law

firm’s profits, petitioner’s share of the law firm’s tax-exempt

income, and the amount of petitioner’s withdrawals and

distributions. Copies of the Schedules K-1 were submitted by the

law firm to the Internal Revenue Service.

Petitioner’s Schedules K-1 reported the following

information: 

(1) petitioner’s contributions to Holland & Knight from 1991

through 2003 totaled $111,756;

(2) petitioner’s share of the taxable income of Holland &

Knight from 1991 to 2003 totaled $2,780,394;4

(3) petitioner’s share of the tax-exempt income of Holland &

Knight from 1991 to 2003 totaled $422;

(4) distributions petitioner received from Holland & Knight

from 1991 to 2003 totaled $2,892,173.

On the basis of these Schedules K-1, respondent determined that

(1) petitioner received $111,357 of distributions in excess of

the amount of his share of Holland & Knight’s taxable and taxexempt income, and (2) petitioner’s basis in Holland & Knight as
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of March 19, 2003 (the date he withdrew from the law firm), was

$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 capital

account and his Schedule C Benefits. Section 6(b) of the

Partnership Agreement provided that with respect to the payment

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 applicable

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 the Capital Amount at any time on

at least thirty (30) [sic] advance written notice to 

Holland & Knight. The Capital 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.
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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, on his death, his 

disability, or his expulsion or withdrawal from Holland & 

Knight and otherwise in accordance with the procedures 

identical to those applicable to Class B (Capital) partners

pursuant to paragraph 27.05 of the Partnership Agreement.

Paragraph 27.05 of the Partnership Agreement provided for

the following payments to be made to a partner who withdrew from

the partnership: Subject to certain limitations, one-twelfth of

the total due the retiring partner was to be made within 3

months after the partner’s withdrawal and one-twelfth every 3

months thereafter until the full sum is paid. Paragraph 27.04

of the Partnership Agreement stated that “Payment will not

additionally be made for goodwill, trade or firm name, contract

and retainer value, work in progress, accounts receivable,

accruals, or other tangible or intangible assets of the firm.” 

Paragraph 27.03 of the Partnership Agreement stated that “For

the purposes of the foregoing computation [the payment of a

withdrawing partner’s interest], the books of the firm will be

accepted as correct. The Managing Partner shall certify the

computation, and the certified computation is binding and

conclusive.”
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Pursuant to the aforementioned provisions, Holland & Knight

made payments to petitioner and recorded them in a second

withdrawal benefits analysis (the benefits paid schedule), as

follows:

Less Pay to

Payment Date Capital Sch. C Receivable Donald Wallis

June 19, 2003 $8,180 $20,000 ($8,180) $20,000

Sept. 19, 2003 8,180 20,000 (8,180) 20,000

Dec. 19, 2003 8,180 20,000 (1,044) 27,136

Mar. 19, 2004 8,180 20,000 -0- 28,180

June 19, 2004 8,180 20,000 -0- 28,180

Sept. 19, 2004 8,180 20,000 -0- 28,180

Dec. 19, 2004 8,180 20,000 -0- 28,180

Mar. 19, 2005 8,180 20,000 -0- 28,180

June 19, 2005 8,180 20,000 -0- 28,180 

Sept. 19, 2005 8,180 20,000 -0- 28,180

Dec. 19, 2005 8,180 20,000 -0- 28,180

Mar. 19, 2006 8,180 20,000 -0- 28,180

Petitioner 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, 2003, petitioner

performed no services for the 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 the

Schedule C Units as income in the year they were awarded. 

Instead, Holland & Knight considered the Schedule C amounts as

additional compensation to the recipient partner in the year the

amount was paid.
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5In 2003 Holland & Knight issued and filed a Form 1099-MISC

reporting $60,000 of nonemployee compensation, the amount Holland

& Knight considered to be payments during 2003 for petitioner’s

Schedule C Units. Holland & Knight issued a Form 1099-MISC in

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.

In 2005 Holland & Knight issued to petitioner, and filed

with respondent, a Form 1099-MISC, Miscellaneous Income,

reporting $80,000 as nonemployee compensation, the amount it

considered as payment for petitioner’s Schedule C Units. 

Holland & Knight deducted this amount as nonemployee

compensation in 2005.5

Holland & Knight paid petitioner $32,721 with respect to

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 payments

described in the benefits due schedule or the benefits paid

schedule. On September 10, 2007, respondent sent petitioners a

CP 2000 notice stating that petitioners’ Form 1040, U.S.

Individual Income Tax Return, for year 2005 did not match the

income and payment information that respondent had on file and

proposing several changes to petitioners’ taxes. Petitioner

replied that he disagreed with respondent’s proposed changes,

stating:

I did, indeed, receive during the tax year in question 

payments totaling the amount reported to the IRS by Holland
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& Knight, LLP. 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, and should 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. 2, petitioners now concede that they

should have reported on their tax return for 2005 the $80,000

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 characterized

and taxed as ordinary income. 

Additionally, petitioners and respondent disagree as to the

amount of petitioner’s basis in Holland & Knight. Petitioners

contend that petitioner’s basis in Holland & Knight as of March

19, 2003, was $98,162, which is the same amount stated as the

amount of petitioner’s partnership capital account in both the

schedule attached to the Class C Partner Agreement, see supra p.

7, and the benefits due schedule, see supra p. 7. In contrast,

respondent maintains that petitioner’s capital account balance

in the law firm was $10,758 as of January 1, 2003, and that
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6Petitioners assert respondent bears the burden of proof

with respect to this issue. We need not, and do not, address

petitioners’ assertion because our conclusion with respect to

this issue does not turn on who bears the burden of proof.

7Neither party asserts that the transaction giving rise to

the payment to petitioner constituted a sale or exchange of an

interest in a partnership within the purview of sec. 741.

8For 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, payments in exchange for an

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).

petitioner’s basis in Holland & Knight as of March 19, 2003, was

approximately $399. See supra pp. 8-9.

Discussion

I. Characterization of the Amount Paid for the Schedule C 

 Units6

Payments made by a partnership in liquidation of the

interest of a retired partner are governed by section 736,7

which divides such payments into three categories; namely: (1)

Those representing the recipient’s distributive share of

partnership income, sec. 736(a)(1); (2) those deemed to be

guaranteed payments, sec. 736(a)(2); and (3) those in exchange

for the partner’s interest in partnership property, sec.

736(b).8 If the payments are considered to represent a

distributive share of partnership income or deemed to be

guaranteed payments, then the amount of the payments received is

taxed to the recipient as ordinary income. On the other hand,
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if the payments are considered to be in exchange for partnership

property, then the amount received in excess of the adjusted

basis of the withdrawing partner’s partnership interest is taxed

as capital gain. We find and hold that the payments for

petitioner’s Schedule C Units are guaranteed payments. 

The record reveals that each partner received the same

number (50) of Schedule C Units each year for services rendered

to the law firm regardless of the size of the partner’s

partnership interest in Holland & Knight and without regard to

the income of the law firm. The Schedule C Units were not

treated as part of the partners’ respective shares of

partnership income or partnership property and were not

reflected in the partners’ respective capital accounts. 

Further, the law firm did not establish a reserve or any other

account to reflect the value of the Schedule C Units. Finally,

the Partnership Agreement states that a partner would receive

the value of his Schedule C Units within 3 months after the

first day of the fiscal year following the partner’s 68th

birthday.

It appears to us that Holland & Knight’s creation of the

Schedule C Units program was a means by which the law firm

provided retirement benefits to its equity partners, since after
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9The historical note to para. 32 of the Partnership

Agreement states that the law firm discontinued its retirement

plan as of Jan. 1, 1992.

December 31, 1991, the law firm had no retirement plan as such.9

The value of the Schedule C Units provided the measurement for

the retirement amounts to be paid to each of the law firm’s

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

withdrawing partner as part of the liquidation of his

partnership interest under section 736 are guaranteed payments. 

Sloan v. Commissioner, T.C. Memo. 1981-641. In Sloan, we had to

determine the proper characterization of payments to a retiring

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. The retiring partner had the option to elect to

receive the additional amount either in a lump sum or over a

period of 12 months or less. The partnership agreement further

provided that the partner had to completely retire from the

practice of medicine to be eligible for the additional amount.

 
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Because of disagreements between the partners, the

partnership ultimately dissolved, with one partner opting to

retire and the two other partners opting to establish a new

partnership. The three former partners entered into a

partnership termination agreement, which provided that in

addition to dividing the partnership assets the retiring partner

would receive $2,000 a month as retirement pay over a period of

18 months. We determined that (1) a liquidation of the retiring

partner’s interest had occurred, and (2) the $2,000-a-month

payments were guaranteed payments pursuant to section 736(a)(2).

Our conclusion in Sloan is consistent with the

Commissioner’s treatment of similar payments. In Rev. Rul. 75-

154, 175-1 C.B. 186, the Commissioner determined that periodic

payments made in satisfaction of a partnership liability to a

previously retired partner, in addition to amounts previously

paid to the retired partner for his interest in partnership

property, were guaranteed payments because they were determined

without regard to the income of the partnership.

We are also mindful that section 1.707-1(c), Income Tax

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 to the income of the partnership. 

However, a partner must include such payments as ordinary 

income for his taxable year within or with which ends the 

partnership taxable year in which the partnership deducted
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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 in

Holland & Knight and therefore the payments should be considered

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

withdrawn Class B (Capital) partner the value of the partner’s

interest in the firm is the sum of his capital account and his

Schedule C amount. Continuing, petitioners maintain that section

1.736-1(b)(1), Income Tax Regs., provides that “Generally, the

valuation placed by the partners upon a partner’s interest in

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, the

valuation of petitioner’s partnership interest must be regarded

as correct and therefore the payments are for partnership

property. We do not subscribe to petitioners’ contention. 

Paragraph 27.01 of the Partnership Agreement does not define

petitioner’s Schedule C Units as partnership property. Moreover,

section 736 makes clear that payments for a partner’s interest in

a partnership may be made up of distributions for partnership

property as well as guaranteed payments. In this regard, section
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1.736-1(a)(2), Income Tax Regs., provides, in part, that the

amounts paid to a withdrawing partner may represent several items

and the payments must be allocated between payments for the value

of the withdrawing partner’s interest in assets, except

unrealized receivables and, generally, goodwill, sec. 736(b), and

other payments, sec. 736(a). As provided in the Partnership

Agreement, Holland & Knight allocated the payments to petitioner

between petitioner’s capital account and the value of his

Schedule C Units.

II. Characterization of Petitioner’s 2005 Capital Account 

 Distribution

Respondent included an adjustment to petitioner’s 2005

income for the $32,721 capital account distribution for the first

time in his Amended Answer. Consequently, respondent concedes

that he bears the burden of proof with respect to this

adjustment. See Rule 142(a)(1); Achiro v. Commissioner, 77 T.C.

881, 889 (1981); Beck Chem. Equip. Corp. v. Commissioner, 27 T.C.

840, 856 (1957). That the parties submitted this case fully

stipulated under Rule 122 does not affect which party has the

burden of proof or the effect of a failure of proof. See Rule

122(b); Borchers v. Commissioner, 95 T.C. 82, 91 (1990), affd.

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

 Both parties agree that petitioner’s capital account

payments are distributions of partnership property to a

withdrawing partner and are governed by the provisions of section
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10However, 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.

736(b). Section 731(a)(1), governing the recognition of gain or

loss on partnership distributions, provides, in part, that gain

is not recognized to the recipient partner except to the extent

of any money distributed in excess of the adjusted basis of the

partner’s interest in the partnership immediately before the

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 exceeds

the partner’s basis in the partnership interest.10

Section 705(a) provides, in part, that a partner’s adjusted

basis in a partnership is the basis of the interest determined

under section 722 (relating to contributions to a partnership) or

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

taxable year and prior taxable years (as determined pursuant to

section 703(a)) and decreased by distributions by the partnership

as provided in section 733.

Section 722 provides that the basis of an interest in a

partnership acquired by a contribution of property, including

money, to the partnership shall be the amount of any money and
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11As a partner in a service partnership, the amount of

petitioner’s capital account and the amount of petitioner’s basis

in Holland & Knight in general should be the same.

12Under respondent’s position, petitioner would have

exhausted his $399 basis in his capital account in 2003.

the adjusted basis of other property to the contributing partner

at the time of contribution, increased by the amount of any gain

recognized under section 721(b) to the contributing partner at

the time of contribution. 

Both respondent and petitioners rely on their respective

calculations of petitioner’s capital account in Holland & Knight

in determining petitioner’s basis in the law firm. But the

parties differ as to the amount of petitioner’s capital

account.11 We must resolve this dispute using only the facts

that were stipulated.

Respondent contends that the $32,721 capital account payment

to petitioner should have been reported as long-term capital

gain.12 To support his contention, respondent introduced

petitioner’s Schedules K-1 for years 1991 through 2003. Relying

on the capital account information provided in Item J on the

Schedules K-1 reported by Holland & Knight, respondent calculated

that petitioner made a total capital contribution of $111,756 to

the law firm, that his distributive share of Holland & Knight’s

income from 1991-2003 aggregated $2,780,394, that his share of

Holland & Knight’s tax-exempt income was approximately $422, and
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that he received distributions totaling $2,892,173 from 1991 

through 2003. Thus, respondent concluded that petitioner’s

capital account when he left Holland & Knight in 2003 was $399.

In contrast, petitioner maintains that his basis in Holland

& Knight on January 1, 2005, was in excess of the $32,721 he

received. To support their position, petitioners rely on several

schedules created by Holland & Knight in the regular course of

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 Class

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, the date of

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 distributions

began and that as of March 19, 2005 (the date of the first

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 to

respondent in compliance with the tax reporting requirements of
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section 6031. On the other hand, the schedules relied upon by

petitioner were created by Holland & Knight to track petitioner’s

capital account and, ultimately, to determine the law firm’s

payments to petitioner in liquidation of his interest in the

partnership. Holland & Knight had an interest in accurately

calculating the amounts that were entered on both the Schedules

K-1 (to comply with the reporting requirements of the Code) and

the schedules provided to petitioner (to ensure that petitioner

was given the proper amount for his interest in the partnership). 

Respondent has the burden of proof with respect to

establishing (1) petitioner’s basis in his partnership property,

and (2) the payments in liquidation of his capital account

exceeded that basis. Petitioner established a reasonable basis

for us to determine that his 2005 capital account payments did

not exceed his basis in his partnership property. Respondent did

not address petitioner’s evidence on brief and has not given us

any reason to believe his calculation is more reliable than that

of petitioner. Consequently, on the basis of the record before

us, we 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

petitioner’s partnership property exceeded his basis. Hence, we

find in favor of petitioner with respect to this issue.
- 24 -

III. Section 6662(a) Accuracy-Related Penalty

Section 6662(a) imposes a 20-percent penalty on the portion

of an underpayment of tax attributable to, inter alia, a

substantial understatement of income tax, as provided in section

6662(b)(2), or negligence or disregard of rules or regulations,

as provided in section 6662(b)(1). An understatement is 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 the 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 prudent person would do under the circumstances. Jean

Baptiste 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, 116 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 Schedule C Units,
- 25 -

respondent’s burden of production is met by petitioners’

concession that they failed to report these payments.

Section 6662(a) penalties are inapplicable to the extent the

taxpayer had reasonable cause and acted in good faith. Sec.

6664(c)(1). “Circumstances that may indicate reasonable cause

and good faith include an honest misunderstanding of fact or law

that is reasonable in light of all of the facts and

circumstances, including the experience, knowledge, and education

of the taxpayer.” Sec. 1.6664-4(b)(1), Income Tax Regs. 

Generally, the most important factor is the extent of the

taxpayer’s efforts to assess the proper tax liability. Id. An

honest misunderstanding of fact or law that is reasonable in the

light of the taxpayer’s experience, knowledge, and education may

indicate reasonable cause and good faith. Halby v. Commissioner,

T.C. Memo. 2009-204; Remy v. Commissioner, T.C. Memo. 1997-72.

Respondent determined that petitioners are liable for a

section 6662(a) accuracy-related penalty for 2005 with respect to

their failure to report the amounts received for petitioner’s

Schedule C Units and capital account. Petitioners assert that

their failure to report the $80,000 of payments for petitioner’s

Schedule C Units in 2005 was reasonable because Holland & Knight

incorrectly reported these payments as nonemployee compensation

on Form 1099-MISC instead of reporting it as a distribution on

Schedule K-1. Petitioners maintain that it was reasonable for
- 26 -

13Petitioners do not argue they received information from

Holland & Knight inconsistent with the partnership return. 

Therefore sec. 6222(b)(2) does not apply.

them to not report the $80,000 on their 2005 Federal income tax

return since they “could not possibly report the receipt of the

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’ argument is circular. 

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, so long as

the partner provides a statement reporting that inconsistent

treatment to the Secretary. See sec. 6222(b)(1)(B); sec.

301.6222(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) accuracyrelated penalty if he fails to comply with this requirement. See

sec. 6222(d); Blonien v. Commissioner, 118 T.C. 541, 550 n.5

(2002). Petitioner, as a tax attorney of long standing, should

be familiar with this mechanism. To simply not report the income

is not reasonable and does not show good faith. We therefore

find the section 6662(a) accuracy related penalty is applicable
- 27 -

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 to

those payments.

To reflect the foregoing,

Decision will be entered

for respondent in the amounts

set forth in the notice of

deficiency.