Court Opinion

ID: 8213864
Source: CourtListenerOpinion
Date Created: 2022-10-13 19:01:08.391593+00
Date Added: 2024-06-11T16:42:25.573774
License: Public Domain

United States Tax Court

                        T.C. Memo. 2022-105

 CLARK RAYMOND & COMPANY PLLC, D. EDSON CLARK, CPA,
            PLLC, TAX MATTERS PARTNER,
                      Petitioner

                                  v.

           COMMISSIONER OF INTERNAL REVENUE,
                       Respondent

                              —————

Docket No. 2265-19.                             Filed October 13, 2022.

                              —————

             CRC, an accounting firm, is a partnership subject to
      the TEFRA provisions of I.R.C. §§ 6221–6234. Three
      single-member entities—C, N, and T—were partners of
      CRC in 2013 and negotiated a buyout of C in anticipation
      of the retirement of C’s principal owner, which they
      memorialized in a restated partnership agreement. The
      partnership agreement also included provisions governing
      allocations of income and distributions (both liquidating
      and non-liquidating) to the partners, and it included a
      qualified income offset (QIO) provision. The partnership
      agreement anticipated that a partner could receive a
      distribution of “clients” from the partnership and provided
      a method for valuing such a distribution.

             Shortly after executing the restated partnership
      agreement, N and T withdrew from CRC, and certain
      clients of CRC stopped engaging CRC and instead retained
      N’s and T’s new partnership (NT PLLC). C, as tax matters
      partner for CRC, reported on CRC’s 2013 Form 1065, “U.S.
      Return of Partnership Income”, that N and T received
      distributions from CRC in amounts equal to the value of
      the clients (as determined under the restated partnership
      agreement) that followed N and T to NT PLLC. C also
      decreased N’s and T’s capital accounts by the value of the

                          Served 10/13/22
                                    2

[*2]   reported distributions, and thereby reduced N’s and T’s
       capital accounts below zero. To restore N’s and T’s capital
       accounts to zero, C allocated (for tax purposes) all of CRC’s
       ordinary income for 2013 to N and T, pursuant to a QIO
       provision in the partnership agreement, and so reported on
       CRC’s tax return. As a result, C allocated to itself no
       taxable income from CRC.

              N and T filed Forms 8082, “Notice of Inconsistent
       Treatment or Administrative Adjustment Request (AAR)”,
       contesting CRC’s 2013 income allocations, and R
       subsequently audited CRC’s 2013 return. R issued a Letter
       1830–F, “Notice of Final Partnership Administrative
       Adjustment” (FPAA), disregarding CRC’s reported “client
       distributions” and redetermining allocations of ordinary
       income to N and T. Specifically, R determined that CRC’s
       “client distributions” had not been substantiated and that
       CRC’s corresponding allocations of income lacked
       substantial economic effect.

             C, as TMP of CRC, timely filed a Petition in this
       Court contesting R’s determinations in the FPAA. The
       parties filed a joint motion to submit this case pursuant to
       Rule 122, which we granted.

             Held: CRC distributed client-based intangible assets
       to N and T when they withdrew from CRC, and the value
       of the assets so distributed are properly valued under the
       terms of CRC’s partnership agreement.

              Held, further, CRC failed to maintain capital
       accounts in accordance with Treas. Reg. § 1.704-1(b)(2)(iv);
       therefore, CRC’s special allocations of income to N and T
       lacked substantial economic effect and must be reallocated
       in accordance with the partners’ interests in the
       partnership under I.R.C. § 704(b) and Treas. Reg. § 1.704-
       1(b)(3).

              Held, further, because N and T had negative capital
       accounts at the end of the taxable year and CRC’s
       partnership agreement included a QIO, ordinary income
       must be allocated first to N and T in an amount necessary
       to bring each partner’s capital account up to zero.
                                            3

[*3]           Held, further, R’s determinations disregarding
        CRC’s “client distributions” and redetermining allocations
        of ordinary income are not sustained.

                                      —————

Sandra Veliz, for petitioner.

Amy Chang and Gregory M. Hahn, for respondent.

            MEMORANDUM FINDINGS OF FACT AND OPINION

       GUSTAFSON, Judge: On December 17, 2018, the Internal
Revenue Service (“IRS”) issued a notice of final partnership
administrative adjustment (“FPAA”) for the taxable year ending
December 31, 2013, to D. Edson Clark, CPA, PLLC (“Clark PLLC”), the
tax matters partner (“TMP”) for Clark Raymond & Co., PLLC (“CRC”).
This case is a partnership-level action under the Tax Equity and Fiscal
Responsibility Act of 1982 (“TEFRA”), 1 see § 6221, 2 based on a Petition
filed by the TMP pursuant to section 6226. After concessions by the
parties, 3 the remaining issues for decision are: (1) whether CRC made

        1 TEFRA, Pub. L. No. 97-248, §§ 401–407, 96 Stat. 324, 648–71, codified at

sections 6221 through 6234, was repealed for returns filed for partnership tax years
beginning after December 31, 2017.
        2Unless otherwise indicated, statutory references in this opinion are to the
Internal Revenue Code (“the Code”, Title 26 of the United States Code) as in effect at
the relevant times; references to regulations are to Title 26 of the Code of Federal
Regulations (“Treas. Reg.”) as in effect at the relevant times; and references to Rules
are to the Tax Court Rules of Practice and Procedure. Some dollar amounts are
rounded. Each citation in this Opinion to a “Doc.” refers to a document so numbered
in the Tax Court docket record of this case, and a pinpoint citation therein refers to the
pagination as generated in the portable document format file.
        3 In stipulations of settled issues (Docs. 18, 28, and 32), the parties have

stipulated that for the 2013 tax year: (1) CRC’s “other income” was −$322,639; (2) CRC
made guaranteed payments in the total amount of $62,000 (comprising $7,200 to Clark
PLLC, $2,400 to Chris Newman CPA, PLLC (“Newman PLLC”), $2,400 to John E.
Town, CPA, Inc., P.S. (“Town PS”), and $50,000 to Tony H. Chang, CPA, PLLC, an
entity that would become a partner of CRC after the events at issue); (3) CRC’s
reported “other deductions” should be increased to $596,818; (4) CRC’s reported
ordinary business income should be increased to $563,118; (5) CRC made distributions
of cash and marketable securities in the total amount of $657,201 (comprising
$632,201 to Clark PLLC, $20,000 to Newman PLLC, and $5,000 to Town PS); (6) CRC
                                          4

[*4] distributions of client-based intangible assets to its partners during
2013; and (2) whether CRC’s ordinary income allocations reported on its
Form 1065, “U.S. Return of Partnership Income”, had substantial
economic effect under section 704(b).          The parties jointly filed
stipulations of fact and moved to submit this case under Rule 122 for
consideration without trial. For the reasons detailed below, we will not
sustain the IRS’s determinations.

                              FINDINGS OF FACT

       The facts below are based on the pleadings and the parties’
stipulations of fact (including the exhibits attached thereto).

I.     CRC’s business activity

       CRC is a professional limited liability company formed under the
laws of the State of Washington. When it filed its Petition, CRC’s
principal place of business was Redmond, Washington. 4

       CRC provides accounting, tax planning and preparation, and
related professional services to its clients. Because it is a service-based
organization, its tangible assets consist solely of office equipment and
supplies, office furniture, cash, accounts receivable, and works-in-
process.

       CRC is generally a successful business and services many clients.
Before performing services for a client, CRC and the client enter into an
engagement agreement specifying the scope of CRC’s services and fees.
The engagement between CRC and a client is terminable at will by
either CRC or its client.

       Generally, a certified public accountancy firm (“CPA firm”) such
as CRC may not require a client to continue to retain its services if the
client decides to terminate the business relationship, and a client may
not require a CPA firm to continue providing services if the CPA firm
decides to terminate the business relationship. Neither the CPA firm
nor its clients (or former clients) may require the other to sign a new

is not liable for the accuracy-related penalty under section 6662(a); and (7) CRC made
a property distribution with a fair market value of $183,737 to Newman PLLC, with
respect to a loan from the Washington Trust Bank.
       4 Absent stipulation otherwise, venue for an appeal in this case would be in the

U.S. Court of Appeals for the Ninth Circuit. See § 7482(b).
                                         5

[*5] engagement agreement or renew a terminated engagement
agreement.

       If an accountant leaves his current CPA firm for a new firm,
clients of the current firm may choose to terminate their relationship
with the current firm and begin a relationship with the new firm. In
such an instance, the client “follows” the accountant to his new firm; and
the accountant, the prior firm, and the client will generally agree upon
procedures to facilitate the transfer of the client’s files from the prior
firm to the new firm. The clients who follow an accountant to a new
firm, and who may generate future cash flow from payments made to
the new firm, are generally referred to as that accountant’s “book of
business”.

II.    Partner-entities in CRC

       D. Edson Clark formed CRC in 2006. Since its formation, various
entities have joined and withdrawn from CRC as partners. 5 The
following entities were partners of CRC during the relevant years: 6

       A.      Clark PLLC

      Clark PLLC is a professional limited liability company organized
under the laws of the State of Washington. Clark PLLC was a partner
of CRC for the taxable years ending December 31, 2011, 2012, and 2013.

       Mr. Clark and his wife, Barbara Clark, have been the sole
shareholders of Clark PLLC, and therefore Mr. Clark held a partnership
interest in CRC indirectly through Clark PLLC for the relevant years.
CRC employed Mr. Clark as an accountant and Mrs. Clark as firm
administrator during the relevant years.

       5  CRC filed as a partnership for federal income tax purposes during the year
at issue. See Treas. Reg. § 301.7701-3(b)(1). Although CRC’s partnership agreements
refer to Clark PLLC, Newman PLLC, and Town PS as “members” (and each, a
“member”), we refer to each of them as “partners” of CRC; and we generally refer to
the members of LLCs as “partners”. See § 761(b) (“the term ‘partner’ means a member
of a partnership”).
        6 Our reference to the “relevant years” means the tax years 2011, 2012, and

2013. Although only the income allocations from the 2013 tax year are at issue, we
discuss partnership operations in the prior years to provide context to the partners’
agreements and prior handling of client distributions upon withdrawal of a partner.
                                         6

[*6]   B.      Benbow PS

      Rachelle A. Benbow, PS (“Benbow PS”), is a professional services
corporation incorporated under the laws of the State of Washington by
Rachelle A. Benbow, who became a CRC employee in 1999.

        Benbow PS purchased a 25% partnership interest in CRC from
Clark PLLC for approximately $580,000 in 2006 and was admitted to
CRC as a partner. The purchase was seller-financed by Clark PLLC,
with Benbow PS obtaining a loan from Clark PLLC for the purchase
price. The purchase price was calculated by totaling CRC’s prior
12 months of gross receipts (intended to reflect the total value of CRC’s
“book of business”) and the net value of CRC’s tangible assets. The
agreement between Benbow PS and Clark PLLC reflected that Benbow
PS purchased an indirect interest in 25% of CRC’s tangible assets and
25% of CRC’s “book of business” when it purchased a 25% partnership
interest in CRC. CRC credited Benbow PS’s capital account with an
initial balance of $580,000.

      CRC employed Ms. Benbow as an accountant from 1999 until
October 2011, at which time Benbow PS ceased being a partner of CRC.

       C.      Town PS

       John E. Town, CPA, Inc., P.S. (“Town PS”), is a professional
services corporation incorporated under the laws of the State of
Washington by John E. Town, who became a CRC employee in 2007.
Town PS did not make a direct capital contribution to CRC but instead
purchased a 25% partnership interest from Clark PLLC in 2009 and was
admitted to CRC as a partner on January 1, 2009.

      The purchase was seller-financed by Clark PLLC, and Town PS
obtained a loan from Clark PLLC for the entire purchase price. 7 Clark
PLLC and Town PS calculated the purchase price for Town PS’s 25%
partnership interest by first summing the values of CRC’s tangible

       7 Though the parties stipulate the fact of the loan, Town PS did not execute a

promissory note to evidence the loan from Clark PLLC. It is unclear whether Town
PS made payments on the loan to Clark PLLC in 2009 or in 2010, because Clark PLLC
reported on its 2009 and 2010 Forms 1120S, “U.S. Income Tax Return for an
S Corporation”, that it received no payments. However, Clark PLLC reported that the
outstanding principal balance of the loan decreased to $606,288 in 2009 and to
$570,347 at the end of 2010. In 2011 Town PS made a payment of $11,371 on the
balance of the loan to Clark PLLC, but it did not make any further payments after
2011.
                                           7

[*7] assets, accounts receivable, and works-in-process, and then
subtracting the total value of CRC’s liabilities to produce an agreed-
upon total net value of CRC of $3,491,985. They then multiplied this
value by 25% to calculate the value of a 25% partnership interest in
CRC, viz., $872,996. However, before his employment at CRC, Mr. Town
had developed professional client relationships, and those clients
decided to retain CRC when Mr. Town became a CRC employee in 2007.
Clark PLLC and Town PS discounted the price to be paid for the 25%
partnership interest in CRC by the amount of revenue generated by Mr.
Town’s “book of business” in the prior year. 8 This discount reduced the
purchase price of $872,996 by $234,046, for a final purchase price of
about $639,000. CRC set Town PS’s initial capital account balance at
$639,000, the amount of the agreed-upon purchase price (and did not
adjust the balance upward to reflect the value of the book of business).

      CRC employed Mr. Town as an accountant from 2007 until May 1,
2013, at which time Town PS ceased being a partner in CRC.

        D.      Chris Newman CPA, PLLC

      Chris Newman CPA, PLLC (“Newman PLLC”), is a professional
limited liability company organized under the laws of the State of
Washington by Chris Newman, who became an employee of CRC in
2009. Newman PLLC became a partner of CRC in December 2012 and
remained a partner until May 1, 2013.

       On December 22, 2012, Newman PLLC made a $200,000 cash
contribution to CRC using funds it obtained from a loan from
Washington Trust Bank (the “WTB Loan”). To obtain the loan, Newman
PLLC executed a promissory note in favor of Washington Trust Bank.
Mr. Newman, Mr. Clark, and Mrs. Clark each executed personal
guaranties with respect to the WTB Loan promissory note. CRC set
Newman PLLC’s initial capital account balance at $200,000.

        8 A detailed description of the purchase price calculation appears in the record.

A note next to the “book of business” discount reads: “Agreed upon value of John’s book
brought in”.
                                         8

[*8] CRC employed Mr. Newman as an accountant from 2009 until
May 1, 2013, at which time Newman PLLC ceased being a partner in
CRC. 9

III.   CRC’s LLC agreement and restatement

        CRC’s operating agreement (which it refers to as a “limited
liability company agreement”) that was applicable during the year at
issue was preceded by a prior version and by transactions that form the
context for construing the operating agreement.

       A.      2009 LLC agreement

        Effective January 1, 2009, through December 30, 2011, a limited
liability company agreement (the “2009 LLC Agreement”, Ex. 9–J
(Doc. 33, at 247)) governed CRC’s operation. The 2009 LLC Agreement
stipulated the partners’ agreement on the allocation of profits and losses
among partners, distributions of cash and property to partners, capital
account maintenance, partner withdrawal, and liquidation of the
company.

     Regarding partner withdrawal, Section 11.1 of the 2009 LLC
Agreement provided:

       In the event of a Withdrawal Event, the Withdrawing
       Member [i.e., Partner] shall first have an option to receive
       as a Distribution in full consideration of all of the Units of
       the Member the following:

               (i) Member Clients. All, or any of, the Clients of the
               Withdrawing Member . . . and

        9 The record does not disclose the number of CRC’s members after the

withdrawal of Town PS and Newman PLLC on May 1, 2013. If their withdrawal left
Clark PLLC as CRC’s sole member, a question would arise concerning CRC’s status as
a partnership. Cf. Treas. Reg. § 301.7701-3(f)(2). However, as explained in note 25,
infra, Tony Chang or an entity he controlled may have been a second continuing
member in CRC after the withdrawal of Town PS and Newman PLLC. Because the
parties have submitted the case on the premise that CRC was properly classified as a
partnership for federal income tax purposes throughout 2013, we have assumed that
the withdrawal of Town PS and Newman PLLC did not leave Clark PLLC as CRC’s
sole member.
                                             9

[*9]            (ii) Net Book Value. [The] Withdrawing Member’s
                Percentage Interest of the Net Book Value [of
                CRC].[10]

Section 8.3(b) of the 2009 LLC Agreement stated that “[i]f any Clients
[were] [d]istributed under [the] agreement, the value of such Client
[would] be the Client Value”, defined (in Section 1.19) as “the gross
revenue generated from [each respective] Client over the prior twelve-
month period.”

       In lieu of taking a distribution of clients, a partner could agree to
“leave” clients at CRC and apply a portion of the value of those clients
to the partner’s outstanding loan balance incurred upon its admission
(if applicable).

      Schedule 1 attached to the 2009 LLC Agreement stated that
Mr. Clark owned a 50% partnership interest in CRC, and Ms. Benbow
and Mr. Town each owned a 25% partnership interest in CRC.

        B.      2011 negotiations and events                   preceding      the    2012
                restatement of the LLC agreement

     In 2011 the partners of CRC were Clark PLLC, Benbow PS, and
Town PS.

                1.       Retirement negotiations

      Mr. Clark planned to transfer ownership and management of
CRC to the remaining partners in preparation for his retirement. 11
Mr. Clark, Ms. Benbow, Mr. Town, and Mr. Newman discussed a
potential buyout of Clark PLLC’s partnership interest in CRC, and the
implementation of a new partner compensation model using a “Finders,

        10The 2009 LLC Agreement defined “Clients” as “any client[s] of the firm”, and
“Net Book Value” as “the net book value of the Company, as determined by sound
accounting principles . . . [with] marketable securities, real estate, tangible property,
and other similar assets . . . valued at fair market value . . . increased by any accounts
receivables and works-in-progress . . . and . . . reduced by liabilities associated with the
collections of such accounts receivable and works-in-progress.”
       11 Accounting firms generally transition ownership either externally, via

merger or acquisition, or internally, with a buy-sell agreement between the partners.
                                          10

[*10] Minders, Grinders” (“FMG”) system 12 and an “Average Annual
Value” (“AAV”) system. 13 They also anticipated that the partners would
execute non-compete and non-solicitation agreements as part of the
proposed buyout of Clark PLLC.

      Negotiations of Clark PLLC’s prospective buyout reached a
stalemate in the last quarter of 2011. At that time Messrs. Clark,
Newman, and Town agreed to continue negotiations in 2012, and CRC
operated under the terms of the 2009 LLC Agreement for the entire 2011
tax year.

               2.      Benbow PS’s withdrawal as partner

      In October 2011 Ms. Benbow’s employment at CRC ended, and
Benbow PS ceased to be a partner of CRC. Ms. Benbow began working
for another CPA firm, and certain clients formerly engaging CRC
decided to retain the services of Ms. Benbow’s new CPA firm. Pursuant
to this transfer, Ms. Benbow, Benbow PS, and the moving clients
executed documents relating to transfer of the client files from CRC to
Ms. Benbow.

               3.      Capital accounts

       Following Benbow PS’s withdrawal as partner and the migration
of clients to Ms. Benbow’s new CPA firm, CRC reported—pursuant to
the 2009 LLC Agreement—a property distribution to Benbow PS (and a
corresponding capital account decrease) in an amount that reduced its

       12 An FMG system calculates wage compensation, profit or loss allocations, and
cash distributions to partners by applying metrics and ratios to determine the revenue
attributable to the accountant that brought the client to the firm (the finder), the
accountant who managed the client and the engagement (the minder), and the
accountant who worked the billable hours on the client’s engagement (the grinder).
       13 An AAV system computes the amount payable to a departing partner for the

value of goodwill that he leaves behind at the firm. A partner’s AAV “balance” at
departure is the amount payable to the departing partner for his portion of the firm’s
goodwill. When implementing an AAV system, the partners will agree upon a value of
the firm’s total goodwill, using the prior 12 months’ revenue multiplied by an
appropriate factor, and allocate a portion of the total to each partner’s AAV balance. A
partner’s AAV balance may increase or decrease according to the formula employed by
the CPA firm to compute the individual partner’s contribution to the CPA firm’s growth
(and presumably, to its goodwill).
                                         11

[*11] capital account to zero. 14 Benbow PS did not contest the property
distribution, but Ms. Benbow disagreed with Mr. Clark regarding the
value assigned to CRC’s departing clients and the impact to Benbow
PS’s loan from Clark PLLC. Ultimately, neither Mr. Clark, Clark PLLC,
nor CRC requested additional payment from Ms. Benbow or Benbow PS.

       C.      2012 restatement of the 2009 LLC agreement and related
               events

      In 2012 Clark PLLC, Town PS, and Newman PLLC continued
negotiations regarding the buyout of Clark PLLC’s interest in CRC. The
parties ultimately agreed on buyout terms and memorialized their
agreement by executing a “restated” version of the 2009 LLC Agreement
on December 24, 2012 (the “2012 LLC Agreement”). The 2012 LLC
Agreement as executed did not include a form security agreement to a
form promissory note (relating to payments to be made to retiring
partners), which the parties continued negotiating and agreed to finalize
in January 2013. The 2012 LLC Agreement was effective as of
December 31, 2011.

       D.      2013 LLC Agreement

       As planned, the three entity partners of CRC finalized the
security agreement and included it when they reaffirmed the terms of
the 2012 LLC Agreement on January 18, 2013. (Hereinafter we refer to
the reaffirmed 2012 LLC Agreement as the “2013 LLC Agreement”,
Ex. 11–J (Doc. 33, at 352).) The 2012 terms remained unchanged in the
2013 LLC Agreement, except for minor items that are inconsequential
to the outcome of this case. The parties to this case agree that the terms
of the 2013 LLC Agreement are operative for this case.

       The 2013 LLC Agreement governs many aspects of CRC’s
operation, including the rights and responsibilities of partners and
managers, admission of new partners, and transfer of partnership
interests. We discuss below only the provisions relevant to this case.

       14 The distribution and capital account adjustment were made pursuant to the

2009 LLC Agreement’s provisions regarding distributions of clients, but it is unclear
whether Benbow PS received in the distribution any assets other than clients.
                                         12

[*12]          1.      Capital account maintenance

       The 2013 LLC Agreement contains sophisticated partnership tax
provisions, including rules governing capital contributions and capital
account 15 maintenance for each partner.

       The 2013 LLC Agreement states that “[a] separate Capital
Account will be maintained for each Member throughout the term of the
Company in accordance with the rules of Regulation Section 1.704-
1(b)(2)(iv).” It states explicitly that each partner’s capital account will
be increased by the fair market value of contributions (in cash or
property), by allocations of “net profit”, 16 and by any items of income and
gain specially allocated to the partner, and will be decreased by the fair
market value of distributions (in cash or property), by allocations of
expenditures, and by items of deduction and loss specifically allocated
to the partner.

       The 2013 LLC Agreement further states that maintenance of
capital accounts under the agreement is intended to comply with “the
requirements concerning substantial economic performance [sic] under
Code Section 704(b)” and that the “[a]greement shall not be construed
as creating a deficit restoration obligation or otherwise personally
obligating any Member to make a capital contribution”.

      As part of the buyout negotiations, Clark PLLC, Town PS, and
Newman PLLC agreed that, effective December 31, 2011, capital
account balances would be as follows: Town PS’s capital account balance
would be $150,000; Clark PLLC’s capital account would be $792,497;
and Newman PLLC’s capital account balance would be $200,000. 17

        15 The 2013 LLC Agreement uses the terms “Capital Account,” “Net Book Value

Capital Account,” and “Tangible Net Worth Capital Account” interchangeably
throughout, and the parties have stipulated that each of these terms refers solely to
the single capital account of each partner.
        16The 2013 LLC Agreement defines “Net Profit” as “an amount equal to the
Company’s taxable income or loss . . . determined in accordance with Code
Section 703(a) [regarding the computation of partnership taxable income, deductions,
and related partnership elections]”.
        17 As we mention below in note 58, the fact that the partners negotiated these

capital account balances leaves open the possibility that the partners might not have
calculated them in accordance with the capital account maintenance rules under
Treasury Regulation § 1.704-1(b)(2)(iv). However, the Commissioner does not contest
the partners’ agreed upon capital account balances, and so we accept these balances
as accurate. Upon commencement of his employment by CRC, Mr. Newman did not
                                         13

[*13] Town PS also agreed to increase its capital account over the next
five years, and accordingly made a $10,000 cash contribution to CRC
before the end of 2012, increasing its capital account balance to
$160,000.

               2.      Allocation of net profits and losses

       Section 8.1 of the 2013 LLC Agreement allocates “Net Profit [and]
Loss” of CRC among its partners using a multi-step formula. Profit and
loss are allocated under Section 8.1 in the following order and priority:
First, income equal to “10% of the average Tangible Net Worth[18]
reflected in each Member’s Net Book Value Capital Account for the year”
is allocated to each partner. Second, Clark PLLC “receive[s] a special
allocation of taxable income with respect to the amounts collected on the
Accounts Receivable that have been reserved for non-collectability”. 19
Finally, all remaining income is allocated according to the FMG
system. 20 The 2013 LLC Agreement also allocates income, gain, loss,
and deductions according to its proportional “Net Profits [and] Loss”
allocation formula. 21

         However, section 8.1 begins by noting that its allocations are
“subject to [the special allocation provisions of] Section[] 8.3”.
Section 8.3 (entitled “Special Allocations”) establishes a “Qualified
Income Offset” (“QIO”), whereby “[i]n the event that any Member
unexpectedly receives any adjustments, allocations, or distributions[,]
. . . items of Company income and gain [are] specially allocated to such
Member in an amount and in a manner sufficient to eliminate as quickly

have a “book of business”, and the initial balances of Newman PLLC’s, Town PS’s, and
Clark PLLC’s capital accounts did not include the value of any intangible assets.
       18   The 2013 LLC Agreement defines “Tangible Net Worth” to be “the net book
value of the Company, . . . [including] marketable securities, real estate, tangible
personal property, and other similar assets . . . [and] in the case of [a] Withdrawal
Event other than by mutual agreement or retirement, such amount [is] reduced by
liabilities”.
       19 The parties have stipulated that the “amount[] collected on the Accounts

Receivable that [was] reserved for non-collectability” in 2013 was $15,387.
       20  The parties have stipulated that the remaining income under this step is
allocated 100% to Clark PLLC for 2013.
        21 Section 8.7 of the 2013 LLC Agreement defines “Net Profit or Net Loss” as

“an amount equal to [CRC’s] taxable income or loss [for each fiscal year], determined
in accordance with Code Section 703(a)”.
                                          14

[*14] as possible[] . . . the Deficit Capital Account of the Member”. 22
This QIO provision is significant in our analysis below.

               3.      AAV system

       Articles 10 and 11 of the 2013 LLC Agreement (along with
definitions in Article 1) provide a method for computing retirement
payments for a retiring partner in a manner that takes account of,
among other things, CRC’s “goodwill”.

       “Average Annual Value” is defined in Section 1.6 to mean “the
goodwill value of the Company, calculated as one times the annual
accrual basis net client fee revenue of the Company” (emphasis added);
and under Section 1.7, the “Average Annual Value Method” is “the
method pursuant to which an individual Member is allocated his portion
of the Average Annual Value”.

        Article 10 of the 2013 LLC Agreement, entitled “Accumulated
Annual Value Method”, provides the method by which each partner’s
“AAV account” (a term not defined in the 2013 LLC Agreement) is
adjusted annually. Each partner’s “AAV” is adjusted up or down in
accordance with the ratio of income allocations under the FMG system
(Article 8 of the 2013 LLC Agreement). Upon a partner’s withdrawal,
the partner’s AAV is “adjusted for any changes in client relationships
that would result in a material decrease in fees billed” before any AAV
distribution to the partner. Upon voluntary withdrawal from the
company, the withdrawing partner forfeits “50% of any vested right to
AAV retirement payments”.

       Article 11 of the 2013 LLC Agreement, entitled “Member
Retirement Payments”, provides the method for calculating payments to
retiring partners. 23 The retiring partner first receives a payment equal
to his capital account balance, then a payment equal to “85% of the
retiring member’s AAV account on the date of retirement”.

       22  The 2013 LLC Agreement defines the “Deficit Capital Account” of any
partner as “the deficit balance, if any, in such Member’s Capital Account as of the end
of the taxable year, after giving effect to [certain] adjustments”.
         23 Certain vesting requirements apply to the payments, but “[i]n order to

receive full payment of vested retirement benefits, the retiring Member must make a
best efforts commitment to actively transition the Company’s clients to the remaining
Members during [the period of transition].”
                                         15

[*15] Clark PLLC, Town PS, and Newman PLLC agreed that the
parties’ beginning AAV balances would be: $2,650,000 for Clark PLLC;
$700,000 for Newman PLLC; and $314,200 for Town PS. Clark PLLC’s
and Town PS’s initial AAV balances were intended to reflect the value
of Clark PLLC’s goodwill in CRC and Mr. Town’s book of business.

               4.      Contributions

       Section 7.1 of the 2013 LLC Agreement states that “[e]ach
Member shall contribute such amount as is set forth in . . . Schedule 1
(or as shown on the books of the Company) as such Member’s share of
the Members’ initial Capital Contribution.” 24 Schedule 1, entitled
“Member and Class B Unit Holder[25] Information (as of December 31,
2011)” consists of a table with each partner’s name and address, AAV
balance, capital account balance, and number of respective voting or
non-voting units, with a total for each column on the last row of the
table. The AAV balance for each partner mirrors the balances
negotiated by the partners, and Clark PLLC, Newman PLLC, and Town
PS each hold an amount of Class A units equal to their respective AAV
balances (2,650,000 units for Clark PLLC, 700,000 units for Newman
PLLC, and 314,200 units for Town PS—for a grand total of 3,664,200
units across all partners). The table shows a zero balance in each
partner’s capital account column (contrary to the partners’ agreement
regarding initial capital account balances), and the total for this column
(theoretically showing the sum of all capital accounts) likewise reflects
a zero balance.

       Asterisks appear next to each partner’s name and link to
footnotes appearing below the table. The footnote corresponding with
Clark PLLC states that Clark PLLC’s initial capital contribution
consisted of “[f]ormation costs, contribution of property from predecessor

       24  Under the 2013 LLC Agreement, “Capital Contribution” means any
contribution to the capital of CRC in cash, or the fair market value of property
contributed.
        25 Under the 2013 LLC Agreement, a “Class B Unit Holder” is an “owner of

Class B Units”, which are “Units issued which do not have an initial Capital Account
and do not have any voting rights associated with them.” Schedule 1 lists one “Class B
Unit Holder”, “Tony Chang, CPA”. Tony H. Chang was an employee of CRC in 2013.
It is unclear from the parties’ stipulations and attached exhibits whether Mr. Chang
(or the professional limited liability company he organized, Tony H. Chang, CPA,
PLLC) was a member of CRC for state law purposes. The parties do not raise (or rebut)
the issue of whether Mr. Chang or Tony H. Chang, CPA, PLLC, was a partner for
federal income tax purposes in 2013, so we do not address that issue in this Opinion.
                                           16

[*16] Company, and buy-out of former Members (including inventory,
business assets and equipment, goodwill and all other tangible and
intangible property) and other amounts shown on the books of the
Company”. Newman PLLC and Town PS share a single footnote stating
that their initial capital contributions consisted of “amounts as shown
on the books of the Company.”

                5.      Distributions

       Article 9 of the 2013 LLC Agreement is entitled “Distributions
from the Company”. Cash distributions are made pursuant to
Section 9.1 (“Net Profit Distributions”) “in the Manager’s reasonable
discretion, provided that such Distributions will be consistent with the
allocations of income made pursuant to Section 8.1” (regarding
allocation of net profit and loss).

       Section 9.3 provides for “Distributions In-Kind”. Section 9.3(a),
addressing “Non-cash assets”, is especially significant in our analysis
below. Section 9.3(a) states that any such assets “shall be distributed in
a manner that reflects how cash proceeds from the sale of such assets
for fair market value would [be] distributed (after any unrealized gain
or loss attributable to such noncash assets has been allocated among the
Members in accordance with Article 8)”. That is, Section 9.3(a) requires
that unrealized gain be allocated among the partners (“in accordance
with Article 8”) 26 and that non-cash assets be distributed like cash
proceeds (which, under Section 9.1, would be “in the Manager’s
reasonable discretion” but “consistent with the allocations of income
made pursuant to Section 8.1”).

       Section 9.3(b) of the 2013 LLC Agreement states for the
distribution in kind of a particular non-cash asset—i.e., “Clients”—“If
any Clients are Distributed under this Agreement, the value of such
Client shall be the Client Value” (defined in Section 1.19 as the “gross
revenue as invoiced to the Client over the prior twelve-month period”). 27

        26 As to allocation of income, Section 8.6(a) similarly states that “income, gain,
loss, deduction, and any other allocations not otherwise provided for shall be divided
among the Members in the same proportions as they share Net Profits or Net Losses”
(i.e., under Section 8.1). Distributions involve “the Manager’s reasonable discretion”
under Section 9.1, but income allocation is simply stated as being made pursuant to
the formula of Section 8.1.
        27 This definition varies slightly from the 2009 LLC Agreement’s definition of

Client Value as the “gross revenue generated from the Client over the prior twelve-
month period”. (Emphasis added.)
                                           17

[*17] Absent from the 2013 LLC Agreement is the 2009 LLC
Agreement’s specific provision (in Section 11.1, quoted above) that a
withdrawing partner has an “option to receive a Distribution” from CRC
consisting of “Clients”. But Section 9.3(b) of the 2013 LLC Agreement
plainly presumes that “Clients [may be] Distributed under this
Agreement”.

         Upon voluntary withdrawal, a partner is entitled to a distribution
in an amount equal to his positive capital account balance, with the
exception that Town PS is not entitled to a distribution unless its
“Tangible Net Worth exceeds $150,000 [or] until Clark [PLLC] is paid in
full”. 28

       In the event of a liquidation, after repayment of CRC’s creditors,
the 2013 LLC Agreement states that liquidating distributions are made
“[t]o the Members in repayment of the positive balances of their
respective Capital Accounts, as determined after taking into account all
Capital Account adjustments for the taxable year during which the
liquidation occurs”.

                6.      Non-solicitation agreement

       The 2013 LLC Agreement contains a non-solicitation agreement
whereby the partners agree (for a period of two years) that a
withdrawing partner will not provide services to or solicit any current
or prospective 29 client of CRC, remove client files from CRC’s offices, or
hire or solicit CRC employees. Partners who violate the non-solicitation
agreement agree to pay certain financial penalties relative to the
category of violation. For example, for violations relating to clients the
violating partner must pay to CRC a penalty equal to a portion of the

        28Because of the apparent omission of a conjunction, it is unclear whether the
exception carved out for Town PS imposes two limitations (i.e., that its capital account
must have a positive balance of at least $150,000 and that the loan from Clark PLLC
must be paid off entirely) or one (i.e., either of the two criteria). We assume the latter
and interpolate “or”.
       29 Under the 2013 LLC Agreement, a prospective client is one with whom the

company has had direct communication within the 24 months before the partner’s
withdrawal.
                                       18

[*18] client’s billings in the prior or subsequent year (depending on the
client’s status as current or prospective).

IV.    Newman PLLC’s and Town PS’s withdrawal as partners

      Effective May 1, 2013 (i.e., not quite four months after the
execution of the 2013 LLC Agreement), Newman PLLC and Town PS
withdrew as partners of CRC. Mr. Newman and Mr. Town thereafter
started their own CPA firm, practicing under the name of “Newman
Town, PLLC” (hereinafter, “NT PLLC”)

       A.     Book of business

       Certain clients of CRC thereafter ceased engaging CRC and
retained the services of NT PLLC. That is, the withdrawing partners
took with them a “book of business”. We find (as the parties have
stipulated) that, under the terms of the 2013 LLC Agreement, the
“Client Value” of the clients that retained NT PLLC was $742,569, that
the portion of this total “Client Value” allocable to Newman PLLC was
$318,144, and that the portion allocable to Town PS was $424,425.

       B.     Civil litigation

      The WTB Loan remained outstanding at the time Newman PLLC
withdrew from CRC. Pursuant to the guaranty that Mr. Clark signed,
Washington Trust Bank looked to Mr. Clark for repayment of the loan.

       Mr. Clark thereafter filed a civil lawsuit in the King County
Superior Court of the State of Washington, suing Newman PLLC,
Mr. Newman, and Mr. Newman’s spouse, praying for relief in an
amount equal to the outstanding balance of the WTB Loan, with
interest. The parties engaged in arbitration and mediation, with
Mr. Town joining the proceedings some time thereafter.

       In preparation for mediation, each party filed a “Statement of
Claims”. Among other items, Mr. Clark claimed that Messrs. Newman
and Town breached the 2013 LLC Agreement and their fiduciary duty
to CRC when they “took CRC clients . . . [and] competed against CRC”.
Mr. Clark’s statement sought relief for, among other things, the “value
of the practice grown by [Mr. Newman] at CRC”. 30 Messrs. Newman

        30 Mr. Clark’s statement also requested relief for other items incident to

Newman PLLC’s and Town PS’s withdrawal from CRC that are not directly related to
the issue in this case.
                                          19

[*19] and Town requested relief for compensation they argued was
outstanding from CRC.

        C.      Settlement

       In October 2013, CRC, Mr. Clark, Clark PLLC, Mr. Newman,
Newman PLLC, Mr. Town, and Town PS agreed to settle the civil
lawsuit and arbitration and entered into a “Civil Rule 2A Agreement”
outlining the terms of the agreed settlement. In February 2014 they
executed a “General Release and Settlement Agreement” (“Settlement
Agreement”, 31 Ex. 33–J (Doc. 33, at 620)) to finalize the settlement
terms. 32 The Settlement Agreement acknowledged the 2013 LLC
Agreement that the parties had executed in January 2013 and settled
all claims relating to Mr. Newman’s and Mr. Town’s departure from
CRC and resolved all claims (known or unknown) that the parties
brought or could have brought in the civil lawsuit or arbitration
proceedings.

      The Settlement Agreement stated that “Newman PLLC” and
“Town PS” would make the $200,000 capital contribution to CRC
(although it did not specify the denomination of capital contribution that
each entity would make—e.g., $100,000 each or otherwise).

       The Settlement Agreement resolved the controversy about the
clients that Newman PLLC and Town PS had taken with them when
they withdrew from CRC. Clark PLLC had previously proposed an
“Agreement Regarding Client File Transfer Procedure”, which had
“anticipate[d] that certain clients of CRC [would] wish to have NT PLLC
provide accounting and tax service” and had set out the routine by which

        31 The terms of the Settlement Agreement generally reflected the terms of the
Civil Rule 2A Agreement, but some provisions of the Settlement Agreement were more
specific. For example, the Settlement Agreement provided that “Newman, PLLC” and
“Town, PS” would make a $200,000 capital contribution to CRC, whereas the Civil Rule
2A Agreement simply stated that “Newman Town” would make such a capital
contribution.
         32 The parties stipulated that all exhibits (including the Settlement

Agreement) could “be accepted as authentic . . . ; provided, however, that either party
[had] the right to object to the admission of any such . . . exhibits in evidence on the
grounds of materiality and relevancy, but not on other grounds unless expressly
reserved [therein]”. Neither party raised an objection regarding the admission of the
Settlement Agreement. Therefore, by failing to make a timely and specific objection
on the basis of Rule 408 of the Federal Rules of Evidence, CRC has waived its right to
contest the admission of the Settlement Agreement on that ground. See, e.g., Gilbrook
v. City of Westminster, 177 F.3d 839, 859 (9th Cir. 1999).
                                         20

[*20] CRC would transfer client records, working papers, and working
files to NT PLLC. In the Settlement Agreement, NT PLLC agreed to
sign this transfer agreement and agreed not to provide accounting
services to any “current client of [CRC] for 2 years”. (Emphasis added.)
Each CRC partner-entity, former partner-entity, and their respective
individual partners signed the Settlement Agreement. As is noted
above, the parties to this case have stipulated that, under the terms of
the 2013 LLC Agreement, the “Client Value” of the clients that retained
NT PLLC was $742,569, of which $318,144 was allocable to Newman
PLLC and $424,425 was allocable to Town PS.

       D.      Adjustments to capital accounts

       CRC made certain adjustments to the capital accounts of the
partners after the withdrawal of Newman PLLC and Town PS. CRC
first decreased Newman PLLC’s capital account by $419,043 and
decreased Town PS’s capital account by $447,437, to account for
property distributions that it reported to each of those partners. 33 It
then decreased Town PS’s capital account further by $150,000 and
increased Clark PLLC’s capital account by the same $150,000 (and later
reported this $150,000 capital account increase as a capital contribution
by Clark PLLC). 34 CRC did not adjust Newman PLLC’s or Town PS’s
capital account to reflect the allocations of any inherent gain in the
property distributions before decreasing the partners’ capital accounts
in the amounts of the distributions.

V.     Realization of ordinary income

       CRC realized $563,118 of ordinary business income for 2013. This
fact is not in dispute. Rather, the dispute is about how that income
should be allocated among CRC’s partners for tax purposes.

VI.    CRC’s federal returns of partnership income

       CRC is a calendar year taxpayer and filed as a partnership for
federal income tax purposes for 2011, 2012, and 2013. CRC was subject
to the TEFRA partnership procedures set forth in Code sections 6221–
6234 for the years 2011, 2012, and 2013. For each of these years,

        See discussion infra p. 23 (regarding the reported distributions to Newman
       33

PLLC and Town PS).
       34 See discussion infra note 39 (regarding the reported capital contribution by

Clark PLLC).
                                   21

[*21] Mr. Clark served as CRC’s tax return preparer, and the company
used a cash receipts and disbursements method of accounting.

      A.     2011

       CRC filed its 2011 Form 1065 in September 2012, and reported
that its partners were Clark PLLC, Town PS, and Benbow PS. On its
attached Schedule L, “Balance Sheets per Books”, CRC reported
$1,512,905 as its amount of intangible assets at the beginning of the
year, and zero as its amount of intangible assets at the end of the year.
                                           22

[*22] The Schedules K–1, “Partner’s Share of Income, Deductions,
Credits, etc.”, issued to the partners reported the following information:

                             Clark PLLC              Town PS            Benbow PS

 Beginning capital
                             $1,834,050               $466,146          $479,297
 account balance

 Capital
                                 238,766                  7,727             —
 contributions 35

 Income allocations
 (net of deductions)
 and other items (e.g.,          665,014               129,920            148,909
 nondeductible
 expenses)

 Distributions

         Cash                    549,329               102,653            113,922

         Property              1,396,004               351,140            514,284

 Ending capital
                                 792,497               150,000              -0-
 account balance 36

        35 Neither Clark PLLC nor Town PS actually made in 2011 a capital
contribution equal to the reported contribution amounts. The upward adjustments to
Clark PLLC’s and Town PS’s capital accounts correspond to reductions in Benbow PS’s
capital account upon its withdrawal. CRC does not offer any explanation regarding
these adjustments.
        36 Clark PLLC’s and Town PS’s reported ending capital account balances for

2011 resulted from the negotiation between Clark PLLC, Newman PLLC, and Town
PS. See discussion supra pp. 12–13. In computing the ending capital account balance
for each of the partners, CRC did not include the book value, fair market value, or tax
basis of any intangible assets, such as goodwill, client-based intangible assets, or
covenants not to compete.
                                          23

[*23] B.         2012

       CRC filed its 2012 Form 1065 in September 2013, and reported
that its partners were Clark PLLC, Newman PLLC, and Town PS. CRC
did not report any intangible assets on its Schedule L for 2012.

      The Schedules K–1 issued to the partners reported the following
information:

                            Clark PLLC             Town PS          Newman PLLC

 Beginning capital
                               $792,497              $150,000             —
 account balance

 Capital contributions           —                     10,000           200,000

 Income allocations
 (net of deductions)
 and other items (e.g.,       1,259,382                (1,817)           (983) 37
 nondeductible
 expenses)

 Distributions

        Cash                    903,585                61,545           164,045

        Property                 16,745               —                   —

 Ending capital
                              1,131,549                96,638            34,972
 account balance 38

        This net figure includes, among other items, an allocation of a loss to
       37

Newman PLLC in the amount of −$3,118.
        38 In computing the ending capital account balance for each of the partners,

CRC did not include the book value, fair market value, or tax basis of any intangible
assets.
                                          24

[*24] C.         2013

      CRC filed its 2013 Form 1065 in September 2014, and issued
Schedules K–1 to Clark PLLC, Newman PLLC, and Town PS. CRC did
not report any intangible assets on its Schedule L for 2013.

      The Schedules K–1 issued to the partners reported the following
information:

                            Clark PLLC             Town PS          Newman PLLC

 Beginning capital
                             $1,131,549               $96,638           $34,972
 account balance

 Capital
                                150,000               100,000           100,000
 contributions 39

 Income allocations
 (net of deductions)
 and other items (e.g.,         789,987               255,799           307,759
 nondeductible
 expenses)

 Distributions

         Cash                   632,201                 5,000            23,688

         Property                —                    447,437           419,043

 Ending capital
                              1,439,335               -0-                 -0-
 account balance 40

        39Clark PLLC did not in fact make a $150,000 capital contribution in 2013.
On CRC’s general ledger for the period January 1 through December 31, 2013, CRC
debited Town PS’s capital account by $150,000 and credited Clark PLLC’s capital
account by the same $150,000. CRC reported capital contributions by Newman PLLC
and Town PS in 2013 to reflect the $200,000 payment CRC received in March 2014
pursuant to the partners’ Settlement Agreement.
        40 In computing the ending capital account balance for each of the partners,

CRC did not include the book value, fair market value, or tax basis of any intangible
assets.
                                        25

[*25] VII.     Newman PLLC’s and Town PS’s Forms 8082

      In September 2014 Newman PLLC and Town PS each filed
Forms 8082, “Notice of Inconsistent Treatment or Administrative
Adjustment Request (AAR)”, with respect to CRC’s 2013 issued
Schedules K–1 that reported the following information: 41

       Newman PLLC—Form 8082

                                   Ordinary income           Property
                                        (loss)             distributions

         Schedule K–1 issued
                                        $307,759              $419,043
         to Newman PLLC

         Form 8082 filed by
                                         -0-                   183,737
         Newman PLLC

       Town PS—Form 8082

                                   Ordinary income           Property
                                        (loss)             distributions

         Schedule K–1 issued
                                        $255,799              $447,437
         to Town PS

         Form 8082 filed by
                                             5,000             -0-
         Town PS

        41 The Forms 8082 also reported variations in the guaranteed payments each

partner received, but neither the variations nor the guaranteed payments are
pertinent to this case. Newman PLLC’s Form 8082 reported a cash distribution
amount of $20,000 (compared to the $23,688 reported on its Schedule K–1), but the
parties have stipulated that the amount of cash distributed to Newman PLLC in 2013
was $20,000, and so we exclude that item from discussion. Newman PLLC also filed a
Form 8082 for the 2012 tax year, in which it contested CRC’s allocation of a loss of
−$3,118 to Newman PLLC. Instead, Newman PLLC reported an income allocation of
$167,872. The Commissioner contests the validity of CRC’s 2012 allocations of income
in his brief, and we address his contentions in our discussion below in note 67.
                                         26

[*26] VIII.    Proceedings before the IRS

       A.      CRC’s partnership-level proceeding

      In response to Newman PLLC’s and Town PS’s filed Forms 8082,
the IRS conducted a partnership-level audit of CRC’s 2013 Form 1065.
On August 24, 2016, the IRS issued the Letter 1787–F, “TMP Notice of
Beginning of Administrative Proceedings”, to notify Clark PLLC that
the IRS was beginning an administrative partnership-level audit of
CRC’s 2013 Form 1065. On November 6, 2017, the IRS issued a
Letter 1827–F proposing adjustments to partnership items on CRC’s
2013 Form 1065 and notifying the TMP of its right to file a protest to
the IRS Appeals Office (“IRS Appeals”). 42

       B.      Notice of Final Partnership Administrative Adjustment

      On December 17, 2018, IRS Appeals issued the TMP an FPAA
determining adjustments to CRC’s 2013 Form 1065.

       The FPAA largely adjusted CRC’s reported property distributions
and income allocations consistently with the corrections proposed by
Newman PLLC and Town PS. 43 With regard to property distributions,
the IRS determined: (1) reported “client distributions” of $705,249 were
not distributions and should be disregarded, or, in the alternative, CRC
failed to substantiate the identities and the values of the clients
distributed (and it failed to show that CRC was capable of valuing the
clients distributed), and therefore the distributions should be
disregarded; and (2) a remaining distribution of $183,737 should be
disregarded because it was the result of a bank loan owed personally by

       42  On July 10, 2017, Clark PLLC, as the TMP of CRC, signed a Form 872–P,
“Consent to Extend the Time to Assess Tax Attributable to Partnership Items”,
extending the period for assessing tax provided for in section 6229(a) to December 31,
2019, for the 2013 tax year.
        43 The FPAA also determined certain adjustments to CRC’s reported ordinary

income, guaranteed payments, business deductions, and cash distributions, and that
CRC was liable for an accuracy-related penalty under section 6662(a). The parties
settled each of these issues before submitting their joint motion to submit the case
pursuant to Rule 122. See supra note 3.
                                         27

[*27] a partner who subsequently defaulted. 44                   The FPAA also
determined that

       [CRC’s] reported allocation of [o]rdinary income [to
       Newman PLLC and Town PS] had no substantial economic
       effect, was not consistent year to year, and did not use the
       allocation method described in Article 8 of the [2013 LLC
       Agreement] . . . [and that] [t]he allocation of [o]rdinary
       [i]ncome should be based on known amounts received by
       the partners.

The FPAA determined that ordinary income should be allocated as
follows: $538,118 to Clark PLLC, $20,000 to Newman PLLC, and $5,000
to Town PS.

       C.      Newman PLLC’s and Town PS’s Forms 870–PT

       In December 2017 Newman PLLC and Town PS executed
Forms 870–PT, “Agreement for Partnership Items and Partnership
Level Determinations as to Penalties, Additions to Tax and Additional
Amounts”, regarding CRC’s 2013 taxable year, and the IRS
countersigned in January 2018. Each Form 870–PT determined,
similarly to the FPAA, that the partner’s distributive share of ordinary
income should be allocated: $538,558 to Clark PLLC, $20,000 to Town
PS, and $5,000 to Newman PLLC. 45 (These agreements resolve the tax
consequences of the withdrawal for Town PS and Newman PLLC, so we
do not adjudicate here any claim by those entitles. Rather, at issue here

       44 The FPAA also disregarded certain “silent distributions” of $80,000 reported
on the Form 1065. Although the parties do not address this item specifically in their
stipulations of settled issues, in their joint motion to submit the case pursuant to
Rule 122, the parties agree that the remaining legal issues in dispute are limited to
(1) “whether CRC made or was deemed to have made additional property distributions
to [Newman PLLC] and [Town PS (beyond the $183,737 property distribution to
Newman PLLC relating to the WTB Loan)] during 2013” and (2) “whether CRC’s
ordinary income allocations as reported on its 2013 Form 1065 had substantial
economic effect.” Therefore, we do not address whether the IRS’s determination
regarding “silent distributions” should be sustained or denied.
        45 The Forms 870–PT thus stated Clark PLLC’s allocation as $538,558 rather

than $538,118 as in the FPAA, and they “swapped” the income allocation amounts for
Newman PLLC and Town PS that were determined in the FPAA—i.e., the FPAA
allocated $20,000 of income to Newman PLLC and $5,000 of income to Town PS, but
the Form 870–PT allocated $20,000 of income to Town PS and $5,000 of income to
Newman PLLC. We need not resolve these discrepancies.
                                        28

[*28] are CRC’s income allocations that ultimately affect Clark PLLC
only.)

IX.    Tax Court proceedings

       CRC’s petition contesting the FPAA was timely filed in this Court
on January 30, 2019. The parties filed three stipulations of settled
issues,    resolving    their   disagreements       regarding    multiple
determinations in the FPAA, and leaving the remaining issues for our
decision. The parties also filed a stipulation of facts and a supplement
to that stipulation. On January 5, 2021, the parties filed a joint motion
to submit the case pursuant to Rule 122, and we granted the motion on
January 27, 2021.

                                    OPINION

I.     Applicable legal principles

       A.      Jurisdiction to determine partnership items

       Under the default rules of Treasury Regulation section 301.7701-
2(a) and (c)(1), noncorporate entities with more than one member (such
as LLCs) are treated as partnerships for federal tax purposes. 46 Because
CRC’s TMP filed the Petition for readjustment of partnership items
within 90 days of the Commissioner’s FPAA, we have jurisdiction under
section 6226(f) to determine all of CRC’s “partnership items” for 2013
and the proper allocation of those items among its partners.
Section 6231(a)(3) defines “partnership item” as “any item required to
be taken into account for the partnership’s taxable year under any
provision of subtitle A [sections 1–1563] to the extent regulations
prescribed by the Secretary provide that, for purposes of this subtitle,
such item is more appropriately determined at the partnership level”.
Treasury Regulation section 301.6231(a)(3)-1(a)(1)(i) provides that
partnership items include the partnership aggregate and each partner’s
share of items of income, gain, loss, deduction, or credit of the
partnership. Thus, the income allocations to partners that CRC
reported on its 2013 Form 1065 (and whether they have substantial
economic effect) are partnership items that are subject to

       46 “A business entity with two or more members is classified for federal tax

purposes as either a corporation or a partnership . . . [and] [t]he term partnership
means a business entity that is not a corporation . . . and that has at least two
members.” Treas. Reg. § 301.7701-2(a), (c)(1).
                                          29

[*29] redetermination in this partnership-level proceeding.                    Neither
party to this case contends otherwise.

        B.      Burden of proof

       As a general rule, the Commissioner’s determinations in an FPAA
are presumed correct, and the taxpayer has the burden of proving them
incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933);
Republic Plaza Props. P’ship v. Commissioner, 107 T.C. 94, 104 (1996).
The Commissioner, however, bears the burden of proof with respect to
any new matter, increase in deficiency, and affirmative defenses pleaded
in the answer. Rule 142(a). Petitioner does not allege that its burden
should shift to the Commissioner for any issue in this case, and thus,
petitioner bears the burden of proof.

        C.      Partnership intangible assets

      Business entities may own intangible assets. See, e.g., Tomlinson
v. Commissioner, 58 T.C. 570, 580 (1972) (“We have long recognized that
these intangibles [including customer lists] are capital assets”), aff’d,
507 F.2d 723 (9th Cir. 1974); Topeka State J., Inc. v. Commissioner, 34
T.C. 205, 215, 221 (1960) (“It is well established that [subscription lists]
are an intangible asset of a newspaper [company]”). 47 Intangible assets
are generally included in the valuation of a partnership (and
partnership interest). See, e.g., Watson v. Commissioner, 35 T.C. 203,
208, 214 (1960) (holding that purchase price for partnership included
payment for tangible assets and goodwill); Tolmach v. Commissioner,
T.C. Memo 1991-538.

       A “client-based intangible” asset (such as a customer list or “book
of business” 48) is one example of an intangible asset, and it may be
capable of valuation, distribution, and sale to third parties. See, e.g.,
Newark Morning Ledger Co. v. United States, 507 U.S. 546, 570 (1993)
(holding that a corporation proved that a customer list of “‘paid

        47 The Code and the Treasury Regulations also anticipate that partnerships
will own intangible assets by providing an amortization deduction for the capitalized
costs of intangibles owned by the partnership (for federal income tax purposes), see
generally § 197, and requiring the inclusion of intangible assets in the valuation of a
transferred business interest (for federal gift tax purposes), see generally Treas. Reg.
§§ 1.197-2, 25.2512-3.
        48 A “book of business” generally has value. See, e.g., Mitchell v. Garrison

Protective Servs., Inc., 819 F.3d 636, 641 (2d Cir. 2016) (affirming the district court’s
valuation of a book of business).
                                         30

[*30] subscribers’ constitute[d] an intangible asset with an
ascertainable value and a limited useful life, the duration of which
[could] be ascertained with reasonable accuracy” for depreciation
purposes); JHK Enters., Inc. v. Commissioner, T.C. Memo. 2003-79, 85
T.C.M. (CCH) 1032, 1032 (“Among the assets received by [the partner]
in the liquidating distribution were client files, a client list, going
concern value (goodwill), and equipment”); Holden Fuel Oil Co. v.
Commissioner, T.C. Memo. 1972-45, 31 T.C.M. (CCH) 184, 187–89
(holding that where the taxpayer purchased customer lists from another
company it was entitled to an amortization deduction for a portion of the
amount paid), aff’d, 479 F.2d 613 (6th Cir. 1973).

      The Commissioner disputes the existence of the client-based
intangible that petitioner asserts and CRC’s ability to distribute such
an asset, and we address that dispute below in Part II.A.

       D.      Substantial economic effect

               1.      General principles

       Section 704(a) provides that the partnership agreement 49
generally determines a partner’s distributive share of partnership
income, gain, loss, deductions, or credits of the partnership. However,
the partners’ ability to allocate partnership items on a basis other than
the partners’ interests in the partnership (i.e., a non-pro rata “special
allocation”) is not unrestricted.       Special allocations must have
substantial economic effect (as opposed to the mere avoidance of tax);
otherwise, the partners’ distributive shares of partnership items “shall
be determined in accordance with the partner’s interest in the
partnership (determined by taking into account all facts and
circumstances)”. § 704(b). The regulations under section 704(b)
describe in detail not only the circumstances in which a special
allocation will have “substantial economic effect” but also the manner of
determining a partner’s “interest in the partnership”.

      The regulations provide that a special allocation of partnership
items is deemed to have economic effect if, in the event there is an
economic benefit or burden that corresponds to an allocation, the
partner to whom the special allocation is made receives a corresponding
benefit or bears a corresponding burden.             See Treas. Reg.

        49 The term “partnership agreement” includes all agreements among the

partners, or between one or more partners and the partnership, concerning affairs of
the partnership and responsibilities of partners. Treas. Reg. § 1.704-1(b)(2)(ii)(h).
                                     31

[*31] § 1.704-1(b)(2)(ii)(a). A determination to this effect is made as of
the end of the partnership taxable year to which the allocation relates.
Treas. Reg. § 1.704-1(b)(2)(i). Moreover, the economic effect of the
special allocation must be substantial; this requires “a reasonable
possibility that the allocation (or allocations) will affect substantially the
dollar amounts to be received by the partners from the partnership,
independent of tax consequences.” Treas. Reg. § 1.704-1(b)(2)(iii)(a).

       Determinations of substantial economic effect, as well as
determinations of a partner’s interest in the partnership, depend upon
an analysis of the partners’ capital accounts. See Treas. Reg. § 1.704-
1(b)(2)(iv)(a). Generally, a partner’s capital account represents the
partner’s equity investment in the partnership. The capital account
balance is determined by adding (1) the amount of money that the
partner contributes to the partnership, (2) the fair market value of other
property the partner contributes (net of liabilities to which the property
is subject or which are assumed by the partnership), and (3) any
allocations of partnership income or gain. Treas. Reg. § 1.704-
1(b)(2)(iv)(b). A partner’s capital account is decreased by (1) the amount
of money distributed to him by the partnership, (2) the fair market value
of property distributed to the partner (net of any liability that the
partner assumes or to which the property is subject), and (3) the
amounts of partnership losses and deductions allocated to the partner.
Id. An allocation of partnership items can have substantial economic
effect only if the partnership maintains capital accounts of the partners
in accordance with these rules. Id.

              2.     Tests for economic effect

       The regulations governing special allocations provide three tests
for economic effect. Special allocations of items to a partner are deemed
to have economic effect if they meet the requirements of any one of these
alternative tests:

                     a.     Basic test of economic effect

       The basic test for economic effect is set forth in Treasury
Regulation section 1.704-1(b)(2)(ii)(b). The test provides, in general,
that a special allocation has economic effect if it is made pursuant to a
partnership agreement that contains provisions requiring: (1) the
determination and maintenance of partners’ capital accounts in
accordance with the rules of Treasury Regulation section 1.704-
1(b)(2)(iv); (2) upon liquidation of the partnership, the proceeds of
                                          32

[*32] liquidation be distributed in accordance with the partners’ positive
capital account balances; and (3) upon liquidation of the partnership,
any partner with a deficit capital account balance is unconditionally
obligated to restore the amount of the deficit balance to the partnership
by the end of the taxable year (commonly referred to as a “deficit
restoration obligation” or “DRO”). Treas. Reg. § 1.704-1(b)(2)(ii)(b). This
test ensures that the economic benefits or burdens corresponding to any
given special allocation are borne by the partner receiving the allocation.

                       b.      Alternate test of economic effect

       Partnership agreements may provide for specific limits upon the
amount the limited partners are required to contribute to the
partnership. These limits on liability, however, are inconsistent with
the requirement in the basic test that each partner must agree to repay
the deficit balance (if any) in that partner’s capital account upon
liquidation. Consequently, the regulations include an “[a]lternate test
for economic effect”, which provides that special allocations of
partnership items may have economic effect even in the absence of a
deficit restoration obligation.

       The alternate test begins by incorporating the first two parts of
the basic test. (That is, the partnership agreement must (1) provide for
properly maintained capital accounts and (2) provide that the proceeds
of liquidation will be distributed in accordance with the partners’
positive capital account balances.) However, instead of a negative
capital account makeup requirement, the alternate test mandates a
hypothetical reduction of the partners’ capital accounts. Specifically,
the alternate test requires that capital accounts be reduced, as of the
end of the year, for any allocation of loss or deduction or distributions
that, at that time, are reasonably expected to be made, to the extent that
such allocations or distributions exceed reasonably expected increases
to the partners’ capital account. 50 See Treas. Reg. § 1.704-1(b)(2)(ii)(d).

      The alternate test also requires that the partnership agreement
provide for a QIO, i.e., a “qualified income offset”. A QIO provision
automatically allocates partnership income (including gross income and
gain) to a limited partner who has an unexpected negative capital
account, either as a result of partnership operations or as a result of

        50 By requiring a prospective reduction of capital accounts, the alternate test

serves to preclude a limited partner from timing the receipt of deductible partnership
expenses in a way that would enable a partner to accumulate a negative capital
account that the partner need not repay.
                                    33

[*33] making the adjustment for reasonably expected reductions. The
QIO must operate “in an amount and manner sufficient to eliminate
such deficit balance as quickly as possible.” Treas. Reg. § 1.704-
1(b)(2)(ii)(d) (flush text).

                    c.     Economic equivalence test

       There is a third economic effect test, referred to as the “economic
equivalence” test.      Treasury Regulation section 1.704-1(b)(2)(ii)(i)
provides that, if an allocation would produce the economic equivalent of
meeting the basic test for economic effect, it will be deemed to have
economic effect even if it does not otherwise meet the formal
requirements of the basic test. We address this issue below in
Part II.B.3.

      E.     Partner’s interest in the partnership

       Section 704(b) provides that an allocation of partnership income,
gain, loss, deductions, or credit (or item thereof) that does not have
substantial economic effect will be “determined in accordance with the
partner’s interest in the partnership”. A “partner’s interest in the
partnership” is defined as the “manner in which the partners have
agreed to share the economic benefit or burden (if any) corresponding to
the income, gain, loss, deduction, or credit (or item thereof) that is
allocated.” Treas. Reg. § 1.704-1(b)(3)(i). The partners’

      sharing arrangement may or may not correspond to the
      overall economic arrangement of the partners. . . . [I]n the
      case of an unexpected downward adjustment to the capital
      account of a partner who does not have a deficit make-up
      obligation that causes such partner to have a negative
      capital account, it may be necessary to allocate a
      disproportionate amount of gross income of the partnership
      to such partner for such year so as to bring that partner’s
      capital account back up to zero.

Id. Accordingly, an examination of a partner’s interest in the
partnership “shall be made by taking into account all facts and
circumstances relating to the economic arrangement of the partners.”
Id. Among the relevant factors to be taken into account in determining
the partners’ interests in the partnership are: (1) the partners’ relative
contributions to the partnership, (2) the interests of the respective
partners in profits and losses (if different from that in taxable income or
loss), (3) the partners’ relative interests in cash flow and other non-
                                           34

[*34] liquidating distributions, and (4) their rights to distributions of
capital upon liquidation. 51 Treas. Reg. § 1.704-1(b)(3)(ii).

       We address the Commissioner’s contentions as to a “partner’s
interest in the partnership” below in Part II.C.

        F.      Partnership distributions

       The basic capital accounting rules in Treasury Regulation
section 1.704-1(b)(2)(iv)(b) require that partners’ capital accounts be
decreased by the fair market values of property distributed to them by
the partnership. Treas. Reg. § 1.704-1(b)(2)(iv)(e)(1). If property is in
fact distributed, then these rules must be applied even if the partners
and the partnership overlook the distribution or attempt to impose
another characterization on it. See, e.g., Seay v. Commissioner, T.C.
Memo. 1992-254, 63 T.C.M. (CCH) 2911, 2913 (holding that the taxpayer
received a distribution of partnership assets when he withdrew cash
from the partnership, despite claiming that his withdrawals were loans
from the partnership). To satisfy this requirement, the capital accounts
of the partners first must be adjusted to reflect how any unrealized52
income, gain, loss, and deduction inherent in the property (not already
reflected in the capital accounts) would be allocated among the partners
if there were a taxable disposition of the property for its fair market
value (colloquially referred to as a “book-up”). Treas. Reg. § 1.704-
1(b)(2)(iv)(e)(1).

        51 “Liquidation” includes both the liquidation of the partnership and the
liquidation of the partner’s interest. Treas. Reg. § 1.704-1(b)(2)(ii)(g).
        52 Gain is defined as the excess of the amount realized from a sale or other
disposition of property over the taxpayer’s adjusted basis in the property. § 1001(a).
An amount realized is the sum of money or fair market value of property received from
the sale or other disposition of the property. § 1001(b). “Realization” of these amounts
typically occurs when the transferor is in receipt of cash or property, but realization
may also occur when the last step is taken by the transferor by which he obtains the
fruition of the economic gain which has already accrued to him. Helvering v. Horst,
311 U.S. 112, 115 (1940). A taxpayer’s basis in an asset is generally its cost of acquiring
the property. § 1012. The basis of property contributed to a partnership by a partner
is the adjusted basis of the property to the contributing partner at the time of the
contribution (adjusted for any gain recognized by the contributing partner). § 723. In
the case of intangible assets, basis includes amounts that are required to be
capitalized, such as amounts paid to create or enhance an intangible asset. Treas. Reg.
§ 1.263(a)-4(b)(1), (g)(1). “Unrealized gain”, therefore, refers to the excess of the fair
market value of property over its basis (i.e., its appreciation in value) at a point before
a realization event (before it is disposed of). See, e.g., Treas. Reg. § 1.704-1(b)(5)
(example 14).
                                   35

[*35] The fair market value assigned to property contributed to,
distributed by, or otherwise revalued by a partnership will be regarded
as correct, provided that (1) the value is reasonably agreed to among the
partners in arm’s-length negotiations and (2) the partners have
sufficiently adverse interests. Treas. Reg. § 1.704-1(b)(2)(iv)(h)(1). The
determination of fair market value is a question of fact. S. Tulsa
Pathology Lab’y, Inc. v. Commissioner, 118 T.C. 84, 101 (2002).

      We address in Part II.A–C the parties’ contentions as to the
existence of “client-based intangibles”, the presence of “unrealized gain”
inherent in those intangibles, and the corresponding “book-up” of the
partners’ capital accounts.

II.   Analysis

      A.     Distribution of client-based intangibles to Newman PLLC
             and Town PS in 2013

       The FPAA determined that CRC’s reported “client distributions”
were not distributions and should be disregarded. In the alternative,
the IRS determined that the “client distributions” had not been
substantiated as to the clients distributed, their overall value, or CRC’s
ability to value each client distributed. In response, petitioner argues
that “goodwill” is an asset of CRC and that when Newman PLLC and
Town PS “took clients from CRC”, they effected a distribution of goodwill
from CRC to each of them. CRC aptly cites Rudd v. Commissioner, 79
T.C. 225, 238 (1982), in which we stated:

             The goodwill of a public accounting firm can
      generally be described as the intangibles that attract new
      clients and induce existing clients to continue using the
      firm. These intangibles may include an established firm
      name, a general or specific location of the firm, client files
      and workpapers (including correspondence, audit
      information, financial statements, tax returns, etc.), a
      reputation for general or specialized services, an ongoing
      working relationship between the firm’s personnel and
      clients, or accounting, auditing, and tax systems used by
      the firm.

The client-based component of such generalized “goodwill” is the asset
at issue here.
                                         36

[*36] To further support its argument that goodwill was a partnership
asset, petitioner alleges that “[t]he partners agreed to transfer their
goodwill to CRC as part of a deal in which they received their interest
in the partnership and specifically, they received an AAV deferred
compensation balance.” The Commissioner rebuts this argument by
pointing to a lack of evidence that the partners contributed any
intangible assets to the partnership 53 and by arguing that CRC could not
“distribute” goodwill to Newman PLLC and Town PS when clients
decided (of their own free will) to cease engaging CRC and instead retain
the services of NT PLLC.

       Taking into consideration the terminology used in the FPAA (i.e.,
“client distribution”), it is clear to us that, although both parties
intermittently refer to a contribution to and distribution of general
“goodwill” from CRC, at issue in this case is a distribution of CRC’s
clients or a client list in particular, both of which we refer to as the
“client-based intangibles”.       Client lists and other client-based
intangibles have value. See, e.g., Newark Morning Ledger Co., 507 U.S.
at 570; Holden Fuel Oil Co., 31 T.C.M. (CCH) at 187–89. This value can
exist even where the client is not contractually bound to keep bringing
his business. See Aitken v. Commissioner, 35 T.C. 227, 230–31 (1960)
(holding that insurance contract “expirations”, which did not guarantee
renewal of an insurance contract, but contained client and policy
information and were analogous to customer lists, goodwill, or just
intangibles in the nature of goodwill, constituted valuable capital assets
capable of transfer); see also Holden, 31 T.C.M. at 184–85, 187
(“[Although] customers [on a customer list] were not obligated to
purchase fuel oil from [the taxpayer] . . . [i]n acquiring the list [the
taxpayer] was afforded the opportunity of contacting persons who were
known to be using fuel oil to heat their homes and who were in the need
of a new supplier; clearly providing [the taxpayer] with a valuable
asset.”). Business entities, such as limited liability companies, may own
and distribute such intangible assets. See, e.g., JHK Enters., Inc.,
8T.C.M. (CCH) at 1032. CRC could therefore hold and distribute such
assets, and although the evidence does not support that Newman PLLC
and Town PS either contributed client-based intangibles to CRC or

        53 We take as true the Commissioner’s point that Town PS did not contribute

an intangible to the partnership because Town PS in fact bought its interest in CRC
not by direct contribution to CRC but rather by purchasing it from Clark PLLC (at a
discount that Clark PLLC allowed in view of the value of Town PS’s book of business).
However, this fact does not at all undermine the fact (which we have found) that Town
PS required and Clark PLLC gave compensation for the value of Town PS’s book of
business.
                                   37

[*37] transferred client-based intangibles in exchange for their AAV
account, the evidence does support CRC’s ownership of client-based
intangible assets capable of valuation and distribution.

        CRC’s dealings demonstrate that it and its partners understood
that a partner’s “book of business” consisting of current clients would be
valued upon entry of a partner and charged for upon withdrawal. For
example, when Benbow PS withdrew from CRC, its capital account was
reduced to zero to reflect the distribution of CRC clients to Benbow PS.
Similarly, when Town PS joined CRC as a partner, Clark PLLC and
Town PS calculated the price that Town PS would pay to Clark PLLC
for 25% of its interest in CRC by adding up the values of CRC’s assets,
multiplying the total by 25% (the amount of Town PS’s anticipated
partnership interest) and then subtracting from that total an amount
(i.e., $234,046) that was equal to the prior year’s revenue generated from
Mr. Town’s “book of business”. The record also contains an exhibit
entitled “John’s Buy-in Calculation” relating to the price for Town PS’s
purchase of a 25% partnership interest from Clark PLLC. This
document was contemporaneously used to determine the purchase price
of Town PS’s partnership interest in CRC, and it reflects the same
purchase price discount with the label “[a]greed upon value of John’s
book brought in”.

       The 2013 LLC Agreement’s distribution provisions likewise treat
clients as a valuable partnership asset. Section 9.3(b) of the 2013 LLC
Agreement (like Section 9.3(b) of the 2012 LLC Agreement and Section
8.3(b) of the 2009 LLC Agreement) states that “[i]f any Clients are
Distributed . . . the value of such Client shall be the Client Value”,
defined as gross revenue invoiced to the client over the prior 12 months.
Although the 2013 LLC Agreement as executed in 2012 and reaffirmed
in 2013 lacks the express client distribution provision of Section
11.1(a)(i) of the 2009 LLC Agreement, the partners agreed to Section
9.3(b) when they executed the 2013 LLC Agreement, and neither party
argues we should disregard their agreement to this effect. In some
cases, we might ignore an agreed-upon valuation method where there
was evidence of collusion between the partners; but here the partners’
interests were adverse at the time they agreed to the 2013 LLC
Agreement. Plainly, the partners were negotiating at arm’s length the
terms of Clark PLLC’s buyout.

      Consequently, we hold that CRC’s method for valuing client-
based intangibles upon the withdrawal of Newman PLLC and Town PS
comports with the fair market value definition of Treasury Regulation
                                         38

[*38] section 1.704-1(b)(2)(iv)(h)(1). In the absence of any competing
valuation presented by the Commissioner, or any critique of this
valuation, we accept it as correct.

       As is stated above, under the terms of the 2013 LLC Agreement,
the “Client Value” of the clients that retained NT PLLC was $742,569,
of which $318,144 was allocable to Newman PLLC and $424,425 was
allocable to Town PS. We therefore hold that petitioner has met its
burden to prove that there was a distribution of clients, and that, on the
evidence before us, 54 CRC did in fact distribute client-based intangible
assets of $318,144 to Newman PLLC and $424,425 to Town PS when
certain clients left CRC and engaged NT PLLC following Newman
PLLC’s and Town PS’s withdrawals.

       Obviously, this was not a textbook instance of a partnership
distribution, labeled as such by agreement of the parties when the
partner withdrew. Rather, CRC initially contended that the taking of
property (i.e., the clients) was wrongful and was a breach of the 2013
LLC Agreement. We can imagine a circumstance in which a partner’s
taking of property from a partnership was outright robbery; and in such
a circumstance it might be treated for tax purposes not as a distribution
but as a theft, perhaps deductible on the partnership return as a theft
loss under section 165(e) and includible as ordinary income to the
partner. See James v. United States, 366 U.S. 213, 219 (1961). But here
the partners and the partnership had a disagreement about the
entitlement to the property, and before the end of the tax year, they
agreed to a settlement of their dispute under which the partners would
be entitled to keep the property they had taken. We conclude we should
accept their agreed-upon resolution of the dispute and should apply the
provisions of the Code pertinent to that characterization. Neither party
to this case argues that it should instead be treated as a theft. The
ultimately agreed-upon transfer of the client-based intangibles is best
understood as a distribution.

       The Commissioner argues, in effect, that the transfer of the client-
based intangibles should be ignored as non-factual, because (he says)
the intangibles did not exist and were not transferred. For the reasons

        54 We do not hold that client-based intangibles always exist in a partnership,

nor that they always have value, nor that a withdrawing partner who thereafter serves
former clients of the partnership always receives a distribution from the partnership.
But we conclude that, in this case, the evidence warrants those holdings.
                                     39

[*39] stated above, we reject that approach. The Commissioner also
presents an alternative argument:

      Having structured the economic deal that goodwill was not
      a partnership asset, petitioner is bound by the treatment
      the parties negotiated. A taxpayer, although free to
      structure his transaction as he chooses, “once having done
      so, he must accept the consequences of his choice, whether
      contemplated or not . . . and may not enjoy the benefit of
      some other route he might have chosen to follow but did
      not.” Comm’r v. National Alfalfa Dehydrating & Milling
      Co., 417 U.S. 134, 149 (1974) (citations omitted). To
      disavow the LLC Agreement’s treatment of goodwill,
      petitioner must present strong proof that the LLC
      Agreement was wrong.

But the partners of CRC did not negotiate a deal that clients were not a
value that could be brought into the firm and taken out of it. Rather,
the partners took into account an entering partner’s book of business in
determining on what terms the partner would enter the partnership;
and Section 5.1 of the 2013 LLC Agreement acknowledges that CRC
“expended substantial time and funds in developing . . . the Company’s
clientele and their patronage”; Section 1.6 postulates a “goodwill value
of the Company” (used for calculating AAV rights); and it expressly
makes provision (in Section 9.3(b)) for “Clients [to be] Distributed under
this Agreement” and (in Section 1.19) for the “Client Value” to be
determined. When Newman PLLC and Town PS did withdraw, they
took clients with them, and the parties executed an “Agreement
Regarding Client File Transfer Procedure”.

       It is true that the 2013 LLC Agreement does not make express
provision for goodwill to be contributed by a partner and included in his
capital account, but that silence does not amount to an agreement that
client-based intangibles do not exist and cannot be transferred. It is also
true that CRC failed to reflect intangible values in partners’ capital
accounts (and that is part of the reason that we hold below that CRC’s
special allocation fails the tests for economic effect, see infra Part II.B);
but a partnership’s failure to reflect an asset on its books does not make
the asset cease to exist. If a partnership fails to book its cash (to choose
an extreme instance), a distribution of that unbooked cash is still a
distribution. Treating the distribution of the client-based intangibles as
a distribution does not (in the words of the Commissioner’s brief quoted
above) require “disavow[ing] the LLC Agreement’s treatment of
                                    40

[*40] goodwill”. Rather, it requires invoking and giving effect to the
express terms of Section 9.3(b).

      B.     Lack of substantial economic effect in 2013 income
             allocations

      Having held that CRC distributed client-based intangible assets
to Newman PLLC and Town PS upon their withdrawal as partners, we
now turn to CRC’s allocation of income to Newman PLLC and Town PS,
which the IRS determined did not have substantial economic effect.

       Petitioner argues that Newman PLLC’s and Town PS’s capital
accounts, which had initial balances of $34,972 and $96,638
respectively, were driven negative by subtracting the value of the clients
distributed to them. These negative capital account balances “triggered”
the QIO provision of the 2013 LLC Agreement and required that CRC
allocate income to Newman PLLC and Town PS in 2013 in amounts
sufficient to restore their capital account balances to zero. CRC argues
that its income allocations have substantial economic effect because
they are consistent with the economic arrangement of the partners in
the 2013 LLC Agreement.

       We first examine whether the income allocation at issue satisfies
any of the tests under Treasury Regulation section 1.704-1(b)(2)(ii), so
that it is deemed to have economic effect.

             1.     The allocation fails the basic test.

       The basic test for economic effect requires (in part) that the
partnership agreement contain a deficit restoration obligation. The
2013 LLC Agreement contains no such provision and in fact explicitly
states that “this Agreement shall not be construed as creating a deficit
restoration obligation or otherwise personally obligating any Member to
make a capital contribution in excess of those required by [a section
detailing initial and additional capital contributions].” (Emphasis
added.) Without a deficit restoration obligation in the 2013 LLC
Agreement, the special allocation cannot satisfy the basic test for
economic effect. See Treas. Reg. § 1.704-1(b)(2)(ii)(b).

             2.     The allocation meets the criteria of the alternate test
                    but does not have economic effect.

      The alternate test requires that the partnership agreement
provide: (1) for the determination and maintenance of partners’ capital
                                        41

[*41] accounts in accordance with Treasury Regulation section 1.704-
1(b)(2)(iv); (2) that upon liquidation of the partnership, the proceeds of
liquidation be distributed in accordance with the partners’ positive
capital account balances; (3) that capital accounts be reduced for any
allocation of loss or deduction or distributions that, as of the end of the
year, are reasonably expected to be made, to the extent that such
allocations or distributions exceed reasonably expected increases to the
partners’ capital account; and (4) for a QIO provision. Treas. Reg.
§ 1.704-1(b)(2)(ii)(d).

       The 2013 LLC Agreement does contain provisions that (1) require
maintenance of capital accounts in accordance with Treasury
Regulation section 1.704-1(b)(2)(iv), (2) require liquidation distributions
in accordance with partners’ positive capital account balances,
(3) require reductions for reasonably expected allocations or
distributions, and (4) implement a QIO. However, the special allocation
of income cannot have economic effect because, as we explain below,
CRC did not actually maintain the capital accounts of its partners in
accordance with the 2013 LLC Agreement and Treasury Regulation
section 1.704-1(b)(2)(iv) (“[A]n allocation of income, gain, loss, or
deduction will not have economic effect . . . unless the capital accounts
of the partners are determined and maintained throughout the full term
of the partnership in accordance with the capital accounting rules”
(emphasis added)).

       The Commissioner asserts persuasively that CRC failed to
maintain capital accounts in accordance with Treasury Regulation
section 1.704-1(b)(2)(iv) because, before distributing those assets, CRC
did not increase the partners’ capital accounts by the value of the
unrealized gain55 inherent in the client-based intangible assets. See
Treas. Reg. § 1.704-1(b)(2)(iv)(e)(1). In response, petitioner argues that
the client-based intangibles did not have unrealized gain because the
partners transferred their “goodwill” (at fair market value) to CRC in
exchange for their AAV account balances, such that the value of that
goodwill resided in the AAV account. Petitioner further argues that the
partners’ AAV accounts control the allocation of any taxable gain on the
sale of the client-based intangibles and that, in effect, “[section] 704 and
its regulations do not apply because [the section] 704 book-up only

        55 See supra note 52.    With his assertion, the Commissioner necessarily
assumes that a client-based intangible asset may indeed bear unrealized gain, and we
therefore adopt his assumption.
                                           42

[*42] applies to capital accounts and not AAV accounts (which are
deferred compensation liability accounts).”

       As we have discussed, petitioner has not shown that the partners
ever actually contributed “goodwill” or client-based intangibles to CRC 56
(or exchanged client-based intangibles for an AAV account), or, if such a
contribution (or exchange) did occur, the value of the assets at that time.
Neither does it cite any authority (controlling or otherwise) to support
its position regarding the AAV accounts and the inapplicability of
section 704(b), so we cannot accept its position. Indeed, AAV accounts
(used here by CRC as a method of calculating deferred compensation
payable to retiring partners) are not capital accounts, and we are
unaware of any authority relieving CRC from its capital account
maintenance responsibilities simply because it used such a mechanism.
We must therefore examine whether the client-based intangible assets
that Town PS and Newman PLLC received contained unrealized gain,
and if so, whether CRC failed to increase the partners’ capital accounts
by such unrealized gain before the distribution to Newman PLLC and
Town PS.

       The FPAA determined that the income allocation lacked
substantial economic effect, and so the burden is on Clark PLLC, as
petitioner, to prove that such allocation did have substantial economic
effect. It necessarily follows that, under an analysis of the economic
effect of the income allocation, one element of petitioner’s burden is to
prove that CRC maintained capital accounts in accordance with
Treasury Regulation section 1.704-1(b)(2)(iv). This burden includes

        56 As we have mentioned, Clark PLLC discounted the purchase price of Town
PS’s partnership interest for the“[a]greed upon value of John’s book brought in”. This
discount by itself is insufficient to establish that Town PS contributed its “book of
business” or “clients” to CRC because Town PS did not make a capital contribution to
CRC to acquire its partnership interest; rather, it purchased its interest from Clark
PLLC. We interpret the discount as the value that Clark PLLC (the seller in that
transaction) must have placed on the future benefit it would realize from its
distributive share of income generated by Town PS’s book of business, and not as an
indication that Town PS was somehow contributing its clients to CRC. Our
interpretation is further supported by the fact that CRC credited Town PS’s capital
account with an initial balance equal to the discounted purchase price of its
partnership interest (i.e., Town PS’s initial capital account balance was not increased
for contribution of a “book of business”, see Treas. Reg. § 1.704-1(b)(2)(iv)(b)). That is,
when the discount reduced Town PS’s purchase price of $872,996 by $234,046, for a
final purchase price of $639,000, CRC set Town PS’s initial capital account balance not
at $872,996 (as if Town PS had contributed the cash and a client-based intangible) but
rather at $639,000 (the amount of cash only).
                                          43

[*43] proving that CRC increased the capital accounts in accordance
with subdivision (iv)(e)(1), or, in the alternative, proving that the client-
based intangible asset lacked any unrealized gain. Petitioner does not
argue that this burden should shift to the Commissioner.

       To determine whether the client-based intangible asset contained
unrealized gain, we must determine the partnership’s adjusted basis in
the asset. See § 1001(a). Petitioner made no showing of the cost to
acquire or develop the client-based intangible assets, see Treas. Reg.
§ 1.263(a)-4(g)(1), or (tangential to its argument that partners
“exchanged” or “contributed” the assets to CRC) the partners’ adjusted
bases in the client-based intangibles before their alleged contribution,
see §§ 723, 732. We hold that petitioner has failed to prove CRC’s
adjusted basis in the client-based intangibles distributed to Newman
PLLC and Town PS, and we therefore assign zero-dollar bases to these
assets. 57 Accordingly, with a collective fair market value of $742,569
and a zero-dollar basis, the unrealized gain in the distributed client-
based intangibles is $742,569. See § 1001(a).

       The parties have stipulated that the partners’ opening capital
account balances in 2013 did not include the value of any intangibles
and that CRC did not increase the partners’ capital accounts by the
value of any inherent gain in the client-based intangibles. Therefore,
CRC failed to maintain the partners’ capital accounts in accordance with
Treasury Regulation section 1.704-1(b)(2)(iv), 58 and the special
allocation accordingly cannot satisfy the alternate test for economic
effect. The allocation will therefore be deemed to have economic effect
only if it is able to satisfy the third test—the economic equivalence test.

        57In the absence of proof of basis by CRC (the party with the burden of proof),
we assume zero basis because that would be the finding adverse to CRC. If we found
instead that the client-based intangible assets had bases equal to their fair market
values at the time of transfer (despite the fact that CRC did not produce evidence to
support it), the assets would not have had built-in gain that CRC would have been
required to allocate among the partners’ capital accounts before distribution. In such
circumstance, it is possible that we would have held that CRC had maintained its
capital accounts in accordance with the Treasury Regulation § 1.704-1(b)(2)(iv) and,
therefore, that CRC’s allocations of income had economic effect. A holding of economic
effect would conflict with the IRS’s determination in the FPAA that the allocations
lacked substantial economic effect, and CRC has the burden to disprove that
determination.
       58 The fact that the partners “agreed” to their capital account balances incident

to negotiations might suggest that CRC did not strictly adhere to the capital
accounting rules of Treasury Regulation § 1.704-1(b)(2)(iv). See supra pp. 12–13.
                                          44

[*44]          3.      The allocation does not have economic equivalence.

       In some cases, despite not adhering to the formal requirements of
the economic effect tests, an allocation may produce the same income
tax results as if the allocation had satisfied the requirements of the basic
test. Treas. Reg. § 1.704-1(b)(2)(ii)(i). Petitioner has neither argued nor
demonstrated that the special allocation satisfies the economic
equivalence test. 59 Therefore, the allocations have neither economic
equivalence nor economic effect.

       The substantial economic effect analysis under Treasury
Regulation section 1.704-1(b)(2)(i) has two parts: first, the allocation
must have economic effect, and second, the economic effect of the
allocation must be substantial. Because we have determined that CRC’s
allocations of income to Newman PLLC and Town PS do not have
economic effect, we do not conduct an analysis of substantiality. 60

        C.     Partner’s interest in the partnership

       Having determined that CRC’s allocations of income to Newman
PLLC and Town PS lack substantial economic effect, we must
redetermine the allocations in accordance with “the partners’ interests
in the partnership”. Treas. Reg. § 1.704-1(b)(1)(i). In this analysis, we
must determine the “manner in which the partners have agreed to share
the economic benefit or burden (if any) corresponding to the income,
gain, loss, deduction, or credit (or item thereof) that is allocated”, taking
into account all the facts and circumstances. Treas. Reg. § 1.704-
1(b)(3)(i). To do so, the regulation calls on us to examine (1) the partners’
relative contributions to the partnership, (2) the interests of the
respective partners in profits and losses (if different from that in taxable
income or loss), (3) their relative interests in cash flow and other non-
liquidating distributions, and (4) their rights to distributions of capital

        59 CRC’s failure to increase the capital accounts by the unrealized gain in the
client-based intangibles before distribution resulted in incorrect capital account
balances (before distribution) for each partner in 2013. Therefore, its income
allocations were not based on correct capital account balances and cannot have
economic equivalence because the resulting amounts of income allocated per partner
differ from those resulting from an application of the basic test for economic effect.
        60 The Commissioner stated that if the Court were to find economic effect, then

he “does not dispute that the economic effect of the allocations was substantial.”
                                          45

[*45] upon liquidation. 61 Treas. Reg. § 1.704-1(b)(3)(ii). Petitioner does
not offer any argument regarding the analysis of “the partner’s interest
in the partnership” or the individual factors set out in the regulation.

       The terms of the 2013 LLC Agreement ostensibly complied with
the criteria of the alternate test for economic effect, but the special
allocation lacked substantial economic effect because the partnership
failed to correctly maintain capital accounts in accordance with those
terms and with the regulations. 62 We proceed with examining the
relevant factors, keeping in mind that our goal is to derive the “manner
in which the partners have agreed to share the economic benefit or
burden (if any) corresponding to the income, gain, loss, deduction, or
credit (or item thereof) that is allocated”, Treas. Reg. § 1.704-1(b)(3)(i)

        61  Treasury Regulation § 1.704-1(b)(3)(iii) provides that if the first two
requirements of the basic test are met (i.e., that the partnership agreement provides
for (1) the determination and maintenance of the partners’ capital accounts in
accordance with the capital account rules and (2) liquidating distributions to be made
in accordance with the positive capital account balances of the partners), then “the
partners’ interests in the partnership with respect to the portion of the allocation that
lacks economic effect will be determined” with a comparative liquidation analysis. See,
e.g., Interhotel Co. v. Commissioner, T.C. Memo. 2001-151, 81 T.C.M. (CCH) 1804,
1809, supplementing T.C. Memo. 1997-449. However, neither party argues that this
comparative liquidation test should govern our analysis (in fact, the Commissioner
argues explicitly that it should not apply, and CRC does not contest the
Commissioner’s argument), so we do not address it.
        62 In some of the cases that have employed a partner’s interest in the
partnership analysis, the Court has examined the actual distributions received by the
partners (and other similar items) to determine the partners’ interests in the
partnership because the partnerships lacked written partnership agreements. See,
e.g., Holdner v. Commissioner, T.C. Memo. 2010-175, 100 T.C.M. (CCH) 108, 116–17,
aff’d, 483 F. App’x 383 (9th Cir. 2012); Estate of Ballantyne v. Commissioner, T.C.
Memo. 2002-160, 83 T.C.M. (CCH) 1896, 1904–06, aff’d, 341 F.3d 802 (8th Cir. 2003).
In other cases the partnership agreement lacked the provisions for capital account
maintenance or distributions in liquidation of the partnership under Treasury
Regulation § 1.704-1(b)(2)(ii)(b)(1) and (2), or the allocations prescribed by the
partnership agreement lacked substantial economic effect, and so the Court relied
heavily on the history of the partners’ relative contributions (or the impact of the
partners’ relative contributions on prospective liquidating distributions) to determine
the partners’ interests in the partnership. See, e.g., Estate of Tobias v. Commissioner,
T.C. Memo. 2001-37, 81 T.C.M. (CCH) 1163, 1169–71; PNRC Ltd. P’ship v.
Commissioner, T.C. Memo. 1993-335, 66 T.C.M. (CCH) 265, 268, 270. In this case,
however, the partnership did have a written partnership agreement, and that written
agreement did have provisions of the sort that, in other cases, were lacking and had to
be inferred or hypothesized.
                                          46

[*46] (emphasis added), and that the 2013 LLC Agreement is evidence
of such agreement.

               1.      The partners’           relative   contributions       to    the
                       partnership

       The record is insufficient to chronicle the entire history of the
partners’ contributions to CRC, and so we are unable to conduct a
complete evaluation of their relative contributions. 63        Town PS
purchased its interest in CRC from Clark PLLC for $639,000 in 2009
and contributed $10,000 in 2012, and Newman PLLC contributed
$200,000 in 2012, but we are lacking information regarding Clark
PLLC’s contributions. Although we lack sufficient information to
calculate overall contributions, the economic reality evidenced by the
partners’ relative ownership of membership “units” in CRC is that Clark
PLLC owned the largest percentage and therefore likely made the
largest “contribution” of his business. 64 Consistent with this economic
reality, the Commissioner reckons Clark PLLC’s “Percentage of total
capital accounts” as 69%, but he “provide[s] more weight to the other
factors”. As a proxy for partners’ contributions, he uses partners’
account balances, but this may understate Clark PLLC’s dominance.

       63  The Commissioner proposes that the partners’ capital contributions are
equal to each partner’s 2012 capital account balance, following Newman PLLC’s
capital contribution of $200,000, but he offers no explanation in support of that
suggestion. We cannot understand the Commissioner’s reasoning in suggesting these
balances to represent the parties’ capital contributions and therefore do not accept his
proposal. While capital accounts are generally intended to represent a snapshot of the
partners’ equity in the partnership (adjusted to reflect the operations of the
partnership), Interhotel, 81 T.C.M. (CCH) at 1807, an analysis of the partners’ capital
contributions for the purpose of the partner’s interest in the partnership analysis
involves a comparison of the partners’ historical contributions, see, e.g., PNRC Ltd.
P’ship, 66 T.C.M. (CCH) at 270. By using a snapshot of the partners’ capital account
balances instead of a historical record of the partners’ contributions, the Commissioner
supplants actual contributions by the parties with a value that may reflect
contributions but may also reflect various distributions and other adjustments
throughout the operation of the partnership; therefore, he fails to analyze the correct
criterion for this step of the analysis.
        64 See supra pp. 15–16.       Clark PLLC’s initial contribution consisted of
“[f]ormation costs, contribution of property from predecessor Company, and buy-out of
former Members (including inventory, business assets and equipment, goodwill and all
other tangible and intangible property) and other amounts shown on the books of the
Company”, and Newman PLLC’s and Town PS’s initial capital contributions (beyond
the $200,000 in cash contributed by Newman PLLC) were said to consist of “amounts
as shown on the books of the Company”.
                                         47

[*47]          2.      The interests of the partners in economic profits and
                       losses

       The 2013 LLC Agreement clearly enumerates the criteria for
allocating income to each of the partners, and we follow the 2013 LLC
Agreement to make our analysis. 65

       The 2013 LLC Agreement allocates income according to a three-
step formula. The first step (in Section 8.1(a)) allocates income equal to
10% of the “Tangible Net Worth” reflected in each partner’s capital
account balance to the respective partner. On the basis of the 2013 LLC
Agreement’s definition of “Tangible Net Worth” and the partnership’s
notable exclusion of intangible assets from the partners’ capital
accounts, we understand this first step to allocate an amount of income
to each partner equal to 10% of such partner’s positive capital account
balance. The second step (in Section 8.1(b)) then allocates income to
Clark PLLC for amounts collected on accounts receivable (which the
parties have stipulated was $15,387 in 2013). Third, Section 8.1(c)
allocates the remaining income according to the FMG system, which the
parties have stipulated should be allocated fully to Clark PLLC for 2013.

       The first step in the formula under Section 8.1 allocates a portion
of income to the partners’ capital accounts in accordance with their
positive capital account balances. Therefore, an income allocation
analysis necessarily begins with the capital accounts balances of the
partners, as adjusted for allocations, distributions, and other
adjustments as stipulated by the parties and as we have held in this
Opinion (in some respects different from the Commissioner’s
contentions, as we will discuss). We outline the necessary adjustments
to the capital accounts below.

        65 The 2013 LLC Agreement’s income allocation provisions are not the reason

that the CRC’s special allocation of clients to Newman PLLC and Town PS lacked
substantial economic effect (rather, the reason was CRC’s failure to maintain capital
accounts in accordance with the regulations).
                                   48

[*48] CRC reported (and the Commissioner does not contest) that the
partners had the following beginning capital account balances in 2013:

                   Partner              Capital account balance

                 Clark PLLC                    $1,131,549

                 Newman PLLC                       34,972

                 Town PS                           96,638

       CRC did not allocate the unrealized gain inherent in the client-
based intangible to the partners’ capital accounts before the decrease
corresponding with the distribution. We have held that the client-based
intangible held unrealized gain, and therefore, such gain must be
allocated to the partners’ capital accounts before the distribution of the
client-based intangibles. The 2013 LLC Agreement states that “all
items of Company . . . gain . . . shall be divided among the Members in
the same proportions as they share Net Profits or Net Losses”.
Therefore, the allocation of unrealized gain realized on the hypothetical
sale of the client-based intangibles follows the same tiered formula
governing income allocations, discussed above.

       Following the allocation of unrealized gain, Newman PLLC’s and
Town PS’s capital accounts must be decreased by the value of the client-
based intangibles distributed to them. See Treas. Reg. § 1.704-
1(b)(2)(iv)(b). The partners’ capital accounts must also be decreased by
the distributions of cash to each partner, and Newman PLLC’s capital
account must be decreased by the value of the distribution to it on
account of the WTB Loan.

        Section 8.1 of the 2013 LLC Agreement, “Allocation of Net Profit
or Loss”, allocates income according to the formula above, but “subject
to Section[] 8.3”. Section 8.3 of the 2013 LLC Agreement includes
(among other provisions that are inapplicable here) the QIO provision.
Therefore, all income allocations under Section 8.1 are subject, first, to
the QIO, which requires that, if any partner unexpectedly receives an
adjustment (i.e., following an unexpected distribution) that results in a
deficit capital account balance for that partner, items of income and gain
must be allocated to that partner to rectify the deficit capital account
balance as quickly as possible.
                                           49

[*49] According to our calculations, the various adjustments discussed
above result in deficit capital account balances for both Newman PLLC
and Town PS at the end of 2013. Therefore, under the terms of the 2013
LLC Agreement, the triggered QIO provision allocates income to each of
them in an amount necessary to bring their capital account balances up
to zero. 66

       Therefore, we hold that, for the purposes of this factor of the
partner’s interest in the partnership analysis, the partners agreed to
allocate income from the 2013 taxable year to Newman PLLC and Town
PS in amounts (yet to be precisely determined) sufficient to increase
their capital account balances to zero.

       We note that the Commissioner calculates the partnership’s
allocation of income using a similar method, but he fails to adjust the
partners’ capital accounts by the various adjustments throughout the
year, in particular: (1) the allocation of unrealized gain; (2) the
distributions of client-based intangible assets to Newman PLLC and
Town PS; and (3) the property distribution to Newman PLLC on account
of the outstanding balance of the WTB Loan. 67 He then calculates the

        66 The parties disagree about whether the $200,000 payment made by Newman
PLLC and Town PS (in proportions that the record does not show) incident to the
Settlement Agreement constitutes a “capital contribution” by either of them for federal
tax purposes. However, because of the stipulated value of the client-based intangibles
that we hold to have been distributed, and the corresponding decrease to the partners’
capital accounts as a result, Newman PLLC’s and Town PS’s capital accounts will be
deficit in amounts greater than CRC’s total ordinary income in 2013—whether or not
the $200,000 payment was a “capital contribution” (i.e., whether their respective
capital accounts were increased by some portion of that payment).
        67 In analyzing in his brief the interests of the partners in gains and losses, the

Commissioner excludes the impact of the distribution on account of the WTB Loan
because he takes issue with CRC’s allocations of income in 2012 (i.e., not the year at
issue). In 2012 CRC had allocated a loss of −$3,118 to Newman PLLC, see supra note
37, which Newman PLLC contested in a Form 8082, see supra note 41, reporting
instead an income allocation of $167,872. The Commissioner contends that CRC’s
allocation of a loss to Newman PLLC was improper, and that instead CRC should have
allocated to Newman PLLC income of $167,872. This allocation of income, the
Commissioner contends, if taken into consideration in the calculation of the partners’
capital accounts, would sufficiently offset any decrease in Newman PLLC’s capital
account caused by the property distribution on account of the WTB Loan. He asks us
to “consider facts in the record regarding the 2012 transactions as it relates to the 2013
year at issue”, and effectively to determine the validity of CRC’s 2012 allocations of
income. Even assuming that we would otherwise have jurisdiction to make such a
determination, the issue is not properly before us: The issue is not stated in the FPAA
                                          50

[*50] allocations of income using the formula in the 2013 LLC
Agreement on the basis of the partners’ initial capital account balances
in 2013 but concludes that 100% of income should be allocated to Clark
PLLC because “all the benefit of CRC’s 2013 business operations inured
to Clark PLLC”. While it is true that Clark PLLC received the largest
cash distribution in 2013, the Commissioner omits from his calculation
the impact of the client-based intangible distribution, and he therefore
disregards the implication of the partners’ negative account balances,
the effect of the QIO, and the income properly allocable to Newman
PLLC and Town PS as a result.

                3.      The interests of the partners in cash flow and other
                        non-liquidating distributions

      The 2013 LLC Agreement states that distributions of “[c]ash may
be made to the Members at such time and amounts as determined in the
Managers’ reasonable discretion, provided that such [d]istributions will
be consistent with the allocations of income made pursuant to
Section 8.1”.

       The Commissioner argues that we should look to the cash
distributions actually received by the partners in 2013 (instead of
looking to the 2013 LLC Agreement) to determine the parties’
agreement as to cash and non-liquidating distributions. He cites Estate
of Tobias, 81 T.C.M. (CCH) at 1163, and Interhotel Co., 81 T.C.M. (CCH)
at 1804, to argue that the economic burden (i.e., the tax burden) should
follow the economic benefit received by the partners. He argues that
Clark PLLC’s receipt of the largest portion ($632,201) of total cash
distributions ($660,889) is evidence of the partners’ agreement as to how
they would share the economic benefit of CRC’s income in 2013.

      However, the facts of this case distinguish it substantially from
those of Interhotel and Estate of Tobias. Notably, the partnership

on which this case is founded; the Commissioner did not plead the issue in his answer
(where it would have constituted “new matter” under Rule 142(a)(1); and the parties,
in their jointly submitted motion to submit the case pursuant to Rule 122, agreed that
the remaining legal issues in dispute are limited to the distribution of the client-based
intangibles and the substantial economic effect of CRC’s income allocations in 2013.
See supra note 44. Therefore, we do not address the Commissioner’s contentions
regarding CRC’s 2012 allocations of income.
                                           51

[*51] agreements at issue in Interhotel did not include QIOs68 (or, as far
as we can tell, the requirement that distributions follow allocations of
income), and the partnership in Estate of Tobias lacked a written
partnership agreement entirely. 69 Here, CRC has a partnership
agreement negotiated by the partners at arm’s length, and neither party
presents a reason why we should disregard its provisions. Therefore, on
the basis of the provisions of the 2013 LLC Agreement, we hold that the
partners, for the purpose of this factor of the partner’s-interest-in-the-
partnership analysis, agreed to make cash and other non-liquidating
distributions in amounts equal to the income allocations for the 2013
year.

                4.      The rights of the partners to distributions of capital
                        upon liquidation

       The 2013 LLC Agreement states that, upon liquidation of the
partnership, assets will be distributed “[t]o the Members in repayment
of the positive balances of their respective Capital Accounts, as
determined after taking into account all Capital Account adjustments
for the taxable year during which the liquidation occurs”. Upon a
partner’s voluntary withdrawal (i.e., a liquidation of that partner’s
interest), a partner is entitled to a distribution amount equal to its
capital account balance. 70

      On the basis of our calculations above, Clark PLLC is the only
partner that ends 2013 with a positive capital account balance after
adjustments. Therefore, under the provisions of the 2013 LLC
Agreement, if CRC liquidated at the end of 2013, Clark PLLC would

         “[N]either the [taxpayer’s] Original Agreement nor the [taxpayer’s] Restated
        68

Agreement contain[ed] a provision requiring capital account adjustments for
reasonably expected distributions or a ‘qualified income offset’.” Interhotel, 81 T.C.M.
(CCH) at 1808.
        69 “[The partners] did not enter into a written partnership agreement and . . .
their oral agreement was merely an informal, general agreement to operate an animal
farm and did not contain any specific terms.” Estate of Tobias, 81 T.C.M. (CCH)
at 1169.
         70 We recognize that whether Town PS is entitled to a distribution of its capital

account balance upon voluntary withdrawal under the 2013 LLC Agreement depends
on some combination of factors (including its capital account balance and/or payment
in full of the loan owed to Clark PLLC). See supra pp. 16–17. However, we are unable
to determine from the 2013 LLC Agreement the exact criteria of this limitation or the
outstanding balance on the loan to Clark PLLC from the record. Therefore, we do not
consider this limitation in our analysis.
                                   52

[*52] receive the partnership’s assets in total. Similarly, given Newman
PLLC’s and Town PS’s negative capital account balances, neither
partner was likely entitled to a distribution on account of its capital
account balance. In support of this outcome, the Commissioner argues
that the terms of the parties’ Civil Rule 2A Agreement (wherein
Newman PLLC and Town PS agreed to make further contributions, and
which did not provide that either was entitled to a liquidating
distribution), and the fact that Newman PLLC and Town PS did not
receive distributions equal to their capital account balances upon their
withdrawal, are evidence that Newman PLLC’s and Town PS’s rights
upon liquidation were zero, and that all income should be allocated to
Clark PLLC.

       This outcome generally comports with the observation that we
made in our contribution analysis: that Clark PLLC owned the largest
portion of CRC. Therefore, it makes intuitive sense that, in a liquidation
of CRC, Clark PLLC would receive the largest portion of distributions.
However, given that the allocation at issue is an allocation of annual
income (not in liquidation of the partnership), we believe that the
partners’ agreement as to how to allocate that income, in particular the
provisions regarding the QIO, are the most indicative of how the
partners agreed to share the economic benefits and burdens of the
partnership. We therefore afford this liquidation factor the least weight
in our consideration of the partner’s interest in the partnership.

      D.     “Align[ing]” distribution and income allocation in the
             “book-up”

       The Commissioner has another argument to resist the allocation
of income away from Clark PLLC and toward the other two partners.
He contends:

      Section 9.3 [of the 2013 LLC Agreement], when read in
      conjunction with . . . section 9.1 requires a matching of the
      book-up and the distribution. Because section 9.3(a)
      requires that non-cash distributions reflect how the cash
      proceeds from the sale of such property would have been
      distributed, it follows that the book-up must be allocated to
      the distributee[s] – had the property been sold first, with
      the proceeds distributed to Newman PLLC and Town PS,
      the matching rule of section 9.1 would have required the
      gain from the hypothetical sale to be allocated in a manner
      that is consistent with that cash distribution from a
                                    53

[*53] hypothetical sale. . . . If CRC would have distributed the
      cash proceeds from a hypothetical sale of $419,043 and
      $447,437, to Newman PLLC and Town PS, respectively,
      then it follows that the book-up would have been allocated
      in these same amounts to the distributee partners,
      resulting in a wash to their capital accounts.

       Assuming his premises, the Commissioner is partly right: He is
right that, if the unrealized gain is allocated only to the distributee
partners (Newman PLLC and Town PS) and not to Clark PLLC, then
that gain allocation would increase their capital accounts, and the
immediately subsequent distribution would reduce their capital
accounts, and the net effect would be “a wash”. Their accounts would
not be driven into negative status; the QIO would not be triggered; and
CRC’s 2013 income would not be allocated to those partners.

       But we disagree with the Commissioner’s insistence that a
“matching” is required and that the unrealized gain is allocated solely
to the distributee partners. The 2013 LLC Agreement explicitly says
otherwise.      Section 9.3(a) requires that, before the distribution,
unrealized gain must be allocated among the partners not in accordance
with their being distributees of the gain but rather “in accordance with
Article 8” (i.e., in accordance with their allocations of “Net Profit or Net
Loss for [the] fiscal year of the Company”). The LLC agreement could
hardly be clearer. The allocation of gain, made before any distribution
has occurred, is in accordance with Article 8.

       Less clear is how to reconcile the 2013 LLC Agreement with the
distribution of client-based intangible assets to only two of the partners.
Section 9.3(a) states that “[n]oncash assets . . . shall be distributed in a
manner that reflects how cash proceeds from the sale of such assets for
fair market value would have been distributed”; and Section 9.1 states
that “Distributions of Distributable Cash may be made to the Members
as such time and amounts as determined in the Managers’ reasonable
discretion, provided that such Distributions will be consistent with the
allocations of income made pursuant to Section 8.1”. Section 9.1 thus
does state that the distributions “will be consistent with” the provisions
of Section 8.1 (providing for allocations of net profit or loss); but
Section 9.1 commits the matter to managerial discretion, so opinions
might differ about the propriety of the client distribution under the 2013
LLC Agreement.
                                          54

[*54] However, we are adjudicating a dispute about the tax
consequences of a distribution that was in fact made; we are not
adjudicating a dispute about a partner’s claim that he was wrongly left
out of a distribution. Either dispute is resolved by the Settlement
Agreement, which compromised the parties’ disagreements about the
withdrawal of Newman PLLC and Town PS from CRC and left the
client-based intangibles in the hands of the withdrawing partners. The
Commissioner is certainly right to begin his analysis with the text of
Sections 8.1, 9.1, and 9.3 of the 2013 LLC Agreement, but ending there
without resort to the Settlement Agreement makes the puzzle seem
more difficult than it actually is. We construe the 2013 LLC Agreement
in light of the later Settlement Agreement, which superseded the LLC
agreement.

        We conclude that the unrealized gain is properly allocated among
all three partners (as set out in Section 8.1) so that the capital accounts
of all three are increased, but we conclude that because the agreed-upon
distribution was made only to the withdrawing partners, only their
capital accounts are reduced. Consequently, the withdrawing partners’
capital accounts did go negative, the QIO was triggered, and considering
our analysis of the partners’ interests in the partnership (and weighing
most heavily the partners’ agreement regarding their interests in
economic profits and losses), CRC’s 2013 income should be allocated to
the withdrawing partners’ accounts to bring them up to zero. 71

       We will order the parties to submit computations under Rule 155
to determine the exact amount of Newman PLLC’s and Town PS’s
capital account balance deficiencies (after applicable adjustments to
their capital accounts) and the amounts of income allocable to the
partners’ capital accounts as a result. Those computations should
account for the following capital account adjustments, beginning with

         71 The Commissioner contends that all of CRC’s ordinary income for the period

of January 2013 to April 2013 is properly allocable to Clark PLLC under Section 8.1(c),
which allocates all income remaining after the allocations of Section 8.1(a) and (b)
according to the FMG system. The parties have stipulated that $15,387 of income is
allocable to Clark PLLC under Section 8.1(b) (for amounts collected on accounts
receivable) and that all remaining income is allocable to Clark PLLC under Section
8.1(c), but our analysis does not reach Section 8.1(a)–(c) of the 2013 LLC Agreement,
and therefore the parties’ stipulations regarding these allocations of income are not
helpful in this regard. Instead, the introductory text of Section 8.1 subjects the
partnership’s income allocations to Section 8.3 (regarding special allocations), and
therefore, due to the deficit capital account balances of Newman PLLC and Town PS,
the QIO provision under Section 8.3 controls the allocation of CRC’s entire amount of
income for 2013.
                                   55

[*55] the partners’ reported opening capital account balances in 2013,
see supra p. 24: (1) the allocation of $742,569 of unrealized gain (in the
client-based intangible assets) according to Section 8.1 of the 2013 LLC
Agreement; (2) the distribution of client-based intangible assets of
$318,144 to Newman PLLC and $424,425 to Town PS; (3) the
distribution on account of the WTB Loan of $183,737, see supra note 3;
and (4) the cash distributions to the partners in the amounts stipulated
by the parties, see supra note 3. By our preliminary calculations, the
amount of CRC’s income in 2013 is insufficient to bring both Newman
PLLC’s and Town PS’s capital accounts up to zero. Therefore, the
income must be allocated between them in some proportion. In the
absence of contentions by the parties as to how to divide the total
amount of ordinary income, we hold that CRC’s income should be
allocated to each partner’s deficit capital account in an amount equal to
that partner’s pro rata “share” of the total negative balances of those
accounts, calculated by dividing the deficit balance of each partner’s
capital account by the combined deficits of both partners’ capital
accounts and then multiplying the resulting ratio for each partner by
the total amount of ordinary income to be allocated.

III.   Conclusion

       CRC’s special allocation of income of $307,759 to Newman PLLC
and $255,799 to Town PS in 2013 did lack substantial economic effect
(as the FPAA determined) because the partnership failed to maintain
capital accounts in accordance with the requirement of Treasury
Regulation section 1.704-1(b)(2)(iv) that CRC must allocate the
unrealized gain inherent in the client-based intangibles across the
partners’ capital accounts before decreasing Newman PLLC’s and Town
PS’s capital accounts by the value of the distribution. However, an
analysis of the partners’ interests in the partnership reveals that
although Clark PLLC was the largest percentage owner of CRC’s
“membership units”, the partners agreed to income allocations in their
partnership agreement (including a QIO) that are most indicative of how
they agreed to share the economic benefits and burdens of the
partnership, particularly in light of the unanticipated distribution of
client-based intangibles to Newman PLLC and Town PS.

      Therefore, the IRS’s determinations in the FPAA disregarding
CRC’s “client distributions” and reallocating CRC’s allocations of
ordinary income in the 2013 taxable year are hereby rejected and shall
                                  56

[*56] be redetermined in accordance with this Opinion. To give effect to
the foregoing and the parties’ concessions,

      Decision will be entered under Rule 155.