Hail the Partnership! Don’t Abuse It.
Of all forms of business enterprise, the partnership (or an LLC treated as a partnership for tax purposes) is most often cited by tax practitioners as the most attractive vehicle for operating a business. Indeed, partnerships permit taxpayers to conduct joint business (including investment) activities through a very flexible economic arrangement without incurring an entity-level tax.
Implicit in the Code’s partnership rules are the requirements that (i) the partnership must be bona fide and each partnership transaction must be entered into for a substantial business purpose, (ii) the form of each partnership transaction must be respected under substance over form principles, and (iii) the tax consequences to each partner of partnership operations and of transactions between the partner and the partnership must accurately reflect the partners’ economic agreement and clearly reflect the partners’ income.
However, the flexibility of this vehicle also enables its misuse for improper tax avoidance purposes. Where a partnership is formed or availed of in connection with a transaction, a principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner that is inconsistent with the intent of the Code’s partnership rules, the IRS may ignore the partnership, or recast the transaction for federal tax purposes.
A recent decision illustrates the IRS’s authority.
Company, which was owned by two shareholders, the Principals, was engaged in the environmental remediation business.
In order to protect themselves from certain personal liabilities that may arise from the operation of the business, the Principals restructured Company so that several other corporate entities stood between them and Company.
Specifically, the Principals each formed holding corporations (“Holding Corps”) as “S” corporations, and they each entered into an employment agreement with their respective Holding Corp, pursuant to which they agreed to render “construction management, indemnity, and financing services” exclusively for the Holding Corp.
Each Holding Corp then adopted an employee stock ownership plan (“ESOP). Each ESOP then purchased all the shares of its respective employer- Holding Corp.
The two Holding Corps (each now owned entirely by its respective ESOP) entered into a general partnership (“Partnership”), to which they agreed to provide (through their respective employees) “construction management, indemnity, and financing services.”
The Principals also formed a third holding corporation, Corp, and transferred their shares in Company to Corp.
Finally, the Partnership purchased all of the shares of Corp.
As a result, Company was owned by Corp, which was owned by the Partnership, which in turn was owned by the Principals’ two Holding Corps, which were owned by ESOPs. This elaborate corporate structure provided the Principals with multiple levels of protection from personal liability, and more . . . .
The “Joint Venture”
An opportunity arose to do environmental remediation work for a large redevelopment project (“Project”). To win the contract, however, Company would have to post a large bond. To ensure that Company could afford the bond, the Principals caused Company and the Partnership to form a joint venture (“Joint Venture”). Interestingly, Company and the Partnership executed the joint venture agreement one week after the Partnership was formed and just over a month before Company won a subcontract for the Project.
Under the terms of the joint venture agreement, Company would do the environmental remediation work, and the Partnership would supply financial guaranties. In exchange for these services, Company would receive thirty percent of the Joint Venture’s profits, and the Partnership would receive seventy percent.
The Tax Court
The Tax Court found that the Principals performed the same roles for Company after forming the Partnership as they did before.
The joint venture agreement provided that the Joint Venture would reimburse Company for costs incurred in the remediation work, plus five percent. The agreement obligated the Joint Venture to keep books and records and to file income tax returns. It contemplated that the general contractor on the Project would award the subcontract to Company, not to the Joint Venture, and make payments directly to Company.
The Joint Venture obtained an employer identification number and its own bank account. It also tracked its own financing and prepared its own progress reports.
As the joint venture agreement contemplated, Company received payment from the general contractor directly, not through the Joint Venture. However, Company then paid the Partnership an amount that represented only 50.4% of the profits, not the 70% contemplated by the joint venture agreement.
Moreover, and notwithstanding the terms of the agreement, the Joint Venture’s accountant opted not to file a tax return for the Joint Venture. Instead, the accountant believed that separately reporting Company’s and the Partnership’s income from the Project was sufficient.
The Tax Court found that the Joint Venture’s structure had significant federal income tax consequences. A joint venture is considered a “partnership” for tax purposes. Accordingly, the Joint Venture would pay no tax on its income, but pass that income on to its members, Company and the Partnership.
Company, a “C” corporation, would have to pay corporate income tax on its thirty-percent share of the venture’s profits. As a general partnership, the Partnership would pay no income tax on its seventy-percent share; instead, that income would pass through to its owners, the two Holding Corps.
The Holding Corps (which owned the Partnership) were S corporations, whose income would pass through to the their respective shareholders. Because all of the Holding Corps’ shares were owned by tax-exempt retirement savings plans (the ESOPs), the Partnership’s seventy percent share of the Joint Venture’s profits would only be subject to federal income tax if and when the ESOPs distributed benefits to their participants (including the Principals).
In short, only thirty percent of the Joint Venture’s income would be subject to tax on a current basis. (Hmm.)
On the basis of the foregoing, the Tax Court held that the Joint Venture was not a valid partnership for tax purposes and, therefore, that all of the Joint Venture’s profits were taxable income to Company.
The Court of Appeals
For tax purposes, a “partnership” is defined as “a syndicate, group, pool, joint venture, or other unincorporated organization” that carries on “any business, financial operation, or venture” and that is not “a corporation or a trust or estate.”
To determine whether a purported joint venture is a valid partnership, courts ascertain whether “the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.”
Over the years, the courts have distilled eight factors to consider in measuring the parties’ intent:
(1) the agreement of the parties and their conduct in executing its terms;
(2) the contributions, if any, which each party has made to the venture;
(3) the parties’ control over income and capital and the right of each to make withdrawals;
(4) whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income;
(5) whether business was conducted in the joint names of the parties;
(6) whether the parties filed federal partnership returns or otherwise represented to persons with whom they dealt that they were joint venturers;
(7) whether separate books of account were maintained for the venture; and
(8) whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.
The court noted that the parties disregarded the terms of the joint venture agreement both by arbitrarily reducing the Partnership’s share of profits and by failing to file a tax return. These deviations from the agreement suggested that the Company and the Partnership did not intend in good faith to act as partners, and did not exercise mutual control over the enterprise.
The court also found that the Partnership contributed nothing of value to the Joint Venture because the performance bond was issued based not on the Partnership’s financial guaranties, but on the collective net worth of Company, the Partnership, the Principals, and the Holding Corps as related entities. The marginal value of the Partnership’s guaranty suggested that the Partnership did not make a meaningful contribution to the Joint Venture, and that the partnership and Company did not act as bona fide partners.
The venture’s imposition of a profit cap on the Partnership demonstrated that the Partnership exercised no control over income and capital, further suggesting that the Partnership did not act as a bona fide partner.
The joint venture agreement’s provision guaranteeing reimbursement of Company’s costs showed that Company and the Partnership did not intend to share profits and losses as bona fide partners would.
On the basis of the foregoing, the Court concluded that the Joint Venture was not a valid partnership for tax purposes.
Don’t Let the Tax Tail Wag Uncontrollably
As we have seen in many prior posts, it is imperative that a business transaction or structure have a bona fide and substantial business purpose, and that analyses of its form and of its substance lead to the same result.
The golden rule is to first determine what is required from a business perspective, to determine what alternative structures or combinations thereof can attain the desired business result, and then to see which of these either is the most tax efficient or can be modified, without unduly impairing the business result, to achieve tax economies.