It is not uncommon for a partner to engage in a business transaction with a partnership of which he is a member. If the partner engages in a transaction with his partnership other than in his capacity as a partner, he will be treated as if he were not a member of the partnership with respect to such transaction. Examples of such transactions include loans of money by the partner to the partnership, the sale of property by the partner to the partnership, the purchase of property by the partner from the partnership, and the rendering of services by the partner to the partnership.
Although not as common, it is sometimes the case that the “partner” with whom the partnership has engaged in a transaction is not a bona fide partner for tax purposes. For example, although a person may be member of a partnership as a matter of local law, the “member” does not have an interest in the capital, profits or losses of the partnership, and has very limited, if any, management rights with respect to the business of the partnership. Indeed, the only reason the person is a member may be to secure some benefit for the partnership under local law, or to satisfy some requirement under local law (as in the case of some foreign jurisdictions that require the presence of a resident in an entity otherwise controlled by a foreign investor).
A recent decision of the Federal Claims Court managed to implicate both of these scenarios.
Taxpayer was a U.S. citizen. She worked for US-Employer, an investment firm based in London, as a senior analyst in its New York office. Taxpayer’s role was to analyze investment opportunities for the US-Employer. She worked for US-Employer on an at-will basis, and received a base salary and a bonus. Taxpayer’s bonus compensation was determined under a formula that was tied to the performance of certain funds.
Although US-Employer’s senior managers who received formulaic bonuses were employees, the company considered those employees to be “partners” in the company, in that they participated in the profitability of the firm according to a specific formula.
However, because US-Employer was a corporation, not a partnership, the participating individuals who received formulaic bonuses, including Taxpayer, were “partners” in name only. Taxpayer’s income from US-Employer, including her bonus, was reported to the IRS on a Form W–2, reflecting her status as an employee of US-Employer.
In January 2008, Taxpayer transferred to US-Employer’s European affiliate, UK-Co., and moved to London. Taxpayer’s job responsibilities and compensation did not change upon transferring to UK-Employer.
Taxpayer became a “member” of UK-Co. in January 2008 by signing a “joinder agreement” and making a capital contribution. By signing the agreement, Taxpayer agreed to “observe and perform the terms and conditions of the [UK-Co.] partnership agreement. The agreement identified US-Employer as the “Corporate Member” of UK-Co., listed certain individuals as members of UK-Co., and identified Taxpayer as a “Further Member.” The agreement did not provide Taxpayer with voting rights in the UK-Co. partnership.
UK-Co. was created under English law. The partnership agreement identified US-Employer and one of the listed individuals as “Designated Members” of UK-Co. and the other listed individual as a “Member.” The agreement designated 82% of the voting rights in UK-Co. to US-Employer and the remaining voting rights to the two listed individuals.
UK-Co. members, other than US-Employer, were required “to devote [their] whole time and attention to [UK-Co.]” and could not engage in other business ventures without the consent of US-Employer. With regard to the allocation of partnership profits and losses, the agreement provided that US-Employer would determine the allocation of UK-Co. profits and losses among the partners at the end of UK-Co.’s fiscal year. UK-Co. never generated its own profits, however, because it “ha[d] no funds to invest. It only ha[d] the money sent over from [US-Employer] to pay its costs and … formulaic bonuses and the staff salaries . . . [UK-Co.] ha[d] no [other] funds.”
Taxpayer did not expect to be asked to make a capital contribution or sign the joinder agreement, but she was told upon arriving in the U.K. that both were required as a condition of her employment at UK-Co. She did not see the partnership agreement before signing the joinder agreement, and she did not receive a copy of it until 2011.
During her time working at UK-Co. Taxpayer remained an at-will employee. She performed the same duties and received the same compensation as she had as an employee at US-Employer. Taxpayer understood that she had to become a member of UK-Co. so that UK-Co. could avoid certain U.K. employment tax obligations.
On December 31, 2008, UK-Co. directed that a formula-based bonus (the “Payment”) be made to Taxpayer. US-Employer wired the necessary funds to UK-Co. for the Payment, and UK-Co. in turn directed that money to Taxpayer’s bank. Taxpayer’s bank received the payment in January 2009, and it was credited to Taxpayer’s account.
The formula used to determine the Payment was the same formula used to calculate Taxpayer’s bonus when she was still employed by US-Employer.
Taxpayer’s 2008 and 2009 Tax Returns
Prior to preparing her 2008 U.S. tax return, Taxpayer requested a tax-reporting statement from UK-Co. for the 2008 tax year, but to no avail. Consequently, Taxpayer reported the salary she received from UK-Co. in 2008 on her original 2008 U.S. tax return, but did not report thereon the Payment that she received in January 2009.
On her 2008 U.K. tax return, Taxpayer reported as her “share of the partnership’s profit or loss” from UK-Co. an amount equal to her salary for those months. Taxpayer paid taxes to the U.K. in 2008, and reported a foreign tax credit on her original 2008 U.S. tax return.
The amount reported on Taxpayer’s 2009 U.K. tax return as her “share of the partnership’s profit or loss” from UK-Co. included the Payment she received in 2009. She had a U.K. tax liability for 2009, and reported a foreign tax credit on her 2009 U.S. tax return.
UK-Co.’s 2008 Tax Return
On its 2008 partnership tax return, UK-Co. included an “Analysis of Partners Capital Accounts” which reflected an entry for “Partner 4” that appeared to include the Payment to Taxpayer. Nonetheless, a Schedule K-1 identifying Taxpayer and setting forth the partnership distributions she received for 2008 was not filed with UK-Co.’s 2008 tax return. The only Schedule K-1 included with the return was for US-Employer.
The IRS Audit
The IRS audited both Taxpayer and UK-Co. for the 2008 tax year.
The IRS requested clarification of Taxpayer’s role at UK-Co. In response, Taxpayer explained that she joined UK-Co. as a limited partner in 2008 and that she spent all of her working time “on duties in relation to the [US-Employer’s] Europe partnership.”
In 2011, Taxpayer received for the first time a 2008 Schedule K-1 from UK-Co. This Schedule K-1 showed that Taxpayer received the Payment in 2008.
Consequently, the IRS treated the Payment as a distribution of Taxpayer’s share of UK-Co.’s profit for 2008; therefore, the IRS asserted that the Payment had to be included by the Taxpayer as ordinary income for her 2008 tax year; i.e., the year with or within which the taxable year of the partnership ended.
In 2012, the IRS issued Taxpayer a Notice of Tax Due showing tax and interest owing.
Refund Claim and Appeal
Taxpayer paid the IRS the tax and interest, but Taxpayer also filed a claim for refund with the IRS.
As her primary ground for relief, Taxpayer alleged that the Payment was made to her in a non-partner capacity, and should be taxed in the year she received it, 2009, rather than in 2008 as reflected on the late-produced Schedule K-1.
The IRS denied Taxpayer’s’ refund claim on the grounds that the Payment was made to her as a partner, rather than as a payment for services rendered by her outside her capacity as a partner.
Taxpayer filed suit in the Court of Federal Claims in 2014, alleging that she was entitled to a refund of the amount paid to the IRS to satisfy the notice of tax due, plus interest. Taxpayer asserted that the Payment was not a partnership distribution but a bonus paid to her in her capacity other than as a partner, and therefore she – as a cash-basis taxpayer – did not need to report the payment until she received it in 2009.
The Court examined Taxpayer’s assertion that the Payment should be taxable in the 2009, when she received the payment, because it was not a partnership distribution. In support of this contention, Taxpayer argued that she was either not a bona fide partner in UK-Co. for U.S. tax purposes, or that, if she was a partner, the Payment was for services performed outside her capacity as a partner. (For purposes of its analysis, the Court assumed, but did not decide, that Taxpayer was a member in UK-Employer in order to analyze the nature of the payment.)
The Code provides that, if a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall generally be considered as occurring between the partnership and one who is not a partner.
If a partner (i) performs services for a partnership, (ii) there is a related direct or indirect allocation and distribution to such partner, and (iii) the performance of such services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership, then (iv) such allocation and distribution shall be treated as a transaction between the partnership and one who is not a partner.
Where partners perform services for a partnership outside their role as a member of the partnership and receive a commensurate payment from the partnership for those services, the payment is not classifiable as a partnership distribution. The payment is, instead, treated as a payment to a non-partner in determining the partnership’s taxable income or loss and the partner’s share thereof.
Not a Partner
The Court determined that the Payment to Taxpayer was appropriately categorized as a payment for services outside her capacity as a partner, and not as a partnership distribution. The Court also noted that the services performed by Taxpayer when she worked at UK-Co. did not change when she transferred from US-Employer in New York to UK-Co. in London and became a member of UK-Co. She continued to analyze investment opportunities for the funds managed by US-Employer. None of these funds were owned by UK-Co. or based in London; rather, Taxpayer’s job duties at UK-Co. continued to center around US-Employer’s business in New York, with UK-Co. acting as a “legal … conduit” for US-Employer and its employees to do business in Europe. Taxpayer only relocated to London to have easier access to European investment opportunities for the funds, and became a “member” of UK-Co. so that UK-Co. could avoid certain U.K. tax obligations.
The fact that she became a partner primarily to obtain tax benefits for the partnership which would not have been available if she had rendered the services to the partnership in a third party capacity was relevant to determining whether the Payment was a partnership distribution.
In her work at UK-Co., Taxpayer did not perform any services on behalf of the partnership itself, but rather the partnership served as a European conduit for Taxpayer to perform the same services she performed as an employee of US-Employer.
Additionally, the circumstances surrounding the issuance and receipt of the Payment indicated that it was not a partnership distribution. Taxpayer’s compensation arrangement, which remained the same when she transferred from US-Employer to UK-Co. was not tied to the success of UK-Co. in any way. Rather, Taxpayer’s formulaic bonus was tied to the yearly performance of the funds that were based at US-Employer in New York; indeed, no funds of any kind were directly tied to or controlled by UK-Co. Taxpayer’s bonus was dependent on the success of the funds, but it was not linked to any profit or risk of UK-Co., which did not generate profits on its own, but rather was merely a conduit for US-Employer to pay its European expenses and personnel. In fact, at the time the Payment was issued, UK-Co. did not have any funds on hand to be subjected to the risks of the partnership. The Payment was entirely under the control, and subject to the risks, of US-Employer, and not UK-Co., thus indicating that the Payment was not a distribution of partnership profits.
The fact that the Payment was disproportionate to Taxpayer’s actual ownership share of the partnership, further supported the conclusion that it was not a partnership distribution, but rather a payment for services performed outside her capacity as a member of UK-Co.
Thus, the Court concluded, the Payment was made to Taxpayer for services performed outside her capacity as a member of the UK-Co. partnership, the payment was taxable to Taxpayer by the U.S. in the year she received it (2009), and she was entitled to a full refund of the tax paid on the Payment for the 2008.
In most cases, it should not be too difficult to determine the capacity in which a partner is dealing with his partnership.
In others, it will be important for the partnership and its partners to clearly establish their intentions at the outset of the transaction though, even then, the IRS will not be bound thereby.
For example, was a transfer of money to the partnership made as a loan or as a capital contribution? The absence of documentation and the presence of inconsistent reporting can only lead to trouble down the road, perhaps because the partnership is in financial straits.
As always, a partner and the partnership will be in a better position to secure the desired tax and economic consequences if (i) they discuss these consequences among themselves and their advisers before engaging in the transaction being contemplated, (ii) they document the transaction accordingly, and, (iii) if necessary, they research and compile the appropriate legal authority to support their position.