By Mark Leeds and Guoyu Tao 1
It's not always apparent when a person cast as a partner should be treated as a disguised service provider or employee. This issue is squarely presented in the private fund area when drafting partnership carried interest provisions and implementing management fee waivers.2 In each of these cases, if the ostensible partnership interest is disguised compensation, the "partner" will have ordinary income instead of an allocable share of the partnership's capital gains and other items. In addition, if an allocation or distribution is disguised compensation, the partnership could be liable for failure to withhold federal income taxes.3
About 70 years ago, the US Supreme Court provided initial guidance on distinguishing compensation arrangements from partnerships for federal income tax purposes.4 Broadly speaking, the Supreme Court defined a partnership as the sharing of income and gains from conduct of a business between two or more venturers. This rule has been loosely codified in Section 761 of the Internal Revenue Code of 1986, as amended (the "Code").While the standard appears simple enough, the question as to when a person is receiving a share of partnership income or compensation continues to be a vexing issue.5 In July 2018, the Tax Court, in White v. Commissioner,6 again took up this issue in the context of the conduct of a real estate mortgage business. This Legal Update examines the court's analysis and the implications of the decision on tax planning for private funds and joint ventures.
The Facts Relevant to Whether the Business Was Conducted as a Partnership
After Marc White ("Marc") retired from a managerial position in an automobile business in late 2010, he was approached by his ex-wife, April Van Patten ("April"), about starting a new business in real estate and mortgage lending. April held a real estate broker license in California and a national mortgage lending originator license. Her current spouse, Kevin Van Patten ("Kevin"), also had experience in the real estate business. Although Marc did not have expertise in real estate, he drew down his retirement savings to provide capital for the new business. Marc's then-wife, Kelly White ("Kelly"), also held a real estate license and a salesperson license.
The couples created a new mortgage business, with Marc providing the initial business capital and overseeing office operations, Kelly overseeing the real estate agents and assisting with the agents' work, Kevin managing the marketing of the business and supervising loan structuring and processing and April serving as the broker of record. Although only Marc made a capital contribution at the beginning of the business, other members contributed professional services with their respective expertise during the conduct of the business. Thus, the recitation of the facts supported the conclusion that each of the parties had contributed services to the venture and was an active participant in the mortgage business.
The business maintained multiple banking accounts and used various names on the banks' records.7 Marc was authorized to use the funds in all of the accounts, while the Van Pattens were not designated as signatory for any of the accounts. Marc was designated as the sole proprietor of the business on at least one set of bank accounts. They retained a bookkeeper to manage the business records if and when the business was profitable. No other professional personnel were employed to assist with the accounting and tax matters of the business.
The parties asserted that they had agreed to split the profits of the business equally. Cash distributions to the parties, however, were haphazard and not recorded. Certain distributions to the Van Pattens were designated as commission payments. The financial accounts of the business were managed quite informally. The Whites commingled their private expenses and private savings with the assets of the business; profits were distributed to the Van Pattens through payments of their expenses on their behalf. In addition, the records that the parties provided were inconsistent with the documented payments. As the Van Pattens did not contribute capital to the business, all losses were borne by Marc.
The business was never profitable. At the end of 2012, the couples dissolved the venture, and the Van Pattens agreed to purchase the Whites' interest in the business.
The tax reporting for the venture was not consistent with there being a partnership between the two couples. The business issued Forms 1099-MISC to April for distributions of cash made to the Van Pattens (or expenses paid on their behalf). The parties did not file a partnership return. Each set of couples reported certain items incurred in connection with the business on Schedule C of their individual income tax returns.
In addition, the Internal Revenue Service ("IRS") asserted that Marc and Kelly had underreported the income from the business. This underreporting gave rise to the Tax Court litigation. The Whites defended against the assertion of federal income tax due by claiming, inter alia, that they were taxable only on their distributive share of the unreported income. Hence, the issue was joined as to whether the parties had entered into a partnership or whether the business was a sole proprietorship owned by Marc.
1 Mark Leeds (firstname.lastname@example.org; +1 212 506 2499) is a tax partner in the New York office of Mayer Brown. Guoyu Tao is a law clerk in the New York office of Mayer Brown. The authors thank Matthew McDonald of the Chicago office of Mayer Brown for his helpful comments and suggestions. The views expressed herein, however, are solely those of the authors and should not be attributed to Mayer Brown or any other person.
2 In July 2015, the Treasury and the Internal Revenue Service issued proposed regulations that address whether arrangements in which the private equity fund managers receive an interest in the managed partnership's future profits in exchange for waiving part or all of their management fees (generally a fixed payment for services provided to the partnership) constitute disguised compensation.
3 See Section 7501 of the Internal Revenue Code of 1986, as amended.
4 See Culbertson v. Comm'r, 69 S. Ct. 1210 (1949).
5 For prior coverage of this issue, see Leeds and Davis, Historic Boardwalk Hall v. Commissioner: IRS Dissolves a Partnership Between Pitney Bowes and the NJSEA, reprinted at https://www.martindale.com/litigation-law/article_Greenberg-Traurig-LLP_1611398.htm. It is also worth noting that the IRS has stated it is actively auditing management fee waiver transactions. See Shreve, IRS Looking for Management Fee Waiver Problems in Audits (BNA Tax Management Report (March 13, 2017)); Davison, Carried Interest Crackdown Stalls After Tax Law Changes (BNA Financial Planning Journal (May 15, 2018)) ("The IRS is pursuing aggressive fee waiver arrangements through audits.").
6 T.C. Memo. 2018-102 (July 2018).
7 In its accounts with the Bank of America, the business was listed in the bank's record as a corporation titled "Mortgage Lending Services of California." In its accounts with American River Bank, the business was listed as a sole proprietorship owned by Mr. White under the names of "Mr. White DBA Mortgage Lending Services of CA," "Mr. White DBA Homebuyers Resource Center" and " Mr. White DBA Mortgage Lending Services – Trust Account."
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