No Actual Tax Partnership Existed, All Income Taxable to Entity That Per Agreement Was to Receive 30% of Income

In the case of DJB Holding Corporation v. Commissioner, 116 AFTR 2d ¶ 2015-5313, CA9, the Ninth Circuit Court of Appeals upheld a Tax Court decision that since no partnership existed, the entire income that had been reported on the partnership return should instead be reported on the return of the claimed 30% partner of the operation, a C corporation.

Below is a diagram of the ownership structure of the various entities involved in this case.

The operating entity in this structure was WCI, Inc, the corporation at the bottom of the diagram.  It was owned by a partnership (WB Partners) that was in turn owned equally by two S corporations, each of which had a single ESOP shareholder and a single employee.  These employees had originally owned the business that became WCI, Inc., had sold it to a third party and then had later reacquired it using the structure shown.

WCI obtained a large job (the NTC project) that it was going to undertake.  Rather than have WCI handle the job entirely, they formed the NTC Joint Venture which was a partnership of WCI and its 100% owner, WB Partners.

Under the terms of the partnership agreement WB Partners would receive 70% of the profits while WCI would receive the remaining 30%.  Since the income from WB Partners would flow to its S corporation partners, then out to the ESOPs, the structure had the effect of deferring tax on 70% of the profits—if the agreement had actually been followed.

The IRS attacked the arrangement claiming that, in fact, there was no partnership between WB Partners and WCI.  Rather, the IRS claimed, this was completely a WCI operation and the entire profits should be taxed to WCI.

The Tax Court found for the IRS on this issue (see WB Acquisition Inc. & Subsidiary v. Commissioner, T.C. Memo. 2011-36) and the taxpayers filed an appeal with the Ninth Circuit.

The Ninth Circuit noted that the Tax Court had analyzed the issue of whether a partnership actually existed by looking at eight factors.  As the Tax Court had noted in its opinion:

[(1)] [t]he 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 coproprietor, 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 respondent or 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.

Luna v. Comm'r, 42 T.C. 1067, 1077-78 (1964)

The key question involved the second factor, as the Tax Court found that WB Partners had contributed nothing of value to the venture.  The taxpayers argued that, in fact, WB Partners had guaranteed the bond on the NTC job and that WCI would not have gotten the job without it.

However, the Ninth Circuit panel found a number of flaws in this argument.  While WB Partners had guaranteed the debt, the Ninth Circuit noted that the two employees who effectively controlled the entire operation had also personally guaranteed the operation although, interesting, they were not paid for their contribution to the operation.

The Court also found it hard to believe that the guarantee of WB Partners, whose only asset was the interest in WCI, actually provided any real “value” in obtaining the bond.  Rather the personal guarantees of the employees were far more important—and, per their employment agreements with their respective S corporations, they were bound to offer such guarantees on behalf of WCI.

As the Court noted:

Had the joint venture never existed, WB Partners would still be obligated to offer Barone's and Watkins's guaranties because both men promised to provide financial services as necessary to support WB Partners' business. As WB Partners' wholly owned subsidiary, WCI would have been entitled to Barone's and Watkins's guaranties even if WB Partners did not promise to provide those guaranties to the joint venture.

In September of 2000, in their employment agreements with the holding corporations DJB and GSW, Barone and Watkins promised to provide guaranties to enable the corporations' clients to post performance bonds. Later that month, DJB and GSW amended WB Partners' general partnership agreement to offer Barone's and Watkins's services as "necessary to manage and conduct the business of [WB Partners]." The amendment offered Barone's and Watkins's services not only to WB Partners itself, but also to any "third parties in connection with" WB Partners' business.

As well, the testimony of an employee of the organization involved with the bond also strongly suggested there was no value in WB’s “contribution” to the entity:

An employee of AIG, one of the companies that executed an indemnity agreement with the NTC Joint Venture, remarked that the performance bond issued because WCI, Barone, and Watkins were "financially sound indemnitors." The employee recalled that WCI's financial condition was "very good" and that Barone and Watkins both had a "pretty high" net worth. He did not remember WB Partners' financial condition (or that of DJB and GSW) at all. Moreover, at the time WB Partners provided its guaranty, it had no other assets outside its equity in the NTC Joint Venture and WB Acquisition. This evidence supports the Tax Court's conclusion that WB Partners' guaranty contributed no additional value to the NTC Joint Venture.

WB Partners also didn’t really act like an independent partner would.  Although entitled to 70% of the profits per the agreement, in reality the entity only received 50.4%.  As the opinion notes:

According to the joint venture agreement, WB Partners was to receive seventy percent of the profits for this service. Instead, as reflected in an invoice, WCI unilaterally reduced WB Partners' share to 50.4%. It is questionable that a company dealing with WCI at arms' length would give up a nearly twenty-percent share of the profits -- approximately $1.6 million -- so casually. This disregard for the joint venture agreement's terms demonstrates that WCI and WB Partners did not intend in good faith to be bound by that agreement.

Thus the panel agreed with the Ninth Circuit’s finding that there was no tax partnership between WB Partners and WCI, and that all income of the operation was income of WCI.