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JOINT VENTURE DISREGARDED FOR TAX PURPOSES AS BEING MERELY A VEHICLE TO DIVERT INCOME

02 / 10 / 2011

In this Tax Court memorandum decision, Judge Haines held that a designed joint venture structure, supported by a written joint venture agreement, would nevertheless be disregarded for Federal income tax purposes.  The joint venture consisted of a newly formed partnership (WB Partners), comprised of the two corporate principals, owned 100% by two ESOPs set up for the benefit of the two individual principals, and a corporation, Watkins Contracting, Inc. (WCI) that had been reacquired by a corporation (WB Acquisitions, Inc.), which was wholly owned by the newly formed partnership, WB Partners.  The joint venture agreement set forth a desired allocation of profits, 30% to WCI and 70% to WB Partners.  While the joint venture agreement required the joint venture to maintain books and records and to file income tax returns, the joint venture did not do so.  Also, a previous subcontract agreement was not amended to replace the prior service provider (WCI) with the joint venture.  Also, the proper contracting licenses to perform the work required for the project were held by WCI, and not the joint venture.  Court, at 15.
 
While the joint venture did apply for and obtain its own employer identification number, and this number was used to open up a joint venture bank account, and the joint venture prepared its own income statements, work in progress schedules, and other financials, the Tax Court noted that income is to be taxed to the person who earns it, citing to United States v. Basye, 410 U.S., 441, 450 (1973), Lucas v. Earl, 281 U.S. 111, 115 (1930), Commisioner v. Banks, 543 U.S. 426 (2005).  Also, whether or not an entity is a partnership for tax purposes is a matter of Federal, not state, law, relying on Commissioner v. Tower, 327 U.S. 280, 287-88 (1946), Luna v. Commissioner, 42 T.C. 1067, 1077 (1964), among other authorities, aimed at determining if the parties "really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses or both."  Commissioner v. Tower, at 287.  Court, at 23. 
 
The Tax Court then went on to apply the Luna factors as relevant in evaluating whether the parties intended to create a partnership for Federal income tax purposes (the Luna factors), with none of the Luna factors conclusive.  Court, at 24-25.  Finding that the purported partners failed to comply with the express terms of the NTC joint venture agreement with respect to allocation of profits and tax return filling requirements, and this being a significant deviation, the first factor weighed against a finding of a valid joint venture.  Court, at 27.  Finding that exclusivity clauses in employment agreements did not prevent the individuals from providing allegedly restricted services in their capacity as officers of WCI, the partners purported contribution of services of these individuals was not necessary to conduct the project.  In attempting to justify the allocation of such a significant portion of the joint venture profits, the parties pointed to the financial guaranties of many of the parties.  Thus, the contributions or purported contributions of WB Partners to the joint venture were held to be of little value to the joint venture, and thus, this factor weighed agaisnt a valid joint venture.  Court, at 33-34.  The Tax Court went on to reject a two-hat theory, whereby the principals claimed to represent the independent and often competing interests of one of the venturers, WB partners, while wearing the other hat, acting in the best interests of WCI.  In attempting to validate some kind of profit cap, the Court found that this was not indicative of an arm's-length agreement, and thus, this weighed against a finding of a valid joint venture for tax purposes.  Court, at 35.  In finding other factors neutral, and yet, the partners failing to exercise mutual control, and no business purpose, five of the 8 Luna factors weighing against a valid joint venture for tax purposes, the Court went on to discuss the overall intent approach from Commissioner v. Culbertson, 337 U.S. 733 (1949), noting that WCI conducted all of the business and WB Partners failing to contribute anything of substance.
 
Notably, the taxpayers claimed that the allocation of profits, to isolate these from other creditors, was a sufficient nontax business purpose.  But, the Court rejected this as being evident of the parties' intent to joint together.  Court, at 40 n.8. 
 
As a separate issue, it was noted that WCI entered into an asset purchase agreement for the sale of its assets for $5.4 million, but how the parties took $3.4 million of the purchase price and attempted to allocate this to a noncompetition agreement, and therefore, to WB Partners.  The IRS contended that the assets belonged to WCI.  The taxpayers attempted to rely on the exclusive services langauge in the principals' employment agreements with the two corporate entities serving as partners in WB Partners.  The reality of the arrangements was that WCI was the only entity involved that actively conducted competing services.  Court at 44.  The Tax Court further imposed an accuracy related penalty, rejecting a reliance on professional advisor defense.  Id, at 52.