Thursday, May 5, 2011

No joint venture between service provider & owner of assets; profits share is ordinary income

Rigas v U.S., (CD TX 5/2/7/2011) 107 AFTR 2d ¶2011-788

A district court has held that a joint venture did not exist between an energy company and the limited partnership that managed some of its assets, although the latter received a share of the profits when the assets were disposed of. Even though there were some indications that a partnership existed, including the marriage of capital and know-how, many more aspects of the relationship, such as who controlled and owned the assets, indicated that the limited partnership merely received a fee for services. As a result, one of the limited partnership's partners could not treat his share of profits from the limited partnership as capital gain; rather, it was taxed as ordinary income.

Background. A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits. Some courts have held joint venture arrangements to be partnerships (and their members held to be partners) even though they did not consider themselves partners and were operating under an agreement specifically providing that they were not partners, and even if they did not held themselves out to others as partners.

Facts. In 2003, Hydrocarbon Capital LLC (Hydrocarbon) bought from Mirant Corporation a portfolio of interests related to the oil and gas industry, including credit agreements, royalty interests, and stock warrants. Hydrocarbon asked five former Mirant employees, including John Rigas, to manage the portfolio of assets due to their past management experience. The five men formed Odyssey Energy Capital I, LP (Odyssey) to carry out the management functions. Each was a limited partner in Odyssey, while Odyssey's general partner was a limited liability corporation.

Odyssey and Hydrocarbon entered into an agreement under which Odyssey provided servicing, management, administration and disposition services for the asset portfolio, including the hiring of necessary environmental and petroleum consultants and conducting physical inspection of the assets within the portfolio. Odyssey agreed to maintain an office, to employ adequate personnel, to collect payments on the assets, and to track overhead expenses. Odyssey's overhead expenses, including salaries of its individual partners, were funded through a $6 million nonrecourse promissory note issued by Hydrocarbon to Odyssey. On a semiannual basis, Odyssey would submit a budget for overhead expenses to Hydrocarbon for its review and approval. Once approved, Hydrocarbon would draw down sums from the promissory note and wire the loan funds to Odyssey. The agreement specifically said that it was not intended that a partnership would be created between Odyssey and Hydrocarbon.

Odyssey had the authority to take actions regarding the assets that were in the best interest of Hydrocarbon, but was subject to certain limitations on its authority, including the inability to enter into binding commitments to dispose of assets, to incur unforeseen expenses, and to enter into transactions that were not previously approved by Hydrocarbon. Title, ownership, and exclusive control of the assets was retained by Hydrocarbon.

Under the agreement, Odyssey was to be paid a performance fee as full compensation for rendering services. Hydrocarbon would: (1) recoup all third-party out-of-pocket expenses plus the initial value of the asset portfolio; (2) receive a preferred return of 10% of the profits; and (3) use the remaining funds to pay off any amounts outstanding on the promissory note. Finally, Odyssey and Hydrocarbon would split the profits whereby Odyssey would take 20% of the profits and Hydrocarbon would retain 80%. Odyssey's performance fee was subject to a “claw-back” provision that ensured Hydrocarbon would receive the amounts provided for in steps (1)–(3).

In 2004, the capital assets in the portfolio were sold for $288 million, yielding a gain of approximately $110 million to Hydrocarbon, After providing for steps (1)–(3) in the above calculation, Odyssey received approximately $20 million as its performance fee. Odyssey later paid Hydrocarbon $31,920 under the claw-back provision of the management agreement.

On its original partnership return for 2004, Odyssey characterized the approximately $20 million it had received from Hydrocarbon as “gross profit” income and issued Schedules K-1 to its limited partners, including Rigas. He, in turn, filed a return for 2004 reporting his $4 million distribution from Odyssey as ordinary business income. In 2007, Odyssey filed an amended return for 2004 and characterized the $20 million it had received from Hydrocarbon as net long-term capital gain. In turn, Rigas filed an amended return for 2004 showing the $4 million he received as net long-term capital gain rather than ordinary business income, and claimed a refund, which IRS disallowed.

The central substantive dispute before the district court was whether the relationship between Odyssey and Hydrocarbon was a joint venture or partnership, as Rigas maintained, or a mere service relationship, as IRS maintained.

Conduct of the parties controls. The district court looked to the following factors in making its decision that no partnership agreement existed between Odyssey and Hydrocarbon:

... Contributions of the parties to the venture. Odyssey contributed funds for overhead expenses through its draw-downs on the promissory note and bought a working interest in a lease for $130,000 using funds from the promissory note. Although both sets of transactions were initially funded by Hydrocarbon through the promissory note, Odyssey later bore the cost of these transactions because of the manner in which the performance fee was calculated. The court thus treated these reductions of Odyssey's promissory note as capital contributions, where the contribution was deferred until the liquidation of the partnership. Odyssey also used its own money to buy furniture and fixtures for its office, and its partners contributed substantial know-how needed to manage the portfolio assets.

... Interest in profits or losses. A clawback provision provided that, after the distribution of the 20% and 80% of income, Hydrocarbon could ask Odyssey to repay some of its 20% income if subsequent expenses or losses on the assets came to light. Odyssey, in fact, did pay approximately $30,000 to Hydrocarbon under the clawback provision. The court found that the clawback was indicative of a partnership arrangement. It also found that the subordination of the profits interest to Hydrocarbon's recovery of its expenses and initial investment could be indicative of a partnership relationship, though it was equally consistent with a theory that Odyssey was a service provider to be rewarded with a percentage of the profits.

... Responsibilities of the parties. Despite the great deal of responsibility Odyssey exercised over the asset portfolio, it did not have authority to withdraw funds from Hydrocarbon's bank accounts, could not increase Hydrocarbon's capital commitment to a particular asset, could not enter into binding agreements in Hydrocarbon's name, and could not dispose of an asset without Hydrocarbon's prior written approval. Thus, the court held that Odyssey's responsibilities, while numerous, did not extend into the key areas of acquiring and disposing of assets or drawing upon Hydrocarbon's bank accounts that would indicate a partnership relationship.

... Parties' right to and control over income and capital. Odyssey did not own title to any of the assets in the portfolio, and, apart from depositing checks, and did not share control with Hydrocarbon over the bank accounts that corresponded with the companies in the asset portfolio. Odyssey could only make recommendations to Hydrocarbon. Thus, the court held that Odyssey's lack of the right to and control over the assets and income of the venture was indicative of a service provider relationship.

... Representations to IRS and third parties. Odyssey and Hydrocarbon did not file joint tax returns or joint financial reports with governmental authorities. In addition, Odyssey and Hydrocarbon had separate checking accounts. The court said these factors indicated that Odyssey and Hydrocarbon maintained separate accounting and financial arrangements, tilting towards a finding that Odyssey was a service provider for, rather than a partner with, Hydrocarbon.

After considering all of the factors indicative of the entities' intent to form a partnership, the district court held that IRS had established by a preponderance of the evidence that a partnership relationship did not exist between Odyssey and Hydrocarbon. As a result, Rigas could not treat his share of the profits from the sale of the assets managed by Odyssey as long-term capital gain. Rather, it was taxable as ordinary income received for services. 888-712-7690

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