Tax News
District Court Rejects Fund Managers' Attempt to Recharacterize Service Contract as Partnership Relationship
May 13, 2011
As may be divined from the site's name, our main goal here is to keep the reader apprised of new developments in the world of taxation that are relevant to the taxation of investment funds and the various fund participants.  Sometimes, the developments take the form of truly new law in the form of IRS regulations or precedential case law; other times, it may be a new case or ruling that simply adds to a larger body of law in an important area.  The opinion of the U.S. District Court for the Southern District of Texas in Rigas v. United States, 107 AFTR 2d 2011-788 (C. D. Tx. 5/2/2011), falls into the latter category.

Rigas involves the fundamental question of how the relationship between investment manager and investment fund should be characterized for tax purposes.    From the manager's perspective, it is generally preferable, for tax purposes, to be  treated as a partner in the fund, at least where it is expected that the fund will produce capital gains.  However, funds, for state law purposes, may prefer management to be brought in as independent contractors under a management contract to limit the rights and powers that management has over the fund and its assets.  In addition, the fund that produces capital gains may sometimes favor an independent contractor relationship for tax purposes as well, as it may be able to take an ordinary deduction for salary paid to management. 

As a fundamental issue in any investment fund/management relationship, the form of the relationship is typically negotiated prior to the commencement of the relationship.  This is what transpired in Rigas--the oil and gas fund's desire not to be partners with management apparently prevailed and the parties entered into a management agreement which expressly disclaimed any desire to form a partnership. Nevertheless, the management entity in Rigas ultimately reported the income it received from the fund, in the form of a performance fee equal to 20% of residual profits, as flow-through capital gain income, as if it were a partner in the fund. 

Generally, taxpayers have been unsuccessful in arguing for a tax treatment that is contrary to the chosen form of their transaction.  This lack of success continued in Rigas, however, importantly, the court held that the form of the transaction, including the management agreement disavowing partnership, was not dispositive of the case.  This is noteworthy, and somewhat surprising, for at least two reasons.  First, in many cases the taxpayer does not get to even argue against its form.  Second, the key inquiry in any analysis of partnership characterization is the intent of the parties, which in this case was relatively clearly expressed in the deal documents. 

To determine intent, the court looked to the well-worn "Luna" factors (see Luna v. Comm'r, 42 T.C. 1067, 1078 (T.C. 1964)) .  For the managers, the consequences of a finding  of partnership were significant--15% capital gain rates on all income from the fund, or a 35% rate of tax on all such income.

The court found several Luna factors in favor of partnership.  First, the court found that  the management entity contributed both services and capital to the venture.  The management entity issued its note to the fund for payment of various expenses and the management entity's performance fee was paid only after repayment of the note, which the court found constituted a from of delayed capital contribution.  Additionally, the court found that the management entity's clawback obligation, pursuant to which the management entity would have to give back a porition of its performance fee should losses be subsequently discovered,  was indicative of a partnership.

However, the balance of Luna factors weighed against the taxpayer, according to the court.  Although profit sharing is an important feauture of partnership arrangements, the court found the performance fee in this case was also consistent with a contingent fee payable under a service agreement, particularly because the performance fee was the sole means of compensation, which distinguished these facts from other authorities where courts have found profit sharing to be indicative of partnership where the service partners also receive a salary in addition to the profits interest. 

More importantly, the court found that the management entity did not share in losses of the venture, which is often considered to be the most significant factor in the Luna analysis.  In short, it is usually fatal to a finding of partnership if the taxpayer does not share in losses.  The taxpayer argued that the management entity shared losses in two ways: (i) the clawback obligation and (ii) if the fund was not profitable, it would have to make payments to the fund under the promissory note.  While the court seemed to agree that the clawback obligation was a form of loss sharing, it noted that it could only be triggered if the fund were profitable, and found that, because the promissory note was nonrecourse and that the fund could only seek repayment out of the performance fee, the management entity would not share in losses if the fund were not profitable.

Furthermore, while the managment entity had numerous responsibilities with respect to asset management, the court placed emphasis on the fact that the management entity could not acquire and dispose of fund assets, nor could it draw upon fund bank accounts without prior written consent of the fund.  Finally, the court looked to the language of the agreement and representations to third parties (e.g., tax returns, representations to portfolio companies) and found that both factors favored an independent contractor classification. 

Managers that have not been able to negotiate for partner status may take heart in the court's holding that the form of the relationship as set forth in the management agreement is not controlling.  However, managers in this situation should be aware that they face an uphill battle against the IRS, who will be fighting against the whipsaw that would result from a fund taking an ordinary deduction and the service provider receiving capital gains.  While no one factor controls, managers in this situation should consider putting amounts at risk (as the management entity could have done in Rigas by making the promissory note fully recourse), as the sharing of losses is a factor that is extremely helpful to partnership characterization.  Furthermore, managers should insist of some salary piece or "management fee" in addition to the performance fee.  In addition, to the extent the fund documents and management agreement do not grant the managers with an equal voice in the acquisition and disposition of portfolio companies, managers should strive to create a record that shows that an equal voice was accomplished in practice.  To the extent the managers can make this showing, they increase their chances of being able to disavow the form of their transaction, which is as close as a tax practitioner can come to tax nirvana.
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Tags: existence of a partnership, management fees, Rigas v. US, substance over form