COMPENSATION VIA SHARE OF PROFITS DID NOT ESTABLISH A PARTNERSHIP

Parties that jointly conduct a business or venture and share the profits and losses will typically meet the definition of a “partnership” for income tax purposes and be taxed accordingly. Such partnership treatment can arise, even though the parties did not intend to create a partnership and merely have some other type of contractual arrangement between them.

This issue often arises when an individual or an entity provides services to another that is conducting a venture or business, and is paid for its efforts in whole or in part with a percentage of the profits of the venture. Since there is a sharing of “profits,” there is a reasonable risk that the IRS may find the arrangement to be a partnership, and not a non-partnership contractual arrangement.

The tax status of the relationship can have significant consequences for the parties, including whether the service provider is taxed immediately on a pass-through basis on the ventures profits, whether the provider can deduct venture losses, whether Section  1446 withholding on foreign participants may apply, and whether the service provider will be taxed on its receipts as ordinary income (nonpartner) vs. capital gain income (partner) if the shared profits are in the nature of capital gains.

It was whether such profits paid to a service provider were capital gains or ordinary income that was the issue in recent tax case.  Interestingly, the court found that the service provider was NOT a partner even though it was paid with a 20% profits interest in the venture. While the court’s examination was very fact specific, the factors looked at by the court and its view whether those facts supported a partnership or nonpartnership relationship can be useful when crafting contractual relationships when no partnership relationship is (or is not) desired. These factors included:

-the contract specifically declared that the relationship was not a partnership (this obviously was a factor against a partnership);

-the contract provider expended its own funds in performing its functions (this was considered by the court as a capital contribution and was a factor in favor of a partnership);

-the contract provider did not have authority to withdraw funds from the business, it could not increase the business owner’s capital commitment to assets, it could not enter into binding agreements in the name of the business, and it could not dispose of an asset without the owner's prior written approval. The court held that the service provider’s responsibilities, while numerous, did not extend into the key areas of acquiring and disposing of assets or drawing upon the business’  bank accounts that would indicate a partnership relationship (factor against partnership);

-the contract provider did not own title to any of the assets in the business, and apart from depositing checks did not share control with the business over the bank accounts that corresponded with the companies in the business portfolio and could only make business recommendations (factor against partnership); and

-the parties did not file partnership tax returns, and the contract provider did not hold itself out as a partner to third parties (factor against partnership).

Compensating employees or independent contractors with a profits share often makes good business sense to owners, as compared to actually making them part owners. Benefits to business owners include avoiding creating statutory rights in the recipients (such as voting rights and rights to examine books and records), and the ability to terminate the relationship without an obligation to repurchase shares or ownership interests, while gaining the incentive benefits of a profit participation. Sometimes, these interests are established as a share of gross profit instead of net profit, to avoid the partnership tax risk  -with a gross profit interest, there is no sharing of expenses or losses, thus eliminating an important factor in the establishment of a partnership relationship for tax purposes.  Thus, in addition to providing helpful factors to avoid partnership status, the case also provides some comfort that compensation via a net profit share will not, in and of itself, necessarily create a partnership relationship.

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

FLORIDA ACTS TO RESOLVE OLMSTEAD ISSUES [FLORIDA]

I previously discussed the Olmstead case – that discussion can be read here. This case created a stir both inside and outside of Florida, when it provided that at least in the situation of a single member LLC, a creditor’s rights are not limited to a charging order but could include a right to foreclose on the debtor’s LLC interest. The potential application of the decision to multimember LLC’s became a much-discussed issue. My partner, Jordan Klingsberg, has written the following summary relating to new LLC legislation that seeks to resolve these issues:

On Friday April 29, 2010 the Florida Senate passed CS/HB 253, Limited Liability Companies, to address some of the uncertainty surrounding Florida LLCs created by the recent Florida Supreme Court case, Olmstead v. Federal Trade Commission, 44 So.3d 76 (Fla. 2010). The bill provides that, except in one situation, a charging order is the "sole and exclusive remedy" to satisfy a judgment from a judgment debtor's interest in an LLC. The exception concerns an LLC with one member where distributions under a charging order will not satisfy the judgment in a reasonable time. In such a situation, a court may order the sale of the single member's interest in the LLC. CS/HB 253 passed both the Florida House and Senate and has been sent to the Governor to be signed into law.

In June of 2010, the Florida Supreme Court in Olmstead held that a charging order is not the exclusive remedy available to a creditor holding a judgment against the sole member of a Florida single member LLC. The court ruled that the judgment debtor had to surrender all right, title, and interest in the member's single member LLC interest in order to satisfy the outstanding judgment. The dissent in Olmstead, however, stated that the majority's holding was not limited to single member LLCs and expressed a desire that the Florida legislature clarify the law in this area.

Many practitioners believed that the Supreme Court's reasoning in Olmstead would apply to all limited liability companies. This lead many businesses to change their situs and organize in states other than Florida where a charging order is the exclusive remedy available to judgment creditors of multimember LLCs. This bill amends Fla. Stat. §608.433 to clarify that the Olmstead decision does not extend to multimember LLCs and provides procedures for applying the Olmstead decision to single member Florida LLCs.

The bill specifically states that a judgment creditor has only the rights of an assignee of the LLC interest to receive distributions to which the judgment debtor would have otherwise been entitled from the LLC. The only situation in which a court may order the sale of a member's interest is where the judgment creditor of a member's interest in a single member LLC establishes "that distributions under a charging order will not satisfy the judgment within a reasonable time." Upon such a showing, the court may order the sale of the single member's interest pursuant to a foreclosure sale and the purchaser becomes a member of the LLC and obtains the prior member's entire interest in the LLC. The foreclosure remedy is not available to a judgment creditor of a multimember LLC and cannot be ordered by a court.

Section 9 of the Bill does provide that nothing in the statute shall (i) limit the rights of a secured creditor, (ii) change the impact of a fraudulent conveyance; or (iii) change the court's right to use equitable principals such as ruling that an LLC was sham or using equitable liens or constructive trusts. These provisions, however, were likely already law in Florida.

The Bill does not contain any provisions for treating a multi-member LLC as a single member LLC and disregarding nominal interests held by minority members such as family members and grantor trusts.

This Act and the amendment to Fla. Stat. §608.433 will hopefully clarify the judgment remedies available against Florida LLCs and remove some of the ambiguity surrounding the treatment and operations of LLCs in Florida.

Special thanks to Richard Josepher of Gutter Chaves Josepher Rubin Forman Fleisher PA and other members of the special committee of the Florida Bar Tax Section who worked extremely hard and supported this legislation.

BUNDLED FIDUCIARY FEES REMAIN DEDUCTIBLE (FOR NOW)

In 2008, the U.S. Supreme Court held that costs paid to an investment advisor by a nongrantor trust or estate generally are subject to the Code §67(a) 2% floor for miscellaneous itemized deductions. Michael J. Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner, 552 U.S. 181 (2008). What happens when the estate or trust pays a bundled fiduciary fee – that is one that does not provide a breakout on the total fee paid between investment advisory fees subject to the 2% limit and other fees that are not subject to the 2% floor? How is the taxpayer supposed to know how much is subject to the 2% floor?

After the Knight case, the IRS has issued Notices on an annual basis that relieved taxpayers of having to determine the portion of a bundled fiduciary fee that is subject to the 2% floor.

The IRS has now issued a Notice that indefinitely extends this relief, until the date that final regulations on the subject are published. Prior to that date, taxpayers may deduct the full fee without regard to the 2% floor. The Notice warns that payments by the fiduciary to third party for investment expenses are deemed to be readily identifiable and must be treated separately from the otherwise bundled fee.

Notice 2011-37, 2011-20 IRB (4/13/11)