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Ninth Circuit Rejects Assignment of Noncompete Income to Partnership that Contributed No Value to Joint Venture.

(Parker Tax Publishing October 27, 2015)

No valid partnership existed where one party to a joint venture did not contribute anything of value and allocations between the parties did not conform to the joint venture agreement. Accordingly, the Ninth Circuit upheld the Tax Court in declining to assign any portion of the proceeds from a noncompetition agreement to the partnership. DJB Holding v. Comm'r, 2015 PTC 361 (9th Cir. 2015).

Background

Daren Barone and Gregory Watkins were experienced in asbestos removal and established a successful environmental remediation company, Watkins Contracting, Inc (WCI). To shield themselves from liability, the two men restructured WCI so that several corporate entities stood between them and the company. Barone and Watkins each formed a holding corporation, and the two corporations entered a partnership, WB Partners. Barone and Watkins also formed a third holding company, WB Acquisition, Inc., and transferred their interest in WCI to this company. Finally, WB Partners purchased all shares of WB Acquisition. As a result, WCI was owned by WB Acquisition, which was owned by WB Partners, which in turn was owned by Barone's and Watkins's holding corporations.

An opportunity arose to do environmental remediation work for a massive redevelopment project at the San Diego Naval Training Center. To win the contract, however, WCI had to post a large bond against the possibility that it would be unable to complete the work. To ensure that WCI could afford the bond, Barone and Watkins caused WCI and WB Partners to form NTC Joint Venture. Under the terms of the joint venture agreement, WCI would do the environmental remediation work, and WB Partners would supply financial guaranties. In exchange for these services, WCI would receive 30 percent of the venture's profits, and WB Partners would receive 70 percent. Barone and Watkins promised to provide financial services as necessary to support WB Partners' business.

NTC Joint Venture obtained an employer identification number and its own bank account. Notwithstanding the terms of the agreement, the joint venture's accountant opted not to file a tax return for the venture. Instead, the accountant believed that separately reporting WCI's and WB Partners' income from the NTC project was sufficient.

The joint venture's structure had significant federal income tax consequences. WCI would have to pay corporate income tax on its 30-percent share of the venture's profits. As a general partnership, WB Partners would pay no income tax on its 70-percent share; instead, that income would pass through to WB Partners' owners, the two holding corporations. The holding corporations were S corporations owned by tax-exempt retirement savings plans.

Because the NTC project was more profitable than expected, the NTC Joint Venture capped WB Partners' profits and awarded WCI approximately $1.6 million more than it was entitled to under the NTC Joint Venture agreement. This additional allocation resulted in an actual allocation of profits between WCI and WB Partners of 49.6 percent and 50.4 percent, respectively.

In 2003, while the NTC project was ongoing, WCI entered an asset purchase agreement with Kuranda Capital, LP. As part of the transaction, Watkins, Barone, and WCI agreed not to compete with Kuranda in the environmental remediation business. The agreement allocated $3.4 million of the purchase price to the noncompetition agreement. All of the noncompetition agreement's proceeds, including interest from the note, was reported on WB Partners' tax returns.

The IRS determined that the NTC Joint Venture was not a partnership for federal tax purposes and notified WB Acquisition and WB Partners of tax deficiencies for tax years 2002 through 2005. The taxpayers contested the deficiencies and took their case to the Tax Court. Before the court, they argued that WB Partners' financial guaranty was an essential contribution to the NTC Joint Venture because WCI could not have won the NTC project without it. Thus, they contended, they had the necessary intent to operate the NTC Joint Venture as a partnership.

Analysis

The Tax Court held that the NTC Joint Venture was not a valid partnership for tax purposes and, therefore, all of the joint venture's profits were taxable income to WCI. The Tax Court also held that the income from the noncompetition agreement was taxable income to WCI. Because WCI had substantially understated its income, the Tax Court upheld the IRS's assessment of accuracy-related penalties. The taxpayers appealed. On appeal, the taxpayers argue that WB Partners' financial guaranty and those of its owners and their employees were in fact a valuable contribution because WCI could not otherwise have posted a performance bond.

The Ninth Circuit affirmed the Tax Court's decision, holding that no valid partnership existed and that the income from the noncompete agreement was taxable to WCI. The court concluded that WB Partners contributed no value to the NTC Joint Venture. The court rejected the argument that WB Partners' financial guaranty was a valuable contribution to the joint venture, noting that WCI won the NTC bond based on the combined net worth and financial guaranties of, among others, WCI, WB Partners, Barone, and Watkins, and not based on WB Partners' guaranty alone. Additionally, the court said that the profit cap on the NTC project, which was at odds with the allocation described in the joint venture agreement, showed that WCI and WB Partners did not intend to share profits and losses as bona fide partners would.

With respect to the income from the noncompetition agreement, the Ninth Circuit noted that when a commercial transaction includes a noncompetition agreement, the portion of the proceeds allocated to that agreement is income to the persons who promised not to compete. The court found that the Tax Court erred in finding that only WCI was bound by the noncompetition agreement. Under California law, the court said, Barone and Watkins were free to sever their ties to WCI and perform environmental remediation services for another company. Thus, the noncompetition agreement bound Barone and Watkins personally not to compete with Kuranda in the environmental remediation business. As a result, WCI, Barone, and Watkins were entitled to a share of the noncompetition agreement. However, the court said, because WB Partners had no claim to Barone's and Watkins's future services, WB Partners was entitled to no share at all and the Tax Court did not err in declining to assign any portion of the proceeds of the noncompetition agreement to WB Partners.

Finally, the court held that because the taxpayers had not supplied their accountant with all the necessary and accurate information on which to prepare their returns, they could not avoid liability for the accuracy-related penalty.

For a discussion of the factors that are considered in determining if a valid partnership exists, see Parker Tax ¶20,105.(Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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