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Partners' "Sweat Equity" Translated into Capital Gain, Not Ordinary Income.

(Parker Tax Publishing September 2, 2015)

Although there was no formal partnership agreement between a partnership that managed oil and gas properties and the business that owned the properties, the eventual sale of the properties resulted in capital gain to the managing partnership because it invested "sweat equity" in the arrangement, increasing the value of the partnerships' capital. U.S. v. Stewart, 2015 PTC 294 (S.D. Tex. 2015).

In March of 2003, Hydrocarbon Capital, LLC bought a portfolio of oil and gas properties from Mirant Corporation. Because it was new to the industry, Hydrocarbon asked the five executives at Mirant, who managed the operation of the properties, to manage its wells. Those five individuals then founded Odyssey Capital Energy I, LP. David Stewart and Richard Plato were two of those people. Odyssey agreed with Hydrocarbon to manage exploration and production of the old Mirant properties. Odyssey operated the wells or worked with other operators. Hydrocarbon had to approve expenses, but Odyssey fully controlled operations.

The deal was structured so that Hydrocarbon lent Odyssey $6 million without recourse for working capital. When the assets were eventually sold, Odyssey had a 20 percent interest in the sales revenue after Hydrocarbon recouped its expenses, its investment plus a 10 percent return, and the loan. The Odyssey partners also agreed to limit the salaries they paid themselves. If Hydrocarbon did not profit, the partners earned nothing from the sale.

A little more than a year later, Hydrocarbon sold the portfolio. It recovered its expenses, its initial investment, its return on investment, and the loan. The remaining revenue was split with Odyssey and Odyssey's 20 percent interest was worth about $20 million.

When Odyssey filed its 2004 federal partnership return, it reported the $20 million as ordinary income. Each partner received a Schedule K-1 and Stewart and Plato reported their respective shares of the $20 million as ordinary income. Two years later, Odyssey determined that its income from the 2004 sale was long-term capital gains, not ordinary income. In 2007, Odyssey amended its 2004 return to report that income as capital gain income and issued amended K-1s to its partners. Stewart and Plato amended their individual returns accordingly and requested refunds from the IRS.

The IRS reviewed Odyssey's amended return and formally approved it in 2008. Steward and Plato received their refunds, as did two of the other partners. However, the IRS denied a fifth partner a refund, concluding that Odyssey's 20 percent interest was compensation for services and the partner's earnings should be taxed as ordinary income. The IRS then decided it had erred in approving the refunds for Stewart and Plato and sued them, demanding a return of the refunds. It could not sue the other two partners who received refunds because it was too late.

The IRS argued that there was no tax partnership between Odyssey and Hydrocarbon because their agreement disclaimed a partnership. Further, the IRS said that Hydrocarbon contributed and controlled the money, owned the assets, and Odyssey had no money at risk. According to the IRS, Odyssey was a contract employee that could not spend money or sell the assets without Hydrocarbon's approval and the parties did not have a joint name, did not jointly file a tax return, and did not maintain a single accounting ledger.

Additionally, the IRS said that because Odyssey did not ask for a formal adjustment, the IRS did not approve the new return, and the original return, with ordinary income, still controlled. Since the partners' returns conflicted with the original return, the IRS argued, the refund was incorrect.

A district court rejected the IRS's arguments and held that the income in question was capital gain income, not ordinary income, and Stewart and Plato were entitled to keep their refunds. Citing Haley v. Comm'r, 203 F.2d 815 (5th Cir. 1953), the court stated that tax partnerships do not depend on contract language; instead, they arise from the reality of relationships. Hydrocarbon encumbered its real-property interests when it granted Odyssey an interest in them, the court said. Although it was not a fee interest, it was an equitable one. Stewart and Plato risked money for that interest by accepting salaries that were lower than the market rate for their work. Many partnerships, the court noted, have a financial partner and an operating partner. According to the court, the arrangement between Hydrocarbon and Odyssey was no different than flipping a house. The gain realized through sweat equity, the appreciation in the value of the house by fixing it up, is a capital gain. In the same way, Odyssey's sweat (i.e., their management) increased the value of the capital (i.e., the portfolio of properties), the court said.

The court also agreed with Stewart and Plato that Odyssey's amended return complied substantially with the applicable requirements. A request for adjustment of a partnership return need not be on Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, as long as it substantially complies with the regulations, the court said. The IRS investigated the amended return and approved the return without adjustment. Thus, the court concluded, Stewart's and Plato's amended returns were correct.

For a discussion of the sale or exchange requirement for recognizing capital gains, see Parker Tax ¶111,113. (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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