Business 101: When Does a Partnership Exist?

So when does a partnership exist?

The IRS has strict rules for what constitutes a partnership. Under Section 761(a), a partnership as defined by the IRS needs to involve ”a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate.”

According to a recent article published by Scarinci & Hollenbeck’s Tax Notes, attorneys John H. Skarbnik and Frank Brunetti stated that this definition is significant for those entities conducting business as partners because the language dictated in any agreement does not necessarily constitute a partnership, whereas its actions do. For this reason, the IRS can dispute the existence of a partnership if it believes that a service provider in a partnership received ordinary income instead of capital gains on the receipt of a distribution. The IRS does not recognize the existence of a partnership in these cases.

Recently, the IRS upheld its definition of what constitutes a partnership in United States v. Stewart, but the case that was cited in that decision involved a similar partnership relationship.

The case

In March 2003, Hydrocarbon Capital LLC purchased a portfolio of oil and gas properties from Mirant Corp. At which point, Hydrocarbon retained Mirant’s five executives who managed those properties, and these individuals formed Odyssey Capital Energy LP. This entity formed an agreement with Hydrocarbon – but the parties insisted this was not a partnership.

For its part in the agreement, Odyssey would oversee all exploration and production activity at the oil and gas properties with the intent of selling the properties under the Mirant umbrella. Upon sale of any of the properties, the five partners in Odyssey would ensure that Hydrocarbon was repaid all expenses, received a 10 percent return on its investment and recouped the full $6 million loan it gave to Odyssey. At which point, Odyssey would receive 20 percent of all remaining profits.

A year later, Hydrocarbon sold the properties after it recouped all expenses, return on investment and the loan. Odyssey then received $20,106,410, which it reported on its 2004 tax return as ordinary income. Each of the five partners also filed this income under Schedule K-1. However, in 2006, the five partners inexplicably filed an amended partnership return for $20,432,323 as capital gains. The partners then issued amended Schedule K-1 to be sent to the other partners. These partners finally filed for refund claims.

As a result of these actions, two partners received refunds of $1,333,067 and $520,222. The federal government then sued the two partners to return the refunds because it ruled they were issued in error. Since Odyssey simply managed Hydrocarbon’s properties, it did not constitute a partnership, as was originally agreed upon – despite the amended partnership returns.

In turn, the IRS argued that Odyssey was set to receive 20 percent of profits as compensation for the services provided. This income should have been taxed as ordinary income, not as capital gains as the partners’ amended tax returns suggested. Furthermore, the IRS also reiterated that Hydrocarbon did not file a partnership tax return with Odyssey.

The decision

The court ruled that a partnership existed between Hydrocarbon and Odyssey for a few reasons. For one thing, it determined that partnerships for tax purposes are not dependent on contract language. The actions of the relationships are the overarching factor.

What the court argued was that Odyssey was not earning commission for sales of each property, like a car salesperson. Their ownership interest from Mirant into the value of the operation took precedence over the contract language between Odyssey and Hydrocarbon. Therefore, because the relationship between the two entities was that Hydrocarbon provided the properties and the financial backing, and Odyssey contributed its expertise in asset management, there was a clear partnership.

Both parties contributed an equal amount of value to the properties. So the equity that Odyssey earned should be considered capital gains because it increased the capital value of the portfolio. Since the partners had a purchased share in the properties, they earned significant profits for Hydrocarbon after each property was sold.

Therefore, execution and financing form a partnership, and the profits for both parties should be considered long-term capital gains. This meant that the federal government could not sue the two partners for re-characterizing their income refunded to them as capital gains. 

Otherwise, for more posts on business and tax, check out:

• NJ May Become First State to Ban Corporate Tax Inversions
• NJ Defines Corporate Business Nexus Guidelines
• The IRS Issues Notice on Cadillac tax