Opinion ID: 3008141
Heading Depth: 2
Heading Rank: 1

Heading: Income from the NTC Project Attributed to WB

Text: Partners Was in Fact Income to WCI. Taxpayers raise two arguments in the alternative. First, they argue that the Tax Court clearly erred in finding that the NTC Joint Venture was not a valid partnership for tax purposes. Second, they argue that, even if the joint venture was not a valid partnership, WCI and WB Partners reached a bona fide agreement to compensate WB Partners for providing financial guaranties. We conclude that the Tax Court properly taxed WCI on all income from the NTC project. 16 DJB HOLDING CORP. V. CIR
Partnership for Tax Purposes. For tax purposes, a “partnership” is “a syndicate, group, pool, joint venture, or other unincorporated organization” that carries on “any business, financial operation, or venture” and that is not “a corporation or a trust or estate.” 26 U.S.C. §§ 761(a), 7701(a)(2). To determine whether a purported joint venture is a valid partnership, courts ascertain whether “the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.” Culbertson, 337 U.S. at 742. The Tax Court distilled from Culbertson eight factors to consider in measuring the parties’ intent: [(1)] [t]he agreement of the parties and their conduct in executing its terms; [(2)] the contributions, if any, which each party has made to the venture; [(3)] the parties’ control over income and capital and the right of each to make withdrawals; [(4)] whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; [(5)] whether business was conducted in the joint names of the parties; [(6)] whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers; [(7)] whether separate books of account were DJB HOLDING CORP. V. CIR 17 maintained for the venture; and [(8)] whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise. Luna v. Comm’r, 42 T.C. 1067, 1077–78 (1964). Here, the Tax Court concluded that the Luna factors weighed against the conclusion that the NTC Joint Venture was a valid partnership. Regarding the first factor, the court noted that the parties violated the terms of the joint venture agreement both by imposing a 50.4% profit cap on WB Partners and by failing to file a tax return. These deviations from the agreement suggested to the Tax Court that WCI and WB Partners did not intend in good faith to act as partners. Second, the court found that WB Partners contributed nothing of value to the joint venture because the performance bond was issued based not on WB Partners’ financial guaranties, but on the collective net worth of WCI, WB Partners, Barone, Watkins, DJB, and GSW as related entities. The marginal value of WB Partners’ guaranty suggested that WB Partners did not make a meaningful contribution to the joint venture. Third, the venture’s imposition of a profit cap on WB Partners demonstrated that WB Partners exercised no control over income and capital, further suggesting that WB Partners did not act as a bona fide partner. Fourth, the profit cap and the joint venture agreement’s provision guaranteeing reimbursement of WCI’s costs showed that WCI and WB Partners did not intend to share profits and losses as bona fide partners would. Concerning the eighth factor, the court found that WB Partners’ concession of a large portion of the profits to which it was entitled showed that the parties did not exercise mutual 18 DJB HOLDING CORP. V. CIR control over the enterprise. The court found the remaining factors neutral in light of the joint venture’s efforts to conduct itself as a valid partnership, such as opening a separate bank account and keeping its own records.7 On appeal, Taxpayers take issue only with the Tax Court’s finding regarding the second Luna factor—that WB Partners contributed nothing of value to the NTC Joint Venture. They do not dispute the Tax Court’s application of the Luna factors in any other respect, except to assert that the court’s assessment of WB Partners’ contribution to the venture “infected” its analysis of the other factors. Before the Tax Court, Taxpayers 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. The Tax Court disagreed. It specifically noted that WCI won the NTC bond based on “the combined net worth and financial guaranties of each of WCI, WB Partners, Barone, Watkins, DJB, and GSW,” not based on WB Partners’ guaranty alone. Moreover, the court reasoned that WB Partners would have supplied a guaranty even if the joint venture had never existed, by virtue of being the parent entity of WCI. Finally, the court noted that only 7 The Tax Court found the fifth factor “mixed” because the NTC Joint Venture obtained and used its own employer identification number as a legitimate entity would, but WCI dealt with Harper, the construction contractor, entirely in its own name. The sixth factor was neutral because, while the joint venture did not file its own tax return, it dealt with various banks as an entity separate from WCI and WB Partners. Finally, the Tax Court found the seventh factor neutral because the joint venture maintained its own bank account, income statements, and progress reports, but did so using WCI employees and did not keep “other books of account that may normally be expected in the operation of a business.” DJB HOLDING CORP. V. CIR 19 WB Partners received compensation for its financial guaranty, while Barone, Watkins, DJB, and GSW each guaranteed the bond without receiving a share of the NTC project’s profits. If WB Partners’ guaranty warranted compensation to the tune of seventy percent of the profits, the Tax Court reasoned, then surely the other entities’ guaranties also called for some share of the proceeds. On appeal, 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. They contend that Tax Court case law supports this conclusion. In Maxwell v. Commissioner, 29 T.C.M. (CCH) 1356 (1970), a bridge construction corporation and its majority owner formed a joint venture to bid on a lucrative contract. Id. at 1358. The corporation supplied all the materials and labor, and the owner provided a personal financial guaranty to enable the corporation to post a bond. Id. Because the corporation’s net worth was not alone sufficient to secure the bond, the Tax Court found that the owner’s guaranty was a valuable contribution showing intent to form a partnership. Id. at 1362. As in Maxwell, Taxpayers argue, WCI could not have secured the necessary $17 million bond on its own. WB Partners’ guaranty, along with those of its partner holding corporations and their employees, made obtaining that bond possible. Because WB Partners’ financial guaranty, as well as those of Barone, Watkins, and their holding corporations, enabled WCI to obtain a performance bond, Taxpayers argue that the Tax Court clearly erred in finding that WB Partners contributed nothing valuable to the joint venture. 20 DJB HOLDING CORP. V. CIR We conclude that the record supports the Tax Court’s finding that WB Partners contributed no value to the NTC Joint Venture. Had the joint venture never existed, WB Partners would still be obligated to offer Barone’s and Watkins’s guaranties because both men promised to provide financial services as necessary to support WB Partners’ business. As WB Partners’ wholly owned subsidiary, WCI would have been entitled to Barone’s and Watkins’s guaranties even if WB Partners did not promise to provide those guaranties to the joint venture. In September of 2000, in their employment agreements with the holding corporations DJB and GSW, Barone and Watkins promised to provide guaranties to enable the corporations’ clients to post performance bonds. Later that month, DJB and GSW amended WB Partners’ general partnership agreement to offer Barone’s and Watkins’s services as “necessary to manage and conduct the business of [WB Partners].” The amendment offered Barone’s and Watkins’s services not only to WB Partners itself, but also to any “third parties in connection with” WB Partners’ business. WCI’s environmental remediation work for the NTC redevelopment project was part of WB Partners’ business because WB Partners wholly owned WB Acquisition, which in turn wholly owned WCI. Because WCI’s work on the NTC project was part of WB Partners’ business, the partnership agreement required Barone and Watkins to provide any financial guaranties necessary to permit WCI to obtain the bond it needed to perform the work. Accordingly, WB Partners was obligated to furnish Barone’s and Watkins’s guaranties independently of the joint venture agreement. WB Partners’ commitment to provide guaranties to the NTC Joint Venture therefore was superfluous. DJB HOLDING CORP. V. CIR 21 Not only did Barone’s and Watkins’s guaranties contribute no value to the joint venture independent of what they were already obligated to provide, but the record also belies any argument that WB Partners’ own guaranty, or those of DJB and GSW, held independent value. An employee of AIG, one of the companies that executed an indemnity agreement with the NTC Joint Venture, remarked that the performance bond issued because WCI, Barone, and Watkins were “financially sound indemnitors.” The employee recalled that WCI’s financial condition was “very good” and that Barone and Watkins both had a “pretty high” net worth. He did not remember WB Partners’ financial condition (or that of DJB and GSW) at all. Moreover, at the time WB Partners provided its guaranty, it had no other assets outside its equity in the NTC Joint Venture and WB Acquisition. This evidence supports the Tax Court’s conclusion that WB Partners’ guaranty contributed no additional value to the NTC Joint Venture. Only Barone’s and Watkins’s guaranties enhanced WCI’s ability to secure a performance bond, and they were obligated to provide the guaranties purely by virtue of their employment agreements and the amended partnership agreement. Maxwell is therefore inapposite, as the majority shareholder in that case was not obligated to offer his personal guaranty by any contract outside of the partnership agreement. See 29 T.C.M. (CCH) at 1358. Because Barone and Watkins were contractually obligated to provide any guaranties necessary to permit WCI to perform environmental remediation work, WB Partners’ separate commitment to provide those guaranties to the joint venture was superfluous. The Tax Court therefore did not clearly err in concluding that WB Partners contributed nothing of value to the NTC Joint Venture. Because Taxpayers do not 22 DJB HOLDING CORP. V. CIR challenge the Tax Court’s analysis of any of the other Luna factors, it necessarily follows that the Tax Court did not clearly err in finding that Taxpayers did not intend to operate the NTC Joint Venture as a bona fide partnership. See Luna, 42 T.C. at 1077–79; Culbertson, 337 U.S. at 742.
Faith To Share Profits. Of course, if the NTC Joint Venture was not a valid partnership for tax purposes, then WB Partners does not have a partnership interest entitling it to declare as income a share of the profits from the NTC project. Taxpayers argue in the alternative that WCI agreed in good faith to assign WB Partners a share of the profits in exchange for WB Partners’ signing the indemnity agreement. Where a taxpayer agreed to pay a portion of the profits from an enterprise in exchange for financial assistance from another, that portion of the profits is income to the entity providing the assistance, not to the taxpayer. See Stevens Bros. & Miller-Hutchinson Co., Inc. v. Comm’r, 24 T.C. 953, 956–57 (1955). In Stevens Brothers, the taxpayer, a corporation in the heavy construction business, was unable to bid on a public works project because it had insufficient capital to obtain a loan. Id. at 954. Another corporation agreed to loan the taxpayer the necessary additional capital in exchange for a one-half share of the profits from the project. Id. at 955. In accordance with the agreement, the taxpayer declared only half of the profits as income. Id. at 956. The Tax Court held that this was proper. Id. The risk of loss to the second corporation was real, the terms of the agreement were fair, and the interests of both corporations were sufficiently “adverse” to permit the conclusion that the DJB HOLDING CORP. V. CIR 23 contract was “bona fide.” Id. In addition, the corporations actually shared the profits at the agreed-upon fifty-percent division, further demonstrating that the agreement was genuine. Id. Taxpayers argue that, as in Stevens Brothers, WCI and WB Partners agreed that WB Partners would receive a portion of the profits from the NTC project in exchange for providing necessary financial assistance to WCI—in this case, a financial guaranty. As in Stevens Brothers, WB Partners assumed substantial financial risk by agreeing to indemnify the surety on the performance bond. Also as in Stevens Brothers, Taxpayers assert, the parties to the joint venture agreed that WB Partners would receive a percentage share of the profits in exchange for its guaranty. To the contrary, Taxpayers’ conduct shows that WCI and WB Partners did not reach a bona fide agreement to transfer a share of the profits to WB Partners in exchange for its guaranty. According to the joint venture agreement, WB Partners was to receive seventy percent of the profits for this service. Instead, as reflected in an invoice, WCI unilaterally reduced WB Partners’ share to 50.4%. It is questionable that a company dealing with WCI at arms’ length would give up a nearly twenty-percent share of the profits—approximately $1.6 million—so casually. This disregard for the joint venture agreement’s terms demonstrates that WCI and WB Partners did not intend in good faith to be bound by that agreement.8 Accordingly, the Tax Court did not clearly err in 8 Taxpayers argue in the alternative that they are entitled to deduct WB Partners’ share “as an ordinary and necessary bond guaranty expense.” See A.A. & E.B. Jones Co. v. Comm’r, 19 T.C.M. (CCH) 1561, 1563 (1960) (permitting the taxpayer to deduct as a business expense a share of profits 24 DJB HOLDING CORP. V. CIR finding that WCI and WB Partners did not reach a bona fide agreement to share profits. Cf. Stevens Bros., 24 T.C. at 956 (noting that the lending corporation received “payment of the agreed amounts”). The record supports the Tax Court’s finding that WB Partners contributed no value to the NTC Joint Venture, and therefore that WB Partners and WCI did not act as bona fide partners. See Luna, 42 T.C. at 1077–79; Culbertson, 337 U.S. at 742. WCI’s arbitrary reduction of WB Partners’ share of the proceeds further supports the Tax Court’s finding that the two entities did not reach a bona fide agreement to share profits. Cf. Stevens Bros., 24 T.C. at 956. Accordingly, the Tax Court properly determined that all of the profits from the NTC Joint Venture were income to WCI. II. Proceeds from the Noncompetition Agreement Were Income to WCI Rather Than WB Partners. The “first principle of income taxation” is “that income must be taxed to him who earns it.” Culbertson, 337 U.S. at 739–40. 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. For example, when an agreement to sell a corporation’s assets includes promises by its shareholders that they will not compete with the purchaser, the shareholders must declare as income the consideration paid to shareholders who indemnified a bond surety). Because we affirm the Tax Court’s conclusion that the parties did not intend in good faith to transfer a share of the profits to WB Partners in exchange for its guaranties, we must also reject the suggestion that WCI is entitled to deduct that share as a business expense. DJB HOLDING CORP. V. CIR 25 they receive for their promises. See Beals’ Estate v. Comm’r, 82 F.2d 268, 270 (2d Cir. 1936) (holding that stock transferred in exchange for a taxpayer’s agreement not to compete was income to the taxpayer, and not merely “ancillary” to a larger reorganization plan); Cox v. Helvering, 71 F.2d 987, 988 (D.C. Cir. 1934) (holding that money paid in exchange for a shareholder’s agreement not to compete was income to the shareholder). By promising not to compete with the purchaser’s business, the shareholders “earn” the consideration that the purchaser offers in exchange for the promise. See Cox, 71 F.2d at 988 (“If [a person] refrains from exercising his skill and ability in a particular line for a definite period, what he receives in compensation . . . is income.”). Of the roughly $5.5 million price at which Kuranda agreed to purchase WCI’s assets, the Tax Court concluded that the $3.4 million portion allocated to the noncompetition agreement was income to WCI, not WB Partners. The noncompetition clause prohibits Barone, Watkins, and WCI from engaging in “Competing Services,” which are defined to include any
or offered by or on behalf of WCI (or any predecessor of WCI) at any time on or prior to the date of this Noncompetition Agreement that involves or relates to asbestos, mold, and lead abatement in residential, commercial and government properties; (ii) service that is substantially the same as, is based upon or competes in any material respect with any service referred to in clause “(i)” of this sentence. 26 DJB HOLDING CORP. V. CIR (alterations omitted). To summarize, Barone, Watkins, and WCI agreed not to compete with Kuranda in providing any service related to “asbestos, mold, and lead abatement.” The Tax Court noted that WCI was the only signatory to the noncompetition agreement ever to perform “asbestos, mold, and lead abatement” services. Moreover, it was the only entity bound by the agreement that “had the proper licenses and permits to perform the necessary construction and excavation work.” While Barone’s and Watkins’s services were necessary to WCI’s operations, the court found that WCI was entitled to those services because both men were WCI officers. As the only entity capable of competing with Kuranda in providing environmental remediation services, the court found, WCI was the only party truly bound by the agreement. The Tax Court therefore concluded that WCI earned all of the proceeds. Accordingly, it found that the interest on Kuranda’s $500,000 promissory note was also income to WCI, not WB Partners. Because the Tax Court’s analysis was “primarily factual,” we review its assignment of the proceeds of the noncompetition agreement to WCI for clear error. See Sparkman, 509 F.3d at 1155, 1157. As Taxpayers correctly observe, the Tax Court erred in finding that only WCI was bound by the noncompetition agreement. Instead, the agreement also bound Barone and Watkins personally. Contrary to the Tax Court’s reasoning, Barone’s and Watkins’s status as WCI officers does not entitle WCI to their services because Barone and Watkins were employees of their holding corporations, DJB and GSW, not of WCI. Further, even if they were employees of WCI, Barone and Watkins were free to terminate their relationship with WCI at any time. Because California is an at-will employment state, WCI was not entitled to Barone and DJB HOLDING CORP. V. CIR 27 Watkins’s services in the future absent a contractual agreement to that effect. See Cal. Lab. Code § 2922 (“An employment, having no specified term, may be terminated at the will of either party on notice to the other.”); Guz v. Bechtel Nat’l, Inc., 8 P.3d 1089, 1110 (Cal. 2000) (“The mere existence of an employment relationship affords no expectation, protectible by law, that employment will continue . . . unless the parties have actually adopted such terms.”). The record contains no evidence of such an agreement. Accordingly, under California law, Barone and Watkins were free to sever their ties to WCI and perform environmental remediation services for another company. The noncompetition agreement therefore bound Barone and Watkins personally not to compete with Kuranda in the environmental remediation business. Taxpayers go on to argue that the noncompetition agreement binds Barone and Watkins alone, not WCI, and that WB Partners, not Barone and Watkins, is entitled to the proceeds of the agreement. This argument rests on two fundamental misapprehensions. First, by its plain terms, the agreement forbids “[e]ach of Seller, Watkins and Barone” from performing competing services. The agreement goes on to provide that the $3.4 million amount be “allocated as partial consideration for Seller’s and the Shareholders’ obligations” not to compete. The asset purchase agreement defines “Seller” as WCI, and “Shareholders” refers to Barone and Watkins. The terms of the noncompetition agreement demonstrate that Barone, Watkins, and WCI each earned a share of the $3.4 million proceeds. Second, the proceeds of the noncompetition agreement are not income to WB Partners because the partnership, like WCI, has no future claim to Barone’s and Watkins’s services. 28 DJB HOLDING CORP. V. CIR It is true that Barone and Watkins agreed to provide their services exclusively for their holding corporations, DJB and GSW. DJB and GSW, in turn, agreed to provide Barone’s and Watkins’s services to WB Partners. However, Barone’s and Watkins’s employment agreements with DJB and GSW provide that either party may terminate employment at any time with ninety days’ notice to the other. Accordingly, Barone and Watkins were free to leave DJB and GSW and go off to perform environmental services for another company. Because WB Partners had no right to expect Barone and Watkins to continue to provide their services into the future, Barone’s and Watkins’s agreement not to compete with Kuranda may not be imputed to WB Partners. WB Partners therefore earned no part of the consideration for the noncompetition agreement. WCI, Barone, and Watkins each are individually bound not to compete with Kuranda, and therefore are each entitled to a share of the noncompetition agreement. See Beals’ Estate, 82 F.2d at 270; Cox, 71 F.2d at 988. Because WB Partners has no claim to Barone’s and Watkins’s future services, WB Partners is entitled to no share at all. See Culbertson, 337 U.S. at 739–40. Accordingly, the Tax Court did not clearly err in declining to assign any portion of the proceeds of the noncompetition agreement to WB Partners.9 9 Were the question before us, we may be inclined to hold that the Tax Court clearly erred in failing to assign any share of the noncompetition agreement’s proceeds to Barone and Watkins individually. Neither party has asked that we do so. DJB HOLDING CORP. V. CIR 29