District Court Rejects Fund Managers' Attempt to Recharacterize Service Contract as Partnership Relationship

... The opinion of the U.S. District Court for the Southern District of Texas in Rigas v. United States, 107 AFTR 2d 2011-788 (C. D. Tx. 5/2/2011)... involves the fundamental question of how the relationship between investment manager and investment fund should be characterized for tax purposes.    From the manager's perspective, it is generally preferable, for tax purposes, to be  treated as a partner in the fund, at least where it is expected that the fund will produce capital gains.  However, funds, for state law purposes, may prefer management to be brought in as independent contractors under a management contract to limit the rights and powers that management has over the fund and its assets.  In addition, the fund that produces capital gains may sometimes favor an independent contractor relationship for tax purposes as well, as it may be able to take an ordinary deduction for salary paid to management. 

As a fundamental issue in any investment fund/management relationship, the form of the relationship is typically negotiated prior to the commencement of the relationship.  This is what transpired in Rigas-the oil and gas fund's desire not to be partners with management apparently prevailed and the parties entered into a management agreement which expressly disclaimed any desire to form a partnership. Nevertheless, the management entity in Rigas ultimately reported the income it received from the fund, in the form of a performance fee equal to 20% of residual profits, as flow-through capital gain income, as if it were a partner in the fund. 

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To determine intent, the court looked to the well-worn "Luna" factors (see Luna v. Comm'r, 42 T.C. 1067, 1078 (T.C. 1964)) .  For the managers, the consequences of a finding  of partnership were significant-15% capital gain rates on all income from the fund, or a 35% rate of tax on all such income.

The court found several Luna factors in favor of partnership.  First, the court found that  the management entity contributed both services and capital to the venture.  The management entity issued its note to the fund for payment of various expenses and the management entity's performance fee was paid only after repayment of the note, which the court found constituted a from of delayed capital contribution.  Additionally, the court found that the management entity's clawback obligation, pursuant to which the management entity would have to give back a porition of its performance fee should losses be subsequently discovered,  was indicative of a partnership.

However, the balance of Luna factors weighed against the taxpayer, according to the court.  Although profit sharing is an important feauture of partnership arrangements, the court found the performance fee in this case was also consistent with a contingent fee payable under a service agreement, particularly because the performance fee was the sole means of compensation, which distinguished these facts from other authorities where courts have found profit sharing to be indicative of partnership where the service partners also receive a salary in addition to the profits interest. 

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Managers that have not been able to negotiate for partner status may take heart in the court's holding that the form of the relationship as set forth in the management agreement is not controlling.  However, managers in this situation should be aware that they face an uphill battle against the IRS, who will be fighting against the whipsaw that would result from a fund taking an ordinary deduction and the service provider receiving capital gains... 

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View Matt Kaden's insights in their entirety on the Private Equity, Venture Capital and Hedge Fund Taxation site.

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