Attorney-at-Law

SUBSTANCE OVER FORM

In Uncategorized on 02/11/2011 at 16:18

But if you put the form in writing, you must abide by it.

While relaxing on South Beach (if you wondered where my blog went to the last ten days, it was behind a mojito on Ocean Drive), my fingers idly strayed across the keyboard looking for something interesting. And I found WB Acquisition, Inc., and Subsidiary, et al., TC. Memo. 2011-36, 2/8/11.

Barone and Watkins were asbestos removers and specialty contractors. Their work involved high-risk, high-reward projects, requiring them to provide personal guarantees to bonding companies. Short-cutting a lengthy explanation (which Judge Haines gives at great length), Barone and Watkins hired an attorney to create a multi-layered ownership structure for WCI, the operating company, which would be undertaking an ultra-high-risk, ultra-high-reward project for the U. S. Naval Base at San Jose, CA.

The corporate structure was elaborately documented, with employment agreements between the entities and Barone and Watkins. But the Navy project was much larger than any project Barone and Watkins had done before. Concerned about shielding the rewards from past creditors, and desiring to minimize any personal liability, Barone and Watkins entered into a joint venture agreement between WCI and an entity two layers up the ownership chain (but still controlled by Barone and Watkins).

The joint venture agreement insulated the upstream partner from loss, but left all responsibility for the work, from initial permit to sign-off at completion, with WCI. The profits were to be split 70-30, the upstream entity getting the larger share, as it had no previous indebtedness or complications.

WCI was the only entity that could obtain permits for the work, or that was recognized by the bonding companies. The joint venture filed no income tax return, claiming that under GAAP they were not required to. That argument did not fly with Tax Court.

Barone and Watkins sold WCI after completion of the project, and the complications arising from that sale are dealt with in the decision, but I am concentrating here on the disregard of the joint venture agreement by Barone and Watkins.

They reallocated the share of the profits between the joint venture entities without amending the joint venture agreement or establishing any business purpose for the reallocation, except stating “the profits were too large”. Tax Court treated this as a prohibited income-shifting device, and proceeded to deconstruct the joint venture.

Using the “distilled” principles enunciated in Luna v. Commissioner, 42 T.C. 1067 (1964), the so-called “Luna factors”, Tax Court examined:

“The agreement of the parties and their conduct in executing its terms; the contributions, if any, which each party has made to the venture; the parties’ control over income and capital and the right of each to make withdrawals; 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; whether business was conducted in the joint names of the parties; whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers; whether separate books of account were maintained for the venture; and whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.” WB Acquisitions, Inc., at p. 24.

Of course, Barone and Watkins were found to have violated the greater part of the Luna factors, and run all the various entities as extensions of themselves. Despite the carefully constructed documents and the elaborate rationalizations of the legal team, the “joint venture” was found to be a smoke screen, and a rather transparent one.

Chiefest among Tax Court’s objections were shifting of profits after the fact and without any basis in the joint venture agreement, the joint venture’s failure to file its own income tax returns, and the lack of any substantial role played by the upstream entity.

In short, “build it–they will come” means not only build it, but play it like it was built.  And the takeaway for tax advisers– it isn’t enough to create a beautiful structure, you have to warn the users of the structure to play by the rules.

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