The question of whether an arrangement was a partnership or was a commission arrangement was the issue before the United States Court for the Southern District of Texas in the case of United States v. Stewart, et al, 116 AFTR 2d ¶ 2015-5159.

As opinion explains the facts:

In March of 2003, Hydrocarbon Capital, LLC, bought a portfolio of oil and gas properties from Mirant Corporation. Because it was new to the oil industry, Hydrocarbon asked the five executives at Mirant who managed the operation of the properties to manage its wells. Those five people 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 initially structured so that Hydrocarbon lent Odyssey $6 million without recourse for working capital. When the assets were sold, Odyssey had a 20% interest in the sale revenue after Hydrocarbon recouped its expenses, its investment, 10% return on its investment, and the loan. Also, the Odyssey partners 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. Odyssey split the remaining revenue with it; Odyssey's 20% interest was worth about $20 million.

Originally Odyssey reported the income from the transaction as generating ordinary income. However, two years later Odyssey amended its return to classify the amount as a capital gain from a sale of a partnership interest and issued amended K-1s to its partners.

The IRS cried foul (but not until after issuing refunds to some of the partners), claiming the arrangement was actually compensation for services rendered, and should be treated as ordinary income. The key issue was whether Odyssey had a profits interest issued for services, or if it was rather an arrangement representing simple compensation for the services provided of arranging the eventual sale of the properties.

The Court outlined the positions of each of the parties as follows:

The government says that Odyssey managed Hydrocarbon's assets and earned a commission that is taxable as ordinary income. It says that no tax partnership existed because:

(a) The agreement disclaimed a partnership;

(b) Hydrocarbon contributed and controlled the money, owned the assets, and Odyssey had no money at risk;

(d) The parties did not have a joint name, jointly file a tax return, or maintain a single accounting ledger.

The partners say that Odyssey's net-profits interest in the portfolio of oil properties is a capital gain. Hydrocarbon and it had a tax partnership; whatever the technical company form, the service allows it to be taxed as a partner with Hydrocarbon because:

(a) Hydrocarbon contributed the cash capital used to acquire the mineral properties;

(b) Odyssey contributed (1) operating expenses, (2) technical and entrepreneurial work, and (3) management;

(d) Although Hydrocarbon had to approve the operations budget, Odyssey devised and implemented it, and it was billed to Odyssey.

The Court sided with the partners’ view of the arrangement. The opinion held:

Tax partnerships do not depend on contract language.1 They arise from the reality of relationships. The partners of Odyssey were not car salesmen earning commissions from individual sales. They had an ownership interest in the value of the entire operation. Hydrocarbon contributed the properties and financing, and they contributed their expertise and energy to make a contingent interest in the asset valuable.

And, it continues:

This arrangement is 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. The very reason it is called sweat equity instead of sweat income. In the same way, Odyssey's sweat, their management, increased the value of the capital, the portfolio of properties.

Having purchased a share of the project, the partners managed the portfolio and earned the venture significant profits when it sold. This merger of execution and financing is a partnership, and its profits are long-term capital gains.

Unfortunately for us as readers, the Court did not detail the specific application of facts to law that was used in arriving at this conclusion. But it is interesting that the IRS was apparently not arguing that the partners had received a partnership interest for services which, under a series of cases dating back to the Sol Diamond case (56 TC 530, affd CA7 33 AFTR 2d 74-852) could lead to ordinary income on the issuance of the interest, but rather was arguing over the nature of the income received and whether a partnership existed. Nor does it appear that the IRS questioned the status of the underlying property sold as capital.

So what the Court decided was that a partnership existed and, once that was found to be the case, the fact that a partnership interest is a capital asset (subject to hot asset rule adjustments) meant a sale of that would be a capital gain.

The IRS did try to argue what might reasonably be viewed as a technicality, arguing that the partnership had not followed proper procedures to request an administrative adjustment. The partnership filed an amended Form 1065 rather than a form request for adjustment of the partnership return with a Form 8082. The IRS argued that the partners returns conflict with the original return which remains the only valid one—so the treatment should be ordinary income.

It appears that either the Odyssey was not a qualified small partnership under IRC §6231(a)(1)(B) or had elected to have the consolidated partnership audit procedures apply despite being eligible to avoid the use of that provision.

The Court agreed with the taxpayers that they had substantially complied with the requirements for a formal request and that the IRS had more than sufficient information about the nature of the adjustment requested. As the Court noted:

When it received the partnership return in 2007, it saw that Odyssey re-categorized more than $20 million from ordinary income to capital gains. That is all it needed to investigate. It had three options: approve the adjustment without investigation, investigate, or do nothing. The government approved Odyssey's request without comment, and the partners' amended returns were correct.

In fact, the Court applied the rules now to argue it was the IRS who was prohibited from changing the classification. As the Court noted:

The law requires the government to determine tax liability at the partnership level. To change the tax treatment of an individual partner, the government must first change the treatment by the partnership. The government cannot sue individual partners to change the characterization of their income.

The service approved Odyssey's new return and has never changed its income back to ordinary. The government cannot sue Stewart and Plato without having changed Odyssey's return first.

Even if the court could change the characterization of the income, the original return was submitted in 2005, and the government has been barred since April 15, 2008, from assessing the tax that would flow from a change back to ordinary income.