Court Finds No Partnership; Treats Profits Interest As Service Income

In Rigas v. United States, 2011-1 U.S.T.C 50,372 (S.D. Tex. 2011), the U.S. district court held that a partnership did not exist between an energy company (the "Company") and a limited partnership (the "Manager") that managed the Company's oil and gas properties (the "Portfolio"). Instead, the court treated the Manager as a service provider whose 20% profits interest was compensation for services taxable as ordinary income and not an allocation of income from a partnership that would have been taxable as a capital gain. The importance of this case is that the facts fit within most hedge fund and private equity structures except that in Rigas the manager did not receive the standard 2% of the annual value of the partnership assets as an annual management fee (in addition to a 20% profits interest) and, unlike most agreements, the parties in Rigas had to argue against their form—an argument the court was willing to entertain—because their agreement stated that no partnership was intended.

Background

Under a management agreement (the "Agreement") with the Company, the Manager agreed to manage and administer the Portfolio in exchange for a performance fee. The Company retained title, ownership, and control of the Portfolio. The Manager could not sign binding commitments to sell any asset in the Portfolio, incur unforeseen expenses or enter into transactions that were not previously approved by the Company. The Agreement expressly stated that the parties did not intend to create a partnership and that the Manager is an independent contractor that would receive a performance fee as compensation for services.

The Manager borrowed funds from the Company to cover its overhead expenses, such as the salaries of its individual partners (of which the taxpayer was one of five partners) in exchange for a nonrecourse promissory note (the "Note"). Under the Agreement, the Manager's performance fee is equal to 20% of the profits derived from the Portfolio based on the following priority of payments: First, the Company would recoup all third party out-of-pocket expenses. Second, the Company would recoup the initial value of the Portfolio. Third, the Company would receive a preferred return of 10% of the profits. Fourth, the Company would be repaid any amount outstanding under the Note. Fifth, the Company and the Manager would split the residual profits, 80% and 20%, respectively; however, the Manager's performance fee (i.e., 20% profits interest) is subject to "clawback" to ensure that the Company receives the amounts provided for in steps one through four above.

Consistent with the statements in the Agreement, the...