Originally published on Forbes.com Dec 8th, 2013
The ruling in last week’s Tax Court decision in the case of Crescent Holdings LLC is an important one. Arthur Fields had a 2% interest in Crescent Holdings(CH). The interest was not fully vested. In order for it to vest, Mr. Fields had to remain on as CEO of Crescent Resources, which was owned by CH, for three years. As it worked out, the interest never vested, so Mr. Fields argued that he should not recognize the income that flowed through to him from CH in 2006 and 2007 – over $4,000,000 – since it was of no ultimate benefit to him. At Joseph B Cohan and Associates we had a term for picking up income without getting any cash. Sorry, I can’t share it – contributor guidelines you know.
What Others Have Written
At any rate, the Tax Court ruled that the partnership allocation of income to Mr. Fields was inappropriate since he should not have been considered the owner of the interest for those two years. Enough other tax bloggers, not obsessed as I was with the clergy housing allowance decision, picked up on the Crescent decision that I might have passed on it. Joe Kristan wrote:
This decision tells partnerships preparing 2012 returns that they shouldn’t allocate taxable income to partners with unvested interests. I suspect some partners and partnerships may file amended returns for open years as a result. It’s not entirely clear, but I read the opinion as saying that a timely Section 83(b) election would change this result.
Monte A. Jackel wrote:
This case illustrates the critical distinction under current law between an unvested partnership profits interest issued for services and an unvested capital interest issued for services. The former interest is granted special treatment under current law based on current IRS revenue procedures whereas the latter interest is subject to the general rules under section 83.
Lew Taishoff ‘s post had a great title – Das Kapital – Part Deux:
No, not Karl Marx. This is the story of Crescent Holdings, LLC, Arthur W. Fields and Joleen H. Fields, A Partner Other Than The Tax Matters Partner, 141 T. C. 15, filed 12/2/13, another romp through the wonderful world of TEFRA, FPAA, and the alleged collision between Section 721 and Section 83.
Partnership Taxation – A Mess
The ruling that partnerships cannot allocate income to some unvested partners will be significant to some, but I think the case has other significance. It is really an illustration of how screwed up partnership taxation is not just in theory, but also in practice. Professor Andrea Monroe gave a pretty good summary of the state of partnership taxation in a paper for the Alabama Law Review:
Partnership taxation has been described as a mess, a disaster,and a magic circle of tax abuse. Additionally, there are thousands of pages of rulings, memoranda, and guidance, both formal and informal, clarifying the application of these provisions in specific situations. Although the sheer quantity of partnership authority introduced great complexity into subchapter K, the deeper problem relates to their design. As previously discussed, subchapter K’s provisions are largely technical, involving specialized language, multi-factored tests, and computational analyses that challenge all but the most experienced partnership tax specialist.
Can’t Anybody Here Play This Game?
Here is the part of the decision that struck me. Mr. Fields was surprised when he received a K-1 for 2006 requiring him to report $423,611 in taxable income. He thought that since his interest was not vested he was not really a partner and should not be allocated income. The CFO of Crescent Resources agreed with him but indicated that the return had already been filed and they did not want to amend since it would require the Morgan Stanley fund that had invested in the deal to amend, which would then affect all the investors. That was bad enough. It gets worse.
On April 15, 2008, Crescent Holdings filed Form 1065 for the 2007 tax year. Crescent Holdings issued a Schedule K-1 to petitioner that allocated $3,608,218 of ordinary business income to him. Petitioner did not receive any distributions from Crescent Holdings in 2007. Petitioner was shocked to receive another Schedule K-1 because he believed that Wayne McGee had indicated he would not receive a Schedule K-1 for 2007. Petitioner spoke with Kevin Lambert, who was then the chief financial officer of Crescent Resources. Kevin Lambert then spoke with the accounting firm that had prepared the Form 1065 and Schedules K-1 for Crescent Holdings. Kevin Lambert told petitioner that the accounting firm believed the economic substance of the transaction indicated that petitioner was a partner.
If that is the way it actually played out, I would see it as a service failure of epic proportion on the part of the accounting firm. The CEO was surprised that he got a K-1 for a few hundred thousand and was assured by his CFO that it was a mistake. In the following year, he gets a K-1 for over three million out of the blue and is told that it is the right answer. How in the world did that return get signed without somebody picking up the phone and calling the CFO? The question should have been resolved before they started working on the return. Assuming that allocating the income to Mr. Fields was as right an answer as there was, the K-1 should not have come as a surprise to him.
What Were They Up To?
Even though I would be hanging my head in shame, if I had been involved in a mess like that, it is actually not all that surprising. Particularly in the partnership area, there is a lack of communication and understanding among the principals, the planners who devise the schemes, the attorneys who draft the agreements, and the preparers of the returns. Mr. Fields’ role as a partner was probably critical to the larger scheme, but apparently, nobody explained it to him.
Reading between the lines, it would appear that the primary motivation for the structure of CH was the optimal tax and financial reporting outcome for the ultimate corporate owner of a nearly 50% stake in CH. The core business of which Mr. Fields was CEO was Crescent Resources. In 2006, Crescent Resources was owned by Duke Ventures which was a wholly-owned subsidiary of Duke Energy, a public company. Here is how the formation is described in Duke Energy’s 10-K:
On September 7, 2006, an indirect wholly owned subsidiary of Duke Energy closed an agreement to create a joint venture of Crescent (the Crescent JV) with Morgan Stanley Real Estate Fund V U.S., L.P. (MSREF) and other affiliated funds controlled by Morgan Stanley (collectively the MS Members). Under the agreement, the Duke Energy subsidiary contributed all of the membership interests in Crescent to a newly-formed joint venture, which was ascribed an enterprise value of approximately $2.1 billion as of December 31, 2005. …. Crescent borrowed approximately $1.21 billion, ….. $1.19 billion was immediately distributed to Duke Energy. …
As a result of Duke Energy’s deconsolidation of Crescent effective September 7, 2006, Crescent’s outstanding debt balance of $1,298 million was removed from Duke Energy’s Consolidated Balance Sheets.
After the formation, borrowing, and distribution Morgan Stanley came into the partnership with a capital contribution of $415 million. Duke Energy booked a $250,000,000 gain for financial accounting purposes on the transaction. I’m still scratching my head over whether Duke Energy recognized any gain for federal income tax purposes. It seems like the point of this was to dance around the disguised sales rules. Clearly, if the distribution happens after Morgan Stanley puts its money in there is a problem. I think that is why it was important to somebody that Mr. Fields be considered a “real partner”. You would think that somebody should have explained that to him. You can’t rule out that somebody did explain it to him and it didn’t quite register.
Then It Gets Ugly
The Tax Court decision on Mr. Fields picking up $4,000,000 in phantom income which seems like a big deal to me and will be a big deal to partnership practitioners is actually something of a footnote to the story of Crescent Holdings. Crescent Resources was a real estate development company with substantial real estate holdings. Applying over a billion dollars of leverage to it in 2006 might have been a pretty good deal for Duke Energy, but for Crescent Holdings, not so much.
You may recall that the second half of the first decade of the third millennium was not such a great time for real estate values. Mr. Fields kept complaining about those K-1’s and he finally got some distributions to cover his tax liabilities. He didn’t last out the three years. Crescent’s bankruptcy trustees sued him to recover the distributions.
This might be considered chasing after crumbs since they were also trying to get Duke Energy to kick back its billion-plus distribution. At any rate, Mr. Fields agreed that they could have the distributions back after he got his taxes refunded. What is not clear to me is whether that four million in income for 2006 and 2007 is just going to go “poof” or if all the Morgan Stanley investors, who are, in reality, among the really big losers in all this, will get adjustments on tax years that they thought were closed.
The other interesting question is whether this decision allows the IRS to take another look at how Duke Energy treated the transaction in 2006. I’ll leave that one for the TEFRA experts.
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