Court grants refund to taxpayer for bonus paid by hedge fund partnership

Court grants refund to taxpayer for bonus paid by hedge fund partnershipIn Herrmann v. United States, No. 1:14-cv-00941, Court of Federal Claims on ruled that an $18 million payment a partnership made to one of its partners was not a partnership distribution, but instead was made in a capacity other than as a partner.  

In Herrmann, the taxpayer, Mina Gerowin Herrmann, became an employee of Paulson & Co., a New York-based investment management firm, in 2005. The fund managed several hedge funds devoted to pursuing different investment strategies. During the relevant tax years, the taxpayer received a salary along with a bonus, determined according to a formula set by the fund. The bonus amounted to 2% of the net incentive fee paid to the funds for which she provided services; if those specific funds did not generate fees, she would not receive a bonus. The fund considered senior employees, such as the taxpayer, to be partners in the firm because they shared in its profitability according to the formula. However, the fund was an S corporation and her compensation was reported on Form W-2, reflecting her status as an employee.

In 2008, the taxpayer moved to London to specialize in analyzing European opportunities for the fund’s hedge funds. When she transferred to London, she was required to join the partnership of fund’s European affiliate, PELLP, because doing so would allow PELLP to avoid certain U.K. employment taxes. In exchange for agreeing to abide by the partnership agreement and making a £30,000 capital contribution, the taxpayer obtained a small (no larger than 4%) interest in PELLP. Unlike with Paulson & Co., PELLP did not manage investments and did not generate its own profits. Rather, all of PELLP’s assets (including cash) were transferred from the fund for the purposes of staff salaries, bonuses and other expenses. The taxpayer’s job responsibilities and compensation did not change, and her bonus was still tied to the performance of specific Paulson & Co.’s hedge funds.

According to the formula set by Paulson & Co., the taxpayer’s bonus for 2008 was $18 million. The fund wired the compensation to PELLP, which directed that she be paid on Dec. 31, 2008. She actually received the funds on Jan. 6, 2009. The taxpayer inadvertently did not include the $18 million payment on her U.S. income tax returns for either the 2008 or 2009 tax years. However, she reported and paid tax on the bonus in the U.K. in 2009, and would have generated sufficient foreign tax credits to fully offset her U.S. federal income tax liability for 2009.

Following an IRS audit of PELLP, the IRS determined that the $18 million payment was a partnership distribution to the taxpayer, and under Section 706(a), the payment should have been reported on her U.S. federal income tax return for 2008. The taxpayer paid the tax and sued for a refund.

The taxpayer asserted that the $18 million payment should be taxable in the 2009 tax year, upon receipt of the payment. Additionally, she argued that the $18 million payment was not a partnership distribution because she was not a bona fide partner in PELLP for U.S. federal income tax purposes, or if she was a partner, the payment was for services performed outside her capacity as a partner pursuant to Section 707(a)(2)(A). The Claims Court agreed that the $18 million payment was for services outside of her capacity as a partner of PELLP.

The court reasoned that the $18 million payment was a direct transfer to her tied to the work she performed for Paulson & Co.’s hedge funds, and that it had no relation to the financial performance of PELLP or to the PELLP partnership agreement. The court noted that she only became a member of PELLP for U.K. employment tax planning purposes. She did not perform any services on behalf of the partnership itself, but rather the partnership served as a European conduit for her to perform the same services she performed as an employee of Paulson & Co. The taxpayer’s bonus was dependent upon the success of the specific hedge funds and was not a guaranteed payment. The $18 million payment was under the control of the fund, and therefore subject to the risks of the fund, not PELLP, indicating that it was not a distribution of partnership profits. The court also noted the $18 million payment was disproportionate to her actual ownership share of PELLP. While she owned no more than 4% of PELLP, the payment represented approximately 27% of PELLP’s total receipts for the year.

Because the $18 million payment was made to the taxpayer for her services outside her capacity as a member of PELLP under Section 707(a)(2)(A), it was taxable to her in 2009 when the payment was received.

The court’s analysis was limited to the Section 707(a)(2)(A) issue, assuming that the taxpayer was a partner of PELLP. While the court noted that the $18 million payment was not a guaranteed payment, the court did not provide additional detail on how it should be reported, (i.e., on Form W-2 or a Form 1099). Some of the issues that the court did not specifically address included (1) whether the taxpayer was a bona fide partner of PELLP, (2) whether PELLP was a bona fide partnership for U.S. federal income tax purposes, and (3) determining the employee and employer relationships among Herrmann, PELLP, and Paulson & Co.

Nevertheless, the Claims Court’s analysis shows that in evaluating a transaction between a partner and a partnership under Section 707(a)(2)(A), the substance rather than the legal form controls. Practitioners should consider whether a court might look through an entity that serves as a mere conduit to determine the true source of funds paid to a service provider as well as the entity to which the individual is performing services.

Grace Kim
Principal, Washington National Tax Office
T +1 202 521 1590

Jose Carrasco
Senior Manager, Washington National Tax Office
T +1 202 521 1552

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