DJB Holding Corp. v. Comm'r

• Decision Date: 07 October 2015
• Docket Number: 12–70575,Nos. 12–70574,12–70576.,s. 12–70574
• Citation: 803 F.3d 1014
• Parties: DJB HOLDING CORPORATION; Tax Matters Partner; WB Partners, FKA WB Acquisition Partners, Petitioners–Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee. WB Acquisition & Subsidiary, Petitioner–Appellant, v. Commissioner of Internal Revenue, Respondent–Appellee. WB Acquisition, Inc., Petitioner–Appellant, v. Commissioner of Internal Revenue, Respondent–Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

803 F.3d 1014

DJB HOLDING CORPORATION; Tax Matters Partner; WB Partners, FKA WB Acquisition Partners, Petitioners–Appellants

v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.

WB Acquisition & Subsidiary, Petitioner–Appellant

v.Commissioner of Internal Revenue, Respondent–Appellee.

WB Acquisition, Inc., Petitioner–Appellant

v.Commissioner of Internal Revenue, Respondent–Appellee.

Nos. 12–70574

12–70575

12–70576.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted Dec. 9, 2014.

Filed Oct. 7, 2015.

Lacey Strachan and Steven Toscher (argued), Hochman, Salkin, Rettig, Toscher & Perez, P.C., Beverly Hills, California, for Petitioners–Appellants.

Andrew Weiner (argued) and Teresa Ellen McLaughlin, Attorneys, and Gilbert Steven Rothenberg, Deputy Assistant Attorney General, United States Department of Justice, Washington, D.C.; William J. Wilkins, Chief Counsel, Internal Revenue Service, Washington D.C., for Respondent–Appellee.

Appeal from a Decision of the Tax Court. Tax Ct. No. 29106–07, Tax Ct. No. 26187–06, Tax Ct. No. 5039–08.

Before: ALEX KOZINSKI, JOHNNIE B. RAWLINSON, and MARY H. MURGUIA, Circuit Judges.

OPINION

MURGUIA, Circuit Judge.

Daren Barone and Gregory Watkins drew upon their experience in asbestos removal to establish a successful environmental remediation company, Watkins Contracting, Inc. (“WCI”). With success came risk—in particular, the danger that Barone and Watkins would be held personally liable for the cost of completing any projects that WCI was unable to finish. To shield themselves from this risk, the two men restructured WCI so that several corporate entities stood between them and the company. Barone and Watkins each formed a holding corporation, and the two corporations entered a partnership, Appellant WB Partners. Barone and Watkins also formed a third holding company, Appellant WB Acquisition, Inc., and transferred their interest in WCI to this company. Finally, WB Partners purchased all shares of WB Acquisition. As a result, WCI was owned by WB Acquisition, which was owned by WB Partners, which in turn was owned by Barone's and Watkins's holding corporations. This elaborate corporate structure provided Barone and Watkins with multiple levels of protection from personal liability. See Appendix.

An opportunity arose to do environmental remediation work for a massive redevelopment project at the San Diego Naval Training Center (“NTC”). To win the contract, however, WCI would have to post a large bond against the possibility that it would be unable to complete the work. To ensure that WCI could afford the bond, Barone and Watkins caused WCI and WB Partners to form a joint venture, dubbed the NTC Joint Venture. Under the terms of the joint venture agreement, WCI would do the environmental remediation work, and WB Partners would supply financial guaranties. In exchange for these services, WCI would receive thirty percent of the venture's profits, and WB Partners would receive seventy percent.

The joint venture's structure had significant federal income tax consequences. WCI would have to pay corporate income tax on its thirty-percent share of the venture's profits. As a general partnership, WB Partners would pay no income tax on its seventy-percent share; instead, that income would pass through to WB Partners' owners, the two holding corporations. The holding corporations were S corporations, whose income is treated in the same manner as that of a general partnership—it passes through to the S corporations' shareholders. And because all shares of Barone's and Watkins's holding corporations were owned by tax-exempt retirement savings plans, WB Partners' seventy-percent share of the NTC Joint Venture's profits would only be subject to federal income tax if and when the retirement plans distributed benefits to their holders.

While the NTC project was ongoing, WCI sold its assets to Kuranda Capital, LP (“Kuranda”). The purchase agreement allocated a portion of the sales price as consideration for a noncompetition agreement, whereby Watkins, Barone, and WCI agreed not to compete with Kuranda in the environmental remediation business. WB Partners claimed all of the proceeds of the noncompetition agreement on its tax returns.

This action began when Appellants WB Partners, WB Acquisition, and Barone's holding corporation (collectively, “Taxpayers”) challenged certain tax deficiencies identified by the Commissioner of Internal Revenue. In three consolidated decisions, the Tax Court found that the NTC Joint Venture was not a valid partnership for tax purposes, and therefore that all of the joint venture's profits were taxable income to WCI. The Tax Court determined that all of the proceeds from the noncompetition agreement were income to WCI as well. Because WCI had substantially understated its income, the Tax Court upheld the Commissioner's assessment of accuracy-related penalties. Taxpayers appealed.

For the reasons that follow, we affirm the decisions of the Tax Court.

BACKGROUND

I. History of Watkins Contracting, Inc.

In the early 1980s, Barone and Watkins worked in the asbestos removal business in Hawaii. Watkins later returned home to San Diego, where he went to work for his father's asbestos removal company. The company soon expanded into other areas of environmental remediation. When Barone joined the company in the early 1990s, he and Watkins purchased it themselves, renaming it Watkins Contracting, Inc. (“WCI”).

Barone was uncomfortable with the degree of personal liability involved in the environmental remediation business. In 1997, Barone and Watkins sold WCI's stock to REXX Environmental Corp. (“REXX”), another environmental remediation company, thereby relieving themselves of any personal liability on future projects. REXX in turn hired Barone and Watkins to manage WCI. Barone became WCI's CEO, and was responsible for “[t]he day-to-day business affairs, ... anything from managing employees to handling financing to business development.” Watkins “oversaw a lot of the field.”

REXX soon encountered financial difficulties, and approached Barone and Watkins to gauge their interest in repurchasing WCI. Barone and Watkins entered an agreement to buy WCI's shares on June 10, 1999. The purchase closed on September 19, 2000.

II. Birth of WB Partners

Barone wanted to structure the purchase agreement to afford “(1) [p]ersonal protection from creditors; (2) layers of liability protection to operate WCI; (3) the ability to invest both together [with Watkins] and separately, depending on the risks involved in each project; (4) ... qualified retirement plans; and (5) avoid[ance of] probate.” To accomplish these goals, Barone and Watkins stacked a number of holding companies between them and WCI to form a multi-layered liability shield.

Barone and Watkins created WB Acquisition, Inc., and arranged for the company to receive WCI's shares when the repurchase from REXX closed. They created two S corporations¹ —DJB Holding Corporation (“DJB”) and GSW Holding Corporation (“GSW”). Barone and Watkins then entered employment agreements with DJB and GSW, respectively, and each corporation adopted an employee stock ownership plan² (“Plan”). The DJB Plan purchased all shares of DJB, and the GSW Plan purchased all shares of GSW. DJB and GSW then formed a general partnership called WB Partners, in which each corporation owned a fifty-percent interest. Finally, WB Partners acquired all shares of WB Acquisition. All the necessary documents were executed in September 2000.³

According to Barone, the Plans were intended to provide qualified retirement plans, personal protection from creditors, and avoidance of probate. The holding corporations, DJB and GSW, permitted Barone and Watkins to pursue separate endeavors, while WB Partners allowed them to work together if they wished. Another consequence of the arrangement was that WB Partners' income would escape taxation until the Plans distributed benefits: WB Partners, DJB, and GSW are all “pass-through” entities, 26 U.S.C. §§ 701, 1363(a), 1366(a) -(c), and valid employee stock ownership plans are tax exempt, 26 U.S.C. §§ 401(a), 501(a), 4975(e)(7) ; T.D. 9081, 68 Fed.Reg. 42970, 42970 (July 21, 2003).⁴

As part of their employment agreements, Barone and Watkins agreed to render “construction management, indemnity, and financing services” exclusively for DJB and GSW, respectively. “Indemnity and financing services” include “providing personal guarantees required in order for clients of [DJB and GSW] to obtain a required performance bond.” In turn, DJB and GSW agreed on September 20, 2000, to provide these services to WB Partners to the extent “necessary to manage and conduct the business of the Partnership.”

The Tax Court found, and Taxpayers do not dispute, that Barone and Watkins performed the same roles for WCI after forming WB Partners as before. Watkins continued to oversee WCI's work on a “day-to-day basis.” Barone continued to handle “business development” and “the financing.”

In short, after the restructuring, WCI became a subsidiary of WB Acquisition, which was owned by WB Partners, which in turn was owned by the holding corporations DJB and GSW. Barone and Watkins became employees of their respective holding corporations rather than WCI, but continued to provide services to WCI according to the terms of their employment agreements. And WB Partners' structure ensured that Barone and Watkins would pay no tax on any of the partnership's income until they began to receive benefits from their respective retirement plans.

III. The NTC Joint Venture

In 1999 or 2000, the Corky McMillin Companies (“McMillin”), the Harper–Nielsen–Dillingham Joint Venture (“Harper”), and WCI joined forces to bid on a large redevelopment project at the San Diego Naval Training Center (“NTC”). The work would include removing various hazardous materials from nearly two hundred buildings. The City of San Diego awarded the contract to McMillin, who hired Harper as construction manager. WCI entered a...