Wb Acquisition Inc. & Subsidiary v. Comm'r Of Internal Revenue

• Court: U.S. Tax Court
• Writing for the Court: HAINES.
• Decision Date: 08 February 2011
• Docket Number: Docket No. 26187-06,Docket No. 5039-08.,Docket No. 29106-07,T.C. Memo. 2011-36
• Citation: WB Acquisition, Inc. v. Comm'r of Internal Revenue, Docket No. 26187-06, Docket No. 29106-07, Docket No. 5039-08. (T.C. Feb 08, 2011)
• Parties: WB ACQUISITION, INC. & SUBSIDIARY, ET AL.,1 Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

WB ACQUISITION, INC. & SUBSIDIARY, ET AL., ¹ Petitioners,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

T.C. Memo. 2011-36

Docket No. 26187-06

Docket No. 29106-07

Docket No. 5039-08.

UNITED STATES TAX COURT.

Filed: February 8, 2011

Petitioners,

Ernest S. Ryder, Richard V. Vermazen, Lauren A. Rinsky, and John W. Sunnen, for petitioners.

Monica D. Gingras and Mistala G. Merchant, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HAINES, Judge:

These cases are before the Court consolidated for purposes of trial, briefing, and opinion. WB Acquisition, Inc., & Subsidiary petitioned the Court for redetermination of the following Federal income tax deficiencies and penalties:

+------+-------------+-----------+
                | Year | Deficiency  | Penalty   |
                |      |             | Sec. 6662 |
                +------+-------------+-----------+
                | 2002 | $987,222    | $197,444  |
                +------+-------------+-----------+
                | 2003 | 3, 543, 011 | 708, 602  |
                +------+-------------+-----------+
                | 2004 | 226, 162    | 45, 232   |
                +------+-------------+-----------+
                | 2005 | 131, 302    | 26, 260   |
                +------+-------------+-----------+
                

The tax matters partner of WB Partners separately petitioned the Court for readjustment of final partnership administrative adjustments with respect to 2003, 2004, and 2005. WB Acquisition, Inc., and Watkins Contracting, Inc., filed consolidated tax returns for taxable years 2002-2005.

The issues for decision after concessions² are:

1.Whether Watkins Contracting, Inc., and WB Partners conducted the environmental remediation of the San Diego Naval Training Center as a joint venture for Federal tax purposes during taxable years 2002-2004;

2. whether the proceeds of a covenant not to compete and interest income resulting from the 2003 sale of Watkins Contracting, Inc.'s assets were properly included in the income of WB Partners in 2003 and 2004;

3.whether an NOL claimed by Watkins Contracting, Inc., as a carryforward from 2001 to 2003 was substantiated; and

4.whether WB Acquisition, Inc., & Subsidiary are liable for section 6662(a) penalties.³

FINDINGS OF FACT

I. History of WCI

Daren J. Barone (Barone) and Gregory S. Watkins (Watkins) began their careers in the business of specialty contracting, environmental remediation, and demolition in Hawaii in the early 1980s. Soon after, they expanded into the asbestos removal trade. In the early 1990s, Barone and Watkins returned to their hometown of San Diego, where Watkins worked for his father's company, Watkins & Son, a business specializing in asbestos removal. In late 1991 or early 1992 Barone joined Watkins & Son as an employee. Together with Watkins' father, Barone and Watkins ran the company until Watkins' father retired in the mid-1990s. Barone and Watkins subsequently purchased Watkins' father's interest in the company and renamed it Watkins Contracting, Inc. (WCI).

Barone and Watkins operated WCI until 1997, when they sold the stock of the company to REXX Environmental Corp. (REXX) for cash and stock. Barone testified that he encouraged Watkins to sell WCI in part because of the personal liability associated with the business, which required Barone and Watkins to obtain performance bonds and sign indemnity agreements to guarantee the completion of certain projects. The sale relieved Barone and Watkins from any such personal guaranties.

In connection with the sale, REXX hired Barone and Watkins as employees to manage WCI. Under REXX, Barone managed employees and accounts, handled financing, and developed business. Similarly, Watkins bid jobs, managed construction, and oversaw field work.

By 1999 REXX encountered financial difficulties in its operation of WCI. These financial difficulties significantly impaired WCI's ability to bond future projects. REXX's executives refused to execute personal indemnities and guaranties for WCI to bond its projects and began looking to sell the company. Under these circumstances, REXX's executives turned to Barone and Watkins to sign personal guaranties for WCI to bond projects. In exchange for their personal guaranties, REXX offered Barone and Watkins a percentage of profits from WCI projects.

During this time a profitable opportunity arose for WCI to perform remediation work for the U.S. Navy in San Diego in a job known as the IDIQ project. Because of WCI's financial position, however, REXX was unable to secure the bonding on the IDIQ project without personal guaranties for the completion of the project. Consequently, an agreement was reached with REXX for Barone and Watkins to personally guarantee the bond for the IDIQ project. In exchange for their personal guaranties, the agreement entitled Barone and Watkins to 66.66 percent of the profits from the IDIQ project.

As WCI's financial problems mounted, REXX became more eager to sell the company and approached Barone and Watkins to gauge their interest in reacquiring WCI. Barone and Watkins initially were hesitant about a potential deal because they were concerned with a number of liability issues surrounding WCI. Nonetheless, Barone and Watkins eventually offered to purchase the stock of WCI for approximately one-third of the price they had received for it just 2 years earlier. As a condition of their offer, Barone and Watkins required the sale to be structured in a way that would limit their personal exposure.

To address this concern, Barone met with Ernest S. Ryder (Ryder), an attorney, to discuss asset protection vehicles for the purchase and subsequent ownership of WCI. Barone and Watkins had a laundry list of concerns they wanted to address beforemoving forward, including: (1) Personal protection from creditors; (2) layers of liability protection to operate WCI; (3) the ability to invest both together and separately, depending on the risks involved in each project; (4) creating qualified retirement plans; and (5) avoiding probate. Barone and Watkins ultimately contracted the services of Ryder to design a structure to meet their concerns.

The structure designed by Ryder began with forming a corporate owner of WCI, WB Acquisitions, Inc. (Acquisitions). Acquisitions is a C corporation wholly owned by a partnership, WB Partners. The partnership had two equal S corporation partners, DJB Holding Corporation (DJB) and GSW Holding Corporation (GSW). DJB and GSW are wholly owned by the DJB Holding Corporation ESOP (DJB ESOP) and the GSW Holding Corporation ESOP (GSW ESOP), respectively, each of which is an employee stock ownership plan. Barone is the lone participant in the DJB ESOP, and Watkins is the lone participant in the GSW ESOP. This structure is reflected in the following diagram:

Barone & Watkins Entities

This structure addressed each of Barone's and Watkins' concerns. Acquisitions served as a corporate owner of WCI to protect Barone and Watkins from the risks of personal liability. WB Partners was a vehicle that allowed Barone and Watkins to invest together on projects unrelated to the environmental remediation and construction work performed by WCI.⁴ DJB and GSW were corporate vehicles which allowed Barone and Watkins to invest individually⁵ and added another layer of protection from personal liability. Finally, the DJB ESOP and the GSW ESOP provided Barone and Watkins with qualified retirement plans. On June 10, 1999, Barone and Watkins finalized the purchase of the stock of WCI from REXX, and on September 19, 2000, Barone and Watkins assigned their ownership interests in WCI to Acquisitions.

II. The Services of Barone and Watkins

In connection with the purchase from REXX and with the formation of the above-described structure, Barone and Watkins entered into employment agreements with their respective corporations, DJB and GSW, to provide construction management, indemnity, and financing services full time. Several relevantprovisions describe Barone's and Watkins' responsibilities pursuant to their employment agreements. Section 1.1.4 of each employment agreement provides for the services of Barone and Watkins to include any and all services related to the present or future business of DJB, GSW, WCI, any related entity, and any party that may acquire an interest in any of the above-listed entities. Section 1.3 of each employment agreement is a noncompetition provision, preventing Barone and Watkins from engaging in any business activity which is, or could become, competitive with or adverse to any of the above-listed entities. Finally, section 2.2 of each employment agreement requires Barone and Watkins to provide their services exclusively for the benefit of DJB and GSW.

DJB and GSW each hold a 50-percent partnership interest in WB Partners. Pursuant to section 1.6 of the WB Partners partnership agreement, which provides that DJB and GSW controlled the exclusive rights to the services of Barone and Watkins, the S corporations contributed such services to the partnership as necessary to manage and conduct its business.

Despite the exclusivity clauses of their employment agreements, Barone and Watkins performed services for WCI without the permission of DJB, GSW, or WB Partners. Barone testified that he continued to perform the same services he had performed for WCI while it was controlled by REXX after Barone and Watkinsrepurchased the stock of WCI. Those services included managing employees and accounts, handling financing, and developing business. Further, Watkins testified that he "bid and got and oversaw" nearly three-quarters of WCI's projects.

III. The NTC Joint Venture

A. The NTC Project

In late 1999 or early 2000, the city of San Diego solicited bids for a redevelopment project at the San Diego Naval Training Center (the NTC project). This project required extensive environmental remediation work, including the removal of asbestos, lead-based paint, and contaminated soil from close to 200 buildings. The city of San Diego ultimately chose the Corky McMillin Cos. (McMillin) as the master developer of the project. McMillin then hired the Harper-Nielsen-Dillingham Joint...