Management Arrangement Wasn't Partnership

[2] ISSUES

(1) Whether a commercial arrangement, represented by a "management agreement," between a domestic insurance company and four foreign insurance companies can be considered to constitute a partnership for federal income tax purposes.

(2) If so, and the Service unsuccessfully litigates these cases under another theory, whether the Service would be preempted from later instituting partnership audit and litigation procedures under TEFRA.

[3] CONCLUSIONS

(1) Although the domestic insurance company is authorized to act on behalf of the foreign insurance companies in the same manner as would a general partner in a partnership, and the domestic insurance company receives a contingent commission calculated on the basis of the net profits from the policies that it places with the foreign insurance companies, these are not sufficient indicia that a partnership exists. A significant indication that a partnership exists -- the sharing of the risk of loss between co-proprietors -- is missing in the relationship between the domestic and the foreign insurance companies. We conclude that the domestic insurance company is a managing general agent for, but is not a partner or joint venturer with, the respective foreign insurance companies.

(2) As the result of our conclusion with respect to Issue 1, the Service should not issue Notices of Final Partnership Administrative Adjustment.

[5] In each of the docketed cases, a * * * insurance company entered into an arrangement with * * *, a domestic insurance company, evidenced by what purports to be a "management agreement." Each petitioner's agreement with * * * is identical. Under Article * * * of the management agreement, the * * * insurance company (referred to in the agreements as the "Member") appoints * * * (the "Manager") as its representative

[6] The term of the management agreement is one year (the "initial Management Year"), with automatic renewals (constituting separate "Management Years") until termination by either party upon six months' written notice.

[7] As compensation, * * * is entitled to a management fee calculated as a percentage of original gross earned premiums, subject to various caps on the total management fees from all Members in any one Management Year. Additionally, * * * is entitled to reimbursement for brokerage expenses, issuing commissions, profit commissions, acquisition fees, policy issuing fees, foreign exchange losses, premium taxes, and all expenses relating to claims, losses, and adjustments. * * * however, is responsible for those expenses attributable solely to the conduct of its business. * * * also receives a percentage of override commissions and profit commissions received on ceded reinsurance which it has placed. Finally, * * * receives a contingent commission equal to * * * percent of the annual net profits accruing to the Member during each Management Year with respect to the reinsurance contracts written on behalf of the * * * company.

[8] Under Article * * * of the management agreement, the * * * insurance company generally agrees to accept its respective proportion of all reinsurance business written by * * *.

[9] The Member's liability is several and not joint with that of other members in the reinsurance pool.

[12] The hallmarks of a partnership or joint venture are the sharing of profits, the contribution of capital and its risk of loss, and the sharing of control over the enterprise. Reinberg v. Commissioner, 90 T.C. at 137. In Luna v. Commissioner, 42 T.C. 1067 (1964), the Tax Court articulated the following particular factors, none of which is conclusive, which tend to indicate whether a partnership or joint venture has been formed: the agreement of the parties; their conduct; the parties' contributions to the business enterprise; control over the income and capital; the right of each party to make withdrawals; whether each party is a principal and coproprietor; whether separate books of account are maintained for the venture; and whether the parties have represented to third parties with whom they dealt that they are partners. See also Barron v. Commissioner, T.C. Memo. 1992-598; Mayhew v. Commissioner, T.C. Memo. 1992-68.

[13] An overview of the case law by McKee, et al., has discerned three requisites that generally must be satisfied for a commercial undertaking to be classified as a partnership for federal tax purposes. See McKee, supra, para. 3.02[2]. First, there is a requirement of profit motive. Second, the parties must contemplate that the profits will be shared jointly. Finally, the parties must be sharing the profits as coproprietors. The third requisite is the ultimate, as well as the most elusive, distinction between a partnership and other profit-sharing arrangements. Id., para. 3.02[5].

[14] A strong indicator of a proprietary interest is a sharing of net profits. As McKee, et al., notes, coproprietors generally divide the net income from the enterprise. Id. Nevertheless, "[w]hile a share interest in net profits is strong evidence of the existence of a partnership, a person who holds a bare net profits interest may not be a partner if other factors indicate that he lacks proprietorship status." Id.

[15] Another factor indicating that a party is a coproprietor is a sharing of the losses of the venture. Indeed, where an arrangement includes a sharing of net profits, the absence of corresponding sharing of the burden of any losses may override the other evidence of a partnership or joint venture. See, e.g., Smith v. Commissioner, 33 T.C. 465 (1959), aff'd, 313 F.2d 724 (8th Cir. 1963) (commodity trading funds governed by "partnership" agreements found to be associations taxable as corporations; fund manager had no economic interest in the funds despite an interest in a share of the profits which might be realized, and was obligated to cover losses only to the extent it had withdrawn its share of profits); Koss v. Commissioner, T.C. Memo. 1989-330. But see McDougal v. Commissioner, 62 T.C. 720 (1974) (joint venture found where profits were to be shared equally by the parties, while losses were allocated to one partner). The absence of a an agreement to share losses often distinguishes an employment, or independent contractor, or agency relationship from a partnership, particularly where significant or shared participation in the overall management and control of the enterprise (another indicator of a partnership) is coupled with a profits interest:

[17] * * * is what is known in the insurance industry as a "managing general agent" or "MGA." ⁴ An MGA does not act in the role of a traditional agent. Due to its specialized knowledge of placements of insurance and reinsurance policies (particularly in the area of writing unusual policies), an MGA has extensive authority on behalf of its principal to bind, to decide whether to accept risk, to price the risk, to underwrite, to code, to settle claims, to approve settlements, and to shift risks via reinsurance and retrocession. However, the MGA does not share in the risk of loss; the potential for unlimited liability on insurance claims remains with the principal insurer.

[18] The upside of the MGA's role is that it receives its compensation from the "cream" while it does not bear a corresponding proportionate share of the risk of loss. Special skill is required in determining and pricing insurance risk, but if the MGA misjudges the risk of loss, or underprices the risk, the liability is ultimately paid from the assets of the principal. For this reason, contingent commissions are commonly employed as incentive for the MGA to place only the most profitable policies with its principal. In the present case, by basing a "bonus" commission on the profitability of the reinsurance contracts written on behalf of the * * * companies (and including in the formula a carryforward of net losses in a Management Year to future management years), the * * * companies give * * * an incentive to thoroughly assess the degree of risk of the various reinsurance contracts it considered, accept only appropriate reinsurance contracts, seek solvent reinsurers and retrocessionaires to share that risk, accurately price the risk, and responsibly manage the investment and reinvestment of the premiums. Such incentive compensation serves the purpose of minimizing the * * * insurance companies' potential loss liability.

[19] Inasmuch as we have concluded that a partnership does not exist for federal tax purposes, we advise that the Service should not commence TEFRA partnership proceedings with respect to these petitioners.

[20] This document may include confidential information subject to the attorney-client and deliberative process privileges, and may also have been prepared in anticipation of litigation. This document should not be disclosed to anyone outside the IRS, including the taxpayers involved, and its use within the IRS should be limited to those with a need to review the document in relation to the subject matter or case discussed herein. This document may also contain tax information of the instant taxpayers which is subject to I.R.C. section 6103.

[21] If you have any questions regarding this field service advice, please contact * * *, at (202) * * *

² A "joint venture" is defined as a "special combination of two or more person, where in some specific venture, a profit is jointly sought without any actual partnership or corporate designation." Beck Chemical Equipment Corp. v. Commissioner, 27 T.C. 840, 848-849 (1957). By statutory definition, a joint venture is a form of partnership for federal tax purposes. The same principles that govern whether a partnership has been formed also govern whether a joint venture exists. Long v. Commissioner, 77 T.C. 1045, 1065 (1981), citing Luna v. Commissioner, 42 T.C. 1067, 1077 (1964).

³ Our conclusion is not altered by the fact that * * * has a wholly owned, offshore subsidiary to which some share of the risk under reinsurance agreements was sold. The risk of loss due to a claim under the policy was borne by the captive insurance company, but there is no reason to attribute the subsidiary's risk of liability to * * *. The captive insurance company is a separate entity. It can be likened to a bank's credit insurance subsidiary that insures some loans made by the bank.

⁴ In concluding that * * * is an agent of the * * * insurance companies, we express no legal opinion as to whether * * * was an agent of "dependent" or "independent" status within the meaning of Article * * * of the Convention. This is a matter currently under consideration by the Associate Chief Counsel (International).