Construction Industry Audit Technique Guide (ATG) - Chapter 10
Publication Date - May 2009
NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
- Types of Joint Ventures
- Joint Venture Examinations
- Potential Joint Venture Issues
A joint venture is composed of two or more businesses combining their resources to build one or more projects. Construction companies may choose to extend and expand their capital, bonding capacity, or expertise by joining together with other competent contractors to perform work that is challenging either in terms of size or type. Other construction companies have restricted access to international or domestic markets. By forming joint ventures, construction companies can often overcome these market limitations or restrictions. Although these forms of business have both advantages and disadvantages, they are often necessary for the construction company's survival and growth in a highly competitive industry. .
Construction projects can be structured as joint ventures that are generally considered partnerships under IRC Sections 761(a) and 7701(a)(2). Joint ventures are generally formed for one specific purpose such as a job, a contract, or a project with the intent of operating for a limited duration.
IRC Section 7701(a)(2) provides that the term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term “partner” includes a member in such a syndicate, group, pool, joint venture, or organization.
The Treasury and IRS have published regulations for classifying business arrangements for federal tax purposes. These regulations became effective January 1, 1997. When classifying a business arrangement, first determine if there is a separate entity for federal tax purposes. A joint venture may create a separate entity for federal tax purposes if the participants: (1) carry on a trade, business, financial operation, or venture, and (2) divide the profits from the activity. Nonetheless, a joint undertaking merely to share expenses does not create a separate entity for federal tax purposes.
Whether a joint venture is a separate entity for federal tax purposes is a question of federal law. Treasury Regulation Section 301.7701-1 prescribes the classification of various organizations for federal tax purposes. Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law. In addition, certain joint undertakings give rise to entities for federal tax purposes. A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits.
For example, a separate entity exists for federal tax purposes if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent. Nevertheless, a joint undertaking merely to share expenses does not create a separate entity for federal tax purposes. For example, if two or more persons jointly construct a ditch merely to drain surface water from their properties, they have not created a separate entity for federal tax purposes. Similarly, mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes. For example, if an individual owner, or tenants in common, of farm property lease it to a farmer for a cash rental or a share of the crops, they do not necessarily create a separate entity for federal tax purposes.
A separate entity conducting construction operations will generally be treated as a business entity under the new regulations. A business entity with two or more members is classified either: (1) an association taxable as a corporation or (2) a partnership. Except for certain business entities that are defined as corporations, a business entity may elect to be treated as either an association or a partnership to be an eligible entity. See Treasury Regulation Section 301.7701-2.
Treasury Regulation Section 301.7701-2(a) and Treasury Regulation Section 301.7701-3 provide that a business entity is any entity recognized for federal tax purposes including an entity with a single owner that may be disregarded as an entity separate from its owner under Treasury Regulation Section 301.7701-3 that is not properly classified as a trust under Treasury Regulation Section 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code.
A business entity with two or more members is classified for federal tax purposes as either a corporation or a partnership. A business entity with only one owner is classified as a corporation is disregarded if the entity is disregarded and its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.
The regulations provide default rules that classify eligible entities without requiring them to file elections. Unless it elects otherwise, a domestic eligible entity that is formed after January 1, 1997 is classified as a partnership if it has at least two members. Unless it elects otherwise, a foreign eligible entity that is formed after January 1, 1997 is classified as either: (1) a partnership if it has at least two members and at least one member does not have limited liability, or (2) an association if all members have limited liability. Generally, an eligible entity in existence prior to January 1, 1997 maintains the classification it claimed under the classification regulations in effect prior to January 1, 1997. An eligible entity may elect to be classified other than as provided in the default rules or to change its classification by filing a Form 8832, Entity Classification Election, with the appropriate service center. See Treasury Regulation Section 301.7701-3.
For financial statement purposes, investments in joint ventures are accounted for by each member of the joint venture under the cost method, the equity method, as a pro rata share, or the entity is consolidated with the investor's financial statements. For financial accounting purposes, the accounting method used to account for the construction company's investment in a joint venture is based on the ownership percentage and the degree of control the construction company has over the venture. Inspection of the taxpayer's consolidated financial statements can provide the examiner with an extended view of the construction company's investment in joint ventures because both incorporated projects and joint ventures are often consolidated. In addition, financial information of unconsolidated joint ventures is frequently disclosed in the notes to the financial statements.
Joint ventures classified, as partnerships are generally required to file separate income tax returns using Form 1065. Individual partners or investors recognize a distributive share of partnership items reported on Schedule K-1 from the construction joint venture on their income tax returns. Partnerships are formed as general partnerships or limited partnerships. A general partnership is an association where all partners have unlimited liability. A limited partnership is an association in which one or more general partners have unlimited liability and one or more limited partners have limited liability.
Auditors examining construction companies that are involved in joint ventures should be aware of the unique issues regarding the formation, operation, and liquidation of joint ventures. The gross receipts of each joint venture need to be considered in the rules of attribution in determining the member’s eligibility to meet the small contractor’s exception under IRC Section 460(e)(1). See an earlier chapter for additional information regarding the rules of attribution. Each member of a joint venture brings individual resources to a joint venture and can be compensated in various ways. Each party should be viewed independently. Such a review often raises questions and potential issues:
- What are the assets, capital, services, and other resources contributed by each party?
- What was the value and basis of the property contributed?
- Did a partner contribute appreciated property to the venture?
- Was the contributed property encumbered?
- What are the profit, loss and capital sharing ratios?
- Do the partnership allocations have substantial economic effect within the meaning of IRC section 704(b)?
- Have there been changes in the ownership structure?
- Have there been distributions or partial liquidations from the joint venture?
- What type of property was distributed and to whom?
- How has the construction company been compensated (cash, increase in capital interest, etc.) for its construction work?
- How does the construction company allocate its overhead or indirect expenses to joint venture projects?
- Are there related transactions (compensation payments, leases, loans, etc.) between the joint venture and the members of the joint venture?
- What method of accounting does the joint venture use?
- What effects do long-term contracts have on the allocation of income to incoming/outgoing partners?
- Has construction period interest been properly capitalized?
Examiners who conduction examinations of joint ventures must deal with the common issues found in other construction entity examinations. However, joint ventures are classified primarily as partnerships and have unique tax issues. These issues often can be divided into three broad categories involving formation, operation, and liquidation or distribution issues. These are briefly summarized below:Formation Issues
- Failure to file partnership returns. See IRC Sections 761 and 6698.
- Capitalization or amortization of organization and syndication fees. See IRC Section 709.
- Contribution of construction services by the construction company in exchange for a capital interest in the partnership. See Treasury Regulation Section 1.721-1(b)(1).
- Contribution of construction services (by the construction company) in exchange for a profits interest in the partnership when a predictable income stream exists. See Revenue Procedure 93-27.
- Deemed cash distributions on the assumption of a partner's liability on property contributed. See IRC Section 752(b).
- Allocation of income, gains, deductions, and losses not having substantial economic effect. See IRC Section 704(b).
- Cancellation of indebtedness income (COD income) upon bankruptcy or insolvency. See IRC Section 61(a)(12) and IRC Section 108.
- Withholding tax on distributive share of partnership taxable income to a foreign partner. See IRC Section 1446.
- Distributions of cash in excess of basis in the partnership interest. See IRC Sections 731, 752, 741, and 751.
- Interest expense deductions in connection with debt financed distributions. See IRC Section 163(h).
- Disguised sales. See IRC Section 707(a)(2)(B).
In addition to the other construction industry tax issues, joint ventures by the nature of the entity produce separate issues that need consideration.