A Joint Venture Agreement (aka, “JV Agreement”) is a document many business owners and investors should become familiar with. In short, a JV Agreement is a contract between two or more parties where the parties outline the venture, who is providing what (money, services, credit, etc.), what the parties responsibility and authority are, how decisions will be made, how profits/losses are to be shared, and other venture specific terms.
A joint venture agreement is typically used by two parties (companies or individuals) who are entering into a “one-off” project, investment, or business opportunity. In many instances, the two parties will form a new company such as an LLC to conduct operations or to own the investment and this is usually the recommended path if the parties intend to operate together over the long term. However, if the opportunity between the parties is a “one-off” venture where the parties intend to cease working together once the agreement or deal is completed, a joint venture agreement may be an excellent option.
For example, consider a common JV Agreement scenario used by real estate investors. A real estate investor purchases a property in their LLC or s-corporation and intends to rehab and then sell the property for a profit. The real estate investors finds a contractor to conduct the rehab and the arrangement with the contractor is that the contractor will be reimbursed their expenses and costs and is then paid a share of the profits from the sale of the property following the rehab. In this scenario, the JV Agreement works well as the parties can outline the responsibilities and how profits/losses will be shared following the sale of the property. It is possible to have the contractor added to the real estate investors s-corporation or LLC in order to share in profits, but that typically wouldn’t be advisable as that contractor would permanently be an owner of the real estate investor’s company and the real estate investor will likely use that company for other properties and investments where the contractor is not involved. As a result, a JV Agreement between the real estate investors company that owns the property and the contractors construction company that will complete the construction work is preferred as each party keeps control and ownership of their own company and they divide profits and responsibility on the project being completed together.
While a new company is not required when entering into a JV Agreement, many JV Agreements benefit from having a joint venture specific LLC that is created just for the purpose of the JV Agreement. This venture specific LLC is advisable in a couple of situations. First, where the parties do not have an entity under which to conduct business and which will provide liability protection. In this instance, a new company should be formed anyways for liability purposes and depending on the parties future intentions a new LLC between the parties may work well. Second, where the arrangement carries significant liability, capital, or other resources. The more money, time, and liability involved in the venture will give more reason to having a separate new LLC to own the new venture and to isolate liability, capital, and other resources. A $1M deal or venture could be done with a JV Agreement alone, however, the parties would be well advised to establish a new entity as part of the JV Agreement. On the other hand, if the venture is only a matter of tens of thousands of dollars, the costs of a new entity may outweigh the benefits of a separate LLC for the venture.
There are numerous scenarios where JV Agreements are used in real estate investments, business start-ups, and in other business situations. Careful consideration should be made when entering into a JV Agreement and each Agreement is always unique and requires some special tailoring.
While every self directed IRA investor enters into investments with high hopes and expectations of large gains, sometimes an IRA has to declare a loss on its investments and sometimes those losses are total losses. However, how does an IRA document a loss on a private partnership investment or an uncollectible promissory note investment? Two Tax Court opinions released today show us what not to do. Berks v. Commissioner, T.C. Summary Opinion 2014-2, Gist v. Commissioner, T.C. Summary Opinion 2014-1.
Berks v. Commissioner and Gist v. Commissioner
In Berks and Gist, self directed IRA owners invested their IRAs into various real estate partnerships and had equity interests and promissory note interests. Approximately five years after the investments were made, the IRA owners sought to declare the values on all of the investments worthless as the partnerships were no longer in business and as the IRA owner was told by their friend who they invested with that the investments were worthless. The IRA custodian for Berks and Gist sought additional documentation before agreeing to write down the value of the investments. Writing down the value of an investment and closing an account is a red flag for the custodian and the IRS as both want to ensure that IRA owners are not unfairly writing down investments in an effort to avoid taking distributions from the IRA which are taxable. As a result, the IRA custodian sought documentation as to the valuation change and upon receiving no documentation; the IRA custodian distributed the account to the IRA owners with the original investment amounts made from the account.
The self directed IRA accounts were closed by the custodian and the IRA owners were responsible for the taxes due from the 1099-R as well as accuracy related penalties. Eventually the un-claimed 1099-R went into collections with the IRS and the IRS sought payment of the additional taxes owed. The taxpayers disputed the amounts owed and took the case to Tax Court. The case eventually proceeded to trial and the taxpayers both lost in separate cases because they went into the case with no documentation or evidence of collection attempts. Instead, there was only testimony from the IRA owner and from their advisor that assist them in the investments. In Berks, the Court stated, “…[the IRA owner] simply took Mr. Blazer [their friend they invested with] at his word, and they apparently never saw the need to request any documentation that would substantiate that the partnerships had failed or that the promissory notes in the IRA accounts had become worthless.” Accordingly, the Court ruled against the IRA owners and held that the investment values as reported by the custodian (the initial investment amounts) were the best representation of fair market value. As a result, the IRA owners were subject to taxes owed on the higher valuation amounts.
I handled a very similar case to this one in Tax Court myself. In my case, the case resulted in the IRS reducing the valuation of the distributed IRA down to the proper discounted fair market valuation the IRA owner was seeking. As a contrast to what the taxpayers did to document their losses in Berks and Gist (e.g., no documents or records), I have outlined the steps that should be taken to properly document a loss with your IRA custodian and/or with the IRS/Tax Court.
Documenting a Loss/Failed Investment
- Hire a Third Party to Prepare an Opinion as to Value. Your custodian, the IRS, and the Tax Court all want to see an independent person’s opinion as to the value of an investment.
- Provide Accounting Records Showing Losses and No Profits/Income. In my Tax Court case on the same issue (obviously different facts and investments), we were able to re-construct the accounting records and losses from the company that demonstrated the significant valuation change. These accounting records we assembled were accompanied by financial records and third party documents which supported our numbers. The IRS agreed with our decreased valuation before trial, and dismissed their case against our client.
- Document Fraud. If fraud was involved by persons receiving the income. Was a lawsuit filed? Were complaints made to regulatory bodies (e.g. SEC or state divisions of securities)? Provide those documents to your custodian.
- If the Investment Losses are from a Un-Collectible Promissory Note.
- Engage a lawyer or collection agency to make collection efforts. Keeps documents of their collection efforts.
- If the borrower filed bankruptcy, provide the bankruptcy documentation.
- If the loan is totally un-collectible, Issue a 1099-C (Forgiveness of Debt Income to the Defaulted Borrower, you’ll need the borrower’s SSN/EIN for this).
The best way to document an investment loss is to provide a third party valuation to your custodian. A custodian cannot accept an e-mail or letter from the IRA owner saying the investments didn’t pan out. If a third party opinion as to value cannot be produced, you’ll need to provide some of the records and documents I outlined above to demonstrate the loss. Remember, as Tom Cruise said in A Few Good Men, “It doesn’t matter what happened. It only matters what I can prove.” To prove an investment loss in your IRA, you’ll need documents and records showing what went wrong.