One of the great ironies of New York business divorce litigation is that so much of it involves the breakup of law firms. Perhaps it’s because New York is the center of the legal universe and the home state of thousands of law firms. Maybe it’s because lawyers are litigious by nature. Another, less obvious reason: law firms often imprecisely use the term “partner” to describe their lawyers.
Under Section 10 of the Partnership Law, the term “partnership” means an association of two or more people to carry on a business for profit “as co-owners.” By definition, “partner” means an owner who shares in profits and losses. But the archetypal law firm general partnership long ago gave way to other business forms, and even law firms that still adhere to the partnership form adopt agreements opting out of the default rules to provide for a wide variety of so-called “partners” – “equity partner,” “non-equity partner,” “income partner,” “profits partner,” “contract partner,” “general partner,” “limited partner.” The use of the term “partner” to describe folks who are not equity “partners” creates the potential for ambiguity, and ambiguity begets litigation.
If there is apparent ambiguity, to what extent must courts rely on the entity’s tax returns to decide the issue of ownership? In Mahoney-Buntzman v Buntzman, 12 NY3d 415 , New York State’s highest court wrote a seemingly hard-and-fast rule: “A party to litigation may not take a position contrary to a position taken in an income tax return.” Business divorce lawyers love to cite this rule when they believe it helps their position to prove or disprove ownership status in a business. A few months ago, we wrote about precisely such a case, Rosin v Schnitzler, 2018 NY Slip Op 32320(U) [Sup Ct, Kings County Sept. 4, 2018], in which Commercial Division Justice Lawrence S. Knipel, relying on Mahoney-Buntzman, held that an LLC’s filing of Schedule K-1s identifying the plaintiff as a member proved his membership status in the business.
Two weeks ago, New York County Commercial Division Justice Andrea Masley arrived at the opposite conclusion in Barrison v D’Amato & Lynch, LLP, 2019 NY Slip Op 30905(U) [Sup Ct, NY County Apr. 2, 2019], a thoughtful decision involving a well-known insurance litigation firm (the “Firm”) brought by one of its former partners. Barrison contended he was a true equity partner. The Firm said no. Its tax returns in effect said yes. Let’s see how the Court sorted it out.
The Law Firm and its Partners
In the late 1970s, D’Amato and Lynch Sr. founded the Firm. In 1990, Barrison joined the Firm. In 1995 or 1996, D’Amato told Barrison he was promoted to “partner.” Barrison did not enter into a written partnership agreement and did not make a capital contribution to the Firm. Barrison “admitted he never inquired and was never told by anyone at the Firm whether he had an equity interest.”
In 1999, Lynch Sr. passed away. In 2002, D’Amato and Lynch Jr. entered into a written “Memorandum of Partnership Agreement.” Under the agreement, D’Amato and Lynch Jr. were the Firm’s “General Partners” and the dozens of other partners, who did not sign the agreement, were “Limited Partners” with “no right or interest in the assets, capital, goodwill, income, losses, receivables, unbilled time” or other property of the Firm. In 2007, D’Amato died and Lynch Jr. became sole General Partner of the Firm.
According to Lynch Jr. and the Firm’s outside accountants, Barrison was a “non-equity, income-interest partner” whose “profit” distribution was determined the end of each year “entirely within Lynch’s discretion” based on Barrison’s productivity and other factors. According to Lynch Jr., “these discretionary payments are allocated from the Firm’s net profits, after salaries and bonuses are paid, but that non-equity partners have not entitlement to any set percentage of profits.”
Here is where it gets interesting. From the late 1990s until 2010, the Firm and its accountants filed Federal and State income tax returns, including Schedule K-1s, identifying Barrison as “general partner” with a “capital account.” Moreover, in 2010, the Firm filed a tax return in New Jersey which included a “Partnership Directories” listing Barrison, under a column labeled “Percent Owned,” as owner of “2.035590” of the Firm.
Barrison’s Departure and the Litigations
In 2011, Barrison left the Firm claiming Lynch Jr. forced him out by refusing to assign him work. According to Lynch Jr., he could not assign Barrison new matters because clients expressed dissatisfaction with his work. Litigation ensued, including an earlier case brought by Barrison, in which Justice Jeffrey K. Oing dismissed Barrison’s complaint, including for dissolution of the Firm, in full.
Barrison sued a second time, this time naming the Firm, Lynch Jr., and the Firm’s accountants as defendants. After years of litigation, which whittled down Barrison’s claims to just three: (i) fraud, (ii) negligent misrepresentation, and (iii) equitable estoppel, the parties moved and cross-moved for summary judgment. Justice Masley held oral argument, then in a written decision issued a number of holdings. We’ll focus on her main one – the binding effect, if any, of the Firm’s tax filings upon Barrison’s status as an equity partner.
The (Non)Binding Effect of Tax Returns
On the vital issue of ownership based on tax returns alone, Justice Masley ruled:
[P]laintiff fails to establish that he was an equity partner as a matter of law. Plaintiff points to various tax documents-specifically, the K-1s that the Firm filed with the IRS, identifying plaintiff as a ‘[g]eneral partner’ and indicating that he had a ‘capital account,’ as well as the New Jersey Partnership Directories, showing that in 2010, under a column labeled ‘Percent Owned,’ the Firm reported ‘2.035590’ for plaintiff, and relies on Mahoney-Buntzman . . . to argue that the Firm Defendants are now estopped from asserting a position in this proceeding that is ‘contrary to declarations made under the penalty of perjury on income tax returns’ (citations omitted).
Notwithstanding Mahoney-Buntzman, Justice Masley continued:
‘[W]hether partnership status is enjoyed turns on various factors, including sharing in profits and losses, exercising joint control over the business, and making capital investment and possessing an ownership interest in the partnership” (Mazur v Greenberg, Cantor & Reiss, 110 AD2d 605, 605 [1st Dept 1985], affd 66 NY2d 927  [internal quotation marks and citation omitted]). Tax returns, without any other indicia of partnership, are insufficient (Matter of Bhanji v Baluch, 99 AD3d 587, 587-588 [1st Dept 2012] [internal quotation marks and citation omitted] [‘corporate and personal tax returns, even when filed with government agencies, are not in and of (themselves) determinative’]).
The Court concluded:
Here, aside from the tax documents, plaintiff does not provide any evidence that he actually contributed capital to, possessed an ownership interest in or shared in the losses of the Firm. Nor does plaintiff offer any evidence of control over the Firm’s policies or hiring decisions. Therefore, plaintiff has failed to establish that he was an equity partner with the Firm (see D’Esposito v Gusrae, Kaplan & Bruno PLLC, 44 AD3d 512, 512-513 [1st Dept 2007] [finding that plaintiff ‘was never a true equity member of the firm,’ where, ‘notwithstanding that plaintiff was called a partner and listed as such in Martindale-Hubble, on the firm’s letterhead and tax return, and he received distributions of net profits from the firm at a fixed rate, he was not responsible for the firm’s rent or losses, was not a signatory of the partnership and/or operating agreement, made no capital investment and had no ownership interest in the firm’ or control over its policies]).
Same Rule, Different Outcome
One of the most difficult jobs a judge faces is reconciling conflicting legal rules addressing the same subject. In Barrison, Justice Masley weighed two competing strands of case law, on the one hand Mahoney-Buntzman, seeming to state a per se rule that tax returns always bind the legal positions of those who file them, and on the other, cases like Bhanji and D’Esposito, in which courts have long held that, under the law of partnerships, tax filings are just one item of evidence to be considered among various “indicia of partnership” to determine true “partner” status. It is worth noting that while often cited in business divorce litigation, Mahoney-Buntzman involved distribution of property in a matrimonial case, i.e., a real divorce, not a business divorce.
Do any facts in Barrison differ from Rosin to explain the divergent outcomes?
First, Rosin was an LLC dispute, for which there is comparatively little case law to help determine whether one has “membership” status. Under the law of LLCs, ownership is primarily a matter of contract. In the absence of a clear legal test in New York for determining LLC ownership status, and without a contract specifying the entity’s owners, perhaps tax returns take on greater significance.
Second, as noted in the opening paragraph of this article, law firms often loosely use the term “partner.” In Barrison, Justice Masley wrote, “Despite being a seasoned attorney, plaintiff admitted that he never made any inquiries regarding the terms of his partnership;” “never asked what sort of partner he was and whether he had any equity interest in the firm;” and the “K-1s were plaintiff’s sole basis for believing he was a partner with ownership interest.” In short, the Court found it inherently incredible that a veteran lawyer could truly believe himself to be “equity partner” of a large law firm without a writing, or any of the objective rights associated with true partnership status, to support his claim.
One question left unanswered by Barrison: could the Firm really have just one partner? By definition, Partnership Law § 10 requires “two or more persons to carry on as co-owners” to form a partnership. Was that the reason for the K-1s to Barrison? With Barrison’s complaint now dismissed, it seems the Court will never reach these tantalizing questions.