By Jim Kehl, CPA, MST
Weil, Akman, Baylin & Coleman, P.A., Timonium, MD
A partnership normally exists when two or more parties join together for the purpose of carrying on and sharing in the profits and losses of a trade or business.1 Developers and investors have typically used the partnership form of business to construct and operate real estate projects. Under the terms of these partnership arrangements, the developers typically received payments as compensation for their services and investors usually received tax benefits and a return of their capital contributions. As deal structuring techniques evolved, investors became very sophisticated at reducing their risk. The issue raised by some recent circuit court decisions is whether certain investors have eliminated the uncertainties of their investments to such an extent that they do not share in the business risks of partnership operations in the manner of a true partner.2 This issue was recently addressed by the Third Circuit in Historic Boardwalk Hall, LLC et. al. vs. Comr., No. 11-1832 (3d Cir. 8/27/12).
This case involved the rehabilitation of a historic boardwalk hall located in Atlantic City, New Jersey. A state agency (NJSEA) owned a long-term leasehold interest in this historic building and desired to rehabilitate it. The building was a certified historic structure that qualified for tax credits equal to 20% of the qualified rehabilitated expenditures for the property. NJSEA partially financed this rehabilitation by obtaining grants and by issuing bonds. As NJSEA was a tax-exempt entity, the historic tax credits that would result from the rehabilitation had no value to NJSEA. In order to receive value from these tax credits, NJSEA and a corporate investor, PB, formed a limited liability company (LLC), HBH, which was treated as a partnership for tax purposes. NJSEA subleased its interest to HBH in a transaction characterized as a sale and agreed to provide $90 million of loans to that LLC in exchange for a managing member interest of 0.1% in HBH. PB ultimately agreed to make capital contributions of $18.195 million and an investor loan of $1.1 million in exchange for a 99.9% interest in partnership profits, losses and cash flow. HBH also allocated 99.9% of its Qualified Rehabilitation Expenditures to PB. PB received approximately $21,778,200 of historic tax rehabilitation credits over three years. PB was also to receive a 3% Preferred Return on its capital contributions.
In addition, PB's capital contributions were protected through other agreements, which are customary in syndications. PB's capital contributions were to be paid in installments that were contingent upon project completion and the incurrence of rehabilitation costs sufficient to generate an amount of tax credits that matched the cumulative amount of its installments. NJSEA agreed to pay all excess development costs, fund all operating deficits and indemnify PB for any loss that resulted from certain environmental events. NJSEA also had an option to purchase PB's interest during the 12 month period that began 60 months after the project was placed in service for a purchase price equal to the present value of any unrealized tax benefits and cash distributions due to PB through the five-year recapture period. To secure payment of this purchase price, NJSEA was required to obtain a Guaranteed Investment Contract. PB also had a Put Option whereby PB could require NJSEA to purchase its interest. Finally, there was a Tax Benefits Guaranty pursuant to which HBH was required to pay PB an amount equal to the sum of: (1) any reduction in PB's projected tax benefits due to an IRS challenge; (2) any additional tax liability of PB due to an IRS audit that resulted in reallocation to another partner of partnership items initially allocated to PB; (3) interest and penalties imposed on PB by an IRS challenge; and (4) certain legal costs of PB related to an IRS challenge.
The IRS audited HBH and reallocated its partnership items for all years examined from PB to NJSEA. The reasons for these adjustments were: (1) HBH was created in order to pass tax benefits to PB and was not a partnership; and (2) PB did not have a bona fide partnership interest in HBH because PB "had no meaningful stake in the success or failure of HBH." When this dispute was litigated in Tax Court, the Tax Court disagreed with the IRS because it felt that HBH did have economic substance and that PB's investment in HBH was for legitimate business purposes. The Tax Court believed that PB faced the risk that the rehabilitation would not be completed and the risk of environmental liabilities. The Tax Court reasoned that PB was a legitimate partner because, in addition to its risks of loss, PB could realize an economic profit through its annual 3% preferred return and through its rehabilitation tax credits. Because HBH operated at a loss, PB's interest was not like a creditor's because PB was not guaranteed its 3% preferred return. The Tax Court was also impressed with the investigation and documentation demonstrated by both partners in carrying out their responsibilities required by the various agreements.3 The Tax Court thus ruled in favor of HBH. The IRS then appealed to the Third Circuit.
Decision of Third Circuit
The IRS appellate brief alleged that the transactions described above were equivalent to an indirect sale of the tax credits by NJSEA to PB through the use of a partnership. The Third Circuit focused on the contention that PB was not "a bona fide partner in HBH because PB did not have a meaningful stake" in HBH's success or failure. The Third Circuit ultimately concluded that PB was not a partner in HBH.
The Third Circuit began its analysis by stating that the holding in the Culbertson case required it to analyze the indications of PB's equity interest and determine whether those indications reflected an intention of PB to share in HBH's profits and losses or whether those indications were "illusory or insignificant." The Third Circuit considered the Castle Harbour4 case relevant to its analysis because the conclusion of the Second Circuit in Castle Harbour was that two foreign banks were lenders rather than partners due to the ability of those banks to recover their investments through loan guaranties and other means that were not "dependent on the entrepreneurial risk of partnership operations."5 Similarly, the Third Circuit concluded that PB "did not have any meaningful downside risk or any meaningful upside potential in HBH" and was thus not a partner in HBH.
The Third Circuit felt that "PB had no meaningful downside risk" because PB was certain to recover its capital contributions and receive either the tax credits or cash equal to the value of its projected tax credits. Evidence supporting this conclusion was as follows: (1) installments of capital contributions were scheduled to be made only when the rehabilitation generated enough tax credits equal to all required cumulative capital contributions; (2) the rehabilitation was fully funded before PB became a partner; (3) NJSEA's agreement to cover all excess development costs; and (4) the Tax Benefits Guaranty that eliminated any adverse consequences to PB of IRS disallowance of the projected tax credits. The Third Circuit also felt that the real purpose for NJSEA and PB becoming partners in HBH was the sale and purchase of the tax credits rather than the rehabilitation of the historic boardwalk hall. Evidence of this purpose was found in the Confidential Memorandum and other correspondence between the syndicator and NJSEA. PB's Preferred Return was not subject to meaningful risk because the Call and Put Options assured PB of receiving that compensation.
The Third Circuit concluded that there was also no realistic possibility of any "meaningful upside potential" for PB for two reasons. First, even though PB had a 99.9% interest in residual cash flow, financial projections forecasted that there would be no available cash flow. Second, even if there was profit potential, NJSEA could exercise its option to purchase PB's interest and prevent PB from participating in the potential profit by paying PB a purchase price that was not related to the fair market value of PB's interest.
Finally, even though PB and HBH complied with all of the formalities that would indicate PB was a partner in a partnership with "economic substance," the substance of the transaction did not indicate that there was any "meaningful intent" for PB to share in HBH's profits and losses. For all of the above reasons, the Third Circuit concluded that PB was not a partner in HBH because it "lacked a meaningful stake" in HBH's success or failure.
Significance of Third Circuit's Decision
The structure of HBH, the investor-protective clauses in HBH's operating and other agreements, and guaranties obtained by PB are similar to agreements and guaranties used in other deals. Immediately after the Third Circuit rendered its decision, many professionals engaged in structuring syndicated partnerships were unsure as to how to react to Historic Boardwalk Hall LLC.6 However, this decision, the Castle Harbour decision and the Fourth Circuit's decision in Virginia Historic Tax Credit Fund 2001 LP v. Comr.,7 indicate that the courts will evaluate the substance of an arrangement in order to determine if an entity is a partner even in the case of transactions with economic substance. The Historic Boardwalk Hall LLC decision is an example of another appellate court refusing to allow the partnership form of doing business to be used to facilitate the sale of tax credits by one entity to another party.8
The Third Circuit did not suggest "that a limited partner is prohibited from capping its risk at the amount it invests in a partnership." The Third Circuit stated that a limited partner's equity participation "will not be stripped away merely because it has successfully negotiated measures that minimize its risk of losing a portion of its investment." However, if the limited partner's investment is protected from all "meaningful risk," then the limited partner may not be a bona fide equity participant that is exposed to the "entrepreneurial risks of partnership operations." The borderline between measures that protect all or a portion of a partner's investment and measures that limit the investor's stake in the partnership's operations to the extent that a lack of equity participation is indicated was not identified by the Third Circuit.
The three cases discussed in this article all made the point that a partner must be exposed to the business risks of an investment in the same manner as a true business owner. The transactions themselves may have economic substance.9 However, the existence of economic substance does not mean all participants are legitimate partners. These cases indicate that the partnership form of business may not be used to disguise loan transactions10 or to camouflage transactions that are in substance the purchase and sale of tax credits. Persons involved in structuring future deals should be mindful of these three cases.
For more information, in the Tax Management Portfolios, see Manning, 710 T.M., Partnerships-Conceptual Overview, and in Tax Practice Series, see ¶4040, Income Taxation of Partnership Operations.
1 Comr. v. Culbertson , 337 U.S. 733 (1949); Comr. v. Francis E. Tower, Husband and wife partnership, 327 U.S. 280 (1946); Southgate Master Fund, LLC v. U.S., 659 F.3d 466 (5th Cir. 2011), and other cases.
2 TIFD III-E, Inc. v. U.S., 459 F.3d 220 (2d Cir. 2006), sometimes referred to as the "Castle Harbour" case.
3 Historic Boardwalk Hall, LLC et al. v. Comr., 136 T.C. 1 (2011).
4 See Note 2 above.
5 Virginia Historic Tax Credit Fund 2001 LP et al. v. Comr., 639 F.3d 129 (4th Cir. 2011).
6 Ryan, "Decision in `Historic Boardwalk Hall' Case Creates Challenges for Investors," 183 BNA Daily Tax Rep. J-1 (9/21/12).
7 639 F.3d 129 (4th Cir. 2011).
8 For an analysis of the Virginia Historic Tax Credit Fund 2001 LP v. Comr. decision, see Kehl, "Disguised Sales and the Virginia Historic Tax Credit Fund 2001 LP Decision," 27 Tax Management Real Estate J., No. 6, 230 (6/1/11).
9 This point was also made in Ryan, "Decision in `Historic Boardwalk Hall' Case Creates Challenges for Investors," 183 BNA Daily Tax Rep. J-1 (9/21/12).
10 TIFD III-E, Inc. v. U.S., 459 F.3d 220 (2d Cir. 2006).
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