Third Circuit Denies Rehearing in Historic Boardwalk Case

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By David I. Kempler, Esq. and Elizabeth Carrott Minnigh, Esq.  

Buchanan Ingersoll & Rooney PC, Washington, DC

Under §47(a)(2), a taxpayer is eligible for a tax credit equal to "20 percent of the qualified rehabilitation expenditures with respect to any certified historic structure." Section 47 historic rehabilitation tax credits are only available to the owner of the property interest. Accordingly, §47 historic rehabilitation tax credits cannot be sold. However, §47 historic rehabilitation tax credits may be allocated among partners. The use of joint ventures or single purpose limited partnerships or limited liability companies is common in real estate development and redevelopment projects as such an arrangement can help the parties in a real estate transaction to pool resources and limit liability exposure to the underlying partners while also providing for a specific division of control, splitting up the profits and setting out an exit strategy upon completion of the project. However, it is general principle of tax law that income is taxed to the person who earns it,1 and the entity earning income "cannot avoid taxation by entering into a contractual arrangement whereby that income is diverted to some other person or entity."Accordingly, in order for the new entity to have an effect for federal income tax purposes, the entity must be treated as a valid partnership with economic substance.

On August 27, 2012, the Third Circuit in Historic Boardwalk Hall, LLC v. Comr., No. 11-1832 (3d Cir. 2012), reversed the Tax Court's previous taxpayer-favorable decision, holding that the investor member in a historic tax credit partnership was not a bona fide partner for federal income tax purposes because the investor member had not undertaken a meaningful risk of failure nor meaningful upside potential. Accordingly, the Third Circuit held that the investor member could not be allocated the historic rehabilitation tax credits generated by the entity. On October 22, 2012, the Third Circuit issued a denial of the taxpayer's request for an en banc rehearing of the decision (No. 11-1832 (10/22/12)). The Third Circuit's decision was surprising to the historic rehabilitation tax credit industry where partnership structures such as the one in Historic Boardwalk are common place ways to implement the acknowledged public policy motivation behind §47 to encourage taxable entities to invest in historic rehabilitation. This decision could have a significant impact on the structure on entities used in the historic rehabilitation tax credit.


New Jersey Sports and Exposition Authority ("NJSEA"), an entity of the state of New Jersey, owned a lease on East Hall, a convention center located in Atlantic City, New Jersey. NJSEA received a state grant to renovate East Hall and, although East Hall's rehabilitation would have been funded entirely by state bonds in the absence of an equity investor, retained the services of a financial advisor to find an equity investor for the project. The financial advisor prepared a confidential offering memorandum that described the proposed transaction as a "sale" of tax credits. Based upon the offering memorandum, Pitney Bowes ("PB") expressed an interest in providing an equity investment.

NJSEA formed Historic Boardwalk Hall, LLC ("HBH") as sole member, and thereafter, allowed PB to invest in the East Hall rehabilitation, admitted PB as a 99.9% owner and investor member and retained interest as a 0.1% owner and managing member pursuant to an amended and restated operating agreement ("AROA").  Because East Hall was a historic building, the rehabilitation project had the potential to earn §47 historic rehabilitation tax credits.   The structure of HBH allowed PB, a private party, to earn §47 historic rehabilitation tax credits from the rehabilitation of a public, governmentally-owned building.

After forming HBH, NJSEA subleased East Hall to HBH, then executed a lease agreement which was treated as a "sale" for federal income tax purposes, which purported to give HBH ownership of East Hall in exchange for a mortgage and note. NJSEA also entered into a construction loan agreement with HBH to lend amounts to HBH from time to time to pay for the remainder of the renovations to East Hall. NJSEA's obligation to lend to HBH was evidenced by a mortgage note and a second mortgage on the property.

The AROA made clear that the potential §47 historic rehabilitation tax credits were an integral part of the transaction.  Pursuant to the AROA, PB was required to make four capital contributions totaling $18,195,757 and PB had a 3% return on its "adjusted capital contribution." PB also made an investor loan in the amount of $1.1 million to HBH. HBH drew against a construction loan to pay management fees and a developer's fee to NJSEA for obtaining all government approvals for rehabilitation, insurance coverage and overseeing the project's completion. Pursuant to the AROA, NJSEA was required to indemnify PB for any costs associated with environmental hazards, for which East Hall was assessed to be an "unknown risk." Additionally, the AROA provided several possible options to transfer PB's interest to NJSEA, secured by a guaranteed investment contract (purchased with a portion of HBH's second capital contribution).  The AROA also provided a guarantee that NJSEA would indemnify PB against IRS challenges of the transaction.

Although the rehabilitation of East Hall was successful, East Hall operated at a deficit. In tax years 2000-2002, HBH claimed qualified rehabilitation expenditures and allocated them to PB, allowing PB to claim §47 historic rehabilitation tax credits. The IRS issued a notice of final partnership administrative adjustment (FPAA). The FPAA contained an "Explanation of Adjustments" which provided alternative arguments in support of the IRS's adjustments, including, among other things, that: (i) HBH was created for the express purpose of improperly passing along tax benefits to PB and was a sham; (ii) PB had no bona fide partnership interest in HBH because it had no meaningful stake in the success or failure of HBH; and (iii) pursuant to the authority in the anti-abuse provisions of Regs. §1.701-2(b), the IRS had determined that HBH should be disregarded for Federal income tax purposes.

Tax Court Decision  

In the Tax Court decision (136 T.C. 1 (1/3/11)), the Tax Court held that formation of a limited liability company had economic substance and business purpose, and was not an abuse of partnership vehicle, where rehabilitation credit was an integral part of a structured transaction Since the transaction occurred prior to the codification of the economic substance doctrine under §7701(o), the Tax Court applied the judicial doctrine of the economic substance for the Third Circuit set forth in IRS v. CM Holdings, Inc., 301 F.3d 96, 102 (3d Cir. 2002), which required analysis of whether the transaction had objective substance and the subjective business motivation behind it. Applying this test, the Tax Court first held that the transaction had both economic substance and a legitimate business purpose because the transaction put PB in a different economic position, and, therefore, the partnership was not a sham.

The Tax Court then looked at whether PB was a partner and HBH was a valid partnership. Citing Comr. v. Culbertson, 337 U.S. 733, 742 (1949), and Luna v. Comr., 42 T.C. 1067, 1077-8 (1964), the Tax Court concluded that PB and NJSEA, in good faith and acting with a business purpose, joined together in a partnership to conduct a business enterprise with economic substance to allow PB to invest in the East Hall rehabilitation.  Further, the Tax Court stated that the decision to invest provided a net economic benefit to PB through its 3% preferred return and §47 historic rehabilitation tax credits. Accordingly, the Tax Court held that HBH was a valid partnership and that PB was a bona fide partner. 

The Tax Court also held that the IRS's reliance on the anti-abuse rule of Regs. §1.701-2(b) was inappropriate. In declining to apply the anti-abuse rules, the Tax Court emphasized that allowing PB to invest in East Hall's rehabilitation was a legitimate business purpose, and that the use of a partnership was necessary to permit a private corporation to invest in the rehabilitation of a public, government-owned building. The Tax Court further observed that, although an integral part of the transaction was the use of the §47 historic rehabilitation tax credits to reduce PB's aggregate tax liability, Congress intended the use of the §47 historic rehabilitation tax credits to draw private investments into public rehabilitations. The Tax Court also noted that Regs. §1.701-2(d), Ex. 6, contemplates situations in which a partnership is validly used to transfer valuable tax attributes from an entity that cannot use them to taxpayers who can use them.

Third Circuit Opinion  

In reversing the Tax Court decision, the Third Circuit focused on whether PB was a bona fide partner in HBH. In Culbertson, the Supreme Court stated that there is a partnership for federal tax purposes when considering all the facts the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise. Citing TIFD III-E, Inc. v. U.S., 459 F.3d 220 (2d Cir. 2006), and Virginia Historic Tax Credit Fund 2001 LP v. Comr., 639 F.3d 129 (4th Cir. 2011), the Third Circuit scrutinized PB's participation in a downside risk and upside potential in determining whether its "partner" interests should be respected, and thus whether partnership allocations should be upheld.

The Third Circuit determined that PB had no meaningful downside risk because it was almost certain to recoup the contributions it had made to HBH and to receive the benefit it sought, namely use of the §47 historic rehabilitation tax credits. Firstly, the Third Circuit concluded that PB had no investment risk because PB was required to make its installment capital contributions to HBH only upon confirmation by NJSEA that sufficient construction progress had been made to assure §47 historic rehabilitation tax credits at least equal to the amount of that installment contribution. Secondly, the Third Circuit concluded that PB had no audit risk because the tax benefits guaranty eliminated any risk that, due to a successful IRS audit, PB would not receive at least the cash equivalent of the bargained-for tax credits. Finally, the Third Circuit found PB had no project risk either because the project was already fully funded by NJSEA before PB entered into an agreement to provide any contributions.  Accordingly, the Third Circuit concluded that, as a result of the various agreements between parties, PB bore no meaningful risk in joining HBH that a partner would bear in joining a bona fide partnership.  Moreover, the Third Circuit noted that its conclusion was not undermined by the uncertainty of PB's 3% preferred return on its contributions to HBH, because in substance PB could exercise its put option to receive this return.

The Third Circuit also found that PB's interest was devoid of any meaningful upside potential. The Third Circuit concluded that PB's 99.9% interest in HBH's residual cash flow was illusory because: (i) its right to distributions was subordinate to a number of other significant payment obligations, including: the preferred return to PB and payments on various loans to NJSEA; (ii) the most favorable cash flow projections for HBH forecast no residual cash flow; and (3) even assuming an upside, if either NJSEA exercised its call option or PB exercised its put option, PB would not share in any upside. Thus, the Third Circuit concluded that the transaction was structured to ensure that PB would never receive any economic benefits from HBH beyond the 3% preferred return.

While the Third Circuit decision concluded that the structure of HBH placed form over substance, it stated that it was not attacking the use of the §47 historic rehabilitation tax credits to draw private investments into public rehabilitation when done through a valid partnership. However, the Third Circuit refused to comment on where the "line lies between a defensible distribution of risk and reward in a partnership on the one hand and a form-over-substance violation of the tax laws on the other."

Denial of Rehearing  

The Third Circuit denied taxpayer's petition for a rehearing en banc, noting that none of the judges who participated in the decision requested a rehearing and a majority of the circuit judges did not vote for rehearing. The taxpayer's final recourse in this case is to seek Supreme Court review.

Assuming the Supreme Court does not reverse the Third Circuit's decision, it could have a significant impact on structuring joint ventures or single purpose limited partnerships or limited liability companies used in rehabilitation projects. The guiding principle from the Third Circuit's decision is that if a tax credit investor has no realistic possibility of upside and is insulated from all tax risk, then that investor may lose the tax credits it entered into the transaction to take advantage of.

For more information, in the Tax Management Portfolios, see Milder and Borod, 584 T.M., Rehabilitation Tax Credit and Low-Income Housing Tax Credit,  and in Tax Practice Series, see ¶3140, Investment Tax Credit.

  1 See Comr. v. Banks, 543 U.S. 426 (2005); U.S. v. Basye, 410 U.S. 441, 450 (1973); Lucas v. Earl, 281 U.S. 111, 115 (1930).

  2 Basye, 410 U.S. at 449.