In a case of potentially far reaching implications, the Third Circuit Court of Appeals in Historic Boardwalk Hall, LLC v. Commissioner of Internal Revenue  reversed the U.S. tax court’s decision and issued a decision considered to be a seminal ruling on use of the Federal Historic Rehabilitation tax credit (Historic Tax Credit). As codified under Section 47 of the Internal Revenue Code, the Historic Tax Credit allows a taxpayer to claim a 20 percent tax credit calculated on certain qualified expenses used towards the rehabilitation of certified historic structures. Since Historic Tax Credits may not be sold, transactions are often structured to allow investors to take an equity interest in the entity rehabilitating a historic structure so that the investor can claim the tax credit. In Historic Boardwalk Hall, the central issue was whether an investor in the Boardwalk Hall project could take advantage of the historic tax credit based upon its ownership interest in the project’s sponsor and the related contractual arrangements associated with such interest.
The case involved the rehabilitation of Atlantic City’s Boardwalk Hall – a building constructed in the late 1920s that certified as a National Historic Landmark in 1987. Site of the Miss America Pageant for many years, Boardwalk Hall had fallen into a state of disrepair. In 1992, the New Jersey Legislature authorized the New Jersey Sports and Exposition Authority (NJSEA) to use its legislatively proscribed powers to construct the Atlantic City Convention Center and renovate the deteriorated Boardwalk Hall exhibition facility. NJSEA formed Historic Boardwalk Hall, LLC (HBH), a single member limited liability company, to carry out these objectives.
The renovation of Boardwalk Hall commenced in late 1998. The renovation project was capitalized through several grants and bond issuances such that the project was considered to be fully funded by the end of 1999. However, in August 1998, NJSEA learned of an opportunity to raise additional capital for the project through the sale of federal Historic Tax Credits to a private investor. NJSEA solicited offers to potential investors through a confidential offering memorandum and Pitney Bowes (PB) was ultimately selected as the investor.
Through a wholly-owned subsidiary, PB purchased an interest in HBH as the investor member and entered into an operating agreement to memorialize its contractual obligations to HBH. The transaction required PB to make an initial capital contribution of $650,000 and three additional capital contributions totaling $17,545,797 contingent upon the verification of certain rehabilitation costs incurred to generate Historic Tax Credits. The transaction was structured to allow PB to receive a 99.9 interest in the profits and losses of the entity as well as the right to an allocation of 99.9 percent of the Historic Tax Credits generated by the project. Between 2000 and 2002, Boardwalk Hall LLC incurred nearly $104 million in qualified rehabilitation expenditures.
In 2002, the Internal Revenue Service (IRS) conducted an audit of HBH and determined that PB could not be allocated the Historic Tax Credits for two reasons. First, the IRS stated that HBH should not be recognized as a partnership for federal income tax purposes because it was a sham transaction structured to allow PB to improperly obtain the benefits of the credits. Second, based on the totality of the circumstances surrounding the transaction, PB was not a bona fide partner in HBH as it had no meaningful stake in the company. In reversing the IRS’s decision, the United States Tax Court rejected the IRS’s findings and instead determined that the transactions had “economic substance” and a “legitimate business purpose – to allow [PB] to invest in the [rehabilitation of Historic Boardwalk Hall.”
The Third Circuit Court of Appeals reversed the tax court’s ruling and held that PB was not a bona fide partner in HBH. The court’s analysis focused on whether HBH satisfied the test of being a bona fide partnership, defined as “parties in good faith and acting with a business purpose intend[ing] to join together in the present conduct of the enterprise.” The court emphasized that the transaction should be reviewed for substance over form and should turn on the totality of the circumstances. In its analysis, the court found that PB did not have a meaningful stake in the success or failure of the enterprise based on the following factors:
- PB had no meaningful risk in joining HBH as HBH provided PB with various guaranties including the protection against recapture or disallowance of the tax credits, cost overruns and operating deficits;
- PB had no meaningful upside potential as the project was highly leveraged and there was no residual cash flow available for distribution even under HBH’s “rosy” financial projections; and
- Although HBH met partnership formalities, there was no “meaningful intent [for PB] to share in the profits and losses of the investment.”
In essence, the court found that if a tax credit investor has no real possibility of upside and is insulated from construction, operational and task risk, the investor may not be qualified for the tax credits as such risk mitigation is inconsistent with the investor’s status as a partner.
Based on this decision, the tax credit industry is forced to carefully evaluate the use of partnership structures to qualify for Historic Tax Credits as the mechanisms that were built into the structure described in the case are common place. Practitioners have been actively restructuring transactions with the principles of this case in mind. Guidance from the IRS has been requested in light of the unsettling impact of this decision.