Background

The Third Circuit recently addressed the availability of federal historic rehabilitation tax credits (“HRTCs”) in connection with the restoration of East Hall (also known as “Historic Boardwalk Hall”), an iconic venue located on the boardwalk in Atlantic City, New Jersey.1 The New Jersey Sports and Exposition Authority (“NJSEA”), a state agency that owns a leasehold interest in East Hall, was charged with restoring East Hall. Code Sec. 47 provides for a tax credit equal to 20% of the qualified rehabilitation expenditures with respect to any certified historic structure. These tax credits cannot be sold; they are only available to the owner of the property interest. As a tax-exempt entity, NJSEA was unable to take advantage of the tax credits. NJSEA sought to overcome these limitations by taking advantage of the market for HRTCs among corporate investors. NJSEA created a New Jersey limited liability company, Historic Boardwalk Hall, LLC (“HBH”) and subsequently transferred ownership of NJSEA’s property interest in East Hall to HBH. NJSEA then sold a 99.9% investor membership interest in HBH to a wholly-owned subsidiary of Pitney Bowes, Inc. (“PB”) to enable PB to utilize the federal HRTCs generated from the East Hall restoration. NJSEA retained a 0.1% interest as a managing member of HBH.

In 2001 and 2002, HBH issued to PB Schedule K-1s allocating 99.9% of the HRTCs. The IRS audited HBH’s 2001 and 2002 tax returns and ultimately issued a notice of final partnership administrative adjustment. This adjustment determined that all separately stated partnership items should be reallocated from PB to NJSEA. The IRS made this determination on various alternative grounds, two of which were relevant on appeal. First, the IRS claimed that HBH should not be recognized as a partnership for federal income tax purposes because it was created for the express purpose of improperly passing along tax benefits to PB and should be treated as a sham transaction. Second, the IRS alleged that, based on the totality of the circumstances, PB’s claimed partnership interest in HBH was not a bona fide partnership interest because PB had no meaningful stake in the success or failure of HBH.

The Tax Court rejected the Commissioner’s argument that HBH was a sham under the economic substance doctrine. It reasoned that PB could not have invested in HBH solely for the tax benefit of the HRTCs because PB also received a three percent preferred return. Additionally, even though NJSEA had sufficient funding to complete the restoration without PB’s investment, PB’s investment provided NJSEA with more money than it otherwise would have had and, as a result, PB’s investment reduced the costs of the rehabilitation to the State of New Jersey.

The Tax Court also rejected the Commissioner’s assertion that PB was not a bona fide partner in HBH. The Tax Court applied the totality of the circumstances partnership test set forth in Commissioner v. Culbertson,2 and determined that “PB and NJSEA, in good faith and acting with a business purpose, intended to join together in the present conduct of a business enterprise.” PB’s three percent preferred return was not guaranteed because it would not be paid if HBH lacked sufficient cash flow to pay it. Therefore, the Tax Court concluded that PB had a meaningful stake in HBH’s success or failure and that PB’s interest in HBH was more like equity than debt.

The IRS appealed the Tax Court’s decision. The Third Circuit agreed with the IRS and held that PB was not a bona fide partner in HBH because PB did not have a meaningful stake in the success or failure of the partnership.

The Third Circuit’s Application of the Culbertson Test

The Culbertson test provides that a partnership exists when two or more “parties in good faith and acting with a business purpose intend to join together in the present conduct of the enterprise.”3 This test is used to analyze the bona fides of a partnership and to decide whether a party’s interest constitutes a bona fide equity partnership interest. In essence, to be a bona fide partner for tax purposes, a party must have a “meaningful stake in the success or failure” of the enterprise. To determine whether PB was a bona fide partner in HBH, the Third Circuit considered the totality of the circumstances.

The Third Circuit used two recent cases as guideposts bearing on the bona fide partner inquiry: TIFD III-E, Inc. v. U.S. (“Castle Harbour”)4 and Virginia Historic Tax Credit Fund 2001 v. Commissioner (“Virginia Historic”).5 In Castle Harbour, the court found that the two foreign banks in a partnership with a U.S. corporation should not be treated as equity partners because they had no meaningful stake in the success or failure of the partnership. The banks’ purported partnership interests were, in substance, in the nature of a secured lender’s interest, which would neither be harmed by poor performance nor significantly enhanced by extraordinary profits. In determining whether the banks’ interests were bona fide partnership interests, the Castle Harbour court considered whether the interests had the prevailing character of debt or equity. A significant factor in making this determination was whether the banks’ funds were advanced with reasonable expectation of repayment regardless of the success of the venture or were placed at the risk of the business. Thus, the court focused both on the banks’ lack of downside risk and lack of upside potential in the partnership. In assessing the upside potential, the court held that governing inquiry is the realistic possibility of upside potential rather than the absence of formal caps. In Castle Harbor, the U.S. partner had the power either to effectively restrict the banks’ share of profits at one percent above an agreed upon return, or to buy out their interest at any time at a negligible cost. Thus, the court found that the banks realistically had no possibility of upside potential.

In Virginia Historic, investment funds were structured as partnerships that investors could join by contributing capital. In exchange for the contribution of capital, the partnership would allocate state tax credits to the investor. The Virginia Historic court found that the Commissioner properly characterized the transactions at issue as “sales” under the disguised-sale rules and that the partnerships should have reported the money received from the investors as taxable income. Specifically, the court explained that a transaction should be reclassified as a sale if, based on all of the facts and circumstances, (a) a partner would not have transferred money to the partnership but for the transfer of property (i.e., the receipt of tax credits) to the partner; and (b) the later transfer (i.e., the receipt of tax credits) is not dependent on the entrepreneurial risks of partnership operations. In holding that there was no true entrepreneurial risk faced by the investors in the transactions at issue, the court pointed to several different factors: (i) the investors were essentially promised a fixed rate of return on the investment; (ii) the investors were secured against losing their contributions by the promise of a refund from the partnerships if tax credits could not be delivered or revoked; and (iii) the funds hedged against the possibility of insolvency by promising investors that contributions would be made only to completed projects.

The Third Circuit analogized to both Castle Harbour and Virginia Historic in applying the Culbertson test to the present case. In applying the Culbertson test, the Third Circuit stated that resolving whether a purported partner had a meaningful stake in the success or failure of the partnership goes to the core of the ultimate determination of whether the parties intended to join together in the present conduct of the enterprise. The conclusions of Castle Harbour and Virginia Historic are highly relevant to the question of whether HBH was a partnership in which PB had a true interest in profit and loss. The court in Castle Harbour concluded that the banks’ indicia of an equity participation in a partnership was only “illusory or insignificant.” The court in Virginia Historic concluded that the limited partner investors did not face the entrepreneurial risks of partnership operations. Thus, to determine whether PB had a true interest in profit and loss, the Third Circuit assessed PB’s risk participation and found that PB did not have any meaningful downside risk or any meaningful upside risk.

In Historic Boardwalk, the Third Circuit concluded that PB had no meaningful downside risk because it was, for all intents and purposes, certain to recoup its contributions to HBH and receive the primary benefit it sought—the HRTCs or their cash equivalents. PB’s obligation to make a contribution to HBH was conditioned upon NJSEA’s achievement of a certain level of progress with the East Hall renovation that would generate enough cumulative HRTCs to equal PB’s contribution. To further guarantee availability of the HRTCs, the partnership agreement obligated NJSEA to pay PB not only the amount of tax credits disallowed, but also any penalties and interest, legal and administrative expenses associated with any IRS challenge, and the amount necessary to pay any tax due on those reimbursements. Lastly, the renovation project was fully funded before PB entered into any agreement to provide contributions to HBH. Thus, PB was virtually guaranteed to receive the HRTCs and bore no meaningful risk in joining HBH. The Third Circuit found that PB’s three percent preferred return on its contributions to HBH did not undermine this conclusion. Although such return was not technically guaranteed, PB had the power to ensure it received the return through the exercise of its put option. When exercised, the put option would require NJSEA to pay a purchase price that was determined based on PB’s accrued and unpaid preferred return. Thus, the Third Circuit found that PB had no meaningful downside risk.

Nor did PB have any meaningful upside potential in its investment in HBH. Although PB had a 99.9% interest in residual cash flow, PB would benefit from this interest after it received payments on its preferred return and after HBH’s creditors were paid. Additionally, HBH’s financial projections forecasted no residual cash flow available for distribution. NJSEA also had a call option which it could exercise at any time to prevent PB from sharing in any upside. Based on this evidence, the Third Circuit found that PB lacked any meaningful upside potential.

In a final argument, HBH presented evidence, including various recitations of partnership formalities (such as the fact that HBH was duly organized, it had a stated purpose, and bank accounts were opened in its name) to prove that PB was a partner in HBH under the Culbertson test. The Third Circuit found this evidence of “superficial formalities” of the transaction to be without merit. Such formalities gave an outward appearance of an intent to engage in a common enterprise but did not demonstrate a meaningful stake in the success or failure of the enterprise. HBH also presented evidence that PB received a net economic benefit from HBH and made a substantial financial investment in HBH. The court explained that this evidence could support a finding that PB is a bona fide partner only if there was a meaningful intent to share in the profits and the losses of that investment. Because the recovery of PB’s contributions was assured by various agreements, there was no such intent. Additionally, PB’s net after-tax economic benefit from the transaction in the form of tax credits and the effectively guaranteed preferred return merely demonstrated PB’s intent to make an economically rational use of its money on an after-tax basis.

Implications

Going forward, investments in partnerships that are structured to be relatively risk free may no longer be respected by the IRS. Relevant factors and deal terms present in the Historic Boardwalk Hall case included: shield from construction risk and audit risk; guaranteed receipt of tax benefits; a highly leveraged project such that the investor was unlikely to earn amounts in excess of its guaranteed return; the investor’s put option that is protected by a guaranteed investment contract; and the true owner’s option to purchase the investor’s interest at a price equal to the future value of the investor’s tax benefits and preferred return. If the IRS determines that an investor is not a bona fide partner, special allocations of items such as HRTCs will not be respected. To avoid the risk of IRS reallocation, taxpayers and their advisors should structure the partnership agreement so that the investor has a meaningful stake in the success or failure of the enterprise.