On August 27, 2012, the U.S. Court of Appeals for the Third Circuit in Historic Boardwalk Hall, LLC v. Commissioner, No. 11-1832 (3d Cir. 2012), in reversing the Tax Court's previous taxpayer-favorable decision, held that the investor member in a historic tax credit partnership was not a bona fide partner for federal income tax purposes because it had "no meaningful stake" in the success or failure of the partnership. Thus, it could not be allocated the federal historic rehabilitation tax credits (HRTCs) generated by the historic tax credit partnership. This decision raises a number of questions regarding transaction structuring, not only for HRTCs, but also potentially for other federal and state tax credit programs.
FACTUAL OVERVIEW OF THE ARRANGEMENT
The HRTC allocation at issue arose from the formation of a public-private partnership between the New Jersey Sports and Exposition Authority (NJSEA), an agency of the state of New Jersey charged with renovating the historic Atlantic City convention center, and a subsidiary of Pitney Bowes, Inc. (PB), a private investor in the project. NJSEA transferred its interest in the project to Historic Boardwalk Hall, LLC (HBH). PB was thereafter admitted into HBH as a 99.9 percent investor member while NJSEA retained a 0.1 percent managing member interest therein. PB agreed to make a series of capital contributions to HBH, contingent upon the completion of certain project-related events, including confirmation of qualified rehabilitation expenditures (QREs) to generate the HRTCs. PB's membership interest entitled it to an allocation of 99.9 percent of the HRTCs, a distribution of 99.9 percent of residual cash flow and a three percent preferred return on its investment in HBH.
The operating agreement of HBH included a post-compliance period exit arrangement involving a put/call option. The purchase price for both the put and call was equal to the greater of the fair market value of PB's membership interest or any outstanding accrued and unpaid preferred return due to PB. In order to ensure NJSEA would have the funds necessary to pay the purchase price under either the put or call, the HBH operating agreement required NJSEA to purchase a guaranteed investment contract to secure payment, which it did using some of PB's capital contribution dollars.
In addition to the post-compliance period put/call arrangement, the HBH operating agreement also provided certain other repurchase rights prior to the end of the five-year compliance period. PB could put its interest to NJSEA in the event of a material default by NJSEA (Material Default Option), and NJSEA had an option to purchase PB's interest in the event NJSEA desired to take certain actions that were prohibited under the HBH operating agreement or that would have required it to obtain PB's consent to such action (Consent Option). In either case, the purchase price was equal to the present value of any yet-to-be realized projected tax benefits and cash distributions to PB.
NJSEA provided a completion guaranty, operating deficit guaranty and environmental guaranty to PB. HBH also entered into a comprehensive tax benefits guaranty agreement with PB, backed by NJSEA's commitment to fund any obligations of HBH to PB thereunder, which insulated PB from the risk of a reduction in projected tax benefits, as well as associated costs, as a result of a possible IRS challenge.
THE IRS CHALLENGE AND TAX COURT DECISION
The IRS audited HBH and issued a notice of final partnership administrative adjustment determining that the HRTCs should be reallocated from PB to NJSEA. The IRS based its determination on a number of alternative grounds, including: (1) that HBH should be disregarded as a sham entity because it was created for the purpose of improperly passing along tax benefits from NJSEA to PB (i.e., the transaction lacked economic substance); and (2) that PB was not a bona fide partner because it had no meaningful stake in the success or failure of HBH.
The Tax Court rejected all of the IRS's arguments and entered judgment in favor of HBH. The IRS appealed to the Third Circuit.
THE THIRD CIRCUIT ANALYSIS
As noted above, the Third Circuit rested its decision exclusively on its finding that PB was not a bona fide partner in HBH. The bona fide partner test has its underpinnings in Commissioner v. Culbertson, 337 U.S. 733 (1949), which evaluates the existence of a partnership by analyzing whether, considering the totality of the circumstances, "parties in good faith and acting with a business purpose intended to join together in the present conduct of [an] enterprise." In analyzing whether PB was a legitimate partner, the court considered the decisions in both TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) (hereinafter referred to as Castle Harbour) and Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011), the two cases cited by the Commissioner as "recent guideposts" for the bona fide partner inquiry. The courts in both cases scrutinized the putative partners' participation in downside risk and upside potential in determining whether their "partner" interests should be respected, and thus whether partnership allocations should be upheld. After reviewing such cases, the Third Circuit ultimately boiled the inquiry down to the following rule of law: "[T]o be a bona fide partner for tax purposes, a party must have a 'meaningful stake in the success or failure' of the enterprise." 
THE LACK OF DOWNSIDE RISK
The court deemed PB's downside risk extremely circumspect and illusory due to a number of risk-hedging mechanisms built into the arrangement, which left PB virtually certain to achieve its return on investment. In reaching this conclusion, the court focused on the effective elimination of PB's investment risk, audit risk and operational risk. First, the court characterized PB's investment risk as "non-existent" 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 HRTCs at least equal to the amount of such installment contribution. The court was not swayed by the alleged uncertainty of PB's three percent preferred return (due to potentially insufficient annual cash flow from HBH) because, in substance, PB could ultimately assure such return by unilaterally exercising its put option (the purchase price for which was effectively measured by PB's accrued and unpaid preferred return). Moreover, NJSEA was required to purchase a guaranteed investment contract to ensure that sufficient funds would be available to pay such purchase price. Second, the tax benefits guaranty eliminated any risk of reduction in PB's bargained-for tax benefits as a result of an IRS examination. Finally, the court found there was no operational risk involved either. The project was already fully funded by NJSEA before PB entered into an agreement to provide any contributions. Furthermore, because of the various guaranty arrangements that were in place and its "deep pockets," NJSEA had both the legal obligation and the financial capacity to fund any excess development costs or operational deficits and to indemnify PB against any environmental liabilities.
THE ABSENCE OF UPSIDE POTENTIAL
The court also found that PB's interest was devoid of any realistic possibility of upside potential. It deemed PB's 99.9 percent interest in HBH's residual cash flow illusory because: (1) its right to distributions was subordinate to a number of other significant payment obligations including the preferred return to PB, as well as payments on the construction, acquisition and operating deficit loans to NJSEA; (2) the most favorable cash flow projections for HBH forecast no residual cash flow; and (3) even assuming an upside, NJSEA could exercise its Consent Option to divest PB of its interest. Even though in form, PB had the potential to receive the fair market value of its interest if either the put or call options would be exercised, the court found that the parties never anticipated that fair market value would exceed the amount of the accrued but unpaid preferred return. Thus, the Third Circuit concluded that the transaction was structured to ensure that PB would never receive any economic benefits from HBH (beyond the three percent preferred return which the court considered to be assured).
Tax credit investors, syndicators, developers and other transaction participants may want to review and consider their customary tax credit deal structures in light of Historic Boardwalk Hall. BakerHostetler is evaluating this developing area in order to help clients assess the risks as well as planning opportunities afforded by this decision. According to the Third Circuit, the absence of a realistic upside potential along with elimination of investment, operational and tax risk may be inconsistent with a tax credit investor's status as a partner and could cause the loss of expected credits.