On August 27, 2012, the US Court of Appeals for the Third Circuit struck down a historic rehabilitation tax credit transaction, handing a victory to the government and dealing a blow to the taxpayer. In reversing the US Tax Court, the Third Circuit held that the private investor in a public-private partnership was not a “true” partner because it had “no meaningful stake” in the success or failure in the partnership’s enterprise, essentially disallowing the tax credits allocated to the private investor.

The decision, Historic Boardwalk Hall LLC v. Commissioner, No. 11-1832 (3d Cir. 2012), may have far reaching implications for developers, sponsors and investors involved in transactions involving tax credits, including not only historic rehabilitation tax credits, but low income housing tax credits, new markets tax credits and renewable energy tax credits.

Factual Overview

The New Jersey Sports and Exposition Authority (NJSEA), an agency of the state of New Jersey, was tasked with renovating the historic Atlantic City convention center known as Historic Boardwalk Hall or the East Hall (the Project). Upon learning about the market for historic rehabilitation tax credits (HRTCs), NJSEA explored using a partnership to raise additional capital by taking advantage of the HRTCs. It ultimately decided to enter into a partnership with Pitney Bowes Inc. (PB).

NJSEA transferred its interest in the Project to Historic Boardwalk Hall LLC (HBH). PB was admitted to HBH as a 99.9 percent investor, and NJSEA retained a 0.1 percent interest as the manager. PB agreed to make a series of capital contributions to HBH in the aggregate amount of approximately $19.3 million. The capital contributions were contingent upon the Project reaching certain completion milestones, including verification that rehabilitation expenditures that qualified for HRTCs had been incurred. PB’s interest entitled it to an allocation of 99.9 percent of the HRTCs to be generated by the Project as well as a distribution of 99.9 percent of residual cash flow. PB’s interest also entitled it to a 3 percent preferred return on its investment.

Under the partnership agreement, NJSEA had the option to purchase PB’s interest if NJSEA wanted to take actions that were prohibited or that required PB’s consent, with the purchase price being an amount equal to the present value of any yet-to-be realized projected tax benefits and cash distributions. PB had the option to sell its interest to NJSEA for that same price if NJSEA committed a material default. In addition, there were separate put and call options exercisable in certain circumstances for a purchase price equal to the greater of the fair market value of PB’s interest or any outstanding accrued and unpaid preferred return due to PB. NJSEA was required to provide security for the purchase price under the various options.

Finally, NJSEA and PB entered into a tax benefits guaranty agreement, whereby NJSEA agreed to reimburse PB for any lost tax benefits or assessed tax liabilities (together with any interest and penalties thereon) and any costs and legal fees up to $75,000, and provide a tax gross-up on the reimbursement.

Procedural History

Following an audit, the Internal Revenue Service (IRS) issued HBH a notice of final partnership administrative adjustment (FPAA) determining that the HRTCs should be reallocated from PB to NJSEA. The IRS based its determination on a number of alternative grounds: first, that HBH should be disregarded as a sham because it was created for the express purpose of improperly passing along tax benefits from NJSEA to PB; second, that PB was not a bona fide partner because it had no meaningful stake in the success or failure of HBH; third, that HBH should not be treated as the owner of the Project because the benefits and burdens of ownership remained with NJSEA; and fourth, that HBH should be disregarded under the partnership anti-abuse rule in Treasury Regulations section 1.701-2(b). NJSEA, as the tax matters partner of HBH, filed a petition with the Tax Court.

After a four-day trial in April 2009, the Tax Court issued its opinion in favor of HBH. It rejected all of the IRS’s arguments, concluding that the determinations in the FPAA were incorrect. Accordingly, it entered a decision in favor of HBH. The IRS appealed to the Third Circuit.

Following oral arguments in June 2012, the Third Circuit issued a unanimous opinion reversing the Tax Court and remanding the case for further proceedings.

Bona Fide Partner Test

As noted above, the Third Circuit decided the case based solely on the issue of whether PB was a bona fide partner, as evidenced by a meaningful stake in the success or failure of HBH. In analyzing the status of PB as a partner, the Third Circuit relied almost exclusively on two cases the IRS characterized as “guideposts”: the Second Circuit’s analysis of bona fide equity participation in TIFD III-E, Inc. v. United States1 (referred to as “Castle Harbour”) and the Fourth Circuit’s analysis of disguised sales in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner2 (referred to as “Virginia Historic”).

Downside Risk

The Third Circuit cited three main categories of risk that PB eliminated via contractual arrangements: (i) investment risk, which was non-existent because PB was not required to make a contribution until NJSEA generated enough HRTCs to equal PB’s cumulative investment; (ii) audit risk, which was eliminated through the tax benefits guaranty; and (iii) project risk, which was effectively eliminated because the Project was fully funded before PB entered into the transaction and PB was not subject to any legally meaningful risk that the renovation would not be completed. Accordingly, the court determined that PB’s investment was shielded from any meaningful downside risk.

The court did not feel that its conclusion was undermined by the fact that PB’s 3 percent preferred return was not technically guaranteed. It found that PB eventually would have received that return through either the put option or the call option because PB’s accrued and unpaid preferred return established a floor on the purchase price. The court signaled, however, that a limited partner is not prohibited from capping its risk in a venture at its investment amount, which the court distinguished from avoiding any meaningful risk.

Upside Potential

Even though, in form, PB was entitled to a 99.9 percent interest in HBH’s residual cash flow, even the most rosy financial projections forecasted that there would be no residual cash flow available for distribution to PB, due to various payments to NJSEA. Moreover, to the extent residual cash was available, NJSEA could effectively cut off PB’s upside by exercising the purchase option, which had a purchase price unrelated to the fair market value of PB’s interest.

Economic Substance and Other Musings

The Third Circuit dodged the question of whether the transaction possessed economic substance. Specifically, the court did not opine on whether, under the Ninth Circuit’s decision in Sacks v. Commissioner,3 tax credits can be considered (presumably by treating them like an item of after-tax cash flow) in determining whether a transaction has economic substance. It did, however, indicate its agreement with HBH and amicus that the economic substance doctrine and the substance-over-form doctrine are distinct. The court noted, “even if a transaction has economic substance, the tax treatment of those engaged in the transaction is still subject to a substance-over-form inquiry to determine whether a party was a bona fide partner in the business engaged in the transaction.”

The court also rejected the taxpayer’s argument that, under the totality-of-the circumstances test set forth by the US Supreme Court in Commissioner v. Culbertson,4 PB’s interest was that of a bona fide partner. The court did so based largely on its determination that the evidence cited focused on the form, rather than the substance, of the transaction.

Notwithstanding the Third Circuit’s musings on economic substance, the opinion gives no comfort regarding the correctness of the Tax Court’s conclusion that the transaction had economic substance. It may be that the Third Circuit viewed the bona fide partner test as an easy way to dispose of the case without having to address the intricacies of the economic substance doctrine. In any event, little can be read into the court’s assumption that the transaction possessed economic substance.


The Third Circuit’s decision may have a significant impact on the availability of financing for projects generating tax credits. It calls into question certain structures and features that are frequently used (although not with universal acceptance) in transactions involving HRTCs, low income housing tax credits, new markets tax credits, renewable energy tax credits and other tax incentives. Although the court did not dwell on the policy implications of its decision, it was “mindful of Congress’s goal of encouraging rehabilitation of historic buildings” and confirmed that it was not attacking the “tax credit provision itself.” Instead, it was addressing the “prohibited sale of tax credits” that the IRS challenged.

The decision also may increase the audit risk for existing transactions. There are a number of transactions in the marketplace that utilize structures similar to the transaction in Historic Boardwalk Hall. However, most transactions are carefully structured to comply with IRS guidance, including the IRS safe harbor for wind partnerships5 or the IRS advance ruling guidelines for leveraged leases.6 The outcome of any audit will, of course, depend largely on the specific facts. The more a purported equity investment looks like debt, the more likely it will be subject to close scrutiny by the IRS.

The decision leaves a lot of unanswered questions, including the extent to which risklimiting features are appropriate and how much upside potential an investor must have. Nevertheless, the case provides a valuable— albeit cautionary—reminder for developers, sponsors and investors in tax credit transactions: Although tax credits are Congressionally sanctioned incentives designed to encourage certain types of investment activity, the form and substance of the investment must be consistent with the intent of the underlying tax credit.