HISTORIC BOARDWALK HALL, LLC v. U.S., Cite as 110 AFTR 2d
2012-XXXX, 08/27/2012
HISTORIC BOARDWALK HALL, LLC, NEW JERSEY SPORTS AND
EXPOSITION AUTHORITY, TAX MATTERS PARTNER v. COMMISSIONER OF INTERNAL REVENUE,
Appellant.
Case Information:
Code Sec(s):
Court Name: UNITED
STATES COURT OF APPEALS FOR THE THIRD CIRCUIT,
Docket No.: No.
11-1832,
Date Argued:
06/25/2012
Date Decided:
08/27/2012.
Prior History:
Disposition:
HEADNOTE
.
Reference(s):
OPINION
Tamara W. Ashford Arthur T. Catterall [ARGUED] Richard
Farber Gilbert S. Rothenberg William J. Wilkins United States Department of
Justice Tax Division 950 Pennsylvania Avenue, N.W. P. O. Box 502 Washington,
D.C. 20044Counsel for Appellant
Robert S. Fink Kevin M. Flynn [ARGUED] Kostelanetz &
Fink, LLP 7 World Trade Center, 34th Floor New York, NY 10007Counsel for
Appellees
Paul W. Edmondson Elizabeth S. Merritt William J. Cook
National Trust for Historic Preservation 1785 Massachusetts Ave., N.W.
Washington, D.C. 20036
David B. Blair Alan I. Horowitz John C. Eustice Miller &
Chevalier, Chartered 655 Fifteenth Street, N.W., Suite 900 Washington, D.C.
20005Counsel for Amicus National Trust for Historic Preservation
A. Duane Webber Richard M. Lipton Robert S. Walton Derek M.
Love Samuel Grilli Baker & McKenzie LLP 300 East Randolph Drive, Suite 5000
Chicago, IL 60601Counsel for Amicus Real Estate Roundtable
UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT,
On Appeal from the United States Tax Court (No. 11273-07)
Judge: Hon. Joseph Robert Goeke
Before: SLOVITER, CHAGARES, and JORDAN, Circuit Judges.
OPINION OF THE COURT
Judge: JORDAN, Circuit Judge.
PRECEDENTIAL
TABLE OF CONTENTS
Page
----
I. Background
................................................ 9
A. Background of
the HRTC Statute ......................... 9
B. Factual
Background of the East Hall Renovation ........ 15
1. NJSEA
Background ................................... 15
2. Commencement
of the East Hall Renovation ........... 16
3. Finding a
Partner .................................. 18
a) The
Proposal from Sovereign Capital
Resources ..................................... 18
b) The
Initial and Revised Five-Year
Projections ................................... 20
c)
Confidential Offering Memorandum .............. 22
d)
Selection of Pitney Bowes ..................... 23
e) Additional Revisions to Financial
Projections ................................... 25
4. Closing
............................................ 26
a) The HBH
Operating Agreement ................... 27
b) Lease
Amendment and Sublease .................. 32
c)
Acquisition Loan and Construction Loan ........ 33
d)
Development Agreement ......................... 34
e) Purchase
Option and Option to Compel .......... 35
f) Tax
Benefits Guaranty ......................... 36
5. HBH in
Operation ................................... 37
a)
Construction in Progress ...................... 37
b)
Post-Construction Phase ....................... 41
6. The Tax
Returns and IRS Audit ...................... 44
C. The Tax Court
Decision ................................ 46
II. Discussion
.............................................. 51
A. The Test
.............................................. 54
B. The
Commissioner's Guideposts ......................... 56
C. Application of
the Guideposts to HBH .................. 64
1. Lack of
Meaningful Downside Risk ................... 69
2. Lack of
Meaningful Upside Potential ................ 77
3. HBH's
Reliance on Form over Substance .............. 80
III. Conclusion
............................................. 85
This case involves the availability of federal historic
rehabilitation tax credits (“HRTCs”) in connection with the restoration of an
iconic venue known as the “East Hall” (also known as “Historic Boardwalk
Hall”), located on the boardwalk in Atlantic City, New Jersey. The New Jersey
Sports and Exposition Authority (“NJSEA”), a state agency which owned a leasehold
interest in the East Hall, was tasked with restoring it. After learning of the
market for HRTCs among corporate investors, and of the additional revenue which
that market could bring to the state through a syndicated partnership with one
or more investors, NJSEA created a New Jersey limited liability company,
Historic Boardwalk Hall, LLC (“HBH”), and subsequently sold a membership
interest in HBH 1to a wholly-owned subsidiary of Pitney Bowes, Inc. (“PB”). 2
Through a series of agreements, the transactions that were executed to admit PB
as a member of HBH and to transfer ownership of NJSEA's property interest in
the East Hall to HBH were designed so that PB could earn the HRTCs generated
from the East Hall rehabilitation. The Internal Revenue Service (“IRS”)
determined that HBH was simply a vehicle to impermissibly transfer HRTCs from
NJSEA to PB and that all HRTCs taken by PB should be reallocated to NJSEA. 3
The Tax Court disagreed, and sustained the allocation of the HRTCs to PB
through its membership interest in HBH. Because we agree with the IRS's
contention that PB, in substance, was not a bona fide partner in HBH, we will
reverse the decision of the Tax Court.
I. Background
A. Background of the HRTC Statute
We begin by describing the history of the HRTC statute.
Under Section 47 of the Internal Revenue Code of 1986, as amended (the “Code”
or the “I.R.C.”), a taxpayer is eligible for a tax credit equal to “20 percent
of the qualified rehabilitation expenditures [“QREs” 4] with respect to any
certified historic structure. 5”I.R.C. § 47(a)(2). HRTCs are only available to
the owner of the property interest.See generally I.R.C. § 47; see also I.R.S. Publication, Tax
Aspects of Historic Preservation, at 1 (Oct. 2000), available
athttp://www.irs.gov/pub/irs-utl/faqrehab.pdf. In other words, the Code does
not permit HRTCs to be sold.
The idea of promoting historic rehabilitation projects can
be traced back to the enactment of the National Historic Preservation Act of
1966, Pub. L. No. 89-665, 80 Stat. 9156 (1966), wherein Congress emphasized the
importance of preserving “historic properties significant to the Nation's
heritage,” 16 U.S.C. § 470(b)(3). Its purpose was to “remedy the dilemma that
“historic properties significant to the Nation's heritage are being lost or
substantially altered, often inadvertently, with increasing frequency.”” Pye v.
United States, 269 F.3d 459, 470 (4th Cir. 2001) (quoting 16 U.S.C. §
470(b)(3)). Among other things, the National Historic Preservation Act set out
a process “which require[d] federal agencies with the authority to license an
undertaking “to take into account the effect of the undertaking on any ... site
... that is ... eligible for inclusion in the National Register” prior to
issuing the license.” Id. (quoting 16 U.S.C. § 470f). It also authorized the
Secretary of the Interior to “expand and maintain a National Register of
Historic Places.” 16 U.S.C. § 470a(a)(1)(A).
The Tax Reform Act of 1976 furthered the goals of the 1966
legislation by creating new tax incentives for private sector investment in
certified historic buildings. See Tax Reform Act of 1976, Pub. L. No. 94-455,
90 Stat. 1520 (1976). The pertinent provisions of the 1976 Act indicate that
Congress wanted to encourage the private sector to restore historic buildings,
and, to provide that encouragement, it established incentives that were similar
to the tax incentives for building new structures. See, e.g., 122 Cong. Rec.
34320 (1976). Specifically, to equalize incentives affecting the restoration of
historic structures and the construction of new buildings, it included a
provision allowing for the amortization of rehabilitation expenditures over
five years, or, alternatively, an accelerated method of depreciation with
respect to the entire depreciable basis of the rehabilitated property.See
I.R.S. Publication, Rehabilitation Tax Credit, at 1–2 (Feb. 2002), available
athttp://www.irs.gov/pub/irs-mssp/rehab.pdf (hereinafter referred to as
“IRS-Rehab”).
The Revenue Act of 1978 went further to incent the
restoration of historic buildings. It made a 10% rehabilitation credit
available in lieu of the five-year amortization period provided by the 1976
Act. See Revenue Act of 1978, Pub. L. No. 95-600, 92 Stat. 2763 (1978); see
also IRS-Rehab, at 1–2. In 1981, Congress expanded the rehabilitation credit to
three tiers, so that a taxpayer could qualify for up to a 25% credit for
certain historic rehabilitations. See Economic Recovery Tax Act of 1981, Pub.
L. No. 97-34, 95 Stat. 172 (1981); see also IRS-Rehab, at 1–2.
The Tax Reform Act of 1986 made extensive changes to the tax
law, including the removal of many tax benefits that had been available to real
estate investors. See Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat.
2085 (1986);see also Staff of J. Comm. on Tax'n, 99th Cong.,General Explanation
of the Tax Reform Act of 1986 (Comm. Print. 1987) (hereinafter referred to as
“General Explanation of TRA 86”). The HRTC survived, although it was reduced to
its modern form of a two-tier system with a 20% credit for QREs incurred in
renovating a certified historic structure, and a 10% credit for QREs incurred
in renovating a qualified rehabilitated building 6 other than a certified
historic structure. See Tax Reform Act of 1986 § 251, 100 Stat. at 2183; see
also I.R.C. § 47. A Congressional report
for the 1986 Act discussed the rationale for keeping the HRTC:
In 1981, the Congress restructured and increased the tax
credit for rehabilitation expenditures [because it] was concerned that the tax
incentives provided to investments in new structures (e.g., accelerated cost
recovery) would have the undesirable effect of reducing the relative
attractiveness of the prior-law incentives to rehabilitate and modernize older
structures, and might lead investors to neglect older structures and relocate
their businesses.
The Congress concluded that the incentives granted to
rehabilitations in 1981 remain justified. Such incentives are needed because
the social and aesthetic values of rehabilitating and preserving older
structures are not necessarily taken into account in investors' profit
projections. A tax incentive is needed because market forces might otherwise
channel investments away from such projects because of the extra costs of
undertaking rehabilitations of older or historic buildings.
General Explanation of TRA 86, at 149.
Evidently mindful of how the tax incentives it had offered
might be abused, Congress in 2010 codified the “economic substance doctrine,”
which it defined as “the common law doctrine under which tax benefits ... with
respect to a transaction are not allowable if the transaction does not have
economic substance or lacks a business purpose.” 7I.R.C. § 7701(o)(5)(A). At
the same time, however, Congress was at pains to emphasize that the HRTC was
preserved. A Congressional report noted:
If the realization of the tax benefits of a transaction is
consistent with the Congressional purpose or plan that the tax benefits were
designed by Congress to effectuate, it is not intended that such tax benefits
be disallowed.... Thus, for example, it is not intended that a tax credit
(e.g., ...section 47[, which provides for HRTCs,] ...) be disallowed in a
transaction pursuant to which, in form and substance, a taxpayer makes the type
of investment or undertakes the type of activity that the credit was intended
to encourage.
Staff of J. Comm. on Tax'n, Technical Explanation of the
Revenue Provisions of the “Reconciliation Act of 2010,” as amended, In
Combination with the “Patient Protection and Affordable Care Act,” at 152 n.344
(Comm. Print 2010) (emphasis added). In sum, the HRTC statute is a deliberate
decision to skew the neutrality of the tax system to encourage taxable entities
to invest, both in form and substance, in historic rehabilitation projects.
B. Factual Background of the East Hall Renovation
1. NJSEA Background
In 1971, the State of New Jersey formed NJSEA to build, own,
and operate the Meadowlands Sports Complex in East Rutherford, New Jersey. The
State legislature expanded NJSEA's jurisdiction in 1992 to build, own, and
operate a new convention center in Atlantic City and to acquire, renovate, and
operate the East Hall. Completed in 1929, the East Hall was famous for hosting
the annual Miss America Pageant, and, in 1987, it was added to the National
Register of Historic Places as a National Historic Landmark.
In October 1992, before renovations on the East Hall began,
NJSEA obtained a 35-year leasehold interest in the property for $1 per year
from the owner, the Atlantic County Improvement Authority. About a month later,
NJSEA entered into an agreement with the Atlantic City Convention Center
Authority, the then-operator of the East Hall, to operate both the East Hall
and the new convention center. In July 1995, NJSEA and the Atlantic City
Convention Center Authority handed over management responsibility for both the
East Hall and the yet-to-be-completed convention center to a private entity,
Spectacor Management Group (“Spectacor”).
2. Commencement of the East Hall Renovation
Once construction started on the new convention center in
the early 1990s, NJSEA began planning for the future of the East Hall and
decided to convert it into a special events facility. That conversion was
initially anticipated to cost $78,522,000. Renovations were to be performed in
four phases, with the entire project expected to be completed in late 2001.
The renovation project began in December of 1998. By that
time, NJSEA had entered into agreements with the New Jersey Casino Reinvestment
Development Authority 8 pursuant to which the Casino Reinvestment Development
Authority agreed to reimburse NJSEA up to $4,146,745 for certain pre-design
expenses and up to $32,574,000 for costs incurred in the East Hall renovation.
In a March 1999 document prepared in connection with a separate bond issuance,
9 NJSEA noted that it had received grants from the Casino Reinvestment
Development Authority to pay for the first phase of the East Hall renovation
and that “[f]unding for the remaining cost of the project ... is expected to be
obtained through the issuance by [NJSEA] of Federally Taxable State Contract
Bonds.” (J.A. at 708.) In June 1999, NJSEA issued $49,915,000 in State Contract
Bonds to fund the East Hall renovation.
The first two phases of the renovation were completed prior
to the Miss America Pageant held in September 1999, and Phase 3 began the
following month. Through 1999, NJSEA had entered into rehabilitation contracts
for approximately $38,700,000, and had expended $28,000,000 of that amount.
Also at about that time, the estimate of the total cost of the project
increased to $90,600,000. NJSEA's 1999 annual report stated that the Casino
Reinvestment Development Authority had agreed to reimburse NJSEA for “all costs
in excess of bond proceeds for the project.” (Id. at 1714.) Thus, by the end of
1999, between the proceeds it had received from the bond issuance and funds
provided — or to be provided — by the Casino Reinvestment Development
Authority, NJSEA had assurances that the East Hall rehabilitation project was
fully funded.
3. Finding a Partner
a) The Proposal from Sovereign Capital Resources
In August 1998, a few months prior to the beginning of
renovations on the East Hall, Paul Hoffman from Sovereign Capital Resources
(“Sovereign”) 10 wrote to NJSEA regarding a “consulting proposal ... for the
sale of the historic rehabilitation tax credits expected to be generated” by
the East Hall rehabilitation. (Id. at 691.) That proposal was “designed to give
[NJSEA representatives] a better perspective on the structure of the historic
tax credit sale, as well as the [potential] financial benefits (estimated in excess
of $11 million) to the project.” (Id.) As an initial summary, Hoffman stated
that “the best way to view the equity generated by a sale of the historic tax
credits is to think of it as an $11 million interest only loan that has no term
and may not require any principal repayment.” (Id.) Hoffman noted that although
NJSEA, as a tax-exempt entity, would have no use for the 20% federal tax credit
generated by QREs incurred in renovating historic structures, there were
“entities that actively invest in [HRTC] properties ... and are generally
Fortune 500 corporations with substantial federal income tax liabilities.” (Id.
at 692.) Hoffman explained that because “[t]he [HRTC] is earned when the
building is placed into service” and “cannot be transferred after the fact,”
“the corporate investor should be admitted into the partnership that owns the
project as soon as possible.” (Id.)
Hoffman next sketched out the proposed transactions that
would allow NJSEA to bring an investor interested in HRTCs into co-ownership of
the East Hall and yet provide for NJSEA to “retain its long-term interests in
the [East Hall].” (Id. at 693.) First, NJSEA would sublease its interest in the
East Hall to a newly created partnership in which NJSEA would be the general
partner and a corporate investor would be the limited partner. The sublease
agreement would be treated as a sale for tax purposes since the sublease would
extend longer than the useful life of the property under tax rules. Next, that
partnership would allocate 99% of its profit and loss to the limited partner
corporate investor so that such investor could claim substantially all of the
tax credits, but only be allocated a “small portion” of the cash flow. (Id. at
694.) Finally, after a sufficient waiting period, NJSEA would be given a
purchase option to buy-out the corporate investor's interest. With all that
said, however, Hoffman warned that “[c]orporate purchasers of [HRTCs] rarely
accept construction risk,” and “[t]ypically ... provide no more than 10% of
their equity to the partnership during the construction period.” (Id. at 695.)
Thus, Hoffman “recommend[ed] that NJSEA plan to issue enough bonds to meet the
construction financing requirements of the project.” (Id.)
Hoffman then provided a valuation of the HRTCs. He estimated
that NJSEA could expect an investor to contribute approximately $0.80 to $0.90
per each dollar of HRTC allocated to the investor. In valuing the HRTCs,
Hoffman “assume[d] that NJSEA would like to minimize the cash distribution to
the investor and retain long-term ownership of [the East Hall].” (Id.) He also
listed four “standard guarantees” that “[i]nvestors in the tax credit industry”
would “require” as part of the transaction: (1) a construction completion
guaranty; (2) an operating deficit guaranty; (3) a tax indemnity; and (4) an
environmental indemnity. (Id. at 696.) Additionally, Hoffman noted that “the
investor will expect that either NJSEA or the State of New Jersey be obligated
to make debt service on the bond issuance if operating revenue is insufficient
to support the debt payments.” (Id.)
NJSEA decided to further explore the benefits described by
Sovereign. In March 1999, NJSEA issued a request for proposal (as supplemented
by an addendum on April 30, 1999, the “RFP”) from “qualified financial advisors
... in connection with a proposed historic rehabilitation tax credit
transaction ... relating to the rehabilitation of the East Hall.” (Id. at 710.)
The RFP provided that the selected candidate would “be required to prepare a
Tax Credit offering Memorandum, market the tax credits to potential investors
and successfully close a partnership agreement with the proposed tax credit
investor.” (Id. at 721.) In June 1999, after receiving four responses, NJSEA
selected Sovereign as its “[f]inancial [a]rranger” for the “Historic Tax Credit
transaction.” (Id. at 750.)
b) The Initial and Revised Five-Year Projections
In September 1999, as the second phase of the East Hall
renovation had just been completed, Spectacor, as the East Hall's operator, produced
draft five-year financial projections for the East Hall beginning for the 2002
fiscal year. 11 Those projections estimated that the East Hall would incur a
net operating loss of approximately $1.7 million for each of those five years.
Sovereign received a copy of the projections, and, in a memo dated October 1,
1999, responded that it was “cautious about [Spectacor's] figures as they might
prove excessively conservative.” (Id. at 793.) In a December 10, 1999 memo to
NJSEA representatives, Sovereign said that, for the yet-to-be-created
partnership between NJSEA and an HRTC investor to earn the desired tax credits,
the partnership “should be able to reasonably show that it is a going concern.”
12 (Id. at 804.) To that end, Sovereign suggested that “[t]o improve the
operating results, NJSEA could explore shifting the burden of some of the
operating expenses from the [partnership] to the Land Lessor (either [the
Atlantic County Improvement Authority] or NJSEA depending upon [how the
partnership was structured]).” (Id.) Approximately two months later, Sovereign
received revised estimates prepared by Spectacor. Those pro forma statements
projected much smaller net operating losses, ranging from approximately
$396,000 in 2002 to $16,000 in 2006. Within two weeks, Spectacor made
additional revisions to those projections which resulted in estimated net
operating income for those five years, ranging from approximately $716,000 in
2002 to $1.24 million in 2006. About 90% of the remarkable financial turnaround
the East Hall thus was projected to enjoy on paper was due to the removal of
all projected utilities expenses for each of the five years ($1 million in
2002, indexed for 3% inflation each year thereafter). When the accountants for
the project, Reznick, Fedder & Silverman (“Reznick”), included those
utilities expenses in their compiled projections one week later, Sovereign
instructed them to “[t]ake [the] $1MM Utility Cost completely out of Expenses,
[because] NJSEA [would] pay at [the] upper tier and [then] we should have a
working operating model.” (Id. at 954.)
c) Confidential Offering Memorandum
On March 16, 2000, Sovereign prepared a 174-page
confidential information memorandum (the “Confidential Memorandum” or the
“Memo”) which it sent to 19 potential investors and which was titled “The Sale
of Historic Tax Credits Generated by the Renovation of the Historic Atlantic
City Boardwalk Convention Hall.” (Id. at 955.) Although the executive summary
in the Confidential Memorandum stated that the East Hall renovation would cost
approximately $107 million, the budget attached to the Memo indicated that the
“total construction costs” of the project were $90,596,088. (Id. at 1035).
Moreover, the Memo stated that “[t]he rehabilitation [was] being funded
entirely by [NJSEA].” (Id. at 962). The difference between the $107 million
“estimated ... renovation” (id. at 961), and the “total construction costs” of
$90,596,088 was, as the Memo candidly put it, the “[p]roceeds from the sale of
the historic tax credits” (id. at 963). The Memo did not contemplate that those
proceeds, estimated to be approximately $16,354,000, would be applied to “total
construction costs” but rather indicated that the funds would be used for three
things: (1) payment of a $14,000,000 “development fee” to NJSEA; (2) payment of
$527,080 in legal, accounting, and syndication fees related to the tax-credit
transaction; and (3) the establishment of a $1,826,920 working capital reserve.
The Memo also provided financial projections through 2009.
Those projections assumed that the investor would receive a 3% priority
distribution (the “Preferred Return”) from available cash flow on its
$16,354,000 contribution, which contemporaneous NJSEA executive committee notes
described as “required by tax rules.” (Id. at 1135.) The financial projections
provided for sufficient net operating income — ranging from $715,867 in 2002 to
$880,426 in 2009 — to pay a portion of the Preferred Return on an annual basis
(varying from $465,867 in 2002 to $490,620 in 2009), but also showed
substantial tax losses through 2009 that were mainly attributable to
depreciation deductions.
d) Selection of Pitney Bowes
Four entities, including PB, responded to the Confidential
Memorandum and submitted offers “regarding the purchase of the historic tax
credits anticipated to be generated by the renovation” of the East Hall. (Id.
at 1143.) In a May 2000 letter supplementing its offer, PB recommended that
NJSEA fund the construction costs through a loan to the partnership, rather
than in the form of capital contributions, so that “the managing member could
obtain a pre-tax profit and therefore the partnership would be respected as
such for US tax purposes.” (Id. at 1145.)
On July 13, 2000, PB and NJSEA executed a letter of intent
(“LOI”) reflecting their agreement that PB would make “capital contributions”
13totaling $16.4 million over four installments in exchange for a 99.9%
membership interest in HBH, which NJSEA had recently formed. The LOI further
indicated that PB would also make an “Investor Loan” of $1.1 million.
Consistent with PB's earlier recommendation, the LOI said that NJSEA, as the
managing member retaining a 0.1% interest in HBH, would provide approximately $90
million in the form of two loans: (1) a purchase money obligation that
represented the amount of QREs incurred by NJSEA in the East Hall renovation
prior to PB's investment (the “Acquisition Loan”); and (2) a loan to finance
the remainder of the projected QREs (the “Construction Loan”). According to the
LOI, it was anticipated that the project would qualify for a minimum of
$17,602,667 in HRTCs: $9,379,981 in 2000 and $8,222,686 in 2001. The LOI also
noted that a 3% Preferred Return would be paid to PB. Although the LOI
contemplated that PB would receive 99.9% of any available cash flow, HBH's
financial projections from 2000 to 2042 forecasted no cash flow available for
distribution during that time frame. Similarly, while the LOI mentioned that PB
would receive 99.9% of the net proceeds from a sale of HBH, a pre-closing memo
from NJSEA's outside counsel to NJSEA suggested that, “[d]ue to the structure
of the transaction,” the fair market value of PB's interest in HBH would be
insignificant. (J.A. at 1162.) Thus, for its investment of $17.5 million ($16.4
million in capital contributions and the $1.1 million Investor Loan), PB would
receive, in addition to the 3% Preferred Return, 99.9% of the approximately
$17.6 million worth of HRTCs that would be generated from the QREs.
e) Additional Revisions to Financial Projections
Prior to the closing on PB's commitment to purchase a
membership interest in HBH, an accountant from Reznick who was preparing HBH's
financial projections, sent a memo to Hoffman indicating that the two proposed
loans from NJSEA to HBH “ha[d] been set up to be paid from available cash flow”
but that “[t]here was not sufficient cash to amortize this debt.” (Id. at
1160.) To remedy the problem, Hoffman instructed the accountant to increase the
projection of baseline revenues in 2002 by $1 million by adding a new revenue
source of $750,000 titled “naming rights,” and by increasing both “parking
revenue” and “net concession revenue” by $125,000 each. Additionally, whereas
the initial projections assumed that baseline revenues and expenses would both
increase by 3% on an annual basis, the revised projections used at closing
assumed that baseline revenues would increase by 3.5% annually, while
maintaining the 3% estimate for the annual increases in baseline expenses. With
those modifications, Reznick was able to project that, even after paying PB its
3% Preferred Return, HBH could fully pay off the Acquisition Loan by 2040, at
which point HBH would then be able to make principal payments on the Construction
Loan.
Also prior to closing, by moving certain expenditures from
the “non-eligible” category to the “eligible” category, 14 Reznick increased by
about $9 million the amount of projected QREs that the East Hall renovation
would generate. That increase in QREs resulted in an approximately $1.8 million
increase in projected HRTCs from $17,602,667 to $19,412,173. That uptick in
HRTCs, in turn, resulted in an increase in PB's anticipated capital
contribution from $16,400,000 to $18,195,797. 15
4. Closing
On September 14, 2000, 16 NJSEA and PB executed various
documents to implement the negotiated transaction, and PB made an initial
contribution of $650,000 to HBH.
a) The HBH Operating Agreement
The primary agreement used to admit PB as a member of HBH
and to restate HBH's governing provisions was the amended and restated
operating agreement (the “AREA”). The AREA stated that the purpose of HBH was
“to acquire, develop, finance, rehabilitate, own, maintain, operate, license,
lease, and sell or otherwise dispose of a[n] 87-year subleasehold interest in
the Historic East Hall ... for use as a special events facility.” (Id. at 157.)
The AREA provided that PB would hold a 99.9% ownership interest as the
“Investor Member,” and NJSEA would hold a 0.1% ownership interest as the
“Managing Member.” The AREA also provided that PB, in addition to its $650,000
initial contribution, would make three additional capital contributions
totaling $17,545,797 (collectively, with the initial capital contribution,
$18,195,797). Those additional contributions were contingent upon the
completion of certain project-related events, including verification of the
amount of rehabilitation costs that had been incurred to date that would be
classified as QREs to generate HRTCs. According to Section 5.01(c)(v) of the
AREA, each of the four contributions were to be used by HBH to pay down the
principal of the Acquisition Loan contemplated by the LOI. Pursuant to the
AREA, NJSEA, in addition to providing HBH with the Acquisition Loan and the
Construction Loan, agreed to pay all “Excess Development Costs” (the
“Completion Guaranty”), 17 fund all operating deficits through interest-free
loans to HBH (the “Operating Deficit Guaranty”), and indemnify PB against any
loss incurred by PB as a result of any liability arising from “Hazardous
Materials” relating to the East Hall, 18including remediation costs (the
“Environmental Guaranty”).
The AREA also set forth a detailed order of priority of
distributions from HBH's cash flow. After distributing any title insurance
proceeds or any environmental insurance proceeds to PB, cash flow was to be
distributed as follows: (1) to PB for certain repayments on its $1.1 million
“Investor Loan” contemplated by the LOI; (2) to PB and NJSEA, in accordance with
their respective membership interests, until PB received an amount equal to the
current and any accrued and unpaid 3% Preferred Return as mentioned in the LOI;
(3) to PB for an amount equal to the income tax liability generated by income
earned by HBH that was allocated to PB, if any; (4) to NJSEA for an amount
equal to the current and any accrued and unpaid payments of interest and
principal owed on the Acquisition Loan and the Construction Loan; (5) to NJSEA
in an amount equal to any loans it made to HBH pursuant to the Operating
Deficit Guaranty; and (6) the balance, if any, to PB and NJSEA, in accordance
with their respective membership interests.
Additionally, the AREA provided the parties with certain
repurchase rights and obligations. 19 In the event that NJSEA desired to take
certain actions that were prohibited under the AREA or otherwise required it to
obtain PB's consent to take such actions, NJSEA could instead — without the
consent of PB — purchase PB's interest in HBH. In the papers submitted to us,
the ill-fitting name the parties gave to this ability of NJSEA to buy out PB
without PB's consent is the “Consent Option.” The purchase price under the
Consent Option is not measured by any fair market value of PB's interest, if
any such value were even to exist, but rather is equal to the then-present
value of any yet-to-be realized projected tax benefits and cash distributions
due to PB through the end of the five-year tax credit recapture period. 20 In
the event that NJSEA committed a material default as defined by the AREA, PB
had the right to compel NJSEA to purchase its interest (the “Material Default
Option”) for that same price. 21
To protect PB's interest, Section 8.08 of the AREA mandated
that NJSEA obtain a guaranteed investment contract (the “Guaranteed Investment
Contract”). 22 The Guaranteed Investment Contract had to be “reasonably
satisfactory to [PB], in the amount required to secure the payment of the
purchase price” to be paid by NJSEA in the event that NJSEA exercised the
option to purchase PB's interest under another purchase option agreement that
NJSEA had. 23 (Id. at 187–88; see supra note 19.) The AREA also provided that
the Guaranteed Investment Contract had to be obtained on or before the payment
of PB's second capital contribution. In a memo dated two days prior to closing,
Sovereign explained to NJSEA that “[t]he [Guaranteed Investment Contract]
should be sized to pay off the Investor Loan of $1.1 million, accrued but
unpaid interest on the [Investor Loan], and [PB's] annual priority
distributions.” (Id. at 1211.)
b) Lease Amendment and Sublease
NJSEA also executed several documents that purported to
transfer ownership of its interest in the East Hall to HBH. First, NJSEA
entered into an amended and restated agreement with its lessor, Atlantic County
Improvement Authority, to extend the term of NJSEA's leasehold interest in the
East Hall from 2027 to 2087. 24After that agreement, NJSEA and HBH entered into
a “Sublease” with NJSEA, as landlord, and HBH, as tenant. (Id. at 413.)
c) Acquisition Loan and Construction Loan
As contemplated in the LOI, NJSEA provided financing to HBH
in the form of two loans. First, NJSEA and HBH executed a document setting
forth the terms of the Acquisition Loan, reflecting NJSEA's agreement to
finance the entire purchase price that HBH paid to NJSEA for the subleasehold
interest in the East Hall, which amounted to $53,621,405. That amount was
intended to represent the construction costs that NJSEA had incurred with
respect to the East Hall renovation prior to PB making its investment in HBH. The
Acquisition Loan provided for HBH to repay the loan in equal annual
installments for 39 years, beginning on April 30, 2002, with an interest rate
of 6.09% per year; however, if HBH did not have sufficient cash available to
pay the annual installments when due, the shortfall would accrue without
interest and be added to the next annual installment. HBH pledged its
subleasehold interest in the East Hall as security for the Acquisition Loan.
Second, NJSEA and HBH executed a document setting forth the
terms of the Construction Loan, reflecting NJSEA's agreement to finance the
projected remaining construction costs for renovating the East Hall, to be
repaid by HBH in annual installments for 39 years, beginning on April 30, 2002,
at an annual interest rate of 0.1%. Although the parties only anticipated
$37,921,036 of additional construction costs, 25 the maximum amount that HBH
could withdraw from the Construction Loan provided by NJSEA was $57,215,733.
That difference, $19,294,697, was nearly identical to the total investment that
PB was to make in HBH ($18,195,797 in capital contributions and $1,100,000 for
the Investor Loan). See infra Section I.B.5.a. Similar to the Acquisition Loan,
the Construction Loan provided for equal annual installments out of available
cash flow, but, if sufficient cash was not available, any shortfall would
accrue without interest and be added to the next annual installment. HBH gave
NJSEA a second mortgage on its subleasehold interest in the East Hall as
security for the Construction Loan.
d) Development Agreement
HBH and NJSEA also entered into a development agreement in
connection with the ongoing rehabilitation of the East Hall. The agreement
stated that HBH had “retained [NJSEA as the developer] to use its best efforts
to perform certain services with respect to the rehabilitation ... of the
[East] Hall ... including renovation of the [East] Hall, acquisition of
necessary building permits and other approvals, acquisition of financing for
the renovations, and acquisition of historic housing credits for the
renovations.” (Id. at 267.) The agreement noted that “since December 1998,
[NJSEA] ha[d] been performing certain of [those] services ... in anticipation
of the formation of [HBH].” (Id.) The agreement provided that HBH would pay a
$14,000,000 development fee to NJSEA, but that fee was not to be earned until
the rehabilitation was completed. Prior to the execution of the development
agreement, as NJSEA was spending over $53 million towards the renovation of the
East Hall, it did not pay itself any development fee or otherwise account for
such a fee.
e) Purchase Option and Option to Compelon current with the
AREA and the sublease agreement, PB and NJSEA entered into a purchase option
agreement (the “Call Option”) and an agreement to compel purchase (the “Put
Option”). The Call Option provides NJSEA the right to acquire PB's membership
interest in HBH, and the Put Option provides PB the right to require NJSEA to
purchase PB's membership interest in HBH. Under the Call Option, NJSEA had the
right to purchase PB's interest in HBH at any time during the 12-month period
beginning 60 months after the East Hall was placed in service. 26 If NJSEA did
not exercise the Call Option, then PB had the right to exercise the Put Option
at any time during the 12-month period beginning 84 months after the East Hall
was placed in service. For both the Put Option and the Call Option, the
purchase price was set at an amount equal to the greater of (1) 99.9% of the
fair market value of 100% of the membership interests in HBH; or (2) any
accrued and unpaid Preferred Return due to PB. As already noted, supra Section
I.B.4.a, the AREA mandated that NJSEA purchase the Guaranteed Investment
Contract to secure funding of the purchase price of PB's membership interest,
should either of the options be exercised. 27
f) Tax Benefits Guaranty
As contemplated by the Confidential Memorandum, HBH and PB
entered into a tax benefits guaranty agreement (the “Tax Benefits Guaranty”).
Pursuant to that guaranty, upon a “Final Determination of a Tax Benefits
Reduction Event,” 28 HBH agreed to pay to PB an amount equal to the sum of (1)
any reduction in projected tax benefits, “as revised by the then applicable
Revised Economic Projections,” 29 as a result of an IRS challenge; (2) any
additional tax liability incurred by PB from partnership items allocated to it
by HBH as a result of an IRS challenge; (3) interest and penalties imposed by
the IRS on PB in connection with any IRS challenge; (4) an amount sufficient to
compensate PB for reasonable third-party legal and administrative expenses
related to such a challenge, up to $75,000; and (5) an amount sufficient to pay
any federal income tax liability owed by PB on receiving any of the payments
listed in (1) through (4). (Id.at 300.) Although HBH was the named obligor of
the Tax Benefits Guaranty, the agreement provided that “NJSEA ... shall fund
any obligations of [HBH] to [PB]” under the Tax Benefits Guaranty. (Id. at
303.)
5. HBH in Operation
a) Construction in Progress
Pursuant to an Assignment and Assumption Agreement executed
on the day of closing between NJSEA, as assignor, and HBH, as assignee, various
agreements and contracts — including occupancy agreements, construction
contracts, architectural drawings, permits, and management and service
agreements — were assigned to HBH. HBH opened bank accounts in its name, and it
deposited revenues and paid expenses through those accounts.
As previously indicated, supra Section I.B.4.a, PB's capital
contributions were, pursuant to the AREA, supposed to be used to pay down the
Acquisition Loan. Although that did occur, any decrease in the balance of the
Acquisition Loan was then offset by a corresponding increase in the amount of
the Construction Loan. As the Tax Court explained:
Shortly [after PB's capital contributions were used to pay
down the principal on the Acquisition Loan], a corresponding draw would be made
on the [C]onstruction [Loan], and NJSEA would advance those funds to [HBH].
Ultimately, these offsetting draws left [HBH] with cash in the amount of [PB's]
capital contributions, a decreased balance on the [A]cquisition [L]oan, and an
increased balance on the [C]onstruction [L]oan. These funds were then used by
[HBH] to pay assorted fees related to the transaction and to pay NJSEA a
developer's fee for its work managing and overseeing the East Hall's
rehabilitation.
(Id. at 17–18.) Also as discussed above, supra Section
I.B.4.c, the parties set the upper limit of the Construction Loan approximately
$19.3 million higher than the anticipated amount of the total remaining
construction costs as of the closing date, which would allow HBH to use PB's
approximately $19.3 million in contributions to pay NJSEA a development fee and
expenses related to the transaction without being concerned that it would
exceed the maximum limit on the Construction Loan provided by NJSEA.
PB made its second capital contribution in two installments,
a $3,660,765 payment in December 2000, and a $3,400,000 payment the following
month. Once those contributions were received by NJSEA and used to pay down the
principal on the Acquisition Loan, NJSEA, instead of using the entire capital
contribution to fund a corresponding draw by HBH on the Construction Loan, used
$3,332,500 of that amount to purchase the required Guaranteed Investment
Contract as security for its potential obligation or opportunity to purchase
PB's interest in HBH. 30
HBH experienced a net operating loss 31 for both 2000 32
($990,013) and 2001 ($3,766,639), even though projections had indicated that
HBH would generate net operating income of $500,000 in 2001. 33 For the tax
years ending in 2000 and 2001, HBH reported approximately $107.7 million in
QREs, about $10.75 million more QREs than contemplated in the financial
projections attached to the AREA. 34See supra note 25. As a result, PB's
required aggregate capital contribution was increased by approximately $2
million to $20,198,460 and the Investor Loan was increased by $118,000 to
$1,218,000. 35
b) Post-Construction Phase
According to NJSEA's 2001 annual report, the “$90 million
renovation” 36 of East Hall “was completed on time and on budget” and reopened
“in October 2001.” (Id. at 1757, 1758.) Approximately a year later, PB made its
third — and largest — capital contribution of $10,467,849. Around the time that
contribution was made, Reznick prepared revised financial projections. Whereas,
at closing, Reznick had forecasted $1,715,867 of net operating income for 2002,
the accountants now projected a net operating loss of $3,976,023. Ultimately,
after reality finished with the pretense of profitability, HBH's net operating
loss for 2002 was $4,280,527. Notwithstanding the discrepancy between the
initial and actual budgets for 2002, Reznick did not alter projections for 2003
and future years. For years 2003 through 2007, 37 Reznick projected an
aggregate net operating income of approximately $9.9 million. HBH actually
experienced an aggregate net operating loss of over $10.5 million for those
five years. In early 2004, PB made a portion of its fourth and final capital
contribution, paying $1,173,182 of its commitment of $2,019,846. 38
When Reznick was preparing HBH's 2003 audited financial
statements, it “addressed a possible impairment issue under FASB 144.” 39 (Id.
at 1638.) FASB 144 requires a write down of an impaired asset to its actual
value “whenever events or changes in circumstances indicate that its carrying
amount may not be recoverable,” such as when there is “[a] current-period
operating or cash flow loss combined with a history of operating or cash flow
losses or a projection or forecast that demonstrates continuing losses
associated with the use of a long-lived asset.”Statement of Financial
Accounting Standards No. 144 , Financial Accounting Standards Board, 9 (Aug.
2001), http://www.fasb.org/pdf/fas144.pdf) (hereinafter referred to as “FASB
144”). In a memo to HBH's audit file, Reznick considered a write down of HBH's
interest in the East Hall pursuant to FASB 144, “[d]ue to the fact that [HBH]
has experienced substantial operating losses and has not generated any
operating cash flow since its inception.” (J.A. at 1638.) In the end, however,
Reznick was persuaded by the powers at HBH that HBH was never meant to function
as a self-sustaining venture and that the State of New Jersey was going to make
good on HBH's losses. In deciding against a write down, Reznick explained:
Per discussions with the client, it was determined that
[HBH] was not structured to provide operating cash flow. Instead, the managing
member, [NJSEA], agreed to fund all operating deficits of [HBH] in order to
preserve the [East Hall] as a facility to be used by the residents of the State
of New Jersey. [NJSEA] has the ability to fund the deficits as a result of the
luxury and other taxes provided by the hospitality and entertainment industry
in the state.
(Id.) “Since there is no ceiling on the amount of funds to
be provided [by NJSEA to HBH] under the [AREA],” Reznick concluded “there [was]
no triggering event which require[d] [a write down] under FASB 144.” (Id.) That
same discussion and conclusion were included in separate memos to HBH's audit
files for 2004 and 2005. 40 By the end of 2007, the operating deficit loan
payable to NJSEA was in excess of $28 million.
6. The Tax Returns and IRS Audit
On its 2000 Form 1065, 41HBH reported an ordinary taxable
loss of $1,712,893, and $38,862,877 in QREs. 42 On its 2001 Form 1065, HBH
reported an ordinary taxable loss of $6,605,142 and $68,865,639 in QREs. On its
2002 Form 1065, HBH reported an ordinary taxable loss of $9,135,373 and
$1,271,482 of QREs. In accordance with its membership interest in HBH, PB was
issued a Schedule K-1 allocating 99.9% of the QREs for each of those tax years
(collectively referred to herein as the “Subject Years”). 43
Following an audit of the returns of the Subject Years, the
IRS issued to HBH a notice of final partnership administrative adjustment
(“FPAA”). That FPAA determined that all separately stated partnership items
reported by HBH on its returns for the Subject Years should be reallocated from
PB to NJSEA. The IRS made that adjustment on various alternative, but related,
grounds, two of which are of particular importance on appeal: first, the IRS
said 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; and,
second, it said that PB's claimed partnership interest in HBH was not, based on
the totality of the circumstances, a bona fide partnership participation
because PB had no meaningful stake in the success or failure of HBH. 44 The IRS
also determined that accuracy-related penalties applied.
C. The Tax Court Decision
NJSEA, in its capacity as the tax matters partner of HBH, 45
filed a timely petition to the United States Tax Court in response to the FPAA.
46 Following a four-day trial in April 2009, the Tax Court issued an opinion in
favor of HBH.
The Tax Court first rejected the Commissioner's argument
that HBH is a sham under the economic substance doctrine.See supra note 7 and
accompanying text. As the Court saw it, “all of [the IRS's] arguments
concerning the economic substance of [HBH] [were] made without taking into
account the 3-percent return and the [HRTCs].” (Id. at 37.) The Court disagreed
with the IRS's assertion that “[PB] invested in the [HBH] transaction solely to
earn [HRTCs].” (Id. at 41.) Instead, the Court “believe[d] that the 3-percent
return and the expected tax credits should be viewed together,” and “[v]iewed
as a whole, the [HBH] and the East Hall transactions did have economic
substance” because the parties “had a legitimate business purpose — to allow
[PB] to invest in the East Hall's rehabilitation.” (Id.) In support of that determination,
the Tax Court explained:
Most of [PB's] capital contributions were used to pay a
development fee to NJSEA for its role in managing the rehabilitation of the
East Hall according to the development agreement between [HBH] and NJSEA. [The
Commissioner's] contention that [PB] was unnecessary to the transaction because
NJSEA was going to rehabilitate the East Hall without a corporate investor
overlooks the impact that [PB] had on the rehabilitation: no matter NJSEA's
intentions at the time it decided to rehabilitate the East Hall, [PB's]
investment provided NJSEA with more money than it otherwise would have had; as
a result, the rehabilitation ultimately cost the State of New Jersey less. [The
Commissioner] does not allege that a circular flow of funds resulted in [PB]
receiving its 3—percent preferred return on its capital contributions. In
addition, [PB] received the rehabilitation tax credits.
(Id. at 41–42.)
The Tax Court further explained that “[PB] faced risks as a
result of joining [HBH]. First ... it faced the risk that the rehabilitation
would not be completed,” and additionally, “both NJSEA and [PB] faced potential
liability for environmental hazards from the rehabilitation.” (Id. at 43.)
While recognizing that HBH and PB were insured parties under NJSEA's existing
environmental insurance policy, the Tax Court noted that “there was no guaranty
that: (1) The insurance payout would cover any potential liability; and (2) if
NJSEA was required to make up any difference, it would be financially able to
do so.” (Id. at 43–44.) In sum, because “NJSEA had more money for the
rehabilitation than it would have had if [PB] had not invested in [HBH],” and
“[b]oth parties would receive a net economic benefit from the transaction if
the rehabilitation was successful,” the Tax Court concluded that HBH had
“objective economic substance.” (Id.at 46–47.)
The Tax Court used similar reasoning to reject the
Commissioner's assertion that PB was not a bona fide partner in HBH.
Specifically, the Court rejected the Commissioner's contentions that “(1) [PB]
had no meaningful stake in [HBH's] success or failure; and (2) [PB's] interest
in [HBH] is more like debt than equity.” (Id. at 47.) After citing to the
totality-of-the-circumstances partnership test laid out inCommissioner v.
Culbertson , 337 U.S. 733 [37 AFTR 1391] (1949), the Court 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” (J.A. at 49).
After “[t]aking into account the stated purpose behind [HBH's] formation, the
parties' investigation of the transaction, the transaction documents, and the
parties' respective roles,” the Tax Court held “that [HBH] was a valid
partnership.” (Id. at 52.)
Regarding the formation of a partnership, the Court said
that, because “[PB] and NJSEA joined together in a transaction with economic
substance to allow [PB] to invest in the East Hall rehabilitation,” and “the
decision to invest provided a net economic benefit to [PB] through its
3-percent preferred return and rehabilitation tax credits,” it was “clear that
[PB] was a partner in [HBH].” (Id. at 49–50.) The Court opined that, since the
East Hall operated at a loss, even if one were to “ignore the [HRTCs], [PB's]
interest is not more like debt than equity because [PB] [was] not guaranteed to
receive a 3-percent return every year ... [as] there might not be sufficient
cashflow to pay it.” (Id. at 51.)
The Tax Court also placed significant emphasis on “the parties'
investigation and documentation” to “support [its] finding that the parties
intended to join together in a rehabilitation of the East Hall.” (Id. at 50.)
According to the Court, the Confidential Memorandum “accurately described the
substance of the transaction: an investment in the East Hall's rehabilitation.”
(Id.) The Court then cited to the parties' investigation into mitigating
potential environmental hazards, as well as the parties' receipt of “a number
of opinion letters evaluating various aspects of the transaction, to “support[]
[its] finding of an effort to join together in the rehabilitation of the East
Hall.” (Id.) The Court decided that “[t]he executed transaction documents
accurately represent[ed] the substance of the transaction ... to rehabilitate
and manage the East Hall.” (Id.) Also, the Court found it noteworthy that “the
parties ... carried out their responsibilities under the AREA[:] NJSEA oversaw
the East Hall's rehabilitation, and [PB] made its required capital
contributions.” 47 (Id. at 51.)
Hence, the Tax Court entered a decision in favor of HBH.
This timely appeal by the Commissioner followed.
II. Discussion 48
The Commissioner 49 alleges that the Tax Court erred by
allowing PB, through its membership interest in HBH, to receive the HRTCs
generated by the East Hall renovation. He characterizes the transaction as an
impermissible “indirect sale of the [HRTCs] to a taxable entity.... by means of
a purported partnership between the seller of the credits, [NJSEA], and the
purchaser, [PB].” (Appellant's Opening Br. at 30.) While the Commissioner
raises several arguments in his effort to reallocate the HRTCs from NJSEA to
PB, we focus primarily on his contention that PB should not be treated as a
bona fide partner in HBH because PB did not have a meaningful stake in the
success or failure of the partnership. 50 We agree that PB was not a bona fide
partner in HBH.
A. The Test
A partnership exists when, as the Supreme Court said
inCommissioner v. Culbertson , two or more “parties in good faith and acting
with a business purpose intend[] to join together in the present conduct of the
enterprise.” 337 U.S. at 742; see also Comm'r v. Tower, 327 U.S. 280, 286 [34
AFTR 799]–87 (1946) (“When the existence of an alleged partnership arrangement
is challenged by outsiders, the question arises whether the partners really and
truly intended to join together for the purpose of carrying on business and
sharing in the profits or losses or both.”);Southgate Master Fund, L.L.C. ex
rel. Montgomery Capital Advisors v. United States , 659 F.3d 466, 488 [108 AFTR
2d 2011-6488] (5th Cir. 2011) (“The sine qua non of a partnership is an intent
to join together for the purpose of sharing in the profits and losses of a
genuine business.”).
The Culbertson test is used to analyze the bona fides of a
partnership and to decide whether a party's “interest was a bona fide equity
partnership participation.” TIFD III-E, Inc. v. United States, 459 F.3d 220,
232 [98 AFTR 2d 2006-5616] (2d Cir. 2006) (hereinafter “Castle Harbour”). To
determine, underCulbertson , whether PB was a bona fide partner in HBH, we must
consider the totality of the circumstances, considering all the facts — the
agreement, the conduct of the parties in execution of its provisions, their
statements, the testimony of disinterested persons, the relationship of the
parties, their respective abilities and capital contributions, the actual
control of income and the purposes for which it is used, and any other facts
throwing light on their true intent.
337 U.S. at 742. That “test turns on the fair, objective
characterization of the interest in question upon consideration of all the
circumstances.” Castle Harbour, 459 F.2d at 232.
The Culbertson test “illustrat[es] ... the principle that a
transaction must be judged by its substance, rather than its form, for income
tax purposes.”Trousdale v. Comm'r , 219 F.2d 563, 568 [46 AFTR 1732] (9th Cir.
1955). Even if there are “indicia of an equity participation in a partnership,”
Castle Harbour, 459 F.3d at 231, we should not “accept[] at face value
artificial constructs of the partnership agreement,”id. at 232. Rather, we must
examine those indicia to determine whether they truly reflect an intent to
share in the profits or losses of an enterprise or, instead, are “either
illusory of insignificant.” Id. at 231. 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. Id.
B. The Commissioner's Guideposts
The Commissioner points us to two cases he calls “recent
guideposts” bearing on the bona fide equity partner inquiry. (Appellant's
Opening Br. at 34.) First, he cites to the decision of the United States Court
of Appeals for the Second Circuit inCastle Harbour , 459 F.3d 220 [98 AFTR 2d
2006-5616]. The Castle Harbour court relied on Culbertson in disregarding the
claimed partnership status of two foreign banks. Those banks had allegedly
formed a partnership, known as Castle Harbour, LLC, with TIFD III-E, Inc.
(“TIFD”), a subsidiary of General Electric Capital Corporation, with an intent
to allocate certain income away from TIFD, an entity subject to United States
income taxes, to the two foreign banks, which were not subject to such taxes.
Id. at 223. Relying on the sham-transaction doctrine, the district court had
rejected the IRS's contention that the foreign banks' interest was not a bona
fide equity partnership participation “because, in addition to the strong and
obvious tax motivations, the [partnership] had some additional non-tax motivation
to raise equity capital.” Id. at 231. In reversing the district court, the
Second Circuit stated that it “[did] not mean to imply that it was error to
consider the sham test, as the IRS purported to rely in part on that test. The
error was in failing to test the banks' interest also under Culbertson after
finding that the [partnership's] characterization survived the sham test.” Id.
The Second Circuit focused primarily on the Culbertson inquiry, and
specifically on the IRS's contention that the foreign banks “should not be
treated as equity partners in the Castle Harbour partnership because they had
no meaningful stake in the success or failure of the partnership.” Id. at 224.
Applying the bona fide partner theory as embodied
inCulbertson 's totality-of-the-circumstances test, theCastle Harbour court
held that the banks' purported partnership interest was, in substance,
“overwhelmingly in the nature of a secured lender's interest, which would
neither be harmed by poor performance of the partnership nor significantly
enhanced by extraordinary profits.” Id. at 231. Although it acknowledged that
the banks' interest “was not totally devoid of indicia of an equity
participation in a partnership,” the Court said that those indicia “were either
illusory or insignificant in the overall context of the banks' investment,”
and, thus, “[t]he IRS appropriately rejected the equity characterization.”Id. C
The Castle Harbour court observed that “consider[ing]
whether an interest has the prevailing character of debt or equity can be
helpful in analyzing whether, for tax purposes, the interest should be deemed a
bona fide equity participation.” Id. at 232. In differentiating between debt
and equity, it counseled that “the significant factor ... [is] whether the funds
were advanced with reasonable expectation of repayment regardless of the
success of the venture or were placed at the risk of the business.” Id.
(citation and internal quotation marks omitted). Thus, in determining whether
the banks' interest was a bona fide equity participation, the Second Circuit
focused both on the banks' lack of downside risk and lack of upside potential
in the partnership. It agreed with the “district court['s] recogni[tion] that
the banks ran no meaningful risk of being paid anything less than the
reimbursement of their investment at the [agreed-upon rate] of return.” Id. at
233. In support of that finding, the Court noted that:
[TIFD] was required ... to keep ... high-grade commercial
paper or cash, in an amount equal to 110% of the current value of the [amount
that the banks would receive upon dissolution of the partnership.] The
partnership, in addition, was obliged for the banks' protection to maintain
$300 million worth of casualty-loss insurance. Finally, and most importantly,
[General Electric Capital Corporation] — a large and very stable corporation —
gave the banks its personal guaranty, which effectively secured the partnership's
obligations to the banks.
Id. at 228.
Regarding upside potential, however, the Second Circuit
disagreed with the district court's conclusion that the banks had a “meaningful
and unlimited share of the upside potential.”Id. at 233. That conclusion could
not be credited because it “depended on the fictions projected by the
partnership agreement, rather than on assessment of the practical realities.”
Id. at 234. Indeed, the Second Circuit stated that “[t]he realistic possibility
of upside potential — not the absence of formal caps — is what governs this
analysis.” Id. In reality, “the banks enjoyed only a narrowly circumscribed
ability to participate in profits in excess of” the repayment of its
investment, id., because TIFD had the power to either effectively restrict the
banks' share of profits at 1% above an agreed-upon return of $2.85 million, or
to buy out their interest at any time at a “negligible cost” of approximately
$150,000, id. at 226, 235. The return on the banks' initial investment of $117.5
million was thus limited to $2.85 million plus 1% — “a relatively insignificant
incremental return over the projected eight-year life of the partnership,” id.
at 235. In sum, “look[ing] not so much at the labels used by the partnership
but at true facts and circumstances,” asCulbertson directs, the Castle
Harbourcourt was “compel[led] [to] conclu[de] that the ... banks' interest was,
for tax purposes, not a bona fide equity participation.”Id. at 241.
The second, more recent, precedent that the Commissioner
directs us to as a “guidepost” is Virginia Historic Tax Credit Fund 2001 LP v.
Commissioner, 639 F.3d 129 [107 AFTR 2d 2011-1523] (4th Cir. 2011) (hereinafter
“Virginia Historic”). There, the United States Court of Appeals for the Fourth
Circuit held that certain transactions between a partnership and its partners
which sought to qualify for tax credits under the Commonwealth of Virginia's
Historic Rehabilitation Credit Program (the “Virginia Program”) 51 were, in
substance, sales of those credits which resulted in taxable income to the
partnership. Id. at 132. In Virginia Historic, certain investment funds (the
“Funds”) were structured “as partnerships that investors could join by
contributing capital.” Id. at 133. Through four linked partnership entities
with one “source partnership” entity (the “Source Partnership”), “[t]he Funds
would use [the] capital [provided by investors] to partner with historic
property developers [“Operating Partnerships”] renovating smaller projects, in
exchange for state tax credits.” Id.The confidential offering memorandum given
to potential investors provided that, “[f]or every $.74–$.80 contributed by an
investor, [one of the] Fund[s] would provide the investor with $1 in tax
credits. If such credits could not be obtained, the partnership agreement
promised a refund of capital to the investor, net of expenses.” Id. at 134
(citation and internal quotation marks omitted). Additionally, “the partnership
agreement stated that the Funds would invest only in completed projects,
thereby eliminating a significant area of risk” to the investors. Id. “[T]he
Funds reported the money paid to Operating Partnerships in exchange for tax
credits as partnership expenses and reported the investors' contributions to
the Funds as nontaxable contributions to capital.” Id. at 135.
The IRS “challenged [the Funds'] characterization of
investors' funding as “contributions to capital”” because the IRS believed that
the investors were, in substance, purchasers of state income tax credits, and
thus the money that the Funds received from the investors should have been
reported as taxable income. Id. At trial, the Commissioner supported his
position with two theories. First, he relied on the substance-over-form
doctrine, saying that the investors were not bona fide partners in the Funds
but were instead purchasers; and, second, he said that the transactions between
the investors and the partnerships were “disguised sales” under I.R.C. § 707.
52Id. at 136. The Tax Court rejected both of those assertions, and found that
the investors were partners in the Funds for federal tax purposes. Id. at
136–37.
The Fourth Circuit reversed the Tax Court. “Assuming,
without deciding, that a “bona fide” partnership existed,” the Virginia
Historic court found that “the Commissioner properly characterized the
transactions at issue as “sales”” under the disguised-sale rules.Id. at 137.
The Fourth Circuit first turned to the regulations that provide guidance in
determining whether a disguised sale has occurred. See id. at 137–39 (citing
to, inter alia, Treas. Reg. §§ 1.707-3, 1.707-6(a)). Specifically, it explained
that a transaction should be reclassified as a sale if, based on all the facts
and circumstances, (1) a partner would not have transferred money to the
partnership but for the transfer of property — the receipt of tax credits — to
the partner; and (2) the latter transfer — the receipt of tax credits — “is not
dependent on the entrepreneurial risks of partnership operations.” Id. at 145
(quoting Treas. Reg. § 1.707-3(b)(1)). The Fourth Circuit concluded that the
risks cited by the Tax Court — such as the “risk that developers would not
complete their projects on time because of construction, zoning, or management
issues,” “risk ... [of] liability for improper construction,” and “risk of
mismanagement or fraud at the developer partnership level” — “appear[ed] both
speculative and circumscribed.” Id. While the Fourth Circuit acknowledged that
“there was ... no guarantee that resources would remain available in the source
partnership to make the promised refunds,” it determined “that the Funds were
structured in such a way as to render the possibility of insolvency remote.”
Id.
In holding “that there was no true entrepreneurial risk
faced by investors” in the transactions at issue, theVirginia Historic court
pointed to several different factors:
First, investors were promised what was, in essence, a fixed
rate of return on investment rather than any share in partnership profits tied
to their partnership interests.... Second, the Funds assigned each investor an
approximate .01% partnership interest and explicitly told investors to expect
no allocations of material amounts of ... partnership items of income, gain,
loss or deduction. Third, investors were secured against losing their
contributions by the promise of a refund from the Funds if tax credits could
not be delivered or were revoked. And fourth, the Funds hedged against the
possibility of insolvency by promising investors that contributions would be
made only to completed projects and by requiring the Operating Partnerships to
promise refunds, in some cases backed by guarantors, if promised credits could
not be delivered.
Id. (internal citations and quotation marks omitted). In
sum, the Fourth Circuit deemed “persuasive the Commissioner's contention that
the only risk ... was that faced by any advance purchaser who pays for an item
with a promise of later delivery. It [was] not the risk of the entrepreneur who
puts money into a venture with the hope that it might grow in amount but with
the knowledge that it may well shrink.” Id. at 145–46 (citingTower , 327 U.S.
at 287; Staff of J. Comm. on Tax'n, 98th Cong., 2d Sess., General Explanation
of the Revenue Provisions of the Deficit Reduction Act of 1984, at 226 (“To the
extent that a partner's profit from a transaction is assured without regard to
the success or failure of the joint undertaking, there is not the requisite
joint profit motive.” (alteration in original))). Accordingly, it agreed with
the Commissioner that the Funds should have reported the money received from
the investors as taxable income. Id.at 146.
The Fourth Circuit concluded its opinion with an important
note regarding its awareness of the legislative policy of providing tax credits
to spur private investment in historic rehabilitation projects:
We reach this conclusion mindful of the fact that it is “the
policy of the Federal Government” to “assist State and local governments ... to
expand and accelerate their historic preservation programs and activities.” 16
U.S.C. § 470-1(6). And we find no fault in the Tax Court's conclusion that both
the Funds and the Funds' investors engaged in the challenged transactions with
the partial goal of aiding Virginia's historic rehabilitation efforts. But
Virginia's Historic Rehabilitation Program is not under attack here.
Id. at 146 n.20.
C. Application of the Guideposts to HBH
The Commissioner asserts that Castle Harbour andVirginia
Historic “provide a highly pertinent frame of reference for analyzing the
instant case.” (Appellant's Opening Br. at 40.) According to the Commissioner,
“[m]any of the same factors upon which the [Castle Harbour court] relied in
finding that the purported bank partners ... were, in substance, lenders to the
GE entity also support the conclusion that [PB] was, in substance, not a
partner in HBH but, instead, was a purchaser of tax credits from HBH.” 53(Id.)
That is so, says the Commissioner, because, as confirmed by the Virginia
Historic court's reliance on the “entrepreneurial risks of partnership
operations,” Treas. Reg. § 1.707-3(b)(1), “the distinction between an equity
contribution to a partnership ... and a transfer of funds to a partnership as
payment of the sales price of partnership property [, i.e., tax credits,] ...
is the same as the principal distinction between equity and debt” (Appellant's
Opening Br. at 40–41). The key point is that the “recovery of an equity
investment in a partnership is dependent on the entrepreneurial risks of
partnership operations, whereas recovery of a loan to a partnership — or
receipt of an asset purchased from a partnership — is not.” (Id. at 41.) In
other words, “an equity investor in a partnership (i.e., a bona fide partner)
has a meaningful stake in the success or failure of the enterprise, whereas a
lender to, or purchaser from, the partnership does not.” (Id.) In sum, the
Commissioner argues that, just as the banks in Castle Harbour had no meaningful
stake in their respective partnerships, and the “investors” in Virginia
Historic were more like purchasers than participants in a business venture, “it
is clear from the record in this case that [PB] had no meaningful stake in the
success or failure of HBH.” (Id.)
In response, HBH asserts that “[t]here are a plethora of
errors in the IRS's tortured effort ... to applyCastle Harbour and Virginia
Historic... to the facts of the present case.” (Appellee's Br. at 38.) First,
HBH argues that it is “abundantly apparent” that Castle Harbour “is completely
inapposite” to it because the actual provisions in Castle Harbour's partnership
agreement that minimized the banks' downside risk and upside potential were
more limiting than the provisions in the AREA. (Appellee's Br. at 35.) HBH
contends that, unlike the partnership agreement in Castle Harbour, “[PB] has no
rights under the AREA to compel HBH to repay all or any part of its capital
contribution,” PB's 3% Preferred Return was “not guaranteed,” and “NJSEA has no
... right to divest [PB] of its interest in any income or gains from the East
Hall.” (Id.)
As to Virginia Historic, HBH argues that it “has no
application whatsoever” here. (Id. at 38.) It reasons that the decision in that
case “assumed that valid partnerships existed as a necessary condition to
applying I.R.C. § 707(b)'s disguised sale rules” (id.at 36), and that the case
was “analyzed ...solely under the disguised sale regime” — which is not at
issue in the FPAA sent to HBH (id.at 38).
Overall, HBH characterizes Castle Harbour andVirginia
Historic as “pure misdirections which lead to an analytical dead end” (id. at
32), and emphasizes that “[t]he question ...Culbertson asks is simply whether
the parties intended to conduct a business together and share in the profits
and losses therefrom” (id. at 39). We have no quarrel with how HBH frames the
Culbertson inquiry. But what HBH fails to recognize is that resolving whether a
purported partner had a “meaningful stake in the success or failure of the
partnership,” Castle Harbour, 459 F.3d at 224, goes to the core of the ultimate
determination of whether the parties ““intended to join together in the present
conduct of the enterprise,”” id. at 232 (quoting Culbertson, 337 U.S. at
742).Castle Harbour 's analysis that concluded that the banks' “indicia of an
equity participation in a partnership” was only “illusory or insignificant,”id.
at 231, and Virginia Historic's determination that the limited partner
investors did not face the “entrepreneurial risks of partnership operations,”
639 F.3d at 145 (citation and internal quotation marks omitted), are both
highly relevant to the question of whether HBH was a partnership in which PB
had a true interest in profit and loss, 54and the answer to that question turns
on an assessment of risk participation. We are persuaded by the Commissioner's
argument that PB, like the purported bank partners in Castle Harbour, did not
have any meaningful downside risk or any meaningful upside potential in HBH.
1. Lack of Meaningful Downside Risk
PB had no meaningful downside risk because it was, for all
intents and purposes, certain to recoup the contributions it had made to HBH
and to receive the primary benefit it sought— the HRTCs or their cash
equivalent. First, any risk that PB would not receive HRTCs in an amount that
was at least equivalent to installments it had made to-date (i.e., the
“Investment Risk”) was non-existent. That is so because, under the AREA, PB was
not required to make an installment contribution to HBH until NJSEA had
verified that it had achieved a certain level of progress with the East Hall
renovation that would generate enough cumulative HRTCs to at least equal the
sum of the installment which was then to be contributed and all prior capital contributions
that had been made by PB. (See J.A. at 176, 242 (first installment of $650,000
due at closing was paid when NJSEA had already incurred over $53 million of
QREs which would generate over $10 million in HRTCs); id. at 176–77 (second
installment, projected to be $7,092,588, was not due until, among other events,
a projection of the HRTCs for 2000 (which were estimated at closing to be
$7,789,284) based on a “determination of the actual rehabilitation costs of
[HBH] that qualify for Tax Credits in 2000”);id. at 177 (third installment,
projected to be $8,523,630, was not due until the later of, among other events,
(1) “evidence of Substantial Completion of Phase 4 ....”; and (2) a projection
of the HRTCs for 2001 (which were estimated at closing to be $11,622,889) based
on a “determination of the actual rehabilitation costs of [HBH] that qualify
for Tax Credits in 2001”); id. (fourth installment, projected to be $1,929,580,
was not due until, among other events, PB received a “K-1 for 2001 evidencing the
actual Tax Credits for 2001,” a tax document that would not have been available
until after the estimated completion date of the entire project).) While PB did
not have the contractual right to “compel HBH to repay all or any part of its
capital contribution” (Appellee's Br. at 35), PB had an even more secure deal.
Even before PB made an installment contribution, it knew it would receive at
least that amount in return.
Second, once an installment contribution had been made, the
Tax Benefits Guaranty eliminated any risk that, due to a successful IRS
challenge in disallowing any HRTCs, PB would not receive at least the cash
equivalent of the bargained-for tax credits (i.e., the “Audit Risk”). The Tax
Benefits Guaranty obligated NJSEA 55 to pay PB not only the amount of tax
credit disallowed, but also any penalties and interest, as well as up to
$75,000 in legal and administrative expenses incurred in connection with such a
challenge, and the amount necessary to pay any tax due on those reimbursements.
Cf. Virginia Historic, 639 F.3d at 145 (noting the fact that “investors were
secured against losing their contributions by the promise of a refund from the
Funds if tax credits could not be delivered or were revoked” “point[ed] to the
conclusion that there was no true entrepreneurial risk faced by investors”).
Third, any risk that PB would not receive all of its
bargained-for tax credits (or cash equivalent through the Tax Benefits
Guaranty) due to a failure of any part of the rehabilitation to be successfully
completed (i.e., the “Project Risk”) was also effectively eliminated because
the project was already fully funded before PB entered into any agreement to
provide contributions to HBH. (See J.A. at 962 (statement in the Confidential
Memorandum that “[t]he rehabilitation is being funded entirely by [NJSEA]”);
id. at 1134 (notes from a NJSEA executive committee meeting in March 2000
indicating that “[t]he bulk of the Investor's equity is generally contributed
to the company after the project is placed into service and the tax credit is
earned, the balance when stabilization is achieved”); id. at 1714 (notes to
NJSEA's 1999 annual report stating that the Casino Reinvestment Development
Authority had “agreed to reimburse [NJSEA] [for] ... all costs in excess of bond
proceeds for the project”).) That funding, moreover, included coverage for any
excess development costs. 56 In other words, PB's contributions were not at all
necessary for the East Hall project to be completed. Cf. Virginia Historic, 639
F.3d at 145 (noting that the fact that “the Funds hedged against the
possibility of insolvency by promising investors that contributions would be
made only to completed projects” “point[ed] to the conclusion that there was
not true entrepreneurial risk faced by investors”). Furthermore, HBH's own
accountants came to the conclusion that the source of the project's funds —
NJSEA (backed by the Casino Reinvestment Development Authority) — was more than
capable of covering any excess development costs incurred by the project, as
well as any operating deficits of HBH, and NJSEA had promised that coverage
through the Completion Guaranty and the Operating Deficit Guaranty,
respectively, in the AREA. (SeeJ.A. at 1638 (memo to audit file noting that,
because “[NJSEA] has the ability to fund the [operating] deficits as a result
of the luxury and other taxes provided by the hospitality and entertainment
industry in the state,” and “there is no ceiling on the amount of funds to be
provided [by NJSEA to HBH],” “no triggering event [had occurred] which
require[d] [a write down] under FASB 144”).) Cf. Virginia Historic, 639 F.3d at
145 (noting that although “[i]t [was] true ... there was ... no guarantee that
resources would remain available in the source partnership to make the promised
refunds ... it [was] also true that the Funds were structured in such a way as
to render the possibility of insolvency remote”).) Thus, although the Tax Court
determined that PB “faced the risk that the rehabilitation would not be
completed” (J.A. at 43), the record belies that conclusion. Because NJSEA had
deep pockets, and, as succinctly stated by Reznick, “there [was] no ceiling on
the amount of funds to be provided [by NJSEA to HBH]” (id. at 1638), PB was not
subject to any legally significant risk that the renovations would falter. 57
In short, PB bore no meaningful risk in joining HBH, as it
would have had it acquired a bona-fide partnership interest.See ASA
Investerings P'ship v. Comm'r , 201 F.3d 505, 514 [85 AFTR 2d 2000-675] (D.C.
Cir. 2000) (noting that the Tax Court did not err “by carving out an exception
for de minimis risks” when assessing whether the parties assumed risk for the
purpose of determining whether a partnership was valid for tax purposes, and
determining that the decision not to consider de minimis risk was “consistent
with the Supreme Court's view ... that a transaction will be disregarded if it
did “notappreciably affect [taxpayer's] beneficial interest except to reduce
his tax”” (alteration in original) (quoting Knetsch v. United States, 364 U.S.
361, 366 [6 AFTR 2d 5851] (1960))). 58
PB's effective elimination of Investment Risk, Audit Risk,
and Project Risk is evidenced by the “agreement ... of the parties.”
Culbertson, 337 U.S. at 742. PB and NJSEA, in substance, did not join together
in HBH's stated business purpose — to rehabilitate and operate the East Hall.
Rather, the parties' focus from the very beginning was to effect a sale and
purchase of HRTCs. (See J.A. at 691 (Sovereign's “consulting proposal ... for
the sale of historic rehabilitation tax credits expected to be generated” by
the East Hall renovation); id. at 955 (Confidential Memorandum entitled “The
Sale of Historic Tax Credits Generated by the Renovation of the Historic
Atlantic City Boardwalk Convention Hall”); id. at 1143 (cover letter from
Sovereign to NJSEA providing NJSEA “with four original investment offers from
institutions that have responded to the [Confidential] Memorandum regarding the
purchase of the historic tax credits expected to be generated by” the East Hall
renovation).) 59
That conclusion is not undermined by PB's receipt of a
secondary benefit — the 3% Preferred Return on its contributions to HBH.
Although, in form, PB was “not guaranteed” that return on an annual basis if
HBH did not generate sufficient cash flow (Appellee's Br. at 35), in substance,
PB had the ability to ensure that it would eventually receive it. If PB
exercised its Put Option (or NJSEA exercised its Call Option), the purchase
price to be paid by NJSEA was effectively measured by PB's accrued and unpaid
Preferred Return.See infra note 63 and accompanying text. And to guarantee that
there would be sufficient cash to cover that purchase price, NJSEA was required
to purchase the Guaranteed Investment Contract in the event that NJSEA
exercised its Call Option. 60 Cf. Virginia Historic, 639 F.3d at 145 (noting
the fact that “investors were promised what was, in essence, a fixed rate of
return on investment rather than any share in partnership profits tied to their
partnership interests” “point[ed] to the conclusion that there was not true
entrepreneurial risk faced by investors”). Thus, the Tax Court's finding that
PB “might not receive its preferred return ... at all” unless NJSEA exercised
its Call Option (J.A. at 51–52), was clearly erroneous because it ignored the
reality that PB could assure its return by unilaterally exercising its Put
Option. 61
HBH, of course, attacks the Commissioner's assertion that PB
lacked downside risk, claiming that “the IRS's theory that a valid partnership
cannot exist unless an investor-partner shares in all of the risks and costs of
the partnership has no basis in partnership or tax law,” and “is contrary to
the standard economic terms of innumerable real estate investment partnerships
in the United States for every type of real estate project.” (Appellee's Br. at
44.) HBH also asserts that many of the negotiated provisions — such as the
Completion Guaranty, Operating Deficit Guaranty, and the Preferred Return — are
“typical in a real estate investment partnership.” (Id. at 45.) The
Commissioner has not claimed, however, and we do not suggest, that a limited
partner is prohibited from capping its risk at the amount it invests in a
partnership. Such a cap, in and of itself, would not jeopardize its partner
status for tax purposes. We also recognize that a limited partner's status as a
bona fide equity participant will not be stripped away merely because it has
successfully negotiated measures that minimize its risk of losing a portion of
its investment in an enterprise. Here, however, the parties agreed to shield
PB's “investment” from any meaningful risk. PB was assured of receiving the
value of the HRTCs and its Preferred Return regardless of the success or
failure of the rehabilitation of the East Hall and HBH's subsequent operations.
And that lack of meaningful risk weighs heavily in determining whether PB is a
bona fide partner in HBH. Cf. Virginia Historic, 639 F.3d at 145–46 (explaining
that “entrepreneurial risks of partnership operations” involves placing “money
into a venture with the hope that it might grow in amount but with the
knowledge that it may well shrink”);Castle Harbour , 459 F.3d at 232 (noting
that “Congress appears to have intended that “the significant factor” in
differentiating between [debt and equity] be whether “the funds were advanced
with reasonable expectations of repayment regardless of the success of the
venture or were placed at the risk of the business”” (quoting Gilbert v.
Comm'r, 248 F.2d 399, 406 [52 AFTR 634] (2d Cir. 1957))).
2. Lack of Meaningful Upside Potential
PB's avoidance of all meaningful downside risk in HBH was
accompanied by a dearth of any meaningful upside potential. “Whether [a
putative partner] is free to, and does, enjoy the fruits of the partnership is
strongly indicative of the reality of his participation in the
enterprise.”Culbertson , 337 U.S. at 747. PB, in substance, was not free to
enjoy the fruits of HBH. Like the foreign banks' illusory 98% interest in
Castle Harbour, PB's 99.9% interest in HBH's residual cash flow gave a false
impression that it had a chance to share in potential profits of HBH. In
reality, PB would only benefit from its 99.9% interest in residual cash flow
after payments to it on its Investor Loan and Preferred Return and the
following payments to NJSEA: (1) annual installment payment on the Acquisition
Loan ($3,580,840 annual payment for 39 years plus arrears); (2) annual
installment payment on the Construction Loan; 62 and (3) payment in full of the
operating deficit loan (in excess of $28 million as of 2007). Even HBH's own
rosy financial projections from 2000 to 2042, which (at least through 2007) had
proven fantastically inaccurate, forecasted no residual cash flow available for
distribution. Thus, although in form PB had the potential to receive the fair
market value of its interest (assuming such value was greater than its accrued
but unpaid Preferred Return) if either NJSEA exercised its Call Option or PB
exercised its Put Option, in reality, PB could never expect to share in any
upside. 63 Cf. Castle Harbour, 459 F.3d at 234 (“The realistic possibility of
upside potential — not the absence of formal caps — is what governs [the bona
fide equity participation] analysis.”). Even if there were an upside, however,
NJSEA could exercise its Consent Option, and cut PB out by paying a purchase
price unrelated to any fair market value. 64 See supra Section I.B.4.a. In sum,
“the structure of the ... transaction ensured that [PB] would never receive any
[economic benefits from HBH].” Southgate Master Fund, 659 F.3d at 486–87. And
“[i]n light of Culbertson's identification of “the actual control of income and
the purposes for which it [was] used” as a metric of a partnership's
legitimacy, the terms of the [AREA and the structure of the various options]
constitute compelling evidence” that PB was not a bona fide partner in HBH. Id.
at 486 (quoting Culbertson, 337 U.S. at 742).
3. HBH's Reliance on Form over Substance
After attempting to downplay PB's lack of any meaningful
stake in the success or failure of the enterprise, HBH presses us to consider
certain evidence that it believes “overwhelmingly proves that [PB] is a partner
in HBH” under theCulbertson totality-of-the-circumstances test. (Appellee's Br.
at 38.) That “overwhelming” evidence includes: (1) that HBH was duly organized
as an LLC under New Jersey law and, as the AREA provides, “was formed to
acquire, develop, finance, rehabilitate, maintain, operate, license, and sell
or otherwise to dispose of the East Hall” (id. at 40; see J.A. at 157); (2)
PB's “net economic benefit” from the HRTCs and the 3% Preferred Return
(Appellee's Br. at 41); (3) PB's representatives' “vigorous[] negotiat[ion]
[of] the terms of the AREA” (id. at 41); (4) “the nature and thoroughness” of
PB's “comprehensive due diligence investigation in connection with its
investment in HBH” (id. at 42); (5) PB's “substantial financial investment in
HBH” (id.); (6) various business agreements that had been entered into between
NJSEA and certain third parties that were all assigned to, and assumed by, HBH
(id. at 43); (7) bank and payroll accounts that were opened in HBH's name and
insurance agreements that were amended to identify HBH as an owner and include
PB as an additional insured; and (8) the fact that, following closing, “NJSEA
kept in constant communication with [PB] regarding the renovations to the East
Hall, and the business operations of the Hall” (id.).
Much of that evidence may give an “outward appearance of an
arrangement to engage in a common enterprise.”Culbertson , 337 U.S. at 752
(Frankfurter, J., concurring). But “the sharp eyes of the law” require more
from parties than just putting on the “habiliments of a partnership whenever it
advantages them to be treated as partners underneath.” Id. Indeed,
Culbertsonrequires that a partner “really and truly intend[] to ... shar[e] in
the profits and losses” of the enterprise, id. at 741 (majority opinion)
(emphasis added) (citation and internal quotation marks omitted), or, in other
words, have a “meaningful stake in the success or failure” of the enterprise,
Castle Harbour, 459 F.3d at 231. Looking past the outward appearance, HBH's
cited evidence does not demonstrate such a meaningful stake.
First, the recitation of partnership formalities — that HBH
was duly organized, that it had a stated purpose under the AREA, that it opened
bank and payroll accounts, and that it assumed various obligation — misses the
point. We are prepared to accept for purposes of argument that there was
economic substance to HBH. The question is whether PB had a meaningful stake in
that enterprise. See Castle Harbour, 459 F.3d at 232 (“The IRS's challenge to
the taxpayer's characterization is not foreclosed merely because the taxpayer
can point to the existence of some business purpose or objective reality in
addition to its tax-avoidance objective.”); Southgate Master Fund, 659 F.3d at
484 (“The fact that a partnership's underlying business activities had economic
substance does not, standing alone, immunize the partnership from judicial
scrutiny [underCulbertson ]. The parties' selection of the partnership form
must have been driven by a genuine business purpose.” (internal footnote
omitted)). To answer that, we must “look beyond the superficial formalities of
a transaction to determine the proper tax treatment.” Edwards v. Your Credit,
Inc., 148 F.3d 427, 436 (5th Cir. 1998) (citation and internal quotation marks
omitted).
Second, evidence that PB received a “net economic benefit”
from HBH and made a “substantial financial investment in HBH” can only support
a finding that PB is a bona fide partner if there was a meaningful intent to
share in the profits and the losses of that investment. The structure of PB's
“investment,” however, shows clearly that there was no such intent. Recovery of
each of the contributions that made up the “substantial financial investment”
was assured by the provisions of the AREA and the Tax Benefits Guaranty. And,
as the Commissioner rightly notes, PB's net after-tax economic benefit from the
transaction — in the form of the HRTCs (or the cash equivalent via the Tax
Benefits Guaranty) and the effectively guaranteed Preferred Return — “merely
demonstrates [PB's] intent to make an economically rational use of its money on
an after-tax basis.” (Appellant's Reply Br. at 13.) Indeed, both parties in a
transaction such as this one will always think they are going to receive a net
economic benefit; otherwise, the transaction would never occur. If in fact that
was the test, there would be a green-light for every tax-structured transaction
that calls itself a “partnership.”
Third, the fact that NJSEA “kept in constant communication”
regarding the East Hall is hardly surprising. As discussed earlier, supra
Section II.C.1, each installment contribution from PB was contingent upon NJSEA
verifying that a certain amount of work had been completed on the East Hall so
that PB was assured it would not be contributing more money than it would be
guaranteed to receive in HRTCs or their cash equivalent. The mere fact that a
party receives regular updates on a project does not transform it into a bona
fide partner for tax purposes.
Fourth, looking past the form of the transaction to its
substance, neither PB's “vigorous[] negotiat[ion]” nor its “comprehensive due
diligence investigation” is, in this context, indicative of an intent to be a
bona fide partner in HBH. We do not doubt that PB spent a significant amount of
time conducting a thorough investigation and negotiating favorable terms. And
we acknowledge that one of the factors cited by Culbertson is “the conduct of
the parties in execution of its provisions.” 337 U.S. at 742. But the record
reflects that those efforts were made so that PB would not be subject to any
real risks that would stand in the way of its receiving the value of the HRTCs;
not, as HBH asserts, “to form a true business relationship.” (Appellee's Br. at
41.) We do not believe that courts are compelled to respect a taxpayer's
characterization of a transaction for tax purposes based on how
document-intensive the transaction becomes. Recruiting teams of lawyers,
accountants, and tax consultants does not mean that a partnership, with all its
tax credit gold, can be conjured from a zero-risk investment of the sort PB
made here.
In the end, the evidence HBH cites focuses only on form, not
substance. From the moment Sovereign approached NJSEA, the substance of any
transaction with a corporate investor was calculated to be a “sale of ...
historic rehabilitation tax credits.” (J.A. at 691.) Cf. Castle Harbour, 459
F.3d at 236 (finding that the banks' interest “was more in the nature of window
dressing designed to give ostensible support to the characterization of equity
participation ... than a meaningful stake in the profits of the venture”). And
in the end, that is what the substance turned out to be.
Like the Virginia Historic court, we reach our conclusion
mindful of Congress's goal of encouraging rehabilitation of historic buildings.
See 639 F.3d at 146 n.20. We have not ignored the predictions of HBH and amici
that, if we reallocate the HRTCs away from PB, we may jeopardize the viability
of future historic rehabilitation projects. Those forecasts, however, distort
the real dispute.
The HRTC statute “is not under attack here.”Id. It is the
prohibited sale of tax credits, not the tax credit provision itself, that the
IRS has challenged. 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 is not for us to say in the abstract.
But, “[w]here, as here, we confront taxpayers who have taken a circuitous route
to reach an end more easily accessible by a straightforward path, we look to
the substance over form.” Southgate Master Fund, 659 F.3d at 491 (citation and
internal quotation marks omitted). And, after looking to the substance of the
interests at play in this case, we conclude that, because PB lacked a
meaningful stake in either the success or failure of HBH, it was not a bona
fide partner.
III. Conclusion
For the foregoing reasons, we will reverse the Tax Court's
January 3, 2011 decision, and remand the case for further proceedings consistent
with this opinion.
1
An LLC “offers the
best of both worlds — the limited liability of a corporation and the favorable
tax treatment of a partnership.” Canterbury Holdings, LLC v. Comm'r, 98 T.C.M.
(CCH) 60, 61 [TC Memo 2009-175] n.1 (2009). Generally, an LLC is a pass-through
entity that does not pay federal income tax.See
I.R.C. § 701;Treas. Reg. § 301.7701-3(a). Rather, profits and losses
“pass through” the LLC to its owners, called members, who pay individual income
tax on their allocable shares of the tax items. SeeI.R.C. §§ 701-04, 6031.
Although an LLC with just one owner is, for tax purposes, disregarded as an
entity separate from its owner for tax purposes, an LLC with two or more
members is classified as a partnership for tax purposes unless it elects to be
treated as a corporation. Treas. Reg. § 301.7701-3(b)(1). Once HBH, as a duly
formed New Jersey limited liability company, had two members, it did not elect
to be treated as a corporation and thus was classified as a partnership for tax
purposes for the tax years in which it had more than one member. Thus, as the
parties do, we refer to HBH as a partnership when analyzing whether one of its
stated members was a bona fide partner.
2
PB's membership
interest in HBH was through PB Historic Renovations, LLC, whose sole member was
Pitney Bowes Credit Corp. At all relevant times, Pitney Bowes Credit Corp. was
a wholly-owned subsidiary of PB. For ease of reference, we will refer to PB
Historic Renovations, LLC, Pitney Bowes Credit Corp., and PB as “PB.”
3
The alphabet-soup of
acronyms in this case is perhaps beyond parody, but the acronyms are a more
efficient means of referring to various corporate and state entities, as well
as the tax credits and other concepts, so we reluctantly fall into the soup.
4
The Code defines a
QRE as:
[A]ny amount properly chargeable to [a] capital account —
(i) for property for which depreciation is allowable under [I.R.C. §] 168 and
which is — (I) nonresidential real property, (II) residential real property,
(III) real property which has a class life of more than 12.5 years, or (IV) an
addition or improvement to property described in subclause (I), (II), or (III),
and (ii) in connection with the rehabilitation of a qualified rehabilitated
building.
I.R.C. § 47(c)(2)(A).
5
The Code defines a
“certified historic structure” as “any building (and its structural components)
which — (i) is listed in the National Register, or (ii) is located in a
registered historic district and is certified by the Secretary of the Interior
to the Secretary as being of historic significance to the district.” I.R.C. §
47(c)(3).
6
The Code defines a
“qualified rehabilitated building” as:
[A]ny building (and its structural components) if — (i) such
building has been substantially rehabilitated, (ii) such building was placed in
service before the beginning of the rehabilitation, (iii) in the case of any
building other than a certified historic structure, in the rehabilitation
process — (I) 50 percent or more of the existing external walls of such building
are retained in place as external walls, (II) 75 percent or more of the
existing external walls of such building are retained in place as internal or
external walls, and (III) 75 percent or more of the existing internal
structural framework of such building is retained in place, and (iv)
depreciation (or amortization in lieu of depreciation) is allowable with
respect to such building.
I.R.C. § 47(c)(1)(A). Additionally, “[i]n the case of a
building other than a certified historic structure, a building shall not be a
qualified rehabilitated building unless the building was first placed in
service before 1936.”Id. § 47(c)(1)(B).
7
Specifically, the
codification of the economic substance doctrine provides:
In the case of any transaction to which the economic
substance doctrine is relevant, such transaction shall be treated as having
economic substance only if ... (A) the transaction changes in a meaningful way
(apart from Federal income tax effects) the taxpayer's economic position, and
(B) the taxpayer has a substantial purpose (apart from Federal income tax
effects) for entering into such transaction.
I.R.C. § 7701(o)(1). Section 7701(o) applies to all
transactions entered into after March 30, 2010. Thus, the common-law version of
the economic substance doctrine, and not § 7701(o), applies to the transaction
at issue here.
8
The Casino
Reinvestment Development Authority, as described by the Tax Court, “is a State
agency created by the New Jersey State Legislature that uses funds generated
from governmental charges imposed on the casino industry for economic
development and community projects throughout the State.” (Joint Appendix
(“J.A.”) at 11 n.4.)
9
The proceeds from
that bond issuance by NJSEA, described as the 1999 Luxury Tax Bonds, were not directly
applied to the East Hall renovation. Rather, the 1999 Luxury Tax Bonds were
issued to effect the refunding of certain amounts from an earlier bond
issuance.
10
Sovereign describes
itself as “a boutique consulting firm that facilitates equity financing and
offers financial advisory services for historic rehabilitation ... tax credit
transactions.” (J.A. at 696.)
11
Because it was
projected that the East Hall renovation would be completed in late 2001, fiscal
year 2002 was anticipated to be the East Hall's first full year of operations.
12
A “going concern” is
“[a] commercial enterprise actively engag[ed] in business with the expectation
of indefinite continuance.” Black's Law Dictionary 712 (8th ed. 2004).
Evidently and understandably, Sovereign viewed year after year of large losses
from the operations of the East Hall as inconsistent with an ordinary
expectation of indefinite continuance.
13
Although we use the
term “capital contributions” because that was the term used by the parties in
this context, we do not attribute any dispositive legal significance to it as
used herein.
14
Reznick apparently
used the terms “eligible” and “non-eligible” construction expenditures to
differentiate between costs that were QREs and those that were not.
15
The LOI provided
that PB's contribution would be “adjusted ... upward by $0.995 per additional
$1.00 of Historic Tax Credit in the event that ... the QREs for the Project
after 1999 support[ed] Historic Tax Credits in excess of the projected Historic
Tax Credits.” (J.A. at 1148.)
16
Although it is
unclear from the record exactly when Phase 3 of the four-phase rehabilitation
project was completed, the March 2000 Confidential Memorandum estimated that
Phase 3, which began in October 1999, would be completed by August 2000. That
same memo stated that NJSEA anticipated that the entire renovation would be
completed by December 2001, and, in fact, the East Hall reopened in October
2001. Thus, it is likely that Phase 3 of the renovation was entirely completed by
the time NJSEA and PB executed the various documents effecting PB's investment
in HBH.
17
The AREA defined the
term “Excess Development Costs” as “all expenditures in excess of the proceeds
of the [Acquisition and Construction] Loans and the Capital Contributions of
the Members which are required to complete rehabilitation of the [East] Hall,”
including, but not limited to, “(1) any interest, taxes, and property insurance
premiums not payable from proceeds of the Loans or Capital Contributions, and
(2) any construction cost overruns and the cost of any change orders which are
not funded from proceeds of the Loans or Capital Contributions of the Members.”
(J.A. at 161.)
18
The term “Hazardous
Materials” under the AREA included, among other things, “any “hazardous
substance”, “pollutant” or “contaminant” as defined in any applicable federal
statute, law, rule or regulation now or hereafter in effect ... or any
amendment thereto or any replacement thereof or in any statute or regulation
relating to the environment now or hereafter in effect,” and “any hazardous
substance, hazardous waste, residual waste or solid waste, as those terms are
now or hereafter defined in any applicable state or local law, rule or
regulation or in any statute or regulation relating to the environment now or
hereafter in effect.” (J.A. at 162.)
19
Those rights and
obligations are distinct from the put and call options set forth in separate
agreements which were executed the same day and which are discussed infra in
Section 1.B.4.e.
20
In this context, the
term “tax credit recapture” is apparently used to convey the concept that a
taxpayer is required to repay to the IRS a portion of a tax credit it had
previously claimed with respect to a property interest because that property
interest did not continue to qualify for the tax credit for the requisite
period of time. Specifically, if the East Hall were disposed of or “otherwise
cease[d] to be [an HRTC] property with respect to” HBH within five years after
the East Hall was placed into service, any HRTCs allocated to PB through its
membership interest in HBH would be recaptured by, in effect, increasing PB's
tax (through its membership interest in HBH) by the amount of the total HRTCs
taken multiplied by a “recapture percentage,” which varies based on the holding
period of the property. See I.R.C. § 50(a). The amount of HRTCs subject to
recapture would decrease by 20% for each of the first five years after the East
Hall was placed in service.See id. §
50(a)(1)(B).
21
At the time that the
IRS challenged this series of transactions, neither the Consent Option nor the
Material Default Option had been exercised.
22
A “guaranteed
investment contract” is “[a]n investment contract under which an institutional
investor [here, NJSEA] invests a lump sum ... with an insurer that promises to
return the principal (the lump sum) and a certain amount of interest at the
contract's end.” Black's Law Dictionary 845 (8th ed. 2004).
23
That option, known
as the call option, was one of two vehicles (the other being the Consent
Option) that was available to NJSEA if it wanted to buy out PB's interest in
HBH. PB had a corresponding put option which gave it the right to compel NJSEA
to buy out PB's interest. As noted earlier, supra note 19, the put and call
options are discussed infra in Section 1.B.4.e.
24
It appears that the
leasehold interest was extended so that its term was longer than the
depreciable basis of the improvements to be made on the East Hall for tax
purposes. That extension was in accord with Hoffman's ultimate plan for NJSEA
to transfer ownership of the East Hall (for tax purposes) to the newly created
partnership, a plan he laid out in Sovereign's consulting proposal to NJSEA
(albeit the actual lease extension was longer than that suggested in that
proposal). (See J.A. at 693 (“Since the useful life of commercial improvements
is 39.5 years, the tax industry consensus is that the sub-lease should be for a
period of 50 years.”). Extending the lease term beyond the useful life of the
improvements was necessary so that when NJSEA entered into a sublease with HBH
in connection with the East Hall, HBH, as Hoffman put it, could “be recognized
as the “owner” for tax purposes” (id.), and thus would be eligible to incur
QREs that, in turn, would generate HRTCs.See
I.R.C. § 47(c)(2)(B)(vi) (“The term “[QRE]” does not include ... any expenditure
of a lessee of a building if, on the date the rehabilitation is completed, the
remaining term of the lease (determined without regard to any renewal periods)
is less than the recovery period determined under [I.R.C. § 168(c)].”).
25
The final projections
prepared during the week prior to closing contemplated $27,421,036 of remaining
construction costs. During that week, Sovereign sent a memo to PB identifying
an additional $10.5 million of “[p]otential additional expenditure[s]” that
included environmental remediation costs ($3.0 million), tenant improvements
($2.5 million), and an additional rehabilitation contingency ($5.0 million).
(J.A. at 1209.) If those expenditures were treated as QREs, the memo indicated
that the transaction would generate an additional $2.1 million in HRTCs.
26
The 60-month period
was likely imposed so that, if NJSEA did exercise the Call Option, any of the
HRTCs that PB had previously been allocated through its membership interest in
HBH would not be subject to recapture.See supra note 20.
27
Neither of those
options were exercised prior to the IRS's challenge.
28
Pursuant to the Tax
Benefits Guaranty, a “Tax Benefits Reduction Event means as of any Final
Determination for any taxable year the amount by which the Actual Tax Benefits
for such year are less than the Projected Tax Benefits.” (J.A. at 300.) A
“Final Determination” was defined as the earliest to occur of certain
non-construction related events which, “with respect to either [HBH] or [PB],
... result[] in loss of Projected Tax Benefits.” (Id. at 299.)
29
The “Revised
Economic Projections” refer to the revised projections made by Reznick that
“reflect the actual Tax Credits and federal income tax losses ... at the time
of payment of the Second, Third and Fourth Installments.” (Id. at 300.)
30
As noted, supra
Section 1.B.4.a, the AREA required that NJSEA purchase the Guaranteed
Investment Contract in the amount required to secure the purchase price to be
paid by NJSEA if it exercised its Call Option. However, pursuant to a pledge
and escrow agreement entered into by NJSEA, PB, and an escrow agent in January
2001, NJSEA also pledged its interest in the Guaranteed Investment Contract as
security for its potential purchase obligation in the event that PB exercised
its Put Option, subject to NJSEA's right to apply the proceeds of that contract
toward payment of the purchase price if it exercised its Call Option or Consent
Option, or if PB exercised its Material Default Option.
31
We use the terms
“net operating income” or “net operating loss” to mean the net income or loss
before interest and depreciation expenses.
32
HBH's statement of
operations for 2000 covered the period June 26, 2000 (date of inception)
through December 31, 2000.
33
HBH's accountants
did not make financial projections for operating revenues and expenses prior to
2001.
34
It was possible for
HBH to claim QREs that were incurred prior to its purported acquisition of the
East Hall. See Treas. Reg. § 1.48-12(c)(3)(ii) (“Where [QREs] are incurred with
respect to a building by a persons (or persons) other than the taxpayer [i.e.
NJSEA] and the taxpayer [i.e. HBH] subsequently acquires the building, ... the
taxpayer acquiring the property shall be treated as having incurred the [QREs]
actually incurred by the transferor ..., provided that ... [t]he building ...
acquired by the taxpayer was ... not placed in service ... after the [QREs]
were incurred and prior to the date of acquisition, and ... [n]o credit with respect
to such [QREs] is claimed by anyone other than the taxpayer acquiring the
property.”). Additionally, even if “total construction costs” were only
approximately $90.6 million as projected, it would also have been possible to
generate over $107 million in QREs. See id.
§ 1.48-12(c)(2) (noting that QREs could include, among other things,
“development fees,” “legal expenses,” and certain “[c]onstruction period
interest” expenses). In any event, as discussed infra, the IRS has not
challenged the amount of the QREs reported by HBH, but rather the allocation of
any HBH partnership items to PB.
35
As contemplated by
the LOI,see supra note 15, the AREA provided that “if the 2000 or 2001 Tax
Credits which [HBH] will be entitled to claim with respect to such
rehabilitation are greater than the Projected Tax Credits ... the aggregate
amount of [PB's] Capital Contribution shall be increased by $.995 for each
$.999 by which the Tax Credits exceed the Projected Tax Credits.” (J.A. at
178.) It is unclear from the record why a portion of the required increase in
capital contributions was instead applied to increase the Investor Loan.
36
The “$90 million”
figure is at odds with the statement in the Confidential Memorandum that the
renovation project would cost $107 million. The difference approximates the sum
eventually invested by PB. Seesupra Section I.B.3.c.
37
The record does not
contain audited financial statements for HBH beyond 2007.
38
After paying that
portion of the fourth installment, PB had made $19,351,796 of its $20,198,460
required capital contribution. The notes to HBH's 2007 audited financial
statements indicate that the $846,664 balance, plus interest, was still due,
and was being reserved pending the outcome of litigation with the IRS. The Tax Court
also said that a “portion of [PB's] fourth capital contribution ... is
currently being held in escrow.” (J.A. at 17.)
39
FASB is an acronym
for the Financial Accounting Standards Board, an organization that establishes
standards which are officially recognized as authoritative by the SEC for
financial accounting and which govern the preparation of financial reports by
nongovernmental entities. The number “144” refers to the number assigned to the
particular standard at issue here.
40
The record does not
contain Reznick's audit files for HBH beyond 2005.
41
As detailed earlier,
supra note 1, since HBH was a duly formed New Jersey limited liability company,
had two members by the end of its 2000 tax year, and did not elect to be
treated as a corporation, it was classified as a partnership for tax purposes
for the tax years at issue here. See Treas. Reg. § 301.7701-3(b)(1).
Partnerships do not pay federal income taxes, but rather are required to file a
Form 1065, which is an annual information return of the partnership. A Form
1065 also generates a Schedule K-1 for each partner, which reports a partner's
distributive share of tax items. The individual partners then report their
allocable shares of the tax items on their own federal income tax returns. See
I.R.C. §§ 701–04, 6031.
42
HBH's 2000 Form 1065
stated that it began business on June 26, 2000.
43
While PB was also
allocated 99.9% of the ordinary taxable loss for both 2001 and 2002, it appears
it was only allocated approximately 69% of the ordinary taxable loss for 2000.
Although it is unclear from the record, PB could have only been allocated 99.9%
of the loss from the time it joined as a member in HBH in September 2000,
although, as noted above, it was allocated 99.9% of the QREs for HBH's entire
taxable year in 2000.
44
The FPAA provided
two additional grounds for reallocating partnership items from PB to NJSEA. It
determined that no sale of the East Hall occurred between NJSEA and HBH for
federal income tax purposes because the burdens and benefits of ownership of
the East Hall interest did not pass from NJSEA, as the seller, to HBH, as the
purchaser. Although the IRS has appealed the Tax Court's rejection of that
argument, see infra note 47, we will not address that contention in view of our
ultimate disposition. The FPAA also determined that HBH should be disregarded
for federal income tax purposes under the anti-abuse provisions of Treas. Reg.
§ 1.701-2(b). The Tax Court also rejected that determination, and the IRS has
not appealed that aspect of the decision.
45
A partnership such
as HBH “designates a tax matters partner to handle tax questions on behalf of
the partnership,” and that “partner is empowered to settle tax disputes on
behalf of the partnership.” Mathia v. Comm'r, 669 F.3d 1080, 1082 [109 AFTR 2d
2012-375] n.2 (10th Cir. 2012).
46
“Upon receiving an
FPAA, a partnership, via its tax matters partner, may file a petition in the
Tax Court.... Once an FPAA is sent, the IRS cannot make any assessments
attributable to relevant partnership items during the time the partnership
seeks review....” Mathia, 669 F.3d at 1082. Once that petition is filed, a
partnership-level administrative proceeding is commenced, governed by the Tax
Equity and Fiscal Responsibility Act of 1982. Under that Act, all partnership
items are determined in a single-level proceeding at the partnership level,
which is binding on the partners and may not be challenged in a subsequent
partner-level proceeding. See I.R.C. §§ 6230(c)(4), 7422(h). This streamlined
process “remove[s] the substantial administrative burden occasioned by
duplicative audits and litigation and ... provide[s] consistent treatment of
partnership tax items among partners in the same partnership.” (J.A. at 31–32.)
47
Rejecting a third
alternative ground brought by the IRS, see supra note 44, the Tax Court
determined that NJSEA had transferred the benefits and burdens of its interest
in the East Hall to render HBH the owner of the East Hall for tax purposes, see
supra note 24. To support that conclusion, the Court observed that (1) “[t]he
parties treated the transaction as a sale”; (2) “possession of the East Hall
vested in [HBH]”; (3) “[HBH] reported the East Hall's profits and stood to lose
its income if the East Hall stopped operating as an event space”; and (4)
“[b]ank accounts were opened in [HBH's] name by [Spectacor] as operator of the
East Hall.” (J.A. at 54–55.) Because of our ultimate resolution, we will not
specifically address the Tax Court's analysis of that contention.
48
The Tax Court had
jurisdiction pursuant to I.R.C. §§ 6226(f) and 7442, and we have jurisdiction
pursuant to I.R.C. § 7482(a)(1). We exercise de novo review over the Tax
Court's ultimate characterization of a transaction, and review its findings of
fact for clear error. Merck & Co., Inc. v. United States, 652 F.3d 475, 480
[107 AFTR 2d 2011-2596]–81 (3d Cir. 2011).
49
The current
Commissioner of Internal Revenue is Douglas Shulman.
50
The Commissioner
also contends that HBH was a sham. Specifically, the Commissioner invokes a
“sham-partnership theory,” which he says is “a variant of the
economic-substance (sham-transaction) doctrine.” (Appellant's Opening Br. at
50.) That theory, according to the Commissioner “focus[es] on (1) whether the
formation of the partnership made sense from an economic standpoint, as would
be the case [under the Culbertsoninquiry], and (2) whether there was otherwise
a legitimate business purpose for the use of the partnership form.” (Id.)
HBH contends that the IRS's sham-partnership theory, which
HBH asserts is “merely a rehash of the factual claims that [the IRS] made in
challenging [PB's] status as a partner in HBH,” is distinct from the
sham-transaction doctrine (also known as the economic substance doctrine) that
was litigated before the Tax Court. Amicus Real Estate Roundtable (the
“Roundtable”) agrees, submitting that the Commissioner's sham-partnership
argument “inappropriately blur[s] the line between the [economic substance
doctrine] and the [substance-over-form doctrine],” the latter of which applies
when the form of a transaction is not the same as its economic reality.
(Roundtable Br. at 7.) The point is well-taken, as the economic substance
doctrine and the substance-over-form doctrine certainly “are distinct.”
Neonatology Assocs., P.A. v. Comm'r, 299 F.3d 221, 230 [90 AFTR 2d 2002-5442]
n.12 (3d Cir. 2002); see generally Rogers v. United States, 281 F.3d 1108, 1115
[89 AFTR 2d 2002-1115]–17 (10th Cir. 2002) (noting differences between the
substance-over-form doctrine and the economic substance doctrine). The
substance-over-form doctrine “is applicable to instances where the “substance”
of a particular transaction produces tax results inconsistent with the “form”
embodied in the underlying documentation, permitting a court to recharacterize
the transaction in accordance with its substance.” Neonatology Assocs., 299
F.3d at 230 n.12. On the other hand, the economic substance doctrine “applies
where the economic or business purpose of a transaction is relatively
insignificant in relation to the comparatively large tax benefits that accrue.”Id.
As the Roundtable correctly explains, “[t]he fact that [a]
taxpayer might not be viewed as a partner (under the [substance-over-form
doctrine]) or that the transaction should be characterized as a sale (again,
under the [substance-over-form doctrine]) [does] not mean that the underlying
transaction violated the [economic substance doctrine].” (Roundtable Br. at 7.)
Put another way, 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.See Southgate Master Fund, L.L.C. ex rel. Montgomery
Capital Advisors, LLC v. United States , 659 F.3d 466, 484 [108 AFTR 2d
2011-6488] (5th Cir. 2011) (“The fact that a partnership's underlying business
activities had economic substance does not, standing alone, immunize the
partnership from judicial scrutiny [under Culbertson].”); id.(“If there was not
a legitimate, profit-motivated reason to operate as a partnership, then the
partnership will be disregarded for tax purposes even if it engaged in
transactions that had economic substance.”).
At oral argument, the IRS conceded that this case “lends
itself more cleanly to the bona fide partner theory,” under which we look to
the substance of the putative partner's interest over its form. Oral Argument
at 11:00, Historic Boardwalk Hall, LLC v. Comm'r (No. 11-1832),available at
http://www.ca3.uscourts.gov/oralargument/audio/11-1832Historic%20Boardwalk%20LLC%20v%20Commissioner%20IRS.wma.
Accordingly, we focus our analysis on whether PB is as a bona fide partner in
HBH, and in doing so, we assume, without deciding, that this transaction had
economic substance. Specifically, we do not opine on the parties' dispute as to
whether, under Sacks v. Commissioner, 69 F.3d 982 [76 AFTR 2d 95-7138] (9th
Cir. 1995), we can consider the HRTCs in evaluating whether a transaction has
economic substance.
51
The Virginia
Program, much like the federal HRTC statute, was enacted to encourage
investment in renovating historic properties. Virginia Historic, 639 F.3d at
132. Similar to federal HRTCs, the credits under the Virginia Program could be
applied to reduce a taxpayer's Virginia income tax liability, dollar-for-dollar,
up to 25% of eligible expenses incurred in rehabilitating the property.Id. Also
like federal HRTCs, credits under the Virginia program could not be sold or
transferred to another party. Id. at 132–33.
52
Under I.R.C. §
707(a)(2)(A),
[i]f (i) a partner performs services for a partnership or
transfers property to a partnership, (ii) there is a related direct or indirect
allocation and distribution to such partner, and (iii) the performance of such
services (or such transfer) and the allocation and distribution, when viewed
together, are properly characterized as a transaction occurring between the
partnership and a partner acting other than in his capacity as a member of the
partnership, such allocation and distribution shall be treated as a transaction
[between the partnership and one who is not a partner].
53
The Commissioner
acknowledges that “[a]lthough certain aspects of [PB's] cash investment in HBH
were debt-like (e.g., its 3-percent preferred return), this case does not fit
neatly within the debt-equity dichotomy, since [PB] recovered its “principal,”
i.e. its purported capital contributions to HBH, in the form of tax credits
rather than cash.” (Appellant's Opening Br. at 40 n.14.)
54
We reject, moreover,
any suggestion that the disguised-sale rules and the bona fide-partner theory
apply in mutually exclusive contexts. Virginia Historic did not “assume[] that
valid partnerships existed as a necessary condition” prior to applying the
disguised-sale rules. (Appellee's Br. at 36.) Rather, as the Virginia Historic
court observed, “[t]he Department of the Treasury specifically contemplates
that its regulations regarding disguised sales can be applied before it is
determined whether a valid partnership exists.” 639 F.3d at 137 n.9 (citing
Treas. Reg. § 1.707-3).
More importantly, HBH simply ignores why many of the
principles espoused in Virginia Historic are applicable here. It is true that
the challenged transaction here does not involve state tax credits and that the
IRS has not invoked the disguised-sale rules, but distinguishing the case on
those grounds fails to address the real issue. Virginia Historic is telling
because the disguised-sale analysis in that case “touches on the same
risk-reward analysis that lies at the heart of the bona fide-partner
determination.” (Appellant's Reply Br. at 9.) Under the disguised-sale
regulations, a transfer of “property ... by a partner to a partnership” and a
“transfer of money or other consideration ... by the partnership to the
partner” will be classified as a disguised sale if, based on the facts and
circumstances, “(i) [t]he transfer of money or other consideration would not
have been made but for the transfer of property; and (ii) [i]n cases in which
the transfers are not made simultaneously, the subsequent transfer is not
dependent on the entrepreneurial risks of partnership operations.” Treas. Reg.
§ 1.707-3(b)(1).
Thus, the disguised-sale analysis includes an examination of
“whether the benefit running from the partnership to the person allegedly acting
in the capacity of a partner is “dependent upon the entrepreneurial risks of
partnership operations.”” (Appellant's Reply Br. at 9 (quoting Treas. Reg. §
1.707-3(b)(1)(ii)).) That entrepreneurial risk issue also arises in the bona
fide-partner analysis, which focuses on whether the partner has a meaningful
stake in the profits and losses of the enterprise. Moreover, many of the facts
and circumstances laid out in the pertinent treasury regulations that “tend to
prove the existence of a [disguised] sale,” Treas. Reg. § 1.707-3(b)(2), are
also relevant to the bona fide-partner analysis here. See, e.g., id.§
1.707-3(b)(2)(i) (“That the timing and amount of a subsequent transfer [i.e.,
the HRTCs] are determinable with reasonable certainty at the time of an earlier
transfer [i.e., PB's capital contributions];”);id. § 1.707-3(b)(2)(iii) (“That the partner's
[i.e., PB's] right to receive the transfer of money or other consideration
[i.e., the HRTCs] is secured in any manner, taking into account the period
during which it is secured;”); id. §
1.707-3(b)(2)(iv) (“That any person [i.e., NJSEA] has made or is legally
obligated to make contributions [e.g., the Tax Benefits Guaranty] to the
partnership in order to permit the partnership to make the transfer of money or
other consideration [i.e., the HRTCs];”);id.
§ 1.707-3(b)(2)(v) (“That any person [i.e., NJSEA] has loaned or has
agreed to loan the partnership the money or other consideration [e.g.,
Completion Guaranty, Operating Deficit Guaranty] required to enable the
partnership to make the transfer, taking into account whether any such lending
obligation is subject to contingencies related to the results of partnership
operations;”). Although we are not suggesting that a disguised-sale
determination and a bona fide-partner inquiry are interchangeable, the analysis
pertinent to each look to whether the putative partner is subject to meaningful
risks of partnership operations before that partner receives the benefits which
may flow from that enterprise.
55
Although HBH was the
named obligor under the Tax Benefits Guaranty, the agreement provided that
“NJSEA ... shall fund any obligations of [HBH] to [PB]” under the Tax Benefits
Guaranty. (J.A. at 303.)
56
PB had no exposure
to the risk of excess construction costs, as the Completion Guaranty in the
AREA provided that NJSEA was obligated to pay all such costs. Additionally,
even after the renovation was completed, PB need not worry about any operating
deficits that HBH would incur, as NJSEA promised to cover any such deficits
through the Operating Deficit Guaranty. Furthermore, as detailed infra note 58,
PB ran no real risk of incurring any environmental liability in connection with
the East Hall renovation.
57
Although the
question of the existence of a risk is a factual issue we would review for
clear error, there was certainly no error in acknowledging that there were
risks associated with the rehabilitation. The relevant question, here, however,
is not the factual one of whether there was risk; it is the purely the legal
question of how the parties agreed to divide that risk, or, in other words,
whether a party to the transactions bore any legally significant risk under the
governing documents. That question — whether PB was subject to any legally
meaningful risk in connection with the East Hall rehabilitation — depends on
the AREA and related documents and hence is a question of law that we review de
novo.
58
The Tax Court
thought that “[PB] faced potential liability for environmental hazards from the
rehabilitation.” (J.A. at 43.) Specifically, it theorized that PB could be on
the hook for environmental liability (1) if environmental insurance proceeds
did not cover any such potential liability, and (2) NJSEA was unable to cover
that difference. In reality, however, PB was not subject to any real risk of
environmental liability because of the Environmental Guaranty and the fact that
PB had a priority distribution right to any environmental insurance proceeds
that HBH received (HBH's counsel at oral argument indicated that HBH carried a
$25 million policy). Moreover, PB received a legal opinion that it would not be
subject to any environmental liability associated with the East Hall
renovation.
59
Although we do not
“[p]ermit[] a taxpayer to control the economic destiny of a transaction with
labels” when conducting a substance-over-form inquiry, Schering-Plough, Corp.
v. United States, 651 F. Supp. 2d 219, 242 [104 AFTR 2d 2009-6157] (D.N.J.
2009), the labels chosen are indicative of what the parties were trying to
accomplish and thus those labels “throw[] light on [the parties'] true
intent,”Culbertson , 337 U.S. at 742.
60
As noted supra in
Section I.B.4.a, the Guaranteed Investment Contract was “sized to pay off” the
accrued but unpaid Preferred Return, as well as the outstanding balance on the
Investor Loan with accrued interest. (J.A. at 1211.)
61
It is true, of
course, that PB could not exercise its Put Option until seven years from the
date that the East Hall was placed in service. However, PB would have no
interest in exercising that option within the first five years anyway because
the HRTCs that PB received would be subject to recapture during that period.See
supra note 20.
62
The Construction Loan
called for annual interest-only payments until April 30, 2002, and thereafter,
called for annual installments of principal and interest that would fully pay
off the amount of the principal as then had been advanced by April 30, 2040.
Under the original principal amount of $57,215,733 with an interest rate of
0.1% over a 39-year period, and assuming no arrearage in the payment of
principal and interest, the annual installment of principal and interest would
be approximately $1.5 million.
63
To put it mildly,
the parties and their advisors were imaginative in creating financial
projections to make it appear that HBH would be a profit-making enterprise. For
example, after Sovereign said that it was “cautious about [Spectacor's
projections of net losses for HBH since] they might prove excessively
conservative” (J.A. at 793), and suggested that NJSEA “could explore shifting
the burden of some of [HBH's] operating expenses ... to improve results” (id.
at 804), Spectacor made two sets of revisions to HBH's five-year draft
projections that turned an annual average $1.7 million net operating loss to
annual net operating gains ranging from $716,000 to $1.24 million by removing
HBH's projected utilities expenses for each of the five years. Similarly, when
an accountant from Reznick informed Hoffman that the two proposed loans from
NJSEA to HBH “ha[d] been set up to be paid from available cash flow” but that
“[t]here was not sufficient cash to amortize this debt” (id. at 1160), Hoffman
instructed that accountant to remedy that issue by increasing the projection of
baseline revenues in 2002 by $1 million by adding a new revenue source of
$750,000 titled “naming rights,” and by increasing both “parking revenue” and
“net concession revenue” by $125,000 each (id. at 1196). Overall, although
Reznick projected near closing that HBH would generate an aggregate net
operating income of approximately $9.9 million for 2003 through 2007, HBH
actually experienced an aggregate net operating loss of over $10.5 million for
those five years.
Despite the smoke and mirrors of the financial projections,
the parties' behind-the-scenes statements reveal that they never anticipated
that the fair market value of PB's interest would exceed PB's accrued but
unpaid Preferred Return. (See id. at 1162 (pre-closing memo from NJSEA's
outside counsel to NJSEA that “[d]ue to the structure of the transaction,” the
fair market value would not come into play in determining the amount that PB
would be owed if NJSEA exercised its Call Option).) That admission is hardly
surprising because the substance of the transaction indicated that this was not
a profit-generating enterprise. Cf. Virginia Historic, 639 F.3d at 145 (noting
that the fact that “the Funds ... explicitly told investors to expect no
allocation of material amounts of ... partnership items of income, gain, loss,
or deduction” “point[ed] to the conclusion that there was no true
entrepreneurial risk faced by investors” (citation and internal quotation marks
omitted)).
64
Thus, contrary to
HBH's assertion, NJSEA effectively did have the “right to divest [PB] of its
interest in any income or gains from the East Hall.” (Appellee's Br. at 35.)
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