Historic court case shows the IRS could name you a lender, not an investor
You have done your due diligence, met with your CPA, obtained tax opinions from reputable law firms, and you have a duly executed partnership agreement. To top it off, you have just made a really big capital contribution. Absolutely you have a partnership. . . right? That is what Pitney Bowes(PB) thought until last month when the US Supreme Court refused to hear their appeal of the Third Circuit’s Court of Appeals ruling in Historic Boardwalk Hall LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012).
Background of the case
In 2000, New Jersey had started rehabilitation of the convention center where the Miss America Pageant has been held for many years, when an advisor told the convention authority that the rehabilitation qualified for the 20% federal, historic rehabilitation tax credit. Because the convention authority was a non-profit organization, the credit wasn’t going to be utilized by them. However, if a private equity partner were brought into the project, that partner would be able to take advantage of the credit. Based on the size of the project, the convention authority realized they could raise another $15 – $20 million by admitting an equity investor. The convention authority sent out requests for proposals for the purchase of the credits to a number of corporate investors, and Pitney Bowe’s proposal was accepted. PB agreed to invest $18 million in equity contributions, and another $1 million in investor loans, in return for a 99.9% ownership interest in the LLC that would own a sublease interest in the property.
Most of the terms of the agreement were not uncommon for commercial real estate development. For example, public – private joint ventures frequently occur in the rehabilitation of historic buildings. Special purpose partnerships and LLCs are commonly used to bring developers and investors together. Investors regularly insist that the operating agreements for these types of transactions contain a number of guarantees (Completion, Operating Deficit, Tax Benefit, and Environmental Hazard). Likewise, put and call options provide investors a degree of assurance that they will receive the benefit of their investment.
The unique aspect of this case is that most of the rehabilitation generating the tax credit had already been completed prior to PB’s admittance. Compounding the matter, the order of distributions in the operating agreement limited PB’s upside to a preferred distribution– irrespective of the actual operations of the venture. The ultimate effect of these facts was that PB had no real downside risk, nor did they have any real opportunity to benefit from the ongoing operations of the venture.
A difference of opinion
Upon audit the IRS noted this structure was not a true partnership, and PB was really a lender. The Tax Court disagreed and ruled the parties had formed a valid partnership, the assurances were necessary in order to attract an equity investor, and the structure therefore had objective economic substance. Unfortunately, the Third Circuit disagreed, concluding that PB was acting as a lender rather than an investor/partner. In the Third Circuit’s analysis PB did not have any true economic risk as the equity investment was made after the work was done, and PB had upside and downside protection.
Consider these 4 takeaways
1) This is primarily a partnership tax case, not a historic rehabilitation tax credit case.
2) When evaluating the validity of a partnership, courts look at the substance of the transaction, not just the written documents.
3) To be conservative, partnership agreements should provide both an upside and a downside risk.
4) When conducting your due diligence, it is critical that you consult knowledgeable tax professionals to help you evaluate whether the documents will accomplish what you intend.
Chadd Weisert is a Principal Accountant with Clark Schaefer Hackett and can be reached at [email protected].