The Tax Court held that a partnership created to transfer a historic rehabilitation credit to a taxable corporation was valid and that the transfer and the corporation’s participation in the partnership had objective economic substance.
The state of New Jersey in 1992 authorized the New Jersey Sports and Exposition Authority (NJSEA) to build and operate a new convention center on Atlantic City’s famous Boardwalk and to rehabilitate and operate the old one, subsequently known as Historic Boardwalk Hall. The rehabilitation would generate a federal tax credit under section 47, which allows a credit of 10% of qualified expenditures of rehabilitating a building built before 1936, or 20% of qualified expenditures to rehabilitate a structure listed in the National Register of Historic Places or certified as having historic significance within a registered historic district.
To generate the funds to fulfill the project, the NJSEA created Historic Boardwalk Hall (HBH), an LLC treated for tax purposes as a partnership, with business equipment and services company Pitney Bowes Inc. as investor member. HBH’s operating agreement allocated 100% of the section 47 credit to Pitney Bowes, plus a 3% preferred return. The parties also signed a contract that contained future purchase options. One option allowed the NJSEA to purchase Pitney Bowes’ interest during the 12-month period following the section 47 holding period (60 months after the property is placed in service). A second option gave Pitney Bowes the right to demand that the NJSEA purchase its interest during the 12 months following 24 months after the expiration of the holding period. Both options’ prices were set to provide Pitney Bowes a return of its investment plus the 3% preferred return. (Pitney Bowes would have already received the tax benefit from the section 47 credit.) HBH was required to purchase a contract from a bank that guaranteed the funds to fulfill the purchase options.
The government denied Pitney Bowes the tax credit on the grounds that the transaction lacked economic substance and that HBH was a sham. In addition, the government contended that Pitney Bowes was not a partner, since its contribution was actually a loan, and that the NJSEA never transferred ownership of the hall to HBH.
The court first considered whether the transaction had economic substance, that is, whether it had both a profit potential and a business purpose. The government argued that the project would not be profitable to Pitney Bowes without the tax credit, and therefore, the project did not have a valid nontax profit potential. The court rejected this argument on the grounds that Congress enacted section 47 to stimulate otherwise unprofitable rehabilitation projects, and therefore the credit should be included in the analysis. Combining the credit with the 3% preferred return was sufficient, according to the court, to provide a profit potential. Next, the court determined the subjective business purpose requirement was met, because the partnership was created to allow Pitney Bowes to invest in the hall’s rehabilitation. Given that the rehabilitation was necessary for the hall to generate any future revenue, the court concluded that the rehabilitated hall would be a viable business location and that Pitney Bowes was an investor in the business.
The government pointed out that the original investment documents referred to the transaction as a “sale of tax credits.” The court ignored this statement on the grounds that the true substance of the transaction was an investment and not a sale of credits. The government also argued that Pitney Bowes was not a partner. The court turned to the Supreme Court’s decision in Commissioner v. Culbertson (337 U.S. 733 (1949)) for the factors to decide whether a partnership had been formed. These factors include the agreement, the conduct of the parties and the actual control of income. Based on these factors, the court concluded that the NJSEA and Pitney Bowes joined to conduct a business enterprise partnership, despite the fact that the NJSEA ran the operation and Pitney Bowes simply made capital contributions. As for the government’s related argument that the cash given to HBH by Pitney Bowes was a loan and not a capital contribution, the court concluded it was not a loan, because Pitney Bowes was not guaranteed an annual payment but rather had to wait until HBH was profitable or for the NJSEA to repurchase its interest to receive a return on its investment.
The court also rejected the government’s argument that the NJSEA did not sell the hall to HBH. The government pointed to the fact that the NJSEA was individually liable for the expenses of rehabilitation and had an absolute right to reacquire the property, thereby preventing the transfer of the benefits and detriments of ownership. The court disagreed, stating first that the IRS’ contention that the NJSEA remained liable for the rehabilitation and expenses of the hall was erroneously based on statements made by the NJSEA to third parties. Further, the court found that the purchase agreement did not disqualify the transaction, because the purpose of the transaction was to allow Pitney Bowes to invest in the rehabilitation project and earn the section 47 rehabilitation credits. The court concluded that the recapture provisions of the holding period for the section 47 credit were a sufficient disincentive and deterrent to a premature buyout of Pitney Bowes’ interest, so that the purchase option was not contrary to the purpose of the rehabilitation credit.
In addition, the government argued that the anti-abuse rule of Treas. Reg. § 1.701-2(b) allowed it to reject the claimed existence of a partnership. The court disagreed with the use of the anti-abuse rule because, it said, the transaction had economic substance and section 47 is specifically designed to override the normal rules on accurate reflection of income.
This is the second taxpayer victory in the Tax Court in recent years allowing a taxable entity as a partner to acquire a historic tax credit and upholding the validity of the partnership and the transaction. In Virginia Historic Tax Credit Fund 2001 LP v. Commissioner (TC Memo 2009-295, cited in the instant case), the Tax Court upheld the partnership status of a marketed fund and two lower-tier partnerships that together had hundreds of investor partners that shared in Virginia state historic rehabilitation tax credits. The IRS’ appeal of that decision is currently before the Fourth Circuit (docket no. 10-1333).
By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.
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