Debt arrangement did not give rise to an interest in partnership equity

The Tax Court rebuffed an attempt by the IRS to deny a partnership’s deduction for interest payments that effectively represented a sharing of the profits from the partnership’s real estate development activity with the lender.

Facts: Alex Deitch and Jonathan Barry formed West Town Square Investment Group LLC (WTS), classified as a partnership for federal income tax purposes, to acquire and develop a single piece of commercial real estate in Rome, Ga. To fund the acquisition and development, WTS entered into a series of agreements with Protective Life Insurance Co. (PLI), an unrelated third party.

First, under agreements collectively referred to as the “loan agreements,” PLI agreed to advance WTS the funds needed to acquire and develop the real estate project. The loan agreements provided PLI with a security interest in the acquired real estate and provided for a variable interest rate. PLI and WTS also entered into an “additional interest agreement,” which provided that WTS would pay PLI 50% of WTS’s net cash flow from the operation of the acquired real estate, along with 50% of the net gain from its ultimate sale, both as “interest” on the advances provided for under the loan agreements. The additional interest agreement and the loan agreements were closely interrelated, and PLI provided no separate capital or services under the additional interest agreement. Both the loan agreements and additional interest agreement indicated that the parties intended to form solely a debtor/creditor relationship and that nothing in the documents should be construed as creating a partnership, joint venture, or other arrangement of co-ownership.

Ultimately, WTS’s real estate development activity proved successful, and WTS paid 50% of the proceeds of the sale of the real estate to PLI under the additional interest agreement. On its partnership tax return for the year of the sale, WTS deducted the payments made to PLI under the additional interest agreement as interest expense and allocated the gain from the sale, along with the interest deduction, to its partners.

On audit, the IRS disallowed WTS’s interest deductions for amounts paid under the additional interest agreement.

Deitch and Barry each petitioned the Tax Court to contest the IRS’s disallowance of WTS’s interest deduction for the payments made under the additional interest agreement. The taxpayers and the IRS stipulated facts including that the loan agreements constituted genuine indebtedness, the loan agreements and additional interest agreement were the result of an arm’s-length transaction, and PLI did not own a member interest in WTS. The cases were consolidated for judgment.

Issues: The Tax Court described two prior situations in which courts and the IRS had evaluated whether a loan packaged with rights that provided the lender with significant exposure to the borrower’s potential profits should be classified as debt, equity, or bifurcated. In Farley Realty Corp., 279 F.2d 701 (2d Cir. 1960), aff ’g T.C. Memo. 1959-93, the IRS succeeded in disallowing a taxpayer’s interest deduction for an “appreciation” payment similar to the payment under the additional interest agreement at issue in Deitch. In that case, Z, an individual, loaned money to a corporation, C, to finance a portion of C’s purchase of real estate. Z was entitled to repayment of principal after a term of 10 years, a fixed interest payment on the amount advanced, and 50% of any appreciation in the value of the property. In Farley, the court sustained the IRS’s disallowance of an interest deduction for C’s payment to Z for 50% of the appreciation in the property, reasoning that Z’s right to share in the appreciation of the property was separable from his right to repayment of his loan and that the right to share in the property’s appreciation constituted an equity interest in the property.

In General Counsel Memorandum (GCM) 36,702, however, the IRS criticized the bifurcation approach previously supported by the IRS and adopted by the court in Farley. GCM 36,702 notes that the assertion that Z held an equity interest in the property was tantamount to claiming that Z was in a partnership with C. The GCM cited Culbertson, 337 U.S. 733 (1949), for the premise that a partnership is an organization for the production of income to which each partner contributes capital or services. However, since in Farley, Z’s entire “contribution” was made as a loan, the GCM concluded that there was no basis for finding that Z intended to join with the corporation as a partner in the present conduct of the enterprise and, thus, no basis for finding the existence of a partnership. Although conceding that the economic realities of the arrangements in Farley warranted recognition of both debt and equity elements, GCM 36,702 observed that there would be serious computational problems in allocating a single contribution to severable debt and equity interests. These computational problems could be avoided if the entire contribution was allocated to a single equity interest.

In Deitch, the IRS maintained the position described in GCM 36,702 and did not argue that PLI’s advances under the loan agreements and additional interest agreement should be bifurcated between an equity interest and a debt interest. The IRS’s primary argument for disallowing deductions for payments on the additional interest agreement was that the loan agreements and additional interest agreement constituted equity in their entirety.

In evaluating whether a particular instrument is treated as a partnership interest (i.e., equity) versus partnership debt, courts have often employed multifactor facts-and-circumstances tests similar to those used in debt-versusequity analyses for corporations (see Hambuechen, 43 T.C. 90 (1964)). The IRS argued that the 13 debt-versusequity factors typically employed by the Eleventh Circuit (the circuit to which an appeal of the case would lie) clearly demonstrated that PLI’s advance was made in respect of an equity interest and not debt (for instance, WTS’s thin capitalization and PLI’s entitlement to a share of the Rome property’s net profits could suggest that PLI held an equity investment).

However, the court first evaluated whether the arrangement between WTS and PLI gave rise to a partnership in which PLI might obtain an equity interest. Originally, the IRS had contended that the amount paid to PLI reduced the capital gain income of WTS (and of its partners) and was a nondeductible return on PLI’s equity interest in WTS. Subsequently, the IRS refined its position and asserted that the additional interest agreement created a joint venture between WTS and PLI so that the amount paid to PLI was a nondeductible return on PLI’s equity interest not in WTS but in a joint venture between WTS and PLI. If the IRS’s position were correct, then the payments made to PLI under the additional interest agreement might simply be allocations of partnership income rather than payments by WTS of deductible interest.

In evaluating whether PLI and WTS formed a partnership, the court looked to the factors set forth in Luna, 42 T.C. 1067, 1077 (1964), which are frequently cited in determining whether an economic relationship constitutes a partnership or whether a taxpayer is a partner in a partnership:

1. The agreement of the parties and their conduct in executing its terms;
2. The contributions, if any, that each party has made to the venture;
3. The parties’ control over income and capital and the right of each to make withdrawals;
4. Whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for its services contingent compensation in the form of a percentage of income;
5. Whether business was conducted in the joint names of the parties;
6. Whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that they were joint venturers;
7. Whether separate books of account were maintained for the venture; and
8. Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.

Holding: Of these factors, the court found that only the third weighed in favor of a finding that a partnership existed between WTS and PLI; i.e., that PLI’s rights under the loan documents and additional interest agreement resembled a preferred equity interest and gave it control over the income and capital associated with the Rome property that would remain in place even if the advances under the loan documents were refinanced and/or prepaid.

However, for the remaining factors, the legal form of the agreements between WTS and PLI and the parties’ stipulation that the loan agreements were properly treated as debt weighed heavily against finding any joint venture between WTS and PLI. For instance, in evaluating the second factor, the court found that PLI contributed little of value to a potential venture, in a manner similar to the IRS’s analysis in GCM 36,702. Despite PLI’s having advanced substantially all the capital used by WTS to develop the Rome property, because those advances were stipulated to be bona fide indebtedness for tax purposes, PLI could be viewed as providing nothing (capital or services) under the additional interest agreement in exchange for an equity interest in a partnership.

Considering the fourth Luna factor, the court noted that PLI was not obligated under the parties’ agreements to share in any operating losses with respect to the Rome property. Although PLI had an economic exposure to any decline in the value of the Rome property, this exposure arose in PLI’s capacity as a lender. Choosing to lean on the parties’ stipulation that the loan from PLI to WTS was genuine indebtedness, the court did not consider whether, if the parties’ stipulations were set aside, inadequate capitalization might be grounds to view PLI as holding an equity interest in the Rome property.

Ultimately, the court rejected the IRS’s argument that a partnership existed between WTS and PLI.

Observations: This case may provide taxpayers considering similar loan arrangements a hint as to how the IRS may seek to recharacterize those arrangements. The stipulations by the parties effectively served as concessions of significant issues in the case by the IRS and may limit the case’s direct applicability to other taxpayers.

Absent such a stipulation, presumably, taxpayers and the IRS would need to deal with a more rigorous debt-versus-equity analysis based on the facts and circumstances of the particular arrangement. For example, inadequate or “thin” capitalization might be taken into account as a factor that sways the analysis toward equity treatment.

■ Deitch, T.C. Memo. 2022-86

— Grace Kim, J.D., LL.M., and Whit Cocanower, J.D., LL.M., are with Grant Thornton LLP in Washington, D.C. To comment on this column, contact Paul Bonner, the JofA’s tax editor.