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Chief Counsel Memo Reveals IRS Seeks to Build on its Recent Victories in Partnership Cases


The IRS Chief Counsel's Office released a Field Counsel memorandum rejecting the use of a partnership to allow new investors to access historic rehabilitation tax credits that otherwise would have gone unused. The memorandum argued that the partnership lacked economic substance and was a sham partnership because the new partner had no meaningful stake in the partnership when it came to either risk or reward. This memorandum, which follows the Third Circuit's decision rejecting a rehabilitation tax credit structure in Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3rd Cir. 2012), demonstrates that the IRS continues to scrutinize partnership structures designed to allocate tax credits to partners that the IRS views as taking on little of the risk associated with the activities generating the credits. Moreover the IRS's technical arguments build on the IRS's victories in TIFD III-E, Inc. v. United States, 459 F.3d 200 (2nd Cir. 2006) ("Castle Harbour"), VA Historic Tax Credit Fund 2001 v. Commissioner, 639 F.3d 129 (4th Cir. 2011), and Southgate Master Fund, LLC v. United States, 659 F.3d 466 (5th Cir. 2011), where the IRS successfully recharacterized or disregarded purported partnership interests that lacked the entrepreneurial risks typically associated with a capital interest in a partnership.    

In the situation discussed in the memo, Company B, through a subsidiary, owned a historic property, the rehabilitation of which potentially qualified for the I.R.C. § 47 rehabilitation credit. Company B, unable to benefit from the rehabilitation credits itself, hired a promoter to syndicate the credits by forming a partnership with an investor (the "HTC Partnership"). The promoter then formed a fund —referred to in the Chief Counsel memorandum as "the Fund"—to serve as the investor. The Fund was in a position to take advantage of the tax credits that the HTC Partnership would receive. 

The Chief Counsel memorandum concluded that the Fund's use of the credits was precluded by the sham nature of its partnership interest and of the partnership in general. Specifically, the Chief Counsel found that 1) the Fund was not a bona fide partner in HTC Partnership; 2) HTC Partnership was a sham; and 3) HTC Partnership was not, in substance, the owner of the historic property.

In finding that the Fund was not a bona fide partner, the Chief Counsel's Office relied on the Second Circuit's interpretation, in Castle Harbour, of the test set forth by the Supreme Court in Commissioner v. Culbertson, 337 U.S. 733, 742 (1949). In Culbertson, the Court stated that a partnership exists where the parties, "in good faith and acting with a business purpose, intend to join together in the present conduct of an enterprise." The Second Circuit, in Castle Harbour, applied this test to disregard the partner status of two banks that purported to join a partnership, but held partnership interests that the court characterized as effectively debt. In the memorandum, the IRS pointed to the "key inquiry" in Castle Harbour, "whether the purported partner had a meaningful stake in the success or failure of the enterprise."

Applying these principles to the facts in the Chief Counsel memorandum, the IRS found that the Fund was not a bona fide partner because it had no "meaningful stake" in either the downside risk or the upside potential of the historic preservation venture. The IRS pointed to several features of the partnership structure that led it to this conclusion:

  • The Fund's receipt of the tax credits was virtually assured because its capital contributions came mainly after the rehabilitation was finished.
  • Company B was responsible for any excess development costs, operating deficits, or liabilities.
  • The Fund's capital contributions could be adjusted, or its partnership interest sold back to Company B, to reflect changes in the historic tax credits.
  • The Fund's return on its preferred interest was guaranteed by Company B and Company B shareholders.
  • Although the Fund held a nominal interest in HTC Partnership's residual profits, this residual interest came after rent, loan repayments, development fees, and other charges and distributions designed to siphon off any net cash flow.
  • Various provisions, including options, of the agreements effectively collared the Fund's return at the priority return, eliminating the Fund's ability to share in capital appreciation of the HTC Partnership. Company B was managing member of the partnership while the Fund did not take part in the management or control of the partnership and did not have authority to bind the partnership.

The IRS also found that the partnership itself was a sham. Here, the IRS relied on the Fifth Circuit's opinion in Southgate Master Fund, for the proposition that courts have tended to focus on "1) whether the formation of the partnership made sense from an economic standpoint and 2) whether there was otherwise a legitimate business purpose for the use of the partnership form." The IRS concluded that "the Fund and Company B did not have the requisite intent to share in the economic benefits and risks of the project as partners in a true partnership arrangement would." The IRS also found that the partnership served no non-tax business purpose: the Fund's sole aim, it stated, was to get the historic tax credits. Chief Counsel's picking up this second factor from the Southgate decision could be significant; taxpayers have generally assumed that the selection of a form for an entity (e.g., partnership vs. corporation) was largely elective. The Southgate court's discussion of a business purpose for selection of the partnership form has raised some alarm bells. 

The IRS specifically distinguished Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), in which the Ninth Circuit held that a sale-leaseback transaction involving solar energy equipment was not a sham transaction notwithstanding that the investment had a negative return before taking tax credits into account. The transaction in Sacks, the Chief Counsel memorandum argued, had independent economic substance and "did not become a sham just because its profitability was based on after-tax instead of pre-tax projections." In contrast, in the present case, "although Congress clearly intended to encourage [historic preservation], it cannot be said that the structure of this transaction . . . is so unmistakably within the contemplation of congressional intent as to warrant departure from the normal application of the sham-partnership doctrine." The IRS's characterization of its argument as an attack on the partnership structure, rather than an attack on the creditable activities, is reminiscent of the IRS argument in Historic Boardwalk Hall

Lastly, the IRS concluded that HTC partnership was not the owner of the historic property, because the partnership did not truly obtain both the benefits and burdens of ownership of the property. Company B and its related entities bore the burdens, risks, and ownership responsibilities both before and after the partnership was created, the IRS argued. The IRS raised a similar tax ownership argument in Historic Boardwalk Hall.


IRS Circular 230 Disclosure: To comply with certain U.S. Treasury regulations, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication, including attachments, was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding any penalties that may be imposed on such taxpayer by the Internal Revenue Service. In addition, if any such tax advice is used or referred to by other parties in promoting, marketing, or recommending any partnership or other entity, investment plan, or arrangement, then (i) the advice should be construed as written in connection with the promotion or marketing by others of the transaction(s) or matter(s) addressed in this communication and (ii) the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor. To the extent that a state taxing authority has adopted rules similar to the relevant provisions of Circular 230, use of any state tax advice contained herein is similarly limited.

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