Let’s talk about an esoteric tax topic: selling tax credits.
You didn’t know it could be done, did you? To be fair, we have to divide this discussion between federal tax credits and state tax credits. Some states by statute allow the sale of their tax credits. Massachusetts will allow the sale its “motion picture” tax credit and Colorado will allow its “conservation easement” tax credit.
The federal rules are a bit different. These transactions usually involve the use of partnerships and LLCs, and the purchaser takes on the role of a “partner” in the deal. The business problem commonly present is that the purchaser (the “investor”) has little interest in the project other than the credit and a great deal of interest in getting out of the project as soon as possible. It is somewhat like a Kardashian marriage. There are technical problems lurking here, not the least of which is the IRS determining that a genuine partnership never existed. Tax planners and attorneys have stretched this specialized area to unbelievable lengths, and – in most cases – the IRS has gone along. Congress has said that it wants to incentivize the construction of low-income housing, for example, and to do so it has provided a tax credit. Say that someone decides to develop low-income housing, and to make the deal work that someone decides to “sell” the credit. If the IRS come in and nixes the deal, there are negative consequences - to the participants, to the industry and to the advisors to the industry. The IRS may also be called in before a Congressional tax committee for a lecture on overreach.
Which makes the recent decision in Historic Boardwalk Hall LLC v Commissioner unnerving to tax pros. The property in question was the Atlantic Center convention center (known as the Historic Boardwalk Hall or the East Hall). We know it as the home of the Miss America pageant. The Boardwalk was owned by the New Jersey Sports and Exposition Authority (NJSEA). The NJSEA solicited bids for the historic rehabilitation tax credit. The winner was Pitney Bowes.
They put a deal together. NJSEA would be the general partner with a 0.1% partnership interest. Pitney Bowes would be the limited partner with a 99.9% partnership interest, including a 99.9% right to profits, losses and tax credits. Goodness knows that NJSEA – a government agency – did not need tax credits. Government agencies do not pay tax.
Pitney Bowes agreed to make capital contributions of approximately $16 million. Each installment depended on attaining certain benchmarks. Pitney Bowes was to receive 3% preferred return on its cash investment and approximately $18 million in historic tax credits
In case Pitney Bowes and the NJSEA had a falling-out, the NJSEA could buy-out Pitney Bowes for an amount equal to the projected tax benefits and cash distributions due them.
NJSEA also had a call option to buy-out Pitney Bowes at any time during the 12-month period beginning 60 months after East Hall was placed in service. Pitney Bowes decided to make certain on this point, and they included a put option to force NJSEA to buy them out during the 12-month period beginning 84 months after East Hall was placed in service.
To make sure they had beaten this horse to death, Pitney Bowes also obtained a “tax benefits guaranty” agreement. This agreement assured Pitney Bowes that, at minimum, it would receive the projected tax benefits from the project. The guarantee also indemnified Pitney Bowes for any taxes, penalties, interest and legal fees in case of an IRS challenge.
The IRS challenged. Its principal charge was simple: the partnership had no economic substance. That arrangement was as likely as Charlie Sheen and Chuck Lorre spending a golf weekend together. The Tax Court did not see it the IRS’ way and decided in favor of Pitney Bowes. Not deterred, the IRS appealed to the Third Circuit.
The Third Circuit reversed the Tax Court and decided in favor of the IRS.
More specifically, the Circuit Court decided that Pitney Bowes had virtually no downside risk. Pitney Bowes was not required to make capital contributions until a certain amount of rehabilitation work had been done. This meant they knew they would be receiving an equivalent amount of tax credits before writing any checks. Then you have the tax benefits guaranty, which gave them a “get out of jail free” card.
The Court did not like that the funds contributed by Pitney Bowes were unnecessary to the project. NJSEA had been appropriated the funds before it began the renovation. NJSEA had been approached by a tax consultant with a “plan” to generate additional funds by utilizing federal historic tax credits.
Still, Pitney Bowes could argue that it had upside potential. That is a powerful argument in favor of the validity of a partnership arrangement. Wait, Pitney Bowes could not argue that it had any meaningful upside potential. While It was entitled to 99.9% of the cash flow, Pitney Bowes had to wait until all loan payments, including interest, as well as any operating deficits had been repaid. The put and call options also did not help. NJSEA could call away any upside potential from Pitney Bowes. The Court decided Pitney Bowes had no skin in the game.
This tax pro’s opinion: The deal was over-lawyered. The problem is that many of these deals are constructed in a very similar manner, which fact has thrown the industry (rehabilitation credit, low-income housing credit, certain energy credits, etc.) and their tax advisors into tumult. The advisors have to back this truck up a little, at least enough to giving the illusion that a valid partnership is driving the transaction.
Do not feel bad for Pitney Bowes. Remember that they have a tax indemnity agreement with NJSEA. I wonder how much this tax case just cost the state of New Jersey.
