OPINION OF THE COURT
JORDAN, Circuit Judge.
TABLE OF CONTENTS
Page I. Background .........................................................429 A. Background of the HRTC Statute ................................429 B. Factual Background of the East Hall Renovation ................432 1. NJSEA Background .........................................432 2. Commencement of the East Hall Renovation .................432 3. Finding a Partner ........................................433 a) The Proposal from Sovereign Capital Resources .......433 b) The Initial and Revised Five-Year Projections .......434 c) Confidential Offering Memorandum ....................435 d) Selection of Pitney Bowes ...........................436 e) Additional Revisions to Financial Projections .......436 4. Closing ..................................................437 a) The HBH Operating Agreement .........................437 b) Lease Amendment and Sublease ........................437 c) Acquisition Loan and Construction Loan ..............440 d) Development Agreement ...............................440 e) Purchase Option and Option to Compel ................441 f) Tax Benefits Guaranty ...............................441 5. HBH in Operation .........................................442 a) Construction in Progress ............................442 b) Post-Construction Phase .............................443 6. The Tax Returns and IRS Audit ............................444 C. The Tax Court Decision ........................................445 II. Discussion .........................................................447 A. The Test ......................................................449 B. The Commissioner's Guideposts .................................449 C. Application of the Guideposts to HBH ..........................453 1. Lack of Meaningful Downside Risk .........................455 2. Lack of Meaningful Upside Potential ......................459 3. HBH's Reliance on Form over Substance ....................460 III. Conclusion .........................................................463
This case involves the availability of federal historic rehabilitation tax credits ("HRTCs") in connection with the restoration of an iconic venue known as the "East Hall" (also known as "Historic Boardwalk Hall"), located on the boardwalk in Atlantic City, New Jersey. The New Jersey Sports and Exposition Authority
A. Background of the HRTC Statute
We begin by describing the history of the HRTC statute. Under Section 47 of the Internal Revenue Code of 1986, as amended (the "Code" or the "I.R.C."), a taxpayer is eligible for a tax credit equal to "20 percent of the qualified rehabilitation expenditures ["QREs"
The idea of promoting historic rehabilitation projects can be traced back to the enactment of the National Historic Preservation Act of 1966, Pub. L. No. 89-665, 80 Stat. 9156 (1966), wherein Congress emphasized the importance of preserving "historic properties significant to the Nation's heritage," 16 U.S.C. § 470(b)(3). Its purpose was to "remedy the dilemma that `historic properties significant to the Nation's heritage are being lost or substantially altered, often inadvertently, with increasing frequency.'" Pye v. United States, 269 F.3d 459, 470 (4th Cir.2001) (quoting 16 U.S.C. § 470(b)(3)). Among other things, the National Historic Preservation Act set out a process "which require[d] federal agencies with the authority to license an undertaking `to take into account the effect of the undertaking on any ... site ... that is ... eligible for inclusion in the National Register' prior to issuing the license." Id. (quoting 16 U.S.C. § 470f). It also authorized the Secretary of the Interior to "expand and maintain a National Register of Historic Places." 16 U.S.C. § 470a(a)(1)(A).
The Tax Reform Act of 1976 furthered the goals of the 1966 legislation by creating new tax incentives for private sector investment in certified historic buildings. See Tax Reform Act of 1976, Pub. L. No. 94-455, 90 Stat. 1520 (1976). The pertinent provisions of the 1976 Act indicate that Congress wanted to encourage the private sector to restore historic buildings, and, to provide that encouragement, it established incentives that were similar to the tax incentives for building new structures. See, e.g., 122 Cong. Rec. 34320 (1976). Specifically, to equalize incentives affecting the restoration of historic structures and the construction of new buildings, it included a provision allowing for the amortization of rehabilitation expenditures over five years, or, alternatively, an accelerated method of depreciation with respect to the entire depreciable basis of the rehabilitated property. See I.R.S. Publication, Rehabilitation Tax Credit, at 1-2 (Feb. 2002), available at http://www.irs.gov/pub/irs-mssp/rehab.pdf (hereinafter referred to as "IRS-Rehab").
The Revenue Act of 1978 went further to incent the restoration of historic buildings. It made a 10% rehabilitation credit available in lieu of the five-year amortization period provided by the 1976 Act. See Revenue Act of 1978, Pub. L. No. 95-600, 92 Stat. 2763 (1978); see also IRS-Rehab, at 1-2. In 1981, Congress expanded the rehabilitation credit to three tiers, so that a taxpayer could qualify for up to a 25% credit for certain historic rehabilitations. See Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, 95 Stat. 172 (1981); see also IRS-Rehab, at 1-2.
The Tax Reform Act of 1986 made extensive changes to the tax law, including the removal of many tax benefits that had been available to real estate investors. See Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085 (1986); see also Staff of J. Comm. on Tax'n, 99th Cong., General Explanation of the Tax Reform Act of 1986 (Comm. Print. 1987) (hereinafter referred to as "General Explanation of
General Explanation of TRA 86, at 149.
Evidently mindful of how the tax incentives it had offered might be abused, Congress in 2010 codified the "economic substance doctrine," which it defined as "the common law doctrine under which tax benefits... with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose."
Staff of J. Comm. on Tax'n, Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010," as amended, In Combination with the "Patient Protection and Affordable Care Act," at 152 n.344 (Comm. Print 2010) (emphasis added). In sum, the HRTC statute is a deliberate decision to skew the neutrality of the tax system to encourage taxable entities to invest, both in form and substance, in historic rehabilitation projects.
B. Factual Background of the East Hall Renovation
1. NJSEA Background
In 1971, the State of New Jersey formed NJSEA to build, own, and operate the Meadowlands Sports Complex in East Rutherford, New Jersey. The State legislature expanded NJSEA's jurisdiction in 1992 to build, own, and operate a new convention center in Atlantic City and to acquire, renovate, and operate the East Hall. Completed in 1929, the East Hall was famous for hosting the annual Miss America Pageant, and, in 1987, it was added to the National Register of Historic Places as a National Historic Landmark.
In October 1992, before renovations on the East Hall began, NJSEA obtained a 35-year leasehold interest in the property for $1 per year from the owner, the Atlantic County Improvement Authority. About a month later, NJSEA entered into an agreement with the Atlantic City Convention Center Authority, the then-operator of the East Hall, to operate both the East Hall and the new convention center. In July 1995, NJSEA and the Atlantic City Convention Center Authority handed over management responsibility for both the East Hall and the yet-to-be-completed convention center to a private entity, Spectacor Management Group ("Spectacor").
2. Commencement of the East Hall Renovation
Once construction started on the new convention center in the early 1990s, NJSEA began planning for the future of the East Hall and decided to convert it into a special events facility. That conversion was initially anticipated to cost $78,522,000. Renovations were to be performed in four phases, with the entire project expected to be completed in late 2001.
The renovation project began in December of 1998. By that time, NJSEA had entered into agreements with the New Jersey Casino Reinvestment Development Authority
The first two phases of the renovation were completed prior to the Miss America Pageant held in September 1999, and Phase 3 began the following month. Through 1999, NJSEA had entered into rehabilitation contracts for approximately $38,700,000, and had expended $28,000,000 of that amount. Also at about that time, the estimate of the total cost of the project increased to $90,600,000. NJSEA's 1999 annual report stated that the Casino Reinvestment Development Authority had agreed to reimburse NJSEA for "all costs in excess of bond proceeds for the project." (Id. at 1714.) Thus, by the end of 1999, between the proceeds it had received from the bond issuance and funds provided — or to be provided — by the Casino Reinvestment Development Authority, NJSEA had assurances that the East Hall rehabilitation project was fully funded.
3. Finding a Partner
a) The Proposal from Sovereign Capital Resources
In August 1998, a few months prior to the beginning of renovations on the East Hall, Paul Hoffman from Sovereign Capital Resources ("Sovereign")
Hoffman next sketched out the proposed transactions that would allow NJSEA to bring an investor interested in HRTCs into co-ownership of the East Hall and yet provide for NJSEA to "retain its long-term interests in the [East Hall]." (Id. at 693.) First, NJSEA would sublease its interest in the East Hall to a newly created partnership in which NJSEA would be the general partner and a corporate investor would be the limited partner. The
Hoffman then provided a valuation of the HRTCs. He estimated that NJSEA could expect an investor to contribute approximately $0.80 to $0.90 per each dollar of HRTC allocated to the investor. In valuing the HRTCs, Hoffman "assume[d] that NJSEA would like to minimize the cash distribution to the investor and retain long-term ownership of [the East Hall]." (Id.) He also listed four "standard guarantees" that "[i]nvestors in the tax credit industry" would "require" as part of the transaction: (1) a construction completion guaranty; (2) an operating deficit guaranty; (3) a tax indemnity; and (4) an environmental indemnity. (Id. at 696.) Additionally, Hoffman noted that "the investor will expect that either NJSEA or the State of New Jersey be obligated to make debt service on the bond issuance if operating revenue is insufficient to support the debt payments." (Id.)
NJSEA decided to further explore the benefits described by Sovereign. In March 1999, NJSEA issued a request for proposal (as supplemented by an addendum on April 30, 1999, the "RFP") from "qualified financial advisors ... in connection with a proposed historic rehabilitation tax credit transaction ... relating to the rehabilitation of the East Hall." (Id. at 710.) The RFP provided that the selected candidate would "be required to prepare a Tax Credit offering Memorandum, market the tax credits to potential investors and successfully close a partnership agreement with the proposed tax credit investor." (Id. at 721.) In June 1999, after receiving four responses, NJSEA selected Sovereign as its "[f]inancial [a]rranger" for the "Historic Tax Credit transaction." (Id. at 750.)
b) The Initial and Revised Five-Year Projections
In September 1999, as the second phase of the East Hall renovation had just been completed, Spectacor, as the East Hall's operator, produced draft five-year financial projections for the East Hall beginning for the 2002 fiscal year.
Approximately two months later, Sovereign received revised estimates prepared by Spectacor. Those pro forma statements projected much smaller net operating losses, ranging from approximately $396,000 in 2002 to $16,000 in 2006. Within two weeks, Spectacor made additional revisions to those projections which resulted in estimated net operating income for those five years, ranging from approximately $716,000 in 2002 to $1.24 million in 2006. About 90% of the remarkable financial turnaround the East Hall thus was projected to enjoy on paper was due to the removal of all projected utilities expenses for each of the five years ($1 million in 2002, indexed for 3% inflation each year thereafter). When the accountants for the project, Reznick, Fedder & Silverman ("Reznick"), included those utilities expenses in their compiled projections one week later, Sovereign instructed them to "[t]ake [the] $1MM Utility Cost completely out of Expenses, [because] NJSEA [would] pay at [the] upper tier and [then] we should have a working operating model." (Id. at 954.)
c) Confidential Offering Memorandum
On March 16, 2000, Sovereign prepared a 174-page confidential information memorandum (the "Confidential Memorandum" or the "Memo") which it sent to 19 potential investors and which was titled "The Sale of Historic Tax Credits Generated by the Renovation of the Historic Atlantic City Boardwalk Convention Hall." (Id. at 955.) Although the executive summary in the Confidential Memorandum stated that the East Hall renovation would cost approximately $107 million, the budget attached to the Memo indicated that the "total construction costs" of the project were $90,596,088. (Id. at 1035). Moreover, the Memo stated that "[t]he rehabilitation [was] being funded entirely by [NJSEA]." (Id. at 962). The difference between the $107 million "estimated ... renovation" (id. at 961), and the "total construction costs" of $90,596,088 was, as the Memo candidly put it, the "[p]roceeds from the sale of the historic tax credits" (id. at 963). The Memo did not contemplate that those proceeds, estimated to be approximately $16,354,000, would be applied to "total construction costs" but rather indicated that the funds would be used for three things: (1) payment of a $14,000,000 "development fee" to NJSEA; (2) payment of $527,080 in legal, accounting, and syndication fees related to the tax-credit transaction; and (3) the establishment of a $1,826,920 working capital reserve.
The Memo also provided financial projections through 2009. Those projections assumed that the investor would receive a 3% priority distribution (the "Preferred Return") from available cash flow on its $16,354,000 contribution, which contemporaneous NJSEA executive committee notes described as "required by tax rules." (Id. at 1135.) The financial projections provided for sufficient net operating income
d) Selection of Pitney Bowes
Four entities, including PB, responded to the Confidential Memorandum and submitted offers "regarding the purchase of the historic tax credits anticipated to be generated by the renovation" of the East Hall. (Id. at 1143.) In a May 2000 letter supplementing its offer, PB recommended that NJSEA fund the construction costs through a loan to the partnership, rather than in the form of capital contributions, so that "the managing member could obtain a pre-tax profit and therefore the partnership would be respected as such for U.S. tax purposes." (Id. at 1145.)
On July 13, 2000, PB and NJSEA executed a letter of intent ("LOI") reflecting their agreement that PB would make "capital contributions"
e) Additional Revisions to Financial Projections
Prior to the closing on PB's commitment to purchase a membership interest in HBH, an accountant from Reznick who was preparing HBH's financial projections, sent a memo to Hoffman indicating that the two proposed loans from NJSEA to HBH "ha[d] been set up to be paid from available cash flow" but that "[t]here was not sufficient cash to amortize this debt." (Id. at 1160.) To remedy the problem, Hoffman instructed the accountant to increase the projection of baseline revenues in 2002 by $1 million by adding a new revenue source of $750,000 titled "naming
Also prior to closing, by moving certain expenditures from the "non-eligible" category to the "eligible" category,
On September 14, 2000,
a) The HBH Operating Agreement
The primary agreement used to admit PB as a member of HBH and to restate HBH's governing provisions was the amended and restated operating agreement (the "AREA"). The AREA stated that the purpose of HBH was "to acquire, develop, finance, rehabilitate, own, maintain, operate, license, lease, and sell or otherwise dispose of a[n] 87-year subleasehold interest in the Historic East Hall ... for use as a special events facility." (Id. at 157.) The AREA provided that PB would hold a 99.9% ownership interest as the "Investor Member," and NJSEA would hold a 0.1% ownership interest as the "Managing Member." The AREA also provided that PB, in addition to its $650,000 initial contribution, would make three additional capital contributions totaling $17,545,797 (collectively, with the initial capital contribution, $18,195,797). Those additional contributions were contingent upon the completion of certain project-related events, including verification of the amount of rehabilitation costs that had been incurred to date that would be classified as QREs to generate HRTCs. According to Section 5.01(c)(v) of the AREA, each of the four contributions were to be used by HBH to pay down the principal of
The AREA also set forth a detailed order of priority of distributions from HBH's cash flow. After distributing any title insurance proceeds or any environmental insurance proceeds to PB, cash flow was to be distributed as follows: (1) to PB for certain repayments on its $1.1 million "Investor Loan" contemplated by the LOI; (2) to PB and NJSEA, in accordance with their respective membership interests, until PB received an amount equal to the current and any accrued and unpaid 3% Preferred Return as mentioned in the LOI; (3) to PB for an amount equal to the income tax liability generated by income earned by HBH that was allocated to PB, if any; (4) to NJSEA for an amount equal to the current and any accrued and unpaid payments of interest and principal owed on the Acquisition Loan and the Construction Loan; (5) to NJSEA in an amount equal to any loans it made to HBH pursuant to the Operating Deficit Guaranty; and (6) the balance, if any, to PB and NJSEA, in accordance with their respective membership interests.
Additionally, the AREA provided the parties with certain repurchase rights and obligations.
To protect PB's interest, Section 8.08 of the AREA mandated that NJSEA obtain a guaranteed investment contract (the "Guaranteed Investment Contract").
b) Lease Amendment and Sublease
NJSEA also executed several documents that purported to transfer ownership of its interest in the East Hall to HBH. First, NJSEA entered into an amended and restated agreement with its lessor, Atlantic County Improvement Authority, to extend the term of NJSEA's leasehold interest in the East Hall from 2027 to 2087.
c) Acquisition Loan and Construction Loan
As contemplated in the LOI, NJSEA provided financing to HBH in the form of two loans. First, NJSEA and HBH executed a document setting forth the terms of the Acquisition Loan, reflecting NJSEA's agreement to finance the entire purchase price that HBH paid to NJSEA for the subleasehold interest in the East Hall, which amounted to $53,621,405. That amount was intended to represent the construction costs that NJSEA had incurred with respect to the East Hall renovation prior to PB making its investment in HBH. The Acquisition Loan provided for HBH to repay the loan in equal annual installments for 39 years, beginning on April 30, 2002, with an interest rate of 6.09% per year; however, if HBH did not have sufficient cash available to pay the annual installments when due, the shortfall would accrue without interest and be added to the next annual installment. HBH pledged its subleasehold interest in the East Hall as security for the Acquisition Loan.
Second, NJSEA and HBH executed a document setting forth the terms of the Construction Loan, reflecting NJSEA's agreement to finance the projected remaining construction costs for renovating the East Hall, to be repaid by HBH in annual installments for 39 years, beginning on April 30, 2002, at an annual interest rate of 0.1%. Although the parties only anticipated $37,921,036 of additional construction costs,
d) Development Agreement
HBH and NJSEA also entered into a development agreement in connection with the ongoing rehabilitation of the East Hall. The agreement stated that HBH had "retained [NJSEA as the developer] to use its best efforts to perform certain services with respect to the rehabilitation ... of the [East] Hall ... including renovation of the [East] Hall, acquisition of necessary building permits and other approvals, acquisition of financing for the renovations, and acquisition of historic housing credits
e) Purchase Option and Option to Compel
Concurrent with the AREA and the sublease agreement, PB and NJSEA entered into a purchase option agreement (the "Call Option") and an agreement to compel purchase (the "Put Option"). The Call Option provides NJSEA the right to acquire PB's membership interest in HBH, and the Put Option provides PB the right to require NJSEA to purchase PB's membership interest in HBH. Under the Call Option, NJSEA had the right to purchase PB's interest in HBH at any time during the 12-month period beginning 60 months after the East Hall was placed in service.
f) Tax Benefits Guaranty
As contemplated by the Confidential Memorandum, HBH and PB entered into a tax benefits guaranty agreement (the "Tax Benefits Guaranty"). Pursuant to that guaranty, upon a "Final Determination of a Tax Benefits Reduction Event,"
5. HBH in Operation
a) Construction in Progress
Pursuant to an Assignment and Assumption Agreement executed on the day of closing between NJSEA, as assignor, and HBH, as assignee, various agreements and contracts — including occupancy agreements, construction contracts, architectural drawings, permits, and management and service agreements — were assigned to HBH. HBH opened bank accounts in its name, and it deposited revenues and paid expenses through those accounts.
As previously indicated, supra Section I.B.4.a, PB's capital contributions were, pursuant to the AREA, supposed to be used to pay down the Acquisition Loan. Although that did occur, any decrease in the balance of the Acquisition Loan was then offset by a corresponding increase in the amount of the Construction Loan. As the Tax Court explained:
(Id. at 17-18.) Also as discussed above, supra Section I.B.4.c, the parties set the upper limit of the Construction Loan approximately $19.3 million higher than the anticipated amount of the total remaining construction costs as of the closing date, which would allow HBH to use PB's approximately $19.3 million in contributions to pay NJSEA a development fee and expenses related to the transaction without being concerned that it would exceed the maximum limit on the Construction Loan provided by NJSEA.
PB made its second capital contribution in two installments, a $3,660,765 payment in December 2000, and a $3,400,000 payment the following month. Once those contributions were received by NJSEA and used to pay down the principal on the Acquisition Loan, NJSEA, instead of using the entire capital contribution to fund a corresponding draw by HBH on the Construction Loan, used $3,332,500 of that amount to purchase the required Guaranteed Investment Contract as security for its potential obligation or opportunity to purchase PB's interest in HBH.
b) Post-Construction Phase
According to NJSEA's 2001 annual report, the "$90 million renovation"
When Reznick was preparing HBH's 2003 audited financial statements, it "addressed a possible impairment issue under FASB 144."
(Id.) "Since there is no ceiling on the amount of funds to be provided [by NJSEA to HBH] under the [AREA]," Reznick concluded "there [was] no triggering event which require[d] [a write down] under FASB 144." (Id.) That same discussion and conclusion were included in separate memos to HBH's audit files for 2004 and 2005.
6. The Tax Returns and IRS Audit
On its 2000 Form 1065,
Following an audit of the returns of the Subject Years, the IRS issued to HBH a notice of final partnership administrative adjustment ("FPAA"). That FPAA determined that all separately stated partnership items reported by HBH on its returns for the Subject Years should be reallocated from PB to NJSEA. The IRS made that adjustment on various alternative, but related, grounds, two of which are of particular importance on appeal: first, the IRS said that HBH should not be recognized as a partnership for federal income tax purposes because it was created for the express purpose of improperly passing along tax benefits to PB and should be treated as a sham transaction; and, second, it said that PB's claimed partnership interest in HBH was not, based on the totality of the circumstances, a bona fide partnership participation because PB had no meaningful stake in the success or failure of HBH.
C. The Tax Court Decision
NJSEA, in its capacity as the tax matters partner of HBH,
The Tax Court first rejected the Commissioner's argument that HBH is a sham under the economic substance doctrine. See supra note 7 and accompanying text. As the Court saw it, "all of [the IRS's] arguments concerning the economic substance of [HBH] [were] made without taking into account the 3-percent return and the [HRTCs]." (Id. at 37.) The Court disagreed with the IRS's assertion that "[PB] invested in the [HBH] transaction solely to earn [HRTCs]." (Id. at 41.) Instead, the Court "believe[d] that the 3-percent return and the expected tax credits should be viewed together," and "[v]iewed as a whole, the [HBH] and the East Hall transactions did have economic substance" because the parties "had a legitimate business purpose — to allow [PB] to invest in the East Hall's rehabilitation." (Id.) In support of that determination, the Tax Court explained:
(Id. at 41-42.)
The Tax Court further explained that "[PB] faced risks as a result of joining [HBH]. First ... it faced the risk that the rehabilitation would not be completed," and additionally, "both NJSEA and [PB] faced potential liability for environmental hazards from the rehabilitation." (Id. at 43.) While recognizing that HBH and PB were insured parties under NJSEA's existing environmental insurance policy, the Tax Court noted that "there was no guaranty that: (1) The insurance payout would cover any potential liability; and (2) if NJSEA was required to make up any difference, it would be financially able to do so." (Id. at 43-44.) In sum, because "NJSEA had more money for the rehabilitation than it would have had if [PB] had not invested in [HBH]," and "[b]oth parties would receive a net economic benefit from the transaction if the rehabilitation was successful," the Tax Court concluded that HBH had "objective economic substance." (Id. at 46-47.)
The Tax Court used similar reasoning to reject the Commissioner's assertion that PB was not a bona fide partner in HBH. Specifically, the Court rejected the Commissioner's contentions that "(1) [PB] had no meaningful stake in [HBH's] success or failure; and (2) [PB's] interest in [HBH] is more like debt than equity." (Id. at 47.) After citing to the totality-of-the-circumstances
Regarding the formation of a partnership, the Court said that, because "[PB] and NJSEA joined together in a transaction with economic substance to allow [PB] to invest in the East Hall rehabilitation," and "the decision to invest provided a net economic benefit to [PB] through its 3-percent preferred return and rehabilitation tax credits," it was "clear that [PB] was a partner in [HBH]." (Id. at 49-50.) The Court opined that, since the East Hall operated at a loss, even if one were to "ignore the [HRTCs], [PB's] interest is not more like debt than equity because [PB] [was] not guaranteed to receive a 3-percent return every year ... [as] there might not be sufficient cashflow to pay it." (Id. at 51.)
The Tax Court also placed significant emphasis on "the parties' investigation and documentation" to "support [its] finding that the parties intended to join together in a rehabilitation of the East Hall." (Id. at 50.) According to the Court, the Confidential Memorandum "accurately described the substance of the transaction: an investment in the East Hall's rehabilitation." (Id.) The Court then cited to the parties' investigation into mitigating potential environmental hazards, as well as the parties' receipt of "a number of opinion letters evaluating various aspects of the transaction, to "support [its] finding of an effort to join together in the rehabilitation of the East Hall." (Id.) The Court decided that "[t]he executed transaction documents accurately represent[ed] the substance of the transaction ... to rehabilitate and manage the East Hall." (Id.) Also, the Court found it noteworthy that "the parties ... carried out their responsibilities under the AREA[:] NJSEA oversaw the East Hall's rehabilitation, and [PB] made its required capital contributions."
Hence, the Tax Court entered a decision in favor of HBH. This timely appeal by the Commissioner followed.
A. The Test
A partnership exists when, as the Supreme Court said in Commissioner v. Culbertson, two or more "parties in good faith and acting with a business purpose intend to join together in the present conduct of the enterprise." 337 U.S. at 742, 69 S.Ct. 1210; see also Comm'r v. Tower, 327 U.S. 280, 286-87, 66 S.Ct. 532, 90 L.Ed. 670 (1946) ("When the existence of an alleged partnership arrangement is challenged by outsiders, the question arises whether the partners really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses or both."); Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors v. United States, 659 F.3d 466, 488 (5th Cir.2011) ("The sine qua non of a partnership is an intent to join together for the purpose of sharing in the profits and losses of a genuine business.").
The Culbertson test is used to analyze the bona fides of a partnership and to decide whether a party's "interest was a bona fide equity partnership participation." TIFD III-E, Inc. v. United States, 459 F.3d 220, 232 (2d Cir.2006) (hereinafter "Castle Harbour"). To determine, under Culbertson, whether PB was a bona fide partner in HBH, we must consider the totality of the circumstances,
337 U.S. at 742, 69 S.Ct. 1210. That "test turns on the fair, objective characterization of the interest in question upon consideration of all the circumstances." Castle Harbour, 459 F.2d at 232.
The Culbertson test "illustrat[es]... the principle that a transaction must be judged by its substance, rather than its form, for income tax purposes." Trousdale v. Comm'r, 219 F.2d 563, 568 (9th Cir.1955). Even if there are "indicia of an equity participation in a partnership," Castle Harbour, 459 F.3d at 231, we should not "accept at face value artificial constructs of the partnership agreement," id. at 232. Rather, we must examine those indicia to determine whether they truly reflect an intent to share in the profits or losses of an enterprise or, instead, are "either illusory of insignificant." Id. at 231. In essence, to be a bona fide partner for tax purposes, a party must have a "meaningful stake in the success or failure" of the enterprise. Id.
B. The Commissioner's Guideposts
The Commissioner points us to two cases he calls "recent guideposts" bearing on the bona fide equity partner inquiry. (Appellant's Opening Br. at 34.) First, he cites to the decision of the United States Court of Appeals for the Second Circuit in Castle Harbour, 459 F.3d 220. The Castle Harbour court relied on Culbertson in disregarding the claimed partnership status of two foreign banks. Those banks had allegedly formed a partnership, known as Castle Harbour, LLC, with TIFD III-E, Inc. ("TIFD"), a subsidiary of General Electric Capital Corporation, with an intent to allocate certain income away from TIFD, an entity subject to United States
Applying the bona fide partner theory as embodied in Culbertson's totality-of-the-circumstances test, the Castle Harbour court held that the banks' purported partnership interest was, in substance, "overwhelmingly in the nature of a secured lender's interest, which would neither be harmed by poor performance of the partnership nor significantly enhanced by extraordinary profits." Id. at 231. Although it acknowledged that the banks' interest "was not totally devoid of indicia of an equity participation in a partnership," the Court said that those indicia "were either illusory or insignificant in the overall context of the banks' investment," and, thus, "[t]he IRS appropriately rejected the equity characterization." Id.
The Castle Harbour court observed that "consider[ing] whether an interest has the prevailing character of debt or equity can be helpful in analyzing whether, for tax purposes, the interest should be deemed a bona fide equity participation." Id. at 232. In differentiating between debt and equity, it counseled that "the significant factor ... [is] whether the funds were advanced with reasonable expectation of repayment regardless of the success of the venture or were placed at the risk of the business." Id. (citation and internal quotation marks omitted). Thus, in determining whether the banks' interest was a bona fide equity participation, the Second Circuit focused both on the banks' lack of downside risk and lack of upside potential in the partnership. It agreed with the "district court['s] recogni[tion] that the banks ran no meaningful risk of being paid anything less than the reimbursement of their investment at the [agreed-upon rate] of return." Id. at 233. In support of that finding, the Court noted that:
Id. at 228.
Regarding upside potential, however, the Second Circuit disagreed with the district court's conclusion that the banks had a "meaningful and unlimited share of the upside potential." Id. at 233. That conclusion
The second, more recent, precedent that the Commissioner directs us to as a "guidepost" is Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir.2011) (hereinafter "Virginia Historic"). There, the United States Court of Appeals for the Fourth Circuit held that certain transactions between a partnership and its partners which sought to qualify for tax credits under the Commonwealth of Virginia's Historic Rehabilitation Credit Program (the "Virginia Program")
The IRS "challenged [the Funds'] characterization of investors' funding as `contributions to capital'" because the IRS believed that the investors were, in substance, purchasers of state income tax
The Fourth Circuit reversed the Tax Court. "Assuming, without deciding, that a `bona fide' partnership existed," the Virginia Historic court found that "the Commissioner properly characterized the transactions at issue as `sales'" under the disguised-sale rules. Id. at 137. The Fourth Circuit first turned to the regulations that provide guidance in determining whether a disguised sale has occurred. See id. at 137-39 (citing to, inter alia, Treas. Reg. §§ 1.707-3, 1.707-6(a)). Specifically, it explained that a transaction should be reclassified as a sale if, based on all the facts and circumstances, (1) a partner would not have transferred money to the partnership but for the transfer of property — the receipt of tax credits — to the partner; and (2) the latter transfer — the receipt of tax credits — "is not dependent on the entrepreneurial risks of partnership operations." Id. at 145 (quoting Treas. Reg. § 1.707-3(b)(1)). The Fourth Circuit concluded that the risks cited by the Tax Court — such as the "risk that developers would not complete their projects on time because of construction, zoning, or management issues," "risk ... [of] liability for improper construction," and "risk of mismanagement or fraud at the developer partnership level" — "appear[ed] both speculative and circumscribed." Id. While the Fourth Circuit acknowledged that "there was ... no guarantee that resources would remain available in the source partnership to make the promised refunds," it determined "that the Funds were structured in such a way as to render the possibility of insolvency remote." Id.
In holding "that there was no true entrepreneurial risk faced by investors" in the transactions at issue, the Virginia Historic court pointed to several different factors:
Id. (internal citations and quotation marks omitted). In sum, the Fourth Circuit deemed "persuasive the Commissioner's contention that the only risk ... was that faced by any advance purchaser who pays for an item with a promise of later delivery. It [was] not the risk of the entrepreneur who puts money into a venture with the hope that it might grow in amount but with the knowledge that it may well shrink." Id. at 145-46 (citing Tower, 327 U.S. at 287, 66 S.Ct. 532; Staff of J. Comm. on Tax'n, 98th Cong., 2d Sess., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 226 ("To the extent that a partner's profit from a transaction is assured without regard to the success or failure of the joint undertaking, there is not the requisite joint profit motive." (alteration in original))). Accordingly, it agreed with the Commissioner that the Funds should have reported the money received from the investors as taxable income. Id. at 146.
The Fourth Circuit concluded its opinion with an important note regarding its awareness of the legislative policy of providing tax credits to spur private investment in historic rehabilitation projects:
Id. at 146 n. 20.
C. Application of the Guideposts to HBH
The Commissioner asserts that Castle Harbour and Virginia Historic "provide a highly pertinent frame of reference for analyzing the instant case." (Appellant's Opening Br. at 40.) According to the Commissioner, "[m]any of the same factors upon which the [Castle Harbour court] relied in finding that the purported bank partners ... were, in substance, lenders to the GE entity also support the conclusion that [PB] was, in substance, not a partner in HBH but, instead, was a purchaser of tax credits from HBH."
In response, HBH asserts that "[t]here are a plethora of errors in the IRS's tortured effort ... to apply Castle Harbour and Virginia Historic ... to the facts of the present case." (Appellee's Br. at 38.) First, HBH argues that it is "abundantly apparent" that Castle Harbour "is completely inapposite" to it because the actual provisions in Castle Harbour's partnership agreement that minimized the banks' downside risk and upside potential were more limiting than the provisions in the AREA. (Appellee's Br. at 35.) HBH contends that, unlike the partnership agreement in Castle Harbour, "[PB] has no rights under the AREA to compel HBH to repay all or any part of its capital contribution," PB's 3% Preferred Return was "not guaranteed," and "NJSEA has no ... right to divest [PB] of its interest in any income or gains from the East Hall." (Id.)
As to Virginia Historic, HBH argues that it "has no application whatsoever" here. (Id. at 38.) It reasons that the decision in that case "assumed that valid partnerships existed as a necessary condition to applying I.R.C. § 707(b)'s disguised sale rules" (id. at 36), and that the case was "analyzed ... solely under the disguised sale regime" — which is not at issue in the FPAA sent to HBH (id. at 38).
Overall, HBH characterizes Castle Harbour and Virginia Historic as "pure misdirections which lead to an analytical dead end" (id. at 32), and emphasizes that "[t]he question ... Culbertson asks is simply whether the parties intended to conduct a business together and share in the profits and losses therefrom" (id. at 39). We have no quarrel with how HBH frames the Culbertson inquiry. But what HBH fails to recognize is that resolving whether a purported partner had a "meaningful stake in the success or failure of the partnership," Castle Harbour, 459 F.3d at 224, goes to the core of the ultimate determination of whether the parties "`intended to join together in the present conduct of the enterprise,'" id. at 232 (quoting Culbertson, 337 U.S. at 742, 69 S.Ct. 1210). Castle Harbour's analysis that concluded that the banks' "indicia of an equity participation in a partnership" was only "illusory or insignificant," id. at 231, and Virginia Historic's determination that the limited partner investors did not face the "entrepreneurial risks of partnership operations," 639 F.3d at 145 (citation and internal quotation marks omitted), are both highly relevant to the question of whether HBH was a partnership in which PB had a true interest in profit and loss,
1. Lack of Meaningful Downside Risk
PB had no meaningful downside risk because it was, for all intents and purposes, certain to recoup the contributions it had made to HBH and to receive the primary benefit it sought — the HRTCs or their cash equivalent. First, any risk that PB would not receive HRTCs in an amount that was at least equivalent to installments it had made to-date (i.e., the "Investment Risk") was non-existent. That is so because, under the AREA, PB was not required to make an installment contribution to HBH until NJSEA had verified that it had achieved a certain level of progress with the East Hall renovation that would generate enough cumulative HRTCs to at least equal the sum of the installment which was then to be contributed and all prior capital contributions that had been made by PB. (See J.A. at 176, 242 (first installment of $650,000 due at closing was paid when NJSEA had already incurred over $53 million of QREs which would generate over $10 million in HRTCs); id. at 176-77 (second installment,
Second, once an installment contribution had been made, the Tax Benefits Guaranty eliminated any risk that, due to a successful IRS challenge in disallowing any HRTCs, PB would not receive at least the cash equivalent of the bargained-for tax credits (i.e., the "Audit Risk"). The Tax Benefits Guaranty obligated NJSEA
Third, any risk that PB would not receive all of its bargained-for tax credits (or cash equivalent through the Tax Benefits Guaranty) due to a failure of any part of the rehabilitation to be successfully completed (i.e., the "Project Risk") was also effectively eliminated because the project was already fully funded before PB entered into any agreement to provide contributions to HBH. (See J.A. at 962 (statement in the Confidential Memorandum that "[t]he rehabilitation is being funded entirely by [NJSEA]"); id. at 1134 (notes from a NJSEA executive committee meeting in March 2000 indicating that "[t]he bulk of the Investor's equity is generally contributed to the company after the project is placed into service and the tax credit is earned, the balance when stabilization is achieved"); id. at 1714 (notes to NJSEA's 1999 annual report stating that the Casino Reinvestment Development Authority had "agreed to reimburse [NJSEA] [for] ... all costs in excess of bond proceeds for the project"). That funding, moreover, included coverage for any excess development costs.
In short, PB bore no meaningful risk in joining HBH, as it would have had it acquired a bona fide partnership interest. See ASA Investerings P'ship v. Comm'r, 201 F.3d 505, 514 (D.C.Cir.2000) (noting that the Tax Court did not err "by carving out an exception for de minimis risks" when assessing whether the parties assumed risk for the purpose of determining whether a partnership was valid for tax purposes, and determining that the decision not to consider de minimis risk was "consistent with the Supreme Court's view... that a transaction will be disregarded if it did `not appreciably affect [taxpayer's] beneficial interest except to reduce his tax'" (alteration in original) (quoting Knetsch v. United States, 364 U.S. 361, 366, 81 S.Ct. 132, 5 L.Ed.2d 128 (1960))).
That conclusion is not undermined by PB's receipt of a secondary benefit — the 3% Preferred Return on its contributions to HBH. Although, in form, PB was "not guaranteed" that return on an annual basis if HBH did not generate sufficient cash flow (Appellee's Br. at 35), in substance, PB had the ability to ensure that it would eventually receive it. If PB exercised its Put Option (or NJSEA exercised its Call Option), the purchase price to be paid by NJSEA was effectively measured by PB's accrued and unpaid Preferred Return. See infra note 63 and accompanying text. And to guarantee that there would be sufficient cash to cover that purchase price, NJSEA was required to purchase the Guaranteed Investment Contract in the event that NJSEA exercised its Call Option.
HBH, of course, attacks the Commissioner's assertion that PB lacked downside
2. Lack of Meaningful Upside Potential
PB's avoidance of all meaningful downside risk in HBH was accompanied by a dearth of any meaningful upside potential. "Whether [a putative partner] is free to, and does, enjoy the fruits of the partnership is strongly indicative of the reality of his participation in the enterprise." Culbertson, 337 U.S. at 747, 69 S.Ct. 1210. PB, in substance, was not free to enjoy the fruits of HBH. Like the foreign banks' illusory 98% interest in Castle Harbour, PB's 99.9% interest in HBH's residual cash flow gave a false impression that it had a chance to share in potential profits of HBH. In reality, PB would only benefit from its 99.9% interest in residual cash flow after payments to it on its Investor Loan and Preferred Return and the following payments to NJSEA: (1) annual installment payment on the Acquisition Loan ($3,580,840 annual payment for 39 years plus arrears); (2) annual installment payment on the Construction Loan;
3. HBH's Reliance on Form over Substance
After attempting to downplay PB's lack of any meaningful stake in the success or failure of the enterprise, HBH presses us to consider certain evidence that it believes "overwhelmingly proves that [PB] is a
Much of that evidence may give an "outward appearance of an arrangement to engage in a common enterprise." Culbertson, 337 U.S. at 752, 69 S.Ct. 1210 (Frankfurter, J., concurring). But "the sharp eyes of the law" require more from parties than just putting on the "habiliments of a partnership whenever it advantages them to be treated as partners underneath." Id. Indeed, Culbertson requires that a partner "really and truly intend to ... shar[e] in the profits and losses" of the enterprise, id. at 741, 69 S.Ct. 1210 (majority opinion) (emphasis added) (citation and internal quotation marks omitted), or, in other words, have a "meaningful stake in the success or failure" of the enterprise, Castle Harbour, 459 F.3d at 231. Looking past the outward appearance, HBH's cited evidence does not demonstrate such a meaningful stake.
First, the recitation of partnership formalities — that HBH was duly organized, that it had a stated purpose under the AREA, that it opened bank and payroll accounts, and that it assumed various obligation — misses the point. We are prepared to accept for purposes of argument that there was economic substance to HBH. The question is whether PB had a meaningful stake in that enterprise. See Castle Harbour, 459 F.3d at 232 ("The IRS's challenge to the taxpayer's characterization is not foreclosed merely because the taxpayer can point to the existence of some business purpose or objective reality in addition to its tax-avoidance objective."); Southgate Master Fund, 659 F.3d at 484 ("The fact that a partnership's underlying business activities had economic substance does not, standing alone, immunize the partnership from judicial scrutiny [under Culbertson]. The parties' selection of the partnership form must have been driven by a genuine business purpose." (internal footnote omitted)). To answer that, we must "look beyond the superficial formalities of a transaction to determine the proper tax treatment." Edwards v. Your Credit, Inc., 148 F.3d 427, 436 (5th Cir.1998) (citation and internal quotation marks omitted).
Second, evidence that PB received a "net economic benefit" from HBH and made a "substantial financial investment in HBH" can only support a finding that PB is a bona fide partner if there was a meaningful intent to share in the profits and the losses of that investment. The structure of PB's "investment," however, shows
Third, the fact that NJSEA "kept in constant communication" regarding the East Hall is hardly surprising. As discussed earlier, supra Section II.C.1, each installment contribution from PB was contingent upon NJSEA verifying that a certain amount of work had been completed on the East Hall so that PB was assured it would not be contributing more money than it would be guaranteed to receive in HRTCs or their cash equivalent. The mere fact that a party receives regular updates on a project does not transform it into a bona fide partner for tax purposes.
Fourth, looking past the form of the transaction to its substance, neither PB's "vigorous negotiat[ion]" nor its "comprehensive due diligence investigation" is, in this context, indicative of an intent to be a bona fide partner in HBH. We do not doubt that PB spent a significant amount of time conducting a thorough investigation and negotiating favorable terms. And we acknowledge that one of the factors cited by Culbertson is "the conduct of the parties in execution of its provisions." 337 U.S. at 742, 69 S.Ct. 1210. But the record reflects that those efforts were made so that PB would not be subject to any real risks that would stand in the way of its receiving the value of the HRTCs; not, as HBH asserts, "to form a true business relationship." (Appellee's Br. at 41.) We do not believe that courts are compelled to respect a taxpayer's characterization of a transaction for tax purposes based on how document-intensive the transaction becomes. Recruiting teams of lawyers, accountants, and tax consultants does not mean that a partnership, with all its tax credit gold, can be conjured from a zero-risk investment of the sort PB made here.
In the end, the evidence HBH cites focuses only on form, not substance. From the moment Sovereign approached NJSEA, the substance of any transaction with a corporate investor was calculated to be a "sale of ... historic rehabilitation tax credits." (J.A. at 691.) Cf. Castle Harbour, 459 F.3d at 236 (finding that the banks' interest "was more in the nature of window dressing designed to give ostensible support to the characterization of equity participation ... than a meaningful stake in the profits of the venture"). And in the end, that is what the substance turned out to be.
Like the Virginia Historic court, we reach our conclusion mindful of Congress's goal of encouraging rehabilitation of historic buildings. See 639 F.3d at 146 n. 20. We have not ignored the predictions of HBH and amici that, if we reallocate the HRTCs away from PB, we may jeopardize the viability of future historic rehabilitation projects. Those forecasts, however, distort the real dispute. The HRTC statute "is not under attack here." Id. It is the prohibited sale of tax credits, not the
For the foregoing reasons, we will reverse the Tax Court's January 3, 2011 decision, and remand the case for further proceedings consistent with this opinion.
I.R.C. § 47(c)(2)(A).
I.R.C. § 47(c)(1)(A). Additionally, "[i]n the case of a building other than a certified historic structure, a building shall not be a qualified rehabilitated building unless the building was first placed in service before 1936." Id. § 47(c)(1)(B).
I.R.C. § 7701(o)(1). Section 7701(o) applies to all transactions entered into after March 30, 2010. Thus, the common-law version of the economic substance doctrine, and not § 7701(o), applies to the transaction at issue here.
HBH contends that the IRS's sham-partnership theory, which HBH asserts is "merely a rehash of the factual claims that [the IRS] made in challenging [PB's] status as a partner in HBH," is distinct from the sham-transaction doctrine (also known as the economic substance doctrine) that was litigated before the Tax Court. Amicus Real Estate Roundtable (the "Roundtable") agrees, submitting that the Commissioner's sham-partnership argument "inappropriately blur[s] the line between the [economic substance doctrine] and the [substance-over-form doctrine]," the latter of which applies when the form of a transaction is not the same as its economic reality. (Roundtable Br. at 7.) The point is well-taken, as the economic substance doctrine and the substance-over-form doctrine certainly "are distinct." Neonatology Assocs., P.A. v. Comm'r, 299 F.3d 221, 230 n. 12 (3d Cir.2002); see generally Rogers v. United States, 281 F.3d 1108, 1115-17 (10th Cir.2002) (noting differences between the substance-over-form doctrine and the economic substance doctrine). The substance-over-form doctrine "is applicable to instances where the `substance' of a particular transaction produces tax results inconsistent with the `form' embodied in the underlying documentation, permitting a court to recharacterize the transaction in accordance with its substance." Neonatology Assocs., 299 F.3d at 230 n. 12. On the other hand, the economic substance doctrine "applies where the economic or business purpose of a transaction is relatively insignificant in relation to the comparatively large tax benefits that accrue." Id.
As the Roundtable correctly explains, "[t]he fact that [a] taxpayer might not be viewed as a partner (under the [substance-over-form doctrine]) or that the transaction should be characterized as a sale (again, under the [substance-over-form doctrine]) [does] not mean that the underlying transaction violated the [economic substance doctrine]." (Roundtable Br. at 7.) Put another way, even if a transaction has economic substance, the tax treatment of those engaged in the transaction is still subject to a substance-over-form inquiry to determine whether a party was a bona fide partner in the business engaged in the transaction. See Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors, LLC v. United States, 659 F.3d 466, 484 (5th Cir.2011) ("The fact that a partnership's underlying business activities had economic substance does not, standing alone, immunize the partnership from judicial scrutiny [under Culbertson]."); id. ("If there was not a legitimate, profit-motivated reason to operate as a partnership, then the partnership will be disregarded for tax purposes even if it engaged in transactions that had economic substance.").
At oral argument, the IRS conceded that this case "lends itself more cleanly to the bona fide partner theory," under which we look to the substance of the putative partner's interest over its form. Oral Argument at 11:00, Historic Boardwalk Hall, LLC v. Comm'r (No. 11-1832), available at http://www.ca3.uscourts.gov/oralargument/audio/11-1832Historic%20Boardwalk%20LLC%20v%20Commissioner%20IRS.wma. Accordingly, we focus our analysis on whether PB is as a bona fide partner in HBH, and in doing so, we assume, without deciding, that this transaction had economic substance. Specifically, we do not opine on the parties' dispute as to whether, under Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), we can consider the HRTCs in evaluating whether a transaction has economic substance.
More importantly, HBH simply ignores why many of the principles espoused in Virginia Historic are applicable here. It is true that the challenged transaction here does not involve state tax credits and that the IRS has not invoked the disguised-sale rules, but distinguishing the case on those grounds fails to address the real issue. Virginia Historic is telling because the disguised-sale analysis in that case "touches on the same risk-reward analysis that lies at the heart of the bona fide-partner determination." (Appellant's Reply Br. at 9.) Under the disguised-sale regulations, a transfer of "property ... by a partner to a partnership" and a "transfer of money or other consideration ... by the partnership to the partner" will be classified as a disguised sale if, based on the facts and circumstances, "(i) [t]he transfer of money or other consideration would not have been made but for the transfer of property; and (ii)[i]n cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations." Treas. Reg. § 1.707-3(b)(1).
Thus, the disguised-sale analysis includes an examination of "whether the benefit running from the partnership to the person allegedly acting in the capacity of a partner is `dependent upon the entrepreneurial risks of partnership operations.'" (Appellant's Reply Br. at 9 (quoting Treas. Reg. § 1.707-3(b)(1)(ii)).) That entrepreneurial risk issue also arises in the bona fide-partner analysis, which focuses on whether the partner has a meaningful stake in the profits and losses of the enterprise. Moreover, many of the facts and circumstances laid out in the pertinent treasury regulations that "tend to prove the existence of a [disguised] sale," Treas. Reg. § 1.707-3(b)(2), are also relevant to the bona fide-partner analysis here. See, e.g., id. § 1.707-3(b)(2)(i) ("That the timing and amount of a subsequent transfer [i.e., the HRTCs] are determinable with reasonable certainty at the time of an earlier transfer [i.e., PB's capital contributions];"); id. § 1.707-3(b)(2)(iii) ("That the partner's [i.e., PB's] right to receive the transfer of money or other consideration [i.e., the HRTCs] is secured in any manner, taking into account the period during which it is secured;"); id. § 1.707-3(b)(2)(iv) ("That any person [i.e., NJSEA] has made or is legally obligated to make contributions [e.g., the Tax Benefits Guaranty] to the partnership in order to permit the partnership to make the transfer of money or other consideration [i.e., the HRTCs];"); id. § 1.707-3(b)(2)(v) ("That any person [i.e., NJSEA] has loaned or has agreed to loan the partnership the money or other consideration [e.g., Completion Guaranty, Operating Deficit Guaranty] required to enable the partnership to make the transfer, taking into account whether any such lending obligation is subject to contingencies related to the results of partnership operations;"). Although we are not suggesting that a disguised-sale determination and a bona fide-partner inquiry are interchangeable, the analysis pertinent to each look to whether the putative partner is subject to meaningful risks of partnership operations before that partner receives the benefits which may flow from that enterprise.
Despite the smoke and mirrors of the financial projections, the parties' behind-the-scenes statements reveal that they never anticipated that the fair market value of PB's interest would exceed PB's accrued but unpaid Preferred Return. (See id. at 1162 (pre-closing memo from NJSEA's outside counsel to NJSEA that "[d]ue to the structure of the transaction," the fair market value would not come into play in determining the amount that PB would be owed if NJSEA exercised its Call Option).) That admission is hardly surprising because the substance of the transaction indicated that this was not a profit-generating enterprise. Cf. Virginia Historic, 639 F.3d at 145 (noting that the fact that "the Funds ... explicitly told investors to expect no allocation of material amounts of ... partnership items of income, gain, loss, or deduction" "point[ed] to the conclusion that there was no true entrepreneurial risk faced by investors" (citation and internal quotation marks omitted)).