On August 27, the Third Circuit overturned the taxpayer friendly decision issued by the Tax Court in litigation over a tax credit investor’s ability to claim historic tax credits in connection with the certified historic rehabilitation of the Historic Boardwalk Hall (“HBH”) in Atlantic City. (Historic Boardwalk Hall v. Commissioner). The Tax Court had applied a more liberal than normal analysis in the case of this HTC transaction to further Congressional intent. The Third Circuit held that notwithstanding Congressional intent, the investor still needed to be a partner in the entity entitled to pass through the credit. Under a traditional partner tax analysis, the Court found that the investor had no risk and no possibility of an upside, so it was not a partner for tax purposes.
While this memo will not list every factor mentioned in the 85 page opinion, the Court’s analysis had to have been colored by the broker’s offering document that described the “sale” of tax credits. Further, the broker told the accountants to add income items to the projections to make them look better, such as a line item for naming rights. But, even the rosy projections showed no upside to the investor and of course the property performed much worse than projected.
In addition, the Investor had the usual HTC guaranties (environmental, completion, tax and operating deficit). The guaranties were provided by a state agency, the New Jersey Sports Exposition Authority, and the Court apparently did not attribute any credit risk with respect to the guaranties. In addition, the Investor was the beneficiary of a guaranteed investment contract which would cover its preferred return and put price. Once again, there was unfortunate language from the broker describing the GIC as in part paying off the Investor “loan.” Based on the guaranties and the GIC, the Court applied the analysis required by Culbertson, a venerable Supreme Court case, and found that the Investor was more like a lender and not a tax partner.
The other curious feature of this litigation is that it was not coordinated with the IRS national office. While this case was pending, we received a favorable private ruling with respect to an HTC transaction. We were told that the HBH litigators never consulted the policy attorneys in chief counsel’s office. In other instances, most notably the issuance of partnership interests for services, isolated cases were litigated while the national office continued to follow a more taxpayer friendly analysis than that adopted by the courts in those cases. So while the IRS national office issued a favorable private ruling, we are aware of one case where an IRS auditor, acting on his own, was holding an HTC audit in abeyance until HBH was decided.
Today the industry is trying to digest the meaning of the case and gauge IRS reaction. The events of 2008, etc., proved that the normal tax credit guaranties are not iron clad. The downturn led to investor losses as guaranties proved elusive. The good tax fact was not viewed as good news by investors who have been insisting upon cash holdbacks or escrows to guaranty payment of put price and or preferred return. The HBH opinion confirms that funded arrangements will raise serious tax issues.
On the other hand, many HTC transactions with the major credit investors have different facts from HBH. Careful investors look for projections that realistically show a cash upside to the investor, even if it is in the out years of a transaction. In addition, careful taxpayers (or taxpayers with careful counsel) avoid the mischaracterizations (credit “sale,” loan repayment, etc) contained in the HBH literature. So, if investors drop insistence upon cash holdbacks, escrows or other funded guaranty mechanisms, there will be a number of factors differentiating a typical HTC transaction from the HBH facts.
What does HBH mean to the HTC industry? Investors temporarily are closing off deal flow while they evaluate the situation and try to ascertain how the IRS will react to this case. If investors have to give up certain protections, they could be more selective in choosing deals and pricing could reflect the new uncertainties. Another factor to be considered is the risk to guarantors. In the past, a guarantor could take comfort from the fact that the IRS was approving “usual” HTC transactions where the investor expected meaningful cash to be distributed over time. When tax credit investors return to the table, how will guarantors react to the new risks? For example, even if the IRS decides to ignore the HBH victory, that will not necessarily stop an ambitious auditor from challenging an HTC pass through.
In the past, investors began to ignore basic tax principles and guarantors ignored tax risk. HBH is a wake up call. Future transactions will be subject to greater scrutiny and negotiations over HTC guaranties will draw much more attention. But unless the IRS national office follows up on HBH by directing auditors to challenge “typical” HTC transactions, we expect the industry to survive.
HTC transactions have always been very fact specific. Our firm has been actively involved in these projects. Lawrence Arem, 215.569.4142 or email@example.com, and Jennifer O’Leary, 215.569.4928 or firstname.lastname@example.org are available to discuss your project.
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