In a recent opinion in a pair of consolidated cases (Deitch v. Commissioner and Barry v. Commissioner, T.C. Memo. 2022-86, collectively “Deitch”), the Tax Court rebuffed an attempt by the IRS to deny a partnership’s deduction for interest payments which effectively represented a lender’s share of the profits from the partnership’s real estate development activity. The court’s opinion placed a great deal of weight on the stipulations of fact agreed to by the parties as part of the litigation process. As described below, these stipulations seem to have preordained the result of portions of the court’s analysis and may limit taxpayers’ ability to broadly rely on the result in the case. However, the case may still provide taxpayers with insight into how the IRS may seek to attack similar structures in future cases.
In Deitch, two individuals formed “WTS,” a limited liability company classified as a partnership for U.S. federal tax purposes. WTS intended to acquire and develop a single piece of commercial real estate. To fund the acquisition and development of this real estate, WTS entered into a series of agreements with “PLI,” an unrelated third party.
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 to PLI 50% of WTS’ net cash flow from the operation of the acquired real estate, along with 50% of the net gain from its ultimate sale 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 solely intended to form a debtor/creditor relationship.
Ultimately WTS’ real estate development activity proved successful and WTS paid 50% of the net gain from the sale of the real estate to PLI under the additional interest agreement. On its partnership tax return for the year of 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’ interest deductions for amounts paid under the additional interest agreement.
WTS’ individual partners petitioned the Tax Court to contest the IRS’ disallowance of WTS’ interest deduction for the payments made under the additional interest agreement. In preparation of the case for trial and in accordance with Tax Court rules, the taxpayer and the IRS entered into a stipulation of facts, an agreement as to factual matters not in dispute in the case. These stipulations included that the loan agreements constituted bona fide debt for U.S. federal income tax purposes, the loan agreements and additional interest agreement were the result of arm’s length negotiations, and PLI did not own a member interest in WTS.
It is worth noting that the IRS appears to have taken an “all-or-nothing” litigation approach before the Tax Court. Relying on its own long-standing positions, the IRS 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. However, in a footnote, the Tax Court suggested that it might consider such a bifurcation should the IRS change its position in a future case and provide the evidence necessary to divide the advances between debt and equity. Instead, the primary argument advanced by the IRS was that the loan agreements and additional interest agreement represented the formation of a new partnership between WTS and PLI. If the IRS’ 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.
The court rejected the IRS’ argument that a partnership existed between WTS and PLI. The Tax Court applied the factors set forth in Luna v. Commissioner, 42 T.C. 1067, 1077 (1964), which provide a frequently cited framework for the determination of whether a particular economic relationship constitutes a partnership — or whether a particular taxpayer is a partner in a partnership — for U.S. federal income tax purposes. In applying these factors, the court’s analysis paid particular attention to the legal form of the agreements between WTS and PLI, which reflected an intent to treat the loan agreements and additional interest agreement as debt as opposed to any form of equity longstanding positions — for both legal and tax purposes. The court’s analysis also reflected the parties’ stipulation that the loan agreements represented bona fide debt for tax purposes. If the loan agreements were debt, there was nothing (capital or services) that PLI could be viewed as providing under the additional interest agreement in exchange for an equity interest in a partnership. Ultimately the court concluded that no partnership between PLI and WTS existed.
The stipulations by the parties in Deitch effectively served as concessions of significant issues in the case by the IRS and may limit the case’s direct applicability to other taxpayers. Nevertheless, the opinion in the case is interesting in several respects. The case provides an insightful example of the application of the Luna factors to an interesting set of facts and the importance of considering the Luna factors to determine whether a partnership exists for U.S. federal income tax purposes.
The case also may provide taxpayers considering similar loan arrangements a hint as to how the IRS may seek to recharacterize such arrangements in future cases. As noted above, in Deitch, the IRS did not look to bifurcate the advances under the loan agreements and additional interest agreement between separate debt and equity interests. Given the interwoven nature of the agreements, the IRS’ stipulation that the loan agreements constituted bona fide debt seems to have undercut the IRS’ arguments that the agreements provided PLI with a single equity interest (in either WTS or a separate partnership). In the absence of such a stipulation, the IRS might simply argue that agreements similar to those in Deitch provide the lender with a partnership interest in the borrowing partnership, with any payments to the lender being treated as guaranteed payments for the use of capital or as the lender’s distributive share of partnership income, rather than a deductible payment of interest by the partnership to a creditor.
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