“If the government treats tax-advantaged transactions as shams unless they make economic sense on a pre-tax basis, then it takes away with the executive hand what it gives with the legislative.”[1] Despite these words issued by the Ninth Circuit in 1995, the Internal Revenue Service continues to challenge certain investments that Congress expressly encourages through various tax incentives. Using these various tax incentives, Congress encourages, and rightly so, many socially desirable activities, such as land conservation, development of low-income housing, business development in impoverished areas, and the production of cleaner, renewable energy, among others. In August of 2022, the U.S. Circuit Court of Appeals for the District of Columbia issued its ruling in Cross Refined Coal, LLC v. Comm’r, where the IRS challenged the validity of the taxpayer’s claim of refined-coal tax credits.
Background
Congress created the refined-coal tax credit in 2004 to encourage the production of coal that burns cleaner than its unrefined counterpart.[2] The statute provided that taxpayers who opened facilities that produced refined coal before 2012 could claim a tax credit for each ton sold over the next ten years.[3] This original legislation limited the ability to claim the credit to those who sold the refined coal for 50% more than the market value of unrefined coal.[4] Due to this limitation, the credit failed to generate any significant investment in refined coal facilities. In response, Congress lifted this restriction in 2008.[5]
The removal of the 50% limitation and the expansion of the credit produced Congress’s desired effect; more taxpayers began investing in refined coal facilities. One of these taxpayers so incentivized was AJG Coal, Inc. (“AJG”), who formed a new subsidiary, Cross Refined Coal, LLC (“Cross”) to launch a coal-refining facility in South Carolina. Cross entered into three key contracts to begin its coal-refining operations:
- First, Cross entered into a lease with a coal generator to build and operate a coal refining facility in its generating station.
- Second, Cross entered into a purchase-and-sale agreement with the generator in which Cross agreed to purchase unrefined coal from the generator, refine it, and sell the refined coal back to the generator at a price $0.75 less per ton than it was purchased, ensuring Cross would lose money on each sale.
- Third, Cross entered into a sub-license agreement with its parent company, AJG, to use its coal-refining technology.
Considering the operating expenses, lease, licensing agreement, and particularly the purchase and sale agreement that was guaranteed to produce a loss, Cross was certain to, and indeed anticipated, realize a pre-tax loss. The tax credit was paramount to Cross having a viable business model that would produce a post-tax profit. Shortly after beginning operation in 2009, two new members purchased interests in Cross. The addition of these two members allowed Cross’s initial sole member, AJG, to diversify its own investment over different projects, reducing its risk of loss. Additionally, AJG would be unable to claim most of the generated tax credits, instead having to carry them forward to future years. AJG therefore welcomed new partners who could claim the generated credits sooner rather than later.
All three members were actively involved in Cross’s operations. Each member made monthly pro-rata contributions to cover Cross’s operating expenses, as well as reviewing daily production reports, communicating with management, and signing off on any major decision. Cross operated for four years, before two different lengthy shutdowns due to permitting and regulatory issues lead to the dissolution of the partnership.
Cross claimed approximately $25.8 million in refined-coal credits in the 2011 and 2012 tax years, which it distributed among its three members on a pro-rata basis. In 2017, the IRS issued a notice of final partnership adjustment, stating that only AJG, not the two other members, could claim the credits. The IRS reasoned that Cross was not a partnership for federal tax purposes “because it was not formed to carry on a business or for the sharing of profits and losses,” but instead “to facilitate the prohibited transaction of monetizing ‘refined coal’ tax credits.” The Tax Court disagreed, ruling that Cross was a “bona fide partnership” because all three members made substantial contributions to Cross, participated in its management, and shared in its profits and losses. The IRS subsequently appealed to the DC Circuit.
Question Presented
The Circuit Court was presented with the question of whether Cross was a partnership for federal tax purposes, which would allow the generated tax credits and operating losses to be passed through to Cross’s three members. As the term “partnership” is not defined by statute, the Court turned to case law to determine whether Cross was a partnership for federal tax purposes.[6]In these cases, the Supreme Court established two requirements for a business to be considered a partnership.
First, the business must be “undertaken for profit or for other legitimate nontax business purposes.”7 This is usually decided on whether the business has a genuine opportunity to make a profit and whether the partners direct their efforts toward realizing it.[7] On the other hand, a business that has “no practical effect other than the creation of tax losses” is a sham, not a partnership.[8] Tax minimization as the primary consideration, however, is not unlawful.[9]
The Supreme Court’s second requirement for a partnership is that the partners must intend to “shar[e] in the profits or losses or both,”[10] and the partners’ interest must have the prevailing character of equity, not debt.[11] If a partner is protected from the fluctuating business risk, its interest resembles debt rather than equity.[12]
Holding
Applying the analysis provided by the Supreme Court, the Circuit Court affirmed the Tax Court’s decision that Cross satisfies the federal definition of a partnership. The Court held that the three partners intended to jointly carry on a business, finding that AJG had legitimate non-tax motives, such as diversifying investment risk. The Court also pointed out AJG recruiting the partners who could make immediate use of the tax credits provided financing that made this project, which Congress expressly incentivized by way of the credits, possible.
The IRS’s primary argument was that Cross did not conduct business activity to obtain a pre-tax profit, but rather the tax credits were the sole determinant of profit. Because of this, the IRS contended that Cross’s partners lacked the requisite intent to jointly carry on a business because Cross was not “undertaken for profit or for other legitimate nontax business purposes.” The Court emphatically rejected this argument, stating, “As a general matter, a partnership’s pursuit of after-tax profit can be legitimate business activity for partners to carry on together. This is especially true in the context of tax incentives, which exist precisely to encourage activity that would not otherwise be profitable.”
The IRS alternatively argued that a partnership is bona fide only if each partner expects to make a pre-tax profit at some point in time. Again, the Court rejected the IRS’s argument, stating, “… an investment does ‘not become a sham just because its profitability was based on after-tax instead of pre-tax projections.’”[13] The Court points out that Cross actively sought to produce an after-tax profit by engaging in business that Congress expressly encouraged – producing refined coal. Additionally, the organization of Cross as a partnership enabled AJG to raise more capital and spread its investment risk to two additional coal-refining projects. Indeed, the IRS even conceded that Cross would have a legitimate business purpose, even with no potential for pre-tax profit, had AJG been the sole member. The Court responded by stating that if one entity could lawfully seek after-tax profit through Cross, there is no reason why three partners could not validly pursue the same objective.
The Court also affirmed the Tax Court’s ruling that the two additional partners shared in the potential for gain and loss, indicating their interest resembled equity, not debt. Notably, the Court found that even the liquidated-damages provision in the purchase agreement of one of the partners did not constitute an interest resembling debt. While insulating the partners from minor fluctuations, their success corresponded with the amount of coal that Cross refined, which made them bona fide equity partners.
Conclusion
The Circuit Court of Appeals eloquently ended its opinion by stating, “The production of refined coal is legitimate business activity that Congress sought to make profitable through tax incentives, including for partnerships. Without more, high-after tax profit margins suggest only that the tax credit is a generous one, not that the entities obtaining them are something other than a legitimate partnership.” Going forward, it will be interesting to see if and how the IRS will continue to closely scrutinize activity that Congress is encouraging. Conserving land, producing clean energy, and investing in low-income communities are all causes that most people would consider noble and just, and as such Congress is rewarding these behaviors. One could argue that the executive branch’s watchful eye acts as a deterrent to behavior that is not only endorsed but incentivized by the legislative branch.
[1] Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995).
[2] 26 U.S.C. § 45(c)(7)(A).
[3] Id.
[4] American Jobs Creation Act of 2004, Pub. L. No. 108-357, § 710(a)(7)(A)(iv), 118 Stat. 1418, 1553.
[5] Energy Improvement and Extension Act of 2008, Pub. L. No. 110-343, Div. B, Tit. I, § 101(b)(1)(A), 122 Stat. 3765, 3808.
[6] Comm’r of Internal Revenue v. Tower, 327 U.S. 280, 286, 66 S.Ct. 532, 90 L.Ed. 670 (1946); Comm’r v. Culbertson, 337 U.S. 733, 752, 69 S.Ct. 1210, 93 L.Ed. 1659 (1949).
7 BCP Trading & Invs., LLC v. Comm’r, 991 F.3d 1253, 1263 (D.C. Cir. 2021).
[7] Id. at 1271.
[8] Id. at 1272.
[9] BCP Trading 991 F.3d at 1271.
[10] Tower, 327 U.S. at 287.
[11] TIFD III-E, Inc. v. United States, 459 F.3d 220, 231-32 (2d Cir. 2006).
[12] Historic Boardwalk Hall, LLC v. Comm’r, 694 F.3d 425, 462 (3d Cir. 2012).
[13] Sacks, 69 F.3d at 991.
