Today, August 5, the US Court of Appeals for the DC Circuit released its opinion in Cross Refined Coal, LLC v. Commissioner, No. 20-1015. The Circuit Court upheld the Tax Court’s decision that the appellee was a bona fide partnership. The case, which was argued in April 2021, has been closely watched by practitioners and taxpayers for the insight it can provide into the treatment of partnership transactions involving the allocation of tax credits.
Lawrence Hill, who co-heads Steptoe’s tax controversy practice, was lead counsel of record for the project’s sponsor/partner, AJG Coal, Inc. in the Tax Court trial and DC Circuit appeal.
The Cross Refined Coal case is only the latest chapter in the ongoing saga of the IRS’s efforts to police the use of partnerships to allocate tax credits away from project sponsors and towards investors who are more able to use them. In its opinion, the Circuit Court reaffirmed and expanded on the central holding of Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995) that the impossibility of a pre-tax profit, in and of itself, does not make these kinds of partnership transactions a sham or lacking in economic substance. In particular, the Circuit Court rejected the IRS’s argument that investors must be able to eventually turn a pre-tax profit for the Sacks holding to apply.
Furthermore, the Circuit Court rejected the IRS’s proposed economic substance analysis, which would weigh the amount of capital placed at risk against the magnitude of the expected tax benefits, explaining that “[w]ithout 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.”
Instead, to determine whether investors were partners in a bona fide partnership, the Circuit Court looked to factors such as:
- The carrying on of those business activities that Congress intended to incentivize, regardless of whether these activities are profitable on a pre-tax basis, instead of “wasteful activity”;
- The extent to which investors bear their proportionate share of the operating expenses of the partnership;
- The degree of participation of investors in major decisions;
- The extent of due diligence and of communications between the investors and project managers and other investor involvement in day-to-day business operations;
- The presence of other, non-tax motives for seeking investors, such as spreading investment risk over a larger number of projects; and
- The absence of protections that make the investors’ investments effectively like debt, for which funds are “advanced with reasonable expectations of repayment regardless of the success of the venture” rather than being “placed at the risk of the business.”
Nature of the Transaction
Cross Refined Coal, LLC (Cross) was a limited liability company, treated as a partnership for US federal income tax purposes, formed in response to the incentives Congress provided through refined coal production tax credits under Internal Revenue Code section 45. The project’s sponsor was only able to claim a fraction of the refined-coal tax credits in any given year. For this and other reasons, the sponsor recruited two other investors who had a greater capacity to make use of the tax credits.
After several months of due diligence, the two other investors each purchased an interest in Cross. The purchase agreement contained a liquidated-damages provision allowing one of these investors to exit Cross and receive a prorated portion of its investment if Cross did not meet certain benchmarks. Each member reviewed daily production reports, signed off on major decisions, and communicated regularly with Cross management. Each member also made monthly contributions, proportional to each member’s ownership share, to cover Cross’s operating expenses such as payroll, health insurance, and materials.
Cross’s business relied on three key contracts. First, Cross signed a lease with a utility company that owned a coal-to-electricity generating station. The lease allowed Cross to build and operate a coal-refining facility in the middle of the station. Second, Cross and the utility company entered into a purchase-and-sale agreement. Under the agreement, Cross would buy unrefined coal from the utility company, refine it, and then sell it back to the utility for $0.75 less per ton, ensuring that Cross would lose money on each resale. Third, Cross entered into a sub-license agreement with the sponsor to use its coal-refining technology.
Because Cross lost money on every ton of coal it purchased, processed, and sold; had other expenses from operating its equipment and paying royalties to the sponsor; and had no additional sources of revenue, it was impossible for Cross to realize a pre-tax profit. Its sole opportunity to turn a profit was to claim a tax credit that exceeded these costs. Consistent with this tax-centric model, Cross’s lease, purchase-and-sale agreement, and sub-license all had ten-year terms matching the ten-year window during which it could generate tax credits.
IRS Adjustment and Tax Court Decision
In June 2017, the IRS issued a notice of final partnership administrative adjustment. It determined 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.” Accordingly, the IRS concluded that only the sponsor could claim the tax credits.
Cross sought a readjustment in Tax Court, and the Tax Court ruled 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.
DC Circuit Opinion
The DC Circuit upheld the Tax Court’s decision. The Circuit Court looked to the Supreme Court’s holdings in Commissioner v. Tower, 327 U.S. 280 (1946) and Commissioner v. Culbertson, 337 U.S. 733 (1949), which it interpreted as providing two requirements for treatment as a bona fide partnership: (i) the partners must intend to “carry on business as a partnership,” i.e. an enterprise “undertaken for profit or for other legitimate nontax business purposes”; and (ii) the partners must intend to “shar[e] in the profits or losses or both,” i.e., that the partners’ interests have the prevailing character of equity.
The DC Circuit concluded that the members of Cross entered into an enterprise undertaken for profit or for other legitimate nontax business purposes. The Circuit Court noted that the sponsor had legitimate non-tax motives for forming Cross and for recruiting partners, such as spreading its investment risk over a larger number of projects. Critically, the Circuit Court also stated that “there was nothing untoward about seeking partners who could apply the refined-coal credits immediately, rather than carrying them forward to future tax years.” The Circuit Court also stressed that the other investors, and not just the sponsor, “jointly controlled major decisions” and made monthly contributions for operating expenses “commensurate with their status as partners.”
The IRS’s arguments focused on the impossibility of earning a pre-tax profit and the various ways in which the production of tax credits “permeated every aspect of [Cross’s] business model.” The Circuit Court rejected these arguments, explaining that tax incentives like the production tax credits “exist precisely to encourage activity that would not otherwise be profitable.” Instead, the Circuit Court noted that Cross’s business activities had a “practical economic effect,” namely the production of cleaner-burning refined coal, which Congress specifically sought to encourage. The Circuit Court also rejected the view that a partnership is bona fide only if each partner expects to make a pre-tax profit “at some point in time.”
The Circuit Court also concluded that the investors in Cross shared in Cross’s potential for profit and risk of loss, giving their investment the prevailing character of equity. The Circuit Court explained that if Cross refined more coal, the investors would make more money, and if Cross struggled—whether due to regulatory obstacles, environmental problems, or shortcomings in the newly developed refining technology—the investors would lose money. In particular, Cross experienced two shutdowns, during which it incurred almost $2.9 million in operating expenses without generating any offsetting revenue. As partners, the investors were liable for, and paid, their pro rata shares of those expenses.
Although the investors were protected from some business risks—including by the liquidated damages provision described above—these provisions did not provide so much protection that their interest effectively became like debt, for which funds are “advanced with reasonable expectations of repayment regardless of the success of the venture” rather than being “placed at the risk of the business.” In particular, the Circuit Court rejected the IRS’s proposed analysis which weighed the amount of capital placed at risk against the magnitude of the expected tax benefits. The Court again emphasized that this kind of analysis assumes the illegitimacy of Congress’s objective to provide tax incentives to otherwise unprofitable ventures. The Circuit Court explained that “[w]ithout 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.”