Cross Refined Coal, LLC v. Cmsnr. IRS ( 2022 )


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  •  United States Court of Appeals
    FOR THE DISTRICT OF COLUMBIA CIRCUIT
    Argued April 12, 2021                  Decided August 5, 2022
    No. 20-1015
    CROSS REFINED COAL, LLC, ET AL.,
    APPELLEES
    v.
    COMMISSIONER OF INTERNAL REVENUE,
    APPELLANT
    Appeal from the United States Tax Court
    Norah E. Bringer, Attorney, U.S. Department of Justice,
    argued the cause for appellant. With her on the briefs was
    Arthur T. Catterall, Attorney.
    Timothy S. Bishop argued the cause for appellees. With
    him on the brief were Brian W. Kittle, Geoffrey M. Collins, Joel
    V. Williamson, David W. Foster, Robert S. Walton, and
    Lawrence M. Hill. Colleen Campbell entered an appearance.
    Michael B. Kimberly, Paul W. Hughes, and Daryl Joseffer
    were on the brief for amici curiae the Chamber of Commerce
    of the United States of America and the National Mining
    Association in support of appellees. Steven P. Lehotsky entered
    an appearance.
    2
    Before: MILLETT, KATSAS, and RAO, Circuit Judges.
    Opinion for the Court filed by Circuit Judge KATSAS.
    KATSAS, Circuit Judge: Congress enacted a tax credit to
    incentivize the production of refined coal, which releases fewer
    emissions than unrefined coal. AJG Coal, Inc. responded by
    forming Cross Refined Coal, LLC and recruiting two other
    investors in that enterprise. Limited-liability companies are
    taxed like partnerships, so the company’s tax liabilities and
    credits passed through to its member investors. Yet the Internal
    Revenue Service balked when Cross’s members tried to claim
    the refined-coal credit. The IRS asserted that Cross was not a
    bona fide partnership for tax purposes, in part because it could
    never have made a profit without the tax credit. The tax court
    disagreed, and so do we. We hold that partnerships formed to
    conduct activity made profitable by tax credits engage in
    legitimate business activity for tax purposes. We further
    conclude that all of Cross’s members shared in its profits and
    losses, and thus had a meaningful stake in its success or failure.
    Accordingly, we affirm the tax court’s conclusion that Cross
    was a bona fide partnership.
    I
    A
    In 2004, Congress created a refined-coal tax credit to
    promote the production of treated, cleaner-burning coal. 
    26 U.S.C. § 45
    (c)(7)(A). Taxpayers that opened refined-coal
    production facilities before 2012 could claim a tax credit for
    each ton sold over the following ten years. 
    Id.
     § 45(d)(8),
    (e)(8). If multiple taxpayers had an ownership interest in a
    facility, the credit was allocated according to their respective
    ownership shares. Id. § 45(e)(3). Initially, a producer could
    3
    receive the credit only if it sold the refined coal for 50% more
    than the market value of unrefined coal. American Jobs
    Creation Act of 2004, Pub. L. No. 108-357, § 710(a)(7)(A)(iv),
    
    118 Stat. 1418
    , 1553. Congress lifted that restriction in 2008,
    after the tax credit had failed to stimulate significant
    investment in refined coal.          Energy Improvement and
    Extension Act of 2008, Pub. L. No. 110-343, Div. B, Tit. I,
    § 101(b)(1)(A), 
    122 Stat. 3765
    , 3808.
    B
    Shortly after Congress expanded the refined-coal tax
    credit, AJG Coal, Inc. began developing coal-refining
    technology. It then set out to launch a coal-refining facility at
    the Cross Generating Station in South Carolina. To do so, it
    formed a new subsidiary, Cross Refined Coal, LLC, which
    made three key contracts. First, Cross signed a lease with the
    utility that owned the generator, Santee Cooper. The lease
    allowed Cross to build and operate a coal-refining facility in
    the middle of the station. Second, Cross and Santee entered
    into a purchase-and-sale agreement. Cross would buy
    unrefined coal from Santee, refine it, and then sell it back to
    Santee for $0.75 less per ton, ensuring that Cross would lose
    money on each resale. Third, Cross entered into a sub-license
    agreement with AJG to use its coal-refining technology. AJG
    made similar arrangements at two other Santee-owned
    generating stations, Jefferies and Winyah, forming separate
    LLCs to do business at each.
    Cross’s business model made economic sense only by
    accounting for the tax credit. Considering (1) the operating
    expenses that Cross incurred to refine coal, (2) the losses it
    sustained in buying and then re-selling the coal, and (3) the
    royalties it paid to obtain the necessary technology, Cross’s
    operations inevitably would produce a pre-tax loss. Its sole
    4
    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. See 
    26 U.S.C. § 45
    (e)(8)(A)(i).
    Cross built the refining facility and began to operate it in
    December 2009. Over the next four months, AJG recruited two
    other members to Cross: Fidelity Investments and Schneider
    Electric, both acting through subsidiaries. For AJG, bringing
    other investors into Cross had two primary benefits. First, the
    new members’ investments enabled AJG to spread its own
    investment over a larger number of projects. This allowed AJG
    to reduce its overall risk and to collect useful data from plants
    with differing characteristics, without exceeding its parent
    company’s limited appetite for coal investments. Second,
    AJG’s parent company could claim only a fraction of the
    refined-coal tax credits in any given year; it would have had to
    carry the rest forward. Because money has a time value, it
    made sense to have partners who could claim the credits
    sooner. See 
    26 U.S.C. § 702
    (a)(7) (each partner separately
    reports its share of the partnership’s tax credits).
    AJG projected that Cross would realize a $140 million
    after-tax profit over ten years. After several months of due
    diligence, Fidelity purchased a 51% indirect stake in Cross for
    $4 million. The purchase agreement contained a liquidated-
    damages provision allowing Fidelity to exit Cross and receive
    a prorated portion of its investment if Cross did not meet
    certain benchmarks. Schneider purchased a 25% ownership
    share for $1.8 million, with no provision for liquidated
    damages. Fidelity and Schneider also contributed about $1.1
    million and $564,000 respectively to cover two months of
    5
    Cross’s operating expenses.1 Finally, Fidelity and Schneider
    invested in the LLCs to produce refined coal at the Jefferies
    and Winyah generating stations.
    Between 2010 and 2013, all three members of Cross were
    actively involved in its operations. Each reviewed daily
    production reports, signed off on major decisions, and
    communicated regularly with Cross management. Each
    member also made monthly contributions to cover Cross’s
    operating expenses such as payroll, health insurance, and
    materials. They paid these amounts in arrears, by reimbursing
    Cross for the prior month’s expenses. The contributions were
    proportional to each member’s ownership share.
    Cross proved profitable, but it endured two lengthy
    shutdowns that ultimately ended the partnership. First,
    permitting issues caused Cross to halt production between
    November 2010 and August 2011. Second, increased bromine
    levels at a nearby lake caused another shutdown beginning in
    May 2012. During these shutdowns, Cross incurred about $2.9
    million in operating expenses, which were not offset by the
    generation of tax credits. In March 2013, as Cross languished
    through its second shutdown, AJG bought out Schneider’s
    interest for $25,000. In November 2013, Fidelity exited Cross
    and received about $2.5 million in liquidated damages.
    Over the four years when Fidelity and Schneider were
    members of Cross, the company generated almost $19 million
    in after-tax profits—a substantial amount to be sure, but a far
    cry from the lofty projections that AJG had forecast in
    recruiting Fidelity and Schneider. The other refining projects
    were less successful. In October 2012, Santee shut down the
    1
    The tax court reported these figures as slightly lower, but we
    agree with the Commissioner that the discrepancies are immaterial
    in this appeal. Appellant Br. at 14 n.5.
    6
    Jefferies coal-refining operation because of insufficient
    demand for local power. As a result, Fidelity and Schneider
    suffered after-tax losses of $2.9 million and $700,000
    respectively on their investments in the Jefferies LLC.
    C
    For the 2011 and 2012 tax years, Cross claimed more than
    $25.8 million in refined-coal tax credits and $25.7 million in
    ordinary business losses. Because LLCs are taxed as
    partnerships by default, Cross distributed the credits and losses
    among its three members proportionally. See 
    26 C.F.R. § 301.7701-3
    (b)(1). But 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.”
    A. 556. Accordingly, the IRS concluded that only AJG could
    claim the tax credits.
    Cross sought a readjustment in the tax court under 
    26 U.S.C. § 6234
    (a)(1). That 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. A. 1818–32.
    II
    On appeal, the Commissioner contests the conclusion that
    Cross was a bona fide partnership. We have jurisdiction under
    
    26 U.S.C. § 7482
    (a)(1). We review tax court decisions “in the
    same manner and to the same extent as decisions of the district
    courts in civil actions tried without a jury.” 
    Id.
     Therefore, we
    review the tax court’s legal conclusions de novo and its
    findings of fact and determinations of mixed questions for clear
    7
    error. Andantech L.L.C. v. Comm’r, 
    331 F.3d 972
    , 976 (D.C.
    Cir. 2003). Under clear-error review, we may overturn the tax
    court’s findings only if we have a “definite and firm
    conviction” that the court committed a “serious mistake as to
    the effect of evidence.” BCP Trading & Invs., LLC v. Comm’r,
    
    991 F.3d 1253
    , 1263 (D.C. Cir. 2021) (cleaned up).
    A
    Because of the special benefits that the tax code affords
    partnerships, businesses face “special temptations to appear as
    a partnership” for tax purposes. Comm’r v. Culbertson, 
    337 U.S. 733
    , 752 (1949) (Frankfurter, J., concurring); see
    Southgate Master Fund, L.L.C. ex rel. Montgomery Cap.
    Advisors, LLC v. United States, 
    659 F.3d 466
    , 483 (5th Cir.
    2011) (“many abusive tax-avoidance schemes are designed to
    exploit the [Internal Revenue] Code’s partnership provisions”).
    One aspect of partnership taxation is particularly alluring:
    Partnerships are not taxed at the entity level. Instead, a
    partnership’s tax burdens and benefits pass through to the
    partners. 
    26 U.S.C. § 701
    . Thus, a business can offset its own
    tax liability if it is a partner in an entity that generates a tax loss.
    See, e.g., ASA Investerings P’ship v. Comm’r, 
    201 F.3d 505
    ,
    506 (D.C. Cir. 2000).
    Even if an enterprise formally organizes itself as a
    partnership—for example, by filing the appropriate paperwork
    under state law—it is not treated as a partnership for federal tax
    purposes unless it qualifies as a partnership under federal law.
    Yet the tax code does not supply a comprehensive definition of
    the term “partnership.” It states only that “[t]he term
    ‘partnership’ includes” certain kinds of entities, 
    26 U.S.C. § 7701
    (a)(2), and the IRS’s anti-abuse regulations merely
    explain that a partnership must be “bona fide,” 
    26 C.F.R. § 1.701-2
    (a)(1).
    8
    Without any legal text to construe, we are guided by the
    Supreme Court’s definition of partnership, which is based on
    background partnership law. Comm’r v. Tower, 
    327 U.S. 280
    ,
    286 (1946); see Culbertson, 
    337 U.S. at
    751 n.1 (Frankfurter,
    J., concurring) (“use of the words ‘The term “partnership”
    includes’ presupposes that the term has a recognized content”
    which “can only be found in the general law of partnership”).
    In Tower, the Court held that a partnership is formed where two
    or more persons “intend[] to join together for the purpose of
    carrying on business and sharing in [its] profits or losses.” 
    327 U.S. at 287
    . Three years later, the Court reiterated that “the
    parties [must] in good faith and acting with a business purpose
    intend[] to join together in the present conduct of the
    enterprise.” Culbertson, 
    337 U.S. at 742
    . The question of
    “bona fide intent” to form a partnership is one of fact, which
    depends on a totality of the circumstances. 
    Id.
     at 741–43.
    The partnership definition in Tower and Culbertson
    consists of two requirements. First, the partners must intend to
    “carry on business as a partnership.” Tower, 
    327 U.S. at 287
    ;
    Culbertson, 
    337 U.S. at
    742–43. In other words, the enterprise
    must be “undertaken for profit or for other legitimate nontax
    business purposes.” BCP Trading, 991 F.3d at 1271 (cleaned
    up). In most cases, this inquiry turns on whether the
    partnership has a genuine opportunity to make a profit and
    whether the partners direct their efforts toward realizing it. See
    id. at 1271–72. In contrast, a partnership that has “no practical
    economic effect other than the creation of tax losses” is treated
    as a sham. Id. at 1272; see ASA Investerings, 
    201 F.3d at 506
    (finding sham partnership where “transactions that in substance
    added up to a wash were transmuted into ones generating tax
    losses of several hundred million dollars”). Other factors that
    are probative of a sincere intent to carry on a business include
    the duration of the partnership, see Andantech, 
    331 F.3d at 979
    ,
    and the business rationale for using the partnership form, 
    id.
     at
    9
    980; Boca Investerings P’ship v. United States, 
    314 F.3d 625
    ,
    632 (D.C. Cir. 2003).
    Though we look to economic reality in assessing intent to
    carry on a business, we do not lightly set aside de jure
    partnerships as shams. “It is uniformly recognized that
    taxpayers are entitled to structure their transactions in such a
    way as to minimize tax,” ASA Investerings, 
    201 F.3d at 513
    , so
    “[t]ax minimization as a primary consideration is not
    unlawful,” BCP Trading, 991 F.3d at 1272. Taxpayers that
    structure their dealings to receive tax benefits afforded by
    statute are entitled to those benefits, no matter their subjective
    motivations. Otherwise, the sham-partnership doctrine, like
    the more general economic-substance doctrine, would allow
    the Commissioner “to place labels on transactions to avoid
    textual consequences he doesn’t like.” Summa Holdings, Inc.
    v. Comm’r, 
    848 F.3d 779
    , 787 (6th Cir. 2017).
    The second requirement of the Supreme Court’s definition
    of partnership is that the partners must intend to “shar[e] in the
    profits or losses or both.” Tower, 
    327 U.S. at 287
    . In other
    words, the partners’ interests must have the “prevailing
    character” of equity, with each partner having a “meaningful
    stake in the success or failure” of the partnership. TIFD III-E,
    Inc. v. United States, 
    459 F.3d 220
    , 231–32 (2d Cir. 2006). If
    one putative partner is insulated from the upside and downside
    risks of the business, its interest resembles that of a secured
    creditor, not an equity partner. See Historic Boardwalk Hall,
    LLC v. Comm’r, 
    694 F.3d 425
    , 462 (3d Cir. 2012) (“a
    partnership, with all its tax credit gold, can[not] be conjured
    from a zero-risk investment”); Southgate, 
    659 F.3d at
    486–89.
    In our circuit, the leading case on partnership validity
    epitomizes the failure to meet these two requirements. In ASA
    Investerings, a U.S. corporation seeking to offset a large capital
    10
    gain formed a putative partnership with a foreign bank not
    subject to U.S. tax. 
    201 F.3d at 508
    . During its brief existence,
    the partnership executed only two transactions: the purchase
    and offsetting sale of certain debt instruments. 
    Id.
     Relying on
    the tax code’s installment-sale rules, the partners engaged in
    wash transactions that created a large capital gain for the tax-
    indifferent bank and a large capital loss (and accompanying tax
    deduction) for the U.S. corporation. 
    Id.
    We held that the purported partnership was not bona fide.
    First, the partners did not intend to carry on a business together,
    for the partnership was not designed to be profitable on a pre-
    or post-tax basis, and it had no other apparent non-tax business
    purpose. 
    201 F.3d at
    513–14. The partnership claimed that it
    hoped to profit from a change in interest rates between the time
    of the offsetting transactions, but we found that they were
    designed to eliminate all relevant risks. 
    Id. at 514
    . Second,
    and relatedly, the foreign bank did not share in the supposed
    risk of the putative partnership. Instead, it received a
    guaranteed rate of return for its participation and faced only a
    “de minimis risk” to its investment. 
    Id.
     at 514–15 (“A partner
    whose risks are all insured at the expense of another partner
    hardly fits within the traditional notion of partnership.”).
    B
    Applying these principles, we agree with the tax court that
    Cross satisfies the federal definition of a partnership.
    1
    First, the tax court correctly determined that AJG, Fidelity,
    and Schneider intended to jointly carry on a business. As the
    tax court found and the government concedes, AJG had
    legitimate non-tax motives for forming Cross and for recruiting
    partners, such as spreading its investment risk over a larger
    11
    number of projects. Moreover, there was nothing untoward
    about seeking partners who could apply the refined-coal credits
    immediately, rather than carrying them forward to future tax
    years. Low-tax entities (like AJG) often use the prospect of tax
    credits to attract high-tax entities (like Fidelity and Schneider)
    into a partnership, and in return, the high-tax partners provide
    the financing needed to make the tax-incentivized project
    possible. See Va. Historic Tax Credit Fund 2001 LP v.
    Comm’r, 
    639 F.3d 129
    , 132–33 (4th Cir. 2011); Office of the
    Comptroller of the Currency, Low-Income Housing Tax
    Credits: Affordable Housing Investment Opportunities for
    Banks 1–3 (last updated Apr. 2014). And Congress expressly
    provided for coal refiners to employ this investment strategy,
    for the tax code specifies how the credit must be divided when
    a refining facility has multiple owners. 
    26 U.S.C. § 45
    (e)(3).
    Cross therefore fits comfortably within the scope of entities
    that Congress envisioned claiming the credit.
    Fidelity and Schneider, while no doubt motivated by the
    prospect of refined-coal tax credits, also became legitimate
    partners in the enterprise. Though AJG did much of the heavy
    lifting to launch Cross, Fidelity and Schneider jointly
    controlled its major decisions once they became members, and
    they were actively involved in its day-to-day operations. Both
    also made monthly contributions to Cross “commensurate with
    their status as partners”—Fidelity contributed $26 million, and
    Schneider contributed $12.3 million. A. 1821–22. And both
    remained members of Cross for several years, even during
    unprofitable shutdowns.
    The Commissioner’s chief objection is that Cross did not
    pursue business activity to obtain a pre-tax profit. Instead, tax
    credits were its sole profit driver, and the production of those
    credits thus permeated every aspect of its business model.
    According to the Commissioner, Cross’s partners did not have
    12
    the requisite intent to carry on a business together because
    Cross was not “undertaken for profit or for other legitimate
    nontax business purposes.” BCP Trading, 991 F.3d at 1271
    (cleaned up) (emphasis added).
    We disagree. 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 production
    of refined coal illustrates this point: Congress recognized its
    environmental benefits, but, as the tax court explained, refiners
    must sell it at a discount “in order to induce the utility to assume
    the risk of buying and using” it. A. 1792–93. Thus, Cross did
    not simply engage in “wasteful activity,” which is typical of
    sham partnerships that merely manufacture tax losses. ASA
    Investerings, 
    201 F.3d at 513
    . Rather, Cross engaged in
    business activity with a “practical economic effect,” BCP
    Trading, 991 F.3d at 1272—the production of cleaner-burning
    refined coal, which Congress specifically sought to encourage.
    The Ninth Circuit has likewise held that taxpayers may
    legitimately conduct business activity that Congress has
    deliberately made profitable through statutory tax incentives—
    and may do so with no hope of a pre-tax profit. In Sacks v.
    Commissioner, 
    69 F.3d 982
     (9th Cir. 1995), that court
    explained: “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.” 
    Id. at 992
    . For “Congress has
    purposely used tax incentives” to “induce investments which
    otherwise would not have been made,” and “[i]f the
    Commissioner were permitted to deny tax benefits when the
    investments would not have been made but for the tax
    advantages, then only those investments would be made which
    13
    would have been made without the Congressional decision to
    favor them.” 
    Id.
     at 991–92. The Commissioner’s view would
    thus hamstring Congress’s ability to use tax credits to
    encourage all kinds of activity that is socially desirable but
    unprofitable to those undertaking it—such as building low-
    income housing, 
    26 U.S.C. § 42
    ; producing renewable energy,
    
    id.
     § 45; or developing medicines for rare diseases, id. § 45C.
    The Commissioner falls back to the position that a
    partnership is bona fide only if each partner expects to make a
    pre-tax profit “at some point in time.” Reply Br. at 23–24. He
    invokes Alternative Carbon Resources, LLC v. United States,
    
    939 F.3d 1320
     (Fed. Cir. 2019), which held that a taxpayer
    could not claim an alternative-fuel tax credit absent evidence
    that it “ever reasonably expected to generate any profit apart
    from the tax credits.” 
    Id. at 1330
     (cleaned up). Like the
    Commissioner, Alternative Carbon sought to distinguish Sacks
    as a case where the taxpayer could eventually turn a pre-tax
    profit. 
    Id. at 1331
    . But Sacks did not turn on that possibility;
    to the contrary, it explained that an investment does “not
    become a sham just because its profitability was based on after-
    tax instead of pre-tax projections.” 
    69 F.3d at 991
    . And even
    Alternative Carbon acknowledged that a transaction
    “unprofitable absent a tax credit” may still have economic
    substance if it “meaningfully alters the taxpayer’s economic
    position (other than with regard to the tax consequences)” and
    has a “bona fide business purpose.” 939 F.3d at 1331–32
    (cleaned up). Cross passes muster under this test: Its partners
    all made sizable contributions to become part owners and help
    Cross engage in the business of producing refined coal.
    The Commissioner also points to our remark in ASA
    Investerings that “the absence of a nontax business purpose is
    fatal” to bona fide partnership status. 
    201 F.3d at 512
    . But
    transactions that are profitable only on a post-tax basis can still
    14
    have a “nontax business purpose.” The ASA partnership—an
    “elaborate” scheme that engaged in “wasteful activity” with
    “very substantial transaction costs”—had no purpose apart
    from the creation of tax losses. 
    Id. at 513, 516
    . Indeed, the
    partnership itself could not profit even on a post-tax basis,
    making it “no more than a facade.” 
    Id.
     at 513–14. Cross, on
    the other hand, sought to produce a post-tax profit, and it did
    so by pursuing the congressionally encouraged business
    purpose of producing refined coal. Moreover, its use of the
    partnership form furthered that purpose by enabling AJG to
    raise more capital and spread its investment risk across
    multiple coal-refining projects.
    Even the Commissioner ultimately recognizes that an
    enterprise profitable only on a post-tax basis can have a valid
    business purpose. He acknowledges that Cross would have had
    a legitimate business purpose had AJG alone operated it, even
    with no potential for pre-tax profit. But if one entity could
    validly seek after-tax profit through Cross, there is no reason
    why three partners could not validly pursue the same objective.
    2
    The tax court also correctly concluded that Fidelity and
    Schneider shared in Cross’s potential for profit and risk of loss,
    giving their investment the prevailing character of equity. If
    Cross refined more coal, Fidelity and Schneider made more
    money. If Cross struggled—whether due to regulatory
    obstacles, environmental problems, or shortcomings in the
    newly developed refining technology—Fidelity and Schneider
    would lose money. And Cross did at times struggle: During
    its two shutdowns, it incurred almost $2.9 million in operating
    expenses without generating any offsetting revenue. As
    15
    partners, Fidelity and Schneider were liable for, and paid, their
    pro rata shares of those expenses.
    To be sure, Fidelity and Schneider were insulated from
    some of Cross’s downside risk. Most notably, Fidelity’s
    purchase agreement contained the liquidated-damages
    provision. Likewise, Cross’s sub-license agreement was
    structured to protect Fidelity and Schneider from minor
    fluctuations in variable operating costs. But these provisions
    hardly made their 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.” Gilbert v. Comm’r,
    
    248 F.2d 399
    , 406 (2d Cir. 1957). By and large, Fidelity and
    Schneider’s fortunes rose or fell with the amount of coal that
    Cross refined, which made them bona fide equity partners. See
    Historic Boardwalk, 694 F.3d at 459 (“a limited partner’s
    status as a bona fide equity participant will not be stripped away
    merely because it has successfully negotiated measures that
    minimize its risk of losing a portion of its investment”); Hunt
    v. Comm’r, 
    59 T.C.M. (CCH) 635
    , 648 (1990) (bona fide
    partner could have a 98% guaranteed return of its capital
    contribution).
    The Commissioner acknowledges that Fidelity and
    Schneider faced downside risk, but he contends that it was not
    meaningful given the magnitude of the expected tax benefits.
    In support of this argument, the Commissioner invokes cases
    relying on the economic-substance doctrine, which evaluates
    transactions based on economic reality as opposed to formal
    labels. See Gregory v. Helvering, 
    293 U.S. 465
    , 468–70
    (1935). The cited cases assessed the legitimacy of offshore
    transactions that gave rise to large U.S. tax losses. Bank of N.Y.
    Mellon Corp. v. Comm’r, 
    801 F.3d 104
    , 106–07 (2d Cir. 2015);
    Reddam v. Comm’r, 
    755 F.3d 1051
    , 1055–57 (9th Cir. 2014).
    16
    In these cases, the courts compared the magnitude of the
    expected tax and non-tax benefits to gauge whether the
    disputed transactions had a legitimate business purpose. Bank
    of N.Y. Mellon, 801 F.3d at 120; Reddam, 755 F.3d at 1061.
    Similar logic applies to sham-partnership analysis, the
    Commissioner contends, as evidenced by our statement in ASA
    Investerings that “any potential gain from the partnership’s
    investments was in its view at all times dwarfed by its interest
    in the tax benefit.” 
    201 F.3d at 513
    .
    In this case, the Commissioner modifies the comparison
    and balances capital placed at risk with the expected tax
    benefits. He asserts that at most, Fidelity and Schneider
    respectively placed at risk about $4 million and $3 million,
    which represent the sum of (1) the initial buy-in amounts (less
    the amount that Fidelity later received in liquidated damages),
    (2) the initial contributions to cover two months of operating
    expenses, and (3) the monthly contributions to cover operating
    expenses during shutdown months when no tax credits accrued.
    On the other side of the ledger, Fidelity and Schneider
    anticipated that, under a best-case scenario, they would
    collectively earn $105 million in after-tax profit over ten years.
    The Commissioner contends that this imbalance between the
    relatively small amounts that Fidelity and Schneider placed at
    risk and the large expected tax benefits shows that they merely
    bought tax credits rather than becoming true equity partners.2
    2
    The Commissioner argues that the tax court, in evaluating the
    extent of Fidelity and Schneider’s risk, improperly considered
    operating expenses accrued during non-shutdown months when
    Cross produced refined coal and thus earned the tax credit. The tax
    court did not do so. See A. 1825–32. But regardless of whether these
    expenses are considered, we conclude that Fidelity and Schneider
    had meaningful downside risk.
    17
    We reject this argument. The cited economic-substance
    cases compared expected tax and non-tax benefits to discern
    the nature of the contested transactions for tax purposes. As
    explained above, Congress recognized the environmental
    benefits of cleaner coal and provided tax incentives that it
    deemed appropriate as a result. We thus cannot ignore tax
    consequences in assessing the legitimacy of the encouraged
    activity. By contrast, the financial engineering in Bank of New
    York Mellon and Reddam had no “practical economic effects,”
    Reddam, 755 F.3d at 1062 (quoting Sacks, 
    69 F.3d at 987
    );
    Bank of N.Y. Mellon, 801 F.3d at 120 (similar), and the
    comparison between the transactions’ tax and non-tax benefits
    confirmed that they lacked substance. As for ASA Investerings,
    the putative partnership activity there was unprofitable even on
    a post-tax basis, in contrast to the activity here of producing
    refined coal. Also, in weighing expected benefits, the
    Commissioner relies on a best-case scenario “assum[ing]
    uninterrupted high volume sales of refined coal over the entire
    10-year period,” A. 1794, rather than a more realistic, risk-
    adjusted projection.
    Moreover, even if we accepted the Commissioner’s
    modification and compared capital placed at risk to anticipated
    tax benefits under a best-case scenario, we still see no reason
    to doubt Fidelity and Schneider’s status as bona fide partners.
    As explained above, 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. In this case, for
    example, nobody doubts that AJG could benefit from the tax
    credit, no matter how small its investment or how large its tax-
    driven profits. Fidelity and Schneider were no less eligible to
    reap the rewards of Congress’s generosity.
    18
    We recognize that Fidelity and Schneider could not fairly
    be treated as equity partners if their investments in Cross were
    so trivial or so insulated from risk as to make them indifferent
    to Cross’s success or failure. But as shown above, Fidelity and
    Schneider had much skin in the game. Through their initial
    investments and contributions to operating expenses, they put
    millions of dollars at risk, in amounts proportionate to their
    respective ownership interests. Moreover, as the tax court
    explained, “it was entirely within the realm of possibility” that
    they would not recover much of their capital, A. 1829, in sharp
    contrast to the cases cited by the Commissioner, see ASA
    Investerings, 
    201 F.3d at
    514–15 (hedge transactions made any
    risk of loss “de minimis”); Bank of N.Y. Mellon, 801 F.3d at
    122 (transactions amounted to a “circular cash flow”); Reddam,
    755 F.3d at 1061 (“tax loss” from transaction “would always
    … have overshadowed” any underlying gains or losses). The
    tax benefits that the partners received varied entirely with the
    amount of coal that Cross was able to refine. And there were
    significant downside risks, which materialized for long
    periods. For instance, though the best-case forecasts projected
    that Fidelity and Schneider would receive $105 million in tax
    credits over 10 years, they ended up earning only $14.25
    million over four years due to two lengthy shutdowns.
    Moreover, the two partners lost $2.9 million and $700,000
    respectively on the Jefferies refining facility, which used the
    same investment structure as Cross. And it could have been
    even worse: Fidelity and Schneider were exposed to
    significant litigation and regulatory risks, and they faced the
    possibility that the refined coal might not meet emissions
    standards and thus not qualify for any tax credits.
    A material risk of failing to receive a return on investment
    is the essence of every equity stake. Fidelity and Schneider’s
    investments in Cross carried that risk, which distinguishes this
    case from sham partnerships that guarantee a fixed return to
    19
    one putative partner. The tax court correctly concluded that all
    members of Cross shared its profits and losses. See Tower, 
    327 U.S. at 287
    .
    III
    For these reasons, we affirm the tax court’s ruling that
    Cross was a bona fide partnership.
    So ordered.