Jonathan D. Barry & Susan S. Barry ( 2022 )

United States Tax Court
T.C. Memo. 2022-86ALEXANDER C. DEITCH,
Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
JONATHAN D. BARRY AND SUSAN S. BARRY,
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket Nos. 21282-17, 21283-17. Filed August 25, 2022.
—————
Ps were partners in the partnership WTS. In 2006
WTS purchased a commercial rental property in Georgia
by financing the property with the proceeds of a loan from
PLI. The integrated loan documents included an
“Additional Interest Agreement” that entitled PLI to
additional interest of two types—“NCF Interest” (i.e., 50%
of the net cashflow from the property) and “Appreciation
Interest” (i.e., 50% of the appreciation in the value of the
property if it was ever sold or the loan was terminated).
WTS owned no other real property.
During the years WTS owned the commercial rental
property, it made regular loan payments to PLI, which
consisted of repayment of principal, stated interest at a
fixed rate, and 50% of the net income from the property, all
of which it characterized as interest. WTS sold the
Served 08/25/22
2
[*2] property in 2014 and, in accordance with the loan
documents, paid to PLI the appreciation interest.
On its partnership tax return for 2014, WTS claimed
an I.R.C. § 163(a) deduction for its payment of the
appreciation interest to PLI and reported a net loss in
excess of $1 million on the commercial rental property.
WTS reported net I.R.C. § 1231 gain of $2.6 million. Ps
reported their distributive shares of income and loss of
WTS on their individual income tax returns for 2014.
R sent statutory notices of deficiency to Ps,
determining that Ps’ incomes should each be increased by
$517,841, resulting from R’s disallowance of the
appreciation interest WTS claimed as a deductible interest
expense.
Held: Notwithstanding I.R.C. § 6221(a) and Tax
Court Rule 240(c), we have jurisdiction to determine
whether WTS and PLI were engaged in a joint venture
constituting a partnership for federal income tax purposes,
and we hold that they were not so engaged.
Held, further, PLI did not have a “single equity
interest” in its dealings with WTS that transformed WTS’s
loan payments on genuine indebtedness to PLI into
guaranteed payments made to a partner pursuant to I.R.C.
§ 707(c).
Held, further, in light of the facts stipulated by the
parties, the appreciation interest that WTS paid to PLI was
interest deductible under I.R.C. § 163, not a payment in
respect of any equity interest held by PLI.
—————
David D. Aughtry and John W. Hackney, for petitioners.
Christopher D. Bradley, for respondent.
3
[*3] MEMORANDUM FINDINGS OF FACT AND OPINION
GUSTAFSON, Judge: In these consolidated cases, the Internal
Revenue Service (“IRS”) issued pursuant to section 6212 1 statutory
notices of deficiency (“NOD”) to petitioner Alex Deitch and to married
petitioners Jonathan and Susan Barry 2 on July 14, 2017. The NOD
issued to Mr. Deitch determined a deficiency of $211,217 for 2014, and
the NOD issued to Mr. and Mrs. Barry determined a deficiency of
$188,271 for 2014. 3 The issues for decision are: (1) whether West Town
Square Investment Group, LLC (“WTS”, which was co-owned by
petitioners), and its lender Protective Life Insurance Co. (“PLI”) formed
a joint venture that was a partnership for federal income tax purposes
(we hold that they did not); and (2) whether a payment in 2014 of
$1,035,683 by WTS to PLI was deductible as interest under section 163
(we hold that it was).
FINDINGS OF FACT
On the basis of the parties’ stipulations and the evidence before
us, and employing the burden-of-proof principles set out below, we find
the following facts.
Petitioners
At the time that they filed their Petitions in these consolidated
cases, Mr. Deitch and Mr. and Mrs. Barry all resided in Georgia. At all
relevant times, Mr. Deitch and Mr. Barry worked in the commercial real
estate industry, and Mr. and Mrs. Barry were married.
1 Unless otherwise indicated, statutory references are to the Internal Revenue
Code (“the Code”, Title 26 of the United States Code) as in effect at the relevant times;
references to regulations are to Title 26 of the Code of Federal Regulations (“Treas.
Reg.”) as in effect at the relevant times; and references to Rules are to the Tax Court
Rules of Practice and Procedure. Some dollar amounts are rounded.
2Jonathan D. Barry and Susan S. Barry are married petitioners in docket
No. 21283-17 who filed jointly for 2014; they and Alex Deitch (the sole petitioner in
docket No. 21282-17) are the three petitioners whose income tax liabilities for 2014 are
addressed in this Opinion. For convenience we use the term “petitioners” to refer to
Messrs. Deitch and Barry, the sole partners in West Town Square.
3 Each NOD also determined an accuracy-related penalty under section 6662,
but the Commissioner has conceded the penalties, so we will not discuss them further.
4
[*4] PLI
From 2006 through 2014, PLI (the lender discussed below) was a
subsidiary of Protective Life Corp. The parties stipulated that PLI “did
not own a member interest” in WTS and that PLI and Protective Life
Corp. were not related to petitioners or to WTS within the meaning of
sections 267(b) and 707(b)(1).
Organization and ownership of WTS
On August 31, 2006, Mr. Barry organized WTS, a Georgia limited
liability company, in order to purchase and operate a 6.85-acre parcel of
commercial rental property on Shorter Avenue in Rome, Georgia (the
“Rome property”). Mr. Deitch purchased an interest consisting of 500
membership units in WTS on December 13, 2006, for a price of five
dollars. (Mr. Barry and Mr. Deitch had each made a capital contribution
to WTS of five dollars.) Upon execution of a subscription agreement and
an amendment to WTS’s operating agreement, Mr. Deitch and
Mr. Barry each owned 500 member units (i.e., a one-half interest in
WTS), which was a partnership for federal income tax purposes.
Mr. Barry served as the tax matters member 4 and company manager.
WTS’s stated company purpose was, among other things, “[t]o engage in
any lawful business, purpose or activity . . . [of] acquiring, developing,
improving, leasing (including leasing to affiliated Entities), managing,
renovating, repairing, maintaining and selling, or otherwise dealing
with, real property, including the [Rome] Property”.
WTS’s deal to acquire the Rome property
In 2006 Mr. Barry was operating a commercial real estate
brokerage and property management company called Spectrum Cauble
Management, a joint venture with Colliers International (“Colliers”). In
that capacity he was commonly engaged by a tenant of a commercial
property seeking other suitable commercial space, or alternatively,
engaged by the owner of a commercial property to find suitable tenants.
Mr. Barry first learned of the Rome property when one of his associates
was engaged by Redmond Hospital to seek locations for an additional
unit to provide physical therapy services outside of the hospital. The
4 WTS’s amended operating agreement makes this designation of a tax matters
member pursuant to section 6231(a)(7) of the unified audit and litigation procedures
of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), Pub. L. No. 97-248,
§ 402(a), 96 Stat. 324, 663, discussed below. No TEFRA proceedings were undertaken
before the issuance of the NODs to petitioners.
5
[*5] associate discovered that the Rome property was owned by
Walmart Realty Co., and had formerly been the site of a Walmart store
before being vacated, at which time the building was subdivided into
three units. Two of the units were subleased, and the third (a 35,000-
square-foot space) remained vacant. Mr. Deitch worked with Mr. Barry
and discovered that the two existing tenants in the Rome property,
Office Depot and Ferguson Plumbing, had relatively short terms
remaining on their leases. Petitioners decided to make an offer to
purchase the Rome property in order to rehabilitate it to suit the needs
of Redmond Hospital, and then, as the new owners of the Rome property,
to lease it to Redmond Hospital. In Mr. Barry’s words, “initially
[petitioners were the] broker trying to find a suitable location, and then
landlord and investor to facilitate the transaction”.
WTS projected that renovations to the entire exterior of the
building plus the engagement of Redmond Hospital to be the third
tenant would create substantial additional value for the property.
Petitioners hired an architect and an engineer, selected appropriate
contractors, and priced out the renovation, estimating that it would cost
approximately $1.8 million to complete. They needed a loan “to put the
entire transaction together”, and such a loan would need to cover the
$2.2 million acquisition cost of the property, a $700,000 allowance to
Redmond Hospital for transferring their operations to a suitable facility,
and construction costs for exterior renovations (totaling $4.4 million for
the entire project).
Mr. Barry had a relationship with Colliers (by virtue of their joint
venture, Spectrum Cauble) that gave him access to its mortgage
origination group. Colliers was a correspondent lender for PLI, which
meant that PLI had essentially given Colliers pre-approval to solicit
lending opportunities for PLI in the marketplace. Mr. Barry knew of
PLI’s “well-known and highly successful participating loan program”
and believed it would be suitable to fund the Rome property because it
included both interim financing to complete the renovation and a
permanent loan that “was a fixed-rate product [as opposed to a] more
traditional commercial bank loan . . . [with] a floating rate”. Mr. Barry
stated that “even if I was paying a little bit more for the interest rate, I
felt that the numbers laid out adequately for me to proceed.”
PLI’s participating loan product
PLI offered conventional and participating loans. In a
participating loan, which is a high-leverage loan, PLI would lend up to
6
[*6] 100% of the cost or 85% of the stabilized value of the property to be
acquired. For a conventional loan, on the other hand, the maximum
loan-to-value ratio that PLI would approve was 75%. The difference
between the two types of loans (from PLI’s perspective) is that the
conventional loan is a stabilized product, meaning that “those cash flows
[from the underlying property] are pretty much guaranteed for the life
of the loan”, whereas a participating loan is given where “the value is
not yet created [and] has to be created through the process”.
The typical loan documents PLI used with both conventional and
participating loans included a promissory note, security instruments,
the deed to secure debt, a limited guaranty, and indemnity agreements.
The primary difference between the loan documents PLI required for a
conventional loan versus a participating loan was that a participating
loan also required an additional interest agreement.
PLI’s loan commitment to WTS
PLI issued a “Permanent Loan Commitment” to WTS on
November 28, 2006, agreeing to provide secured first lien financing of
up to $4.4 million for WTS to buy the Rome property. PLI’s loan
commitment estimated that the minimum appraised value of the
property for purposes of calculating the “initial funding” was
$2.9 million, and that the minimum appraised value for purposes of
calculating the “ceiling loan” was $5.2 million. The loan commitment
provided that PLI would initially disburse $2.4 million to WTS in order
to acquire the property and provided for a “holdback” of $2 million. The
holdback amount was to be funded no later than a year after the initial
funding, but only upon WTS’s satisfying certain conditions with respect
to completing the renovations, providing PLI with an appraisal meeting
its requirements and subject to its approval, and executing all of the
leases in full force and effect with tenants in occupancy.
In accordance with the requirements of the loan commitment,
WTS provided PLI with an appraisal before closing on the loan. The
appraisal estimated that “the Prospective Value at Completion and
Stabilization . . . [of the Rome property] is . . . $5,300,000.” That value
was
predicated upon completion of the building renovations in
a workmanlike manner in conformity with the plans,
specifications, and other financial representations made to
the appraisers. These representations included the
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[*7] extraordinary assumptions that the lease arrangement
with Redmond Medical Center is in full force and effect as
of the date of stabilization and that existing leases are
assigned under the current terms and conditions.
Under the loan commitment, Mr. Barry personally guaranteed
the repayment of the outstanding loan balance before the completion of
the rehabilitation work specified in the loan, and was to be released from
the guaranty thereafter.
The loan commitment also summarized the essential economic
terms of the loan arrangement that would be reflected in the loan
documents, including the interest due over the life of the loan. It
specified that loan proceeds would incur base interest at a fixed rate of
6.25% per annum (defined as “payment interest”), as well as “additional
interest” of “fifty percent of the Net Cash Flow and Appreciation of the
Project as provided in the Additional Interest Agreement attached” 5 to
the loan commitment. The commitment further stated:
Upon acceptance of this Commitment by Borrower,
the Additional Interest Agreement will be in full force and
effect. Borrower and Lender intend that Lender shall be
entitled to receive its Net Cash Flow Interest and/or
Appreciation Interest or Substitute Interest (all as defined
in the Additional Interest Agreement) from any net cash
flow or proceeds of any sale occurring at any time after the
date upon which Borrower accepts this commitment.
WTS accepted the loan commitment on December 5, 2006, by
paying a commitment fee of $44,274 and executing a copy of the
commitment, thus entering into a binding contract. WTS’s acceptance
of the loan commitment was also a binding acceptance of the Additional
Interest Agreement. Pursuant to the terms of the contract, PLI held the
commitment fee pending the funding of the loan on the terms specified
in the commitment; PLI later refunded that fee to WTS after all of the
loan documents were executed and duly recorded.
5 The Additional Interest Agreement that was attached to the loan
commitment is in fact the same document with that title that is described below. It
contains the same section 7.4 quoted below (which includes the provision that
“[n]othing contained in the Additional Interest Agreement . . . shall be deemed or
construed to create a . . . joint venture . . . by or between Lender and Borrower”).
8
[*8] WTS’s purchase of the Rome property
WTS agreed to purchase the Rome property from Walmart Realty
Co. for $2.2 million and closed on its purchase on December 22, 2006.
Other than proceeds from PLI’s loan, the only cash that WTS put toward
the closing on the property was a $50,000 earnest money deposit that
became “hard money” after the due diligence period outlined in the loan
documents, during which period WTS could have withdrawn from the
deal with Walmart. PLI’s initial disbursement of $2.4 million, along
with WTS’s earnest money deposit of $50,000, paid the purchase price
and WTS’s acquisition costs of approximately $250,000. (WTS received
nearly all of its earnest money in cash back at closing.)
Over the life of the loan, the remaining proceeds (from the
$2 million “holdback” portion) were used to pay $700,000 in specific
renovations for Redmond Hospital, and approximately $1.3 million in
general renovations for the benefit of the entire property. WTS was
formed as a “single-purpose entity”; i.e., its purpose was to own and
manage the Rome property; and it had minimal assets other than the
Rome property and the leases on that property.
Loan documents
Consistent with the loan commitment, on December 22, 2006,
WTS signed a promissory note (“the original note”) and entered into a
Deed to Secure Debt and Security Agreement (the “security agreement”)
by which it granted PLI a security interest in the Rome property and in
the leases on the property. The three documents—the original note, the
security agreement, and the Additional Interest Agreement—are
integrated documents (negotiated and executed as a set) that cross-
reference each other. The Additional Interest Agreement became
effective on December 5, 2006, the date on which WTS accepted the loan
commitment from PLI. The original note and the security agreement
became effective December 22, 2006. The parties have stipulated that
the original note, its modifications, and the Additional Interest
Agreement (all of which the parties have stipulated treat WTS as the
borrower and PLI as the lender) constitute legally enforceable
agreements under Alabama law, and that the security agreement was
legally enforceable under Georgia law. Further, the parties stipulated:
9
[*9] 34. The Original Note, Modifications, Security
Agreement, and Additional Interest Agreement arose from
an arm’s length transaction.
35. The Original Note, Modifications, and
Security Agreement[6] constitute genuine indebtedness by
West Town Square to Protective Life.
Original note
The original note (and its modifications, discussed below)
expressly treated WTS as the “Borrower” and PLI as the “Lender”.
Section 12 of the note provided:
12. Relationship of Lender and Borrower as
Creditor and Debtor Only. The relationship between
Lender and Borrower is solely that of creditor and debtor
and alternate forms of structuring the extension of credit,
as well as alternate sources of financings, were available to
Borrower and Borrower choose, however to proceed with
the transaction in the manner described in the Additional
Interest Agreement and other Loan Documents. Nothing
contained in any Loan Document or instrument made in
connection with the loan, shall be deemed or construed to
create a partnership, tenancy-in-common, joint tenancy,
joint venture, or co-ownership by or between Lender and
Borrower, or any relationship other than that of creditor or
debtor. . . .
As to WTS’s debts and losses, section 12 also provided that PLI “shall
not be in any way responsible or liable for the debts, losses, obligations
6 Unlike paragraph 34, paragraph 35 of the Stipulation lists only three of the
documents and not the Additional Interest Agreement; and the Stipulation is explicit
(in paragraph 69) that “[t]he parties dispute whether the Additional Interest
Agreement constitutes part of integrated loan documents”. It is not clear whether the
Commissioner still maintains that dispute, since his answering brief acknowledges
that “the agreement between WTS and PLI, despite consisting of multiple documents,
must be considered as a whole.” In any event, the non-inclusion of the Additional
Interest Agreement in paragraph 35 does not dissuade us from our conclusion,
discussed below, that the entire $4.4 million amount of PLI’s advances was a loan by
PLI and was indebtedness [owed] by WTS, and that therefore the payments of
“Additional Interest” were interest on indebtedness.
10
[*10] or duties of Borrower or any guarantor with respect to the
Property or otherwise.”
The principal amount of the note was about $4.4 million, of which
only about $2.4 million was disbursed as of December 22, 2006, the date
of its execution. The terms obligated WTS to pay interest only on funds
disbursed from the date of disbursement until January 1, 2008, the
latest date of disbursement of any of the remaining balance on the
original note. Thereafter WTS was obligated to make monthly
payments of principal and interest until the maturity date of
December 1, 2009, when the entire principal balance plus accrued
interest was due and payable if not sooner paid. Interest due included
base interest at a fixed rate of 6.25%, calculated on the basis of a 25-year
amortization period, plus any amount due under the terms of the
Additional Interest Agreement. Payments were applied first to fixed
interest, then to principal, and finally to sums due under the Additional
Interest Agreement. The original note permitted voluntary prepayment
“in full, but not in part”, without penalty, upon 30 days’ prior written
notice to PLI. That prepayment in full would consist of “payment of all
sums due under the Loan Documents, including the Additional Interest
Agreement.”
The original note defined the term “Loan Documents” to include
(in addition to the note itself) the security agreement, the loan
commitment, and the Additional Interest Agreement. Its terms also
included an explicit statement that the relationship between the lender
and borrower was solely that of a creditor and debtor, and that nothing
in the original note or loan documents should be construed as creating
a partnership, joint venture, or other arrangement of co-ownership.
Modifications of the note
WTS and PLI modified the original note on four occasions over
the course of the loan to extend the disbursement and maturity dates.
Each of the modifications treated WTS as the borrower and PLI as the
lender. Each of the modifications specified that WTS and petitioners (as
the guarantors of WTS’s debt) “requested that the Loan and Note be
amended as set forth herein, and Lender [PLI] has agreed to do so as
provided in this Agreement.”
Security agreement
Under the security agreement, the debt under the “Loan
Documents” (defined therein to include the security agreement, the
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[*11] original note, and the Additional Interest Agreement) was secured
by the Rome property itself, all leases of it, and all of the profits and
proceeds of any sale, conversion, insurance, or taking for public or
private use associated with the Rome property. The security agreement
included certain covenants that required WTS to obtain prior written
consent from PLI before undertaking any of the following with respect
to the secured property: making any material alterations, improve-
ments, or additions to it; changing its use; or changing the professional
company charged with its management and leasing. Similarly, WTS
could not sell or further encumber the secured property without prior
written consent from PLI, and WTS was obligated to provide PLI with
annual reports consisting of a balance sheet and annual operating
statement showing all of WTS’s income and expenses.
Additional Interest Agreement
Like the original note (and its modifications), the Additional
Interest Agreement expressly treated WTS as the “Borrower” and PLI
as the “Lender”. Under the terms of the Additional Interest Agreement,
WTS agreed to pay PLI “Additional Interest” consisting of two items:
“NCF [“Net Cash Flow”] Interest” and “Appreciation Interest”,
payments of which were “in addition to and not in substitution of all
Payment Interest and other amounts payable” under the original note
and additional loan documents. The agreement separately defined the
“lender’s percentage” of any payments of additional interest as 50%. The
parties to the Additional Interest Agreement agreed that these
payments of additional interest were “contingent and uncertain, that
the payment of and amount, if any, thereof are speculative in nature and
dependent upon a number of contingencies which are not within [PLI]’s
control”.
Like section 12 of the original note, section 7.4 of the Additional
Interest Agreement expressly disclaimed joint-venture status:
7.4 Relationship of Lender and Borrower as
Creditor and Debtor Only
Lender and Borrower intend that the relationship
between them shall be solely that of creditor and debtor.
Nothing contained in the Additional Interest Agreement or
in any other Loan Document or instrument made in
connection with the Loan, including without limitation
Lender’s right to receive Net Cash Flow Interest and
12
[*12] Appreciation Interest under this Additional Interest
Agreement, shall be deemed or construed to create a
partnership, tenancy-in-common, joint tenancy, joint
venture or co-ownership by or between Lender and
Borrower, or any relationship other than that of creditor
and debtor.
As to WTS’s debts or losses, section 7.4 provided that PLI “shall not be
in any way responsible or liable for the debts, losses, obligations or
duties of Borrower with respect to the Property or otherwise.”
The Additional Interest Agreement was “effective as of the date
that . . . [WTS] accepts the [loan] commitment”, which occurred
December 6, 2006, more than two weeks before WTS and PLI executed
the remaining loan documents. The Additional Interest Agreement
remained
in full force and effect until the earlier of: (a) payment of all
sums due Lender for Additional Interest hereunder or
(b) until such date as this Agreement is terminated by
mutual consent of Lender and Borrower. Borrower shall
pay lender its Additional Interest realized on account of the
Project[7] at any time during the term of this Agreement,
whether or not the Loan is funded and whether or not the
Project is sold.
As is noted above, the Additional Interest Agreement was one of
an integrated set of documents. The original note defined “Loan
Documents” to include the Additional Interest Agreement, and “Secured
Debt” was defined in the security agreement to include “all principal,
interest, additional interest, [and] interest at the After-Maturity Rate
set forth in the Note.” (Emphasis added.)
PLI’s “NCF interest” under the Additional Interest Agreement
The first item of additional interest that WTS agreed to pay PLI
was 50% of net cashflow from the Rome property (“NCF interest”), an
7 The “Project” is not defined in the Additional Interest Agreement, which
provides that any terms not defined therein “have the meanings described in the other
Loan Documents” (including the loan commitment). The loan commitment designates
the specific address of the Rome property as the “Project”, which appears consistent
with the usage of the term throughout.
13
[*13] amount calculated after subtracting all expenses 8 from all gross
revenues of the property, as computed and paid quarterly. If the NCF
calculation for any particular quarter was negative, WTS did not make
a quarterly payment to PLI, nor was WTS entitled to make an
immediate corresponding deduction or offset to PLI’s quarterly NCF
interest. However, WTS was obligated to furnish PLI with annual
statements showing the NCF calculations, and each year PLI’s NCF
interest was adjusted on the basis of the annual calculation. Upon this
annual reconciliation of prior quarters, any amounts due to PLI (i.e.,
overdue amounts from previous quarters) incurred additional interest
at a rate 2% above the prime rate; and any amounts due from PLI to
WTS (as would have resulted from a negative NCF calculation in a
previous quarter) would be credited to WTS and accordingly “deducted
from the next payment(s) of . . . [PLI]’s NCF [i]nterest due until the
credit has been depleted”.
PLI’s “appreciation interest” under the Additional Interest Agreement
The other item of additional interest that the interest agreement
required WTS to pay to PLI was so-called “appreciation interest” equal
to 50% of the “gross proceeds” derived upon the occurrence of one of
seven defined events, “reduced by the sum of the Approved Deductions
related to such transaction or event . . . provided that in no event shall
Appreciation Interest be less than zero”. The “events triggering [WTS’s
obligation to pay PLI] appreciation interest” were, unless PLI agreed
otherwise, (1) sale of the Rome property; (2) recovery of damages or other
compensation from a third party in the event of a condemnation or
similar circumstance; (3) junior financing in the form of an additional
encumbrance being placed on the Rome property; (4) any refinancing of
the loan or any portion of the Rome property with a third-party lender,
in which case the Additional Interest Agreement remained in full force
and effect with respect to the Rome property; (5) default under the loan
documents; (6) maturity of the original note; or (7) prepayment of the
original note, including “all modifications, renewals and extensions
thereof”.
The gross proceeds used to calculate the appreciation interest
varied depending on the applicable triggering event. In the event of a
8 For purposes of calculating NCF, “all expenses” was defined to exclude income
taxes, depreciation, any loan expenses or payments except those made on the loan to
PLI, any management compensation or fees in excess of those expected in a reasonable,
arms-length arrangement, and any capital improvements to the Rome property.
14
[*14] sale, “gross proceeds” included all of the cash and the fair market
value of any non-cash consideration payable to WTS. In the event of a
recovery or junior financing, the “gross proceeds” meant all gross
proceeds received in any form as a result of that event. In the event of
a default, maturity, or prepayment, “gross proceeds” were calculated on
the basis of the fair market value of the Rome property in accordance
with an appraisal procedure specified in the interest agreement. The
interest agreement does not state a definition for “gross proceeds” in the
context of a third-party refinance, presumably because the agreement
remains in full force and effect until the occurrence of any of the other
triggering events defined therein. The agreement defines the approved
deductions for the purpose of calculating the appreciation interest
differently depending on which of the triggering events applies.
The Additional Interest Agreement also contains the following
provision for “Substitute Interest” in certain circumstances:
If the right to payment of all or part of the Additional
Interest shall at any time be held to be invalid by a final
judgment of a court of competent jurisdiction or if the
method of computation of Additional Interest shall become
in the Lender’s opinion legally or practically impeded or
uncertain or if it becomes impractical in the Lender’s
opinion to assess damages by virtue of the non-payment by
Borrower to Lender of said amounts, as computed above, or
in the event of a Default, at the option of the Lender, the
Borrower agrees to pay to the Lender in lieu of and not in
addition to such Lender’s NCF Interest or Lender’s
Appreciation Interest, interest upon the Note retroactive to
the date thereof and until the Note and all indebtedness
secured thereby shall be fully paid, in such amount
(“Substitute Interest”) as is necessary to give the Lender
(considering Payment Interest[ 9] and any Additional
Interest, if any, received by the Lender), an effective
interest rate per annum equal to (i) the Payment Interest
and, added thereto, (ii) interest at the rate of five percent
(5%) per annum on the Loan, subject to no offset or
deduction, which sum is intended to be additional
9 The interest agreement defines payment interest as “the stated rate of
interest payable under the Note for scheduled monthly payments”.
15
[*15] consideration to the Lender for the use of the principal sum
advanced to Borrower . . . .
WTS’s operation
Mr. Barry’s company, Spectrum Cauble, was pre-approved in the
loan documents to professionally manage the Rome property and was so
engaged over the course of the loan. Spectrum Cauble maintained books
and records for the rental units, collected rents, and was charged with
the responsibility to pursue any tenant defaults under the terms of their
leases of commercial spaces at the Rome property. Mr. Barry, acting for
WTS, oversaw the renovations, reviewed and agreed to lease extensions,
sought out new tenants for the space, and maintained account files.
Over the life of the loan, WTS sought and found suitable replacement
tenants for both Office Depot and Ferguson Plumbing. PLI was not
involved in the management of WTS.
In 2014 WTS determined that the market seemed receptive to a
sale of the Rome property; it engaged Collier to solicit offers on the
property and negotiated the terms of the purchase.
Payments to PLI under the loan documents
From 2008 until the sale of the Rome property in 2014, WTS
earned income by renting out the spaces in the Rome property to third
parties. Nothing in the record suggests that WTS failed to make
payments on the loan in accordance with the loan documents, and no
party so contends.
WTS’s tax reporting over the life of the loan
WTS’s tax reporting was consistent with performance in
accordance with the terms of the loan, which it characterized as a
“nonrecourse liability”. From 2006 through 2014, WTS reported the
amounts of its outstanding nonrecourse debt and interest expense, net
income, 10 and the balances of partners’ capital accounts at yearend on
its Form 1065, “U.S. Return of Partnership Income”, as follows:
10 Most of WTS’s net income was rental real estate income, though it also had
a small amount of interest income from 2008 through 2014.
16
[*16] Nonrecourse Interest Partner
Year Income (loss)
debt expense capital
2006 $2,448,651 $3,956 ($6,365) ($6,365)
2007 3,613,669 218,587 56,392 10,027
2008 4,377,364 302,419 61,592 31,619
2009 4,298,231 311,342 (84,620) (93,001)
2010 4,214,007 266,252 (39,252) (132,253)
2011 4,124,366 260,834 (30,417) (162,670)
2012 4,028,960 2[9]5,069 96,250 (326,420)
2013 3,924,424 248,847 187,335 (319,085)
2014 [-0-] 142,551 1,418,427 1,099,342
For certain years petitioners reported distributions from WTS (reflected
in reductions to partner capital, above), as follows: for each of 2007,
2008, and 2009, petitioners reported receiving $20,000 each in
distributions; for 2012, petitioners reported receiving $130,000 each in
distributions; and for 2013, petitioners reported receiving $90,000 each
in distributions. For 2014 petitioners reported receiving $549,671 in
distributions—i.e., the balance of the partner capital accounts upon
liquidation. We find that WTS’s tax reporting was consistent with
WTS’s stated obligations under the loan documents, including the
Additional Interest Agreement.
Sale of the Rome property
WTS sold the Rome property in 2014 for $6.3 million. (That sale
price included $5,678,204 attributable to the building and $621,796
attributable to improvements.) As part of the sale, WTS paid to PLI
$1,035,683 (i.e., 50% of the net proceeds of the sale) as appreciation
interest pursuant to the Additional Interest Agreement.
17
[*17] WTS’s tax reporting of the Rome property sale
As a result of the sale, WTS reported a gain of $2,647,854 on
Form 4797, “Sales of Business Property”, attached to its Form 1065 for
2014. On Schedules K–1, “Partner’s Share of Income, Deductions,
Credits, etc.”, of its Form 1065, WTS reported for each partner
$1,323,927 of net section 1231 gain on line 10, i.e., his 50% distributive
share of the gain from the sale.
WTS claimed a deduction for the $1,035,683 payment it made to
PLI in respect of its obligation to pay appreciation interest under the
Additional Interest Agreement, but it did not report that payment as
part of its itemized “interest” deduction. Rather, on its Form 8825,
“Rental Real Estate Income and Expenses of a Partnership or an S
Corporation”, under its itemized rental real estate expenses, WTS
reported this amount with other items in the category “other”, and
further described it in an attached statement as “interest expense/loan
participation by lender”.
As a result of passing through WTS’s items of income and
expense, the Schedules K–1 showed net rental real estate income losses
of $614,720 for Mr. Barry and $614,719 for Mr. Deitch. The losses
included, in each instance, the partner’s 50% share (i.e., $517,842) of the
appreciation interest payment ($1,035,683). On their Forms 1040, “U.S.
Individual Income Tax Return”, for 2014, each petitioner reported his
respective shares of WTS’s loss as ordinary and WTS’s gain as capital,
in the amounts reported by WTS on the Schedules K–1.
NODs and Tax Court petitions
The IRS examined petitioners’ 2014 tax returns. On July 14,
2017, the IRS issued to Mr. and Mrs. Barry an NOD that determined a
deficiency of $188,271, and issued to Mr. Deitch an NOD that
determined a deficiency of $211,217. In each NOD the attached
Form 886–A, “Explanation of Adjustments”, contained the following
statement with respect to the item of “Net income (loss)” from the rental
real estate activities of WTS:
It is determined that since you did not establish that the
amount claimed on your return [i.e., WTS’s Form 1065] of
18
[*18] $1,035,683.00[11] was (a) interest expense, and (b) an
ordinary and necessary business expense, the amount is
not deductible. Accordingly, net income (loss) from rental
real estate activities is increased $1,035,683.00 for tax year
ended December 31, 2014. [Emphasis added.]
For each petitioner the Form 886–A included the following statement
passing through to the partner his share of that determination:
It is determined that your distributive share of the net real
estate activity loss from the partnership known as West
Town Square investment LLC is ($96,878.00) rather than
the ($614,720.00) shown on your tax return. See Exhibit A
for details. Accordingly, your taxable income is increased
$517,842.00 [i.e., the partner’s 50% share of WTS’s
adjustment of $1,035,683] for the year ended December 31,
2014.
Thus, the NODs disallowed deductions for the appreciation interest that
had been paid to PLI but made no corresponding reduction to the
reported gain from the sale of the property. (This anomaly has been
addressed in the stipulation described below.)
On October 11, 2017, Mr. Deitch and Mr. and Mrs. Barry timely
petitioned the Tax Court under section 6213(a) to redetermine the
deficiency.
The Commissioner’s position in the stipulation of facts
Several months before the trial of these cases, the parties filed a
Joint Stipulation of Facts in which the Commissioner made a partial
concession of the deficiency. As we noted above, WTS and petitioners
had treated as capital gain all the sale proceeds (including the portion
that WTS then paid over to PLI as appreciation interest) and had
treated the appreciation interest payment as an ordinary deduction.
The NODs had addressed this by simply disallowing the interest
deduction but had left the entire gain in income. In the Stipulation,
however, the Commissioner acknowledged that if he is correct that,
11 This adjustment addressed only the appreciation interest, and not the NCF
interest or the normal interest on the original note. Consistent with the NODs, the
Commissioner has challenged in this litigation only the appreciation interest, and not
the NCF interest that was also paid under the Additional Interest Agreement, nor the
normal interest paid under the original note.
19
[*19] under the terms of the Additional Interest Agreement, the lender
PLI acquired an equity interest in the Rome property, then it should
follow that therefore “WTS should not have included the $1,035,683 paid
over to PLI pursuant to the additional interest agreement in gross
income”. This position is reflected in the parties’ Stipulation 71:
The parties agree that if the Court determines the
Appreciation Payment should be treated as an equity
payment (instead of interest expense as originally
reported), West Town Square’s gross sales of $5,678,204 for
the “Sale of Building” should also be reduced by $1,067,467
($1,035,638 + $31,829).
The parties have stipulated that the only issue for decision is
whether WTS properly classified its $1,035,683 payment of so-called
“appreciation interest” to PLI as deductible interest. 12 While petitioners
take the position that the Additional Interest Agreement was part of the
integrated loan documents that created an obligation to pay deductible
interest, the Commissioner maintains that, taking into account the
Additional Interest Agreement, the documents gave PLI equity in the
arrangement, with the result that the payment of the appreciation
interest should be treated as an equity payment to PLI. The tax effect
of the NODs as issued would have been the complete disallowance of the
$1 million interest deduction and a resulting increase in taxable income
at ordinary rates; but the tax effect of the Commissioner’s revised
position would be, as before, the disallowance of the $1 million interest
deduction—but partially mitigated by the elimination of capital gain of
that same amount.
The Commissioner’s position at trial
At trial (and in his Pretrial Memorandum and Post-trial Briefs)
the Commissioner continued to contend that the amount paid to PLI
reduced the capital gain income of WTS (and of its partners, the
petitioners) and that the payment to PLI did not constitute the payment
of deductible interest. However, whereas previously the Commissioner
had contended that the ostensible interest paid to PLI was a
nondeductible return on PLI’s equity interest in WTS, the
Commissioner now refines that position and asserts that the Additional
Interest Agreement created a joint venture between WTS and PLI, so
12 If petitioners prevail on this issue, the parties have further stipulated that
WTS’s interest expense should be increased by $31,829.
20
[*20] that the ostensible interest paid to PLI was a nondeductible return
on PLI’s equity interest not in WTS but in the supposed WTS-PLI joint
venture.
OPINION
I. Preliminary legal principles
A. Jurisdiction
1. Deficiency jurisdiction
Under section 6213(a) the Tax Court has jurisdiction over a
deficiency case if the IRS issues to the taxpayer a timely notice of
deficiency and the taxpayer files a timely petition in the Tax Court. The
parties stipulate that these prerequisites have been met in these cases.
2. TEFRA jurisdiction
a. Partnership-level proceedings
However, our jurisdiction to address issues in a deficiency case
may be limited. Where the IRS would adjust a taxpayer’s “partnership
items”, as defined in section 6231(a)(3), those items “shall be determined
at the partnership level”, § 6221(a), under the unified audit and
litigation procedures of TEFRA that were in effect for the year at issue.
Partnership-level proceedings in the IRS may result in the issuance of a
notice of final partnership administrative adjustment (“FPAA”), see
§ 6223(a)(2), (d)(2), which may then be the subject of a so-called “TEFRA
case” brought in the Tax Court, see § 6226(a)(1), (b)(1). These
partnership items cannot be litigated in a deficiency case; and where no
FPAA has been issued, the Tax Court “does not have jurisdiction”.
Rule 240(c).
b. WTS as a “small partnership”
WTS—the entity that passed through to petitioners the loss
deductions at issue in these cases—was a partnership for federal income
tax purposes, but no partnership-level TEFRA proceedings were
undertaken and no FPAA was issued before the issuance of the NODs
to petitioners. However, there exists a “small partnership” exception of
section 6231(a)(1)(B), which applies where there are “10 or fewer
partners each of whom is an individual . . . , a C corporation, or an estate
of a deceased partner.” Since WTS was owned solely by two
21
[*21] individuals—Mr. Deitch and Mr. Barry—we conclude that the
“small partnership” exception applies to WTS. WTS is therefore not to
be treated as a “partnership” for purposes of TEFRA, and we therefore
have jurisdiction to redetermine its items in this deficiency case, even if
they would otherwise be partnership items. Consequently, to the extent
the Commissioner’s position (as in the NODs) posits adjustments to
WTS’s items and corresponding adjustments to the petitioners’ returns,
we have jurisdiction to entertain that position.
c. WTS-PLI joint venture as a TEFRA
partnership
As we explain below, however, the position that the
Commissioner advanced at trial (and not in the NODs) posits the
existence of an additional entity that, he contends, should be treated as
a partnership for federal income tax purposes—i.e., the Commissioner
postulates a joint venture between WTS (petitioners’ partnership) and
PLI (the lender). The Commissioner contends that (for tax purposes) a
WTS-PLI joint venture existed (while petitioners contend it did not), and
he asks us to determine that the payments at issue that PLI received
from WTS were not interest paid on indebtedness but were instead
returns on PLI’s equity in the postulated WTS-PLI joint venture.
The “partnership items” that fall within the jurisdiction of a
TEFRA case—and thus fall outside our deficiency jurisdiction—include
the issue of whether a partnership exists; and “in a partnership-level
proceeding the Court may determine whether a ‘partnership’ existed
during the year.” Petaluma FX Partners, LLC v. Commissioner,
131 T.C. 84, 92–93 (2008), aff’d in part, rev’d in part, vacated and
remanded, 591 F.3d 649 (D.C. Cir. 2010). If a WTS-PLI joint venture
did exist as a partnership, the “small partnership” exception could not
apply to it because the partners to that joint venture would be a
corporation (PLI) and an LLC treated as a partnership for federal
income tax purposes (WTS). The “small partnership” exception of
section 6231(a)(1)(B) can apply only where each partner is an individual,
or a C corporation, or an estate of a deceased petitioner—not another
pass-through entity such as WTS. The WTS-PLI joint venture would
therefore be a TEFRA partnership; all of the partnership items of that
partnership would likewise be outside our deficiency jurisdiction; and,
under Rule 240(c), the Tax Court “does not have jurisdiction” in the
22
[*22] absence of an FPAA. As we stated in Jimastowlo Oil, LLC v.
Commissioner, T.C. Memo. 2013-195, at *24:
The principle . . . that we lack jurisdiction to redetermine
affected items attributable to a source partnership before
the source partnership-level proceedings have been
completed, applies even when the members of the source
partnership have failed to recognize that they have created
a separate entity (i.e., a partnership) for Federal income
tax purposes and have not, therefore, filed a partnership
return on its behalf, and the Commissioner has neither
conducted a source partnership-level audit nor issued an
FPAA to it.
Consequently, to the extent the Commissioner’s position posits a WTS-
PLI joint venture and alleges distributions by it on account of equity
interests, we lack jurisdiction to entertain that position.
In his most recent brief, the Commissioner acknowledges that the
preceding analysis is correct, but he also correctly observes:
[T]he question necessary to determine the question of
jurisdiction happens to be the same question at the heart
of the case: whether the relationship between WTS and PLI
is that of partners in a joint venture, as respondent
contends, or borrower and lender, as petitioners contend.
If petitioners are right, the Court also has jurisdiction over
the substantive issue; if respondent is right, the Court does
not have jurisdiction over the substantive issue. But there
is no way to answer the question of jurisdiction without
entertaining respondent’s argument [as to the asserted
WTS-PLI joint venture].
It is a truism that the Tax Court has jurisdiction to determine its
jurisdiction. U.S. Auto Sales, Inc. v. Commissioner, 153 T.C. 94, 97
(2019); Alpha Chem. Partners v. Commissioner, T.C. Memo. 1995-141,
69 T.C.M. (CCH) 2292, 2292.
Consequently, we can proceed to decide whether there was a
WTS-PLI joint venture. If we were to conclude that there was such a
joint venture, then we would lack jurisdiction to adjudicate the issues in
the NODs, and (as in Jimastowlo Oil) we would have to dismiss the case
for lack of jurisdiction. However, for the reasons explained below, we
conclude that there was not such a joint venture, and we proceed to
23
[*23] decide the issues founded on the NODs, over which we do have
jurisdiction.
B. Burden of proof
The IRS’s determination is presumed correct, and taxpayers
generally bear the burden to prove incorrect the adjustments made by
the IRS in its NOD, whether adjustments to income or to deductions.
See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
Petitioners argue that the burden of proof has shifted to the
Commissioner because they have met the requirement of
section 7491(a)(1) to “introduce[] credible evidence with respect to any
factual issue relevant to ascertaining the liability of the taxpayer”. But
this is not a case where the evidence presented on any issue is in
equipoise; rather, here we find that the preponderance of the evidence
resolves the issues in dispute, thereby negating the importance of which
party bears the burden of proof. See Dagres v. Commissioner, 136 T.C.
263, 279 (2011).
C. Effect of parties’ stipulations
Stipulations are the “bedrock” of Tax Court practice, see
Branerton Corp. v. Commissioner, 61 T.C. 691, 692 (1974), and we
require parties “to stipulate, to the fullest extent to which complete or
qualified agreement can or fairly should be reached, all matters not
privileged which are relevant to the pending case, regardless of whether
such matters involve fact or opinion or the application of law to fact”,
Rule 91(a)(1). As we have noted above, the parties’ stipulations in these
cases included the following facts of particular significance:
34. The Original Note, Modifications, Security
Agreement, and Additional Interest Agreement arose from
an arm’s length transaction.
35. The Original Note, Modifications, and
Security Agreement constitute genuine indebtedness by
West Town Square to Protective Life.
Such stipulations have a binding effect in the particular
proceeding in which the parties enter into those stipulations, in that
[a] stipulation shall be treated, to the extent of its terms,
as a conclusive admission by the parties to the stipulation,
unless otherwise permitted by the Court or agreed upon by
24
[*24] those parties. The Court will not permit a party to a
stipulation to qualify, change, or contradict a stipulation in
whole or in part, except that it may do so where justice
requires.
Rule 91(e). The Court generally enforces stipulations unless “manifest
injustice” would result. Bokum v. Commissioner, 992 F.2d 1132,
1135–36 (11th Cir. 1993), aff’g 94 T.C. 126 (1990); see also Mathia v.
Commissioner, T.C. Memo. 2007-4, 93 T.C.M. (CCH) 653, 655 (denying
the Commissioner’s motion for relief from stipulations after he argued
that disputed stipulations contained erroneous legal conclusions and
stating that “we do not set aside a stipulation of fact that is consistent
with the record simply because one party claims the stipulation is
erroneous”).
No party requests that we grant relief from any stipulation, and
none contends that any manifest injustice would otherwise result. We
will therefore treat all of the parties’ stipulations as conclusive
admissions of the terms stated therein.
D. Formation of a partnership for tax purposes
Section 761(a) defines a partnership as “includ[ing] a syndicate,
group, pool, joint venture, or other unincorporated organization through
or by means of which any business, financial operation, or venture is
carried on, and which is not . . . a corporation or a trust or estate.” See
also § 7701(a)(2). “Partnership” for tax purposes is generally a more
inclusive term than “partnership” at common law, and for tax purposes
it may include entities not traditionally considered partnerships.
Dickerson v. Commissioner, T.C. Memo. 2012-60. “A partnership is
generally said to be created when persons join together their money,
goods, labor, or skill for the purpose of carrying on a trade, profession,
or business and when there is community of interest in the profits and
losses.” Commissioner v. Tower, 327 U.S. 280, 286 (1946). “A
partnership is, in other words, an organization for the production of
income to which each partner contributes one or both of the ingredients
of income—capital or services.” Commissioner v. Culbertson, 337 U.S.
733, 740 (1949). To decide whether a partnership exists, a court must
also analyze the relevant facts to determine whether “the parties in good
faith and acting with a business purpose intended to join together in the
present conduct of the enterprise”. Id. at 742.
25
[*25] Here the Commissioner contends that WTS and PLI formed a
“joint venture” that constituted a partnership under section 761(a), and
we evaluate that “joint venture” contention “by reference to the same
principles that govern the question of whether persons have formed a
partnership which is to be accorded recognition for tax purposes”. Luna
v. Commissioner, 42 T.C. 1067, 1077 (1964) (first citing Estate of Smith
v. Commissioner, 313 F.2d 724 (8th Cir. 1963), aff’g in part, rev’g in part
and remanding 33 T.C. 465 (1959); and then citing Beck Chem. Equip.
Corp. v. Commissioner, 27 T.C. 840, 848–49 (1957)). These principles
require us to consult
[t]he following factors, none of which is conclusive . . . :
[1] The agreement of the parties and their conduct in
executing its terms; [2] the contributions, if any, which
each party has made to the venture; [3] the parties’ control
over income and capital and the right of each to make
withdrawals; [4] whether each party was a principal and
coproprietor, sharing a mutual proprietary interest in the
net profits and having an obligation to share losses, or
whether one party was the agent or employee of the other,
receiving for his services contingent compensation in the
form of a percentage of income; [5] whether business was
conducted in the joint names of the parties; [6] whether the
parties filed Federal partnership returns or otherwise
represented to respondent or to persons with whom they
dealt that they were joint venturers; [7] whether separate
books of account were maintained for the venture; and
[8] whether the parties exercised mutual control over and
assumed mutual responsibilities for the enterprise.
Id. at 1077–78 (citations omitted).
II. Analysis
A. The Commissioner’s attempt to thread the needle
The Commissioner asks us to sustain the disallowance of WTS’s
deduction of the appreciation interest that WTS paid to PLI after the
sale of the Rome property. As we perceive it, articulating an argument
in support of this position is made difficult by two considerations:
26
[*26] 1. The relation of the appreciation interest obligation to
the stipulated “genuine indebtedness”
The Commissioner accepts that three of the agreements at issue
here—the original note, the modifications, and the security agreement—
constitute “genuine indebtedness” by WTS to PLI. But the fourth
agreement—the Additional Interest Agreement that gave rise to WTS’s
obligation to pay appreciation interest—cannot be separated from these
other three agreements. Indeed, the four agreements were inextricably
integrated with each other. They were simultaneously bargained for,
and they cross-reference each other.
WTS’s obligation to pay appreciation interest arose from the same
advances, totaling $4.4 million, that gave rise to WTS’s obligation to pay
the other interest components (which are concededly deductible—even
the NCF interest that, like appreciation interest, was provided for in the
Additional Interest Agreement). There are no other advances that PLI
made that could be characterized as giving rise to the obligation to pay
appreciation interest.
One might still consider arguing for an allocation of the
appreciation interest to a portion of the $4.4 million of advances that
should be characterized as equity, but the Commissioner has
affirmatively disclaimed that argument, as we now explain.
2. The inseparability of the profit sharing and the right
to repayment with interest
Adhering to the position of a General Counsel Memorandum
(“G.C.M.”), the Commissioner here acknowledges that PLI’s “right to
share in the partnership’s profits” cannot be said to be “separable from
its right to repayment of its advance with interest thereon”, and
acknowledges that it cannot be held “that only the right to share in
profits is an equity interest”. I.R.S. G.C.M. 36,702 (Apr. 12, 1976), 1976
WL 38976, at *5. This G.C.M. was issued in response to (and in criticism
of) the opinion of the Court of Appeals for the Second Circuit in the case
of Farley Realty Corp. v. Commissioner, 279 F.2d 701 (2d Cir. 1960), aff’g
T.C. Memo. 1959-93. Even though this is an argument that the
Commissioner disclaims in these cases, we discuss it to explain the
reason for the issues that we must decide.
In Farley two individuals (A and B) organized a corporation (C) to
purchase a building for $380,000. The seller took a first mortgage on
the building for $280,000; A and B financed the remaining $100,000
27
[*27] with $30,000 cash and the proceeds of a $70,000 loan from another
individual (Z). Id. at 703. Z explicitly desired to participate in the
venture solely as a creditor. Id. The terms of C’s second mortgage to Z
provided that Z would advance $70,000 to C for ten years in exchange
for payments consisting of 15% interest for the first two years and 13%
interest thereafter, as well as “50 per cent of the appreciation in the
value of the property if it appreciated in value”, which was determined
at such time that either C or Z extended an offer to sell or to purchase
the other’s interest in the property; the $70,000 “principal” was not due
until the end of the ten-year term, and repayment of the principal was
expressed as “seventy per cent of the first $100,000 of the amount by
which the purchase price exceeded the amount outstanding on the first
mortgage”. Id. C made payments in accordance with the agreement.
Shortly before the principal was due, and when only $583 of interest
remained to be paid, Z died and his administrators sought to collect the
amounts due under the agreement. Id. In a state court suit, C
challenged the enforceability of Z’s entitlement to a 50% share in the
appreciation, and the parties settled for $120,583, which represented
$70,000 in principal, $583 in interest, and $50,000 for Z’s share of the
appreciation. When C filed its tax return, it claimed interest deductions
totaling $50,583, and the Commissioner disallowed the $50,000 portion
of the interest deduction that corresponded to Z’s $50,000 appreciation
payment.
The court sustained the disallowance of $50,000 of the interest
deductions and held that Z’s “right to share in the appreciation of
petitioner’s property is separable from his right to repayment of his
$70,000 loan with interest thereon, and that the right to share in the
property’s appreciation constituted an equity interest in the property.”
Id. at 704. The court reasoned that Z’s entitlement to the appreciation
payment, taken separately and apart from the interest of $583, exposed
Z to downside risk, was of an indefinite amount, and lacked a fixed
maturity date, id. at 704–05, and therefore was not “interest on an
indebtedness”. (The court explicitly did not reach the question of
whether Z’s “equity interest in the property had the features of a ‘joint
venture’” under relevant state law, id. at 706, which is what the
Commissioner contends occurred in these cases.)
The position that the IRS has taken on Farley—and the position
that the Commissioner expressly takes in these cases—is that Farley
was wrongly decided insofar as it “suggests that the taxpayer’s right to
share in the partnership’s profits is separable from its right to
repayment of its advance with interest thereon and that only the right
28
[*28] to share in profits is an equity interest”. G.C.M. 36,702, 1976 WL
38976, at *5. As the G.C.M. observes, “serious computational problems”
would arise with determining that Z held an equity interest in C, if in
fact all of Z’s $70,000 contribution constituted a loan. Id. at *6. If his
entire contribution was a loan, then Z “contributed neither capital nor
services in his capacity as a ‘partner.’ . . . In short the Farley decision
appears unsound to the extent that it holds that Z held an equity
interest for which he contributed neither capital nor services”. Id. at *5.
Fixing this anomaly by separating the loan from the equity interest
“might require computing the amount [of the advance] allocable to the
loan as a portion of the contribution sufficient to establish the fixed
interest as a true, arm’s length return and then allocating the remaining
portion to equity”, id. at *6, an exercise that would involve “difficulty”,
“mak[ing] this type of allocation undesirable”, id. at n.3.
We do not attempt here any such allocation between debt and
equity because the Commissioner has not argued for it, has disclaimed
it, 13 and has not put on any evidence to enable the necessary
computations to make the allocation. Therefore, we cannot allocate
PLI’s $4.4 million advance between a loan and an equity interest. 14 This
leaves the Commissioner backed into a corner: If the transaction is
entirely debt, then the appreciation interest is deductible interest; but
he cannot argue that only a portion of it is equity; so he argues instead
that PLI’s interest is all equity—to wit, its equity share of a WTS-PLI
joint venture. Adjudicating that argument would require us to have
jurisdiction over partnership issues of such an entity, and we must
determine whether such an entity exists.
B. Whether WTS established a joint venture with PLI
The Commissioner contends, notwithstanding the ostensible loan
agreement between WTS and PLI—embodied in the four documents
that we find to be integrated—that the two entities in fact entered into
13 For example, the Commissioner’s Post-trial Answering Brief asserts “that
PLI’s advance to WTS was . . . not part equity, part debt”.
14 In the absence of stipulations to the contrary and the Commissioner’s
disclaimer, one might note PLI’s practice of advancing 75% of the stabilized value for
a conventional loan, versus PLI’s practice of increasing the amount to 85% of a
projected stabilized value for a participating loan (as is at issue here), and might
entertain the possibility that the additional 10% was not bona fide indebtedness but
was in fact capital contributed not as part of a loan advance but for a participating
profits interest. But this we cannot do, see Rule 90(e) and (f), and the Commissioner
does not ask us to do so.
29
[*29] a joint venture. He now argues that the parties’ entire agreement
created a “relationship between WTS and PLI . . . of joint venturers, not
lender and borrower, and that PLI’s advance was more in the nature of
a capital contribution than a loan.” We think that this argument must
be rejected if we take at face value the parties’ binding stipulation that
the original note, the modifications, and the security agreement
“constitute genuine indebtedness by West Town Square to Protective
Life” and the Commissioner’s acknowledgement that “the agreement
between WTS and PLI, despite consisting of multiple documents, must
be considered as a whole”. Whatever else PLI might have been in this
arrangement, we know it was a creditor. As we have noted, PLI
advanced its entire $4.4 million as proceeds pursuant to those
documents. There was no separate or additional advance that did not
“constitute genuine indebtedness” and that could be characterized as
giving rise to WTS’s obligation to pay the appreciation interest.
The Commissioner’s stipulation of the existence of “genuine
indebtedness”, and his acceptance that the four loan documents “must
be considered as a whole” and that they gave PLI a single interest,
contradict the argument he now seeks to advance. Paragraph 35 of the
stipulation reflects the parties’ agreement that PLI held debt in WTS,
and the Commissioner now accepts that PLI’s advance created a single
interest that must be characterized as either wholly debt or wholly
equity. Consequently, the Commissioner’s contention that PLI has a
single interest properly characterized as equity must fail. The
documents created “genuine indebtedness”, and this fact precludes a
finding that they created no debt but rather a single equity interest in a
supposed joint venture.
With the same result, we turn now to a more detailed analysis of
the eight “Luna factors”, which analysis shows that WTS and PLI did
not form a joint venture that was a partnership for tax purposes.
1. The agreement of the parties and their conduct in
executing its terms
The loan documents executed by WTS and PLI could hardly have
been more explicit in naming their relationship. Affirmatively, the
documents stated that WTS and PLI were borrower and lender.
Negatively, the documents expressly stated that WTS and PLI did not
form a joint venture. WTS and PLI conducted themselves in accordance
with the terms of the loan documents (including the Additional Interest
Agreement), and the Commissioner does not contend that any terms of
30
[*30] the agreement were not followed. This weighs against the
existence of a joint venture.
The Commissioner asserts otherwise, stating (with record
citations omitted):
As to the first factor, the agreement between PLI
and WTS contemplated the purchase, operation, and
eventual sale of a shopping center. . . . A key piece of that
agreement was that PLI would share in the potential
upside of the investment, both by receiving half of the
operating profits but also half of the net proceeds from a
sale of the shopping center.
This assertion reflects a misunderstanding of the first factor. It is true
that the substance rather than the ostensible form of the transaction
controls a determination of the existence of a joint venture, see WB
Acquisition, Inc. & Sub. v. Commissioner, T.C. Memo. 2011-36,
101 T.C.M. (CCH) 1157, 1164, aff’d sub nom. DJB Holding Corp. v.
Commissioner, 803 F.3d 1014 (9th Cir. 2015), and that the
characterization reflected in a written agreement is not necessarily
determinative of whether the parties entered into a joint venture. It
may also sometimes be true that a “shar[ing] in the potential upside” is
an indication of a possible joint venture, and there is no denying that
PLI acquired—apart from its right to receive conventional interest—the
right to share in the appreciated value of the shopping center. But that
analysis concerns the fourth factor, discussed below. The first factor
considers whether the form of the purported agreement is a joint
venture and whether the parties departed from the ostensible form. In
W.B. Acquisition we held, in examining the first factor, that an
ostensible joint venture agreement was contradicted by the actual
conduct of the parties, so we held that a joint venture had not been
created, despite its ostensible form. Here the ostensible form—a series
of integrated documents that expressly deny joint venture status and do
create “genuine indebtedness”—is debt and not a joint venture, and the
parties have operated according to the terms of their agreement.
Therefore, the first factor continues to weigh against the existence of a
joint venture. (We will proceed to address whether the other factors
disclose contrary substance.)
31
[*31] 2. The contributions, if any, which each party has made
to the venture
There is no dispute that WTS contributed the services that made
the operation of the Rome property a successful venture, including
rehabilitating and maintaining the property and securing the tenants
that produced the rental income on the property. The Commissioner
argues that PLI’s contribution was the capital, indicating that both were
members of a joint venture.
However, the advanced funds of a lender are a loan and not a
contribution to capital, so it is insufficient for the Commissioner to note
the undisputed fact that PLI was the source of money for the project.
One must ask in what capacity PLI provided that money; and it is fair
for the Commissioner to insist that one must look past PLI’s ostensible
loan to ask whether perhaps the advances were not really true debt. But
the answers to these questions come easily from the Commissioner’s
stipulation that the indebtedness evidenced by the original note and its
modifications—i.e., the entire $4.4 million amount of the funds
advanced by PLI to WTS—was “genuine indebtedness”. (As we explain
below in part II.C, treatment of that amount as genuine indebtedness
precludes a finding that PLI had a “single equity interest” that
transformed the payments on the indebtedness into guaranteed
payments made to a partner of the partnership.)
PLI contributed little of value outside of its capacity as an arm’s-
length lender of the entire advance to WTS. This factor weighs against
finding a joint venture between WTS and PLI. See DJB Holding Corp.
v. Commissioner, 803 F.3d at 1026 (citing Luna, 42 T.C. at 1077–79, and
Culbertson, 337 U.S. at 742, for the proposition that a purported partner
who contributes no value to a joint venture is not a bona fide partner in
the venture).
3. The parties’ control over income and capital and the
right of each to make withdrawals
Other than the payments that WTS was contractually obligated
to make to PLI under the loan documents, WTS controlled the income
from the Rome property. PLI was contractually entitled to
approximately half of the net income of the Rome property, modified by
defining exclusions from “expenses” for purposes of calculating the NCF
payment on terms favorable to PLI, whereas WTS was entitled to
whatever net income remained after the payments to PLI (which in some
32
[*32] years resulted in an overall loss). WTS and PLI did not have
equivalent interests in the income stream from the Rome property. PLI
was always guaranteed to receive what amounted to more than half of
the income from the property, provided that the property was profitable.
PLI was likewise not liable for any operating losses, except to the extent
that they offset the quarterly amounts due to PLI under the NCF
calculation at the end of the year.
PLI also exerted control over the primary capital that was the
source of the income at issue, under the terms of the interest agreement
and otherwise. For instance, if PLI had not repeatedly agreed to extend
the term of the original note (which it was permitted, but by no means
obligated, to undertake under the terms of the loan documents), PLI
could have effectively forced a sale of the property, because all of the
principal remaining on the loan would have been due and WTS had few
other assets of value beyond the Rome property itself and its income
stream, all of which were pledged to PLI as security for the loan.
Moreover, the interest agreement became effective before PLI funded
the loan; it was a binding contract that governed the parties’ conduct
“whether or not the Loan is funded and whether or not the Project is
sold”. Therefore, if WTS had sought junior financing or a full refinance
with a different lender during the life of the loan from PLI, or even if
WTS had prepaid the full amount of the principal, it would have
nonetheless continued to owe PLI appreciation interest, pursuant to
Article 4 of the interest agreement, based on the fair market value of the
Rome property at the time that WTS exited the deal (and in certain of
those instances, would have continued to owe the NCF payments). Any
such actions were subject to approval by PLI or were subject to penalty
of default, which likewise would not have relieved WTS of its obligation
to make the additional interest payments. PLI therefore had significant
control over the capital that WTS employed in its business.
PLI’s economic interest under the terms of the Additional Interest
Agreement, and as demonstrated by the conduct of the parties,
resembles that of a holder of a preferred equity interest in the business.
See Estate of Mixon v. United States, 464 F.2d 394, 410–11 (5th Cir.
1972) 15 (hampering ability to borrow from other creditors at the time the
15 Because petitioners resided in Georgia, venue for any appeal of these cases
would, under section 7482(b)(1)(A), be the U.S. Court of Appeals for the Eleventh
Circuit. That court has adopted as precedent decisions of the former U.S. Court of
Appeals for the Fifth Circuit rendered before October 1, 1981. Bonner v. City of
Prichard, 661 F.2d 1206, 1209 (11th Cir. 1981) (en banc). The Fifth and Eleventh
33
[*33] advance is made, using of funds to acquire capital assets, and the
corporation’s failure to repay on the due date weigh in favor of finding
equity, not debt). Accordingly, this factor weighs in favor of finding that
the parties engaged in a joint venture.
4. Whether each party was a principal and
coproprietor, sharing a mutual proprietary interest
in the net profits and having an obligation to share
losses, or whether one party was the agent or
employee of the other, receiving for his services
contingent compensation in the form of a percentage
of income
As we observed with respect to the third Luna factor, WTS and
PLI each had an interest in the net profits of the business, but PLI was
somewhat shielded from operating losses during the operation of the
Rome property. The Commissioner asserts—and we agree—that the
entitlement to a share of net profits is generally indicative of an equity
interest in the enterprise generating those profits. See Estate of Mixon,
464 F.2d at 405; see also Stevens Bros. & Miller-Hutchinson Co. v.
Commissioner, 24 T.C. 953, 956–57 (1955) (finding advance of capital
from one corporation to another in exchange for a one-half share of the
profits of the project was a bona fide agreement resulting in half the
profits’ being taxed as income to each corporation).
However, PLI did not have an obligation to share pro rata in the
operating losses from the Rome property. With respect to overall loss
on a final disposition of the Rome property, the Commissioner correctly
observes that the operation of the Rome property was capitalized almost
exclusively with debt and that the assets of WTS that were not pledged
as collateral on the loan to PLI were of minimal value; and he plausibly
argues that PLI was exposed to a risk of loss. If the Rome property were
to decline in value, then PLI would risk losing, to the extent of that
decline, the proceeds it had advanced. “Thin capitalization” of an entity
is generally a factor favoring a finding that the advance that funds the
Circuits evaluate 13 factors in a debt versus equity analysis, of which no single factor
is controlling, nor are all factors entitled to equivalent significance. Estate of Mixon,
464 F.2d at 402. The Commissioner argues that an analysis of these 13 factors results
in the conclusion that PLI’s advance was made in respect of an equity interest and not
debt, and petitioners urge the opposite. We find that analysis of the Luna factors is
determinative of the issues in these cases, which require first that we find the existence
of the relationship between WTS and PLI that could potentially give rise to an equity
interest before we have occasion to characterize that interest.
34
[*34] venture should be viewed as an equity interest (subject to
downside risk). See Estate of Mixon, 464 F.2d at 408 (observing that
“thin capitalization is very strong evidence of a capital contribution
where (1) the debt-to-equity ratio was initially high, (2) the parties
realized the likelihood that it would go higher, and (3) substantial
portions of these funds were used for the purchase of capital assets and
for meeting expenses needed to commence operations”). But while it is
true that the operation of the Rome property was capitalized almost
exclusively with debt, we cannot view this factor in a vacuum. The
parties stipulated that the loan from PLI to WTS was genuine
indebtedness, and we do not disregard that stipulation to consider
whether inadequate capitalization might be a sign of equity rather than
debt.
Setting aside the Commissioner’s contention with respect to the
Rome property’s thin capitalization, this factor weighs against finding a
joint venture between WTS and PLI, because PLI did not have an
obligation to share pro rata in the operating losses from the Rome
property. See WB Acquisition, Inc. & Sub., 101 T.C.M. (CCH) at 1167.
5. Whether business was conducted in the joint names
of the parties
The Commissioner concedes that business was conducted in the
name of WTS, not PLI or any other entity; and we find that this factor
weighs against finding a joint venture.
6. Whether the parties filed federal partnership returns
or otherwise represented to the Commissioner or to
persons with whom they dealt that they were joint
venturers
The Commissioner concedes that the parties did not file tax
returns indicating that they were partners, and that WTS and PLI did
not otherwise represent to the IRS or any other persons that they were
engaged in a joint venture. Rather, WTS and PLI held themselves out
as distinct entities whose relationship was solely that of borrower and
lender. This factor weighs against finding that WTS and PLI engaged
in a joint venture.
35
[*35] 7. Whether separate books of account were maintained
for the venture
No books of account were maintained for the Rome property other
than by WTS. The Commissioner argues that “the parties agreed to the
manner in which the books and records of their joint activity would be
kept”, but this was solely for purposes of calculating the payments due
under the interest agreement. WTS and PLI did not jointly maintain
books of account that would normally be expected in the operation of a
business. See WB Acquisition, Inc. & Sub., 101 T.C.M. (CCH) at 1167.
This factor weighs against finding a joint venture.
8. Whether the parties exercised mutual control over
and assumed mutual responsibilities for the
enterprise
While it is clear that PLI exercised control over the capital that it
lent to WTS, most of the terms set forth in the security agreement and
elsewhere are standard terms present in an arm’s-length secured
commercial loan, which is consistent with the undisputed evidence that
PLI used the same agreements (other than the Additional Interest
Agreement) for its conventional loans. WTS exercised primary
responsibility and control over the rental operations of the Rome
property; and the only involvement PLI had with respect to those
operations was its pre-approval of Spectrum Cauble to serve as the
commercial property manager. In light of Mr. Barry’s involvement with
Spectrum Cauble, this pre-approval looks much more like the product of
an arm’s-length negotiation rather than PLI’s exerting responsibility or
control over operations. We conclude that this factor weighs against
finding that PLI held an equity interest in a joint venture with WTS.
See Luna, 42 T.C. at 1078–79; see also Estate of Mixon, 464 F.2d at 406.
Seven of the eight Luna factors weigh against a finding of a joint
venture, while one Luna factor weighs in favor. We find particularly
significant the absence of any contribution by PLI to the purported joint
venture, where the parties have stipulated that all of the funds it
advanced to WTS were genuine indebtedness. Under the holding of
Culbertson, 337 U.S. at 740, to the extent a partner must contribute “one
or both of the ingredients of income—capital or services”, we find no
basis to conclude that PLI made a contribution to an organization with
WTS for the production of income. Viewing the transaction as a whole,
and in light of our findings on all of the Luna factors, with no one factor
36
[*36] being conclusive, we hold that there was no joint venture between
WTS and PLI.
C. Whether on other grounds the appreciation interest
constituted a return on equity
The fact that there was no WTS-PLI joint venture forecloses the
argument that the Commissioner advanced in his Pretrial
Memorandum and his Post-trial Briefs. It does not directly address the
position in the NOD, which does not posit a WTS-PLI joint venture. To
determine whether we need to address the NOD apart from the joint
venture contention, we ordered the Commissioner to answer this
question:
If we conclude that we lack jurisdiction to entertain the
Commissioner’s [joint venture] argument . . . , what issues
remain to be decided in the case in light of the parties’
stipulations? See Doc. 10, stip. paras. 13, 15, 24, 27, 32-35,
68.
The Commissioner responded:
[T]he issues revolve around what are properly partnership
issues of a joint venture between WTS and PLI. Because
the Court has no jurisdiction over partnership items in a
deficiency proceeding, if the Court finds that the WTS and
PLI are joint venturers, there are no issues remaining for
the Court to decide.
Thus, he did not explicitly state what issues remain to be decided if we
hold there was not a WTS-PLI joint venture. He does not say whether
we should decide the issue as framed in the NOD, apart from the
existence of a joint venture. Rather than deeming that position waived
or abandoned, we address it.
In his opening brief filed after trial, the Commissioner
summarizes his operative contention thus: “When all of the facts are
considered, the Court should conclude that the advances made by PLI
to WTS were equity, not debt.” As we have said, we conclude that this
argument is foreclosed by the stipulated fact of “genuine indebtedness”.
The Commissioner nonetheless urges, despite this stipulation,
that we characterize as equity not just a portion of PLI’s loan but the
entire advance. This position avoids the necessity of an allocation
37
[*37] between debt and equity (which, rejecting Farley and following the
G.C.M., he has disclaimed). However, if successful, this argument that
PLI’s entire advance was equity would contradict his concession that
WTS was entitled to deduct as interest the regular interest and the NCF
interest. To attempt to cure this contradiction, he argues that the
interest payments that WTS made pursuant to the original note should
be treated as “guaranteed payments” to a partner pursuant to section
707(c), 16 which provides:
To the extent determined without regard to the income of
the partnership, payments to a partner for . . . the use of
capital shall be considered as made to one who is not a
member of the partnership, but only for the purposes of
section 61(a) (relating to gross income) and, subject to
section 263, for purposes of section 162(a) (relating to trade
or business expenses). [Emphasis added.]
Section 707(c) thus creates a narrow exception to allow a payment
by a partnership to “be considered as made to one who is not a member
of the partnership”, 17 and by the text emphasized above it limits the
effect of that exception to only the explicit Code sections cross-referenced
therein. “For the purposes of other provisions of the internal revenue
laws, guaranteed payments are regarded as a partner’s distributive
share of ordinary income.” Treas. Reg. § 1.707-1(c). Accordingly, the
Commissioner urges that treatment of PLI’s advance of the loan funds
as part of a single equity interest—
would have the same tax results to WTS and PLI for
payments made pursuant to the promissory note [i.e., the
regular interest] as though it were a traditional loan, with
the payments deductible to WTS (as guaranteed payments
16 In making the argument under section 707(c), the Commissioner follows here
the G.C.M., which states: “Application of Code § 707(c) would thus permit the entire
interest to be characterized as equity, while at the same time recognizing that the
holder of that interest is receiving some payments as a creditor.” G.C.M. 36,702, 1976
WL 38976, at *6. By this approach, the “problems of allocation can be avoided by
finding that the taxpayer holds only a single interest rather than separable debt and
equity interests. Such a finding does not preclude recognizing that a single interest
may have elements of both debt and equity.” Id. This analysis posits an “entire
interest . . . characterized as equity” but with “elements of both debt and equity.” Id.17 We observe that Congress used wording here different from that in section
707(a), which is implicated “[i]f a partner engages in a transaction with a partnership
other than in his capacity as a member of such partnership.” (Emphasis added.)
38
[*38] or interest) and includable in income for PLI as interest.
Only the payments [of appreciation interest] made
pursuant to the additional interest agreement—such as the
payment of a portion of the proceeds from the sale of the
shopping center at issue here [which payments are made
with “regard to the income of the partnership”, i.e., from
the sale of the shopping center]—would be treated
differently.
We see two immediate problems with the Commissioner’s
argument. First, the text of this subsection requires, as a definitional
prerequisite to its applicability, that the transfer be made by a
partnership to a partner of that partnership. In other words, payments
made by any person other than a partnership or payments made to any
person other than a partner of that partnership cannot be “guaranteed
payments” under section 707(c). Therefore the Commissioner’s
argument is impossible if we reject (as we do) his positing of a WTS-PLI
joint venture. Section 707(c), if it applied, might cure the contradiction
and save the deductibility of the regular interest and the NCF interest,
but we cannot tell whether the Commissioner intended that this section
707(c) analysis be applied as between WTS and PLI (without the joint
venture). If he did, then the analysis founders on the stipulated fact
that PLI did not own a membership interest in WTS (and was therefore
not a partner of the partnership WTS). The only payments at issue are
those that were made from the partnership WTS to the non-partner PLI.
The payment of appreciation interest was therefore not a “payment[] to
a partner” under section 707(c).
Second, as we have frequently noted, the Commissioner has also
stipulated that the advance at issue was “genuine indebtedness” that
WTS owed to PLI. Though a partner may indeed make a bona fide loan
to a partnership of which he is a partner, such an arm’s-length
transaction properly results in treating the loan as one made by the
partner in a non-partner capacity under section 707(a), rather than as a
guaranteed payment for the use of capital pursuant to section 707(c).
See Pratt v. Commissioner, 550 F.2d 1023, 1027 (5th Cir. 1977) (“since
there is no dispute in this case that the taxpayers’ loans to their
partnerships were bona fide loans, the loan transactions are to be
treated under § 1.707-1(a) of the Treasury Regulations, as coming within
the provisions of § 707(a) and . . . the interest accrued on such loans
therefore does not constitute a ‘guaranteed payment’ under § 707(c)”),
aff’g in part, rev’g in part, and remanding 64 T.C. 203 (1975); Gaines v.
Commissioner, T.C. Memo. 1982-731, 45 T.C.M. (CCH) 363, 374 n.15
39
[*39] (“Transactions between a partner and his partnership when the
partner is not acting in his capacity as a partner are governed by section
707(a), not section 707(c)”); see also Treas. Reg. § 1.707-1(a) (“Such
transactions [under section 707(a)] include, for example, loans of money
or property by the partnership to the partner or by the partner to the
partnership . . . . [T]ransfers of money or property by a partner to a
partnership as contributions . . . are not transactions included within
the provisions of this section”); G.C.M. 36,702, 1976 WL 38976, at *7
(“deductions under Code § 163 require a true indebtedness which by
definition is not present when Code § 707(c) applies”). Therefore,
contrary to the Commissioner’s brief quoted above, a partnership’s
payments “to a partner for . . . the use of capital” (to which section 707(c)
would apply) are not equivalent to such payments made to a partner
“other than in his capacity as a member of such partnership” in respect
of genuine indebtedness (to which section 707(a) would apply).
We therefore hold that PLI did not have a “single equity interest”
in its dealings with WTS that transformed WTS’s loan payments on
genuine indebtedness to PLI into guaranteed payments made to a
partner pursuant to section 707(c) or into something else.
D. Whether WTS’s payment of appreciation interest to PLI was
deductible interest pursuant to section 163(a)
Section 163(a) provides the “general rule” that “[t]here shall be
allowed as a deduction all interest paid or accrued within the taxable
year on indebtedness”. This general rule is subject to a number of
limitations imposed by the remaining paragraphs of section 163,
including a general prohibition against deductions for “personal
interest”, see § 163(h), but neither party contends that any of these
limitations apply here. Rather, the Commissioner contends that the
appreciation interest payment was not interest, as petitioners have
asserted.
The Supreme Court has defined “interest on indebtedness” as
“compensation for the use or forbearance of money”. Deputy v. du Pont,
308 U.S. 488, 498 (1940); see also Old Colony R.R. Co. v. Commissioner,
284 U.S. 552, 560 (1932) (“the usual import of the term [i.e., “interest”]
is the amount which one has contracted to pay for the use of borrowed
money”). We therefore must decide whether, in light of the other
holdings in this Opinion, WTS’s payment of the appreciation interest to
PLI was compensation for the use of the funds that PLI advanced to
WTS.
40
[*40] Petitioners cite a number of precedents in support of their
argument that the appreciation interest was “interest” within the
meaning of section 163. In the case of Kena, Inc. v. Commissioner,
44 B.T.A. 217, 218 (1941), the Board of Tax Appeals (predecessor to the
Tax Court) held that a payment of “money in lieu of interest” calculated
as 80% of the net profits of the borrowing corporation for the duration of
the loan, was in fact interest. So holding, it stated that “[i]t is not
essential that interest be computed at a stated rate, but only that a sum
definitely ascertainable shall be paid for the use of borrowed money,
pursuant to the agreement of the lender and borrower.” Id. at 221.
Since that decision, the IRS has issued guidance concluding that sums
calculated at other than a fixed rate may also constitute interest,
including such sums calculated in addition to a fixed rate of interest.
See Rev. Rul. 83-51, 1983-1 C.B. 48, 48–49 (concluding that home
mortgage interest composed of 12% fixed interest plus 40% of the
appreciation of the home during the period of the loan was “interest”
under section 163); Rev. Rul. 76-413, 1976-2 C.B. 213, 213–14
(concluding that a real estate loan that charged fixed interest at 11%
plus contingent interest calculated as “the greater of 1.75 percent of the
gross receipts or $300 per acre from the sale of portions of the property”
qualified as mortgage interest).
The parties have stipulated that the full amount of the funds
advanced by PLI was advanced pursuant to documents that “constituted
genuine indebtedness”, and we have concluded above that WTS and PLI
were not engaged in a joint venture or another arrangement that could
give rise to an equity interest entitling PLI to any portion of the
payments at issue. Rather, WTS was obligated to pay the additional
interest because WTS entered into the loan transaction structured by a
series of interdependent contracts governing the terms of its
indebtedness to PLI. We therefore conclude that WTS paid the
appreciation interest as compensation to PLI for the use of the funds
advanced, and that the appreciation interest was “interest” within the
meaning of section 163.
Conclusion
WTS’s payment to PLI of the appreciation interest was a
deductible payment of interest and not a payment in respect of equity.
Decisions will be entered for petitioners.