The Tax Court in Brief – August 22nd – August 26th, 2022
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Tax Litigation: The Week of August 22nd, 2022, through August 26th, 2022
Alexander C. Deitch v. Comm’r, No. 21282-17; and Jonathan D. Barry and Susan S. Barry v. Comm’r, No. 21283-17, T.C. Memo 2022-86 | August 25, 2022 | Gustafson |
Key Issues:
- Whether West Town Square Investment Group, LLC (“WTS”) and Protective Life Insurance Co. (“PLI”) were engaged in a joint venture constituting a partnership for federal income tax purposes
- Whether a payment in 2014 of $1,035,683 by WTS to PLI was deductible as interest under section 163.
Facts and Primary Holdings:
- The taxpayers in this case 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 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. The taxpayers reported their distributive shares of income and loss of WTS on their individual income tax returns for 2014.
- The IRS sent statutory notices of deficiency to taxpayers, determining that their incomes should each be increased by $517,841, resulting from the IRS’s disallowance of the Appreciation Interest WTS claimed as a deductible interest expense.
- In its first holding, the Tax Court held that, notwithstanding I.R.C. § 6221(a) and Tax Court Rule 240(c), it had jurisdiction to determine whether WTS and PLI were engaged in a joint venture constituting a partnership for federal income tax purposes, and ultimately held that they were not so engaged.
- Next, the Court found 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 I.R.C. § 707(c).
- Finally, the Court held that 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
Key Points of Law:
- 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.
- 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).
- Since WTS was owned solely by two individuals, the Tax Court found that that the “small partnership” exception of §6231(a)(B) applies to WTS, and therefore WTS was not to be treated as a “partnership” for purposes of TEFRA.
- In determining whether WTS and PLI formed a “joint venture” that constituted a partnership under §761(a), the court evaluated the “joint venture” contention by reference to principles governing the question of whether persons have formed a partnership which is to be accorded recognition for tax purposes. These eight Luna factors, named after the case that established this analysis – Luna v. Comm’r, 42 T.C. 1067, 1077 (1964) include the following:
- The agreement of the parties and their conduct in executing its terms;
- The contributions, if any, which each party has made to the venture;
- The parties’ control over income and capital and the right of each to make withdrawals;
- 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;
- Whether business was conducted in the joint names of the parties;
- Whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers;
- Whether separate books of account were maintained for the venture; and
- Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.
Insight:
Where, as here, parties to a transaction have clearly established the terms of their agreement, a debtor-creditor relationship is not going to be reclassified as an equity investment without evidence that simply didn’t exist here.
