Originally published on Passive Activities and Other Oxymorons on January 21, 2011.
Historic Boardwalk Hall, LLC, et al. v. Commissioner, 136 T.C. No. 1
One of the problems with tax incentives is that the people who are interested in doing the things that are being incentivized often don't have sufficient tax liability to absorb the incentive. Some states have simplified this process with some of their credits. If, for example, you shoot a film in Massachusetts and jump through all the proper hoops, you get what you might call a tax coupon that you can transfer to anybody who can use it. There are people who facilitate these type of transactions like my friend Bob Dorfman of Dorfman Capital. So if you have a large Massachusetts or Rhode Island liability that you would like to settle for less than 100 cents on the dollar, you should check him out. Likewise if you are making a film, or renovating an historic structure or cleaning up some brownfields and would like to market your credit. Life is not as simple when it comes to federal credits.
If a building generates a credit you need to be the owner of the building in order to benefit from the credit. Some credits, like that for developing low income housing, would be pointless, if there wasn't a legitimate way to work around this. The most common solution is to use a partnership. Partnerships are sometimes used for abusive transactions, but as noted below getting the low income housing credit to investors is a proper use of partnerships
Reg §1.701-2. Anti-abuse rule(a)Intent of subchapter K. Subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity- level tax. .....
Example (6). Special allocations; nonrecourse financing; low-income housing credit; use of partnership consistent with the intent of subchapter K.
(i) A and B, high-bracket taxpayers, and X, a corporation with net operating loss carryforwards, form general partnership PRS to own and operate a building that qualifies for the low-income housing credit provided by section 42.
The New Jersey Sports and Exposition Authority (NJSEA) built a convention center in Atlantic City. It also operated property known as East Hall (now known as Boardwalk Hall). Once the convention center was built East Hall would no longer be usable without substantial renovations. East Hall was a certified historic structure so its renovation would generate a substantial historic credit. NJSEA could not use the credit itself. Unlike a Massachusetts film credit, you can't just sell a federal historic credit.
So they formed Historic Boardwalk Hall LLC (HBH) and admitted Pitney Bowes (PB) as a partner. PB was entitled to a 3% priority distribution and was allocated the entire credit. Like many such deals it is fairly convoluted. PB has limited upside from the economics of the deal. There are also guarantees that the credits it gets will be sustained. The Service didn't like the deal alleging that :
(1) Historic Boardwalk Hall was created for the express purpose of improperly passing along tax benefits to Pitney Bowes and is a sham;
(2) Pitney Bowes' stated partnership interest in Historic Boardwalk Hall was not bona fide because Pitney Bowes had no meaningful stake in the success or failure of Historic Boardwalk Hall;
(3) the East Hall was not “sold” to Historic Boardwalk Hall because the benefits and burdens of ownership did not pass to Historic Boardwalk Hall. Accordingly, any items of income or loss or separately stated items attributable to ownership of the East Hall were disallowed;
(4) respondent pursuant to his authority in the antiabuse provisions of section 1.701-2(b), Income Tax Regs., had determined that Historic Boardwalk Hall should be disregarded for Federal income tax purposes; and
(5) all or part of the underpayments of tax attributable to the adjustments in the FPAA were attributable to either negligence, a substantial understatement of income tax, or both
The essence of the case is that PB would not have committed large amounts of capital for a stinking 3% return (Remember this was back in the days when you could actually earn interest on your money). The IRS is putting this deal in the same category with the shenanigans in Fidelity International Currency where paired options magically create basis and friendly Irishmen recognize huge currency gains so the wild geese could shelter their stock option income. The tax court does not see it that way though.
PB taking a low economic return on a real estate deal that provides historic credits is the whole point of the historic credits. Historic credits like low income credits are meant to encourage investments that might not otherwise be economically feasible. Although I can't hammer a nail straight I have seen enough of the numbers produced from various real estate ventures to know that the most cost efficient way to rehabilitate a building is to start with dynamite and some big dumpsters. Once you have a nice flat surface, the rest of the rehabilitation will go really smooth.
There is a question as to whether it is a good idea to use tax incentives to promote desired behaviors. While I've been working on this post, Professor Annette Nellen wrote a piece on the Mass Film Credit. BTW if you like serious discussion of how taxes should be her blog is a good choice. Although my general rule about taxes is: "It is what it is. Deal with it.", I'll weigh in just a bit here. The problem with unrestrained capitalism is that it does not account well for externalities. In other words your life might be enhanced if when you go to a great metropolis many of its historic facades are preserved and the number of people living in cardboard boxes is minimized. Then throw in the fact that people, particularly those with entrepreneurial personalities, love to chisel on their taxes. (The fallacy that critics of the credit fall into is the belief that absent the credit there would be that much more revenue rather than creative transactions with no incidental social utility). The credits just might direct that impulse into socially beneficial directions.
At any rate the Tax Court supported PB. Work was done on the building that entitled somebody to the historic credit. PB getting a lower economic return, is the point of having the credit. The point of the credit is to encourage people to preserve the historic facades when the sensible thing to do is to blow the buildings up and start over. As the Court puts it :
The legislative history of section 47 indicates that one of its purposes is to encourage taxpayers to participate in what would otherwise be an unprofitable activity. Congress enacted the rehabilitation tax credit in order to spur private investment in unprofitable historic rehabilitations. As respondent notes, the East Hall has operated at a deficit. Without the rehabilitation tax credit, Pitney Bowes would not have invested in its rehabilitation, because it could not otherwise earn a sufficient net economic benefit on its investment. The purpose of the credit is directed at just this problem: because the East Hall operates at a deficit, its operations alone would not provide an adequate economic benefit that would attract a private investor.
The Service's position in this case was a little disturbing. It is one thing to squash deals that border on economic fictions, but here we had people reaping tax benefits for doing what Congress wanted them to do. I hope its not that they are picking on New Jersey, because I'm from New Jersey.