What’s Is It?
When is a loan not a loan? When it’s something else – for example, equity.
This is one of those pesky facts and circumstances issues that plague courts, taxpayers, and tax advisers to no end.
On one end of the spectrum, we have a pure debtor-creditor relationship. Very, very simply, a lender has transferred a portion of its funds to a borrower entity for the borrower’s use for a stated period of time (the “term” of the loan). In exchange for the use of the lender’s money (the principal), the borrower agrees to pay the lender a fixed rate of interest; basically, compensation for the time value of money – the longer the term of the loan, the higher the rate charged. At the end of the term, the borrower is required to return the principal to the lender, plus the amount of the accrued but unpaid interest. To secure its right to be paid the principal and interest, the lender may require that the borrower provide collateral for the loan, or it may require that the owners of the borrower entity guarantee the borrower’s obligations under the loan. On the liquidation of the borrower entity, the lender is entitled to receive the unpaid principal and interest owed by the borrower and nothing more. However, the lender is entitled to receive this sum before any amounts may be distributed to the owners of the borrower entity. To the extent any amount remains after payment of the principal and interest, such amounts belong to the borrower’s owners.
On the other end of the spectrum, we have the relationship of a business owner to the business entity out of which their business is operated; specifically, the relationship of a partner to their partnership or of a shareholder to their corporation. Again, very simply, the owner has made a contribution of capital to the entity in exchange for which the owner becomes entitled to a share of any current or liquidating distributions by the entity. Upon the occurrence of such a distribution, the owner may be entitled to receive an amount that exceeds the amount of their capital contribution, if the business has done well and appreciated in value. However, it is also possible that no assets will remain in the entity after it has satisfied its creditors, in which case the owner will have lost the amount of their investment, not to mention the opportunity to have invested elsewhere.
Little Bit of Both?
In between these two extremes, there are many variations of debt and equity that partake in features of the other but which are respected as what they purport to be.
For example, preferred stock may provide for a dividend that is based upon a fixed percentage of the stock’s par value; the dividend may be cumulative; preferred stock is senior to common stock in that it will receive distributions before the common stock does; most preferred does not participate in the earnings and appreciation of the issuer, except to the extent of its preferred dividend, let alone its appreciation. However, the dividend is payable only when the issuer’s board of directors declares a dividend; the stock has no maturity date, though it often may be called by the issuer; preferred shareholders are junior to creditors.
However, situations sometimes arise in which the nature of a contractually created relationship may not be immediately obvious. In those cases, the IRS, and ultimately a court, may have to decide whether a particular arrangement between certain taxpayers constitutes a loan or an equity investment before the tax treatment of a transaction between the parties may be determined.
Is It a Partnership?
The U.S. Tax Court recently considered, and rendered an exhaustively thorough opinion in, one such case where which the issue for decision was whether LLC, which was owned by individual Taxpayers A and B, on the one hand, and its lender (“Lender”), on the other, formed a joint venture that constituted a partnership for federal income tax purposes.[i]
Taxpayers organized LLC to purchase and operate a parcel of commercial rental property (the “Property”). Each of the Taxpayers acquired a 50 percent membership interest in LLC for a nominal capital contribution. LLC was a partnership for federal income tax purposes. LLC’s stated purpose was “[t]o engage in any lawful business, purpose or activity . . . [of] acquiring, developing, improving, leasing ( . . . ), managing, renovating, repairing, maintaining and selling, or otherwise dealing with, real property, including the [Property].”[ii]
Taxpayers learned that Hospital was seeking locations at which to provide certain services outside of the hospital. They discovered that the Property, which was owned by Realty Co, had two units that were leased and a third that was vacant. The two existing tenants had relatively short terms remaining on their leases. Taxpayers made an offer to purchase the Property in order to rehabilitate it to suit the needs of Hospital, and then, as the new owners of the Property, to lease it to Hospital.
LLC projected that renovations to the building plus the engagement of Hospital to be the third tenant would create substantial additional value for the property. They needed a loan to cover the acquisition cost of the Property, an allowance to Hospital for transferring their operations, and construction costs for renovations.
Taxpayers knew of Lender’s “participating loan program” and believed it would be suitable to fund the 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.”[iii][iv]
Lender issued a “Permanent Loan Commitment” to LLC, agreeing to provide secured financing for LLC to buy the Property plus a holdback amount to be funded no later than a year after the initial funding, but only upon LLC’s satisfying certain conditions with respect to completing the renovations, providing Lender with an appraisal, and executing all of the leases in full force and effect with tenants in occupancy.[v]
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, 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” to the loan commitment.
LLC accepted the loan commitment and closed on its purchase of the Property.
Over the life of the loan, the holdback proceeds were used to pay specific renovations for Hospital, and general renovations for the benefit of the entire property.
LLC 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 Lender a security interest in the Property and in the leases on the Property. The three documents—the original note, the security agreement, and the Additional Interest Agreement—were integrated documents (negotiated and executed as a set) that cross-referenced each other. The Additional Interest Agreement became effective on the date on which LLC accepted the loan commitment from Lender.[vi]
The original note (and its modifications) expressly treated LLC as the “Borrower” and Lender as the “Lender.”[vii]
As to LLC’s debts and losses, the note also provided that Lender “shall not be in any way responsible or liable for the debts, losses, obligations or duties of [LLC] or any guarantor with respect to the [Property] or otherwise.”
The terms of the note obligated LLC to pay interest only on funds disbursed from the date of disbursement until the latest date of disbursement of any of the remaining balance on the original note. Thereafter LLC was obligated to make monthly payments of principal and interest until the maturity date, when the entire principal balance plus accrued interest was due and payable. Interest due included base interest at a fixed rate 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.[viii]
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 LLC 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 co-ownership arrangement.
LLC and Lender 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 LLC as the borrower and Lender as the lender.
Under the security agreement, the debt under the “Loan Documents” was secured by the 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 Property. The security agreement included certain covenants that required LLC to obtain prior written consent from Lender before undertaking any of the following with respect to the secured property: making any material alterations, improvements, or additions to it; changing its use; or changing the professional company charged with its management and leasing. Similarly, LLC could not sell or further encumber the secured property without prior written consent from Lender, and LLC was obligated to provide Lender with annual reports consisting of a balance sheet and annual operating statement showing all of LLC’s income and expenses.
Additional Interest Agreement
Like the original note (and its modifications), the Additional Interest Agreement expressly treated LLC as the “Borrower” and Lender as the “Lender”. Under the terms of the Additional Interest Agreement, LLC agreed to pay Lender “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 percent. The parties 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 [Lender]’s control.”[ix]
The Additional Interest Agreement expressly disclaimed joint-venture status.[x]
As to LLC’s debts or losses, the agreement provided that Lender “shall not be in any way responsible or liable for the debts, losses, obligations or duties of [LLC] with respect to the Property or otherwise.”
Net Cash Flow Interest
The first item of additional interest that LLC agreed to pay Lender was 50% of net cashflow from the Property (“NCF interest”), an amount calculated after subtracting all expenses from all gross revenues of the property, as computed and paid quarterly. If the NCF calculation for any particular quarter was negative, LLC did not make a quarterly payment to Lender, nor was LLC entitled to make an immediate corresponding deduction or offset to Lender’s quarterly NCF interest.
However, LLC was obligated to furnish Lender with annual statements showing the NCF calculations, and each year Lender’s NCF interest was adjusted on the basis of the annual calculation. Upon this annual reconciliation of prior quarters, any amounts due to Lender (i.e., overdue amounts from previous quarters) incurred additional interest at a rate 2% above the prime rate; and any amounts due from Lender to LLC (as would have resulted from a negative NCF calculation in a previous quarter) would be credited to LLC and accordingly “deducted from the next payment(s) of . . . [Lender]’s NCF [i]nterest due until the credit has been depleted.”
The other item of additional interest that the interest agreement required LLC to pay to Lender was so-called “appreciation interest” equal to 50% of the “gross proceeds” derived upon the occurrence of one of seven defined events, reduced by certain “approved deductions” related to such transaction or event. The “events triggering [LLC’s obligation to pay Lender] appreciation interest” were (1) sale of the 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 Property; (4) any refinancing of the loan or any portion of the Property with a third-party lender, in which case the Additional Interest Agreement remained in full force and effect with respect to the 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.[xi]
Taxpayer B’s management company maintained the 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 Property.
Taxpayer B, acting for LLC, 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, LLC sought and found suitable replacement tenants.
Lender was not involved in the management of LLC.
During the taxable year in question, LLC determined that the market seemed receptive to a sale of the Property; it engaged a broker to solicit offers on the Property and negotiate the terms of the purchase.
Until the sale of the Property, LLC earned income by renting out the spaces in the Property to third parties and made payments on the loan in accordance with the loan documents.
LLC sold the Property and, as part of the sale, LLC paid to Lender 50% of the net proceeds of the sale as appreciation interest pursuant to the Additional Interest Agreement.[xii]
LLC also claimed a deduction for the payment it made to Lender in respect of its obligation to pay appreciation interest under the Additional Interest Agreement.[xiii]
The Tax Returns
LLC’s tax reporting was consistent with LLC’s performance and in accordance with the terms of the loan, which it characterized as a “nonrecourse liability.” LLC reported the amounts of its outstanding nonrecourse debt and interest expense, net income, and the balances of partners’ capital accounts at yearend on its tax return.[xiv]
For certain years, Taxpayers reported distributions from LLC. For the year in which Property was sold, Taxpayers reported receiving distributions (i.e., the balance of the partner capital accounts upon liquidation). LLC’s tax reporting was consistent with LLC’s stated obligations under the loan documents, including the Additional Interest Agreement.
As a result of passing through LLC’s items of income and expense, the Schedules K-1 showed net rental real estate losses for each Taxpayer. The losses included, in each instance, the partner’s 50% share of the appreciation interest payment. On their individual federal income tax return for the year of the sale, each Taxpayer reported his respective shares of LLC’s loss and gain as reported by LLC on the Schedules K-1.
The IRS examined Taxpayers’ tax returns for the year of sale following which it issued a notice of deficiency (“NOD”) to each Taxpayer that disallowed the LLC’s deductions for the appreciation interest that had been paid to Lender.
Each Taxpayer timely petitioned the Tax Court to redetermine the deficiency.[xv]
The Tax Court
The parties stipulated that the only issue for decision was whether LLC properly classified its payment of so-called “appreciation interest” to Lender as deductible interest.[xvi]
While Taxpayers took the position that the Additional Interest Agreement was part of the integrated loan documents that created an obligation to pay deductible interest, the IRS maintained that, taking into account the Additional Interest Agreement, the documents gave Lender equity in the arrangement, with the result that the payment of the appreciation interest should have been treated as an equity payment to Lender.[xvii]
However, whereas the IRS had contended in the NOD that the ostensible interest paid to Lender was a nondeductible return on Lender’s equity interest in LLC, the IRS asserted at trial that the Additional Interest Agreement created a joint venture between LLC and Lender, so that the ostensible interest paid to Lender was a nondeductible return on Lender’s equity interest, not in LLC, but in the supposed LLC-Lender joint venture.
The IRS contended that this joint venture should have been treated as a partnership for federal income tax purposes and asked the Court to determine that the payments at issue that Lender received from LLC were not interest paid on indebtedness but were instead returns on Lender’s equity in a joint venture.
The Court began its analysis by reviewing the Code’s definition of “partnership,” which includes: “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.”[xviii] The Court indicated that the term “partnership” was generally a more inclusive term for tax purposes than at common law, and may include entities not traditionally considered partnerships.
The Court explained that it would evaluate the IRS’s contention that LLC and Lender had formed a “joint venture” that constituted a partnership by consulting the following factors:
“ 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 [the IRS] 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.”
However, before turning to these factors, the Court observed that the IRS’s argument in support of its position was “made difficult” by two considerations.
The IRS accepted that three of the agreements at issue – the original note, the modifications, and the security agreement – constituted “genuine indebtedness” by LLC to Lender. But the fourth agreement – the Additional Interest Agreement that gave rise to LLC’s obligation to pay appreciation interest – could be separated from these other three agreements. Indeed, according to the Court, “the four agreements were inextricably integrated with each other.” They were simultaneously bargained for, and they cross-referenced each other.
LLC’s obligation to pay appreciation interest arose from the same advances that gave rise to its obligation to pay the other interest components (which were concededly deductible—even the NCF interest that, like appreciation interest, was provided for in the Additional Interest Agreement).
There were no other advances that Lender made that could be characterized as giving rise to the obligation to pay appreciation interest.[xix]
The IRS acknowledged that Lender’s “right to share in the partnership’s profits” could not be said to be “separable from its right to repayment of its advance with interest thereon” and acknowledged that it could not be held “that only the right to share in profits is an equity interest.” In fact, the IRS had previously argued in other cases that it was wrong to suggest “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 to share in profits is an equity interest.”[xx]
The Court stated that it would not attempt any allocation between debt and equity because the IRS did not argue for it – indeed, had disclaimed it – and did not put on any evidence to enable the necessary computations to make the allocation. According to the Court, “[t]his left 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 Lender’s interest is all equity – to wit, its equity share of a [LLC-Lender] joint venture.”
The IRS still contended, notwithstanding the ostensible loan agreement between LLC and Lender—embodied in the four documents that we find to be integrated—that the two entities in fact entered into a joint venture. According to the IRS, the parties’ entire agreement created a “relationship between [LLC and Lender] . . . of joint venturers, not lender and borrower, and that Lender’s advance was more in the nature of a capital contribution than a loan.”
The Court rejected this argument based upon the “face value the parties’ binding stipulation that the original note, the modifications, and the security agreement constitute genuine indebtedness by [LLC] to [Lender]” and the IRS’s acknowledgement that “the agreement between them, despite consisting of multiple documents, must be considered as a whole.” The Court continued, “[w]hatever else [Lender] might have been in this arrangement, we know it was a creditor.” Lender advanced funds pursuant to those documents and there was no separate or additional advance that did not “constitute genuine indebtedness” and that could be characterized as giving rise to LLC’s obligation to pay the appreciation interest.
The IRS’s stipulation of the existence of “genuine indebtedness”, and its acceptance that the four loan documents “must be considered as a whole” and that they gave Lender a single interest, contradict the argument the IRS sought to advance. The stipulation reflected the parties’ agreement that Lender held debt in LLC, and the IRS accepted that Lender’s advance created a single interest that had to be characterized as either wholly debt or wholly equity. Consequently, the IRS’s contention that Lender had a single interest properly characterized as equity had to fail. The documents created “genuine indebtedness”, and this fact precluded a finding that they created no debt but rather a single equity interest in a supposed joint venture.
The Court then turned to a more detailed analysis of the eight factors outlined earlier to demonstrate that LLC and Lender did not form a joint venture that was a partnership for tax purposes.
The agreement of the parties and their conduct in executing its terms
The loan documents affirmatively stated that LLC and Lender were borrower and lender. They also expressly stated that LLC and Lender did not form a joint venture. LLC and Lender, the Court found, conducted themselves in accordance with the terms of the loan documents (including the Additional Interest Agreement), and the IRS did not contend that any terms of the agreement were not followed. This weighs against the existence of a joint venture.
The IRS asserted otherwise, stating that the agreement between LLC and Lender contemplated the purchase, operation, and eventual sale of Property. A key piece of that agreement was that Lender 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 Property.
Although the Court acknowledged that the substance rather than the ostensible form of the transaction controlled a determination of the existence of a joint venture, and that the characterization reflected in a written agreement was not necessarily determinative of whether the parties entered into a joint venture, the Court also pointed out that the first factor considered whether the form of the purported agreement was a joint venture and whether the parties departed from the ostensible form. In this case, the Court continued, the ostensible form – a series of integrated documents that expressly denied joint venture status and created “genuine indebtedness” – was debt and not a joint venture, and the parties operated according to the terms of their agreement.
Therefore, the first factor continued to weigh against the existence of a joint venture.
The contributions, if any, which each party has made to the venture
There was no dispute that LLC contributed the services that made the operation of the Property a successful venture, including rehabilitating and maintaining the Property and securing the tenants that produced the rental income on the Property. The IRS argued that Lender’s contribution was the capital, indicating that both were members of a joint venture.
However, the advanced funds of a lender were a loan and not a contribution to capital, so it was insufficient for the IRS to note the undisputed fact that Lender was the source of money for the project. Instead, the Court explained, “[o]ne must ask in what capacity [Lender] provided that money; and it [was] fair for the Commissioner to insist that one must look past [Lender’s] ostensible loan to ask whether perhaps the advances were not really true debt.”
Unfortunately for the IRS, “the answers to these questions,” the Court stated, “come easily from the Commissioner’s stipulation that the indebtedness evidenced by the original note and its modifications was ‘genuine indebtedness’.”
The Court determined that Lender contributed little of value outside of its capacity as an arm’s-length lender of the entire advance to LLC.
Thus, this factor weighed against finding a joint venture between LLC and Lender.
The parties’ control over income and capital and the right of each to make withdrawals
Other than the payments that LLC was contractually obligated to make to Lender under the loan documents, LLC controlled the income from the Property. The Court pointed out, however, that Lender was contractually entitled to approximately half of the net income of the Property, whereas LLC was entitled to whatever net income remained after the payments to Lender (which in some years resulted in an overall loss). LLC and Lender did not have equivalent interests in the income stream from the Property. Moreover, Lender was always guaranteed to receive what amounted to more than half of the income from the Property, provided that the Property was profitable. Lender was likewise not liable for any operating losses, except to the extent that they offset the quarterly amounts due to Lender under the NCF calculation at the end of the year.
According to the Court, Lender 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 Lender had not agreed to extend the term of the original note (which it was permitted, but was not obligated, to undertake under the terms of the loan documents), Lender could have effectively forced a sale of the property, because all of the principal remaining on the loan would have been due and LLC had few other assets of value beyond the Property itself and its income stream, all of which were pledged to Lender as security for the loan.
Moreover, the Court explained, the interest agreement became effective before Lender funded the loan; it was a binding contract that governed the parties’ conduct whether or not the loan was funded and whether or not the Property was sold. Therefore, if LLC had sought junior financing or a full refinance with a different lender during the life of the loan from Lender, or even if LLC had prepaid the full amount of the principal, it would have nonetheless continued to owe Lender appreciation interest based on the fair market value of the Property at the time that LLC exited the deal. Any such actions were subject to approval by Lender or were subject to penalty of default, which would not have relieved LLC of its obligation to make the additional interest payments. Lender, therefore, had significant control over the capital that LLC employed in its business.
The Court found that Lender’s economic interest under the terms of the Additional Interest Agreement, and as demonstrated by the conduct of the parties, resembled that of a holder of a preferred equity interest in the business.
Accordingly, this factor weighed in favor of finding that the parties engaged in a joint venture.
Whether each party was a principal, 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 their services contingent compensation in the form of a percentage of income
LLC and Lender each had an interest in the net profits of the business, but Lender was somewhat shielded from losses during the operation of the Property. The IRS asserted – and the Court agreed – that the entitlement to a share of net profits was generally indicative of an equity interest in the enterprise generating those profits.
However, Lender did not have an obligation to share pro rata in the operating losses from the Property. With respect to overall loss on a final disposition of the Property, the Court stated, the IRS correctly observed that the operation of the Property was capitalized almost exclusively with debt and that those assets of LLC that were not pledged as collateral to Lender were of minimal value. In addition, the Court agreed that the IRS plausibly argued that Lender was exposed to a risk of loss. If the Property were to decline in value, then Lender would risk losing, to the extent of that decline, the proceeds it had advanced.
The Court then described how the “thin capitalization” of an entity was generally a factor favoring a finding that the advance of funds to the venture should be viewed as an equity interest that was subject to downside risk.[xxi]
However, the Court went on to state that, “while it is true that the operation of the [Property] was capitalized almost exclusively with debt, we cannot view this factor in a vacuum. The parties stipulated that the loan from [Lender to LLC] 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 IRS’s contention with respect to the Property’s thin capitalization, the Court found that this factor weighed against finding a joint venture between LLC and Lender because Lender did not have an obligation to share pro rata in the operating losses from the Property.
Whether business was conducted in the joint names of the parties
The IRS conceded that the business was conducted in the name of LLC, not Lender or any other entity.
The Court found that this factor weighed against finding a joint venture.
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 IRS also conceded that the parties did not file tax returns indicating that they were partners, and that LLC and Lender did not otherwise represent to the IRS or any other persons that they were engaged in a joint venture. Rather, they held themselves out as distinct entities whose relationship was solely that of borrower and lender.
This factor, the Court stated, weighed against finding that LLC and Lender engaged in a joint venture.
Whether separate books of account were maintained for the venture
No books of account were maintained for the Property other than by LLC. The IRS argued 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. LLC and Lender did not jointly maintain books of account that would normally be expected in the operation of a business.
Thus, the Court found that this factor weighed against finding a joint venture.
Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise
The Court explained that, although Lender exercised control over the capital that it lent to LLC, most of the terms set forth in the security agreement and elsewhere were standard terms present in an arm’s-length secured commercial loan, which was consistent with the undisputed evidence that Lender used the same agreements (other than the Additional Interest Agreement) for its conventional loans.
LLC exercised primary responsibility and control over the rental operations of the Property.
The Court concluded that this factor weighed against finding that Lender held an equity interest in a joint venture with LLC.
Having found that seven of the eight factors considered above weighed against a finding of a joint venture, while only one factor weighed in favor, the Court particularly significant the absence of any contribution by Lender to the purported joint venture, where the parties have stipulated that all of the funds it advanced to LLC were genuine indebtedness. we find no basis to conclude that Lender made a contribution to an organization with LLC for the production of income.
Viewing the transaction as a whole, and in light of its findings on all of the factors, with no one factor being conclusive, the Court held that there was no joint venture between LLC and Lender. Thus, LLC’s payment to Lender of the appreciation interest was a deductible payment of interest and not a payment in respect of equity.
What Do You Think?
I told you the opinion was exhaustively thorough – any facts and circumstances analysis is necessarily so. But did it reach the right result?
Right off, one has to ask why the IRS refused to bifurcate the arrangement between the parties; specifically, to treat a portion of it as a loan and the remaining portion as an equity investment?
By stipulating that the original note and the security agreement constituted genuine indebtedness owing by LLC to Lender, and by accepting that all the loan documents, including the Additional Interest Agreement, had to be considered as a whole, the IRS left the Court little room to maneuver.
In fact, the IRS’s posture turned the Court’s holding into a foregone conclusion notwithstanding some strong indicators to the contrary, including the thin capitalization of the business and the “interest” that participated in the appreciation of the Property to the tune of 50 percent.[xxii]
Such a substantial interest certainly does not resemble the typical debtor-creditor relationship described earlier in which the upside potential belongs to the debtor.
Stay tuned. This issue is far from resolved.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Deitch v. Comm’r, Docket Nos. 21282-17 August 25, 2022.
[ii] LLC was formed as a “single-purpose entity”; i.e., its purpose was to own and manage the Property; and it had minimal assets other than the Property and the leases on the Property.
[iii] Lender offered conventional and participating loans. In a participating loan, which is a high-leverage loan, Lender would lend up to 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 Lender would approve was 75%. The difference between the two types of loans (from Lender’s perspective) was that the conventional loan was 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”.
[iv] The typical loan documents Lender 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 Lender required for a conventional loan versus a participating loan was that a participating loan also required an additional interest agreement.
[v] Under the loan commitment, Taxpayer B 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.
[vi] Further, the parties stipulated:
- The Original Note, Modifications, Security Agreement, and Additional Interest Agreement arose from an arm’s length transaction.
- The Original Note, Modifications, and Security Agreement constitute genuine indebtedness by [LLC] to [Lender].
[vii] Section 12 of the note provided:
- Relationship of Lender and Borrower as Creditor and Debtor Only. The relationship between Lender and [LLC] 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 [LLC] and [LLC] 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 [LLC], or any relationship other than that of creditor or debtor. . . .”
[viii] The original note permitted voluntary prepayment “in full, but not in part”, without penalty, upon 30 days’ prior written notice to Lender. That prepayment in full would consist of “payment of all sums due under the Loan Documents, including the Additional Interest Agreement.”
[ix] The Additional Interest Agreement also contained 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 [LLC] 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 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 consideration to the Lender for the use of the principal sum advanced to [LLC] . . . .
[x] According to Art. 7.4 of the Agreement, “Relationship of Lender and Borrower as Creditor and Debtor Only”:
Lender and [LLC] 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 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 [LLC], or any relationship other than that of creditor and debtor.
[xi] In the event of a sale, “gross proceeds” included all of the cash and the fair market value of any non-cash consideration payable to LLC. 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 Property in accordance with an appraisal procedure specified in the interest agreement.
[xii] As a result of the sale, LLC reported gain on Form 4797, “Sales of Business Property”, attached to its Form 1065. On Schedules K-1, “Partner’s Share of Income, Deductions, Credits, etc.”, of its Form 1065, LLC reported each partner’s 50% distributive share of the net section 1231 gain from the sale.
[xiii] LLC 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, LLC 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”.
[xiv] IRS Form 1065, “U.S. Return of Partnership Income”.
[xv] Under section 6213(a).
[xvi] The parties stipulated that Lender “did not own a member interest” in LLC, and that Lender and Parent Cop were not related[xvi] to the Taxpayers or to LLC.
[xvii] 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 IRS’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.
[xviii] Section 761(a). See also § 7701(a)(2).
[xix] 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.
[xx] G. C.M. 36,702, 1976 WL 38976. 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. 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”. 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”, an exercise that would involve “difficulty”, “mak[ing] this type of allocation undesirable”.
[xxi] The Court observed 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.”
[xxii] Speaking of appreciation interest, it’s worth noting that the income tax consequences of transactions involving a “shared appreciation mortgage” – a loan in which a taxpayer, borrowing money to purchase real property for commercial or business activities, generally pays a fixed rate of interest on the mortgage loan below the prevailing market rate and will also pay the lender a percentage of the appreciation in value of the real property upon termination of the mortgage – have been on the IRS’s “no rulings” list for many years. Rev. Proc. 2022-3.
See also Farley Realty Corp. v. Commissioner, 279 F.2d 701 (2d Cir. 1960), aff’g T.C. Memo 1959-93, in which the Court found that a 50% participation in appreciation represented equity.