Rehabilitation Credits Disallowed

By James A. Beavers, J.D., LL.M., CPA, CGMA

Credits Against Tax

The Third Circuit held that a corporate partner in a partnership was not entitled to claim historic rehabilitation credits passed through to it from the partnership because the corporation was not a bona fide partner in the partnership.


The New Jersey Sports and Exposition Authority (NJSEA) and Pitney Bowes (PB) formed Historic Boardwalk Hall LLC to allow PB to invest in the historic rehabilitation of the East Hall, a popular convention center in Atlantic City, N.J. The East Hall, which was built in 1926, had become run-down from its many years of use and needed significant work to make it a useful part of the new convention center complex the NJSEA was building. After beginning renovation, the NJSEA learned of the market for historic rehabilitation tax credits (HRTCs) among corporate investors and of the additional revenue that market could bring to the state through a syndicated partnership with one or more investors. These credits were useless to the NJSEA, which was a tax-exempt entity, but could be valuable to a large taxable corporate entity.

Therefore, the NJSEA created a New Jersey limited liability company, Historic Boardwalk Hall LLC (HBH), and subsequently sold a membership interest in HBH to a wholly owned subsidiary of Pitney Bowes Inc. Through a series of agreements, the transactions executed to admit PB as a member of HBH and to transfer ownership of the NJSEA’s property interest in the East Hall to HBH were designed so that PB could earn the HRTCs generated from the East Hall rehabilitation. As part of the overall arrangement, in addition to receiving the tax credits, PB was to receive a 3% preferred return on its investment in HBH.

To ensure that PB received the benefits of the credits if the IRS was successful in challenging PB’s use of them, HBH and PB executed a “Tax Benefits Guaranty” agreement under which HBH guaranteed the projected tax benefits to PB, and the NJSEA was required to fund any payments necessary under the agreement. The arrangement also included put and call buyout agreements for PB’s membership interest in HBH between the NJSEA and PB.

On its Forms 1065, U.S. Return of Partnership Income, for 2000, 2001, and 2002, HBH claimed qualified rehabilitation expenditures and allocated those expenditures to PB, allowing PB to claim HRTCs pursuant to Sec. 47.

On audit, the IRS determined that either HBH was a sham that was used to improperly pass the tax benefits of the rehabilitation credits to PB and that the NJSEA had actually sold the rehabilitation tax credits to PB for a fee or PB was not a bona fide partner in HBH because it had no meaningful stake in the success or failure of HBH. As a result, the IRS determined that the credits should be reallocated from PB to the NJSEA. HBH filed a petition in Tax Court challenging the IRS’s determination.

The Tax Court’s Decision

The Tax Court rejected both of the IRS’s arguments and found that HBH was a valid partnership and that PB was a bona fide partner in HBH (Historic Boardwalk Hall, LLC, 136 T.C. No. 1 (2011)). Thus, it held that PB was entitled to the credits allocated to it through HBH.

According to the Tax Court, HBH was not a sham because it had a legitimate business purpose—to allow PB to invest in the East Hall renovation. The court further found that because of the 3% return agreement, PB could make a profit on the investment outside of the receipt of the tax credits and that, for a variety of reasons, PB faced real downside risks by becoming a member in HBH. Therefore, the partnership had economic substance.

With regard to the IRS’s bona fide partnership argument, the Tax Court analyzed the partnership under the totality of circumstances test from Culbertson, 337 U.S. 733 (1949). That test looks to see whether, taking all factors into account, the purported partners, acting in good faith and with a business purpose, intended to join together in the present conduct of a business enterprise. The Tax Court found, after taking into account the stated purpose behind HBH’s formation, the parties’ investigation of the transaction, the transaction documents, and the parties’ respective roles, that HBH was a valid partnership and that PB had a meaningful stake in the partnership.

The Third Circuit’s Decision

The IRS appealed the Tax Court’s decision to the Third Circuit, where it repeated the arguments it made in the Tax Court. The Third Circuit reversed the Tax Court and held that the credits should be reallocated from PB to the NJSEA. In making its decision, the Third Circuit focused primarily on the argument that PB should not be treated as a bona fide partner in HBH because PB did not have a meaningful stake in the success or failure of the partnership, concluding that PB was not a bona fide partner in HBH.

The Third Circuit agreed that, following the Culbertson case, it was required to look at the totality of the circumstances in determining whether HBH was a valid partnership and whether PB had a valid partnership interest in HBH. However, in analyzing whether PB was a bona fide partner, it looked to the principles set out in two recent cases, TIFD III-E, Inc., 459 F.3d 220 (2d Cir. 2006) (Castle Harbour), and Virginia Historic Tax Credit Fund 2001 LP, 639 F.3d 129 (4th Cir. 2011). In Castle Harbour, the Second Circuit judged whether a partner was a bona fide partner by determining if the partner had meaningful risk of gain or loss in the partnership. If the partner did not, it was not a bona fide partner. In Virginia Historic, the Fourth Circuit concluded that partners in a partnership were entitled to state historic rehabilitation credits passed through from the partnership only if they faced any true entrepreneurial risk in connection with their investment in the partnership.

Consequently, the Third Circuit analyzed whether PB had any meaningful upside or downside risk in its investment in HBH. After reviewing all the facets of the HBH partnership and the agreements between PB and the NJSEA, the court found that while theoretically the form of the overall arrangement made a gain or loss to PB on HBH possible, in actuality there was no meaningful upside or downside potential from the investment in HBH to the company. The court ultimately concluded that, as the IRS had argued, the substance of the transactions between PB and the NJSEA was a sale of the historic rehabilitation credits generated by the renovation of the East Hall.


Congress enacted the Sec. 47 rehabilitation credit to encourage the restoration of historic buildings. It concluded that “[s]uch incentives are needed because the social and aesthetic values of rehabilitating and preserving older structures are not necessarily taken into account in investors’ profit projections” (Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-87), p. 149 (May 4, 1987)). However, as the NJSEA noted, tax credits provide no incentive to tax-exempt organizations.

While the IRS is right to be concerned about sales and purchases of tax credits, it is also true that the NJSEA was engaged in exactly the behavior that Congress specifically encourages through the rehabilitation credit. Since government bodies and nonprofit organizations are in many cases the entities that undertake rehabilitation projects, Congress or the IRS should provide a sanctioned way for them to pass the credit on to investors without having to worry about the vagaries of courts’ interpretations of whether a partnership exists and who is a bona fide partner.

Historic Boardwalk Hall, LLC, No. 11-1832 (3d Cir. 8/27/12), petition for rehearing denied (3d Cir. 10/25/12)

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