Banks Are Lenders to Partnership, Not Partners

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

Partners & Partnerships

The Second Circuit held that two banks were lenders to a partnership, not partners in the partnership under Sec. 704(e)(1).


In 1993, two Dutch banks, ING Bank N.V. and Rabo Merchant Bank N.V., purchased an interest in Castle Harbour LLC, a partnership that owned aircraft that were leased to various airlines, in which TIFD III-E, Inc., served as the tax-matters partner. In 2001, the IRS rejected Castle Harbour’s classification of the banks as partners and issued two notices of administrative adjustment reallocating a large percentage of the partnership’s income for the years 1993 to 1998 from the banks to TIFD III-E.

TIFD III-E challenged the notices of adjustment in district court. The court found that the banks were properly characterized for tax purposes as partners, not lenders (as the IRS had contended), and ruled the notices invalid (TIFD III-E, Inc., 342 F. Supp. 2d 94 (D. Conn. 2004)). The IRS appealed the decision to the Second Circuit. The Second Circuit found that the district court erred by not examining the nature of the banks’ interest in the partnership under the totality-of-the-circumstances test from Culbertson, 337 U.S. 733 (1949) (TIFD III-E, Inc., 459 F.3d 220 (2d Cir. 2006)).

Applying that test, the court held that the evidence showed that the banks’ interest was not “bona fide equity participation,” but instead “overwhelmingly in the nature of a secured lender’s interest.” However, the Second Circuit remanded the case to the district court for consideration of TIFD III-E’s further argument that, regardless of the outcome of the Culbertson inquiry, the banks qualified as partners under Sec. 704(e)(1), which provides that “[a] person shall be recognized as a partner . . . if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift . . .”

The District Court’s Decision on Remand

On remand, the district court, relying on the previously established trial record, ruled that the banks qualified as partners under Sec. 704(e)(1) (TIFD III-E, Inc., 660 F. Supp. 2d 367 (D. Conn. 2009)). Although the IRS argued that the district court was precluded from finding that the banks owned a capital interest because the Second Circuit had held that the banks’ interest was not bona fide equity, the court did not agree. The district court decided that the Second Circuit’s holding that the banks interest was not bona fide equity participation did “not necessarily distinguish the Banks’ interests from other debt-like instruments that, despite appearances, are not considered debt for tax purposes.” The court concluded that the banks met the requirements of Sec. 704(e)(1) because (1) they, as opposed to some other entity, truly owned their interest in Castle Harbour; (2) their interest was a capital interest; and (3) capital, in the form of aircraft, was a material income-producing factor for Castle Harbour.

The district court determined that the banks’ interest was a capital interest because the banks incurred “real risk” that their capital accounts would be negative upon dissolution, requiring them to restore the deficit. The district court attributed this “real risk” to the possibility of partnership losses sufficiently large to trigger the allocation under the partnership agreement of 1% of those losses to the banks, or even so large as to trigger the allocation of 100% of those losses to the banks. Because losses allocated to the banks in those scenarios would not be covered by a provision in the partnership agreement that required the banks to be reimbursed for certain losses, the district court found that their return on the capital investment (and risk of loss) was tied to the availability of partnership capital.

The Second Circuit’s Response

On appeal, the Second Circuit again held that the banks did not hold a capital interest in Castle Harbour and were lenders to, not partners of, the partnership. According to the court, because it had determined that the banks’ interest was “overwhelmingly in the nature of a secured lender’s interest,” the question that arose under Sec. 704(e)(1) is whether it changed the law so that the holding of debt (or of an interest overwhelmingly in the nature of debt) could qualify as a partnership interest. The court concluded that Sec. 704(e)(1) had not changed the law in this respect.

The Second Circuit looked at the legislative history of and prior litigation involving Sec. 704(e)(1) to determine whether the law had been changed. The court found that the legislative history of Sec. 704(e) made it clear “that the provision did not intend to broaden the character of interests in partnerships that qualify for treatment as a partnership interest to include partnership debt.” Rather, Sec. 704(e) was intended to address “whether it matters, for the determination of whether a person is a partner for tax purposes, that the person’s purported partnership interest arose through an intrafamily transfer.” Citing numerous decisions that have involved an interpretation of Sec. 704(e), the court found that none of the decisions “should be construed as drastically altering the pre-existing law of partnership taxation by allowing an interest properly characterized as debt to be recognized as a partnership interest.”

Having determined that Sec. 704(e) had not changed the law to allow a debt interest in a partnership to be treated as an equity interest, the Second Circuit considered the district court’s rationale for holding that the banks’ interest in Castle Harbour qualified as a capital interest in the partnership. The court rejected the district court’s finding that the banks’ interest was a capital interest because there was a real risk that the banks might have a negative capital account at dissolution that they would be required to restore. It found that, due to various provisions of the partnership agreement, there was no real risk that this would occur, only the appearance of risk.

The court stated that, as it had found in its first opinion in the litigation, the banks had no meaningful risk of loss from the investment in the partnership and no meaningful prospect of receiving a return on their investment greater than the fixed rate of return specified in the partnership agreement. Thus, the court held that the banks had interest in debt of the partnership and that their interest was not a capital interest under Sec. 704(e)(1).


The district court had held on remand that, even if the banks’ interests were found to be debt interests in the partnership, the banks would not be liable for a Sec. 6662 substantial understatement of income penalty because there was substantial authority for the banks’ position. The Second Circuit reversed this holding and held that the banks were liable for a Sec. 6662 penalty.

The Second Circuit acknowledged that its own precedent held that, in some cases, interests bearing debt-like features could be treated as equity for tax purposes and that the name given to a security would not necessarily govern its treatment. However, the court held that this precedent did not support treating an interest “overwhelmingly in the nature of a secured lender’s interest,” as the court had found the banks’ interest to be, as a capital interest. Thus, despite the district court’s full endorsement of the banks’ position, they were held not to have substantial authority for the position.

TIFD III-E Inc., No. 10-70-cv (2d Cir. 1/24/12)





Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.