Court Nixes IRS Attempt to Change Loan Payment into Sec. 707(c) Guaranteed Payment

(Parker Tax Publishing September 2022)

The Tax Court held that (1) a partnership that owned commercial rental property and the company that financed the purchase of such property did not form a joint venture that was a partnership for federal income tax purposes, and (2) a payment of more than $1 million of "appreciation interest" by the partnership to the finance company was deductible as interest under Code Sec. 163. The Tax Court rejected the IRS's argument that the finance company and partnership were a joint venture and, as a result, the finance company had a "single equity interest" in its dealings with the partnership that transformed the partnership's loan payments to the finance company into guaranteed payments made to a partner pursuant to Code Sec. 707(c). Deitch v. Comm'r, T.C. Memo. 2022-86.

Background

Alex Deitch and a married couple, Jonathan and Susan Barry, were partners in the West Town Square Investment Group, LLC (WTS). In 2006, WTS purchased a commercial rental property in Georgia by financing the property with the proceeds of a loan from Protective Life Insurance Co. (PLI). The integrated loan documents included an "Additional Interest Agreement" that entitled PLI to additional interest of two types: "NCF Interest" (i.e., 50 percent of the net cashflow from the property) and "Appreciation Interest" (i.e., 50 percent 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 that 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 percent 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 interest deduction under Code Sec. 163(a) 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 Code Sec. 1231 gain of $2.6 million. The WTS partners reported their distributive shares of income and loss of WTS on their individual income tax returns for 2014.

The IRS sent notices of deficiency to the partners after 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. According to the IRS, the Additional Interest Agreement created a joint venture between WTS and PLI, so that the ostensible interest paid to PLI was a nondeductible return on PLI's equity interest not in WTS but in the supposed WTS-PLI joint venture. The IRS determined that the interest payments that WTS made pursuant to the original note should be treated as "guaranteed payments" to a partner pursuant to Code Sec. 707(c). The case went to the Tax Court where the parties made certain stipulations, one of which was that PLI did not own a member interest in WTS and that PLI was not related to the WTS partners or to WTS within the meaning of Code Sec. 267(b) and Code Sec. 707(b)(1). In addition, the parties stipulated that the debt agreements arose from an arm's length transaction and constituted genuine indebtedness from WTS to PLI.

Analysis

The Tax Court held that WTS and PLI were not engaged in a joint venture constituting a partnership for federal tax purposes and 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 Code Sec. 707(c) or into something else. The court thus concluded that the appreciation interest that WTS paid to PLI was interest deductible under Code Sec. 163, not a payment in respect of any equity interest held by PLI.

In determining that the relationship between WTS and PLI was not a joint venture constituting a partnership, the court examined the eight factors it had considered in Luna v. Comm'r, 42 T.C. 1067 (1964), to determine whether a joint venture existed. Using the Luna criteria, the court said that only one factor weighed in favor of finding a joint venture while the other seven weighed against such a finding. The court found particularly significant the absence of any contribution by PLI to the purported joint venture, as the parties had stipulated that all of the funds advanced to WTS were genuine indebtedness. The court observed that, under the holding of Comm'r v. Culbertson, 337 U.S. 733 (1949), to the extent a partner must contribute one or both of the ingredients of income - capital or services - there was no basis to conclude that PLI made a contribution to an organization with WTS for the production of income. Viewing the transaction as a whole, and in light of the findings on all of the Luna factors, with no one factor being conclusive, the court held that there was no joint venture between WTS and PLI.

With respect to the IRS's Code Sec. 707(c) argument, the court saw at least two problems. First, the text of Code Sec. 707(c) requires, as a definitional prerequisite to its applicability, that the transfer be made by a partnership to a partner of that partnership. In other words, payments made by any person other than a partnership or payments made to any person other than a partner of that partnership cannot be "guaranteed payments" under Code Sec. 707(c). Therefore, the court stated, the IRS's argument was an impossibility since the court rejected the IRS's positing of a WTS-PLI joint venture. Second, the court said, was the fact that the IRS had stipulated that the advance at issue was "genuine indebtedness" that WTS owed to PLI. The court noted that while a partner may indeed make a bona fide loan to a partnership of which he is a partner, such an arm's-length transaction properly results in treating the loan as one made by the partner in a non-partner capacity under Code Sec. 707(a), rather than as a guaranteed payment for the use of capital pursuant to Code Sec. 707(c). The court therefore held 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 Code Sec. 707(c) or into something else.

Finally, the Tax Court also rejected the IRS's argument that WTS's payment of appreciation interest to PLI was not deductible interest under Code Sec. 163(a). In Deputy v. du Pont, 208 U.S. 488 (1940), the court noted, the Supreme Court defined "interest on indebtedness" as "compensation for the use or forbearance of money." The Tax Court also noted that the parties had stipulated that the full amount of the funds advanced by PLI was advanced pursuant to documents that "constituted genuine indebtedness." The court found that WTS was obligated to pay the additional interest because WTS entered into the loan transaction structured by a series of interdependent contracts governing the terms of its indebtedness to PLI. Thus, the Tax Court concluded that WTS paid the appreciation interest as compensation to PLI for the use of the funds advanced, and that the appreciation interest was deductible "interest" within the meaning of Code Sec. 163.

For a discussion of the requirements that must be met to deduct interest expense, see Parker Tax ¶92,305. For a discussion of the taxation of guaranteed payments made by a partnership to a partner, see Parker Tax ¶25,550.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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