Pursuit of After-Tax Profit Through Use of Tax Credits Is a Legitimate Business Activity

(Parker Tax Publishing August 2022)

The D.C. Circuit affirmed the Tax Court and held that a limited liability company was a partnership and was entitled to more than $25 million in refined-coal tax credits and more than $25 million in ordinary business losses. The court concluded that a partnership's pursuit of after-tax profit can be legitimate business activity for partners to carry on together and this is especially true in the context of tax incentives, which exist precisely to encourage activity that would not otherwise be profitable. Cross Refined Coal, LLC v. Comm'r, 2022 PTC 229 (D.C. Cir. 2022).

Background

In 2004, Congress enacted a refined-coal tax credit under Code Sec. 45 to promote the production of treated, cleaner-burning coal. Taxpayers that opened refined-coal production facilities before 2012 could claim a tax credit for each ton sold over the following ten years. If multiple taxpayers had an ownership interest in a facility, the credit was allocated according to their respective ownership shares. In 2008, Congress expanded the refined coal tax credit by removing a rule that limited the credit to producers that sold refined coal for 50 percent more than the market value of unrefined coal.

Shortly after Congress expanded the refined-coal tax credit, AJG Coal, Inc. (AJG) began developing coal-refining technology. It then set out to launch a coal-refining facility at the Cross Generating Station in South Carolina. To do so, it formed a new subsidiary, Cross Refined Coal, LLC (Cross), which made three key contracts. First, Cross signed a lease with the utility that owned the generator, Santee Cooper (Santee). The lease allowed Cross to build and operate a coal-refining facility in the middle of the station. Second, Cross and Santee entered into a purchase-and-sale agreement. Cross would buy unrefined coal from Santee, refine it, and then sell it back to Santee for $0.75 less per ton, ensuring that Cross would lose money on each resale. Third, Cross entered into a sub-license agreement with AJG to use its coal-refining technology. AJG made similar arrangements at two other Santee-owned generating stations.

Cross's business model made economic sense only by accounting for the tax credit. Considering (1) the operating expenses that Cross incurred to refine coal, (2) the losses it sustained in buying and then re-selling the coal, and (3) the royalties it paid to obtain the necessary technology, Cross's operations inevitably would produce a pre-tax loss. Its sole opportunity to turn a profit was to claim a tax credit that exceeded these costs. Consistent with this tax-centric model, Cross's lease, purchase-and-sale agreement, and sub-license all had ten-year terms matching the ten-year window during which it could generate tax credits.

Cross built the refining facility and began to operate it in December 2009. Over the next four months, AJG recruited two other members to Cross: Fidelity Investments (Fidelity) and Schneider Electric (Schneider), both acting through subsidiaries. For AJG, bringing other investors into Cross had two primary benefits. First, the new members' investments enabled AJG to spread its own investment over a larger number of projects. Second, AJG's parent company could claim only a fraction of the refined-coal tax credits in any given year; it would have had to carry the rest forward. Because money has a time value, it made sense to have partners who could claim the credits sooner.

AJG projected that Cross would realize a $140 million after-tax profit over ten years. After several months of due diligence, Fidelity purchased a 51 percent indirect stake in Cross for $4 million. The purchase agreement contained a liquidated-damages provision allowing Fidelity to exit Cross and receive a prorated portion of its investment if Cross did not meet certain benchmarks. Schneider purchased a 25 percent ownership share for $1.8 million, with no provision for liquidated damages. Between 2010 and 2013, all three members of Cross were actively involved in its operations. Each member also made monthly contributions to cover Cross's operating expenses such as payroll, health insurance, and materials. The contributions were proportional to each member's ownership share.

Cross proved profitable, but it endured two lengthy shutdowns that ultimately ended the partnership. In March 2013, as Cross languished through its second shutdown, AJG bought out Schneider's interest and, in November 2013, Fidelity exited Cross and received about $2.5 million in liquidated damages. Over the four years when Fidelity and Schneider were members of Cross, the company generated almost $19 million in after-tax profits - a far cry from the projections that AJG had forecast in recruiting Fidelity and Schneider. The other refining projects were less successful and were shut down. As a result, Fidelity and Schneider suffered after-tax losses of $2.9 million and $700,000 respectively on their investments.

For the 2011 and 2012 tax years, Cross claimed more than $25.8 million in refined-coal tax credits and $25.7 million in ordinary business losses. Because LLCs are taxed as partnerships by default, Cross distributed the credits and losses among its three members proportionally. But in June 2017, the IRS issued a notice of final partnership administrative adjustment. It determined that Cross was not a partnership for federal tax purposes "because it was not formed to carry on a business or for the sharing of profits and losses," but instead "to facilitate the prohibited transaction of monetizing 'refined coal' tax credits." Accordingly, the IRS concluded that only AJG could claim the tax credits.

Cross sought a readjustment in the Tax Court under Code Sec. 6234(a)(1) and the Tax Court agreed with Cross and concluded that Cross was a "bona fide partnership" because all three members made substantial contributions to Cross, participated in its management, and shared in its profits and losses. The IRS appealed to the D.C. Circuit, arguing that Cross was not a bona fide partnership because it did not pursue business activity to obtain a pre-tax profit. Instead, the IRS contended, tax credits were Cross's sole profit driver, and the production of those credits thus permeated every aspect of its business model. According to the IRS, Cross's partners did not have the requisite intent to carry on a business together because Cross was not undertaken for profit or for other legitimate nontax business purposes.

Analysis

The D.C. Circuit affirmed the Tax Court. Without any legal text to construe, the court was guided by the Supreme Court's definition of "partnership" as espoused in Comm'r v. Tower, 327 U.S. 280 (1946) and Comm'r v. Culbertson, 337 U.S. 733 (1949). In Tower, the Court held that a partnership is formed where two or more persons intend to join together for the purpose of carrying on business and sharing in its profits or losses. In Culbertson, the Court reiterated that the parties must, in good faith and acting with a business purpose, intend to join together in the present conduct of the enterprise.

According to the D.C. Circuit, the question of "bona fide intent" to form a partnership is one of fact which depends on a totality of the circumstances. The court observed that the partnership definition in Tower and Culbertson consists of two requirements. First, the partners must intend to carry on business as a partnership. In other words, the enterprise must be undertaken for profit or for other legitimate nontax business purposes. In most cases, this inquiry turns on whether the partnership has a genuine opportunity to make a profit and whether the partners direct their efforts toward realizing it. The second requirement, the court said, is that the partners must intend to share in the profits or losses or both. In other words, the partners' interests must have the "prevailing character" of equity, with each partner having a meaningful stake in the success or failure of the partnership. If one putative partner is insulated from the upside and downside risks of the business, its interest resembles that of a secured creditor, not an equity partner.

The court disagreed with the IRS's premise that Cross was not a partnership because it did not pursue business activity to obtain a pre-tax profit. As a general matter, the court said, a partnership's pursuit of after-tax profit can be a legitimate business activity for partners to carry on together. This is especially true, the court observed, in the context of tax incentives, which exist precisely to encourage activity that would not otherwise be profitable. The court found that Cross did not simply engage in "wasteful activity," which is typical of sham partnerships that merely manufacture tax losses, but rather engaged in business activity with a practical economic effect - the production of cleaner-burning refined coal, which Congress specifically sought to encourage.

The court also cited the decision in Sacks v. Comm'r, 69 F.3d 982 (9th Cir. 1995), where the Ninth Circuit held that taxpayers may legitimately conduct a business activity that Congress has deliberately made profitable through statutory tax incentives - and may do so with no hope of a pre-tax profit. The court further noted that the Federal Circuit, in Alternative Carbon Resources, LLC v. U.S. 939 F.3d 1320 (Fed. Cir. 2019), acknowledged that a transaction unprofitable absent a tax credit may still have economic substance if it meaningfully alters the taxpayer's economic position (other than with regard to the tax consequences) and has a bona fide business purpose. Cross, the court concluded, passed muster under this test: Its partners all made sizable contributions to become part owners and help Cross engage in the business of producing refined coal.

For a discussion of determining whether or not an entity is a partnership, see Parker Tax ¶20,105.

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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