Government Argues Tax Court Erred in Refined Coal Partnership Case

CROSS REFINED COAL, LLC; USA REFINED COAL, LLC, TAX MATTERS PARTNER,
Petitioners-Appellees

SCHNEIDER ELECTRIC USA, INC., SUCCESSOR IN INTEREST TO SCHNEIDER ELECTRIC INVESTMENTS 2, INC.; AJG COAL, INC.,
Interested Parties-Appellees
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellant

IN THE UNITED STATES COURT OF APPEALS
FOR THE DISTRICT OF COLUMBIA CIRCUIT

ON APPEAL FROM THE DECISION OF
THE UNITED STATES TAX COURT

OPENING BRIEF FOR THE APPELLANT

RICHARD E. ZUCKERMAN
Principal Deputy Assistant Attorney General

ARTHUR T. CATTERALL  (202) 514-2937
NORAH E. BRINGER  (202) 307-6224
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

CERTIFICATE AS TO PARTIES, RULINGS, AND RELATED CASES

A. Parties and Amici. The parties appearing in the Tax Court and in this Court are as follows:

There were no amici or intervenors appearing before the Tax Court, and there are no amici or intervenors who have appeared in this Court.

B. Rulings Under Review. The rulings under review are the Tax Court's oral findings of fact and opinion, delivered by Judge David Gustafson on August 14, 2019 (Doc. 177), as issued in a final bench opinion on August 29, 2019 (Doc. 178), and the subsequent decision entered on October 16, 2019 (Doc. 179).

C. Related Cases. This case was not previously before this Court or any other appellate court. Counsel is not aware of any related cases currently pending in this Court or in any other court, as provided in Cir. R. 28(a)(1)(C).

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TABLE OF CONTENTS

Certificate as to parties, rulings, and related cases

Table of contents

Table of authorities

Glossary

Statement of the issues

Statutes and regulations

Statement of the case

Summary of argument

Argument

Conclusion

Certificate of compliance

Statutory and regulatory addendum

TABLE OF AUTHORITIES

Cases:

Statutes:

Miscellaneous:

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GLOSSARY

For ease of reference, we generally use the defined terms that the Tax Court employed in its oral findings of fact and opinion.

1. Jurisdiction in the Tax Court

On June 20, 2017, the IRS timely issued a notice of final partnership administrative adjustment reflecting its determination that Cross Refined Coal, LLC (“Cross”), was not a valid partnership for federal tax purposes. (Doc. 98, Ex. 9-J.)¹ See 26 U.S.C. (“I.R.C.”) §6223(a)(2).² As a result of that determination, the IRS concluded that two of the three ultimate owners of Cross — affiliates of Fidelity Investments and Schneider Electric S.E. — were not entitled to claim tax benefits passed through to them from Cross, including refined-coal credits under I.R.C. § 45.

On September 14, 2017, USA Refined Coal, LLC (“USARC”), the tax matters partner of Cross, timely filed a petition in the Tax Court on Cross's behalf under I.R.C. § 6226(a). (Doc. 1.) The Tax Court had jurisdiction pursuant to I.R.C. § 6226(a) and (f). 

2. Jurisdiction in the Court of Appeals

Following a trial, the Tax Court (Judge Gustafson) orally issued findings of fact and an opinion in favor of Cross. (Doc. 178.) On October 16, 2019, the court entered its decision, in which it rejected the IRS's adjustments. (Doc. 179.) The Commissioner filed a timely notice of appeal to this Court on January 13, 2020 (Doc. 180), which was less than 90 days following entry of the decision, I.R.C. § 7483; Fed. R. App. P. 13(a)(1)(A). This Court has jurisdiction under I.R.C. § 7482.

STATEMENT OF THE ISSUES

This appeal concerns the Tax Court's determination that Cross was a valid partnership for federal tax purposes. That determination turns on whether the putative partners, “'acting with a business purpose[,] intended to join together in the present conduct of the enterprise.'” (Doc. 178 at 37 (quoting Commissioner v. Culbertson, 337 U.S. 733, 742 (1949)).) At the heart of that inquiry is whether a putative partner had a meaningful stake in the enterprise's possible success (upside potential) and in its possible failure (downside risk).

The issues on appeal are:

STATUTES AND REGULATIONS

Pursuant to Cir. R. 28(a)(5), pertinent statutes and regulations are in an addendum hereto.

STATEMENT OF THE CASE

A. Introduction

The refined-coal credit, which Congress initially enacted in 2004, is calculated as an inflation-adjusted dollar amount per ton of refined coal produced and sold. I.R.C. § 45(e)(8)(A). For 2011, the credit was $6.33 per ton, and for 2012, the credit was $6.475 per ton. See I.R.C. §45(e)(8)(A); IRS Notice 2011-40, 2011-22 I.R.B. 806; IRS Notice 2012-35, 2012-21 I.R.B. 937. Refined-coal producers may claim the credit against income tax during a 10-year period that begins when the production facility is placed in service.³ I.R.C. § 45(e)(8)(A)(i). To qualify for the refined-coal credit, the producer must (1) sell the refined coal to an unrelated person with the reasonable expectation that it will be used for the purpose of producing steam, and (2) certify that such use will achieve specified emissions reductions as compared to raw (“feedstock”) coal. I.R.C. § 45(c)(7)(A) & (B), (e)(8)(A)(ii)(I). The Commissioner is not challenging whether Cross met the technical requirements to claim the refined-coal credit. This case concerns who was entitled to claim the tax benefits that Cross generated.

Federal tax credits are non-transferable. (Doc. 178 at 52-53 (citing Beck v. Commissioner, 85 T.C. 557, 579-80 (1985).) Because the partnership form can be used to achieve the substantive effect of an exchange between two putative partners, the IRS guards against the use of tax-credit partnerships — i.e., partnerships formed to attract funds for use in a specific activity that Congress has incentivized by means of a tax credit — as a front for the impermissible sale of tax credits. See Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012). Here, the IRS determined that Fidelity and Schneider were not bona fide partners in Cross, and that Cross was an artifice through which AJG Coal, Inc. (“AJGC”), an affiliate of Arthur J. Gallagher & Co., impermissibly sold § 45 credits.

Under Commissioner v. Culbertson, 337 U.S. 733, 741 (1949), whether a partner in form is a partner in substance for federal income tax purposes turns on intent. And, as the court in Historic Boardwalk stated, “resolving whether a purported partner had a 'meaningful stake in the success or failure of the partnership' goes to the core of the ultimate determination of whether the parties 'intended to join together in the present conduct of the enterprise.'” 694 F.3d at 454 (citations omitted) (quoting TIFD III-E, Inc. v. United States, 459 F.3d 220, 224 (2d Cir. 2006) (“Castle Harbour”), and Culbertson, 337 U.S. at 742). The issues on appeal concern the manner in which the Tax Court undertook both aspects of the meaningful-stake analysis.

B. Factual background

1. AJGC and the refined-coal technology

In 2004, the same year that Congress initially enacted the refined-coal credit, AJGC began investing in chemical technology to produce refined coal (the “Technology”), which was developed and held by a company called Chem-Mod. (Doc. 178 at 9.) Over the next several years, AJGC acquired 42% of Chem-Mod, and AJGC's parent company began to act as Chem-Mod's manager. (Doc. 178 at 9; Doc. 117 ¶ 78.) In 2008, AJGC licensed the Technology from Chem-Mod “solely for purposes of Section 45 [i.e., refined-coal credit] Projects.” (Doc. 178 at 9; Doc. 97 ¶¶ 22-23; Doc. 99, Ex. 36-J § 2.1(a).) In 2009, as described infra, at 14-17, AJGC sublicensed the Technology to Cross. (Doc. 178 at 22-23.)

AJGC took a number of other significant actions before securing the formal participation of Fidelity and Schneider in Cross. On its own or through Cross (as its sole member at the time), AJGC (1) formed Cross; (2) formed USA Refined Coal, LLC (“USARC”), the entity through which Fidelity would hold its interest in Cross; (3) entered into design and construction agreements with a third party to build the Cross refining facility, which was deemed operational and “placed in service” on December 19, 2009; (4) hired a third party to manage the Cross facility; and (5) executed the Cross Limited Liability Company Agreement, i.e., the primary “Operating Agreement,” for Cross. (Doc. 178 at 17, 19-20; Doc. 97 ¶¶ 8, 12-13, 19.) During this period, as described below, Cross also signed a ground lease, and entered into coal purchase-and-sale agreements, with Santee Cooper, the utility company that owned the Cross Generating Station in Pineville, South Carolina, where the Cross refining facility was located. (Doc. 178 at 19-20; Doc. 97 ¶¶ 21, 26-27.)

AJGC thus played several roles in relation to Cross. AJGC owned 42% of Chem-Mod, licensed Chem-Mod's Technology, created and was a member of Cross and USARC, and sublicensed the Technology to Cross. AJGC thus stood to financially benefit in three ways from the coal-refining operations: (1) as a member of Cross and USARC, from the refined-coal credits and other tax benefits; (2) as the licensee and sublicensor of the Technology, from the excess of the sublicense royalties it received from Cross over the license royalties it paid to Chem-Mod; and (3) as a part-owner of Chem-Mod, through which it recouped the benefit of a portion of the license royalties it paid to Chem-Mod. (Doc. 178 at 9.)

2. Agreements with Santee Cooper and the “inevitable before-tax loss”

Although Cross owned the coal-refining equipment, its facility was built on Santee Cooper's land, between the coal yard and the boilers. (Doc. 178 at 10, 20.) This “interposed [the refining facility] in the existing operation of [Santee Cooper's] power plant.” (Doc. 178 at 10.) Cross purchased raw “feedstock” coal from Santee Cooper, and conveyor belts moved the raw coal to Cross's refining equipment. After the feedstock coal was chemically treated in the refining facility, Cross sold the refined coal back to Santee Cooper as it exited the facility by conveyor belt to Santee Cooper's plant, where it was crushed and burned in the boilers. (Doc. 178 at 10.) The entire process of refining coal took three to five minutes. (Doc. 178 at 10-11.)

During the period when AJGC was its sole member, Cross signed a ground lease with Santee Cooper, with monthly rent of $100, and Cross and Santee Cooper also entered into agreements for the purchase and sale of coal. (Doc. 178 at 19-20; Doc. 97 ¶¶ 21, 26-27; Doc. 99, Ex. 33-J § 5.a.) These agreements each had ten-year terms that explicitly corresponded to the ten-year period in which the refined-coal credits would be available under I.R.C. § 45(e)(8)(A). (Doc. 178 at 20-21; Doc. 99, Ex. 33-J § 4; Doc. 100, Exs. 44-J § 4 & 47-J § 4.) In other words, after the refined-coal credits were no longer available, Cross had no lease for the land on which it built its facility and no agreement to purchase feedstock coal from, or sell refined coal to, Santee Cooper.

The coal purchase-and-sale agreements between Cross and Santee Cooper were structured so that Cross incurred a loss on every sale of refined coal. Cross bought raw coal from Santee Cooper at cost, and after several minutes in the refined-coal facility, Cross sold refined coal to Santee Cooper for seventy-five cents less per ton. (Doc. 178 at 12; Doc. 100, Exs. 44-J § 6(a), 47-J § 6(a), 50-J § 1 (modifying Ex. 47-J §6(a)).) This created “an inevitable before-tax loss every year of the operation,” and Cross made economic sense only with consideration of the refined-coal credits. (Doc. 178 at 12, 15.) The Tax Court agreed that it “was certainly true” “that there was no opportunity for Fidelity or Schneider to earn any pre-tax profit before or after the expiration year of the Tax Credits in 2019.” (Doc. 178 at 45 (internal quotation marks omitted).)

3. Recruitment of members to share tax credits

AJGC recruited Fidelity and Schneider to share in the tax credits that Cross and other refined-coal projects were expected to generate. Sally Batanian (née Wasikowski), President of AJGC, explained that forming a partnership was beneficial because “Gallagher [AJGC's parent company] could only use in a given year a certain amount of tax credits and then [it] would have to carry the balance of them forward. So by having more partners we could improve the time value of money . . . by not having to carry over the credits.” (Doc. 170 at 133.) In addition to AJGC's “limited ability to use credits currently,” the Tax Court found that AJGC sought other investors to spread risk and to create more refined-coal operations using the Chem-Mod Technology than Gallagher (AJGC's parent company) would finance alone. (Doc. 178 at 15.)

Given Cross's “inevitable before-tax loss” (Doc. 178 at 12), AJGC's recruitment efforts — just as inevitably — touted the anticipated tax benefits. To Schneider, Batanian framed the investment not as a share in a refined-coal business but as a share of tax credits. In November 2009, Batanian informed Linda Klopp, of Schneider, “I've been holding some credits for Square D Company [Schneider],” and Batanian asked whether Klopp was “interested in them.” (Doc. 165, Ex. 700-R.) And after Schneider joined Cross in March 2010, Batanian told Schneider that she was “working on [other] sites” and “wanted to know if you are still looking for additional credits. If so, how many per year?” (Doc. 94, Ex. 3314-R at 1.) Similarly, Fidelity's internal Investment Funding Request relating to the AGJC projects included a chart with an entry for “Purchased Tax Credits.” (Doc. 165, Ex. 697-J at 1.)

In July 2009, AJGC provided Schneider with a financial projection reflecting that a $7 million investment in Cross would be paid off in the first year and that over ten years, that $7 million investment would provide a 197% internal rate of return and generate net after-tax benefits of nearly $140 million. (Doc. 178 at 16 (citing Doc. 89, Ex. 909-J).) Fidelity also saw AJGC's projection and prepared its own projections, which reflected a 249% internal rate of return at maximum production and 144% at minimum production. (Doc. 178 at 18 (citing Doc. 165, Ex. 697-J at 12-13).) Fidelity expected to recoup its investment in Cross and other AJGC-affiliated refined-coal facilities “within the first five months of operation (on an after-tax basis).” (Doc. 165, Ex. 697-J at 2.) “Clearly they all expected very high returns,” which “depend[ed] on the section 45 credits.” (Doc. 178 at 18.)

4. Fidelity and Schneider acquire their interests

On January 1, 2010, Feedstock Investments V, LLC, a Fidelity affiliate (collectively, “Fidelity”) purchased a 99% interest in USARC — which owned 51% of Cross — from AGJC for $4,028,000. (Doc. 178 at 21; Doc. 100, Ex. 69-J (Fidelity purchase agreement).) On March 1, 2010, Schneider Electric Investments 2, Inc., a Schneider affiliate (collectively, “Schneider”) purchased a 25% interest in Cross from AJGC for $1,802,000. (Doc. 178 at 21; Doc. 101, Ex. 79-J (Schneider purchase agreement).) At that point, and continuing through the tax years relevant here, the interests in Cross were divided as follows: (1) 51% to USARC (owned 99% by Fidelity and 1% by AJGC); (2) 25% to Schneider; and (3) 24% to AJGC.⁴ (Doc. 178 at 21; Doc. 97 ¶ 53.)

Fidelity's purchase agreement with AJGC contained a “liquidated damages” provision, which allowed Fidelity to exit Cross under certain conditions and required AJGC to pay Fidelity a pro rata portion of its initial $4 million investment. (Doc. 178 at 24-25; Doc. 100, Ex. 69-J §12.) Several of the conditions that could trigger the liquidated damages provision related to the availability of refined-coal credits, and others concerned, e.g., benchmarks for the production of refined coal. (See Doc. 100, Ex. 69-J § 12.4.) Fidelity's $4 million investment, “[i]n effect,” was “spread over the 120 months of the 10-year term of Cross's agreement with Santee Cooper, and Fidelity's exit payment would correspond to the number of months remaining.” (Doc. 178 at 24-25.) Schneider's purchase agreement with AJGC, by contrast, did not contain a “liquidated damages” provision. (Doc. 178 at 25.)

In addition to their respective purchase prices, Fidelity and Schneider were required to make initial contributions to an escrow account intended to cover two months of Cross's operating expenses. (Doc. 178 at 21-22; Doc. 99, Ex. 20-J at 20.) Based on the total initial escrow requirement of $2,255,306 (Doc. 99, Ex. 20-J at 12, 20), Fidelity was required to pay $1,138,704, and Schneider was required to pay $563,827.⁵ (See also Doc. 101, Ex. 79-J at 2.)

5. AJGC's sublicense of the Technology to Cross and its relation to operating expenses

AJGC sublicensed the Chem-Mod Technology to Cross in December 2009. (Doc. 97 ¶ 24; Doc. 99, Ex. 38-J.) As with the Santee Cooper agreements, the term of the Technology sublicense agreement matched the ten-year period in which the refined-coal credits would be available. (Doc. 99, Ex. 38-J § 10.1.)

The sublicensing royalties that Cross paid to AJGC were structured such that, as a practical matter, AJGC alone bore the risks of fluctuating operating expenses. On a quarterly basis, Cross was required to pay AJGC eighty-five cents “per dollar of Qualified Section 45 Tax Credits which are attributable to production and sales of refined coal,” reduced by “the actual capital and operating expenses” during that quarter. (Doc. 99, Ex. 38-J § 3.1.) The payment was capped at 55 cents per dollar of refined-coal credit, and there also was a floor (equal to the much lower royalty that AJGC had to pay to Chem-Mod). (Doc. 99, Ex. 38-J § 3.1; see also Doc. 99, Ex. 37-J ¶ (f).) As an example, if Cross's operating expenses were 35 cents per dollar of refined-coal credit, Cross would pay AJGC sublicense royalties of 50 cents per dollar (below the maximum 55-cent rate). AJGC thus had an incentive to limit Cross's expenses to no more than 30 cents per dollar of refined-coal credit, so that it could receive the maximum royalty. (Doc. 178 at 23.) Fidelity and Schneider, however, were economically indifferent to operating costs that exceeded 30 cents per dollar of refined-coal credit because expenses above the 30-cent mark would simply reduce the royalties that Cross paid to AJGC.

Hypothetically, Fidelity and Schneider could have benefited if operating expenses ever were less than 30 cents per dollar of refined-coal credit. (See Doc. 178 at 23.) For example, if expenses were 25 cents per dollar, AJGC would receive the maximum 55-cent royalty rate, and Cross would keep the five-cent difference ($0.85 — $0.25 (operating expenses) — $0.55 (maximum royalty rate) = $0.05 (remaining in Cross)). (See Doc. 168 at 535-36.) But Cross's expenses never were less than 30 cents per dollar of refined-coal credit, so Fidelity and Schneider never received any benefit from any efforts that Cross may have made to reduce operating expenses. (See Doc. 94, Ex. 3381-R.)⁶

Moreover, before Fidelity joined Cross, it knew that operating expenses were expected to exceed 30 cents per dollar of refined-coal credit, and Fidelity was concerned that its lack of risk regarding operating expenses could harm its claim to Cross's tax benefits. In October 2009, Gary Greenstein, of Fidelity, posed the following query to Batanian at AJGC: “For tax purposes . . . I would like to be able to claim that we have some upside if op. ex. [operating expense] is lower than anticipated. Right now, I think op. ex. is projected to be $.40/$1TC [40 cents per dollar of tax credit]. . . . Would you agree that if operating expenses go below say $.30/$1TC that we would get the benefit? I don't think that would ever occur but papering it might bolster our tax position.” (Doc. 89, Ex. 914-J at 3 (emphasis added). See also Doc. 165, Ex. 697-J at 7 (Fidelity projecting operating expenses of “$.40 per $1TC”); Doc. 168 at 535-36 (Greenstein's related testimony).)

6. Contributions to fund operating deficits

The Cross Operating Agreement required the members to make additional, pro rata capital contributions each month to reimburse Cross for the prior month's operating deficit. (Doc. 178 at 22.) These contributions were required because, as Batanian explained, “[t]he refined coal plant was going to operate at a cash loss, and was subsidized by the tax credits.” (Doc. 170 at 207.) “Without the credits, the operation would have always necessarily been a losing proposition for all three members,” due to the discounted rate at which Cross sold refined coal to Santee Cooper. (Doc. 178 at 27.) These losses were, however, projected to be “much more than offset” by the refined-coal credits. (Doc. 178 at 26.) For Fidelity and Schneider, who did not benefit from the Technology royalties that AJGC received, “the section 45 tax credits . . . were the source of economic return from the operation.” (Doc. 178 at 27.)

Because the monthly contributions were paid in arrears, i.e., to fund the prior month's operating deficit, the Cross members made these contributions after they knew the value of the tax credits that had been generated by such operating expenses. Before Fidelity joined Cross (through USARC), it noted that the ongoing contributions would be paid “in arrears as tax credits are generated.” (Doc. 165, Ex. 697-J at 2.) Fidelity viewed these contributions as a “contingent liability [that] exists only if qualified tax credits are produced in accordance with Section 45.” (Doc. 165, Ex. 697-J at 2. See also id. at 8 (reflecting that the risk of failure to generate tax credits would be mitigated because “Future funding commitment contingent on production of qualified tax credits by virtue of 'put' right,” i.e., the liquidated damages provision (Doc. 168 at 515)).)

As an example of the ongoing contribution obligation, a November 2011 letter (Doc. 111, Ex. 113-J at 1-2) stated that in the prior month (October 2011), Cross had generated $2,244,194.52 in refined-coal tax credits. The letter requested the following contributions by November 18, 2011:

Member	“% of Contributions"	Amount Due
USARC	51%	$516,243.79
Schneider	25%	$253,060.68
AJGC	24%	$242,938.26
Total		$1,012,242.73

By the time these contributions were due on November 18, 2011, Cross's members knew that the $1 million operating deficit for October 2011 already had generated $2.2 million in tax credits for that month.

7. Shutdowns of the Cross facility

In addition to a number of short shutdowns, there were two significant interruptions in Cross's refining operation: (1) from November 2010 to August 2011, due to permitting issues; and (2) starting in May 2012 and continuing past the 2013 exits of Fidelity and Schneider, due to concerns regarding “increased bromine levels in the nearby lake.” (Doc. 178 at 28-29; Doc. 123 ¶¶ 143-150; Doc. 131 ¶¶ 197, 225.) During these shutdown periods, Cross did not generate tax credits for its members, but it also had much lower operating expenses. That is because the overwhelming majority of Cross's operating costs during the years in issue (2011 and 2012) were variable, i.e., incurred only when Cross refined coal and thereby generated refined-coal credits. (See Doc. 178 at 40-41 (noting the Commissioner's contention that 96% of such costs were variable).⁷)

Primarily due to the two lengthy shutdowns, Cross did not meet its members' projections. In March 2013, AJGC purchased Schneider's interest in Cross for a cash payment of $25,000. (Doc. 178 at 31-32.) In November 2013, Fidelity notified AJGC of its intent to opt out of Cross, and AJGC paid Fidelity $2,450,367 pursuant to the liquidated damages provision Fidelity had negotiated. (Doc. 178 at 32; Doc. 97 ¶ 68; Doc. 127 § 162; Doc. 116, Ex. 260-J.) By the time Fidelity and Schneider exited Cross, Cross had generated almost $19 million in after-tax profit, which was fueled solely by the refined-coal credits and the operating loss deductions. (Doc. 178 at 27.)

8. Tax returns and examination

For the 2011 and 2012 tax years, Cross filed IRS Forms 1065 (U.S. Returns of Partnership Income) and issued Schedules K-1 to the members of Cross (USARC, Schneider, and AJGC). (Doc. 178 at 33; Doc. 97 at ¶¶ 3-6.) As relevant to this appeal, Cross claimed more than $25.8 million in refined-coal credits and more than $25.7 million in ordinary business losses on those returns (Doc. 98, Ex. 1-J (2011 Form 1065) at 1, 17-18; Doc. 98, Ex. 5-J (2012 Form 1065) at 1, 17-18):

Tax year	Refined-coal credit	Ordinary business loss
2011	$13,822,682	$14,248,056
2012	$12,003,303	$11,509,375

The Schedules K-1 issued for 2011 and 2012 reflected, inter alia, that Cross allocated those credits and losses to its members as follows (Doc. 98, Exs. 2-J, 3-J, 4-J (2011 K-1s); Doc. 98, Exs. 6-J, 7-J, 8-J (2012 K-1s)):

	USARC (owned 99% by Fidelity)	Schneider	AJGC
2011 refined-coal credit	$7,049,568	$3,455,670	$3,317,444
2011 ordinary business loss	$7,290,114	$3,549,971	$3,407,971
2012 refined-coal credit	$6,121,684	$3,000,826	$2,880,793
2012 ordinary business loss	$5,886,640	$2,868,743	$2,753,992

The IRS examined Cross's 2011 and 2012 returns. In June 2017, the IRS issued a notice of final partnership administrative adjustment, in which it determined that Cross “was not in substance a partnership for federal income tax purposes because it was not formed to carry on a business or for the sharing of profits and losses from the production or sale of refined coal.” (Doc. 98, Ex. 9-J at 9.) “Rather,” the IRS continued, Cross “was created to facilitate the prohibited transaction of monetizing 'refined coal' tax credits.” (Doc. 98, Ex. 9-J at 9.) In particular, the IRS determined that Fidelity (through USARC) and Schneider were not entitled to the tax benefits passed through from Cross because they “entered into the transaction . . . solely to purchase refined-coal credits and other tax benefits from AJG[C].” (Doc. 98, Ex. 9-J at 10.) As clarified during the Tax Court proceedings, the Commissioner's position is that only AJGC may claim Cross's refined-coal credits and losses. (Doc. 175 at 1320-21.)

C. Proceedings in the Tax Court

In September 2017, Cross filed a petition in the Tax Court through USARC (its tax matters partner) challenging the determinations set forth in the IRS's notice of final partnership administrative adjustment. (Doc. 1.) In the Tax Court, the Commissioner argued that Cross was not a valid partnership for tax purposes because Fidelity and Schneider did not make meaningful capital contributions to Cross and did not meaningfully share in its profits and losses.⁸ (Doc. 73 at 19-20; see also, e.g., Doc. 170 at 35.) Adopting the language of Historic Boardwalk Hall v. Commissioner, 694 F.3d 425, 461, 463 (3d Cir. 2012), the Commissioner contended that Fidelity and Schneider lacked any meaningful downside risk and meaningful upside potential vis-à-vis their interests in Cross. (Doc. 73 at 20-25; Doc. 170 at 35.) He argued that any risk of loss to which Fidelity and Schneider may have been subject was de minimis compared to the tax benefits that they expected to receive. He further argued that the only profit potential for Fidelity and Schneider came from the tax benefits. (Doc. 170 at 72.)

After a trial, the Tax Court held that Cross was a valid partnership. (Doc. 178.) First, the court concluded that the total amounts paid by Fidelity and Schneider (purchase price plus capital contributions) made them “appear as bona fide partners.” (Doc. 178 at 39.) The court rejected the Commissioner's contention that the vast majority of the ongoing contributions were not at risk (i.e., because they were paid in arrears, when the partners know how much refined coal — and tax credits — already had been generated). (Doc. 178 at 40-41.) The court also rejected the Commissioner's contention that the comparative magnitude of the anticipated tax benefits must be taken into account in determining whether a putative partner's downside risk is meaningful. (Doc. 178 at 41-42.) Referring again to the total amounts paid and contributed by Fidelity and Schneider, the court opined that “these amounts (a total of $26 million for USARC” — $25.8 million of which is allocable to Fidelity's 99% interest in USARC — “and $12.3 million for Schneider) are hardly negligible.” (Doc. 178 at 42.)

Regarding upside potential, the Tax Court found that it “was certainly true” that “there was no opportunity for Fidelity or Schneider to earn any pre-tax profit before or after the expiration year of the Tax Credits in 2019.” (Doc. 178 at 45 (internal quotation marks omitted).) In fact, due to Santee Cooper's built-in discount for refined coal, “a rise in the production and sale of refined coal [would] only and always result in increased (pre-tax) losses, not profits.” (Doc. 178 at 43.) The Tax Court nonetheless concluded that Fidelity and Schneider did “share in increased profit — i.e., after-tax profit — because of the section 45 credits that are a necessary predicate for the entire arrangement.” (Doc. 178 at 43-44 (citing Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995).) The court stated that, “given the nature and purposes of section 45,” it was proper to look solely to after-tax results in analyzing whether Fidelity and Schneider had the requisite upside potential. (Doc. 178 at 45.) The court thereby rejected the Commissioner's argument that a bona fide partner must, at some point, have a profit potential from the enterprise independent of tax benefits.

SUMMARY OF ARGUMENT

The Tax Court's evaluation of Fidelity's and Schneider's downside risk and upside potential vis-à-vis their interests in Cross is legally defective. On the risk side, the court erred in two respects: (1) It vastly overstated the amounts at risk by taking into account capital contributions that corresponded to previously generated credits, and therefore were not subject to the risk of Cross's operations, and (2) it failed to consider the comparative magnitude of the anticipated tax benefits in determining whether the amounts at risk were meaningful. And the court erred in evaluating upside potential solely on an after-tax basis, having acknowledged that there was no possibility that Fidelity or Schneider would ever earn a profit from the enterprise without the tax benefits. These legal errors call for reversal or, at the very least, vacatur and remand.

1. First, the Tax Court erred in quantifying Fidelity's and Schneider's downside risk by reference to their total payments and contributions — $25.8 million allocable to Fidelity and $12.3 million for Schneider. The vast majority of the contributions, however, were not subject to the risk of Cross's operations. In particular, the lion's share of the operating-expense contributions was not at risk because such contributions reimbursed Cross for expenses it already had incurred to refine coal and generate refined-coal credits. In other words, by the time Fidelity and Schneider made the vast majority of their operating-expense contributions, they knew that such expenses already had generated refined-coal credits during the related time period. Using the Tax Court's numbers for purposes of argument, Fidelity and Schneider had a total of $5.5 million at risk, which is a far cry from the $38.1 million in total payments and contributions that the Tax Court found to be “hardly negligible.”

The Tax Court also erred in declining to weigh the magnitude of Fidelity's and Schneider's share of the anticipated tax benefits ($105.6 million) against their at-risk contributions of, at most, $5.5 million. The court thereby failed to consider whether the amounts at risk were meaningful in context, as opposed to in a vacuum. Given that the anticipated tax benefits were more than nineteen times the amounts at risk, the Tax Court's error in this regard was by no means harmless.

2. Finally, the Tax Court erred in evaluating Fidelity's and Schneider's upside potential solely on an after-tax basis. As a business, Cross was designed to operate at a loss. Cross bought raw coal from Santee Cooper at cost and sold refined coal back to Santee Cooper for less than the purchase price. Thus, without the tax benefits, Fidelity and Schneider had no possibility of profiting from their participation in Cross, a fact that the Tax Court candidly acknowledged.

The Tax Court erroneously held that tax benefits alone can supply the requisite upside potential. In reaching that conclusion, the court solely relied on Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995). Unlike Fidelity and Schneider, however, Sacks had the potential to reap an economic profit — without the aid of tax benefits — after the tax-dependent lease at issue there expired. In contrast, Fidelity and Schneider had no possibility of earning a pre-tax profit before or after the expiration of the ten-year credit period. Sacks, therefore, is distinguishable from the circumstances at issue here, and the Tax Court erred in relying on it.

ARGUMENT

The Tax Court's evaluation of Fidelity's and Schneider's downside risk and upside potential is legally defective

Standard of review

Whether parties intended to join together to form a partnership — whether they “really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses or both” — “is a question of fact.” Commissioner v. Tower, 327 U.S. 280, 287 (1946).

This appeal, however, concerns whether the Tax Court considered the appropriate factors in undertaking that analysis. That is a legal question, which this Court reviews de novo. ASA Investerings P'ship v. Commissioner, 201 F.3d 505, 511 (D.C. Cir. 2000).

A. Legal introduction

1. General principles

For income tax purposes, partnerships are subject “to pass-through tax treatment. Partnerships do not pay income tax; instead a partnership's income and losses flow through to its partners.” Southgate Master Fund, LLC v. United States, 659 F.3d 466, 468-69 (5th Cir. 2011) (citing I.R.C. § 701); see also I.R.C. § 702. Due to the potential use of the partnership form as a means to redistribute tax burdens and benefits, “there are special temptations to appear as a partnership in order to avoid the hardships of heavy taxation.” Commissioner v. Culbertson, 337 U.S. 733, 752 (1949) (Frankfurter, J., concurring). “Because so many abusive tax-avoidance schemes are designed to exploit the [Internal Revenue] Code's partnership provisions,” the “scrutiny of a taxpayer's choice to use the partnership form is especially stringent.” Southgate, 659 F.3d at 483-84 (footnote omitted). Indeed, “existence of a tax avoidance motive gives some indication that there was no bona fide intent to carry on business as a partnership.” Culbertson, 337 U.S. at 744 n.13. Here, the $140 million in anticipated tax benefits for Cross's members — benefits that AJGC could not efficiently enjoy on its own (Doc. 178 at 15) — call for special scrutiny of the partnership's validity.

In 1949, the Supreme Court held that the validity of a partnership for tax purposes depends on “whether, considering all the facts . . . the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.” Culbertson, 337 U.S. at 742. The Culbertson test stemmed from Commissioner v. Tower, where the Supreme Court explained that “the question [is] whether the partners really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses or both.”⁹ 327 U.S. 280, 287 (1946) (emphasis added), quoted in Culbertson, 337 U.S. at 741. Each partner's stake in the profits and losses, moreover, must be “meaningful” in the context of the overall investment, including anticipated tax benefits. TIFD III-E, 459 F.3d at 231, quoted in Historic Boardwalk, 694 F.3d at 449; see also Chemtech Royalty Assocs., L.P. v. United States, 766 F.3d 453, 461-64 (5th Cir. 2014) (discussing TIFD III-E and invalidating a partnership where some partners “did not meaningfully share in any potential upside”).

2. Leading cases

In ASA Investerings P'ship v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000), this Court held that ASA was not a valid partnership for tax purposes. ASA was formed between AlliedSignal, a U.S. taxpayer anticipating a large capital gain (and seeking a way to reduce tax on that gain), and several foreign corporations. Id. at 506. ASA engaged in transactions that generated both gains and losses but “in substance added up to a wash.” Id. But by taking advantage of the redistributive potential of the partnership form and rules regarding the taxation of certain installment sales, (1) the gains for those transactions were allocated to foreign entities that were not subject to U.S. tax, and (2) the losses were allocated to AlliedSignal, which used the related deductions to attempt to reduce the tax burden of its large capital gain. Id.

Examining the risks and benefits of ASA in the context of the anticipated tax benefits, this Court concluded that ASA's members did not meaningfully share in the risks and benefits of the purported partnership.¹⁰ AlliedSignal's “interest in any potential gain from the partnership's investments was in its view at all times dwarfed by its interest in the tax benefit.” 201 F.3d at 513. AlliedSignal anticipated $15 million in profits from the scheme, which generated a capital loss for AlliedSignal of more than $396 million. Id. at 510, 516. The key foreign entity, ABN, “could make no profit from the transaction,” and this Court “agree[d] with the Tax Court that any risks inherent in ABN's investment were de minimis.” Id. at 514. This Court explained that the Tax Court “did not err by carving out an exception for de minimis risks, as no investment is entirely without risk,” and found this approach to be “consistent with the Supreme Court's view . . . that a transaction will be disregarded if it did 'not appreciably affect [taxpayer's] beneficial interest except to reduce his tax.'” Id. at 514 (quoting Knetsch v. United States, 364 U.S. 361, 366 (1960) (alterations in ASA)).

The Second Circuit applied a similar contextual analysis in TIFD III-E, 459 F.3d 220. The court held that two putative partners in a commercial aircraft leasing partnership were not bona fide partners because they “did not meaningfully share in the business risks of the partnership venture.” Id. at 227. The partnership at issue in TIFD III-E “was designed essentially to guarantee [some partners] the reimbursement . . . of their initial investment” at a specified rate of annual return, with “the possibility of a small increase in the event of unforeseen, extraordinary partnership profits.” Id. at 226. The court explained that the possibility of a $2.85 million increase in profit “was insignificant in the context of [some partners'] $117.5 million eight-year investment.” Id. at 241. The Second Circuit further explained that even realization of “unexpected and extraordinary profits . . . would have increased the banks' total return by less than 2.5% — a relatively insignificant incremental return over the projected eight-year life of the partnership.” Id. at 235. Because the banks enjoyed a guaranteed repayment of their initial investment and lacked “a sufficiently sizable share in the profit potential,” the Second Circuit held that they were not “bona fide equity partners” in the partnership. Id. at 240.

The Third Circuit also employed a contextual analysis in Historic Boardwalk, 694 F.3d at 429, where that court held that an affiliate of Pitney Bowes was not a bona fide partner in Historic Boardwalk Hall, LLC, and could not claim the benefits of that entity's historic rehabilitation tax credits under I.R.C. § 47(a)(2). The court recognized that “[i]n essence, to be a bona fide partner for tax purposes, a party must have a 'meaningful stake in the success or failure' of the enterprise,” and the fact that Pitney Bowes did not have a “meaningful stake” in either was the focus of the court's analysis. Id. at 448-49 (quoting TIFD III-E, 459 F.3d at 231).

Akin to AJGC's inability to efficiently use Cross's refined-coal credits, the rehabilitation credits at issue in Historic Boardwalk were worthless to the New Jersey state entity that set out to conduct the underlying rehabilitation, and like AJGC, it sought out investors who would find the credits valuable. Id. at 429. Central to the Third Circuit's analysis was the fact that Pitney Bowes purchased its interest after the rehabilitation project had been fully funded through other sources, and also that Pitney Bowes made its largest capital contribution after the renovation was completed. Id. at 433, 436, 443. Pitney Bowes was not, moreover, required to make contributions until it verified that the project had generated sufficient tax credits to at least equal Pitney Bowes' prior and present contributions. Id. at 455-56. Pitney Bowes's lack of meaningful downside risk “was accompanied by a dearth of any meaningful upside potential.” Id. at 459. Although Pitney Bowes enjoyed a 99.9% interest in residual cash flows on paper, examining the facts on the ground, Pitney Bowes “could never expect to share in any upside.” Id. at 460.

The Third Circuit held that Pitney Bowes did not have “a meaningful stake in th[e] enterprise” and therefore was not a bona fide partner. Id. at 429, 461. The fact that Pitney Bowes “made a substantial financial investment” did not sway the court because there was no “meaningful intent to share in the profits and the losses of that investment.” Id. at 461 (internal quotation marks omitted). The court also discounted the “constant communication” between the partners, as Pitney Bowes (like Fidelity and Schneider) had an interest in monitoring the generation of tax credits in relation to its contributions. Id. (internal quotation marks omitted).

In the cases described above — ASA, TIFD III-E, and Historic Boardwalk — this Court and other courts engaged in a contextualized analysis to determine whether purported partners meaningfully shared in an entity's downside risks and upside potential. In this case, the Tax Court legally erred in both aspects of that analysis.

B. The Tax Court made crucial missteps in its downside-risk analysis

As explained supra, at 31-36, a core characteristic of a bona fide equity interest in a partnership is downside risk. To the extent a putative partner runs the risk of not being able to recoup amounts invested in the enterprise — i.e., to the extent the recovery of such amounts is dependent on the entrepreneurial risks of partnership operations — that person has downside risk. In the context of a tax-credit partnership, the investor may recover its investment in the form of cash, tax credits, or some combination of the two. See Historic Boardwalk, 694 F.3d at 455.

The Commissioner did not argue in the Tax Court (and does not argue on appeal) that Fidelity and Schneider had no downside risk. But it is not enough for purported partners to have minimal skin in the game. Instead, they must have “meaningful downside risk.” TIFD III-E, 459 F.3d at 228 (emphasis added). In evaluating whether Fidelity and Schneider had meaningful downside risk, the Tax Court made two crucial missteps. First, the court failed to recognize that the vast majority of Fidelity's and Schneider's operating-expenses contributions were made after the corresponding tax credits had already been generated and therefore were not at the risk of Cross's operations. And the court compounded that error by declining to consider the comparative magnitude of the anticipated tax benefits.

1. The Tax Court erred in quantifying Fidelity's and Schneider's downside risk by reference to all of the amounts they paid or contributed

The Tax Court concluded that Fidelity and Schneider had meaningful downside risk on the ground that the total amounts they paid or contributed ($25.8 million for Fidelity¹¹ and $12.3 million for Schneider) “are hardly negligible.” (Doc. 178 at 42.) The court's “one size fits all” approach is devoid of any meaningful analysis. Although the court separately addressed (Doc. 178 at 39-41) the purchase price amounts ($4 million for Fidelity; $1.8 million for Schneider) and the ongoing contributions to Cross (including the initial escrow contributions, $21.8 million allocable to Fidelity's interest in USARC and $10.5 million for Schneider), it failed to appreciate the substantive distinction between the two categories. As the Commissioner explained, the vast majority of the ongoing contributions to Cross funded production (credit-generating) activities that had already occurred (i.e., in the prior month). Because Fidelity and Schneider were certain to receive allocations of the corresponding tax credits, that large subset of contributions was not subject to the risk of partnership operations. See Historic Boardwalk, 694 F.3d at 455 (noting that the putative partner's risk in this regard — which the court referred to as “investment risk” — was “non-existent,” since that partner was not required to make contributions until the other putative partner had verified that the corresponding credit-generating expenditures had occurred).

The Commissioner attempted to prove his point by analyzing Cross's various expenses for the years at issue (2011 and 2012) and breaking them out as fixed costs and variable costs. (Doc. 95, Ex. 3395-R at 2-3.) Fixed costs (such as the monthly rent to Santee Cooper) are costs that Cross would incur — and its members would subsequently fund — even if it was not refining coal (and therefore was not generating tax credits). Variable costs (such as the discount at which Cross sold refined coal to Santee Cooper) are costs that Cross would incur — and its members would subsequently fund — only when it was refining coal (and therefore was generating tax credits). As the Tax Court noted, the Commissioner determined that more than 96% of Cross's 2011-2012 costs were variable costs. (Doc. 178 at 40-41.) Thus, more than 96% of the corresponding member contributions had already been recouped — in the form of the previous month's tax credits — before they were even made.

The Tax Court mistakenly understood the Commissioner to argue that the court should “disregard contributions that were recovered promptly from business profits.” (Doc. 178 at 41.) The court got the timing backwards; in Cross's situation, the source from which 96% of the contributions “were recovered” was already in existence when the contributions were made. And, of course, that source took the form of tax credits, not “business profits.”

The Tax Court then remarked that, even if the Commissioner's argument “were correct, it is inapplicable here,” since there were numerous months in which Cross incurred operating expenses “in the absence of refined coal actually being produced (and tax credits being generated).” (Doc. 178 at 41.) But the Commissioner never claimed that Cross incurred no operating expenses when its refining facility was idle; he merely pointed out that Cross's operating expenses were much lower during such periods.

To prove its point that Cross continued to incur operating expenses during shutdown periods, the Tax Court noted that “[d]uring the 9-month shutdown starting November 2010, the members bore expenses of about $1 million when no credits were generated; and during the longer shutdown that began in May 2012, the members bore expenses of $1.9 million before their exit, when, again, no credits were being generated.”¹² (Doc. 178 at 41.) Again, the Commissioner never suggested that Cross ceased incurring operating expenses during those idle periods. But the more salient point is that the Tax Court's observation is actually consistent with the Commissioner's determination that the portion of the members' operating-expense contributions that did not correspond to previously generated credits — i.e., the portion properly viewed as having been subject to the risk of Cross's operations — was exceedingly small. Assuming for purposes of argument on appeal that, during the months encompassing the shutdown periods, Cross's members bore $2.9 million of expenses in excess of previously generated credits,¹³ Fidelity's and Schneider's pro rata shares of that figure amount to 6.56% of their total operating-expense contributions,¹⁴ which is not far off from the 4% figure that the Commissioner extrapolated from his fixed/variable cost analysis.

At most, then (i.e., under the Tax Court's approach), only $2.12 million of Fidelity's and Schneider's $32.36 million of operating-expense contributions ($1.46 million for Fidelity; $0.66 million for Schneider) are  properly viewed as having been subject to the risk of Cross's operations. See note 14, supra. And, at most, only $1.58 million of Fidelity's $4 million purchase price — i.e., the $1.58 million that Fidelity did not recover as liquidated damages when it opted out of Cross — was subject to risk of loss.¹⁵ Thus, at most, Fidelity had $3.04 million at risk ($1.58 million at-risk purchase price + $1.46 million), and Schneider had $2.46 million at risk ($1.8 million purchase price + $0.66 million). Those are the figures that the Tax Court should have considered in determining whether Fidelity and Schneider had meaningful downside risk, not $25.8 million and $12.3 million. (Doc. 178 at 42; see note 11, supra.)

2. The Tax Court erred in evaluating the meaningfulness of Fidelity's and Schneider's downside risk without regard to the outsized tax benefits they anticipated

In addition to vastly overstating the amounts that Fidelity and Schneider subjected to the risk of Cross's operations, the Tax Court erred in rejecting the Commissioner's argument that the second part of the analysis — determining whether a putative partner's amounts at risk were “meaningful” — must take into account the comparative magnitude of the anticipated tax benefits. (Doc. 178 at 41-42.) Indeed, in a colloquy with the Commissioner's counsel during her closing argument, the court remarked that “to ask whether there's any meaningful downside risk isn't answered by saying the amount they were putting in was dwarfed by the potential [after-tax] profit of this venture if it was successful.” (Doc. 176, Tr. 1640.) Determining whether a partner's downside risk is meaningful, however, necessarily depends on context, and in the tax realm, that context includes the magnitude of anticipated tax benefits.

As described supra, at 31-36, this Court and other courts have applied a contextual analysis to determine whether a putative partner's stake in the partnership was meaningful. A similar principle applies in the related context of the economic substance doctrine, which courts invoke to disregard tax-motivated transactions — typically, highly structured financial maneuverings — that have no realistic possibility of yielding a pre-tax (and after-fee) profit. Even where such a transaction may yield a modest pre-tax profit, courts have not hesitated to hold that the transaction lacks economic substance if such profit is dwarfed by the anticipated tax benefits.

For instance, in holding that a transaction lacked economic substance, the Ninth Circuit emphasized that “the magnitude of even the most optimistic gain is dwarfed by the magnitude of the tax loss it was designed to generate and the strong probability of a pretax loss.” Reddam v. Commissioner, 755 F.3d 1051, 1061 (9th Cir. 2014). The Federal Circuit similarly has stated that, “[e]ven if there is some prospect of profit, that is not enough to give a transaction economic substance if the prospect of a non-tax return is grossly disproportionate to the tax benefits that are expected to flow from the transaction.” Salem Fin., Inc. v. United States, 786 F.3d 932, 949 (Fed. Cir. 2015) (emphasis added) (citing Knetsch, 364 U.S. at 365-66). In a case regarding transactions that exploited foreign tax credits, the Second Circuit considered the fact that “the value of the foreign tax credits produced far exceeded any independent potential for economic return from the cross-border transactions.” Bank of N.Y. Mellon Corp. v. Commissioner, 801 F.3d 104, 120 (2d Cir. 2015) (emphasis added). The Tenth Circuit found it meaningful that the “profit potential” of the relevant transactions “appears anemic beside their considerable capacity for tax gaming.” Keeler v. Commissioner, 243 F.3d 1212, 1214 (10th Cir. 2001). And that court's economic-substance analysis in Sala v. United States similarly considered the fact that the “expected tax benefit dwarfs any potential gain” from the transaction. 613 F.3d 1249, 1254 (10th Cir. 2010).¹⁶

Significantly, although determining the validity of a partnership under Culbertson and determining the validity of a transaction under the economic substance doctrine are separate inquiries, this Court held in ASA that there is a “unitary test” for both analyses, i.e., “whether the 'sham' be in the entity or the transaction.” 201 F.3d at 512. That precedent supports applying the proportionality aspect of these cases regarding the economic substance doctrine — pursuant to which pre-tax profit potential must be meaningful in comparison to anticipated tax benefits — to the Culbertson analysis here by likewise requiring a putative partner's downside risk to be meaningful in comparison to anticipated tax benefits. Cf. ASA, 201 F.3d at 513 (finding that purported partner's interest in any potential gain from the partnership's investments was “at all times dwarfed by its interest in the tax benefit”).

As the Tax Court acknowledged, AJGC projected that Cross would generate $140 million in tax benefits for its members. (Doc. 178 at 16 (citing Doc. 89, Ex. 909-J).) Combining Fidelity's 50.49% indirect interest in Cross with Schneider's 25% interest, Fidelity and Schneider stood to reap $105.6 million of those anticipated benefits. As demonstrated above, over the course of their participation in Cross (including the shutdown periods), Fidelity and Schneider had (at most) a total of $5.5 million at risk, only 5.2% of the anticipated $105.6 million in tax benefits. In other words, the anticipated tax benefits were more than nineteen times the amount that Fidelity and Schneider subjected to the risk of Cross's operations. Viewed in this light, Fidelity's and Schneider's downside risk was de minimis and insufficient to support their claimed status as bona fide partners in Cross. See ASA, 201 F.3d at 514 (finding that the “Tax Court's decision not to consider ABN's 'de minimis' risk” was “consistent with the Supreme Court's view, albeit in the 'sham transaction' context, that a transaction will be disregarded if it did 'not appreciably affect [taxpayer's] beneficial interest except to reduce his tax'”) (alteration in original).

C. The Tax Court erred in evaluating Fidelity's and Schneider's upside potential solely on an after-tax basis

Turning to the subject of upside potential, the Tax Court acknowledged that “the agreed-upon discount for [Cross's] sales of refined coal [to Santee Cooper] will assure a loss on the sale of every ton of coal refined,” and, accordingly, “a rise in the production and sale of refined coal will only and always result in increased (pre-tax) losses, not profits.” (Doc. 178 at 43.) In concluding that Fidelity and Schneider nonetheless meaningfully shared in the potential success of the enterprise, the Tax Court “look[ed] to the post-tax profits that [they] anticipated,” i.e., taking into account the benefit of anticipated operating-loss deductions and refined-coal credits. (Doc. 178 at 45.) The court erred in doing so.

In holding that a putative partner's upside potential may stem only from tax benefits, the Tax Court solely relied on Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995). (Doc. 178 at 44.) As explained below, however, the investment at issue in Sacks is distinguishable from Fidelity's and Schneider's interests in Cross because Sacks retained the potential for upside gain, separate from any tax benefits. For Fidelity and Schneider, the only upside potential stemmed from tax benefits because Cross's production of refined coal would “only and always result” in a loss. (Doc. 178 at 43.)

In Sacks, the Ninth Circuit considered the tax consequences of investments that taxpayer Seymour Sacks made in 1982 and 1983 in solar water heaters. 69 F.3d at 985-86. Sacks purchased fifteen heaters and immediately leased them back to the seller for 53 months. Id. Under the lease agreement, Sacks would receive a base amount of rent plus a percentage of the rent that homeowners paid to rent the heaters. The heaters had ten-year warranties and a useful life of up to 20 years. Id. at 984.

The IRS determined that the sale-leaseback transactions were shams (i.e., lacked economic substance) and disallowed Sacks's claimed depreciation deductions and investment tax credits, including some “business energy” credits that Congress created to encourage investment in alternative energy sources. Id. at 986. The Tax Court agreed, id., but the Ninth Circuit reversed and held that the transactions were not shams, id. at 988. The court found that the transactions had economic substance and that Sacks “had a business purpose,” which was “making money after taxes by leasing out solar water heaters.” Id.

Of particular relevance here, the Ninth Circuit stated in Sacks that, “where Congress has purposely used tax incentives to change investors' conduct,” an incentivized transaction that has economic substance “does not become a sham merely because it is likely to be unprofitable on a pre-tax basis.” Id. at 991. But that conclusion rested on the fact that Sacks “own[ed] the potential for upside gain on the water heaters” after the termination of the tax-dependent lease transaction, giving him profit potential apart from the tax benefits. Id. at 991. The court explained that after the 53-month lease term, when the water heaters would be “well within” the ten-year warranty period and their useful life, Sacks “owns them free and clear and can negotiate whatever deal the market will bear.” Id. at 991. In other words, the Ninth Circuit emphasized that Sacks ultimately could profit from the residual (post-lease) value of the water heaters, without the aid of the tax benefits that were necessary to make the lease transaction economically feasible.

In contrast to Sacks, Fidelity and Schneider had no nontax potential for upside gain from Cross after the tax-advantaged portion of the investment — i.e., the ten-year credit period — expired. Cross did not own the Technology that it employed to refine coal and could not benefit from any increase in its value.¹⁷ AJGC's agreement to sublicense the Technology to Cross, moreover, lasted only for the ten-year credit period. In addition to not owning the Technology — the chemical process for which Cross's equipment was built — Cross did not own the land on which it built its refining facility. And both the lease and purchase-and-sale agreements with Santee Cooper ended after the same ten-year period for the refined-coal credits. In contrast to Sacks, Cross would own nothing of value after the refined-coal credits were no longer available. As the Tax Court found, “there was no opportunity for Fidelity or Schneider to earn any pre-tax profit before or after” the tax credits were available. (Doc. 178 at 45 (internal quotation marks omitted and emphasis added).)

Discussing Sacks, the Federal Circuit cautioned that, if a transaction is profitable only due to tax credits, “that situation demands careful review,” particularly regarding “whether the transaction meaningfully alters the taxpayer's economic position (other than with regard to the tax consequences) and whether the transaction has a bona fide business purpose.” Salem Fin., 786 F.3d at 950. And in recently rejecting a taxpayer's reliance on Sacks, the Federal Circuit emphasized the distinction the Tax Court should have made here: Sacks had nontax upside potential from his water-heater investment. Alternative Carbon Res., LLC v. United States, 939 F.3d 1320, 1331 (Fed. Cir. 2019). The court there held that a taxpayer was not entitled to alternative fuel credits under I.R.C. § 6426(e) because the taxpayer did not actually sell the fuel mixture at issue, which was a requirement for the credit, but rather paid others to dispose of the mixture. Id. at 1332. As relevant here, the Alternative Carbon court explained that the taxpayer “offered no evidence it ever 'reasonably expected' to generate any profit apart from the tax credits,” and “[p]ure speculation that Alternative Carbon might someday generate a pre-tax profit” was not sufficient. Id. at 1330 (citing I.R.C. § 7701(o)(2)(A) (codifying the economic-substance doctrine)).

In reaching that conclusion, the Federal Circuit rejected Alternative Carbon's reliance on Sacks. Unlike Alternative Carbon (and Cross), “the taxpayer in Sacks provided evidence about how he could eventually make money through his water heater leaseback program.” Id. at 1331. Alternative Carbon, in contrast, “entered into unprofitable transactions while charging digester operators a nominal fee so it could generate tax credits.” Id. The sales of refined coal by Cross, similarly, would “only and always result in increased (pre-tax) losses, not profits,” while generating millions of dollars in tax benefits. (Doc. 178 at 43.)

The Alternative Carbon court correctly observed that the potential for a nontax profit was critical to the outcome in Sacks, and the Tax Court here should have distinguished Sacks on the same ground.

As this Court held in ASA, 201 F.3d at 512, a valid partnership must have a nontax business purpose, which presupposes some possibility, at some point in time, of generating a profit independent of tax benefits. As in Alternative Carbon, Cross had no potential upside apart from the tax benefits, and the Cross partnership thus did not have a nontax business purpose. This Court “ma[de] clear” in ASA that “'the absence of a nontax business purpose is fatal' to the argument that the Commissioner should respect an entity for federal tax purposes.” Saba P'ship v. Commissioner, 273 F.3d 1135, 1141 (D.C. Cir. 2001) (quoting ASA, 201 F.3d at 512) (remanding for reconsideration of the validity of a partnership). This Court, accordingly, should distinguish this case from Sacks and reverse the Tax Court's holding that Fidelity and Schneider had the requisite upside potential to support their claimed status as bona fide partners in Cross.

CONCLUSION

The decision of the Tax Court is incorrect and should be reversed. Alternatively, the decision should be vacated and the case remanded to the Tax Court with instructions to apply the correct legal standard in determining whether Fidelity and Schneider were bona fide partners in Cross for federal tax purposes.

Respectfully submitted,

RICHARD E. ZUCKERMAN
Principal Deputy Assistant Attorney General

ARTHUR T. CATTERALL (202) 514-2937
NORAH E. BRINGER (202) 307-6224
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

SEPTEMBER 2020