In Deitch, a partnership obtained financing from a corporate lender to acquire commercial real estate. The lender obtained, among other items, contingent rights to "appreciation interest" (i.e., 50% of gross proceeds) on the sale of the property, rights to 50% of the partnership's net cash flow, and other miscellaneous rights restricting use of the financed property. Throughout the term of the loan, the parties made modifications to the loan documents to extend the disbursement and maturity dates of the loan. Without those modifications, the partnership would have defaulted on the loan and caused a forced sale of the property. When the partnership later sold the property as allowed under the loan documents and triggered the lender's rights to appreciation interest, the partnership characterized the payment on the lender's appreciation interest as a deductible interest payment. The Commissioner argued this payment was not deductible because the borrower and lender had formed a deemed partnership, and that the payment was instead a guaranteed payment to a partner under Code section 707(c).
The Tax Court relied on the eight "Luna factors" that form the cornerstone of deemed partnership analysis to conclude that no partnership had been formed, noting that no one single factor is generally determinative: (1) the agreement of the parties and their conduct in executing its terms, (2) the contributions of each party, if any, (3) the parties' control over income and capital and their right to make withdrawals, (4) whether each party had a mutual proprietary interest in net profits and losses, or if one party was a compensated agent or employee of the other, (5) whether business was conducted in the joint names of the parties, (6) whether the parties filed partnership tax returns as or otherwise represented themselves as partners, (7) whether separate books of account were maintained for the venture, and (8) whether the parties exercised mutual control and assumed mutual responsibilities over the venture.
The Tax Court concluded that all "Luna factors" except the third weighed against the existence of a partnership. The loan documents expressly disclaimed any partnership or joint venture between the parties, and the parties' conduct did not contradict this stance. The lender contributed no services and instead made only a loan on defined terms. The lender did not have an obligation to share pro rata in the operating losses of the property despite a right to a portion of the property's net profits, and the Commissioner conceded that the business was not conducted in the joint names of the parties and that no returns evincing a partnership had been filed. Additionally, the parties did not jointly maintain books of account, and the lender had little responsibility over the property absent an event of default.
In contrast, the Court viewed the third "Luna factor" as supporting an equity characterization. Because the lender could have effectively forced a sale of the property by refusing loan extensions, the lender exercised a degree of control over the partnership's sole property and, thus, the capital of the partnership. Further, the partnership would continue to owe the lender appreciation and net cash flow interest payments even if the partnership were to refinance or obtain additional financing on the property. Therefore, the third factor weighed in favor of finding a deemed partnership to exist. However, based on the "Luna factors", taken as a whole, the Tax Court held that there was no deemed partnership, giving particular significance to the absence of any contribution by the lender to the purported joint venture. The Tax Court also did not recast a portion of the loan as an equity investment. As a result, the entire appreciation interest payment was properly characterized by the partnership as an interest payment and was thus deductible.
Deitch informs taxpayers that the IRS may still attempt to recharacterize a loan as an equity investment despite containing a majority of factors that traditionally supports debt characterization. It was particularly helpful in this situation that the "participation" received by the lender was based on "gross" items (sales proceeds and cash flow) instead of net income. Accordingly, taxpayers should take care to properly structure their financing arrangements and seek the advice of tax counsel to maximize the chance of achieving desired tax treatment, especially if equity-like features are present.
