In the Tax Court, the IRS challenged the allocation of Code Section 45 credits and deductions stemming from Schneider Electric’s (Schneider) investment in a partnership created to refine coal. The critical questions were, first, whether Cross Refined Coal LLC (Cross) was a bona fide partnership, and second, whether Schneider and the other members of the partnership, Fidelity Investments (Fidelity) and Arthur J. Gallagher & Co., were bona fide partners. In a rare set of circumstances for a case of this size, Judge David Gustafson issued a bench opinion at the end of trial. The bench opinion, which Judge Gustafson read on August 14, concluded that Schneider, along with the other members, were bona fide partners entitled to their claimed credits and deductions.

The case, USA Refined Coal LLC v. Commissioner, Dkt. No. 19502-17, was a bit unusual in that the facts for each of the three partners were different and, as a result, required an independent analysis for each. USA Refined Coal LLC (an LLC owned by both Fidelity and Arthur J. Gallagher) was the tax matters partner, while Schneider was a participating partner in the case due to its involvement in the Cross refined coal facility at issue.

The Facts

In 2004, AJ Gallagher, through a wholly-owned entity called AJG Coal, Inc. (AJGC), invested in chemical technology used to produce refined coal through a company called Chem-Mod. AJGC helped to license the technology, and in 2009, AJGC sub-licensed the technology to producers in the refined coal industry in return for royalties. AJGC also participated directly in the production of refined coal, and thus received both royalties from the technology as well as the tax credits of section 45.

AJGC’s business model for these refined coal production facilities required a relationship with a utility company that generated electric power by burning coal. AJGC entered into a contract to purchase raw coal from the utility company and then later sell back the refined coal to the utility company. This business model required AJGC to build a coal-refining facility on the premises of the utility company.

The utility company that was involved in the purchase of refined coal with AJGC faced significant risks. Burning refined coal is a complex and costly process which required complicated engineering and risks to the facility’s equipment. Further, the Chem-Mod technology was new, and its long-term impact on the coal and equipment was uncertain. Thus, to incentivize the utility company to take on this risk, AJGC offered a discounted rate at which the utility would purchase back the refined coal. As such, the utility company sold the raw coal at a price higher than the refined coal it later purchased back from the refiner. In other words, the transaction was guaranteed a pre-tax loss to the refiner.

As a part of the American Jobs Creation Act of 2004, Congress expanded section 45 to provide tax credits for the production of refined coal that is “produced” and “sold to an unrelated person” in a 10-year period, provided that the refined coal meets certain emissions reduction requirements. Prior to 2008, section 45 required refined coal to be sold for a profit. However, in the Energy Improvement and Extension Act of 2008, Congress recognized that the industry did not allow for a pre-tax profit and eliminated this requirement to incentivize refined coal production.

Because of the significant risks related to the business of refined coal, AJGC sought to diversify its investments among multiple investors and multiple refined coal production plants. One of these facilities was the Cross Generating Station (Cross) located in Pineville, South Carolina. In the Cross refined coal facility at issue, AJGC partnered with Fidelity and Schneider.

Before Schneider and Fidelity joined the partnership, each undertook significant due diligence with respect to operational risks, the financial aspects of the project, and the reliability of the other partners to assure the appropriateness of the investment. This process involved teams of professionals, both in-house and third-party, to evaluate the refined coal process for all possible discoverable and quantifiable risks. Despite the significant risks involved in this industry, the project was projected to yield significant returns, dependent on the section 45 credits.

On 1 March 2010, Schneider purchased from AJGC a 25% direct interest in Cross and two other refined coal partnerships for a total of $4.25 million, $1.8 million of which was attributable to Cross. Within the terms of the operating agreement, each member of Cross was required to pay its share of ongoing operating costs of the facilities. This included an upfront amount that Schneider placed in escrow from which the partnership could pay for expenditures. At the outset, Schneider’s share of this escrow account was $1.18 million, $496,000 of which was attributable to the Cross facility. Over the next few years before its exit from the partnership, Schneider ultimately paid more than $10.5 million in additional capital contributions.

Per the terms of the agreement, Schneider also owed to AJGC a “Finder’s Fee” to compensate AJGC for its time and effort spent on the research and development of the refined coal technology. Schneider and Fidelity also paid a royalty to AJGC dependent on the operating expenses of the facility – as expenses increased, the royalty to AJGC decreased. Fidelity’s agreement with AJGC also included a liquidated damages provision which allowed Fidelity to leave the partnership upon the occurrence of various triggers. Schneider’s agreement with AJGC did not include a liquidated damages provision.

The Cross facility operated from 2010 to 2013. By the time of the members’ exit from Cross, the facility had generated after-tax profit, including the benefits of the refined coal tax credits, totaling almost $19 million, shared among the three partners. Nonetheless, this benefit fell well below the expected benefit for the same period. Between 2010 and 2013, the Cross facility faced significant operational issues that impeded or completely halted production for various lengths of time.

In mid-2012, Schneider determined that the refined coal partnerships required additional supervision. Without the resources available for this purpose, Schneider asked AJGC whether it had interest in buying Schneider’s share of the partnership. On 1 March 2013, after months of negotiation, AJGC purchased back Schneider’s interest Cross and the other facilities in which Schneider was involved. As to Cross, the arrangement included a $25,000 payment and forgiveness of an unrelated note.

The Opinion

At issue was whether Schneider and Fidelity were partners in Cross and thus entitled to its claimed losses and section 45 credits from its refined coal business. A partnership exists when “parties in good faith and acting with a business purpose intend to join together in the present conduct of the enterprise.” Commissioner v. Culbertson, 337 US 733, 742 (1949). To make this determination, courts look to the facts and circumstances to determine whether a partner has a “meaningful stake in the success or failure” of the enterprise. Id. at 742. The Tax Court, in Luna v. Commissioner, has established eight factors to be considered when assessing the business purpose intent of the parties to a purported partnership. 42 T.C. 1067, 1077-78 (1964). In his pretrial memorandum, the Commissioner acknowledged that the parties to Cross satisfied all but two of the eight factors. The two factors at issue to this case were (1) “the contributions, if any which each party has made to the venture,” and, (2) “whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income.”

With respect to capital contributions, the court recognized Schneider’s $1.18 million initial contribution for its interest in Cross and Schneider’s additional contributions of $10.6 million for operating expenses in 2010 to 2012. The court also acknowledged, that despite Fidelity’s liquidated damages provision, upon its exit, Fidelity received only $2.5 million, leaving behind $1.5 million of its original investment. Ultimately, the court concluded that these contributions were, in substance, investments in equity. In other words, both Schneider and Fidelity were at risk for their initial capital contributions and both Schneider and Fidelity contributed to Cross commensurate with their status as a partners.

As to whether the partners shared in the profits of the venture, the court reasoned that given the nature of the industry and Congress’s change to the requirements under section 45, it must look to the post-tax profits that the members anticipated, and found that the parties did, in fact, share in the profits of the venture. The court distinguished the case at issue from Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 435 (3d Cir. 2012), rev’g 136 T.C. 1 (2011), where the taxpayer entered into the venture for rehabilitation credits well after the project was established and did not have meaningful downside risk or upside potential. On the facts of this case, the court found that “it is difficult to make a serious case that the members did not share risk and the risk of loss.” The court concluded that both Schneider and Fidelity believed that they bore, and that they did in fact bear, risk of loss from the refined coal operation.

Baker McKenzie represented Schneider, while other firms represented the other partners. Baker McKenzie’s trial team was led by Dan Rosen and included Jonathan Welbel, Rob Walton, Christina Norman, and Cameron Reilly.

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