In the U.S. Tax Court case Deitch v. Commissioner, T.C. Memo 2022-186 (August 25, 2022), the court rejected an IRS contention that the partnership and its lender had effectively formed a joint venture for federal income tax purposes, and further held that the partnership’s payment of more than $1 million made to the lender was deductible as interest under Section 163.
West Town Square Investment Group, LLC (WTS, owned by the petitioners, Alexander C. Deitch, 50% owner, and Jonathan Barry and Susan S. Barry, 50% owner), was formed in 2006 and purchased a commercial rental property in Georgia by financing the property with the proceeds of a loan from Protective Life Insurance Co. (PLI, the lender). Besides the base monthly payment (interest of 6.25% and principal), the integrated loan documents included an “Additional Interest Agreement” that entitled PLI to additional interest of two types: “Net Cash Flow (NCF) Interest,” i.e., 50% of the net cash flow from the property, and "Appreciation Interest,” i.e., 50% of the appreciation in the value of the property if it was ever sold or the loan was terminated. In 2014, WTS sold the property and reported the payment to PLI in the amount of $1,035,683, i.e., 50% of the net proceeds of the sale, as deductible interest expense and reported a net §1231 gain of $2,647,854. The IRS rejected the $1 million as deductible interest expense and stated that it’s a nondeductible return on equity payment through a joint venture. The court ruled in favor of the petitioners that their $1,035,683 payment to PLI was a deductible interest, not a payment in respect of equity.
Below are various factors that were considered in the case to determine whether the obligation was debt or equity1:
- Was there a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth and to pay a fixed rate of interest?
- What contributions, if any, had each party made to the venture?
- The parties’ control over income and capital and the right of each to make withdrawals
- Whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses
- Did the parties file federal partnership returns or otherwise represent to the IRS or to persons with whom they dealt that they were joint venturers?
- Were there separate books of account maintained for the venture?
- Did the parties exercise mutual control over and assume mutual responsibilities for the enterprise?
Debt has been defined as “an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor’s income or lack thereof.”2 In contrast, a stockholder intends to join in the business venture, accepting the risk of the business failing and the attendant loss of their investment, in return for the possibility of the business succeeding, with the profits returning to them and other stockholders.3 Whether a particular advance to a partnership represents debt, i.e., a loan to the partnership, or equity, i.e., a partnership interest or a capital contribution to an existing partnership, may affect the income tax consequences to one or more partners. In general, the repayment of equity is only a return of capital; therefore, it’s not deductible. Interest on a loan, however, is deductible under §163.
In most cases, it’s in the taxpayer’s favor to treat the payment as interest, as it’s deductible. However, the IRS has a history of challenging this position. The identification of debt versus equity can be complicated, especially when a corporation is thinly capitalized.
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- 1IRC §385(b); Notice 94-47; Court case Hubert M. Luna v. Commissioner, 42 TC 1067 (09.18.1964)
- 2Gilbert v. Commissioner of Internal Revenue, Cite as 52 AFTR 634 (248 F.2d 399), (CA2), 09/26/1957
- 3U.S. v. Title Guarantee & Trust Co, (1943, CA6) 30 AFTR 1008, 133 F2d 990, 43-1 USTC ¶9293; Com. v. O.P.P. Holding Corp, (1935, CA2) 15 AFTR 379, 76 F2d 11, 35-1 USTC ¶9179