Bona Fide Partners Can Claim Losses, Coal Tax Credits

CROSS REFINED COAL, LLC, USA REFINED COAL, LLC, TAX MATTERS PARTNER,
Petitioner, 
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent

UNITED STATES TAX COURT

ORDER OF SERVICE OF TRANSCRIPT

Pursuant to Rule 152(b) of the Tax Court Rules of Practice and Procedure, it is

ORDERED that the Clerk of the Court shall transmit herewith to petitioner and to respondent a copy of the pages of the transcript of the proceedings in the above case before the undersigned judge at Boston, Massachusetts, containing his oral findings of fact and opinion rendered at the trial session at which the case was heard.

In accordance with the oral findings of fact and opinion, decision will be entered for petitioner.

David Gustafson
Judge

Dated: Washington, D.C.
August 29, 2019

SERVED Aug 29 2019

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PROCEEDINGS

(2:30 p.m.)

THE CLERK: All rise.

THE COURT: Please be seated. Please call the case.

THE CLERK: Calling docket 19502-17, Cross Refined Coal, LLC, USA refined Coal, LLC, Tax Matters Partner.

THE COURT: The Court has decided to render the following as its oral Findings of Fact and Opinion in this case. This Bench Opinion is made pursuant to the authority granted by section 7459 (b) of the internal Revenue Code (26 U.S.C.), and Tax Court Rule 152; and it shall not be relied on as as precedent in any other case.

By notice of final partnership administrative adjustment dated June 20, 2017 (the "FPAA" (Stip 7; Ex. 9-J)), the Commissioner made adjustments to partnership items of Cross Refined Coal, LLC ("Cross"), for the years 2011 and 2012. The Commissioner made the adjustments after determining that the formation of Cross among AJG Coal, Inc. ("AJGC", a subsidiary of Arthur J. Gallagher & Co. ("Gallagher")), USA Refined Coal LLC ("USARC", a subsidiary of FMR LLC ("Fidelity")), and Schneider Electric Investments 2, Inc. ("Schneider", a subsidiary of Schneider Electric S.E. ("Schneider Electric")) was not in substance a partnership for Federal 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 by its partners but rather (the Commissioner determined) was created to facilitate the monetizing of refined coal tax credits provided under section 45(e)(8). The issues for the Court to decide for the relevant years are: (1) whether Cross was a bona fide partnership for federal tax purposes and (2) whether USARC and Schneider were bona fide partners of Cross for federal tax purposes.

Trial of this case was conducted on August 5 through 14, 2019, in Boston, Massachusetts. At trial, petitioner (USARC, tax matters partner of Cross) was represented by Brian W. Kittle, Geoffrey M. Collins, James R. Carroll, and David W. Foster. The Commissioner was represented by Catherine T. Gugar, Justin Scheid, John Healy, James Rider, Charles Dumas, and Rogelio Villageliu. Cross partner Schneider was represented by Daniel A. Rosen, and Cross partner AJGC was represented by Lawrence M. Hill.

FINDINGS OF FACT

AJGC's investment in the Technology

In 2004 AJGC began investing in chemical technology used to product refined coal (the "Technology"). (Stip. 94.) AJGC made its investment by funding tests for the Technology and purchasing interests in a company called Chem-Mod that developed and held the Technology. AJGC acquired 42% of Chem-Mod through direct and indirect investments. (Stip. 94.) In 2008 AJGC entered into an agreement to license the Technology from Chem-Mod. (Stip. 22.)

In 2009 AJGC began to sub-license the Technology to producers in the refined coal industry in exchange for royalties. As sub-licensor of the technology, AJGC directly received royal ties that the producer paid to AJGC; and as part owner of Chem-Mod, AJGC indirectly received a portion of the royal ties that AJGC paid as licensee to Chem-Mod as owner of the Technology. (See Stip. 24.) AJGC also participated directly as a producer of refined coal and thus obtained not only the royal ties but also — important to this case — the tax credits of section 45, discussed below. (See Stips. 34, 47, 53, 83.) AJGC's employee most involved in and responsible for the refined coal projects was Sally Batanian, who was president of Gallagher's Clean Energy Division and president of Chem-Mod LLC.

Refined coal production

AJGC' s refined-coal production model generally involved (1) locating an interested utility company that generated electric power by burning coal, (2) entering into a contract with that utility to (a) purchase "raw", "feedstock" coal from that utility and then (b) sell back "refined" coal to that same utility; (3) building a coal-refining facility where chemical technology is used to produce refined coal; and (4) procuring investors to provide capital to aid in the construction of the facilities and fund the ongoing operations. (See Stips. 24 -27, 47, 53.)

At facilities like the one at Cross, the refining operation was constructed between the coal yard and the boilers, so that it interposed itself in the existing operation of the power plant. The refining process began with moving the coal by conveyor belts to the refining equipment. That equipment treated the coal with chemicals that would reduce the emission of nitrogen oxide and mercury. The coal thus treated was then taken by conveyor belt back to the plant's equipment that then crushed the coal to be burned in the boilers. The entire refining process — from the raw coal being put on the conveyor belts into the refining facility to the refined coal being conveyed back to the power plant — took only 3 to 5 minutes.

The utility's risks and incentives

For the utility participating in AJGC's arrangement, the purchase of the refined coal involved significant risks. Burning coal to produce electricity is a complex and costly process, which employs complicated chemistry and engineering. Altering the character of the coal may affect the process at many stages and in many ways. It can alter the temperature of the burn, change the chemical composition and properties of the gas and liquid generated by the process, affect the boilers and other equipment, and alter the processes already in place by which the plant reduces its harmful emissions. If the refined coal were to create an urgent problem, it might prompt the necessity of shutting down a boiler and requiring the immediate release of the enormous quantity of superheated steam that the process generates — an event that can be heard a mile away. The utility's risks in using refined coal include potential damage to equipment, uncertainty as to the efficacy of the product, and interference with the utility's compliance with environmental regulations.

The utility's principal incentive for entering into the arrangement was the discounted rate at which the utility would purchase back the refined coal. That is, the utility would sell its raw coal to the refiner at the price the utility had previously paid for the coal and then, after the refining took place, would purchase back the refined coal for a price discounted by 75 cents per ton; the utility thus made a profit (of 75 cents per ton) on selling the raw coal to the refiner and buying it back refined.

In addition to that principal incentive of the discount and the resulting savings, the utility also hoped for secondary benefits, such as reducing expenditures for ammonia (which was used to reduce Nitrogen Oxide), or increasing calcium (with a beneficial effect on the plant's catalyst). (Ex. 1510-P.) But these possible secondary benefits were insufficient, without the discount, to induce the utility to agree to purchase refined coal.

The producer's risks and incentives

For the producer, the economics began with a multi-million-dollar investment and an inevitable before-tax loss every year of the operation. The coal must ultimately be sold at a discount in order to induce the utility to assume the risk of buying and using the refined coal. Thus, the producer's best-case scenario would involve a before-tax loss for each ton of refined coal sold, and the more successful the producer was in producing and selling refined coal to the utility, the greater that before-tax loss would be.

Moreover, the producer faced a real risk of the non-sale (or the diminished sale) of refined coal. The power plant was able to by-pass the refining facility and use its unrefined raw coal when that utility judged that it was not expedient to use the refined coal. At the Cross facility itself, production of refined coal was suspended multiple times. Production might be suspended because required construction or operating permits could not be obtained and maintained, or because the refined coal was failing to achieve the intended emissions reductions, or because the refined coal was causing other environmental problems (whether in the gases emitted from the smokestack, or in the ash or liquid that the process produced). Or the utility might suspend its operations for reasons entirely unrelated to the refined coal if the power generating plant itself had to cease operating for other reasons — mechanical, environmental, or economic. And when the utility stopped using refined coal and used raw coal instead, then of course the refining operation stood idle, making no sale of refined coal and generating no section 45 credits.

The producer also faced additional risks: If an environmental problem arose in connection with the coal-fired electrical plant using the producer's refined coal and became publicized, the producer faced "reputational risk". Whether fairly or unfairly, its name could become associated with the problem. And if the problem were severe enough, the producer faced the risk that aggrieved persons might sue for environmental damage under the likes of the federal "Superfund" statute (the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA")), 42 U.S.C. sec. 9601 et seq.; or the Resource Conservation and Recovery Act ("RCRA"), 42 U.S.C. sec. 6791 et seq.; or equivalent provisions of State law. Sufficiently motivated victims of environmental harm might even attempt to go after the producer's parent company by "piercing the corporate veil" or pursuing statutory remedies against de facto owners. These risks are impossible to quantify on the evidence before us, but it suffices to say that the risks are not trivial and that a reasonably prudent investor would have to take them into account in making its investment decision and, if it made the investment, would bear some measure of risk.

The producer's incentive to under take these risks and to incur an inevitable before-tax loss was the tax credits (discussed below) that section 45 awarded for the production and sale of the refined coal. Without those tax credits there was no economic reason for the producer to buy high and sell low — i.e., to purchase coal, incur additional cost to refine it, and then sell it not at a profit but at a discount. Without the tax credits as an incentive to the producer, the utility would not have an occasion to use refined coal and thereby reduce its harmful emissions.

Finding investors

It was in AJGC's interest to have the royalty-generating Chem-Mod process being used in more coal-refining operations than AJG itself could wholly own. Its parent company had a limited appetite for investment in coal operations. In addition, AJGC had a limited ability to use credits currently, and at some level of investment would have been carrying credits forward (and suffering a relative loss of the time value of money). Bringing in other investors would enable it to spread its own investment risk over a larger number of projects, to benefit from lessons being learned at a greater number of facilities, to earn royal ties on all those projects, and to accrue section 45 credits in an amount it could optimally use. Sally Batanian recruited investors, including Fidelity and Schneider Electric.

AJGC described to potential investors the high returns that might be generated by the refined coal operations, and in so doing AJGC emphasized the section 45 credits that were critical to those projected returns. One best-case-scenario that AJGC provided to Schneider in July 2009, which assumed uninterrupted high volume sales of refined coal over the entire 10-year period during which the tax credits would be available, projected an investment of $7 million being paid off before the end of the first year, an internal rate of return ("IRR") of 197%, and total 10-year benefits of almost $10 million. (Ex. 909-J.)

The Santee Cooper projects

In 2009 AJGC began to secure contracts and potential investors to produce refined coal for Santee Cooper, the South Carolina Public Service Authority. (Stip. 26, 27.) Santee Cooper had three generating stations in South Carolina for which AJGC under took to produce refined coal: the Cross Generating Station in Pineville; the Jefferies Generating Station in Georgetown; and the Winyah Generating Station in Moncks Corner. On August 31, 2009, AJGC entered into design and construction agreements with Taggart Global, LLC ("Taggart"), to build a refining facility for each Santee Cooper station. (Stip. 8.) AJGC contacted Fidelity and Schneider Electric to propose that they invest in the projects.

Due diligence

Both Fidelity and Schneider Electric engaged in substantial "due diligence" to assure the appropriateness of the investment in the three Santee Cooper facilities, including Cross. Personnel of both Fidelity and Schneider Electric met multiple times with Sally Batanian to learn about the refined coal process. Both entities brought in professionals from the relevant departments in their affiliated companies to help assess and address risks of all assess and address risks of all sorts — environmental, financial, and market. Fidelity used a detailed "due diligence checklist" (Ex. 951-J) of the sort that it regularly used when deciding whether to make an investment; and Schneider Electric used a similar list recommended by their accountants (Ex. 1269-P). Both entities conducted site visits at the Santee Cooper power plants (see Stip. 117), during which they had AJGC's Manager of Operations take them to places in the facilities that, he said, he had never seen before. Fidelity and Schneider Electric shared the expense (Stip. 124-125) to hire two firms to assist them — Southern Research Institute ("SRI") to assess the Chem-Mod technology and John T. Boyd Company ("Boyd") to review the three Santee Cooper power stations. (Stip. 118-123.) They performed due diligence on Santee Cooper (and inquired into a consent decree under which it operated), on AJGC, and on each other.

And, of course, Fidelity and Schneider Electric both tried to determine whether the investments were likely to make satisfactory returns. They had seen AJGC's projection showing an IRR of 197%. In addition, Fidelity prepared two projections of returns, one at a maximum level of production (with an IRR of 249%) and the other at a minimum level of production (with an IRR of 144%). (Ex. 697-J at 12-13.) Clearly they all expected very high returns-depending on the section 45 credits.

Gary Greenstein was a Senior Vice President at Fidelity, experienced in investments in the energy field, and he led Fidelity's consideration of the refined coal investment. Foreshadowing an issue that later became a large problem, he learned enough about the refined coal process and Santee Cooper's operation that he raised questions about bromide levels in the water run-off from the operation and about a possible need to monitor them. (Exs. 920-J, 1294-P.)

Having conducted their due diligence, Fidelity formally agreed to invest in all three projects beginning in January 2010 (Stip. 36), and Schneider Electric formally agreed to invest in all three projects beginning in March of 2010 (Stip. 48). Schneider Electric also invested in a fourth project called "Canadys"; but losses and credits from the Jefferies, Winyah, and Canadys projects are not at issue here. We include facts about them only as they bear on the Cross facts. By the transactions that we now describe, subsidiaries of Gallagher (i.e., AJGC), of Fidelity (i.e., USARC), and of Schneider Electric (i.e., Schneider) became the three members of Cross.

Forming the entities and investment structure

On December 9, 2009, AJGC formed USARC, Cross, Jefferies refined Coal ("Jefferies"), and Winyah refined Coal ("Winyah"), to serve as vehicles for the operation. (Stip. 12.)

On December 19, 2009, the Cross refined coal facility was deemed operational (Stip. 16) and "placed in service". On December 21, 2009, AJGC and USARC executed various agreements and transfers so that: (1) AJGC owned 100% of USARC; (2) AJGC and USARC owned 49% and 51%, respectively, of the Cross, Jefferies, and Winyah LLCs; (3) Cross, Jefferies, and Winyah owned 100% of the facilities for each station; and (4) LandGas Coal Management, LLC ("LandGas") served as the manager for the Cross, Jefferies, and Winyah LLCs. (Stips. 19, 25, 31, 32, 34.)

Additionally on December 21, 2009, Cross, Jefferies, and Winyah entered into leases with Santee Cooper to locate and operate their coal-refining facilities onsite at each location (Stip. 21), and each LLC also entered into agreements to purchase raw coal from Santee Cooper at the respective stations, refine the coal, and then sell the coal back to the stations at a discounted rate (Stips. 2 6-27). The agreements between Santee Cooper and the three LLCs had terms of 10 years (corresponding to the 10-year period of tax credit availability provided in section 45(e)(8)(A), discussed below).

On January 1, 2010, Fidelity, through a subsidiary, Feedstock Investments V, LLC ("Feedstock Investments"), purchased from AJGC 99% of USARC (Stip. 36) — thereby acquiring 51% indirect ownership of Cross, Jefferies, and Winyah — for a total of $9.5 million, $4 million of which was attributable to Cross. On March 1, 2010, Schneider Electric' s subsidiary Schneider purchased from AJGC a 25% direct interest in each of Cross, Jefferies, and Winyah for a total of $4.25 million (Stip. 48), $1.8 million of which was attributable to Cross.

After these purchases: (1) Fidelity's Feedstock Investments owned 99% of USARC, which owned 51% of Cross, Jefferies, and Winyah; (2) Gallagher's AJGC owned 1% of USARC and 24% of each of Cross, Jefferies, and Winyah; and (3) Schneider owned 25% of each of Cross, Jefferies, and Winyah. (Stip. 53.)

Particular terms

Several terms of the Cross agreements are especially pertinent to the issues in this case:

First, each of the members was required to pay its share of the ongoing operating costs of the three refined coal operations, including Cross. At the commencement of their arrangement, each had to pay an amount that would be put in escrow, from which operations expenditures would be made. The escrow would then be replenished by the further payments that the members made from month to month as those expenditures were incurred. In January 2010 Fidelity (the 51% owner) paid $2.2 million for this escrow of which $929,000 was for Cross; and in March 2010 Schneider (the 25% owner) paid $1.18 million, of which $496,000 was for Cross. Over the course of the next few years before they exited from Cross, Fidelity paid a total of almost $22 million in additional capital contributions, and Schneider paid a total of more than $10.5 million in additional capital contributions. (Ex. 3881-R.)

Second, Schneider owed to AJGC an additional fee under their agreement (Ex. 79-J). Schneider was required by section 4.2 ("Finder's Fee") to pay to AJGC "an amount which is equal to $0.05 per $1.00 of tax credit allocated to" Schneider. Over the course of Schneider's membership in Cross, it paid under this provision a total of $561,354 (i.e., $11,227,080 (Schneider's total credits, see Ex. 3881-R at 9) times .05).

Third, on the basis of its license of the Technology from Chem-Mod, AJGC entered into an License agreement with Cross to sublicense the Technology to Cross (Ex. 38-J). Section 3.1 provided that the royalty that Cross would pay AJGC was 85 cents per a given quantity of coal sold (stated in the coal's ability to yield a dollar of credit) "less the actual capital and operating expenses of Licensee . . . provided, however, that the Royalty Payment shall in no event exceed" 55 cents. (The royalty term also had a floor.) In sum, if expenses (which the members had to pay) increased to more than 30 cents per unit, then the royalty to AJGC decreased, thereby incentivizing AJGC to reduce expenses; but if the expenses were reduced further to less than 30 cents per unit, then the royalty was unaffected (but of course the partners benefitted from having to pay only those lower expenses).

Fourth, pursuant to section 10.12 of the LLC Agreement (Ex. 27-J), "Major Decisions" required the "prior written approval of all the members". There were 26 decisions listed in that section, and Fidelity and Schneider Electric had taken an active role in creating the list. Among those 26 were such decisions as: approving the budget; approving "any expenditure or commitment to make expenditures in excess of Five Thousand Dollars ($5000) except to the extent provided for in the Approved Budget"; hiring an accountant; hiring and firing the manager (an action in which USARC and Schneider later participated); and purchasing insurance.

Fifth, the Membership Interest Purchase Agreement between Fidelity and AJGC included a "liquidated damages" provision, which allowed Fidelity to exit USARC (and its 51% interest in Cross) upon the occurrence of various triggers, such as failure to conduct testing of emissions reduction levels or to achieve required emissions reductions to qualify for section 45 credits; changes in law that adversely affect the value of the tax credits with respect to more than fifty percent of the refined coal produced and sold; violations or noncompliance with environmental laws; bankruptcy of any counterparty to a coal purchase agreement; and subminimal production of refined coal based on minimum quarterly projections. See  Ex. 69-J, sec. 12.4. If Fidelity exercised that right, it would receive from AJGC a pro rata portion of its $4 million investment in Cross. (In effect, the $4 million investment 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.) The liquidated damages provision did not provide for any return of or reimbursement for Fidelity's due diligence costs or its monthly capital contributions for operating costs.

Schneider's agreement with AJGC (Ex. 79-J) did not have any liquidated damages provision. Consequently, the contract had no provision for any payment to Schneider upon its exit from Cross.

Mitigating risks

Schneider Electric and Fidelity clearly sought to identify the risks their subsidiaries might face as co-owners of Cross, and they took reasonable steps to mitigate those risks (in addition to Fidelity's negotiating the liquidated damages provision to be invoked when it wished to exit the arrangement). Schneider and USARC were constituted as limited liability entities subsidiary to other limited liability subsidiaries of the parent company, in order to shield their parent companies from liability as much as possible.

They undertook a high level of effort to monitor the operation of Santee Cooper and Cross and to intervene when needed. They insisted on receiving, and they reviewed, Cross's daily production reports. They established a monthly checklist by which the manager would confirm and report that all "Major Decisions" had been duly referred to the members. (See Ex. 1006-P.) They conferred frequently with Cross personnel and among themselves by email and phone; and in 2010 and 2011 they held annual partner meetings. They reviewed requests for funds and financial statements. Dissatisfied with the manager of the facility, they jointly decided to terminate his employment (see Stips. 138-139; Ex. 303-J) and chose his replacement (see Ex. 1201-P). These decisions were made by personnel of all three members of Cross.

Compensation for the Cross members

Under their agreements' for the Cross LLC (like their agreements for Jefferies and Winyah), each Cross member would incur its percentage share of the Cross expenses — i.e., the cost of purchasing the coal from Santee Cooper (incompletely offset by the revenue from the discounted sale of the refined coal back to Santee Cooper), maintaining the facilities, and paying employee salaries, even during periods when coal was not being refined. However, the resulting losses would be mitigated — and, they projected, much more than offset — by the section 45 tax credits earned from producing and selling the refined coal.

AJGC would also receive royalties for the Technology (both indirectly as owner of Chem-Mod and directly as sublicensor). But for Fidelity and Schneider, because they did not hold any interest in the royalties for the Technology, the section 45 tax credits earned from producing and selling refined coal were the source of economic return from the operation. Without the credits, the operation would have always necessarily been a losing proposition for all three members because of the discount on sale of the refined coal to Santee Cooper.

Production at the Cross facility

The Cross facility operated in 2010, 2011, 2012, and 2013. By 2013 the Cross members had much more than recovered the costs of their due diligence, their initial investment, and their contributions toward operating costs. From 2010 through the time of their exits in 2013, Cross had generated after-tax profit (including the tax credits and the tax benefit of Cross's claimed losses that resulted from the discount on sale of coal to Santee Cooper) totaling almost $19 million, shared among the three members.

Cross shutdowns

However, the operations in those years were not without interruption. Rather, various issues impeded or stopped production throughout these years (see Stips. 61, 62, Exs. 236-J, 239-J, 242-J, 245-J, 248-J). Santee Cooper had the discretion to shut down the refined coal operation, and its managers did so with a frequency that frustrated Cross and its owners. Some shutdowns were apparently reasonable (such as when one of the Cross electricity-generating units was taken offline due to lack of demand for power, but others do seem questionable (such as shutting the refined coal operation because of "drizzle", or because of an overcast sky that might mean rain would come in the future). (See Ex. 239-J.) Every shutdown, however well or poorly justified, meant that no refined coal could be produced or sold and no tax credits could be generated.

There were two interruptions of very substantial duration: First, Cross began operating under temporary construction permits that Santee Cooper had secured (see Stips. 187-202), but issuance of the permanent permits was delayed, so that Cross had to suspend production for about nine months from November 2010 to August 2011. Petitioner demonstrated that during this shutdown the expenses that the members bore exceeded the tax credits generated by about a million dollars. (See Ex. 1918-P at 73, citing Exs. 102-J through 110-J.)

Second, in May 2012, Santee Cooper requested Cross to suspend product on because of allegations that the operation was contributing to increased bromine levels in the nearby lake into which its water drained (Stip. 143). That lake was a source of drinking water for nearby communities, and the lake drained into a river that provided drinking water to additional communities downstream. The bromine in turn had evidently reacted with chlorine in the water treatment process, which caused the presence of carcinogenic trihalomethanes ("THMs") in the water source, and Cross remained shut down for more than three years until late 2015. Petitioner demonstrated that during this shutdown, until the time of USARC's exit in late 2013, the expenses that the members bore exceeded the tax credits generated by about 1.9 million dollars. (See Ex. 1918-P at 70, citing Exs. 120-J through 127-J, 543-J through 552-J.)

During that shutdown in refined coal production and sale, Santee Cooper operated the power plant with its raw coal, not refined coal from Cross. During longer shutdowns, some but not all of the Cross employees were laid off, but during all of the shutdowns, the member s (AJGC, USARC, and Schneider) were required to continue making contributions for maintenance and upkeep of the facilities and for the salaries of at least key employees and managers, but the plant was not producing and selling refined coal, so no section 45 tax credits were being generated during such times.

At several points the trigger events occurred that would have entitled Fidelity to exit Cross with its liquidated damages, but Fidelity did not opt out (until 2013, as described below).

Closing of Jefferies

In October 2012 the Santee Cooper Board of Directors voted to shut down the Jefferies generating Station — not just to suspend the coal-refining operation, but to shut down the electricity-generating plant altogether. (Stip. 140-141.) There was insufficient demand for the power produced by that station. Santee Cooper later decided to convert the Jefferies plant from coal to natural gas (after which there would be no need for a refined coal operation).

Buyout of interests

The returns that Cross refined coal operation had Generated ($19 million after tax, as shown above) was a far cry from the projections that they had made in 2009. The shutdowns described above had resulted in long periods of time with no production and sale of refined coal, and no section 45 tax credits. In fact, petitioner demonstrated that Cross's operating expenses exceeded all revenues (including tax credits) more than half of the months during which Fidelity owned its interest (See Ex. 1918-P at 70, citing Exs. 104-J through 110-J, 120-J through 127-J, 543-J through 552-J.) Moreover, the monitoring and supervising of the project had involved more time and difficulty than they had expected; and the environmental difficulties that had arisen — especially the bromine and THM problem — had heightened their concerns about the ongoing risks of the operation.

Schneider had no liquidated damages provision that would give it compensation upon its exit from the arrangement, so Schneider engaged in a negotiation with AJGC. On March 1, 2013, AJGC purchased back Schneider's interest in each of the Cross, Winyah, Jefferies, and Canadys facilities. As to Cross, the arrangement included a $25,000 payment to Schneider by AJGC for Schneider's interest in Cross (as compared to the $1.8 million Schneider had paid for that interest in March 2010). The arrangement also included AJGC's forgiveness of a seven million dollar — $7,415,483 non-contingent note connected to Schneider's interest in the Canadys project, but the Commissioner does not contend, and the evidence does not suggest, that any portion of that amount should be attributed to the Cross transaction. The transaction effectively released Schneider from any obligation to participate further in the refined coal operations. (Stips. 67, 161.)

On November 13, 2013, Fidelity provided a "Notice of Opt-Out of Cross refined Coal LLC" to AJGC. Pursuant to the "liquidated damages" provision discussed above, AJGC paid $2.5 million for Fidelity's indirect interest (as compared to the $4 million that Fidelity had paid for that interest in January 2010). (Fidelity retained its interests in Jefferies and Winyah until February 28, 2014, when AJGC purchased those interests for $500,000. (Stips. 68, 162-163.))

In their exits from Cross, neither Schneider nor Fidelity received any reimbursement of the due diligence costs that they had incurred before investing nor any of the operating costs that Cross had incurred during their time in the LLC, nor the "finder's fee" that Schneider paid; nor did either member receive any refund of any then-unspent portions of their shares of the operating costs escrow account.

Tax returns

Cross timely filed Forms 1065, "U.S. Return of partnership Income," for the 2011 and 2012 tax years and issued Schedules K-1 to USARC, Schneider, and AJGC. (Stips. 3-6.) The Commissioner timely issued the FPAA dated June 20, 2017, to USARC as "Tax Matters Partner" of Cross relating to the 2011 and 2012 tax years. (Stip. 7.) USARC timely filed a petition in this Court on September 14, 2017. At that time, Cross was no longer active.

OPINION

I. Burden of proof

As a general rule, the Commissioner's determinations in an FPAA are presumed correct, and a party challenging an FPAA bears the burden of proving that the Commissioner's determinations are in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Republic Plaza Props. Pship. V. Commissioner, 107 T.C. 94, 104 (1996).

Petitioner argues that the burden of proof shifts to the Commissioner pursuant to section 7491(a), which provides for such a shift on a factual issue where the "taxpayer introduces credible evidence with respect to * * * such issue." Sec. 7491(a)(1). However, in the case of a partnership (like petitioner), section 7491(a)(2)(C) limits the application of this provision to a "taxpayer . . . described in section 7430(c)(4)(A)(ii)", which in turn limits relief to a party that meets the requirements of section 2412(d)(2)(B) of . . . title 28". That Title 28 provision limits relief to a "partnership . . . the net worth of which did not exceed $7,000,000 at the time the civil action was filed, and which had not more than 500 employees at the time the civil action was filed." Petitioner did not put on evidence of its qualification under this limitation. After petitioner rested its case, we therefore denied its request for a shift in the burden of proof.

However, a shift in the burden of proof "has real significance only in the rare event of an evidentiary tie." Blodgett v. Commissioner, 394 F. 3d 1030, 1039 (8th Cir. 2005), affg. T.C. Memo. 2003-212. We perceive no factual issues as to which the evidence is in equipoise, so we are able to decide this case on the preponderance of the evidence, and the burden of proof is not a factor in our analysis.

II. Refined Coal Credits

As part of the American Jobs Creation Act of 2004, Congress expanded section 45 of the Code to provide tax credits for refined coal that is "produced" and "sold to an unrelated person" in a 10-year period, see sec. 45(e)(8)(A), provided that the refined coal (1) met certain emissions reduction requirements, and (2) increased the market value of the coal by at least 50 percent. Pub. L. 108-357, Title VII, sec. 710(a)-(f). In 2008 Congress again modified section 45 and the refined coal credits by removing the value-enhancement requirement and adopting more stringent emissions-reduction requirements for coal refinement facilities first placed in service after December 31, 2008. Pub. L. 110-343, Div. B, Title I, secs. 101(b), (f). As for the emissions reductions, in order to qualify, the refined coal must result in "a reduction of at least 20 percent of the emissions of nitrogen oxide and at least 40 percent of the emissions of . . . mercury". Sec. 45(c)(7)(B). Although the Commissioner offered expert evidence challenging the effect of the refined coal at Cross, he does not contend that the refined coal failed to meet the standard of the statute for purposes of entitlement to the credit.

The amount of the credit is $4.375 per ton of refined coal, sec. 45(e)(8)(A), adjusted for inflation, sec. 45(b)(2), (e)(2), and in 2009 the amount as adjusted was $6.20 per ton. See Notice 2009-40, 2009-19 I.R.B. 931. The statute explicitly anticipated that "more than one person [might have] an interest in" a production facility and that, in such a case, the credit would be "allocated among such persons in proportion to their respective ownership interests in the gross sales from such facility". Sec. 45(e)(3).

III. Bona Fide Partnership

Where a partnership exists, the partnership itself is not a taxpayer for income tax purposes. Sec. 701. Instead, tax items (such as income, deductions, losses, and credits) are passed through to the partners. Sec. 702. At issue here is whether USARC and Schneider are partners of Cross entitled to claim the losses and section 45 credits that Cross accrued.

A. Business purpose and intent

A partnership exists when two or more "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 U.S. 733, 742 (1949); Commissioner v. Tower, 327 U. S. 280, 287 (1946)(holding that the proper test is whether the partners "intended to join together for the purpose of carrying on business and sharing in the profits or losses or both"). In making this determination, courts must look to the facts and circumstances to determine whether a partner has a "meaningful stake in the success or failure" of the enterprise. Culbertson, 337 U.S. at 742. The Supreme Court stated: "The question is . . . whether, considering all the facts — the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent — the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise." 337 U.S. at 742.

B. The eight LUNA factors

This Court further explained the test in Luna v. Commissioner, 42 T.C. 1067, 1077-78 (1964), identifying eight factors to be considered in assessing the business purpose intent of the parties to a purported partnership. The Commissioner acknowledges those eight factors and states in his pretrial memorandum ("PTM") that "Cross does not meet the factors that require capital contributions and the meaningful sharing in the profits and losses". Thus, the Commissioner does not dispute that Cross fails to satisfy the following six of the eight factors: "the agreement of the parties and their conduct in executing its terms"; "the parties' control over income and capital and the right of each to make withdrawals"; "whether business was conducted in the joint names of the parties"; "whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers"; "whether separate books of account were maintained for the venture"; and "whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise. "

Rather, the two factors as to which the Commissioner disputes Cross's status as a bona fide partnership are, first, "the contributions, if any, which each party has made to the venture", and, second, "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". We therefore consider further these two disputed factors.

C. Contributions to the venture

When we consider the Luna factor of "the contributions, if any, which each party has made to the venture", we note that USARC and Schneider each contributed the purchase price of their interests in Cross (USARC's $4 million and Schneider's $1.18 million) and their additional contributions for operating expenses in 2010 to 2013 (USARC's $22 million and Schneider's $10.5 million). We conclude that these contributions make USARC and Schneider to appear as bona fide partners. But the Commissioner disputes the significance of these amounts:

1. Initial contributions

As for Fidelity, its "liquidated damages" provision entitled it, upon the occurrence of certain triggers, to sell back its interest and receive, in effect, a refund of a pro rata portion of its initial investment (spread ratably over ten years). This certainly reduced Fidelity's risk (compared to that of an investor with no such option), but it by no means eliminated the fact and economic reality of the contribution. One 120th of the investment fell out of reach as each month passed. When Fidelity ultimately exited in 2013, it received back only $2.5 million and left behind $1.5 million of its original investment. Partnership agreements sometimes provide terms for a partner's exit, and on the facts of this case we do not find Fidelity's "liquidated damages" provision inconsistent with its status as a partner.

As for Schneider, the Commissioner posited before — before trial (PTM at 21): "AJGC and Schneider did not have an explicit buy back agreement, but an implicit buy back agreement existed between Schneider and AJGC." However, after trial the Commissioner acknowledged that no evidence had been admitted to support this hypothesis. Consequently, Schneider was at risk for its entire $1.18 million.

2. Additional contributions

The Commissioner stated (PTM at 15-16): "Although the members of Cross were required to continue making capital contributions to fund ongoing operating expenses during periods when the Cross Facility was not producing refined coal, such amounts were de minimis as 96% of Cross's operating costs were required to be paid only during the Planned Processing Dates thereby guaranteeing that the capital contributions of the parties would increase only if the refined coal was being produced and the Tax Credits were being generated." (See also id. At 21.) That is, the "contributions" factor should, in the Commissioner's apparent view, disregard contributions that were recovered promptly from business profits. We doubt the correctness of that view, but even if it were correct, it is inapplicable here. The evidence shows that, during most months, operating expenses were incurred in the absence of refined coal actually being produced (and tax credits being generated). During 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.

3. The amounts of the contributions

It appears that the Commissioner's remaining argument is simply that these contribution amounts, when compared to the returns from the Cross project (or perhaps when compared to the larger projected returns) do not constitute a sufficient contribution to be respected in the partnership analysis. However, "[t]he question is not whether the . . . capital contributed by a partner [is] of sufficient importance to meet some objective standard". Culbertson, 337 U.S. at 742. Even for companies as large as Fidelity and Schneider, these amounts (a total of $26 million for USARC and $12.3 million for Schneider) are hardly negligible — and in their oversight of Cross, they showed themselves genuinely interested in expenditures of much smaller amounts. We conclude that USARC and Schneider made contributions to Cross commensurate with their status as partners.

D. Sharing in profits and losses

When we consider the Luna factor of "whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses", we conclude that USARC and Schneider appear as bona fide partners. (As a disqualifying alternative to sharing in profits and losses, Luna posited a circumstance in which the supposed partner is instead "the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income". As far as we can tell, that is not a characterization that the Commissioner advances in this case, and we do not see how the evidence offered in this case could support it. We discuss below in part V the possible alternative characterization of the members' investments as debt rather than equity. But in this discussion we simply address the sharing of profits and losses.)

1. Sharing in profits

The evidence is clear that the profit that USARC and Schneider might obtain from Cross would rise as production and sale of refined coal rose (because the profit-critical tax credits would rise with production and sale).

The Commissioner sees it otherwise. He contends that, for purposes of partnership analysis, this increase does not constitute actual sharing in profit. Rather, a rise in the production and sale of refined coal will only and always result in increased (pre-tax) losses, not profits.

This is true as far as it goes, since the agreed-upon discount for sales of refined coal will assure a loss on the sale of every ton of coal refined. But it deliberately disregards the obvious economic reality of the situation: The members do share in increased profit — i.e., after-tax profit-because of the section 45 credits that are a necessary predicate for the entire arrangement. The Commissioner disregards the credit because he looks for the deal to justify itself in pre-tax terms, finding an abuse where a deal is undertaken only for tax benefits.

There are indeed abusive situations in which the tax law will disregard transactions that lack substance apart from tax manipulations, but this is not such a circumstance. In Sacks v. Commissioner, 69 F. 3d 982 (9th Cir. 1995), rev'g T.C. Memo. 1992-596, the Ninth Circuit explained that when Congress creates a tax credit for participating in a particular activity that would otherwise be uneconomical without the credit, the economic substance of the activity should be evaluated to include the credit (i.e., the profits of the enterprise must be considered to include the tax credits). Id. at 991. The court stated: "If the government treats tax-advantaged transactions as shams unless they make economic sense on a pre-tax basis, then it takes away with the executive hand what it gives with the legislative. A tax advantage such as Congress awarded for alternative energy investments is intended to induce investments which otherwise would not have been made." Id. at 992.

We agree. It is therefore insufficient to say (as the Commissioner does, PTM at 23) 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”. That was certainly true; and, again, in some circumstances the lack of opportunity for pre-tax profit could indeed be evidence of a lack of real business purpose or intent; but here the partners deliberately and conscientiously pursued the economic goal that Congress incentivized them to seek — that is, an after-tax (and after-tax-credit) profit. On the facts of this case and given the nature and purposes of section 45, we look to the post-tax profits that the members anticipated, and we hold that they did indeed share in the profits of the arrangement.

2. Sharing in losses

The Commissioner contends (PTM at 21) that the members' initial contributions "were largely not at risk" and that their additional contributions were "limited and substantially contingent on the availability of Tax Credits". We have already shown, in part III.C above, that USARC and Schneider had made actual contributions as to which the agreements did not protect them from risk of loss, and we do not repeat that discussion here. But the Commissioner makes the additional contention that, in fact, there were no substantial risks of loss for the investors in Cross.

First, the Commissioner stresses that, before Fidelity and Schneider acquired their interests, everything essential to the refined coal operation was already in place: the technology had been acquired from Chem-Mod and had been qualified under section 45; the lease and purchase agreements with Santee Cooper had been finalized; the coal-refining unit had been built. All that was needed was to flip the switch, put the coal on the conveyor belts, and start receiving the credits. The risk of loss was nonexistent.

(It is hard to reconcile that contention with the Commissioner's Notice 2010-54, 2010 I.R.B. 403, sec. 5.01, which provides that "[t]he refined coal credit is allowed . . . without regard to whether the taxpayer owns the refined coal production facility in which the refined coal is produced. Accordingly, a taxpayer that leases . . . a facility owned by another person may claim the credit for refined coal that the taxpayer produces in the facility." It would seem that such a lessee might be in a circumstance equivalent to Cross's members, stepping into a facility thought ready to commence operations.)

But if were true that risk of loss is necessarily absent where a partner joins a partnership with a facility that is placed or almost placed in service, then that would make this case resemble Historic Boardwalk Hall, LLC v. Commissioner, 694 F. 3d425 (3rd Cir. 2012), rev'g 136 T.C. 1 (2011), which involved Federal historic rehabilitation tax credits ("HRTCs") under sec. 47 — i.e., investment credits. The HRTCs were available for a ratable share of 20% of qualified rehabilitation expenditures ("QREs") and could be claimed in the year that a rehabilitated structure is placed in service. In Historic Boardwalk a state agency (which did not pay Federal tax and could not use tax credits) had already commenced a rehabilitation project and then agreed with a taxpayer to form a partnership, and allocate 99% of the tax credits to the taxpayer-partner. The Court of Appeals held that the latecomer taxpayer was not a bona fide partner because it (1) did not have a meaningful downside risk and (2) did not have meaningful upside potential in the enterprise. Historic Boardwalk, 694 F.3d at 448.

But this case is very unlike Historic Boardwalk for many reasons. For example, it should be noted that critical to the credit claims rejected in Historic Boardwalk is the partnership agreement's special allocation of 99% of the credits to the latecomer, a fact completely absent in this case. But the distinction from Historic Boardwalk that we wish to stress here is that the act that qualifies a taxpayer to receive an investment credit is an investment. In such a circumstance, entitlement to the credit is a fait accompli when the rehabilitated building is placed in service. If one can enter the deal at the eleventh hour, he truly has no risk because of the nature of the credit, and the Fourth Circuit denied the credit in a circumstance that lacked economic reality.

But the section 45 credit at issue here is a production credit, not an investment credit. For purposes of the section 45 tax credit, the placed-in-service date of a refined coal facility is not the project's eleventh hour but its first hour. When the coal refining facility has been built, when all the contractual arrangements have been put in place, when the investors have invested, and when the facility is ready to commence operations, the investors are (so far) entitled to credits of exactly zero. It remains to be seen whether tax credits will ever be generated and in what amounts. Standing between the investors and those credits are all of the remaining risks that might impede the future production and sale of refined coal.

The Commissioner would rejoin by contending that there were no such risks, beyond de minimis or speculative risks. That is an issue of fact as to which we come to a very different conclusion. As we found above, the members of Cross faced very substantial risks that their coal refining operation would be impeded and that they might suffer losses. These risks are manifest even in the undisputed facts: The Jefferies generating station was shut down altogether for reasons unrelated to its coal-refining operation. In its early years the Cross facility itself suffered first a nine-month shutdown when permits were delayed and then a 3-year shutdown when an environmental problem arose-not to mention shorter shutdowns brought on by the weather and other less remarkable circumstances. Although not likely, it was entirely within the realm of possibility that such shutdowns would have occurred before the Cross members had even recouped their initial investments. (Fidelity's "liquidated damages" provision would not have made it whole as to its "additional contributions".)

And those are the undisputed facts. With multiple credible witnesses, both lay and expert, and including some of the Commissioner's own witnesses, petitioner made a most convincing case that the arrangement with Santee Cooper had its own risks, and that the Chem-Mod technology, though well conceived and well tested, had inherent risks that could be mitigated but not eliminated. These included an environmental risk (from bromine) that Fidelity's Gary Greenstein even seemed to sense — but Fidelity made the decision that it was reasonable to proceed. Those risks played out-not to a disastrous extent, nor even to the extent of preventing prof its altogether, but to an extent that made the Cross project more trouble than it was worth. On these facts, it is difficult to make a serious case that the members did not share risk and the risk of loss.

The parties disagreed about whether there was any significant risk that the parent companies of the Cross members might be held liable for environmental damages resulting from the coal refining operation owned by their limited-liability subsidiaries. We assume that the risk of such liability is speculative and should not enter into our analysis; but we do not set aside the related but distinct risk that the parent companies might be sued for such alleged damages. Cross was in a business that impacted the air that people breath and the water that they drink. It is not speculative to note that, if harm or injury did occur, victims would look for deep pockets and attempt to bring them in. Even if we assume that the parent companies would ultimately prevail, they would prevail not without cost, and that is a risk that the investors bore when they signed on to this project.

The parties' expert witnesses disagreed about how to quantify the risks, both because they disagreed about how serious the risks were and because they disagreed about the best methodology for computing and expressing those risks. We conclude that we do not need to numerically quantify the risks beyond finding the fact, which we do find, that the risks were not de minimis or remote but instead were serious risks. An investor might not run shrieking from these risks, but he would consider that he was bearing these risks as he made his investment. And he would be right.

We conclude that USARC and Schneider subjectively believed that they bore, and that they did in fact bear, risk of loss from the Cross coal-refining operation.

IV. Sale of Tax Credits

In his pretrial memorandum (at 3), the Commissioner states that the issue in this case is whether "Cross was not formed to carry on a business or for the sharing of profits and losses from the production or sale of refined coal by its purported members, but rather was formed as a vehicle for the sale of Tax Credits from" AJGC to USARC and Schneider. It is true that the credits were a critical feature of the arrangement, that no rational actor would have invested in the refined coal facility without the credits, that the parties took every necessary effort to assure their obtaining of the credits. It is also true that their communications speak of the obtaining of the credits as the desired outcome, and that some of their communications used "purchasing" or "selling" the credits as a shorthand for entering into or acting under the contracts into which they had entered. There may be circumstances in which such facts might undermine the existence of a bona fide partnership — but that is not the case here.

The Commissioner states (PTM at 17): "Barring express statutory authorization, taxpayers may not sell federal tax benefits. See Beck v. Commissioner, 85 T.C. 557, 579-580 (1985) And in Beck we did hold against a taxpayer whom we characterized as "marketing tax benefits"; but we explained that tax credits were "not intended . . . to create a new economy consisting of paper transactions having no relationship to the real value of goods and services. Thus the mere presence of a valid business enterprise at some levels of a transaction does not automatically entitle passive investors distant from day-to-day operations of the enterprise to the associated tax benefits." Id. At 580. In this case we do not have mere paper transactions or distant, passive investors. Rather, we see obviously real transactions with participants substantially involved in the activity.

Congress created the refined coal credit for the purpose of incentivizing the refined coal activity; it did so because the market, unassisted by credits, was not producing refined coal on the scale that Congress thought beneficial. Congress manifestly decided that, if refined coal was to be produced in sufficient quantity, money beyond that which the market would offer would need to be added to the mix. The intended result of the credit was that investors, knowing they could obtain the credits, made decisions to produce refined coal — decisions that they did not make and would not make unless they could be sure that they would receive the credits. And rational investors, having made that decision, would of course work to assure that they maintained the right to receive those credits. Without the credits, the refined coal activity was a losing proposition; but that fact cannot mean that the activity, undertaken by someone who gains by claiming the credits, lacks economic substance; rather, that fact is the reason for the credits.

V. Debt vs. Equity

If USARC's and Schneider's investments in Cross were not equity and did not make them partners, then what were those investments? One of petitioner's experts observed that the investments must either be debt or equity; and at closing argument, we asked the Commissioner whether those are indeed the alternatives-debt or equity-and, if so, whether he contends that they were debt. Counsel responded that those investments resemble debt more than equity.

By definition, a capital contribution is not a debt for purposes of section 166, a useful analogy. See 26 C.F.R. sec.1.166-1(c). A bona fide debt arises from "a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or  determinable sum of money." Kean v. Commissioner, 91 T.C. 575, 594 (1988); 26 C.F.R. sec. 1.166-1(c), Income Tax Regs. The only aspect of this case that bears any remote arguable relation to this analogous definition is the liquidated damages provision in Fidelity's agreement. Under certain circumstances, AJGC had an obligation to pay Fidelity a pro rata amount of its initial contribution, which one could determine.

But the contention that this was debt collapses with only a little more consideration. Section 385(b), another analogy, sets forth factors to be taken into account in issuing regulations identifying bona fide debt, and the first statutory factor is "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". The liquidated damages provision lacks an "unconditional promise" (rather, it is conditional on the triggering events) and lacks "a fixed rate of interest" (rather, it provides no interest).

To the extent the issue here is whether USARC's and Schneider's initial contributions and their additional contributions were debt or equity, it is clear that they were equity.

 VI. Conclusion

Cross was a bona fide partnership, and USARC and Schneider were both bona fide partners.

Decision will be entered in favor of petitioner.

This concludes the Court's oral Findings, of Fact and Opinion in this case.

THE CLERK: All rise.

(Court adjourned at 3:33 p.m.)