Banks are lenders to partnership, not partners.

• Author: Beavers, James A.

The Second Circuit held that two banks were lenders to a partnership, not partners in the partnership under Sec. 704(e) (1).

Background

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In 1993, two Dutch banks, ING Bank N.V. and Rabo Merchant Bank N.V., purchased an interest in Castle Harbour LLC, a partnership that owned aircraft that were leased to various airlines, in which TIFD III-E, Inc., served as the tax-matters partner. In 2001, the IRS rejected Castle Harbour's classification of the banks as partners and issued two notices of administrative adjustment reallocating a large percentage of the partnership's income for the years 1993 to 1998 from the banks to TIFD III-E.

TIFD III-E challenged the notices of adjustment in district court. The court found that the banks were properly characterized for tax purposes as partners, not lenders (as the IRS had contended), and ruled the notices invalid (T1FD III-E, Inc., 342 E Supp. 2d 94 (D. Conn. 2004)). The IRS appealed the decision to the Second Circuit. The Second Circuit found that the district court erred by not examining the nature of the banks1 interest in the partnership under the totality-of-the-circum-stances test from Culbertson, 337 U.S. 733 (1949) (TIFD III-E, Inc., 459 K3d 220 (2d Cir. 2006)).

Applying that test, the court held that the evidence showed that the banks' interest was not "bona fide equity participation," but instead "overwhelmingly in the nature of a secured lender's interest." However, the Second Circuit remanded the case to the district court for consideration of TIFD III-E's further argument that, regardless of the outcome of the Culbertson inquiry, the banks qualified as partners under Sec. 704 (e) (1), which provides that "[a] person shall be recognized as a partner ... if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift ..."

The District Court's Decision on Remand

On remand, the district court, relying on the previously established trial record, ruled that the banks qualified as partners under Sec. 704(e) (1) (TIFD III-E, Inc., 660 E Supp. 2d 367 (D. Conn. 2009)). Although the IRS argued that the district court was precluded from finding that the banks owned a capital interest because the Second Circuit had held that the banks' interest was not bona fide equity, the court did not agree. The district court decided that the Second Circuit's holding that the banks interest was...