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TAX MATTERS

would be allocated to Clark. Regarding Facts: Alex Deitch and Jonathan Deitch and Barry each petitioned
the allocation of the income between Barry formed West Town Square Invest- the Tax Court to contest the IRS’s
Town and Newman, the court held ment Group LLC (WTS), classified disallowance of WTS’s interest deduc-
that CRC’s income should be allocated as a partnership for federal income tax tion for the payments made under
to each partner’s deficit capital account purposes, to acquire and develop a single the additional interest agreement. The
“in an amount equal to that partner’s piece of commercial real estate in Rome, taxpayers and the IRS stipulated facts
pro rata ‘share’ of the total negative Ga. To fund the acquisition and develop- including that the loan agreements
balances of those accounts, calculated ment, WTS entered into a series of constituted genuine indebtedness, the
by dividing the deficit balance of agreements with Protective Life Insur- loan agreements and additional interest
each partner’s capital account by the ance Co. (PLI), an unrelated third party. agreement were the result of an arm’s-
combined deficits of both partners’ First, under agreements collectively length transaction, and PLI did not
capital accounts and then multiplying referred to as the “loan agreements,” own a member interest in WTS. The
the resulting ratio for each partner by PLI agreed to advance WTS the funds cases were consolidated for judgment.
the total amount of ordinary income to needed to acquire and develop the real Issues: The Tax Court described
be allocated.” estate project. The loan agreements two prior situations in which courts and
■ Clark Raymond & Co., PLLC, T.C. provided PLI with a security interest in the IRS had evaluated whether a loan
Memo. 2022-105 the acquired real estate and provided for packaged with rights that provided the
a variable interest rate. PLI and WTS lender with significant exposure to the
— Charles Keith Kebodeaux, J.D., also entered into an “additional interest borrower’s potential profits should be
LL.M., MSA, is a clinical assistant agreement,” which provided that WTS classified as debt, equity, or bifurcated.
professor at Texas State University in San would pay PLI 50% of WTS’s net cash In Farley Realty Corp., 279 F.2d 701 (2d
Marcos, Texas. flow from the operation of the acquired Cir. 1960), aff ’g T.C. Memo. 1959-93,
real estate, along with 50% of the net the IRS succeeded in disallowing a
gain from its ultimate sale, both as taxpayer’s interest deduction for an
“interest” on the advances provided for “appreciation” payment similar to the
under the loan agreements. The ad- payment under the additional interest
ditional interest agreement and the loan agreement at issue in Deitch. In that
agreements were closely interrelated, case, Z, an individual, loaned money to
and PLI provided no separate capital a corporation, C, to finance a portion
or services under the additional interest of C’s purchase of real estate. Z was
agreement. Both the loan agreements entitled to repayment of principal after
and additional interest agreement indi- a term of 10 years, a fixed interest pay-
Debt arrangement cated that the parties intended to form ment on the amount advanced, and 50%
did not give rise to an solely a debtor/creditor relationship and of any appreciation in the value of the
interest in partnership that nothing in the documents should property. In Farley, the court sustained
be construed as creating a partnership,
the IRS’s disallowance of an interest
equity joint venture, or other arrangement of deduction for C’s payment to Z for
co-ownership. 50% of the appreciation in the property,
The Tax Court respects a Ultimately, WTS’s real estate reasoning that Z’s right to share in
property developer’s interest development activity proved successful, the appreciation of the property was
deductions despite the lender’s and WTS paid 50% of the proceeds of separable from his right to repayment
entitlement to a share of net the sale of the real estate to PLI under of his loan and that the right to share in
profits. the additional interest agreement. On its the property’s appreciation constituted
partnership tax return for the year of the an equity interest in the property.
By Grace Kim, J.D., LL.M., and Whit
sale, WTS deducted the payments made In General Counsel Memorandum
Cocanower, J.D., LL.M.
to PLI under the additional interest (GCM) 36,702, however, the IRS
The Tax Court rebuffed an attempt agreement as interest expense and allo- criticized the bifurcation approach
by the IRS to deny a partnership’s cated the gain from the sale, along with previously supported by the IRS and
deduction for interest payments that the interest deduction, to its partners. adopted by the court in Farley. GCM
effectively represented a sharing of the On audit, the IRS disallowed WTS’s 36,702 notes that the assertion that Z
profits from the partnership’s real estate interest deductions for amounts paid held an equity interest in the property
development activity with the lender. under the additional interest agreement. was tantamount to claiming that Z was

34 | Journal of Accountancy February 2023