In the latest Castle Harbour decision, the Second Circuit Court of Appeals has again concluded that a preferred investor was not a partner for tax purposes, denying an allocation of taxable income to the tax-indifferent investor. In 2004, the District Court originally held that the investor was a partner and the second circuit reversed under the traditional Culbertson “totality-of-the-circumstances test”. However, the appellate court also remanded because the district court had not yet addressed an additional taxpayer argument. The taxpayer argued that the investor should be treated as a partner under section 704(e) because they had a “capital interest” in the partnership. The district court subsequently ruled for the taxpayer based on section 704(e). On appeal the Second Circuit disagreed with the district court and concluded that the interest was still debt and not a “capital interest” under section 704(e). Interestingly the appellate court did not even find there to be substantial authority for the taxpayer’s position and imposed penalties. The appellate court found that, as a practical matter, the structure of the partnership agreement confined the investors’ return to a set rate of return and the interest was, for all practical purposes, a fixed obligation, requiring reimbursement of the investment at a set rate of return in all but the most unlikely of scenarios.
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