The Fourth Circuit has affirmed a decision (Route 231 LLC, et al. v. Commissioner) in which the Tax Court held that a transaction in which an LLC allocated Virginia tax credits to a purported LLC member after cash was transferred by the purported member to the LLC constituted a disguised sale by the LLC of Virginia tax credits under Section 707. Thus, the proceeds received by the LLC resulted in gross income as opposed to a capital contribution.

Facts

Virginia offered an income tax credit equal to 50% of the fair market value of any land or interest in land in the state donated to a public or private agency eligible to hold the property for conservation or preservation purposes. Individuals and corporations could apply the Virginia tax credit on their income tax returns, and partners in pass-through entities that held the Virginia tax credit could use the credit on their individual tax returns in proportion to their interest in the partnership or as set out in the partnership agreement. A taxpayer could also sell or transfer unused, allowable credits to another taxpayer.

On December 28, 2005, Route 231 and Virginia Conservation Tax Credit FD LLLP (Virginia Conservation) executed three escrow agreements. The terms of these agreements provided that certain monies transferred by Virginia Conservation into an escrow account would be released in favor of Route 231 upon written confirmation by Virginia Conservation that it had received verification of the conservation donations and the Virginia tax credits. On December 29, 2005, Virginia Conservation wired $3,816,000 into the escrow account. Effective December 30, 2005, Route 231, a LLC, made three charitable contributions of property. On January 1, 2006, Route 231's original two partners and Virginia Conservation executed an amended operating agreement for Route 231 indicating that the Virginia tax credits were to be allocated to one of the original members and Virginia Conservation. In March 2006, the Virginia Department of Taxation provided the credit beneficiaries, Virginia Conservation and the original member, with a letter regarding the credits and indicating the credits were "effective" in 2005. Soon after, the escrowed funds were released to Route 231.

On March 17, 2010, the IRS issued an FPAA for Route 231's 2005 tax year, asserting the partnership had failed to report $3,816,000 in ordinary income earned from the sale of Virginia Conservation easement tax credits.

Under Section 707(a)(2)(B), a partner and a partnership are considered to engage in a disguised sale when: 1) a partner directly or indirectly transfers money or property to the partnership; 2) the partnership transfers money or property to the partner in return; and 3) the two transfers taken together are more properly characterized as a sale or exchange.

Although the parties agreed that Virginia Conservation transferred money to Route 231, Route 231 argued that it did not transfer property to Virginia Conservation because the Virginia tax credits "retained their character as potential reduction of taxes." The Tax Court referenced Fourth Circuit precedent (Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011)), which indicates that determining whether an item constitutes property is a hybrid federal and state law question — state law determines which items belong to the taxpayer and federal law determines whether these items qualify as property for tax purposes. In that case, the Court of Appeals concluded that Virginia historic rehabilitation tax credits constituted property transferable under Section 707 because they were valuable and carried essential property rights. The Tax Court found the facts in Virginia Historic to be substantially similar to the facts at issue in Route 231. The Tax Court stated that it would follow the Virginia Historic Tax Credit Fund case in light of the fact that it was "squarely on point" and that, if the court were to rule contrary to that opinion, its "reversal upon appeal is inevitable" (citing Golsen v. Commissioner, 54 T.C. 742 (1970), aff'd, 445 F.2d 985 (10th Cir. 1971)).

To determine whether the transfers between Route 231 and Virginia Conservation constituted a sale or exchange of property, the Tax Court considered: whether, but for Virginia Conservation's transfer of $3.8 million, Route 231 would have transferred the $7.2 million in tax credits to Virginia Conservation; and whether Route 231's transfer depended on the entrepreneurial risks of Route 231's operations (Treas. Reg. Section 1.707-3(b)(1)). The Court found the "but for" test (Treas. Reg. Section 1.707-3(b)(1)(i)) was satisfied, and that the transfer of tax credits did not depend on Route 231's operations.

Applying a facts-and-circumstances test to the non-simultaneous transfer under Treas. Reg. Section 1.707-3(b)(2), the Tax Court concluded that the transfers between Route 231 and Virginia Conservation constituted a disguised sale under Section 707(a)(2)(B). Specifically, the Tax Court noted that: (i) the timing and amount of the sale were determinable within reasonable certainty when Virginia Conservation made its transfer (Treas. Reg. Section 1.707-3(b)(2)(i)), (ii) Virginia Conservation had a legally enforceable right to receive the Virginia tax credits (Treas. Reg. Section 1.707-3(b)(2)(ii)), and (iii) Virginia Conservation's right to receive the credits was secured (Treas. Reg. Section 1.707-3(b)(2)(iii)) because Route 231 and its members had guaranteed that Virginia Conservation would receive a refund if the Virginia tax credits were not obtained by Route 231. Additionally, when it became clear that Virginia Conservation would receive fewer tax credits than it had been promised, one of the Route 231 members loaned a portion of his tax credits to Route 231 that the partnership needed to complete the promised transfer to Virginia Conservation (Treas. Reg. Section 1.707-3(b)(2)(v)). Also, the number of credits transferred was large in relation to Virginia Conservation's interest in the partnership and was tied to the amount of money Virginia Conservation contributed (Treas. Reg. Section 1.707-3(b)(2)(ix)). Finally, Virginia Conservation had no obligation to return or repay the tax credits to Route 231 (Treas. Reg. Section 1.707-3(b)(2)(x)).

Finally, the Tax Court considered whether the transaction at issue constituted a disguised sale for 2005 or 2006. Citing state law in effect in 2005, the Court rejected the petitioner's contention that Route 231 could not have sold the Virginia tax credits in 2005 because it did not register the credits with the state until 2006. The Court noted that Virginia's statutory requirements applicable to Virginia tax credits changed in 2006 for conveyances made after January 1, 2007.

To determine the date of the disguised sale, the Court applied a facts-and-circumstances analysis, ultimately concluding that Route 231 sold the Virginia tax credits to Virginia Conservation in 2005. The Tax Court also pointed out that, even if Route 231 had not completed the disguised sale in 2005, as an accrual-method taxpayer, it would have had to report the income in 2005. The Court rejected the petitioner's assertion that the all-events test was not satisfied until 2006.

The petitioner timely appealed the Tax Court's ruling. For a full discussion of the Tax Court's ruling, see Tax Alert 2014-517.

Fourth Circuit ruling

On appeal, Route 231 argued that the Virginia tax credit transaction with Virginia Conservation constituted a nontaxable capital contribution, followed by a permissible allocation of partnership assets to a bona fide partner. Alternatively, Route 231 asserted that the transaction occurred in 2006 and not 2005 and that the IRS could not adjust income in that year because 2006 was a closed tax year.

Route 231 took issue with the Tax Court's reliance on Virginia Historic in the application of Section 707 and sought to distinguish its transaction from what occurred in that case. Route 231 contended that the language of the Virginia Historic case limited that decision to sham partnerships that "ceased to exist as soon as the credits were transferred" and that the "disguised sale rules do not apply to a valid partnership with economic substance like Route 231." Route 231 argued that Virginia Conservation remained a bona fide partner in an ongoing partnership and the transfer of tax credits was "simply an allocation [of partnership assets] among partners, and not a sale of property by a sham entity to transitory investors," so Section 707 should not apply.

The Fourth Circuit disagreed and stated that Section 707 goes to the bona fides of a particular transaction, not to the general status of the participants to that transaction. The Court noted that, by its plain terms, Section 707 applies to designated transactions between otherwise valid ongoing partnerships and their legitimate partners. Further, the appellate court noted that, in Virginia Historic, the Court expressly did not analyze whether the partnership itself was legitimate, nor did it limit Section 707's scope to sham partnerships.

In concurring with the Tax Court's analysis and its conclusion, the Fourth Circuit held that the Virginia tax credits are "property" for purposes of Section 707 and, because the exchange of tax credits for money occurred within two years, the presumption that the transaction was a disguised sale arises unless the "facts and circumstances clearly establish" otherwise. In this regard, the Fourth Circuit concluded that the Tax Court had correctly determined, under its facts-and-circumstances analysis, that the parties' transaction was a sale under Treasury Reg. Section 1.707-3(b)(1) and that the Tax Court did not err in finding that "Route 231 would not have transferred $7,200,000 of Virginia tax credits to Virginia Conservation but for the fact that Virginia Conservation had transferred $3,816,000 to it" and vice versa. Virginia Conservation's right to the tax credits depended on fixed contractual terms, not the entrepreneurial risks of Route 231's operations.

The Fourth Circuit also upheld the Tax Court's decision that Route 231's income was reportable in 2005, rather than 2006, because Route 231 was bound by its representation on its 2005 federal tax form that it received $3,816,000 from Virginia Conservation in 2005. Citing Wichita Coca Cola Bottling Co., in which the Fifth Circuit concluded that, if a taxpayer mistakenly "represented a transaction as to defer taxation on it to a later year, he ought not, when the time for taxation under his view of it comes, to be allowed to assert the tax ought to have been levied in the former year if it is then too late so to levy it," the Fourth Circuit concluded that Route 231 could not claim that its transaction occurred in a different year than the partnership had represented, as it was too late to require Route 231 to report it as income in the later year, 2006.

Beyond the consistency requirements, the Fourth Circuit held that the Route 231 record demonstrated the sale of Virginia tax credits in fact occurred in 2005 and that Virginia Conservation had the legal right to the credits under the benefits and burdens of ownership test, as it had legal title, an equity interest in, and the right to possess the tax credits as soon as Route 231 earned them in 2005; thus, any actions taken in 2006 were mere formalities.

Implications

The Fourth Circuit agreed with the Tax Court's finding that the state tax credits (which were allocated in a percentage different from the profit- and loss-sharing percentages) were property and applied the disguised sale rules to a situation in which one partner contributed cash and received partnership property within two years. While the overall analysis was very similar to the lower court's, the Fourth Circuit specifically addressed the presence of an indemnification clause and the limited financial resources of the guarantors:

We reject Route 231's argument that the amended operating agreements' indemnity clause should not serve as proof that Virginia Conservation's right to the tax credits or their value was secured. Route 231 contends that the indemnity clause did not fully protect [it] from partnership risks' because Route 231, Carr, and Humiston had minimal available assets should any one of them have been required to pay Virginia Conservation in satisfaction of the indemnity obligation. That argument misunderstands the relevant factor, which is whether 'the partner's right to receive the transfer of money or other consideration is secured in any manner[.]' 26 C.F.R. Section 1.707-3(b)(2)(iii). The regulation only asks whether the secured right exists, not whether there is a risk that the secured party may not in fact be able to collect on a judgment for breach of contract at some point in time.

The Appeals Court case illustrates a continuing focus on disproportionate allocations of state tax credits and how the courts continue to view the disguised sale rules as relevant in the analysis of partnerships allocating such credits, particularly when the amount of credit an investor receives is essentially locked in relative to its contribution.

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