State Tax Credit
State tax credit deals were helped by a US Tax Court decision in December.
The court said investors in a partnership who wanted state tax credits and made capital contributions to the partnership of 74¢ for each dollar of tax credit they were allocated were real partners, even though they expected nothing more out of the partnership than the tax credits.
The IRS argued that the partnership made a bare sale of the tax credits to the investors and the other partners should have reported the “capital contributions” from the partners as income.
The court said no.
The case is important because it makes it easier for developers pursuing projects in states that offer state tax credits to keep more of the cash they raise by bartering the tax credits for cash.
The United States encourages renewables projects by offering large subsidies. Few developers can use them. Most end up bartering the tax subsidies in the “tax equity” market in exchange for capital to build their projects. However, national tax equity investors are usually unwilling to pay anything for state tax subsidies. In some states, the state subsidies can be transferred separately to a local tax equity investor.
What the Tax Court decision makes clear is that how the state allows its credits to be transferred is key. The case involved tax credits in Virginia that the state let partnerships specially allocate to local investors in a different ratio than partnership income and loss are allocated and cash is distributed. The case sheds no light on the tax treatment in states that allow overt sales of state tax credits.
Three individuals set up a large partnership to renovate historic buildings in Virginia. The federal government offers a tax credit for 20% of the amount spent on renovating certified historic structures. The federal tax credits were shared by partners in the partnership in the same ratio they shared in other partnership items. Virginia also offers a tax credit for up to 25% of eligible spending. However, it lets the partnership allocate the state credits however the “partners mutually agree.”
The partnership allocated all the state credits to local investors who made capital contributions at inception in exchange for the future credits. The partners expected little else from the partnership, and would have received part of their capital back, as well as other compensation, if the tax credits were worth less than expected. The local investors had a 1% interest in partnership income and losses.
The IRS argued the local investors were not real partners. The Tax Court disagreed. It said they had an intention to join with the other partners in pooling capital for a business purpose of rehabilitating historic buildings.
The IRS argued the investors had to expect a profit apart from tax benefits; the government routinely sets aside transactions that lack a business purpose other than to reduce taxes. The court disagreed; it said the IRS overlooked a “critical distinction,” which was the cases the IRS had in mind involved federal taxes and this was a case of investors trying to reduce state taxes, which it said is a valid business purpose “as long as the reduction of non-Federal taxes is greater than the reduction of Federal taxes.” It also suggested it does not make sense to require investors engaged in an activity that the government is trying to promote through tax incentives to show the incentives were not what motivated them.
The decision may not be the last word. The case is Virginia Historic Tax Credit Fund 2001 LP v. Commissioner. The Tax Court released its opinion on December 21. The IRS has until late February to appeal.