State tax credits were sold, and the sponsor should have reported income from the sale rather than treated the state credits merely as allocated by a partnership to a tax equity partner, the US Tax Court said in February.

Two individuals formed a partnership in 2005 to acquire two tracts of land near Albemarle, Virginia. The properties were Castle Hill, which was 1,203 acres and had a manor house dating to 1764, and Walnut Mountain, which was 345 acres. The two individuals formed a partnership and contributed $2 million each. The partnership, called Route 231, bought both properties in June 2005 for $24 million after borrowing the rest of the purchase price from a bank.

Virginia allowed a tax credit for 50% of the value of any conservation easements donated by property owners to conservation agencies. On December 30, 2005, the partnership contributed a conservation easement in Castle Hill to the Nature Conservancy that an appraiser said was worth $8.8 million. It contributed a conservation easement in Walnut Mountain to the Albemarle County Public Recreational Facilities Authority and contributed its remaining ownership position in Walnut Mountain to the Nature Conservancy (after selling about a sixth of the property a month earlier to an individual). The appraiser said these two contributions were worth $7.3 million. 

Under Virginia law, any partner allocated conservation credits by a partnership can sell the unused tax credits to a Virginia taxpayer. 

Another partnership called Virginia Conservation was interested in the credits. It became a partner in Route 231 in late December 2005. Route 231 allocated it 1% of income and loss and most of the Virginia conservation credits. The two individuals who originally formed Route 231 became 49.5% partners. The amended Route 231 partnership agreement required Virginia Conservation to contribute 53¢ to Route 231 for each dollar of Virginia tax credits allocated to it. The agreement said the credits were expected to be in the range of $6.7 to $7.7 million. It allocated the first $300,000 to one of the two individuals and the rest to Virginia Conservation. The two individuals agreed to indemnify Virginia Conservation if the tax authorities disallowed any of the tax credits allocated to Virginia Conservation.

The two individuals also had an option to purchase Virginia Conservation’s interest at any time after January 1, 2010. The option had not been exercised at the time of trial.

A lawyer for Virginia Conservation sent the two individuals a letter on December 31, 2005 to say that the credits were $84,000 short of what Virginia Conservation expected in view of its capital contribution. The individuals promised to replace the shortfall in credits in 2006, but there were no more charitable donations in 2006.

Route 231 filed a partnership return for 2005 that allocated $215,983 in credits to one of the two individuals and $7.2 million in credits to Virginia Conservation.

The IRS asserted in March 2010 that Route 231 failed to report ordinary income of $3.8 million in 2005 from the “sale” of tax credits. It said the $3.8 million that Route 231 received from Virginia Conservation was income to the partnership. IRS regulations presume that where one partner contributes cash and is distributed property by the partnership within two years, the partner really bought the property from the partnership.

Route 231 argued that there was an allocation of tax credits and not a “distribution” of “property,” but the US Tax Court disagreed. It said the evidence points to a purchase of tax credits. The amount contributed was tied to the amount of tax credits. What Virginia Conservation received in exchange for its capital contribution was not dependent on the entrepreneurial risk of a business. There was no indication that Virginia Conservation even considered Route 231’s business operations before it agreed to contribute a substantial sum of money.

The case is called Route 231, LLC v. Commissioner.

The IRS complained about similar transactions in an internal legal memo in 2007. It said that entities like Virginia Conservation dress up transactions that are essentially bare purchases of tax credits to look like partnership allocations in order to claim a capital loss for the capital contributions of X¢ per dollar of tax credit when the sponsor repurchases the tax equity investor’s partnership interest. The internal IRS memo is  AM 2007-002.

If Virginia Conservation bought tax credits, then it would have a gain for federal income taxes equal to the difference between the full credit and the 53¢ it paid when it used each credit to offset Virginia income taxes, since it would be treated as using “property” — the credits — to pay its Virginia income taxes. It would be able to deduct the full taxes on its federal income taxes, notwithstanding that it did not actually pay the taxes due to the credits.