A Tax Equity Investor
A TAX EQUITY INVESTOR who made capital contributions to a partnership in exchange for being allocated state tax credits bought the tax credits, and the sponsor had to report the capital contributions as income, the US Tax Court said.
The capital contributions were 53¢ per dollar of tax credit. The court reached the same conclusion in another case last year.
An individual bought a 674.5-acre farm in Albemarle County, Virginia, 10 miles south of Charlottesville, in 2001. In 2005, he promised a local public interest group that the land would remain undeveloped by giving the group a “conservation easement” over the property.
Virginia allowed a tax credit for 50% of the fair market value of any such easement. However, no taxpayer could claim more than $100,000 in credits in the year the easement was donated, and then another $100,000 in each of the next five years for $600,000 in total. Any unused credits could be sold or transferred to another taxpayer. A market developed in them over time.
One had to file a form and an appraisal with a state agency, which would then issue an acknowledgement letter and an “LP number” identifying the tax credits. The letter had to be attached to tax returns. The LP number had to be used for any transfer.
The taxpayer did a deal with the Virginia Conservation Tax Credit Fund LLLP in late 2005. The fund planned to contribute 53¢ per dollar of tax credit expected to a partnership. (The individual landowner owned the farm through a corporation. The farm was in a disregarded subsidiary of the corporation. When the fund made the capital contributions for the tax credits, they turned the disregarded subsidiary into a partnership.)
The fund made capital contributions for 53¢ per dollar of projected tax credits to the partnership. The partnership allocated the fund 1% of income and distributed it 1% of cash, but otherwise allowed it all the tax credits less $300,000 that were reserved for the sponsor. The sponsor guaranteed the fund that it would receive $3,050,000 in tax credits and agreed to indemnify the fund for any loss or disallowance of the projected credits. In fact, the tax credits turned out to be more after an appraisal delivered in late 2005 suggested the easement was worth more than expected.
The parties allocated the extra tax credits to the fund without bothering to amend the partnership agreement. The fund increased its capital contribution from $1,616,500 to $1,802,000 to account for the extra tax credits.
The capital contributions were put in an escrow account held by a lawyer hired to implement the deal. The money was not released from escrow to the sponsor until mid-2006 as the fund did not authorize the release until then. The state did not issue a letter confirming the tax credits and assigning an LP number until March 2006. The lawyer did not file the paperwork until 2006.
Meanwhile, 35 individual investors purchased from the fund tax credits of $2,420,000 that they claimed on their 2005 returns.
The sponsor had an option to buy back the fund’s 1% interest for fair market value starting in 2010.
The IRS treated the transaction as a disguised sale of tax credits by the sponsor and said the $1,802,000 in capital contributions by the fund should have been reported as income by the sponsor in 2005.
The US Tax Court agreed.
A disguised sale occurs where one partner contributes property to a partnership and the other contributes cash, and then the cash is distributed to the partner who put in the property. There is a presumption that the two events are linked if the distribution to the partner contributing the property occurs within two years.
The sponsor argued that there was no sale of tax credits; rather the partnership simply allocated the fund an agreed share of tax credits in the fund’s capacity as a partner.
The court said no. It saw money going into the partnership and then going out within two years to another partner who contributed property. It said a number of factors made this transaction essentially a sale of tax credits.
They included that there would have been no transfer of cash but for the amount of tax credits delivered. The fund had no entrepreneurial risk; the amount of tax credits was known at the start. The amount was guaranteed by the sponsor. The fund could get its money back to the extent the amount of tax credits fell short. The share of tax credits to the fund was disproportionately large in relation to the fund’s interest in partnership profits.
The court said the “economic benefit theory” required the sponsor to report the income in 2005, despite not being paid the cash until 2006. A taxpayer must recognize income in the year in which any economic or financial benefit is conferred. The sponsor benefited in 2005 because the cash was irrevocably set aside in escrow for the sponsor that year and was beyond the reach of the fund’s creditors. Substantial restrictions on release of the money would have prevented the income from having to be reported in 2005, but in this case, only ministerial tasks remained before distribution.
The case is SWF Real Estate LLC v. Commissioner. The Tax Court released its decision in early April. Courts have treated other partnership transactions as sales of state tax credits in at least two other cases. (For earlier coverage, see the June 2011 NewsWire article and the April 2014 NewsWire article.)
by Keith Martin in Washington