A Tax Credit Transaction

A Tax Credit Transaction

June 30, 2011 | By Keith Martin in Washington, DC

A tax credit transaction was struck down by a federal appeals court in late March.

Three individuals persuaded 282 investors in November 2001 through April 2002 to invest $6.99 million in a large partnership or fund that used the money, in turn, to buy tiny interests in other partnerships that were renovating historic buildings in Virginia in exchange for state tax credits to which the partnerships were entitled. Virginia allowed a tax credit at the time for 25% of the cost of renovating such buildings.

The fund organizers promised the investors they would receive $1 in tax credits for each 74¢ to 80¢ invested, but that they would receive little else. The fund used the $6.99 million to pay 15 developers $5.13 million to buy $9.2 million in tax credits, or about 55¢ per dollar of tax credit. The rest was profit.

The fund filed a partnership tax return in April 2002 and sent the investors Form K-1s advising each investor what share of the tax credits it could claim. The fund then exercised an option to buy out all the investors for a total of $7,000.

The IRS argued that the fund organizers had used the fund partnership to mask what was a bare sale of tax credits by the fund to the investors. It said the fund should have reported $1.53 million in gain on the sale. The court agreed.

The IRS had argued that the investors were not real partners. The court said it did not have to reach that question because section 707 of the US tax code gives the IRS authority to treat the transaction as a “disguised sale” of the tax credits by the fund to the investors. The fund argued that section 707 does not apply because it only applies to disguised sales of “property” and the particular tax credits are not “property.” The court said the credits are “property.”

The timing and lack of any entrepreneurial risk — the investors paid their money, got the tax credits almost immediately and then were bought out — were fatal. The case is Virginia Historic Tax Credit Fund 2001 LP et al. v. Commissioner. The appeals court released its decision on March 29.