Some sales of state tax credits are running into trouble with the IRS.

The IRS national office said it has trouble with partnerships that are being used to transfer state tax credits to investors who invest in the partnerships solely for the tax credits. The agency criticized the transactions in an internal legal memorandum.

Some states allow certain tax credits to be sold directly for cash to taxpayers who can use them. Other states do not. The IRS said that promoters are forming partnerships of investors to buy unused state tax credits. In states where the credits can be sold directly, the partnerships use cash contributed by the investors to buy the credits. The promoter is a partner and has an option to repurchase the investor interests for fair market value as soon as the tax credits have been claimed. That value is expected to be close to nil since the partnerships have no other business. When their interests are repurchased, the investors deduct the amount each contributed to buy the tax credits as a capital loss.

In other states where unused credits cannot be sold, the investors are brought into a partnership with the company whose tax credits are being transferred.

The internal legal memorandum is AM 2007-002.

The IRS said in the memo that it does not believe the investors are real partners since they are not engaged in a joint business undertaking with the aim of sharing profits.

It said any investor whom a state allows to claim credits anyway has bought a form of property. If he then uses the credits to reduce his state taxes, he has effectively cashed in the property and used the proceeds to pay his state income taxes. He will have a gain from disposition of the property, or tax credit, if the face amount of the credit exceeds what he paid for it.

He should also have a federal tax deduction for the state income taxes paid with the credit. However, the IRS said that most investors in the partnerships cannot use the tax deductions because they are on the alternative minimum tax.

Keith Martin