June 20, 2010
The Tax Court and the U.S. District Court in New Jersey recently issued the first two opinions construing I.R.C. section 707(a)(2)(B), which is somewhat remarkable given that the partnership disguised sale rules have been on the books since 1984. See Va. Historic Tax Credit Fund 2001 LP v. Comm’r, T.C. Memo 2009-295; United States v. G-I Holdings Inc. (In re: G-I Holdings, Inc.), 2009 U.S. Dist. LEXIS 115850 (D.N.J. Dec. 14, 2009). The Government has appealed the Tax Court’s decision in Virginia Historic to the Fourth Circuit.
In Virginia Historic, the Tax Court rejected the IRS’s challenge to the use of partnerships as marketing vehicles for state tax credits. Under Virginia law, taxpayers can receive tax credits for investment in historical renovation projects. The tax credits are made available to stimulate investment in such projects because they are often unprofitable, and as a result, financing for the projects is often difficult to obtain. Because of restrictions on the direct transfer of the tax credits, the taxpayers in this case set up several investment partnerships that pooled funds from many investors and then contributed the funds to several lower-tier developer-partnerships. In exchange for investment in the developer-partnerships the upper-tier partnerships received partnership interests that entitled them to tax credits generated by specific projects. The tax credits would then be pooled by the upper-tier partnerships and distributed to the investors. The IRS took the position that the scheme was a disguised sale of tax credits in exchange for the investors’ cash.
In a memorandum opinion by Judge Kroupa, the Tax Court rejected the IRS’s disguised-sale contention largely on the basis that the investments were subject to the entrepreneurial risks of the enterprise. There was a possibility that developers would not complete the projects on time or in a manner acceptable to the state agency overseeing the projects, which placed receipt of the tax credits at risk. There was also the possibility that the upper-tier partnerships would not be able to pool sufficient credits to be able to make all of the promised distributions. Although distribution of the credits was guaranteed by the partnerships, there was no guarantee that the partnerships would have sufficient resources to make the investors whole. Accordingly, the court held that the investors’ capital was sufficiently at risk in order to avoid disguised sale treatment. Significantly, the degree of risk associated with the acquisition of state tax credits was relatively small, especially given that the investment partnerships spread risk through the pooling of resources and the dispersion of those resources over many developer-partnership projects.
The government has filed its opening brief. The taxpayer’s brief in response is due July 26, 2010. We will continue to monitor the case and post the briefs as soon as they are available.
The district court in GI-Holdings, by contrast, did apply the disguised-sale rule of Code section 707(b). The unpublished decision, linked below, contains a detailed discussion of the issue, but it is not yet an appealable order. Proceedings in the district court have been stayed until September 2010, but there is a strong possibility that the case will be appealed to the Third Circuit after the remaining issues are resolved in the district court.