March 31, 2011
On March 29, 2011, the Fourth Circuit rendered its opinion in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, No. 10-1333 (opinion linked below). As described in our previous coverage, the case involved an IRS challenge to the taxpayer’s treatment of partnerships used as marketing vehicles for state tax credits derived from historic rehabilitation projects. Agreeing with the government’s disguised sale theory, the court reversed the Tax Court and ruled that the transactions at issue were taxable sales of state tax credits, as opposed to non-taxable capital contributions followed by partnership distributions.
After quickly dispensing with the taxpayer’s argument that the tax credits received by investors were not “property” under the statute, and skipping over the question of whether the funds’ investors were bona fide partners for federal tax purposes, the court took a decidedly statutory approach to resolving the case by focusing on the disguised sale regime under I.R.C. § 707(b). In applying the statute, the court largely relied on the guidance in Treas. Reg. § 1.707-3, which sets forth a presumption that reciprocal transfers between a partner and a partnership within a two-year period constitute a disguised sale unless facts and circumstances clearly establish otherwise. The regulation also lists ten factors to consider in determining whether the second transfer in a non-simultaneous pair of transfers is “dependent on the entrepreneurial risks of partnership operations.”
In addition to finding that the transfers-within-two-years presumption required the taxpayer to “clearly establish” that the transfers did not constitute a sale, the court focused on five of the Treas. Reg. § 1.707-3 factors. First, the court found the timing and amount of the second transfer (the allocation of tax credits to the investors) were determinable with reasonable certainty at the time of the first transfer (the alleged contributions to capital made by the investors), and each investor knew with specificity the size of the credits that he or she could expect. Second, the investors had legally enforceable rights to the credits per their subscription agreements; they had been promised state credits in exchange for their capital contributions. Third, the investors’ rights to the credits were secured through a promise of refunds if sufficient state credits were not delivered to the investors. Fourth, the transfers of credits to the investors were disproportionately large compared to the negligible (0.01 percent) interest that most investors held in the partnerships. Significantly, in this regard the court found that “the transfer of tax credits to each investor by the partnership had no correlation to each investor’s interest in partnership profits whatsoever.” Finally, the investors had no further obligations or relationship with the partnership after they received their credits. In light of the presumption, the court opined that these factors “strongly counsel for a finding that these transactions were sales.”
Further girding its rationale, the court noted that the taxpayer did not follow the form of the subscription agreements, assigning each investor a 0.01 percent interest regardless of their capital contributions. The Fourth Circuit further noted that the partnership status of the investors was transitory in nature, which echoed a concern expressed in the legislative history to section 707(b). Also, the court noted that the Tax Court did not analyze the factors in Treas. Reg. § 1.707-3 but rather relied on its own analysis of the investors’ level of entrepreneurial risk. As an interesting aside (from a regulatory deference point of view), the court opined that the Tax Court was not bound to “tick through [the factors] mechanically[,]” but was “free to” conduct its own evaluation of risk, because the regulation “simply reflects those characteristics the Department of the Treasury, given its experience and expertise, thinks significant.” Nonetheless, the court found the Tax Court’s independent analysis of entrepreneurial risk unconvincing, viewing the risks cited as “both speculative and circumscribed.” In the final analysis, the court held that the only risk borne by the investors was “that faced by any advance purchaser who pays for an item with a promise of later delivery. It is not the risk of the entrepreneur who puts money into a venture with the hope that it might grow in amount but with the knowledge that it may well shrink.”