In light of the recent Virginia Historic Tax Credit Fund[i] and Historic Boardwalk Hall[ii] it is clear how investors should account for their investments in state tax credit funds. In other circuits in remains unclear how such investments should be taxed because of the conflicting opinions of the Tax Court in both of those cases. Presumably, this offers the potential for flexibility in tax treatment in jurisdictions other than the third and fourth circuit for these items. But in the fourth circuit[iii] there is no ambiguity.
The structure of the proposed tax credit transfer in Virginia Historic was not uncommon, though its facts were horrible. The basic structure involved a partnership holding the credit property which was owned by three members, the GP developer, the federal credit investor and the fund for the state credit investors. The state credit investors basically enjoyed less than .01% of the economics of the project but 99.99% of the state tax credits. This is fairly standard deal structure. With respect to some of the credits in question, state law provided that the credits could only be allocated to partners of the partnership. In fact, under an unusual state law, some but not all of the credits in question could be transferred by the partnership to taxpayers who were not members of the partnership.
All of the contributions of the state credit investors were treated by the recipient fund as capital contributions. Meanwhile the recipient fund expensed the contributions made to the fund holding the credit property to acquire the credits. Not exactly sound accounting theory. The state credits investors also possessed put rights, which they exercised, allowing them to put their interests for a nominal amount back to the partnership approximately a few months after their admission to the partnership but in the following calendar year. The fund’s prospectus stated that the credit investors would expect to receive insignificant allocations of cash flow, profit and loss from the underlying historic tax project. The state credit investors also received guaranties relating to the validity of the credits they were to receive and were not required to make the capital contributions until the credits were certified by the sate of Virginia.
The Tax Court in Virginia Historic found that the substance over form doctrine didn’t result in the credit investors not being partners under the analysis of Culbertson5 — whether ‘‘the parties in good faith and acting with a business purpose intended to join together in the present conduct of an enterprise.’’ In reaching those holdings, the Tax Court looked to several factors, including: (1) the agreement between the parties; (2) the conduct of the parties in executing its provisions; (3) the parties’ statements; (4) the testimony of disinterested persons; (5) the relationship of the parties; (6) the parties’ respective abilities and capital contributions; and (7) the actual control of income and the purposes for which the income was used. None of those factors were cited as controlling; The Tax Court looked at the totality and did not conduct a factor-by-factor analysis. The Tax Court found that the documents characterized the investors as partners and characterized their payments as capital contributions. The agreements gave the investors a right to share in the profits and liquidation rights.
In its analysis, the Fourth Circuit assumed that the credit investors were partners in the fund under state and federal tax law. Its analysis focused on whether the relationship of the credit partners and the credit partnership fit under the notion of a disguised sale under Section 707 as the IRS had argued. The Court noted that 707 applied when there is a transfer of property either shortly before or after the recipient transfer cash to the partnership. It wasted little time in determining that state tax credits are property for tax purposes. It didn’t matter to the Court that the property (i.e. the tax credits) could only be transferred by allocation by the partnership to its members. The court felt this was sufficient transferability to constitute property.
Next, the Court turned to IRS regulations to shape its analysis. It stated that in determining the applicability of Section 707, Section 1.707-3 calls for an evaluation of “all the facts and circumstances” surrounding the transaction to determine whether (i) The transfer of money or other consideration would not have been made but for the transfer of property; and (ii) In cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations. Id. § 1.707-3(b)(1) (emphasis added). The regulation listed ten factors, five of which were determined to be of relevance here and were required to be considered: (i) the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer; (ii) That the transferor has a legally enforceable right to the subsequent transfer; (iii) That the partner’s right to receive the transfer of money or other consideration is secured in any manner, taking into account the period during which it is secured; . .(ix) That the transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits; and (x) That the partner has no obligation to return or repay the money or other consideration to the partnership, or has such an obligation but it is likely to become due at such a distant point in the future that the present value of that obligation is small in relation to the amount of money or other consideration transferred by the partnership to the partner. Id. § 1.707-3(b)(2).
The Court followed up by stating that, § 1.707-3 also sets forth a presumption that all transfers “made within two years” of each other are sales, “unless the facts and circumstances clearly establish that the transfers do not constitute a sale.” Id. § 1.707-3(c). This presumption places a high burden on the partnership to establish the validity of any suspect partnership transfers. The Court then concluded that the transfers were effectively simultaneous or at least not dependent upon the entrepreneurial risks of the partnership. The partnership guarantees and protections offered the state credit partners effectively eliminated any entrepreneurial risk of the state credit partners. Finally, the value of the state tax credits dwarfed the value of the state credit partners’ share of the partnership’s income. This latter amount was guaranteed to be virtually zero because of the minimal call right the partnership had on the interests held by the state credit partners. Given this analysis, the Court concluded that the capital contribution be re-characterized as a disguised sale under Section 707.
The practical ramifications of this decision are limited but important. The section 707 analysis is limited to scenarios where the credits are transferred within one or two years at most, otherwise, the transfer wouldn’t be simultaneous with the transfer to the contribution to the partnership. The case would apply to most funds which attempt to transfer one-year credits. In particular, in those scenarios where the value of the one-year credits are greatly disproportionate in value to the remaining economic interests the credit partner receives this analysis should apply. This would further be reinforced to the extent of guaranties of the credits which extend to the credit investor or otherwise protect the credit investor minimizing the risks of the credit investor. The presence of partnership put and call rights resulting in the liquidation of the credit partners’ interests at minimal values further supports the analysis. The absence of these put and call rights probably does not change the conclusion of the court.
However, if instead the issuing partnership allocates the capital contribution between 707 proceeds and capital contribution such allocation would likely be respected. A 90-10 to 99-1 allocation should suffice. The IRS’s beef in Virginia Historic was that the partnership didn’t recognize income upon the contribution, but did recognize an expense when it paid for the credits. That would not be present if the aforementioned allocations were made. Moreover, allocations in rough approximation with the value of the credits and the value of the partnership interest should be respected. In many instances the partnership has value from an administrative, compliance and recapture avoidance perspective in addition to any cash flow or profit and loss allocations which may be derived. So, in every case that value is not zero.
Structuring the transaction so the credit investor is recognized as a partner for tax purposes is crucial. In many state statutes, the allocation of credits must be to a partner of the partnership. Many states also follow the federal tax characterization of the partner’s status as a partner. By making a relatively small allocation to partnership capital and a disproportionately large allocation to Section 707 credit proceeds which better reflects the substance of the transaction where partnerships attempt to allocate one year credits to credit investors will result in the reporting of the transaction consistent with the Virginia Historic decision.
From the credit investor’s perspective, the IRS’ treatment of the transaction has been clear and consistent for many years.[iv] For transferable credits, which includes those sold under Section 707, the IRS considers them an intangible asset. It has also been established that transferable credits are a capital asset in the hands of the purchaser.[v] The taxpayer’s basis is equal to the portion of the contribution which is allocated to the credits. The credit is deemed to be sold by the investor when the investor files a tax return which uses the credit to offset their state tax liability. The investor is deemed to receive proceeds equal to the face value of the credits used on their return. The investor then reports a capital gain equal to the difference between the deemed proceeds and their basis in the credits. At that same point, the credit investor is deemed to have made a state income tax payment to the state equal to the deemed value of the proceeds (i.e. the face value of the credits used). So, if you assume a state credit investor on August 1, acquires 100,000 credits for $80,000 in the Fourth Circuit, under this allocation approach $79,200 is allocated to the investor’s basis in the credits and $800 to its capital account in the credit partnership. The following April 15 the investor claims and uses the credits on their state tax return. On April 15 of the following year the investor recognizes a $20,800 (100,000 – 79,200) short-term capital gain. On that same April 15, the investor is deemed to have made a state income tax payment of $100,000 deductible under Section 164. Upon the ultimate liquidation of the partnership the credit investor would recover their remaining $800 basis in the credit partnership.
[i] Virginia Historic Tax Credit Fund 2001, LLP v. Commissioner, T.C. memo. 2009-295, Dec. 2009-28093, 2009 TNT 244-23, rev’d, 639 F.3d 129 (4th Cir. 2011). The Fourth Circuit reversed the Tax Court’s ruling that the transaction did not constitute a disguised sale of tax credits, as recharacterized by the IRS under section 707.
[ii] Historic Boardwalk Hall, LLC v. Commissioner, 136 TC 1 (2011), rev;d, No. 11-1832 (3d Cir. 2012).
[iii] The Fourth Circuit includes the states of North Carolina, South Carolina, Virginia, West Virginia and Maryland.
[iv] See PLR 200348002, IRS AM 2007-002, CCA’s 200704028 and 200704030, IRS Memorandum 200445046, and IRS TAM No. 200126005. Also see ILM 201147024.
[v] Tempel v. Comm., 136 TC No.15 (2011).