Tax reform is a current topic in the news and on talk shows. All agree that the Internal Revenue Code is complicated and there are two cases in the historical tax credit area that illustrate this point and the risk one faces in entering into a tax credit deal.
Virginia Historic Tax Credit Fund 2001 LP v. Comr., 639 F.3d 129 (CA-4 2011), the Fourth Circuit Court of Appeals treated the funds paid by the investors to the partnership as a taxable sale rather than a tax-free contribution by partners. At the level below (Tax Court), the IRS argued that the investors were not partners, but lost on that point. The Court of Appeals did not disturb the lower court’s ruling on that issue; instead, the Court held the transfer of state credits was a disguised sale. A transaction between a partnership and a partner may be treated as a transaction between a partnership and one who is not a partner. The income tax consequence is that the investor’s tax-free contribution of capital to the partnership is transformed into gross sales proceeds to the non-contributing partners. Thus, the tax-free transaction is scuttled. Prior to this decision, most viewed qualifying as a partner to be enough to secure the credit.
The upper court held that the state tax credits were property for federal tax purposes and this upset a long-standing notion between transferrable and non-transferrable state tax credits. A credit that cannot be transferred is allocated to partners. A credit that can be transferred is property once transferred and causes gain to be recognized equal to the difference between the tax liability satisfied by the credit and the amount paid to obtain it. A federal income tax deduction results from the use of the credit to pay tax. (An argument was also made that the state credit is not property because the Virginia credit was not transferable and IRS cannot exert a meaningful lien.)
In Historic Boardwalk Hall, LLC 694 F.3d 425 (CA-3. 2012) Third Circuit Court of Appeals held that the tax credit investors were not true partners. In the decision being appealed, the Tax Court' ruled the transactions had economic substance and allowing the investor to invest in the hall's rehabilitation was legitimate. The Tax Court held that the investor had project risk and was a bona fide partner. The Third Circuit held that the investor had no meaningful downside risk because it recoup contributions it had made to the partnership. The court added there was no upside potential for the investor. Cases use many factors to determine if one is a partner.
Who is a true equity partner?
Who is a true equity partner? Consider some of the following points. The Second Circuit case of TIFD III-E, Inc. v. U.S., 459 F.3d 220 (CA-2, 2006), popularly known as "Castle Harbour", held that foreign banks' purported partnership interest were a secured lender's interest unaffected by poor performance or by extraordinary profits. In both tax credit cases, the courts found no realistic relationship between the investment amount and the percentage of ownership. If there is no true participation in profit or risk of loss, the disproportionate allocation of credits will not be respected.
Although there is a revenue procedure safe-harbor, the area is not for the timid.
Do you have any questions? Would you like to discuss the matter further? If so, please contact me, James McDonough, at 201-806-3364.