Monday, February 27, 2012

Certain transactions can be construed as “disguised sales” under federal tax law (Virginia Historic Tax Credit Fund 2001, LP v. Comm., Cite as 107 AFTR 2d 2011-1523)

Developers, investors, and professionals beware... last year's decision by the Fourth Circuit Federal Court of Appeals involving Virginia state tax credits has game-changing implications for the tax credit industry. 

The state of Virginia has a program where it uses tax credits to provide an incentive for developers to renovate and rehabilitate historic property. Once the state approves and certifies the renovation, the developer becomes eligible for tax credits for up to 25% of expenses incurred, which can offset state tax liability. A partnership can allocate the tax credit disproportionately among the limited partners.

The principals in this case created funds structured as four linked partnerships that would then partner with historical property developers. The funds would provide capital for completed projects and, in exchange, receive state tax credits from the developers. These tax credits would then be used as incentives to solicit investors to become limited partners in the funds - in exchange they would be allocated a proportion of the tax credits. In practice, these limited partners would own a .01% interest in the funds and were explicitly told that they would not receive “any material amounts of partnership income or loss.”

From November 2001 to April 2002, investments in fifteen different projects generated an investment/tax credit ratio of $0.55 on the $1.00. In May 2002, the fund owners bought out all the investors for .1% of their contributions.

The principals of the linked funds reported the transactions as “partnership expenses.” The Commissioner characterized the transactions as disguised sales for the following reasons:

  • The investors were not “bona fide partners” in the funds, but rather mere purchasers. 
  •  The transactions between the partnerships and investors were “disguised” sales under I.R.C. § 707.

Something is considered a sale under § 707 if: (1) the transfer of money “would not have been made but for” the transfer of property in exchange; and (2) the later transfer “is not dependent on the entrepreneurial risks of partnership operations.”


The Appeals Court held that even if they accept that the investors were bona fide partners, the transactions were still “disguised sales.” The credits were considered property for federal tax purposes. The “allocations” of credits to the “limited partner” investors were really transfers of something valuable in exchange for money. The partnership status of the investors was “transitory” in nature, and the receipt of credits was not dependent on the success or failure of the partnership ventures.

Practical Result:

The holding in this case resulted in bad results for everyone involved.  The sale of the tax credits by the funds were treated as sales of capital assets in which they had no basis, such that all of the contributions recieved from investors were treated as taxable capital gains.  The investors were treated as having a basis in the tax credits equal to the amount of their investments, so when they utilized the credits to offset their state income, they also were taxed on capital gains to the extent the value of the credits exceeded their investments.  This result may diminish the value of the credits and hurt the market over time.

The important point to take away from the case is that the court was important to note that the Court's ruling was very narrow and was based on the particular facts of the case, with special attention being given to the structure of the partnership entities in which the investors contributed their investments.  These entities could have been structured in a different way that would likely not have given rise to the disguised sale treatment.  Any transaction involving the allocation of state tax credits to investors in exchange for capital should be carefully structured to avoid this result.

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