United States: Fourth Circuit Affirms Tax Court On Disguised Sale By Partnership Of State Tax Credit

In Route 231, LLC, et. al v. Commissioner, No. 14-1983 (4th Cir. 2016), the U.S. Court of Appeals for the Fourth Circuit affirmed on Jan. 8 the Tax Court's decision that the taxpayer (Route 231) should have reported the amount it received from one of its members as gross income from a disguised sale of state tax credits under Section 707(a)(2)(B), rather than as a capital contribution.

Route 231 was formed in May 2005 as a limited liability company that reported as a partnership for U.S. federal income tax purposes. Each of two individual partners, John Carr and Raymond Humiston, contributed $2.3 million for a 50% membership interest. Shortly thereafter, Route 231 purchased land in Virginia. In 2005, the Commonwealth of Virginia offered state income tax credits (tax credits) equal to 50% of the fair market value of land located in Virginia that was donated to a public or private agency for conservation or preservation purposes. Route 231 wished to donate some of its property and hired a consultant to assist with the process.

On Dec. 27, 2005, Route 231 amended its operating agreement to add Virginia Conservation Tax Credit FD LLLP (Virginia Conservation) as a member with a 1% membership interest (with Humiston and Carr's interests each being reduced to 49.5%). The amended operating agreement stated that Virginia Conservation agreed to make an "initial capital contribution" of $500 plus 53 cents for each $1 of the expected tax credits allocated to it. Route 231 anticipated it would earn tax credits in the range of $6.7 million to $7.7 million as a result of the proposed conservation donations. Carr would receive $300,000 in tax credits and Virginia Conservation would receive the remainder.

On Dec. 30, 2005, Route 231 recorded deeds conveying conservation donations related to the properties it had purchased, as well as a fee interest in one of the properties, subject to the conservation easement. The total value of the donations was approximately $16.1 million. In March 2006, the Virginia Department of Taxation informed Route 231 of the final amount of the tax credits generated, indicating the tax credits were effective in 2005. Virginia Conservation's receipt of the tax credit was handled through an escrow to which Virginia Conservation deposited $3,816,000.

Route 231's 2005 partnership tax return indicated that the members had made cash contributions of $8,416,000 to Route 231, which included the $3,816,000 amount that Virginia Conservation had paid into escrow. The IRS examined the partnership and ultimately issued a final partnership administrative adjustment (FPAA) indicating that the $3,816,000 payment was improperly characterized as a capital contribution and was instead a disguised sale of property by Route 231 to Virginia Conservation. The Tax Court upheld the IRS's position that a disguised sale of property had occurred in 2005.

Section 707(a)(2)(B) provides that if a partner to a partnership transfers money or property and subsequently takes a distribution of the money or property, the two transactions, when viewed together, are properly characterized as a sale or exchange. Based on Treas. Reg. Sec. 1.707-3(b)(1), such a combination of transfers constitutes a sale of property by a partner to a partnership if the "transfer of money or other consideration would not have been made but for the transfer of property," and the "subsequent transfer is not dependent on the entrepreneurial risks of partnership operations." A presumption of sale exists if such transfers between a partner and a partnership occur within a two-year period "unless the facts and circumstances clearly establish that the transfers do not constitute a sale" (Treas. Reg. Sec. 1.707-3(c)). Treas. Reg. Sec. 1.707-6 also provides for disguised sales of property by a partnership to a partner.

In its appeal, Route 231 argued that no disguised sale of property had occurred. Route 231 specifically took issue with the Tax Court's reliance on a previous Fourth Circuit case, Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011), which concluded under similar facts (though the recipients of the state tax credit there were numerous investors) that a disguised sale of property had occurred. In Virginia Historic, the Fourth Circuit assumed, without deciding, that the investors were bona fide partners, but found that the IRS correctly classified the transactions at issue as disguised sales of property by the partnership. Route 231 contended that Virginia Historic's holding should be limited to sham partnerships and that the "disguised sale rules do not apply to a valid partnership with economic substance like Route 231."

Ultimately, the Fourth Circuit determined that the tax credits in Route 231 constituted property within the scope of the disguised sale regulations and that a sale of such property had occurred under those regulations. Additionally, the Fourth Circuit dismissed Route 231's argument that if a disguised sale of property had, in fact, taken place between Route 231 and Virginia Conservation, the sale would have occurred in 2006, which was a closed year for the taxpayer. The Fourth Circuit stated that Route 231 was bound by the representations it made on its 2005 tax return, where it reported that it had received $3,816,000 from Virginia Conservation. As a result, Route 231 was estopped under the duty of consistency from taking an inconsistent position "in an effort to avoid [tax] liability." Aside from Route 231's duty of consistency, the Fourth Circuit added that the sale occurred in 2005 because Route 231 was on the accrual method of accounting and all the events had occurred to establish that a sale had taken place in 2005.

Route 231 illustrates the need to consider whether a purported distribution of property by a partnership needs to be examined for possible recharacterization as a disguised sale of property by the partnership to a partner who makes a transfer to the partnership that in form is labeled a contribution and that is connected to the distribution.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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