Bifurcated Deal U.S. Court Upholds Taxpayer in Virginia Case
By Caitlin Jones
5 min read
Tax Credit Advisor, February 2010: Industry practitioners have welcomed a recent U.S. Tax Court decision upholding the structure and substance of a transaction involving Virginia state historic tax credits against a challenge by the IRS.
If the ruling stands, some believe it will lead to similar structures for future transactions involving “allocated” state tax credits, including those in combination with federal tax credits, such as low-income housing, historic rehabilitation, and new markets.
“It was an outstanding result for our industry,” said Boston tax attorney William Machen, a partner in the law firm of Holland & Knight LLP.
It isn’t clear what if any action the IRS will take in the wake of the Tax Court decision (T.C. Memo 2009-295, 12/21/09). Options include seeking a review by the entire Tax Court rather than a memo decision issued by one judge; appealing to the Circuit Court of Appeals; acquiescing in the decision; or not appealing but continuing to mount similar future challenges.
“It’s not clear precisely what this does [now] to the marketplace,” said Boston tax attorney Forrest Milder, of Nixon Peabody LLP. He predicted industry participants will wait to see how the case “shakes out” and what the legal community does before structuring tax credit deals based on the structure in the Virginia case. However, he said, “If the IRS acquiesces in this ruling, I would expect that virtually all transactions will switch to this model.”
The decision is significant because the Tax Court affirmed the validity of a transaction in which a limited partnership was created that was allocated all of the Virginia state historic tax credits generated by multiple operating partnerships set up to develop individual historic tax credit projects, but that had a very small interest in the federal tax items. In addition, individual investors in the state credit partnership were involved for less than a year, in some cases just weeks. After receiving the state tax credits the investors reportedly disposed of their interests in the partnership for a nominal amount and claimed a federal tax deduction for a capital loss.
IRS Arguments, Court Response
The IRS had contended that the investors, for various reasons, were not truly partners in the partnership for federal tax purposes, and that the exchange of cash from the state credit partnership (capital contributions from investors) to the operating partnerships for state historic tax credits was actually a sale of the tax credits, producing taxable income to the partnership. Alternatively, the Service argued, if the investors were partners, then the transaction was a disguised sale.
The Tax Court rejected all of the IRS’ arguments, and held that:
- The investors were partners for federal tax purposes, rather than purchasers of state tax credits; and,
- The transactions between the investors and the partnerships were not disguised sales.
The court held that the investors were partners, based on: the existence and contents of various agreements (partnership, subscription, option) between the investors and partnerships; the conduct of the general partner and the investors; statements by the investors; and testimony by disinterested parties. The court said that the investors and partnerships were engaged in a valid business purpose (i.e. to obtain the state historic tax credits and to facilitate historic rehabilitation projects) that had economic substance.
Washington, D.C. tax attorney Jerry Breed, a partner in Bryan Cave LLP, called the decision “very favorable.”
Breed and the other two attorneys suggested that the primary benefit of the decision is to give investors in deals that utilize allocated state tax credits more comfort regarding the tax risk of such transactions. A common benchmark that has evolved for the structure of deals has been for investors to have at least a 1% interest in all tax items, and to be in the deal for at least three years. Practitioners noted that if the Virginia decision had gone in favor of the IRS, investors and sponsors might worry even about the tax risk of deals that meet these industry benchmarks, let alone transactions where investors have a smaller interest and are in the deal for a shorter period.
Breed noted that added comfort from the ruling is not only for state tax credit investors but also for investors receiving the federal tax credits in “bifurcated” deals where the state and federal tax credits are allocated to different investors. Were a state credit investor to be disallowed a federal tax deduction for a capital loss claimed for its disposed partnership interest, the tax benefits to the federal credit investor could also be scaled back from projected levels. “The federal [credit] investor community should take some substantial comfort from this decision,” said Breed.
Practitioners are also awaiting a Tax Court ruling – expected soon – in a second, major case raising similar issues involving a claim of federal historic tax credits for the renovation of the old convention center building in Atlantic City, N.J.
(Virginia Historic Tax Credit Fund 2001 LP, et al v. Commissioner of Internal Revenue, T.C. Memo 2009-295, posted at http://www.ustaxcourt.gov/InOpHistoric/virginiahistoric.TCM.WPD.pdf)
