U.S. Tax Court Expands Scope of Virginia Historic Credit Case
By Glenn Petherick
4 min read
Two recent decisions by the U.S. Tax Court provide some additional items for thought for parties structuring transactions proposing to utilize certain kinds of state tax credits, according to Washington, D.C. tax attorney Jerry Breed, a partner at Bryan Cave LLP.
The more significant case was a U.S. Tax Court opinion issued February 24 (Route 231, LLC, John D. Carr v. Commissioner of Internal Revenue, T.C. Memo. 2014-30).
According to Breed, the decision is significant because “it’s the first time that we have seen the IRS expand the scope of the Virginia historic credit case and apply it to a [state] tax credit other than a state historic credit…The Court supported and affirmed the IRS’ conclusions that the transaction should be characterized as a disguised sale of state tax credits.”
In the 2011 Virginia case, the U.S. Court of Appeals for the Fourth Circuit overturned a U.S. Tax Court decision and sided with the IRS by ruling that the exchange of Virginia state historic tax credits from investment funds to investors in return for money was not an allocation of tax credits for capital contributions but rather a sale of property by the funds to investors that triggered taxable income for the funds for federal income tax purposes. The Fourth Circuit agreed with the IRS that the transaction should be characterized as a disguised sale under the Internal Revenue Code, after an analysis to determine the presence or lack of 10 factors in federal tax regulations defining a disguised sale. In the Virginia transaction, federal and state historic tax credits were allocated to different investors.
In Route 231, the transaction involved the transfer of Virginia state conservation tax credits. The conservation credit was claimed in the first year, as is the Virginia historic credit.
According to Breed, the Tax Court decision in Route 231 relied on the same disguised sale analysis of the Fourth Circuit in the Virginia historic credit case, while expanding its scope to a different type of state tax credit, the Virginia conservation credit. As a result, Breed suggested that practitioners should perform a disguised sale analysis when structuring new transactions that propose to utilize any kind of “one-and-done” state tax credit – a credit claimed entirely in the first year – where the state credit investor is different from a federal tax credit investor, at least for deals within the jurisdiction of the Fourth Circuit (Maryland, North Carolina, South Carolina, Virginia, West Virginia).
“If you’re in the Fourth Circuit and have a one-and-done [state] tax credit,” says Breed, “I think you have to make the assumption that you are going to have taxable income on the transfer of that credit to a state credit investor.”
Breed suggested that less reliance should be made on the Tax Court decision in the second case, which he felt the IRS is likely to appeal.
The case involved the financing and redevelopment of two former hotel properties in St. Louis for which Missouri state historic tax credits were claimed (Gateway Hotel Partners, LLC, Gateway Interest Acquisition Corp. v. Commissioner of Internal Revenue, T.C. Memo. 2014-5, Jan. 9, 2014).
In its opinion, the court held that two transfers of Missouri historic tax credits were partnership distributions rather than taxable sales, but ruled that a portion of a third transfer was a taxable sale. The court did not treat the transfers as disguised sales and did not conduct an analysis of whether the investor was a bona fide partner.
Breed indicated that the significance of the decision was muddled because the taxpayer committed errors in the documentation for the transaction. In addition, he said the partnership agreement was crafted to give the investor the option rather than a legal right to receive the state credits, an apparent attempt to avoid disguised sales treatment but an unlikely feature in typical transactions with federal and state tax credits.
