U.S. Tax Court Ruling in State Conservation Tax Credit Case Requires Income Recognition

BY: ALLISON T. DOMSON & J. CONRAD GARCIA 

In its recently issued opinion in the case of Route 231, LLC v. Commissioner, T.C. Memo 2014-30 (2/24/14), the United States Tax Court (the “Court”) held that a transfer of state tax credits to a 1% member who had contributed $3.8 million to the company was a disguised sale requiring the taxpayer to recognize income from the transfer.
 
Factual Background
Two individual Virginia resident taxpayers formed Route 231, LLC, a Virginia limited liability company (“Route 231”), in May 2005. Route 231 purchased Castle Hill, a 1,203 acre tract near Albemarle County, Virginia including an 18th century manor home, and Walnut Mountain, a 345 acre tract in the same vicinity. The loan utilized to purchase these properties was personally guaranteed by the individual members. The members intended to donate conservation easements on these parcels to exploit Virginia Land Preservation Tax Credits (the “credits”).
 
Route 231 obtained an appraisal of both properties on December 9, 2005 valuing a conservation easement on Castle Hill at $8,849,240; a conservation easement on Walnut Mountain at $5,225,249; and a fee interest in Walnut Mountain subject to the Walnut Mountain easement at $2,072,880. Effective December 30, 2005, Route 231 made the following charitable donations: (1) a deed of gift of the Castle Hill easement to the Nature Conservancy; (2) a deed of gift of the Walnut Mountain easement to the Albemarle County Public Recreational Facilities Authority; and (3) a deed of gift of the Walnut Mountain fee interest to the Nature Conservancy (collectively, the “donations”).
 
Virginia Conservation, a Virginia limited liability limited partnership (“Virginia Conservation”), agreed to make a capital contribution to Route 231 based on the number of credits Route 231 agreed to allocate to it. On December 27, 2005, the two individual Route 231 members and Virginia Conservation executed an amended operating agreement in which Virginia Conservation was admitted as a member. Virginia Conservation was deemed to have made a $500 capital contribution and an additional capital contribution of $0.53 for each $1.00 of credits allocated to it. Under the amended operating agreement, the allocation of items of Route 231 partnership profits and losses would be 49.5% to each individual and 1% to Virginia Conservation. In addition, the amended operating agreement provided that, in the event the credits were disallowed by the Virginia Department of Taxation (“VDT”) or Internal Revenue Service (“IRS”), Route 231 and the individual members would indemnify Virginia Conservation for its capital contribution.
 
Route 231 and Virginia Conservation entered into three escrow agreements for the required capital contributions of Virginia Conservation based on the anticipated credits applicable to each of the donations. The funds in each escrow account would be released to Route 231 when escrow agent received the VDT-issued Credit Transaction Number, a recorded deed of gift and a title insurance policy. When Virginia Conservation finally received proof of the credits allocable to it, the credits were $84,000 short and were replaced by credits transferred from one of the individual members. In total, the credits were allocated $215,983 to one individual member and $7,200,000 to Virginia Conservation.

Route 231 received letters from VDT listing the credit transaction number for each of the three donations on March 27, 2006. The credits had an effective year of 2005 and expiration tax year of 2010. On its federal income tax return for the 2005 tax year, Route 231 reported an accrual method of accounting, charitable donations of $14,831,967, and cash capital contributions of $8,416,000. The state income tax return for Route 231 from 2005 included $7,415,893 of Land Preservation Tax Credits.
 
The IRS issued Route 231 a final partnership administrative adjustment for a failure to report incurred ordinary income of $3,816,000 from the sale of the credits on March 17, 2010.
 
Tax Court Ruling
The issue before Judge Kerrigan of the Court was whether the capital contribution of cash by Virginia Conservation and subsequent allocation of credits to it by Route 231 constituted a disguised sale under IRC Section 707. A Virginia limited liability company with two or more members is treated as a partnership for federal income tax purposes unless the company makes an affirmative election for corporate tax treatment. Generally, a partner may contribute capital to a partnership tax free and receive a tax-free return of previously taxed profits, except to the extent that the distribution exceeds the partner’s adjusted basis. IRC Sec. 721, 731. However, a disguised sale occurs (1) when a partner transfers money or property to a partnership, (2) there is a related transfer of money or other property by the partnership to the partner, and (3) when viewed together, the transfers are properly characterized as a sale or exchange of property. IRC Sec. 707(a)(2)(B). Transfers made between a partner and a partnership within a two-year period are presumed to be a disguised sale unless the facts and circumstances indicate otherwise. Treas. Reg. Sec. 1.707-3(c)(1).
 
Defining Disguised Sale
In evaluating whether or not a transfer constitutes a disguised sale, all the facts and circumstances must indicate that the transfer by the partnership would not have been made “but for” the transfer by the partner and, in cases in which the transfers are not simultaneous, the subsequent transfer is not dependent on the entrepreneurial risks. Treas. Reg. Sec. 1.707-3(b)(1). The Court found that, out of a list of ten non-exhaustive facts and circumstances that would tend to prove the existence of a disguised sale, six of the facts and circumstances were relevant to the determination of this case. These facts and circumstances are: (1) timing and amount of the subsequent transfer are determinable with reasonable certainty at the time of the earlier transfer; (2) the transferor has a legally enforceable right to the subsequent transfer; (3) the partner’s right to receive the transfer is secured; (4) the partnership has been loaned the money or other consideration to make the transfer; (5) the transfer by the partnership is disproportionately large compared to the partner’s profits interest; and (6) the partner has no obligation to return or repay the consideration to the partnership. Treas. Reg. Sec. 1.707-3(b)(2).
 
Virginia Historic Tax Credit Fund
Given that the case is appealable to the United States Court of Appeals for the Fourth Circuit, the Court held that Virginia Historic Tax Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011) was “squarely on point.” In that case, the Fourth Circuit held that the tax credit investor faced the same risks of an “advance purchaser who pays for an item with a promise of later delivery.” Here, the Court found sufficient factual similarities between the entities and the transactions such that the disguised sale analysis of Virginia Historic governed. 
 
Valid Transfer of Property
The first issue before the Court was whether Route 231 transferred property related to a prior cash contribution. The taxpayer asserted that the credits were not property, but rather a potential reduction of taxes. Using the analysis of Virginia Historic, the Court determined that the credits were valuable, consisted of essential property rights and were property for purposes of Sec. 707.
 
“But For” Test & Entrepreneurial Risks
The Court found that Route 231 would not have transferred the credits to Virginia Conservation, but for Virginia Conservation’s prior cash transfer. The Court’s conclusion was supported by Route 231’s promise of credits based on the cash transfer amount and the agreement of Route 231 and the individual partners to indemnify Virginia Conservation for any disallowed credits. In addition, the Court held that the amount of credits that Virginia Conservation received was based on a fixed rate of return and was never tied to Route 231’s profits or operations. Virginia Conservation’s risk was also limited by the indemnity clause and the actual transfer of credits by the individual member to make up for a deficiency. As a result, Virginia Conservation’s investment did not face any true entrepreneurial risk as a member.
 
Facts & Circumstances Test
Next, the Court applied the facts and circumstances test outlined in the Treasury Regulations. The Court found that each of the following facts and circumstances weighed in favor of a disguised sale: (1) the amount of credits to be received and the date by which they would be earned were set when Virginia Conservation transferred its funds; (2) Virginia Conservation had a breach of contract claim to assert its rights to the credits; (3) Route 231’s guaranteed refunds in the event of credit disallowance and the individual member’s conveyance of credits to make up Virginia Conservation’s deficiency secured Virginia Conservation’s right to receive the credits; (4) the individual member loaned tax credits to Route 231 to complete the promised transfer of credits to Virginia Conservation; (5) Virginia Conservation held a 1% interest in the company profits and losses and distribution of net cash flow, but received 97% of the credits; and (6) Virginia Conservation had no obligation to return the credits to Route 231. In applying the above facts and circumstances, in addition to the “but for” test and evaluating the entrepreneurial risks, the Court found that Virginia Conservation and Route 231 engaged in a disguised sale.
 
Timing
The Court rejected the taxpayer’s assertion that any potential disguised sale could not have occurred in 2005. The taxpayer asserted that the disguised sale could not have taken place in 2005 because the credits were not registered until 2006. First, the Court noted that under Virginia law in effect during 2005, a taxpayer earned and held a credit when the taxpayer satisfied the statutory requirements. Filing with the VDT was not necessary at the time. The parties did not dispute that Route 231 met the relevant statutory requirements in 2005. In addition, Route 231 transferred the credits to two of its members on December 30, 2005, and it would be impossible to transfer something that the transferor did not possess. In the alternative, the Court noted that Route 231 was an accrual taxpayer that met the “all events” test and, as such, the disguised sale proceeds should be income for 2005.

Conclusion
Unlike the tax credit investor partners in Virginia Historic, Virginia Conservation remained a member in Route 231 up through the litigation of this case. This fact did not change the Court’s analysis. The Court focused on the certainty of the amount of and timing of Virginia Conservation’s received credits, the promise by Route 231 and the individual members of indemnification in the event of credit disallowance and the actual transfer of credits by an individual member to make up for Virginia Conservation’s deficiency. The expansion of Virginia Historic principles to a non-historic credit transaction evinces the intention of the IRS and the courts to look for taxable transactions involving any investment tax style state credit. Taxpayers should continue to exercise caution in their planning and consult their tax advisors as they conduct these tax credit transactions.