Chief Counsel's Office: Conservation Easement Promoter's Gain is Ordinary Income

(Parker Tax Publishing March 2023)

The Office of Chief Counsel advised that the gain a promoter of syndicated conservation easements realized on the sale of limited liability company (LLC) interests was ordinary income under Code Sec. 1221 because the promoter held the LLC interests primarily for sale to customers in the ordinary course of a trade or business. However, the Chief Counsel's Office also found that Code Sec. 741 and Code Sec. 751(d)(1) and (d)(3) did not collectively apply to treat the promoter's gain on the sales of LLC interests as ordinary income because the promoter was not engaged in a trade or business of selling land. CCA 202309015.

Background

The Office of Chief Counsel was asked to advise on the character of gain on the sale of limited liability company (LLC) interests by a taxpayer who was a promoter of syndicated conservation easements.

Between Year 1 and Year 4, the promoter directly, and indirectly through entities owned and managed by the promoter (Managed LLCs), engaged in the promotion and sale of interests in LLCs (SCE LLCs). The promoter, or the promoter through Managed LLCs, managed, marketed, and negotiated all transaction steps. These steps included: (1) acquiring undeveloped land from third parties who held the land for more than a year; (2) subdividing the land into parcels, each of which were contributed to an SCE LLC; and (3) selling SCE LLC interests to investors. Typically, within one to four months of the acquisition of the land, the SCE LLCs donated the easement and/or the land to a Code Sec. 501(c)(3) organization. The SCE LLCs reported the donation as a charitable contribution on their federal tax returns. The promoter and the investors claimed a deduction for their distributive shares of the charitable contribution deduction.

The promoter made oral and written promises to the investors that they would receive a charitable contribution deduction with respect to the donation of the easement and/or the land many times the amount of their investment. The promoter received a promotional fee or other consideration in connection with the sales of the SCE LLC interests to the investors. From Year 1 through Year 4, the promoter and the Managed LLCs, collectively, reported gain on the sales of their interests in the SCE LLCs. Other than in Year 4, the promoter reported the gain from the sales of the SCE LLC interests as long-term capital gain. During Year 4, the promoter also formed an S corporation to which it contributed SCE LLC interests. The S corporation then sold the SCE LLC interests. The promoter reported gain on the sales of the SCE LLC interests sold by the S corporation as Schedule E ordinary income. On the promoter's personal tax return, the promoter reported no other source of income other than the income generated by the promoter from the promotion and sale of the SCE transactions.

Code Sec. 741 provides that in the case of a sale or exchange of an interest in a partnership, the partner's gain or loss is considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in Code Sec. 751 (relating to unrealized receivables and inventory items).

Under Code Sec. 1221(a)(1), the term "capital asset" means property held by a taxpayer (whether or not connected with his or her trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the tax year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his or her trade or business. In Malat v. Riddel, 383 U.S. 569 (1966), the Supreme Court stated that as used in Code Sec. 1221, "primarily" means "of first importance" or "principally." The Court also explained that the purpose of Code Sec. 1221 is to differentiate between the profits and losses arising from the everyday operation of a business on the one hand and the realization of appreciation in value accrued over a substantial period of time on the other.

Under Code Sec. 751(a), on the sale or exchange of an interest in a partnership, the amount of any money, or the fair market value of any property, received by a partner in exchange for all or a part of his interest in the partnership attributable to (1) unrealized receivables of the partnership (Code Sec. 751(a)(1)), or (2) "inventory items" of the partnership (Code Sec. 751(a)(2)), is considered as an amount realized from the sale or exchange of property other than a capital asset.

Code Sec. 751(d) defines "inventory items" as: (1) property of the partnership of the kind described in Code Sec. 1221(a)(1) (Code Sec. 751(d)(1)); (2) any other property of the partnership which, on sale or exchange by the partnership, would be considered property other than a capital asset and other than property described in Code Sec. 1231 (Code Sec. 751(d)(2)); and (3) any other property held by the partnership which, if held by the selling partner, would be considered property of the type described in (1) and (2) (Code Sec. 751(d)(3)).

Thus, under Code Sec. 751(a)(2) and (d)(1), ordinary income treatment is appropriate when a partnership asset is (1) inventory to the partnership or (2) held by the partnership primarily for sale to customers in the ordinary course of the partnership's trade or business. Under Code Sec. 751(a)(2) and (d)(3), ordinary treatment applies when a partnership asset, if held by the selling partner, is property other than a capital asset to the selling partner, or held by the selling partner primarily for sale to customers in the ordinary course of the selling partner's trade or business.

The Chief Counsel's Office was asked whether, despite Code Sec. 741, Code Sec. 1221 applied to treat the promoter's gain on the sales of LLC interests as ordinary income because the promoter held the LLC interests primarily for sale to customers in the ordinary course of a trade or business during Year 3 through Year 4. The Chief Counsel's Office was also asked whether Code Sec. 741 and Code Sec. 751(d)(1) and (d)(3) applied collectively to treat the promoter's gain as ordinary income because the promoter was engaged in a trade or business of selling land during Year 3 through Year 4.

Analysis

The Chief Counsel's Office advised that the promoter's gain on the sales of LLC interests was ordinary income under Code Sec. 1221 because the promoter held the LLC interests primarily for sale to customers in the ordinary course of a trade or business during Year 3 and Year 4. However, the Chief Counsel's Office also advised that Code Sec. 741 and Code Sec. 751(d)(1) and (d)(3) did not collectively apply to treat the promoter's gain as ordinary income because the promoter was not engaged in a trade or business of selling land during Year 3 through Year 4.

The Chief Counsel's Office cited the following factors as indicative of whether property is held primarily for sale to customers in the ordinary course of a trade or business: (1) the frequency and regularity of sales; (2) the substantiality of sales; (3) duration of ownership; (4) whether the property held for sale and property held for investment were separately identified; (5) purpose for acquiring the property; (6) sales and advertising efforts; (7) the time and effort devoted to the sales activity; and (8) how the sales proceeds were used. The Chief Counsel's Office noted that the frequency and regularity of sales are among the most important of these factors. In the view of the Chief Counsel's Office, the promoter's sales of SCE LLC interests met each of these factors. The Chief Counsel's Office also noted that the promoter sold the SCE LLC interests quickly, generally within a year, and did not hold them on a long-term basis. Therefore, the Chief Counsel's Office advised that under Malat, the promoter realized income from the everyday operation of a business rather than the realization of appreciation in value accrued over a substantial period of time.

According to the Chief Counsel's Office, Code Sec. 1221 applied notwithstanding the general rule in Code Sec. 741 that the sale of a partnership interest is a sale of a capital asset. The Chief Counsel's Office explained that Code Sec. 741 contemplates only the sale of partnership assets that are in fact capital assets. The Chief Counsel's Office observed that it was not challenging the entity approach to partnerships taken by Code Sec. 741 (i.e., that the sale of a partnership interest is treated as the sale of a single asset, like corporate stock). Rather, the Chief Counsel's Office said that the application of Code Sec. 1221 to these facts harmonized Code Secs. 1221 and 741 such that capital gain treatment does not apply when a taxpayer's gain or loss arises from the everyday operation of a trade or business.

Next, the Chief Counsel's Office advised that the promoter's gain would not be characterized as ordinary income under Code Sec. 741 and Code Sec. 751(d)(1) and (d)(3). The Chief Counsel's Office said that the facts did not support that the land was included in the inventory of the SCE LLCs, or held by the SCE LLCs primarily for sale to customers. Additionally, the Chief Counsel's Office said there were no facts to support that the SCE LLCs were engaged in the trade or business of selling land. The Chief Counsel's Office also found that the facts did not support that the promoter (or the Managed LLCs) was in the trade or business of selling land. The Chief Counsel's Office noted that the promoter was described in promotional materials as not acting as a real estate broker with respect to the SCE transactions. Additionally, in at least one year, neither the promoter nor the Managed LLCs sold land and were not engaged in the business of selling land. Accordingly, the land in the SCE LLCs, if held by the promoter (or the Managed LLCs), would have been a capital asset to the promoter (or the Managed LLCs) because there was no indication that the land was inventory to the promoter (or the Managed LLCs) or held by the promoter (or the Managed LLCs) primarily for sale to customers in the ordinary course of the promoter's (or the Managed LLCs') trade or business.

For a discussion of the rules for the sale or exchange of a partnership interest, see Parker Tax ¶27,510. For a discussion of capital assets, see Parker Tax ¶111,105.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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