In-Depth: Allocation of Tax Credits to Minority Partner Deemed a Disguised Sale.

(Parker Tax Publishing April 27, 2015)

The Tax Court held that a cash contribution for a minority interest in a partnership that was closely followed by an allocation of state tax credits was a disguised sale resulting in ordinary income and not a tax-free capital contribution. SWF Real Estate LLC v. Comm'r, T.C. Memo. 2015-63.

Background

In 2001, John L. Lewis IV formed SWF Real Estate, LLC (SWF) as an entity taxed as a partnership. Lewis, through a wholly owned S corporation, purchased a large tract of land in Albemarle County, Virginia (Sherwood Farm) and contributed it to SWF. Lewis intended Sherwood Farm to be used for SWF to start a farming business and a cattle breeding operation, but the land was also zoned for residential development. During a regional rise in real estate prices in 2005, many large farms around Albemarle were being developed into subdivisions, and land owners like Lewis felt pressure to do the same. To encourage the preservation of rural land, in 2005 and 2006, Virginia provided a state income tax credit to individuals and corporations equal to 50 percent of the fair market value of any interest in land, including conservation easements, donated to public and private organizations and entities for conservation or preservation purposes. During that time, a taxpayer holding unused Virginia tax credits was able to sell or transfer the unused credits.

In 2005, Lewis was advised by a consulting firm that a charitable gift of an easement on Sherwood Farm would produce state tax credits of approximately $3.2 million (in addition to a potential $6.7 million charitable contribution deduction for federal tax purposes). The consultants advised Lewis that he had two options with respect to any unused Virginia tax credits: he could sell them or he could allocate them using a partnership structure. They further suggested that any unused credits could be transferred or allocated to Virginia Conservation Tax Credit Fund LLLP (VTC), at a rate of 53 cents per dollar of Virginia tax credits.

Lewis decided to move forward with the conservation easement on Sherwood Farm. Because SWF was not profitable enough to use all of the Virginia tax credits, he began planning a transaction to transfer the credits SWF would receive from the easement to VTC (the "VTC transaction"). VTC agreed to contribute to SWF funds of 53 cents per dollar of allocated tax credits and receive a 1 percent nonvoting minority interest in SWF and an allocation of the tax credits. The agreement also specified that SWF would indemnify VTC for any disallowed or reduced tax credits.

Before the transaction was initiated, a second appraisal of the property found the land would produce a $7.4 million charitable gift and associated tax credits of $3.4 million. Lewis agreed VTC would receive the extra credits for a proportional increase in its capital contribution, though VTC would not receive a greater interest in SWF.

In December of 2005, SWF executed a deed conveying a conservation easement on Sherwood Farm to Albemarle County. VTC then transferred $1,802,000 to SWF as a capital contribution in exchange for a 1 percent interest in SWF. On its 2005 Form 1065, U.S. Return of Partnership Income, SWF reported a charitable contribution of $7,398,333 from the easement, and on its Schedule VK-1, filed with its Form 502, Virginia Passthrough Entity Return of Income, SWF allocated $3,400,000 in Virginia tax credits to VTC, pursuant to their agreement.

In 2011, after examining SWF's 2005 return, the IRS issued a Final Partnership Administrative Adjustment (FPAA) with respect to SWF's 2005 tax year. The IRS determined that of the $1,802,000 received from VTC, only $124,857 represented a capital contribution in exchange for a 1 percent interest in SWF, and the remaining $1,677,143 was a disguised sale of the Virginia tax credits pursuant to Code Sec. 707.

Regulations on Disguised Sales

Generally, a partner may contribute capital to a partnership tax free (Code Sec. 721). However, this nonrecognition treatment will not apply if the contribution is a disguised sale under Code Sec. 707(a)(2). A disguised sale occurs when (1) a partner directly or indirectly transfers money or property to a partnership, (2) there is a related direct or indirect transfer of money or other property by the partnership to such partner, and (3) the transfers are properly characterized as a sale or exchange of property when viewed together (Code Sec. 707(a)(2)(B)).

In addition, Reg. Sec. 1.707-3(b)(1) provides that a disguised sale has occurred only if, on the basis of all of the facts and circumstances, (1) the transfer of money or other consideration would not have been made but for the transfer of property and (2) in cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operation.

The Tax Court found that the first two prongs of Code Sec. 707(a)(2)(B) were satisfied because VTC had transferred money to SWF, and SWF subsequently transferred property in the form of Virginia tax credits to VTC. In order to determine if the transfers were properly characterized as a sale under the third prong, the court looked to the two factor test in Reg. Sec. 1.707-3(b)(1), considering (1) whether VTC would not have transferred $1,802,000 to SWF but for the corresponding transfer of $3,400,000 of Virginia tax credits from SWF; and (2) whether SWF's transfer was not dependent on the entrepreneurial risks of SWF's partnership operations.

The court determined VTC's promise to contribute money to SWF equal to 53 cents for each $1 of Virginia tax credits allocated to it was evidence that VTC would not have transferred money to SWF but for the corresponding transfer of credits. In addition, VTC was promised a legally enforceable, fixed rate of return of $1 of credits for every 53 cents contributed and was shielded from suffering any loss of credits through a clause that required SWF to indemnify VTC for any of its credits that were disallowed or revoked. Because of this indemnity clause, the court concluded that SWF's transfer of Virginia tax credits to VTC was not dependent upon the entrepreneurial risks of SWF's business.

10-Factor Facts and Circumstances Test For Disguised Sales

In addition to the three-prong test in Code Sec. 707(a)(2)(B) and the two-factor test of Reg. Sec. 1.707-3(b)(1), Reg. Sec. 1.707-3(b)(2) provides 10 facts and circumstances that help establish whether a transfer is a disguised sale:

(1) Whether the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer;

(2) Whether the transferor has a legally enforceable right to the subsequent transfer;

(3) Whether the partner's right to receive the transfer is secured in any manner;

(4) Whether contributions to the partnership are required for the partnership to make the transfer;

(5) Whether loans to the partnership are required to enable the partnership to make the transfer;

(6) Whether the partnership must incur debt necessary to permit it to make the transfer;

(7) Whether the partnership holds money or other liquid assets, beyond the reasonable needs of the business, that are expected to be made available for the transfer;

(8) Whether partnership distributions are designed to effect an exchange of the burdens and benefits of ownership of property;

(9) Whether the transfer by the partnership to the partner is disproportionately large in relationship to the partner's interest in partnership profits; and

(10) Whether the partner has no obligation to return or repay the money or other consideration to the partnership.

Because the tax court found the VTC transaction could properly be characterized as a sale or exchange under Reg. Sec. 1.707-3(b)(1), it next considered the application of the facts and circumstances listed in Reg. Sec. 1.707-3(b)(2). The court selected six of the ten factors as relevant in determining whether the VTC transaction was a disguised sale.

The court first considered whether the timing and amount of the transfer of credits were determinable with reasonable certainty at the time of the transfer. Because the amount of the capital contribution to SWF was based directly on the amount of credits to be transferred and SWF agreed to record the easement on or before December 31, 2005, so that VTC could use the resulting Virginia tax credits on its 2005 income tax return, the court concluded this weighed in favor of treating the VTC transaction as a disguised sale.

Next, the court considered whether VTC had a legally enforceable right to transfer the tax credits. The court noted the agreement between VTC and SWF stated that VTC's contribution would entitle it to receive an allocation of Virginia tax credits and if SWF failed to fulfill the terms of the agreement, VTC could have pursued breach of contract claims, giving VTC a legally enforceable right. Additionally, the court determined that because the indemnity clause guaranteed SWF would indemnify VTC if any of the tax credits were disallowed or reduced, this secured VTC's rights to the credits and these two factors also supported finding a disguised sale.

The court then considered whether SWF held the Virginia tax credits beyond the reasonable needs of its business. The court noted that SWF agreed that it would not use any portion of the credits allocated to VTC to offset or satisfy its state income tax liability. Further, when the second valuation of the easement created more credits than originally expected, SWF agreed to transfer the additional credits to VTC, rather than use them or sell them to a different party. Because SWF held the credits beyond the reasonable needs of its business, the court concluded that this factor also evidenced a disguised sale.

The court noted that VTC was ultimately allocated 92 percent of the Virginia tax credits despite holding only a 1 percent interest in the partnership's profits and concluded the amount of tax credits that VTC received was proportionate to the amount of money it contributed to SWF, and not to its partnership interest. Because of this, the transfer of credits to VTC was disproportionately large and weighed in favor of finding a disguised sale.

Additionally, the court found that, as VTC was free to use or transfer the credits as it desired after it received them and had no obligation to repay SWF, the final factor also supported finding the transfer was a disguised sale.

Conclusion

After reviewing the facts of the transfer, the Tax Court concluded that the VTC transaction was, in fact, a disguised sale. The transaction included a transfer of money from VTC to SWF and a related transfer of Virginia tax credits from SWF to VTC that, when viewed together, were properly characterized as a sale or exchange of property pursuant to Code Sec. 707(a)(2)(B). In addition, the six relevant factors under Reg. Sec. 1.707-3(b)(2) that the court evaluated all favored finding a disguised sale.

Consequently, the Tax Court held that SWF engaged in a disguised sale pursuant to Code Sec. 707(a) and had improperly reported the VTC transaction as a tax-free contribution of capital. The court sustained the IRS's FPAA, allowing $124,857 as a tax free capital contribution stemming from VTC's 1 percent interest in SWF, and deemed the remaining $1,677,143 ordinary income.

OBSERVATION: The Tax Court noted that it had previously encountered facts nearly identical to those in the present case in Route 231, LLC v. Comm'r, T.C. Memo. 2014-30. There, the partnership had also entered into a transaction with VTC, and there the company also contributed substantial cash to Route 231 in exchange for a 1 percent membership interest in Route 231 and a large allocation of Virginia tax credits. As in SWF, the court held that Route 231 sold Virginia tax credits to VTC in exchange for cash and had engaged in a disguised sale under Code Sec. 707.

For a discussion of disguised sales, see Parker ¶25,520. (Staff Editor Parker Tax Publishing)

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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