Source: https://appellatetax.com/category/pending-cases/virginia-historic-pending-cases/
Timestamp: 2019-04-25 04:27:07+00:00

Document:
On March 29, 2011, the Fourth Circuit rendered its opinion in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, No. 10-1333 (opinion linked below). As described in our previous coverage, the case involved an IRS challenge to the taxpayer’s treatment of partnerships used as marketing vehicles for state tax credits derived from historic rehabilitation projects. Agreeing with the government’s disguised sale theory, the court reversed the Tax Court and ruled that the transactions at issue were taxable sales of state tax credits, as opposed to non-taxable capital contributions followed by partnership distributions.
On January 18, 2011, the taxpayers filed a Notice of Supplemental Authority, drawing the court’s attention to the Tax Court’s recent opinion in Historic Boardwalk Hall, LLC v. Commissioner, 136 T.C. 1 (Jan. 3, 2011). According to the taxpayers in Virginia Historic, the new Tax Court case involves many factual and legal issues similar to those in the instant case. We’ll have an analysis of the recent decision and its potential impact on the issues in Virginia Historic in the near future.
Oral argument is scheduled in Virginia Historic for January 25, 2011.
The government filed its reply brief in Virginia Historic Tax Credit Fund 2001, LLC v. Commissioner, No. 10-1333 (4th Cir.), on September 1, 2010. The brief is linked below.
In its reply, the government argues that the tax characterization of the investor transactions, i.e., whether the investments were equity contributions or merely the purchase of state tax credits, is subject to the de novo standard of review. Accordingly, the government contends that the Tax Court’s determination that the taxpayers were bona fide equity investors is a question of law not subject to the more deferential “clear error” standard of review, as argued by the taxpayers.
In addition to reiterating its positions presented in the opening brief, the government also contends that the IRS has the power to recharacterize, for tax purposes, a transaction according to its substance, in spite of the fact that the parties may have adopted the form of the transaction for purposes other than tax avoidance. The taxpayers argue that the form of the transactions was adopted in order to comply with state law limitations on the transfer of historic preservation tax credits, and therefore the form of the transactions should be respected for federal tax purposes.
The government also supplements its statutory disguised sale theory with the arguments that the transactions were “transfers” of “property” as those terms are employed in I.R.C. § 707 and the regulations thereunder, and that the taxpayers’ arguments regarding the existence of meaningful entrepreneurial risk are not supported by the record.
The Appellees filed their response brief yesterday in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, No. 10-1333 (4th Cir.) (linked below). Our previous discussion of the case is here.
The government has advanced two basic arguments. First, it argues that the partners of the state tax credit partnerships were not bona fide partners that made capital contributions; rather, the government contends, the alleged partners were, in substance, purchasers of state tax credits. As such, the proceeds of these sales transactions are gross income to the partnerships, not non-taxable contributions to capital. In making this argument, the government focuses on the fact that the alleged partners had no possibility of realizing any economic benefit from their purported investments other than the acquisition of state tax credits at a discount from their face value. Second, the government argues that even if the partners were bona fide partners, the disguised sale rules under I.R.C. § 707 apply to recharacterize the transactions as taxable sales of property by the partnership to the partners acting in non-partner capacities.
The Appellees (comprised of two of the tax credit funds at issue and their tax matters partner) contend that the investors in the tax credit funds were bona fide partners for federal income tax purposes because they pooled their capital with the intent of sharing in a pool of non-federal-tax economic benefits pursuant to partnership allocation provisions under state law. Relying on Frank Lyon Co. v. United States, 435 U.S. 561 (1978), Appellees further contend that the partnership form of the transactions at issue was compelled by state-law regulatory realities (Virginia law prohibits the direct transfer of historic preservation tax credits), and thus the form should be respected. With respect to the government’s I.R.C. § 707 argument, Appellees argue that the disguised sale rules do not apply where, as here, the partners were acting in their capacities as partners, the alleged consideration constitutes a contribution to capital, the partnership allocates tax attributes as opposed to transferring property (i.e., the state tax credits are not property), and there is a meaningful sharing of risk among partners.
Stay tuned—the Fourth Circuit’s decision could have a substantial impact on the question of the nature of a partner for federal income tax purposes and the scope of the disguised sale rules, as well as substance-over-form principles generally.
The Tax Court and the U.S. District Court in New Jersey recently issued the first two opinions construing I.R.C. section 707(a)(2)(B), which is somewhat remarkable given that the partnership disguised sale rules have been on the books since 1984. See Va. Historic Tax Credit Fund 2001 LP v. Comm’r, T.C. Memo 2009-295; United States v. G-I Holdings Inc. (In re: G-I Holdings, Inc.), 2009 U.S. Dist. LEXIS 115850 (D.N.J. Dec. 14, 2009). The Government has appealed the Tax Court’s decision in Virginia Historic to the Fourth Circuit.
In Virginia Historic, the Tax Court rejected the IRS’s challenge to the use of partnerships as marketing vehicles for state tax credits. Under Virginia law, taxpayers can receive tax credits for investment in historical renovation projects. The tax credits are made available to stimulate investment in such projects because they are often unprofitable, and as a result, financing for the projects is often difficult to obtain. Because of restrictions on the direct transfer of the tax credits, the taxpayers in this case set up several investment partnerships that pooled funds from many investors and then contributed the funds to several lower-tier developer-partnerships. In exchange for investment in the developer-partnerships the upper-tier partnerships received partnership interests that entitled them to tax credits generated by specific projects. The tax credits would then be pooled by the upper-tier partnerships and distributed to the investors. The IRS took the position that the scheme was a disguised sale of tax credits in exchange for the investors’ cash.
In a memorandum opinion by Judge Kroupa, the Tax Court rejected the IRS’s disguised-sale contention largely on the basis that the investments were subject to the entrepreneurial risks of the enterprise. There was a possibility that developers would not complete the projects on time or in a manner acceptable to the state agency overseeing the projects, which placed receipt of the tax credits at risk. There was also the possibility that the upper-tier partnerships would not be able to pool sufficient credits to be able to make all of the promised distributions. Although distribution of the credits was guaranteed by the partnerships, there was no guarantee that the partnerships would have sufficient resources to make the investors whole. Accordingly, the court held that the investors’ capital was sufficiently at risk in order to avoid disguised sale treatment. Significantly, the degree of risk associated with the acquisition of state tax credits was relatively small, especially given that the investment partnerships spread risk through the pooling of resources and the dispersion of those resources over many developer-partnership projects.
The government has filed its opening brief. The taxpayer’s brief in response is due July 26, 2010. We will continue to monitor the case and post the briefs as soon as they are available.
The district court in GI-Holdings, by contrast, did apply the disguised-sale rule of Code section 707(b). The unpublished decision, linked below, contains a detailed discussion of the issue, but it is not yet an appealable order. Proceedings in the district court have been stayed until September 2010, but there is a strong possibility that the case will be appealed to the Third Circuit after the remaining issues are resolved in the district court.

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