Opinion ID: 3168238
Heading Depth: 2
Heading Rank: 1

Heading: Disguised Sale

Text: It comes as no secret that taxpayers often seek to structure transactions creatively in an effort to minimize the tax consequences. Id. at 138. In response, Congress has enacted various statutes that look beyond form to substance in order to differentiate taxable and nontaxable events. Id. The characterization of the structure of Route 231’s transaction with Virginia Conservation – a contribution to partnership capital or a sale of assets – has significant tax consequences: “[w]hereas a partnership must report any proceeds received from the sale of its assets as taxable income, partners’ contributions to capital and a partnership’s distributions to partners are tax-free.” Id. Relevant to this case is I.R.C. § 707, which “prevents use of the partnership provisions to render nontaxable what would in substance have been a taxable exchange if it had not been ‘run through’ the partnership.” Id. In such a circumstance, the transaction between the partner and partnership is treated as if 11 a transaction between third parties regardless of the partnership format: “[i]f a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner.” I.R.C. § 707(a)(1)(A). Particularly applicable in this case is § 707(a)(2)(B), which provides: (B) Treatment of certain property transfers. If-- (i) there is a direct or indirect transfer of money or other property by a partner to a partnership, (ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and (iii) the transfers described in clauses (i) and (ii), when viewed together, are properly characterized as a sale or exchange of property, such transfers shall be treated either as a transaction described in paragraph (1) . . . . The treasury regulations further explain when such transactions are “properly characterized as a sale or exchange of property.” See 26 C.F.R. § 1.707-3. 7 In general, a partner/partnership 7The regulation describes such “disguised sales” as transactions in which a partner transfers “property” to the partnership and the partnership transfers “money or other consideration to the partner.” 26 C.F.R. § 1.707-3(a)(1). (Continued) 12 transaction is a sale “if based on all the facts and circumstances,” “[t]he transfer of money or other consideration would not have been made but for the transfer of property” and, when the transfers are not simultaneous, “the subsequent transfer is not dependent on the entrepreneurial risks of partnership operation.” § 1.707-3(b)(1). The regulations additionally provide a non-exclusive list of ten relevant facts and circumstances “that may tend to prove the existence of a sale,” including whether “the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer”; “the transferor has a legally enforceable right to the subsequent transfer”; “the partner’s right to receive the transfer of money or other consideration is secured in any manner”; “the transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits”; and “the partner has no obligation to return or repay the money or other consideration to the partnership[.]” § 1.707-3(b)(2). The regulations also create a presumption of a sale whenever the However, we have observed that the regulations specifically provide that these principles also apply when a partnership transfers “property” to a partner in exchange for “money or other consideration.” See Va. Historic, 639 F.3d at 139 (citing 26 C.F.R. § 1.707-6(a)). 13 partner/partnership transfers occur within a two-year period “unless the facts and circumstances clearly establish that the transfers do not constitute a sale.” § 1.707-3(c)(1). “This presumption places a high burden on the partnership to establish the validity of any suspect partnership transfers.” Va. Historic, 639 F.3d at 139. Route 231 takes issue with the Tax Court’s reliance on Virginia Historic in the application of § 707. Its arguments largely attempt to distinguish its transaction with Virginia Conservation from what occurred in that case, where a partnership “reported a series of transactions with investor partners” as capital contributions rather than as income from “sales” of state historic rehabilitation tax credits. Id. at 132-33. The Virginia Historic partnership actively sought investors to contribute “capital” in exchange for a less-thanone-percent partnership interest and an “allocation” of the state tax credits. Id. at 133-35. The Commissioner asserted that the investors were not bona fide partners and that “under the relevant Code provisions and regulations,” “the transactions between the investors and the [partnership] should nevertheless be classified as sales for federal tax purposes[.]” Id. at 137. We assumed, without deciding, that the investors were bona fide partners, but found that the Commissioner correctly classified that series of transactions. Id. After rejecting 14 the partnership’s contention that the tax credits did not constitute “property” for purposes of the “disguised sales” rules, we concluded the partnership failed to overcome the presumption that the exchange was a “sale” based on the applicable regulatory factors. Id. at 140-46. In attempting to distinguish Virginia Historic, Route 231 points to its “emphas[is] that [the Court was] not deciding whether tax credits always constitute ‘property’ in the abstract. Rather, [the Court was] asked to decide only whether the transfer of tax credits acquired by a non-developer partnership to investors in exchange for money constituted ‘a transfer of property’ for purposes of § 707.” Id. at 141 n.15. Route 231 contends this language limited Virginia Historic’s holding to sham partnerships that “ceased to exist as soon as the credits were transferred” and that the “disguised sale rules do not apply to a valid partnership with economic substance like Route 231.” (Opening Br. 26.) Furthermore, Route 231 posits that because Virginia Conservation remains a bona fide partner in an ongoing partnership, the transfer of tax credits was “simply an allocation [of partnership assets] among partners, and not a sale of property by a sham entity to transitory investors.” (Opening Br. 27.) Route 231’s argument misses the mark. We note initially that Route 231 does not challenge the validity of § 707 or the 15 corresponding regulations. For the most part, Route 231 also does not challenge the Tax Court’s application of the § 1.707- 3(c) “facts and circumstances” test to the circumstances surrounding its transaction with Virginia Conservation. Although Route 231 denies doing so, most of its arguments center on the premise that as Virginia Conservation is a bona fide partner in a bona fide partnership, its partner/partnership transactions are immune from the scope of § 707 and related provisions. Put another way, Route 231 contends § 707 cannot apply to the transaction at issue here because the entities involved are bona fide entities in a genuine contractual relationship. The Commissioner does not contest that Route 231 is a valid entity or that Virginia Conservation is a true partner in it. Neither did the Tax Court rely on a failure of the bona fides of the entities in reaching its decision. There was no need to do so as Route 231’s argument fails under the plain language of § 707, which expressly applies to transactions between a partner and partnership without qualification whenever a partner “engages in a transaction with a partnership other than in his capacity as a member of such partnership.” The bona fides of Virginia Conservation’s status as a member of Route 231, or that entity’s status as a valid limited liability company (and valid partnership for tax purposes) do not matter for this inquiry. 16 In short, the analysis under § 707 goes to the bona fides of a particular transaction, not to the general status of the participants to that transaction. Contrary to Route 231’s repeated assertions, I.R.C. § 707 applies by its plain terms to designated transactions between otherwise valid ongoing partnerships and their legitimate partners. 8 Relatedly, in Virginia Historic we expressly did not analyze whether the partnership itself was legitimate, nor did we limit § 707’s scope to sham partnerships. Quite the contrary, the Court expressly assumed the existence of a bona fide partnership and proceeded directly to analyzing whether the transaction nonetheless constituted a disguised sale under § 707. Cf. Va. Historic, 639 F.3d at 137. So, too, here: this case does not turn at all on characteristics of the Route 231 8 To supports its contention that § 707 and the disguised sale rules apply only when a partnership is illegitimate or a sham, Route 231 points to Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012). There, the Third Circuit observed that some of the same principles applicable to disguised sales also apply in the separate context of determining whether a bona fide partnership exists. Where those points overlapped, the court relied in part on our decision in Virginia Historic. See id. at 454-55. Nothing about the Commissioner’s position or the analysis in Historic Boardwalk suggests that the two analyses can only take place together, or that a bona fide partnership cannot engage in a transaction that § 707 recognizes as a disguised sale between a partnership and its partner. To the extent that its analysis is persuasive authority, Historic Boardwalk stands for the unremarkable principle that in certain instances, factors relevant to the one of these inquiries may overlap with factors relevant to the other. 17 entity or its members. Instead, as contemplated by § 707(a), this case turns on the nature of the transaction at issue: the exchange of Virginia tax credits for money. 9 Turning to the specific circumstances of Virginia Conservation and Route 231’s transaction, we first determine whether the Virginia tax credits constitute “property” within the scope of I.R.C. § 707 (regulating the “transfer of money or other property”). We agree with the Tax Court’s analysis and its conclusion that the Virginia tax credits are “property” for purposes of I.R.C. § 707. The tax credits’ status as “property” is evidenced by their value as an inducement to Virginia Conservation to join Route 231. It bears noting that Virginia Conservation was paying fifty-three cents on the dollar for a credit worth a full dollar in tax relief from Virginia state income tax: a transaction of real economic value. Moreover, Route 231’s ownership of the Virginia tax credits gave rise to such essential proprietary rights as the right to own or use an item, to exclude others from ownership, and the right to 9 Nor did Virginia Historic limit § 707(a)’s scope to nondeveloper partnerships as Route 231 contends. To be sure, in examining the transaction at issue in Virginia Historic, we pointed out that our holding that the tax credits were property arose in the factual context of a “non-developer partnership,” and that tax credits may not categorically constitute “property.” But this language simply recognizes the factual setting of Virginia Historic and reflects the requisite analysis of “property” must be made in each case and not taken as a per se rule. 18 transfer them as permitted under state law. In addition, as we explained in greater detail in Virginia Historic, treating the tax credits as “property” is consistent “with Congress’s intent to widen [§ 707’s] reach” when that statute was amended in 1984. See 639 F.3d at 142. Having determined that the Virginia tax credits constitute “property,” we turn to whether the transfer of this property from Route 231 to Virginia Conservation constituted a “sale.” Because the exchange of tax credits for money occurred within a two-year period, the presumption that the transaction is a disguised sale arises unless the “facts and circumstances clearly establish” otherwise. See 26 C.F.R. § 1.707-3(c)(1). The regulations provide that transactions of this nature are in fact sales if, “based on all the facts and circumstances,” (1) the transfer of money would not have been made without the transfer of property, and (2) the subsequent transfer was not dependent on the entrepreneurial risks of the partnership. 26 C.F.R. § 1.707-3(b)(1). The analysis of these two considerations is based on the totality of the “facts and circumstances,” including the ten potentially applicable factors noted earlier. 26 C.F.R. § 1.707-3(b)(2). As the Tax Court noted, among the items that “tend to prove the existence of a sale” in this case are: 19 • the fixed cash-to-credit ratio for the transaction as set out in the amended operating agreements, coupled with Route 231’s agreement to earn those tax credits by December 31, 2005 (cf. 26 C.F.R. § 1.707- 3(b)(2)(i); Va. Historic, 639 F.3d at 143); • Virginia Conservation’s contractual right under the amended operating agreement to all but Carr’s share of the tax credits Route 231 earned (cf. 26 C.F.R. § 1.707-3(b)(2)(ii); Va. Historic, 639 F.3d at 143); • Virginia Conservation’s right to be indemnified by Route 231, Carr, and Humiston should it not receive all the tax credits for which it provided Route 231 money (cf. 26 C.F.R. § 1.707-3(b)(2)(iii); Va. Historic, 639 F.3d at 143-44) 10; • Carr’s agreement to reduce the amount of tax credits he would receive so that Route 231 could transfer to Virginia Conservation the full amount of tax credits for which it had contracted and paid (cf. 26 C.F.R. §
• That Virginia Conservation received a 1% interest in the LLC and yet received 97% of Route 231’s state tax credits for the “contribution” of $3,816,000 while Carr and Humiston each received a 50% (later reduced 10 We reject Route 231’s argument that the amended operating agreements’ indemnity clause should not serve as proof that Virginia Conservation’s right to the tax credits or their value was secured. Route 231 contends that the indemnity clause did not “fully protect [it] from partnership risks” because Route 231, Carr, and Humiston had minimal available assets should any one of them have been required to pay Virginia Conservation in satisfaction of the indemnity obligation. That argument misunderstands the relevant factor, which is whether “the partner’s right to receive the transfer of money or other consideration is secured in any manner[.]” 26 C.F.R. § 1.707- 3(b)(2)(iii). The regulation only asks whether the secured right exists, not whether there is a risk that the secured party may not in fact be able to collect on a judgment for breach of contract at some point in time. Because the indemnity clause creates a legally enforceable right of indemnity, the Tax Court appropriately concluded that this factor weighed in favor of a disguised sale. 20 to 49.5%) interest in the partnership and yet received 3% and 0% of Route 231’s conservation tax credits for their “contributions” of $2,300,000 (cf. 26 C.F.R. § 1.707-3(b)(2)(ix); Va. Historic, 639 F.3d at 144); and • That Virginia Conservation had no obligation to return or repay the tax credits to Route 231, but exercised full ownership rights in them (cf. 26 C.F.R. § 1.707- 3(b)(2)(x); Va. Historic, 639 F.3d at 144). These facts and circumstances form the basis for our conclusion that the Tax Court correctly determined that this transaction was a sale under 26 C.F.R. § 1.707-3(b)(1). Viewing all the circumstances surrounding this transaction, and in particular the terms of the amended operating agreements, the Tax Court did not err in finding that “Route 231 would not have transferred $7,200,000 of Virginia tax credits to Virginia Conservation but for the fact that Virginia Conservation had transferred $3,816,000 to it” and vice versa. J.A. 1526; cf. 26 C.F.R. § 1.707-3(b)(1)(i). Moreover, Virginia Conservation’s right to the tax credits did not depend on the entrepreneurial risks of Route 231’s operations. Cf. 26 C.F.R. § 1.707-3(b)(1)(ii). Arguing to the contrary, Route 231 points to Virginia Conservation’s assuming certain entrepreneurial risks as a partner in an ongoing partnership, but 26 C.F.R. § 1.707-3(b)(1)(ii) focuses on whether the later of the two transfers depended on the entrepreneurial risks of Route 231. Here, the plain language of 21 the amended operating agreements created a fixed cash-to-credit ratio to determine what each party would exchange. They also contained a specific guarantee that Virginia Conservation would receive all of the tax credits it paid for and that it would be entitled to reimbursement in cash for any shortfall. At bottom, Virginia Conservation’s right to the tax credits depended on fixed contractual terms, not the entrepreneurial risks of Route 231’s operations. For these reasons, our review of the record leads us to the firm belief that Route 231 failed to rebut the presumption that the transaction between Route 231 and Virginia Conservation was a sale. Cf. 26 C.F.R. § 1.707-3(c) (creating a presumption that transfers made within two years are presumed to be a sale “unless the facts and circumstances clearly establish” otherwise). Accordingly, we hold that the Tax Court did not err in agreeing with the Commissioner that the money Route 231 received from Virginia Conservation was “income” for federal tax purposes.