04.07.2011 Disguised Sales of State Historic Tax Credits

The U.S. Court of Appeals for the Fourth Circuit held that purported capital contributions to Virginia historic rehabilitation tax credit syndicates organized as partnerships were taxable sales of Virginia Tax Credits.  The Court reversed the decision of the U.S. Tax Court.  Virginia Historic Tax Credit Fund 2001, LP v. Commissioner, No. 10-1333 (4th Cir. 2011).  

The IRS challenged the way that three related Virginia historic rehabilitation tax credit syndicates (the “Funds”) reported the Funds’ transactions with investors (the “Investors”).  The U.S. Tax Court found that the Funds had properly reported the transactions as tax-free capital contributions.  Reversing the Tax Court, the Fourth Circuit held that the Funds had engaged in taxable sales of property and that the Investors lacked the entrepreneurial risk of true partners.

Virginia Historic Rehabilitation Tax Credits

Virginia provides historic rehabilitation tax credits (“Virginia Tax Credits”) to developers (“Developers”) that renovate historic structures, recognizing that the cost of renovating historic structures often exceeds the structures’ fair market value.  Developers apply to the Virginia Department of Historic Resources (“DHR”) for approval of the Virginia Tax Credits.  If the DHR certifies the project, the Developer is entitled to receive Virginia Tax Credits of up to twenty-five percent of eligible rehabilitation expenses.  For example, a Developer may receive $1,250,000 of Virginia Tax Credits if it incurs $5,000,000 of eligible rehabilitation expenses in the course of rehabilitating a historic structure.  Virginia law allows partnerships to allocate the Virginia Tax Credits among their partners in any manner the partners agree.  

A typical Virginia historic rehabilitation tax credit project has multiple layers of entities that transfer the tax credits from Developers to individual and business taxpayers that use the Virginia Tax Credits to offset their Virginia income tax from other sources.  A Developer that is usually a limited partnership or limited liability company taxed as a partnership will rehabilitate a historic structure and obtain approval of the Virginia Tax Credits from the DHR.  The Developer will seek investments from Virginia Tax Credit syndicates who receive de minimis limited partnership interests and disproportionately large allocations of the Virginia Tax Credits in exchange for their payments.  The tax credit syndicates will sell limited partnership interests in the syndicate to individual and business taxpayers who receive disproportionate allocations of the Virginia Tax Credits from the syndicates.

Federal Rehabilitation Tax Credits

Developers frequently also seek investors for federal historic tax credits with respect to the same projects.  The federal and Virginia Tax Credits have similar criteria; however, a significant difference between the two credit programs is that the federal tax credits must be allocated in accordance with the partners’ interests in the partnership.  Thus, the federal tax credit investor may own a 98% or greater interest in the Developer to receive a majority of the federal tax credits.  As the majority owner, the federal credit investor also receives a proportionate amount of the Developer’s other items of profit, loss and deduction, but receives none of the Virginia Tax Credits because such tax credits are disproportionately allocated to the Virginia Tax Credit investor(s).

Illustration of a Historic Tax Credit Project

The following is a simplified illustration of a historic rehabilitation project with a majority federal tax credit investor and a minority Virginia Tax Credit syndicate that passes the Virginia Tax Credit through to multiple Virginia tax credit investors.

The Funds’ Structure in Virginia Historic Tax Credit Fund 2001, LP

The Virginia Tax Credit Investors in the case before the Fourth Circuit received limited partnership interests and promises of a specific amount of Virginia Tax Credits in exchange for payments that the Funds and Investors reported as tax-free capital contributions to the Funds.  For every $0.74 that an Investor invested in the Funds, the Investor received a $1 allocation of Virginia Tax Credits.  An Investor typically received a 0.01% limited partner interest in the Funds regardless of his or her investment.

The Funds’ offering memoranda and partnership agreements explained that Investors should not expect to receive more than negligible allocations of income or loss from the Funds.  The Funds would only invest in Developers holding completed projects entitled to credits, substantially eliminating the Funds’ risks that they will have the Virginia Tax Credits to allocate to their partners.  The Funds would receive reimbursements of their investments if any of the Developers failed to receive and properly allocate Virginia Tax Credits or if DHR revoked the Virginia Tax Credits.  Thus, the offering memoranda and partnership agreements made it evident that Investors’ risk of loss was insignificant.

The Funds collected $6.99 million from the Investors and paid Developers $5.13 million to obtain $9.2 million of Virginia historic rehabilitation tax credits, or about $1 of Virginia Tax Credits for every $0.56 invested.  The Funds obtained about one-third of the Virginia Tax Credits under an expired, one-time transfer provision that allowed Developers to sell their Virginia Tax Credits.  The Funds obtained the rest of their Virginia Tax Credits in exchange for capital contributions to the Developers that entitled them to disproportionate allocations of the Virginia Tax Credits.

The Funds treated the Investors’ payments of $6.99 million as nontaxable capital contributions and allocated Virginia Tax Credits to the Investors on Schedules K-1.  After allocating the Virginia Tax Credits to the Investors, the Funds redeemed the Investors’ interests for a payment of 0.001 times their contributions.  The formula produced a redemption price of approximately $7,000 on the $6.99 million paid by the Investors for their limited partnership interests.  For their taxable years in question, the Funds treated none of the Investors’ payments as taxable income and reported total losses of $3.28 million. 

IRS Recharacterizes the Relationship of the Funds and Investors

The IRS audited the Funds and recharacterized the payments of $6.99 million from the Investors to the Funds.  The IRS’s position was that the Investors had not made capital contributions and were not partners of the Funds.  The IRS believed that, even if the Investors were partners of the Funds, the transactions with the Funds should be reported as taxable sales of state income tax credits to the Investors under Internal Revenue Code §707.  Code §707 governs sales and other transactions between partnerships and partners.  The Funds and the IRS stipulated that, if the IRS’s recharacterization of their relationship was correct, the Funds should have reported income of $1.53 million rather than losses of $3.28 million.

Virginia Tax Credits are Property

The Funds argued that there could be no sale between the Funds and the Investors because there was no exchange of money for property.  They argued that the Virginia Tax Credits were not property because they were nontransferable (other than the one-time transfer provision that has since expired).  The Fourth Circuit noted that the Code does not define “property,” but that the Virginia Tax Credits were clearly property.  To hold otherwise would elevate form over substance.  The Virginia Tax Credits had value, evidenced by the fact that the Funds used the Virginia Tax Credits to attract the Investors to pay money.  The Funds also had control over the tax credits.  Virginia law prohibits buying and selling Virginia Tax Credits (other than the one-time transfer provision that has since expired), but Virginia law permits partnerships to allocate the credits as they choose.  In the case of the Funds, the Investors made purported capital contributions for de minimis limited partnership interests and received disproportionate allocations of Virginia Tax Credits.

Funds Engaged in Taxable Sales of the Tax Credits to Investors

After concluding that the Virginia Tax Credits were property, the Fourth Circuit determined that the transfers of the credits from the Funds to the Investors were sales under Code §707 rather than allocations of Virginia Tax Credits to partners.  Under the Treasury Regulations, there is a presumption of a sale because the Investors’ payment to the Fund and receipt of the Virginia Tax Credits occurred within two years.  The Funds failed to overcome the presumption of a sale.  The Court focused on several factors to uphold that presumption.  The most significant factor was that the value of the property distributed to the Investors, i.e., the Virginia Tax Credits, was disproportionately large in proportion to the Investors’ continuing interest in the partnership.  Most of the Investors only held de minimis 0.1% partnership interests, and they were collectively redeemed for a total payment of approximately $7,000 shortly after receiving the credits.

Investors Faced no Entrepreneurial Risk as Partners

The Tax Court had focused on the Investors’ entrepreneurial risk.  The Tax Court concluded that the Investors faced the risk that Virginia would either not grant the credits or would revoke the credits, putting the Investors’ anticipated economic benefit at risk.  The Fourth Circuit rejected the Tax Court’s conclusion that the Investors bore entrepreneurial risk.  The Funds provided assurances to the Investors that their payments would be refunded if the Virginia Tax Credits were not received or were revoked.  Furthermore, the Funds were structured to render the possibility of insolvency and inability to pay refunds remote.  The Funds promised the Investors a fixed return of $1 for each $0.74 invested in the Funds and expressly told Investors to expect no other return.


The Fourth Circuit did not provide a roadmap that Virginia Tax Credit syndicates can follow to avoid IRS scrutiny.  At the very least, Virginia Tax Credit syndicates such as the Funds will have to consider whether they want to report investors’ payments as taxable income from the sale of property or dramatically restructure themselves to avoid the presumption of a disguised sale under Code §707.  If they choose the latter, they should question whether they can make disproportionately large allocations of Virginia Tax Credits to partners with negligible economic interests in the venture.  They should also question whether they can provide guarantees that diminish the partners’ entrepreneurial risk to a negligible amount.

It is important to note that the disguised sale rules under Code §707 generally recharacterize transactions between partners and partnerships.  Therefore, a party can be a partner in the partnership and still have a transaction recharacterized as a purchase or sale of assets.  Accordingly, extending the time during which the Virginia Tax Credit investor remains in the partnership, or a similar modification to the arrangement, likely will not remedy the result reached by the Fourth Circuit.

Unanswered questions surround the parties’ bases in the Virginia Tax Credits and the character of gain from the sale of the Virginia Tax Credits.  The IRS audited the Funds, and the Tax Court and the Fourth Circuit analyzed the Funds’ relationship with the Investors.  The IRS did not audit the lower tier Developers or their relationship with the Funds, and the Tax Court and the Fourth Circuit did not analyze this relationship.

Tax credit syndicates such as the Funds that are treated as having purchased Virginia Tax Credits for resale to Investors should have basis in the Virginia Tax Credits that they purchase, and they should be able to use that basis to reduce the gain that arises when they sell the tax credits to Investors.  In contrast, the amount of Virginia Tax Credits that Developers are entitled to receive is based on the qualified rehabilitation expenditures incurred in the rehabilitation project.  Such costs traditionally are capitalized real property subject to depreciation.  The question arises whether the Developers have any basis in the Virginia Tax Credits that they transfer to the Virginia Tax Credit syndicates.  If the Developers have no basis in the Virginia Tax Credits, then 100% of the payments from the Virginia Tax Credit syndicates are taxable income to the Developers and their partners.  In many cases, such income will be required to be allocated to the federal tax credit investors resulting in a change in the economics of those investors’ arrangements.  It also must be determined whether such taxable income is capital gain or ordinary trade or business income; however, we anticipate that in most instances the gain is short-term capital gain.

We will continue to evaluate and monitor developments with this case and the issues it presents.

For more information about this topic, please contact the author or any member of the Williams Mullen Tax Law Team.