The third time was not a charm for the taxpayer in the case of SWF Real Estate, LLC, et al. v. Commissioner, TC Memo 2015-63.  As was true in the case of Virginia Historic Tax Credit Fund 2001 v. Commissioner, 693 F.3d 146, CA4 reversing TC Memo 2009-295 and Route 231, LLC v. Commissioner, TC Memo 2014-30 the issue involved whether individuals who paid money to become “partners” that received tax credits from the state of Virginia had really simply bought credits in a disguised sale under IRC §707(a)(2).  And, as was eventually found in the prior cases, the Court determined the answer was yes.

Generally a partner can contribute tax free to a partnership under IRC §721 and can receive a distribution tax free except to the extent that cash distributions (including deemed cash distributions due to a reduction in debt allocable to the partner) exceed the taxpayer’s basis under §731. 

Given that it doesn’t take much thought to figure out how to “game” those provisions, the IRC contains a number of provisions that are exceptions to that rule.  One of those is the “disguised sale” rule of §707(a)(2) which is meant to prevent taxpayers using a contribution followed by a distribution to effect what would be, in terms of pure economics, a tax free sale otherwise.

As the Court explained:

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. Sec. 707(a)(2)(B). In all cases the substance of the transaction governs rather than its form. Sec. 1.707-1(a), Income Tax Regs.

The Court goes on to note:

Section 1.707-3(b)(2), Income Tax Regs., provides the following nonexhaustive list of 10 facts and circumstances that may tend to prove the existence of a disguised sale pursuant to section 1.707-3(b)(1), Income Tax Regs.:

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

(ii) That the transferor has a legally enforceable right to the subsequent transfer;

(iii) That the partner’s right to receive the transfer of money or other consideration is secured in any manner, taking into account the period during which it is secured;

(iv) That any person has made or is legally obligated to make contributions to the partnership in order to permit the partnership to make the transfer of money or other consideration;

(v) That any person has loaned or has agreed to loan the partnership the money or other consideration required to enable the partnership to make the transfer, taking into account whether any such lending obligation is subject to contingencies related to the results of partnership operations;

(vi) That the partnership has incurred or is obligated to incur debt to acquire the money or other consideration necessary to permit it to make the transfer, taking into account the likelihood that the partnership will be able to incur that debt (considering such factors as whether any person has agreed to guarantee or otherwise assume personal liability for that debt);

(vii) That the partnership holds money or other liquid assets, beyond the reasonable needs of the business, that are expected to be available to make the transfer (taking into account the income that will be earned from those assets);

(viii) That partnership distributions, allocation or control of partnership operations is designed to effect an exchange of the burdens and benefits of ownership of property;

(ix) That 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

(x) That the partner has no obligation to return or repay the money or other consideration to the partnership, or has such an obligation but it is likely to become due at such a distant point in the future that the present value of that obligation is small in relation to the amount of money or other consideration transferred by the partnership to the partner.

These factors are considered for their overall effect in determining if the third factor has been met.  As well, any transfers between the partnership and the partner within two years are presumed to be a disguised sale unless facts and circumstances show the transaction was not a sale.  [Reg. §1.707-3(c)(1)}

In Virginia Historic the Tax Court initially found there was no disguised sale, finding that the existence of some entrepreneurial risk and the fact that the transactions were not simultaneous indicated there was not a disguised sale.  However the Fourth Circuit Court of Appeals, pointing to the presumption of a disguised sale, found that the situation was a disguised sale.  As the Tax Court points out in this case when discussing Virginia Historic:

The Court of Appeals also concluded that, while this Court was free to conduct its own evaluation of entrepreneurial risk, our conclusions on the issue were flawed because the only risk the investors faced was that of an “advance purchaser who pays for an item with a promise of later delivery.”

The Court, later facing another partnership dealing in the credits in Route 231, LLC, looked at that case in light of the Fourth Circuit’s ruling.  The Court noted that Route 231’s transaction was as follows:

The partnership had entered into a transaction with Virginia Conservation in which Virginia Conservation contributed $3,816,000 to Route 231 in exchange for a 1% membership interest in Route 231 and an allocation of $7,200,000 in Virginia tax credits arising out of the charitable donation of conservation easements and a fee interest on parcels of land owned by Route 231.

Route 231 and Virginia Conservation agreed to (1) a capital contribution of 53 cents per $1 of Virginia tax credits allocated to Virginia Conservation and (2) an indemnity clause whereby Route 231 and the partners other than Virginia Conservation (the previous partners of the partnership) were jointly and severally liable to indemnify Virginia Conservation if the Virginia tax credits were disallowed. I The previous partners of the partnership also had the option to purchase all, but not less than all, of Virginia Conservation’s membership interest in Route 231 on or anytime after January 1, 2010.

The Tax Court found in this case that the transaction was in all material aspects similar to that in Virginia Historic and thus, under the Golsen rule, the Court was bound to follow the holding of the Fourth Circuit and treat the transaction as a disguised sale based on the fact that an appeal of the decision would go to that same circuit.

The Court noted that, again, an appeal of the case before it now would go to the Fourth Circuit and, again, that the transaction was similar enough to that in Virginia Historic that the holdings of the Fourth Circuit would have to be respected in this case.

The Court begins analyzing this transaction by noting the two year presumption rule, which holds that the transaction is presumed to be just such a disguised sale since all of the relevant portions of the transaction occurred in the two year period.  So now the question is whether that presumption can be overcome by looking at the actual facts and circumstances.

The taxpayer first contended the transfer of the tax credits did not represent property—however, as the Tax Court noted, the Fourth Circuit noted that the question of “property” is analyzed under a combination of federal and state law. 

The opinion notes:

In Va. Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d at 140, the Court of Appeals addressed the issue of whether tax credits constitute property for purposes of section 707 and noted that the issue was a hybrid Federal and State law question. It compared the tax credits in issue in Va. Historic to a “bundle of sticks” where State law determined “which sticks are in a person’s bundle” and Federal law determined whether the sticks qualify as property for purposes of a Federal statute. Id. (citing United States v. Craft, 535 U.S. 274, 278-279 (2002)). The Court of Appeals then asked whether the tax credits embodied “’some of the most essential property rights’”, including the “’right to use the property, to receive income produced by it, and to exclude others from it’”. Id. at 141 (quoting Craft, 535 U.S. at 283). It also considered “’the breadth of the control the taxpayer could exercise’” over the item and whether the item was “valuable.” Id. (quoting Drye v. United States, 528 U.S. 49, 60-61 (1999)). The Court of Appeals determined that the tax credits in question were property; they had pecuniary value because they were used to “induce investors to contribute money” and the funds exercised proprietary control over the credits because they could “exclude others from utilizing the credits and were free to keep or pass along the credits to partners as they saw fit.” Id. at 141 (citing Craft, 535 U.S. at 283).

The Tax Court concluded that, using that analysis, the tax credits in question were property.

The taxpayer also objected that the credits were not actually transferred to the partner, but rather allocated—and, as you will note, only transfers trigger the disguised sale rule.  However, the Tax Court notes, the Fourth Circuit had rejected that view in Virginia Historic, noting:

The Court of Appeals in Va. Historic also contemplated petitioner’s contention that tax credits are allocated, and not transferred, to a partner. The Court of Appeals concluded that the argument was “tautological” and that the only way to determine whether a partnership and a partner were acting in their capacities as such during the transactions in questions was to consider all of the facts and circumstances pursuant to section 707 and section 1.707-3, Income Tax Regs. Va. Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d at 140 n.13. Accordingly, we follow the holding of the Court of Appeals in Va. Historic and reject petitioner’s contention.

Having concluded property was transferred, the Court then went on to look whether the facts and circumstances indicated this was not a sale.

The Court first looks at two tests under Reg. §1.707-3(b)(1) to see if this looks like a sale.  Those tests are:

• Whether the new members would not have transferred their capital contribution to the partnership but for the corresponding transfer of the credits (as a buyer clearly would not do—the “but for” test); and
• If the transfers are not considered simultaneous, whether the partnership's transfer to the new members was not dependent on the entrepreneurial risks of the partnership operations (that is, while the transfer might have been delayed, that transfer did not involve participation in the risks and rewards of the partnership’s operations—the “entrepreneurial risk test”)

The Court decided that the transaction would not have take place “but for” the transfer, noting:

In the instant case, Virginia Conservation similarly promised to contribute money to SWF equal to 53 cents for each $1 of Virginia tax credits allocated to it. Like the other partners (other than Virginia Conservation) in Route 231, petitioner and Mr. Lewis also agreed to indemnify Virginia Conservation if any Virginia tax credits were disallowed in the instant transaction. Moreover, when the donation of the easement on Sherwood Farm resulted in additional Virginia tax credits because of a higher-than-expected valuation, Virginia Conservation was granted the additional Virginia tax credits at a rate of 53 cents of additional capital contribution per $1 of additional Virginia tax credits. Virginia Conservation was ultimately allocated 92% -- the “lion’s share” -- of the Virginia tax credits despite holding only 1% of membership interests in SWF. As we did in Route 231, we find that the material facts are squarely in point with those in Virginia Historic, and we conclude that Virginia Conservation would not have transferred money to SWF but for the corresponding transfer of Virginia tax credits to Virginia Conservation.

The Court also found there was no entrepreneurial risk borne by the new members, finding:

In the instant case, Virginia Conservation was promised a legally enforceable, fixed rate of return of $1 of Virginia tax credits for every 53 cents contributed and was shielded from suffering any loss of Virginia tax credits through an indemnity clause that required SWF and Mr. Lewis to indemnify Virginia Conservation for any of its Virginia tax credits that were disallowed or revoked. In Route 231, LLC v. Commissioner, at *40-*41, we applied the rationale and holding of the Court of Appeals in Va. Historic in a nearly identical transaction and held that those two facts were indicative of a transfer of credits that was not dependent on entrepreneurial risks. Similarly, we again find the facts in the instant case to be squarely in point with those in Va. Historic and apply the holdings therein in the instant case pursuant to the Golsen rule. Additionally, although they represented that they “had obtained sufficient information * * * to evaluate the merits and risks of an investment” in SWF, there is no indication that Mr. Shaw, Mr. Brower, or any other representative party for Virginia Conservation reviewed the relevant financial records pertaining to SWF’s business; Virginia Conservation was solely interested in the VTC transaction in issue rather than the ongoing SWF farming business. See also Route 231, LLC v. Commissioner, at *40-*41 (“[T]here is no indication in the record that Virginia Conservation even considered Route 231’s operations before it agreed to contribute a substantial amount of money[.]”). On the basis of the foregoing, we conclude that SWF’s transfer of Virginia tax credits to Virginia Conservation was not dependent upon the entrepreneurial risks of SWF’s business.

The taxpayers now had to rely on the court’s finding that, despite the above, the facts and circumstances of the transaction tested under the ten tests described above lead to the conclusion that this was not a sale or exchange.

The Court considered what it believed to be the relevant tests in the list and found as follows:

• The timing and amount of transfer of credits was reasonably determinable at the time the new partners transferred funds to the partnership;
• The new partners had a legally enforceable right to the later transfer of the credits transferred to them;
• The right to receive the credits was secured—if the state disallowed the credits, the prior partners would refund the payment to the new partners;
• The partnership had more credits than were reasonably needed for its business purposes—thus it would make sense to sell the excess;
• The transfer of credits was disproportionately large compared to the new partners’ continuing interest in the partnership; and
• The new partners were under no obligation to return the credits to the partnership

Considering these factors, the Court found that this was a sale of the credits and not a pair of tax free transactions (the contribution of capital followed by a distribution to partners).