At the ABA Forum meeting in D.C., representatives of the Chief Counsel’s office met with tax practitioners to discuss LIHTC issues, including compliance issues, Revenue Procedure 2014-12 issues and state tax credit issues.  In the discussion, Faith Colson, who has taken a leadership role at the IRS with respect to the audit of state tax credit transactions, responded to a series of questions regarding the scope of application of the disguised sale rule that was endorsed by 4thCircuit decision in the Virginia historic tax credit case and would treat allocation of state tax credits as a taxable sale.

First, in a helpful comment, Faith said that an allocation of state tax credits proportionally to the interest of the partners in a partnership would not be challenged by the IRS.  Accordingly, in transactions where the federal tax credit investor is also allocated state credits, the IRS would not recharacterize the allocation of the state credit as a taxable sale.

Second, in any transaction in which a state tax credit earned at placement in service is specially allocated to a state investor that holds small interest in the partnership that generates the credit, the IRS would be likely to recharacterize the transaction as a taxable sale of the state credit, regardless of the nature of the credit or whether the state investor intends to hold its interest in the partnership for an extended period of time.

Third, in a surprisingly aggressive response to a question regarding state LIHTC credits that are available to a partnership (1) on an annual basis if the project remains in compliance and (2) that are subject to recapture for a 15 year period, Faith acknowledged that she had not studied such a credit, but was inclined to disregard the fact that only a small portion of the state credit was earned within the two year disguised sale presumption period and treat any specially allocated state credit as property that was “sold” by the allocating partnership.

This position reflects the aggressiveness of the IRS’s approach to the federal taxation of state credits.  While there are strong arguments that can be made that the 10 factors identified in the disguised sale rules found in Treasury Regulation Section 1.707-3(b)(2) should not be reduced to a single factor approach in which any state credit disproportionately allocated is deemed “sold” for federal income tax purposes, taxpayers should expect that the IRS may challenge any disproportionate allocation of state credits.