In recent years, the IRS has successfully challenged the status of many “investment” arrangements as “partnerships” for federal tax law purposes. Several of the successful challenges have centered on partnerships that purported to allocate state or federal tax credits (largely in the historic tax market segment) to investor members. The height of the IRS success culminated in a victory in the Second Circuit Historic Boardwalk decision. The IRS’ victory in Historic Boardwalk produced IRS guidance in the form of Rev. Proc. 2014-12, which provides a safe harbor for when a tax credit partnership will be respected as a “partnership” for federal tax law purposes. Rev. Proc. 2014-12 safe harbor essentially provides that a partner must have both an upside and downside economic risk in order to be treated as a partner for federal tax purposes. The safe harbor can create tensions with the typical tax credit investment structure and, moreover, has not stopped the IRS from challenging other tax credit investment partnerships. A recently issued Legal Advice Issued by Field Attorneys, LAFA 20161101F, that serves as a reminder that investors must truly share in the risks and rewards of the venture to be treated as a partner for federal tax purposes.
In the context of state tax credit partnerships, a successful IRS challenge would typically result in the allocation of state tax credits being treated as a disguised sale for federal tax law purposes. The federal income tax ramification of re-characterizing the transaction is significant: the partnership has a zero basis in the state tax credits and, as a result of the disguised sale treatment, the entire amount received by the partnership is taxable gain.
With respect to federal tax credits, the IRS has taken a slightly different tack. Namely, the IRS has asserted that the tax credit investor is not a “partner” in the partnership. As a result, because most federal tax credits cannot be stripped and sold as separate assets – but rather depend on allocating the tax credits through one or more flow through entities – the investor is denied the tax credits and the partnership is stuck with federal tax credits that it likely cannot use.
When is a partner really a partner for federal tax law purposes? LAFA 20161101F reveals that if the investor’s contributions are tied solely to receiving expected tax benefits, the investor likely has no downside risk and, thus, would not be a partner for federal tax law purposes. Rev. Proc. 2014-12 provides further guidance with respect to the criteria that should be met in order for an investor to be treated as a partner. While the most recent authorities have largely dealt with the allocation of tax credits to a tax credit investor, the guidance has much wider application to partnership tax. This is so because the IRS has primarily based its attack on the theory that no “partnership” exists for federal income tax purposes. Thus, the guidance should also impact structuring other investments through a partnership entity.