In the first Court of Appeals case to consider the question, the Fourth Circuit, reversing the Tax Court, has held that state historic tax credit investors were not partners of tax credit investment funds, but rather were mere purchasers of the state credits. Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, No. 10-1333 (4th Cir., March 29, 2011). As a consequence of this treatment, the funds had to recognize taxable income in this case, $1.53 million from the sale of property, rather than treating the payments received from the investors as a tax-free capital contribution to a partnership. More important, this case calls into question some common credit investment structures.
In Virginia Historic Tax Credit Fund , the state credit investors invested in funds (partnerships or LLCs), which in turn invested in partnerships that were developing historic projects or, in some cases, purchased credits directly from developers. The Tax Court found that the investors were partners and that the funds, therefore, had received capital contributions, rather than selling the state historic tax credits. The Tax Court rejected the Commissioner's arguments that the overall transaction should be disregarded under the "step transaction" doctrine and treated as a sale or, alternatively, that the transfer of the credits to the investor was a so-called "disguised sale," i.e., a sale by the partnership of the credits to the investor partners not in their capacity as partners.
The Court of Appeals did not address the step transaction argument, but instead decided the case on whether the transaction was a disguised sale. The Court held that a number of factors required a conclusion that the investors had purchased the credits and were not acting as partners. Looking to the disguised sale regulations, the Court found numerous factors supporting sale treatment:
- The timing and amount of the transfers of money and credits were related; here, the investors did not contribute money until the underlying projects were completed.
- The investors had a legally enforceable agreement to the transfer of the credits.
- The investors' right to receive the transferred credits was secured effectively, to assure the investors they would receive the credits.
- The transfer of money was disproportionately large in relation to the investors' "general and continuing interest in partnership profits" no investor had more than a .01% partnership interest, yet each contributed money disproportionately to that minimal ownership interest.
- After receipt of the credits, the investors had no further obligations to the funds.
- Finally, the Court noted the transitory nature of the investors' involvement in the partnership: at most for six months but in many cases as little as one month. Moreover, the redemption price was only 0.1% of each investor's contribution.
This is an important case that must be considered in any transaction in which state tax credits, whether historic, Brownfield or other similar credits, are part of the financing. It will not be the last. On the same day the Court of Appeals decided Virginia Historic Tax Credit Fund,the Commissioner filed a notice of appeal in the Third Circuit in Historic Boardwalk Hall, LLC v. Commissioner. While that case involves federal historic credits, the Commissioner argues there, as in the Fourth Circuit case, that the parties engaged in a disguised sale. Unpublished IRS rulings (some of which were based on the Virginia Historic Tax Credit transaction and released before the Tax Court trial) also show that the IRS takes a narrow view of what attributes an investor needs to have in order to be treated as a partner.
As these cases demonstrate, structuring transactions using credits requires careful analysis in a rapidly changing legal environment. Attorneys at Dykema have substantial experience in structuring tax credit transactions for developers, investors and lenders.