Partnership's Allocation of State Tax Credits to Partners (Investors) Are Not Disguised Sales

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By Noah S. Baer, Esq.
Ernst & Young LLP, Washington, DC

In the recent Tax Court decision of Virginia Historic Tax Credit Fund 2001 LP v. Comr.,1 the court concluded that investors in a partnership structured to acquire and distribute state tax credits were indeed partners in the partnership and that their capital contributions did not represent the partnership's sales proceeds for the state tax credits.

Case Summary

The State of Virginia provides tax credits as an incentive to investors in historic rehabilitation projects. The state allows a partnership to allocate excess credits to its partners either in proportion to their ownership interest in the partnership or as the partners mutually agree. Thus, a disproportionate share of credits may be allocated to limited partners. Due to limited transferability of the credits, most investors participate through partnership investment vehicles.

Many historic rehab projects involve a developer partnership composed of a developer, a federal tax credit partner (that is, a partner who is allocated most of the federal tax credits), and a state tax credit partner (a partner who is allocated most of the state tax credits). Since the federal tax credits must be allocated in accordance with the partners' interest in partnership profits (see discussion below), the federal tax credit partner may hold as much at 98% of the partnership interests and receive an equivalent allocation of partnership income, deduction and credit. Thus, the state credit partner may hold only one percent of the partnership, with the remaining one percent held by the general partner. Accordingly, the state tax credit partner may be allocated a de minimis portion of the partnership income and deduction, but nearly all of the partnership's excess state tax credits.

Virginia Historic Tax Credit Fund 2001 LP and two feeder funds (together "the Funds"), invested in various developer partnerships and were allocated the excess state tax credits from qualified rehab projects. In addition, the Funds purchased state tax credits under the credits' limited transfer provisions. Altogether, the Funds had 181 partners who contributed almost $7 million to various rehab projects. The investors signed partnership agreements with the Funds which provided that they would be allocated profits and losses according to their ownership interests and would be entitled to liquidating distributions according to the positive balance in their capital accounts. Generally, an investor would contribute 74 cents to the Funds for every dollar of expected state tax credit.

The Funds filed timely partnership returns for 2001 and 2002 that reported the allocation of the state tax credits to their partners and tracked the partners' capital accounts. The IRS audited the Funds and concluded that they had unreported income because (i) the investors were not partners for federal tax purposes, and (ii) their capital contributions to the Funds were actually the purchase price received by the Funds for the sale of the state tax credits. Alternatively, the IRS argued that were the investors to be viewed as partners, their capital contributions represented the Funds' disguised sale of the credits to them under §707(a)(2)(B).  Interestingly, the IRS had also argued that the status of the Funds as partnerships should be disregarded based on the partnership anti-abuse rule.2 The IRS claimed that the Funds were formed with the principal purpose of reducing the partners' aggregate tax liability in a manner inconsistent with subchapter K of the Code.  However, the IRS withdrew this argument on the eve of trial and conceded that the anti-abuse rule did not apply to partnerships formed to reduce state tax liabilities.

The Tax Court rejected each of the IRS' arguments.

(1) The court rejected the argument that the investors in the Funds were not partners. In its analysis, the court reviewed the partnership documents signed by the partners together with their conduct under those documents and, applying the guidelines set out by the Supreme Court in the Culbertson and Tower cases,3 determined that the parties had intended to join together in good faith with a valid business purpose - to pool their resources and share the results of their investments.

(2) The court rejected the argument that applying substance over form requires the investor to be viewed as purchasing the state tax credits rather than contributing capital to the partnership.  The court concluded that the pooling of investor capital to support developer partnerships and earn state tax credits was a valid business purpose. The court noted that the capital contributions were not made in exchange for credits that had already been received by the Funds and that the investors bore the risk of the rehab projects either not being completed or being inadequately completed and therefore not earning state tax credits. In addition, the court noted that structure of the state program encouraged partnership investment in a manner that did not interfere with the allocation of the federal tax credits.

(3) The court rejected the argument that the capital contributions were, in effect, partnership income from the disguised sale of the state tax credits to its partners. The court based this conclusion on its earlier findings that the investors were partners, the partnership had a valid business purposes, and the capital contributions were not sale proceeds.

Allocation of Federal Tax Credits Under §704(b)

For federal tax purposes, a partnership allocation of income, gain, loss or deduction must have "economic effect." (The economic effect must also be "substantial." However, the rules on substantiality are beyond the scope of the article and are not relevant to the state tax credit discussion.) The partner receiving the allocation must receive the economic benefit or bear the economic burden of the allocations. The allocation must affect the amount of money to be received by the partner upon the partnership's liquidation. If the allocation does not impact the capital account of the partner or if it is tracked and ultimately ignored at liquidation, the allocation merely has tax consequences, not economic effect.4

There are three mechanical requirements for economic effect:5

(1) the partnership must maintain capital accounts in accordance with detailed regulations;

(2) upon liquidation of the partnership, all liquidating distributions must be made in accordance with positive capital accounts; and

(3) a partner must be unconditionally obligated to restore a deficit capital account balance after liquidation. (This requirement may be modified with a "qualified income offset" provision. Regs. §1.704-1(b)(2)(ii)(d)).

The basic rules for capital account maintenance are that each partner's capital account is increased by (i) the amount of money and the fair market value of contributed property (net of liabilities secured by the property), and (ii) allocations of partnership income and gain, and is decreased by (iii) the amount of money and the fair market value of distributed property (net of liabilities secured by the property), (iv) allocations of partnership loss and deduction, and (v) certain nondeductible, noncapitalizable expenses.6

The allocation of tax credits is not reflected by any adjustment to the partners' capitals accounts since credits are uniquely tax items and do not affect the value of the partnership's assets. The rules provide that tax credits must be allocated in accordance with the partners' interests in the partnership at the time they arise.  If a partnership receipt or expenditure that gives rise to a tax credit also gives rise to a valid allocation of income or of loss or deduction, then the partners' interests in the partnership with respect to that credit is in the same proportion as the partners' respective share of the related income or loss. Thus, tax credits "piggyback" the income or deduction giving rise to the credit and, while the credit itself cannot be allocated, the related income or expense can be.7

However, these rules apply to the allocation of federal tax credits. There is no guidance, at least until the current case, how state tax allocations are impacted by the federal economic effect rules.

Implications of Virginia Historic Tax Credit Fund 2001 LP on Allocation of State Tax Credits

As noted in the facts of the case, the Funds invested in lower tier partnerships that allocated to them the state tax credit. These lower partnerships were structured to provide nearly all their income, deduction and tax credits to federal tax investors.  That means that the Funds allocated nearly all the state tax credits with only a minimal amount of partnership income and deduction. Because the state tax credits were divorced from the expenses giving rise to them, the lower-tier allocations could not have had economic effect under §704(b). Similarly, the purchased state tax credits may have had tax basis but also were divorced from any deducible expense. Nonetheless, there appears to have been an acknowledgement by the court that a partnership's allocation of state tax credits does not have to comply with federal rules. (Nonetheless, we should remember that it was the Funds that were audited and not the lower-tier partnerships generating the state tax credits.)

Further, the decision supports the structuring of state tax credit investor partnership where credits are allocated based on capital accounts. This appears to be a reasonable conclusion since it was the capital contributions of the Fund investors that permitted the Funds to invest in lower-tier credit generating partnerships. Thus, the Funds acted as a form of clearing house in acquiring state tax credits with the investors' capital and then allocated those credits to the investors. More fundamentally, the court concluded that as long as the credit had not yet been earned by the Funds the investors were true partners in that their capital was at risk in the joint venture.

The decision represents a significant win for state tax credit investors, not only in real estate ventures but also, increasingly, in alternative energy ventures. It should provide comfort to such investors that their investment vehicles will be recognized as partnerships for federal tax purposes and it should provide comfort to those structuring such vehicles that the allocation of state tax credits, property structured, is not a taxable event for the partnership.

 For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity,  and in Tax Practice Series, see ¶4020, Classification of Partnership.



 1 T.C. Memo 2009-295.

 

 2 Regs. §1.701-2(b).

 

 3 Comr. v. Culbertson, 337 U.S. 733 (1949); Comr. v. Tower, 327 U.S. 280 (1946).

 

 4 Regs. §1.704-1(b)(1)(i).

 

 5 Regs. §1.704-1(b)(2)(ii)(b).

 

 6 Regs. §1.704-1(b)(2)(iv).

 

 7 Regs. §1.704-1(b)(4)(ii).