Partnership taxation is animated by two conflicting goals: Subchapter K of the Internal Revenue Code simultaneously seeks to provide individuals operating as a partnership with freedom to structure their affairs as they see fit and to constrain that freedom when they structure their affairs in ways that seem abusive.
Where there has been a perceived abuse of the partnership form, the IRS has a variety of tools to address it; these tools include judicial doctrines, such as the substance over form doctrine, as well as statutory provisions. For example, the Fourth Circuit recently addressed a partnership case and concluded that what the taxpayers characterized as an investment was actually a disguised sale under Section 707 of the Code. Rule 231 LLC v. Comm’r, 2016 U.S. App. LEXIS 256 (4th Cir. Jan. 8, 2016).
The case involved a donation of real property that generated state tax credits in Virginia. Rule 231, 2016 U.S. App. LEXIS 256, *3. The property was owned by Rule 231 LLC (the “Partnership”), a limited liability company that was taxed as a partnership. The two principals of the Partnership entered into an arrangement with another LLC, Virginia Conservation Tax Credit FD LLLP (“Virginia Conservation”) that provided for Virginia Conservation to make a capital contribution and become a member of the Partnership; it would then receive an allocation of the bulk of the credits generated from the donation of the properties. Id. a *3-*4.
The tax credits would equal 50 percent of the fair market value of the property, which was to be donated for conservation purposes. Virginia Conservation agreed to make an initial capital contribution of $500, plus an additional sum equal to 53 percent of the amount of tax credits to be allocated to it; in return it received a 1 percent interest in the partnership and the vast bulk of the relevant tax credits. Id. at *4. Virginia Conservation then paid $3,816,000 into an escrow account where the funds were held pending the finalization of the conservation donations and the corresponding tax credits.
The Partnership treated the above arrangement as a contribution of capital followed by a distribution, which meant that the transaction was tax free. The IRS disagreed with that treatment; it concluded that the Partnership had recognized $3,816,000 in income from the sale of the tax credits. Id. at *8. The IRS reasoned that the transaction was a disguised sale under Section 707 of the Code, and the Tax Court agreed. 2016 U.S. App. LEXIS 256 at *8-*10.
In a disguised sale, a partner contributes money or other property to a partnership, which is tied to a related transfer from the partnership to the partner or another partner. I.R.C. § 707(A)(2)(B)(i), (ii). If the two transfers are properly viewed together as a sale or exchange of property, then a disguised sale has occurred. I.R.C. § 707(A)(2)(B)(iii). The Treasury Regulations expand upon the issue, indicating that a disguised sale has occurred if the partner’s contribution to the partnership would not have occurred absent the relevant transfer to the partner. Treas. Reg. § 1.707-3(b)(1)(i). If the transfers are not simultaneous, then a disguised sale has occurred if “the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.” Treas. Reg. § 1.707-3(b)(1)(ii). The regulations also call for a multifactor facts and circumstances test. Treas. Reg. § 1.707-3(b)(2). This test is subject to a presumption: related transfers made within two years of each other are presumed to be a sale “unless the facts and circumstances clearly establish that the transfers do not constitute a sale.” Treas. Reg. § 1.707-3(c)(1).
As the Fourth Circuit had previously addressed a similar arrangement in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011), it readily affirmed. The Court began its analysis by determining that the relevant tax credits constituted property. The fact that the credits were used “as an inducement to Virginia Conservation” and that Virginia Conservation was paying for tax relief drove the Court’s decision here. Rule 231, 2016 U.S. App. LEXIS 256 at *20-*21.
Turning to the question whether there had been a sale, the Fourth Circuit initially noted that the case fell within the presumption of Section 1.707-3(c)(1) of the Regulations, placing the onus on the taxpayers to “clearly establish” that there was not sale. Id. at *21 (quoting Treas. Reg. § 1.707-3(c)(1)). The Court then considered whether the facts and circumstances were consistent with a sale, applying the two regulatory criteria: whether the cash transfer to the Partnership would have occurred absent the agreement to transfer the credits, and whether the subsequent transfer of the credits was dependent upon “the entrepreneurial risks of the partnership.” Id. at *22 (quoting Treas. Reg. § 1.707-3(b)(1)(ii)). The Fourth Circuit endorsed the Tax Court’s analysis, which had focused on a variety of factors indicating that the credits had been sold, including the use of a formula tying the credits issued directly to the amount of Virginia Conservation’s “capital contribution,” indemnification rights it enjoyed if it did not receive all of the promised credits, and the disproportionate allocation of 97 percent of the credits to a partner that held a 1 percent interest. Id. at *22-*23. In the Court’s view, these circumstances indicated that there was a but-for relationship between the contribution of Virginia Conservation to the Partnership and the Partnership’s allocation of the credits to Virginia Conservation that was consistent with a sale. Id. at *23-*24.
Given the fact pattern, it is hard to fault either the Tax Court or the Fourth Circuit here.
One interesting aspect of Rule 231 is the decision by the IRS to focus narrowly on the disguised sale rule. In contrast, the earlier Virginia Historic Tax Credit Fund case had featured challenges to the legitimacy of the partnership for tax purposes, as well as a disguised sale argument, both of which were rejected by the Tax Court. 639 F.3d at 136. Similarly, the Third Circuit’s decision in Historic Boardwalk Hall LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012), the focus was on the legitimacy of the partnership, as well as the economic substance doctrine, and the Tax Court rejected both theories. Id. at 429, 445-47. The tactical decision to focus on the disguised sale rule gave the IRS a simpler and narrower case that came with the benefit of a presumption, making the taxpayer’s position more difficult.