Tax Court decision reversed

The 4th Circuit reverses a decision of the Tax Court, and says the Commissioner of Internal Revenue properly characterized transactions between the Virginia Historic Tax Credit Fund LLC and certain investor partners in federal tax returns as “sales” under IRC 707.

transactions and the commissioner appealed. We reverse the Tax Court and find that the commissioner properly treated the challenged transactions as “sales” under IRC § 707.

During an audit, the Commissioner of Internal Revenue challenged the way Virginia Historic Tax Credit Fund LLC (2001 LLC), as the tax matters partner of Virginia Historic Tax Credit Fund 2001 LP, Virginia Historic Tax Credit Fund SCP LLC and Virginia Historic Tax Credit Fund 2001 SCP LP, reported a series of transactions with investor partners in the Funds’ 2001 and 2002 federal tax returns. The U.S. Tax Court found that the Funds had properly characterized these transactions and the commissioner appealed. We reverse the Tax Court and find that the commissioner properly treated the challenged transactions as “sales” under IRC § 707.

In total, the Funds collected $6.99 million from investors between November 2001 and April 2002.

During this same time period, the Fund paid a total of 15 developers $5.13 million, at a price of $.55/$1 tax credit, to obtain $9.2 million in historic rehabilitation tax credits. Approximately one-third of these tax credits were purchased from developers under Virginia’s one-time transfer provision: The rest were obtained in exchange for capital contributions to operating partnerships with which the Fund partnered. In April 2002, the Funds distributed to investors “Schedules K-1” designating to each investor his promised amount of tax credits and attaching the DHR Certificates of Rehabilitation from the Funds’ operating partnerships. Specific credits were not designated as being allocated to any one particular investor; instead the investors were informed of the amount allocated to them from the pool of credits. The Funds then exercised their option to buy out all investors in May 2002, paying them each .001 times their contribution for a total buyout cost of about $7,000.

The instant dispute arose from the way the Funds reported this series of transactions in the 2001 and 2002 federal tax filings.

On appeal, the commissioner makes the same two arguments he made before the Tax Court: that the investors were not bona fide partners of the Funds, and that even if they were, the transactions between the investors and the Funds should nevertheless be classified as sales for federal tax purposes under the relevant Code provisions and regulations.

Assuming, without deciding, that a “bona fide” partnership existed, we nevertheless find the commissioner properly recharacterizd the transactions at issue as “sales” under I.R.C. § 707.
The Funds argue that § 707 cannot be applied to recharacterize their transactions with investors because these transactions did not involve an exchange of money for “property.” They argue that Virginia’s historic rehabilitation tax credits are not “property” because they are non-transferable and non-heritable under state law. There was, they argue, no transfer of money or other property from the Funds to the investors.

We find the transfer of tax credits from the Funds to investors under the circumstances presented here constituted a transfer of “property.” Although Virginia law prohibits historic tax credits from being bought and sold directly, this is a nominal prohibition. To hold these tax credits, which the Funds undeniably gave to investors in exchange for money, are not property simply because they could not be directly bought and sold would elevate form over substance.

We disagree with the Tax Court’s conclusion that the Funds “clearly established” that their investors faced entrepreneurial risks sufficient to overcome the regulatory presumption that these transactions were sales. We agree with the commissioner that the Funds should have included the money received from investors as income in their tax returns and uphold the adjustments issued to the Funds in 2002.

Decision of the Tax Court reversed and case remanded for further proceedings.

Virginia Historic Tax Credit Fund 2001 LP v. Comn’r of Internal Revenue (Duncan) No. 10-1333, March 29, 2011; USTC; Ivan C. Dale, USDOJ; David D. Aughtry for appellees. VLW 011-2-068, 29 pp.