Tax Equity Deal Struck Down

Publication February 8, 2016

A tax equity partnership sold state tax credits rather than allocated them to the tax equity partner, a US appeals court said in January. 

The partnership had to report a $3.8 million “capital contribution” by the tax equity investor as income.

The decision is a reminder that there must be more substance to a tax equity transaction than stripping tax benefits.

Two individuals formed a partnership called Route 231 in 2005 to acquire two tracts of land near Albemarle, Virginia and then contribute conservation easements on the land to the Nature Conservancy and to one of the counties where the land was located. Virginia allowed a tax credit for 50% of the value of any conservation easements donated by property owners to conservation agencies. 

Under Virginia law, any partner allocated conservation credits by a partnership can sell the unused credits to a Virginia taxpayer.

Another partnership called Virginia Conservation was interested in the tax credits and became a partner in Route 231. Route 231 allocated it 1% of income and loss and most of the Virginia tax credits. Each of the two individuals who were the other partners in Route 231 retained a 49.5% interest. 

The partnership agreement required Virginia Conservation to contribute 53¢ to Route 231 for each dollar of Virginia tax credits allocated to it. Virginia Conservation ended up being allocated $84,000 less in tax credits in 2005 than what its $3.8 million capital contribution suggested. The partnership shifted tax credits to Virginia Conservation that had been allocated to the one of the two individuals before filing the 2005 partnership tax return to make up the shortfall.

The IRS said the arrangements were in substance a sale of tax credits to Virginia Conservation. A US appeals court agreed in early January. The US Tax Court reached the same conclusion in 2014. (For earlier coverage, see the April 2014 NewsWire article State Tax Credits.) 

IRS regulations say the government will assume any partner who contributes property to a partnership — in this case, the two individuals were viewed as contributing state tax credits to Route 231 — and then is distributed cash within two years that was contributed by another partner made a sale of the property to the partnership, unless the parties can show there is no link. The US appeals court said the state tax credits are “property” for this purpose. It said the capital contributions were clearly a payment for tax credits.

The court pointed to a number of facts that support treating the transaction as a sale of tax credits.

The capital contributions were X¢ per dollar of tax credits.

Virginia Conservation had a right to be indemnified by the other partners if the tax credits fell short. There was an agreement by one of the other partners to reduce his share if necessary to top up what Virginia Conservation was allocated to ensure it got the full amount of tax credits for which it paid.

The lopsided allocations did not help. Virginia Conservation was allocated only 1% of income and loss, but 97% of tax credits.

“At bottom,” the appeals court said, “Virginia Conservation’s right to the tax credits depends on fixed contractual terms, not the entrepreneurial risks of Route 231’s operations.” The case is called Route 231, LLC v. Commissioner.

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