Tax Court, T.C. Memo. 2015-63, April 2, 2015: Tax due on partnership’s easement tax credit allocation as disguised sale.
The prime issue in this case was how the IRS should treat a limited partnership transaction involving Virginia tax credits for the donation of a conservation easement, and the valuation for federal tax purposes of that donation. Also at issue was the valuation of the conservation easement for federal income tax deduction purposes.
Virginia allows a landowner tax credits for a portion of the value of a charitable contribution of a conservation easement to a qualified donee. An owner may choose to sell some or all of the credits, particularly if the credit exceeds their tax obligation. Under federal tax law, income from the sale of credits may be treated as income on which a tax may be due. In this case, the landowner sought to avoid that federal tax by creating a somewhat complicated deal structure under which, the landowner hoped, the transfer of the credits would not be a taxable event. The tax court decided that the deal structure didn’t work to avoid the federal tax because in substance it was a sale, even if it was made to appear something else in form.
The deal structure developed as follows: In the first stage of the transaction, a tract of land that was owned by an individual, John Lewis, was conveyed to a limited liability company, SWF, which was created and wholly owned by Lewis. With the intention to contribute a conservation easement on the land to a qualified entity, Lewis engaged Conservation Solutions LLC (CS) to advise him. CS advised Lewis that the contribution would generate $3.2 million in Virginia tax credits for the LLC. As CS further advised, SWF (the company that now owned the land and would donate the easement) agreed to transfer most of the credits to an unaffiliated limited partnership called Virginia Conservation Tax Credit Fund LLLP (Virginia Conservation). Virginia Conservation, rather than buy the credits outright, became a 1% limited partner in SWF.
Typically in a limited partnership the burdens and benefits of ownership are divided among the partners, although the allocation is not always in the same proportion as the partners’ ownership percentages, and the allocation of the burdens may be different from the allocation of the benefits. In this case, although the allocation of the SWF partnership’s profits and losses were in proportion to their respective percentage interests of 1% (Virginia Conservation) and 99% (Lewis, through his corporation), the tax credits were allocated in reverse proportions, about 99% for Virginia conservation and 1% for Lewis. Under the partnership operating agreement Virginia Conservation paid $1.6 million for its 1% stake in SWF and would be entitled it to about $3 million in tax credits. Other provisions of the transaction documents effectively eliminated any transaction risk to Virginia Conservation.
After the conservation easement was contributed, SWF claimed on its tax returns that the $1.6 million received from Virginia Conservation was a “capital contribution,” i.e., not income. The IRS disagreed and the matter went to tax court.
The tax court held that the transaction was a disguised sale pursuant to section 707(a)(2)(B) of the Internal Revenue Code. Section 707 “prevents use of the partnership provisions to render nontaxable what would in substance have been a taxable exchange if it had not been `run through’ the partnership.” Accordingly, SWF owed additional federal income tax.
On the valuation question, the IRS’s argument that the appraisal submitted by SWF with its tax return was too high was primarily presented in terms of an attack on the credibility of SWF’s appraiser. The court didn’t find that attack itself credible. At trial, competing appraisals were offered in evidence by SWF and the IRS. The appraisal SWF put into evidence was slightly lower than the appraisal it had submitted with its tax return. The court found SWF’s appraisal evidence more credible than the IRS’s, and so held that SWF was entitled to only a slightly smaller deduction than it claimed.
The decision is available at http://www.ustaxcourt.gov/InOpHistoric/SWFRealEstateLLCMemo.Wells.TCM.WPD.pdf.