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State Tax Credits Transaction for Partnership Interest Ruled a Disguised Sale



The Tax Court held that a transfer of state tax credits in exchange for a 1% partnership interest was a disguised sale, and that the taxpayer must recognize income from the transaction.


In a recent case, the Tax Court held that a transfer of tax credits between LLCs was actually a disguised sale and the transferor recognized income from the sale. The taxpayer formed an LLC for the purpose of acquiring real property. The LLC (“First LLC”) then purchased two parcels of land and made charitable contributions of conservation easements on the land to charitable organizations. For these contributions, First LLC claimed transferable state tax credits equal to 50% of the fair market value of the donated land and interest. Another LLC (“State Credit LLC”) had acquired state tax credits in partnership arrangements with various landowners, contributing about $0.53 for each dollar of state tax credits that the landowner allocated to State Credit LLC.

State Credit LLC became a member of First LLC in exchange for a small capital contribution. In addition, First LLC agreed to allocate some of its transferable state tax credits to State Credit LLC while State Credit LLC agreed to contribute $0.53 for each dollar of state tax credits allocated to it.

The IRS argued that this transaction was, in fact, a “disguised sale” under the Internal Revenue Code.  According to the Code, a disguised sale occurs when a partner transfers money or property to a partnership that results in a related transfer of money or property by the partnership to the partner. When viewed together, the transfers are characterized as a sale or exchange of property.

The Tax Court found that a disguised sale did occur in this transaction. The court used a six-factor test to confirm that First LLC’s state tax credits were transferred in exchange for State Credit LLC’s capital contribution.

(1) The timing and amount of the sale were determinable with reasonable certainty at the time of the transfer
(2) State Credit LLC had a legally enforceable right to receive the state tax credits
(3) State Credit LLC’s right to the credits was secured
(4) Money was lent to the First LLC to make the transfer
(5) The amount of the credits received by State Credit LLC was disproportionately large compared to the capital contribution it made to First LLC
(6) State Credit LLC had no obligation to return or repay the credits to First LLC

The amount of money transferred by State Credit LLC to First LLC was expressly linked to the amount of tax credits that State Credit LLC received in return. Additionally, the transfer of the credits did not depend on any entrepreneurial risk to First LLC’s operations. For these reasons, and after an examination of the facts and circumstances, the Tax Court held that the transfer was a disguised sale and that proceeds resulted in income to First LLC in the first year the proceeds were received.

What Does CohnReznick Think?
The Tax Court closely followed the reasoning in the Virginia Historic Tax Credit case from 2011 when determining that the transaction was a disguised sale. The fact that the State Credit LLC remained a member in First LLC long term did not change the analysis that there was a disguised sale which could mean that any one time credit is subject to similar treatment. When structuring any transaction involving state tax credits, beware that the IRS is on the look-out for the taxable income potentially associated with these transactions. 


For more information, please contact Beth Mullen, Affordable Housing Industry Practice National Director, at 916-930-5750.

To learn more about CohnReznick’s Tax Practice, please visit our webpage.

Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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