The IRS Identifies Pitfalls In State Tax Credits Deals
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Published: February 26, 2007
Source: State Tax Notes
The IRS Identifies Pitfalls In State Tax Credits Deals The Internal Revenue Service recently released Chief Counsel Advice ("CCA") that offers an interesting, and chastening, analysis of state tax credit transfer structures, and why they can spell trouble on the federal income tax front. On first encounter one might wonder why the Internal Revenue Service would interest itself in partnerships designed to transfer state tax credits from, say, a developer to an individual who has a desire to minimize state income taxes. Working through the Chief Counsel Advice ("CCA"), however, it becomes apparent that these kinds of plans not only raise state tax issues regarding whether they effectively transfer state tax credits but also, gone wrong, raise the potential for federal income recognition, and inconsistent audit outcomes. The CCAs considered state income tax credits allowed for rehabilitation projects, and measured by qualified expenditures. (As is usual in these situations, neither the state nor any of the affected parties was identified.) The credit, equal to x% of eligible rehabilitation expenses, could be used as a dollar-for-dollar reduction in state income taxes. It also was allowed to be carried forward for a specified number of years. In one CCA the state tax credit was transferable. Presumably this meant that a developer who was able to establish to the satisfaction of third party investors the existence of a specific dollar amount of available tax credit, could transfer, for a price, the right to apply that credit against the investors' income taxes. In the other CCA the credit was not transferable, so the problem was somewhat more complex. In both cases, promoters, developers and investors sought to use partnership structures through which the investors could claim state income tax credits in respect of the developer/partnerships' expenditures. The CCAs noted that the investors generally were individuals interested in reducing their state income tax exposure because, due for instance to the federal alternative minimum tax, they "were indifferent to the state taxes deduction under Search7RH164 for federal tax purposes." The partnership structures considered in the CCAs generally entailed the following events. Individual investors would subscribe for partnership interests, making cash contributions to partnerships which, directly or through tiers, had purchased credits from developers, or had incurred or were incurring qualified rehabilitation expenditures. Upon the admission of the investors as partners, or shortly thereafter, the partnerships would allocate to the investors the state income tax credits earned as a result of the rehabilitation activities. The investors would also enter into option agreements, under which the partnerships had the option to reacquire the investors' partnership interests at fair market value within a short period. In most cases the investors sold their interests back to the partnership within a few months, reporting capital losses on such sales. In other words, the investors were partners for a short while, during which time state income tax credits were allocated to them; and then they were redeemed out of the partnerships for an amount less than their initial investment. According to the CCAs, the marketing materials relating to these credit transfer transactions stated that the individuals would not receive "any material distributions of cash flow or net proceeds from the sale of the projects," nor would they be allocated any material amounts of income, gain, loss or deduction for federal income tax purposes. In addition, the CCAs described the marketing materials as stating that the return to the investors for their investment in the partnerships would be realized solely through the application of the state tax credits and the tax benefit of the capital losses generated upon the sales of their partnership interests. The IRS analyzed these transactions under four different rubrics, and articulated four reasons why the transactions did not work as the parties had intended, at least not on the federal level. First, the IRS applied the principles of the "substance-over-form" doctrine to evaluate whether the investors should be respected as partners for federal income tax purposes. Citing Culbertson, the IRS stated that "[t]he critical inquiry is the parties' intent to join together in conducting business activity and sharing profits." In concluding that the individual investors were not true partners, the IRS found it important that the transactions were promoted as ones in which the investors would receive no material cash or partnership allocations; the investors subscribed "with full knowledge" that their only benefit would be the state tax credits and federal capital loss deductions; and the interests were held only briefly. Since the investors were not partners, they did not receive the allocations of state income tax credits as partners. Instead, the IRS viewed the individuals' cash investments as the purchase of property, in the form of a state tax credit. In essence the developers sold the credits to the promoters and investors. Since the developers had no basis in the credits, the developers recognized gain on the receipt of the cash from the promoters and/or investors. When the investors then applied the credits against their state income taxes, they too recognized gain, equal to the difference between their cost basis for the credits (the amounts they paid into the partnership) and the amount of state income taxes satisfied through application of the credits. Between the developers and the investors, there would be gain equal to the full amount of the credits. And presumably because the investors were "indifferent" to federal income tax deductions for state taxes paid, the federal deduction for the state taxes they were deemed to have paid through the application of the credits they purchased would be of no use to the investors in offsetting their income. Finally, because the investors were not respected as partners, their claimed capital losses on the sales of their partnership interests back to the partnerships were disallowed. The IRS also analyzed the credit transactions under the disguised sales rules of IRC Search7RH707. Generally, transactions that in form appear to involve partners and their partnerships may be recharacterized under Search7RH707 as transactions between a partnership and someone who is not a partner, thereby turning tax-free transactions into taxable transactions. Utilizing the authority of Search7RH707, the IRS treated the transactions as taxable sales of the state tax credits by the developer partnerships to the individuals. In both CCAs the IRS also applied the "partnership anti-abuse" rule. This rule, which from time to time terrifies tax practitioners with its vagueness and scope, permits the IRS to recharacterize a transaction involving a partnership if the partnership has been formed or availed of in connection with a transaction a principal purpose of which is to reduce federal tax liability in a manner inconsistent with the intent of Subchapter K (the partnership provisions of the IRC). Here, the IRS found that the developer partnerships were formed or availed of for a prohibited purpose -- specifically, they "enabled the promoters of the transactions to effect the sale of large numbers of credits at a profit of $f per dollar of credit without incurring gain at any level. Moreover, by design the investors claimed large amounts of capital losses from the sale of their purported 'partnership interests' . . . These manufactured deductions effectively substituted for state tax payments the investors could not otherwise benefit from, typically because such payments would not have been deductible for AMT purposes." Based on this analysis, the IRS again concluded that the transactions should be treated as taxable sales of the credits. Finally, analyzing the technical rules of the Internal Revenue Code which specify procedures for partnership audits ("TEFRA"), the IRS determined that the question of whether the individuals would be respected as partners was a "partnership item," and thus could be audited at the partnership level, rather than through the much more cumbersome process of identifying and auditing each individual investor. While the IRS acknowledged this conclusion to be controversial, nevertheless they concluded that the issue of the investors' treatment as partners (or not) would be pursued at the partnership level, with the IRS then having an additional year following the conclusion of that process to assess the partners individually for the capital losses they claimed. In sum, the IRS saw these credit transfer partnerships as too thin and lacking in substance to be respected as such, and instead recast the transactions as taxable sales of the state income tax credits by the developers, followed by a second taxable transaction occurring when the investors applied the purchased credits to satisfy their state tax liabilities. Putting numbers to the theory, suppose an individual investor contributed $6 to a developer partnership in the expectation of being allocated $10 of state income tax credit. As structured, the parties planned that the investor would claim a $10 credit, offsetting $10 of state income tax liability. Upon the redemption of his partnership interest a short while later for $0, the investor would claim a capital loss of $6. Instead of paying $10 of state income taxes, which he could not effectively deduct due to the AMT, the plan was for the investor (i) to recognize no income when applying the state tax credit against his state income tax liability; and (ii) to recognize $6 of capital loss on the redemption of his partnership interest, which capital loss could be used to offset capital gains for both federal and state income tax purposes. What the IRS held, by contrast, was that the $6 that was in form contributed to the partnership was in reality $6 of sales proceeds realized by the developer from the sale of an asset that had a zero basis. This produced $6 of gain to the developer. When the investor then applied the credit against his taxable income, he realized another $4 of gain by satisfying a $10 liability with an asset in which he had a basis of $6. The $10 deemed payment of state income tax would give rise to a federal deduction for regular tax purposes, but since the investor was subject to the federal AMT, that deduction was of no use to him. Overall, therefore, the investor (i) would not be entitled to the $6 capital loss reported; (ii) would recognize $4 of gain on the deemed payment of $10 of state income taxes with the credit purchased for $6; and (iii) would have a $10 deduction for the state income taxes deemed paid, which deduction would be disallowed under the AMT. What the IRS did not address, logically enough, is what might happen next, on the state level, at least in cases where the state credits are not intended to be transferable. If the federal recharacterization of the transaction is correct, and means that the investors are not considered to have been partners for state income tax purposes either, and if the state tax credit could properly be allocated only to persons who are bona fide partners in the developer partnerships, then the investors' claimed state income tax credits would presumably be disallowed. The $4 gain the IRS posits the investor as having recognized through the satisfaction of his state tax liability with the partnership's $10 credit would not exist, because the state would disallow the investors' claimed credits. Instead, the investor would owe the state $10 in income tax. The $6 paid to invest in the partnership would be monies lost, rather than the purchase price for a valuable asset. In short, our investor would end up with a state tax bill of $10, plus interest and perhaps penalties, as well as a $6 economic loss, of uncertain tax character, from his purchase of a credit he could not use. Meanwhile the developers, who should still have $6 of gain in respect of the monies received from investors, presumably would not have claimed the $10 state tax credits, thinking them sold to the investors. Whether the developers could still claim the $10 credit, or instead that claim is time-barred, would depend upon the facts. The CCAs are of course only an early installment, a litigation-oriented one at that, in the audit and analysis of these particular structures. They are only an indication of the issues identified By the IRS in those audits, and of the types of challenges other credit transfer plans, with other fact patterns, might face. And as with any dispute, the taxpayers still have their side to tell -- the conclusions expressed by the IRS in these particular CCAs may not stand up to impartial analysis. The CCAs are nonetheless important for highlighting the federal income tax consequences of a plan driven largely by state tax considerations. They serve to demonstrate how a federal audit can unravel state tax planning techniques, and stand as examples of cases in which coordinating the federal and state audits may be of considerable practical importance. It would make no sense for investors to pay federal tax on the profit enjoyed in applying a credit purchased for $6 to pay $10 of state income tax, if the state is of the view that the investors cannot legitimately claim the credit.