Route 231 v. Commissioner - Allocation to 1% Partner of 97% of Tax Credits Generated by Conservation Easement Donations Treated as Disguised Sale

In Route 231, LLC v. Commissioner, T.C. Memo. 2014-30, the Tax Court held that a partnership’s transfer to a 1% partner who had contributed $3.8 million to the partnership of 97% of the state tax credits the partnership received for making charitable contributions of conservation easements and land was a taxable disguised sale under IRC § 707. The partnership (Route 231) treated the transaction as a $3.8 milliion capital contribution by the partner followed by an ”allocation” of the tax credits to that partner. In holding that the transaction was, in substance, a disguised sale, the Tax Court relied on Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011), which the court found to be “squarely on point.” The Tax Court also explained that IRC § 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.”

In Virginia Historic, three individuals set up a web of partnerships for the purpose of passing Virginia historic rehabilitation tax credits to investors. The partnerships solicited investors who contributed money to the partnerships’ capital accounts in return for (i) small (generally 0.01%) partnership interests and (ii) the partnerships’ promise to provide them with a fixed amount of Virginia historic rehabilitation tax credits. The IRS determined that these transactions were disguised sales under IRC § 707 and the Fourth Circuit agreed.

The Tax Court found “compelling similarities” between the transactions at issue in Virginia Historic and the transaction at issue Route 231. Just as in Virginia Historic, Route 231 involved a contribution of money to a partnership in return for (i) a small (1%) partnership interest and (ii) the partnership’s promise to provide the contributor with a fixed amount of tax credits.

There were some factual differences between the transactions at issue in the two cases. Virginia Historic involved a complex web of partnerships with hundreds of investors, most of whom received a 0.01% interest in the partnerships, while Route 231 is a stand-alone partnership with only three partners, including the 1% partner. Unlike the investors in Virginia Historic, who were partners in the partnerships for only approximately five or six months (characterized by Route 231 as “grab the tax credits and run” cases), the 1% partner in Route 231 is still a partner in that partnership. In addition, in Virginia Historic the IRS argued that the investors were not valid partners, whereas in Route 231 the IRS did not question whether the 1% partner was a valid partner. The Tax Court was unmoved by these factual differences, finding that they did not detract from the compelling similarities between the two cases.

Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law