John Varella, Lourie & Cutler

As our readers know, one focus of this column is the never-ending tax credit battle between the Internal Revenue Service and developers who allocated tax credits to investors. In August 2012, the United States Court of Appeals for the Third Circuit ruled in Historic Boardwalk Hall v. Commissioner that an investor in a syndicated partnership sharing in federal historic tax credits was not a bona fide partner and that the partnership was not a true partnership. As a result, the investor was not permitted to use its allocated tax credits. That decision led to an outcry from the historic tax credit industry, and, in response, the IRS issued guidance in 2014 that provided some helpful guidance to the industry but did not override the reasoning of the Third Circuit.

The Historic Boardwalk Court stated that, to be a bona fide partner, the investor was required to share in both the upside benefits and the downside risks of loss. The court determined that the investor in question lacked any meaningful downside risk for several reasons. First, the investor joined the partnership after the partnership had already committed sufficient funding to pay the costs of the project. Second, the investor did not make its capital contribution to the partnership until after the historic credits had been certified and were available to the investor. Third, the court focused on the fact that the partnership and the New Jersey Sports and Exhibition Authority had given guarantees which protected the investor from loss arising from failure to complete the construction, environmental liabilities and any loss or reduction of the tax credits. Finally, a letter of credit secured the payment of the investor’s preferred return and a loan made to the partnership by the investor.

Recently, the Fourth Circuit struck another blow against tax credit partnerships when it affirmed a Tax Court ruling holding that the transfer of Virginia tax credits constituted a disguised sale of property. In Route 231, LLC v. Commissioner, the Fourth Circuit was asked to determine whether a multi-million dollar capital contribution made to a partnership by an investor should be treated as a disguised sale of state tax credits to the investor. The Court determined that the capital contribution, which ordinarily would not result in any taxation, should be treated as a payment of purchase price in exchange for the tax credits. By treating the transaction as a sale of credits for cash, the Court required the taxpayer to recognize income on the sale-a terrible result for the taxpayer.

The lesson of this case cannot be clearer. In creating a tax credit partnership, it is important that counsel comply with all of the steps needed to establish a partnership and allocate credits. The timing of the investment and allocation of credits is critical. It can be the difference between no tax bill and a huge tax bill.

John Varella is an attorney with Lourie & Cutler, Boston, Mass.