07-82 | Virginia Tax

Tax Type

Partnerships

Taxes of Other Agencies

Description

An entity ignored for federal tax purposes is not similarly ignored for other purposes

Topic

Historic Rehabilitation Credit

Date Issued

05-25-2007

May 25, 2007

Re: Historic Rehabilitation Credit

Dear *****:

This is in response to your request for me to consider the impact that advice recently issued by the Internal Revenue Service (`the IRS") could have on the Virginia Historic Rehabilitation Credit.

On January 26, 2007, the IRS released a General Counsel Advice Memorandum ("GCAM") addressing the transfer of state tax credits (AM 2007-002, copy attached).¹ This case involved "promoter partnerships" that obtained state income tax credits and then solicited investors to join the partnership and receive allocations of the credits in exchange for cash. The partnership interests were marketed to the investors as ones in which the investors would not receive any material distributions of cash and would not be allocated partnership items of income, gain, loss or deduction. Further, investors were informed that their sole return, if any, on their investment would be the allocation of the credits and the capital loss that would be claimed for federal income tax purposes upon the sale of their interest in the partnership.

The transactions were usually structured so that the investors were allocated the credits immediately following their contribution of cash to the partnership. Future allocations of credits, if any, were carried out within a short period of time. After holding onto the partnership interests for a brief period of time in order to receive the allocation of credits, the investors would sell their interests back to the partnership or the promoters of the partnership for a small fraction of the cash they paid. On their federal income tax returns, the investors would then claim large capital losses on the sale of their partnership interests.

These promoter partnerships did not engage in any substantial business activities other than the allocation of the credits. Although they may have taken an "acquisition fees" deduction in transactions involving transferable credits, the partnerships and their partners did not report any income related to the disposition of the credits to the investors.

The GCAM addressed the issues of whether the investors in these types of transactions would be considered partners in the partnerships; whether the transactions should be recast under the partnership anti-abuse rule, and whether the issue of whether an investor is a partner in a partnership constitutes a partnership item.

After reviewing the hypothetical facts, the GCAM concludes that a taxpayer will be deemed to have acquired the credit from the partnership by purchase instead of allocation. Because the act of claiming the state tax credit will be treated as a disposition of purchased property, the taxpayer claiming the credit will have to report as income the difference between the amount claimed as a credit and the cash paid to the partnership.

The impact of this GCAM on Virginia state income tax credits is limited. The IRS will continue to respect state law and recognize that the "promoter partnership" is able to effectively transfer a credit to the taxpayer claiming the state credit on his or her state income tax return. In Virginia, income tax returns start with federal adjusted gross income (for individuals) or federal taxable income (for corporations). Thus, Virginia taxable income would include any income recognized for federal purposes, including income recognized as a consequence of the deemed purchase of state tax credits. The taxpayer, however, would also be allowed to claim any Virginia tax credits to which he may be entitled under Virginia law.

The remaining question is whether the IRS treatment has any impact on the parties for other purposes. Specifically, because the IRS treats the credit as having been acquired by purchase, should the Department of Taxation and the Department of Historic Resources deny the credit on the grounds that Virginia law does not allow the transfer of credits?

Although the GCAM does not expressly say so, the essence of the "substanceover-form" analysis invoked by the IRS assumes that the parties followed all of the formalities required by Virginia law in creating a valid partnership, contributing capital, earning the historic rehabilitation tax credit, and distributing partnership property (the credit) to the partners. Despite following all the formalities required by Virginia law, the IRS treats the transaction as if the partnership had nothing to do with the credits for the purpose of computing the federal taxable income of the parties. "This treatment applies whether or not the credits were transferable under state law, and whether or not the transaction is treated as a partnership allocation for state law purposes." AM 2007-002, page 4.

The fact that an entity is ignored for federal income tax purposes does not mean that it is similarly ignored for other purposes. For example, a single-member limited liability company may be disregarded for federal income tax purposes and its income attributed to the member, but transactions between the LLC and its member would still be subject to the retail sales and use tax. See Public Document 98-157 (10/20/98).

Based on the hypothetical facts and implied assumptions in the GCAM, it appears that the historic rehabilitation credits would be granted under Virginia law to a partnership validly created under Virginia law. The statute, Va. Code § 58.1-339.2, refers to various determinations by Virginia agencies and values assessed by local tax authorities. It expressly requires that credits granted to a partnership be passed through to the partners. There is nothing in Virginia law that ties any amount or determination related to the credit to the federal tax treatment of a related item.

Therefore, the IRS action based upon a deemed purchase of state tax credits, which by its terms is limited to the calculation of federal income tax, does not require the Virginia agencies administering the credit to similarly ignore actions otherwise valid under Virginia law and revoke the credit because of the deemed purchase. While there may be circumstances in which the credit could be revoked, the hypothetical facts in the GCAM do not provide a basis to invoke that authority.

I trust that this reply answers your request. If you should have any questions regarding this ruling, you may contact ***** in the Office of Policy and Administration, Policy Development, at *****.

- - - - Sincerely,

- - - - Janie E. Bowen
        Tax Commissioner

¹http://www.irs.gov/pub/irs-utl/am2007002.pdf. An Advice Memorandum may not be used or cited as precedent.

Rulings of the Tax Commissioner