Route 231, LLC v. Comm’r – 4th Circuit Affirms Allocation of 97% of Tax Credits Generated by Conservation Donations to 1% Partner Was Disguised Sale

In Route 231, LLC v. Comm’r, __ F.3d _ (4^th Cir. 2016), the 4^th Circuit affirmed that Tax Court’s holding that a partnership’s transfer to a 1% partner of 97% of state tax credits generated by donations of conservation easements and land was a taxable disguised sale under IRC § 707. The 1% partner had contributed $3.8 million to the partnership and the partnership had treated the transaction as a capital contribution followed by an allocation of tax credits to the 1% partner. As in Route 231, LLC v Comm’r, T.C. Memo. 2014-30, the 4^th Circuit found Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, 639 F.3d 129 (4th Cir. 2011), to be on point and noted 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.” 

            The 4^th Circuit rejected the partnership’s attempt to distinguish Virginia Historic on the ground that Virginia Historic involved sham partnerships that ceased to exist as soon as the credits were transferred, while Route 231 was a valid partnership with economic substance and the 1% partner remained a bona fide partner in that partnership. The 4^th Circuit found that argument “misse[d] the mark” because IRC § 707 “applies by its plain terms to designated transactions between otherwise valid ongoing partnerships and their legitimate partners.” In other words, the disguised sales rules look to the bona fides of a particular transaction rather than the status of the participants to that transaction.

            The 4^th Circuit also affirmed the Tax Court’s holding that the disguised sale occurred in 2005 and, thus, the partnership had to report the $3.8 million as income on its 2005  federal tax return. The partnership sought to treat the $3.8 million as reportable income in 2006 because the IRS had not sought to have the income included on the partnership’s 2006 tax return and any changes to that return were barred by the statute of limitations. The 4^th Circuit found none of the partnership’s arguments on the applicable tax year to be meritorious. The court seemed to find particularly annoying that the partnership had made an affirmative representation on its 2005 federal tax return that it received the $3.8 million in 2005. In holding that the partnership was bound by its representation on its 2005 return, the court explained:

“‘[T]he duty of consistency not only reflects basic fairness, but also shows a proper regard for the administration of justice and the dignity of the law. The law should not be such a[n] idiot that it cannot prevent a taxpayer from changing the historical facts from year to year in order to escape a fair share of the burdens of maintaining our government. Our tax system depends upon self assessment and honesty, rather than upon hiding of the pea or forgetful [equivocation].'” (citation omitted)

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