ROUTE 231, LLC, JOHN D. CARR, TAX MATTERS PARTNER, Petitioner - Appellant,
COMMISSIONER OF INTERNAL REVENUE, Respondent - Appellee
Argued October 28, 2015.
Appeal from the United States Tax Court. (Tax Ct. No. 013216-10).
Timothy Lee Jacobs, HUNTON & WILLIAMS LLP, Washington, D.C., for Appellant.
Richard Farber, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.
William L.S. Rowe, Richmond, Virginia, Richard E. May, Hilary B. Lefko, Matthew S. Paolillo, HUNTON & WILLIAMS LLP, Washington, D.C., for Appellant.
Caroline D. Ciraolo, Acting Assistant Attorney General, Regina S. Moriarty, Tax Division, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.
Before AGEE and WYNN, Circuit Judges, and HAMILTON, Senior Circuit Judge. Judge Agee wrote the opinion, in which Judge Wynn and Senior Judge Hamilton joined.
AGEE, Circuit Judge:
Route 231, LLC, a Virginia limited liability company, (" Route 231" ) reported capital contributions of $8,416,000 on its 2005 federal tax return. This number reflected, in relevant part, $3,816,000 it received from one of its members, Virginia Conservation Tax Credit FD LLLP (" Virginia Conservation" ). Upon audit, the Commissioner of the Internal Revenue Service issued a Final Partnership Administrative Adjustment (" FPAA" ) indicating that Route 231 should have reported the $3,816,000 received as gross income and not a capital contribution. Route 231 challenged the FPAA by petition to the United States Tax Court. After a trial, the Tax Court determined that the transaction was a " sale" and reportable as gross income in 2005. Route 231 now appeals, asserting that the Tax Court erred in finding the transfer was not a capital contribution or, alternatively, that any income was not reportable until 2006. For the reasons set forth below, we disagree with Route 231 and affirm the decision of the Tax Court.
In May 2005, Raymond Humiston and John Carr formed Route 231, a limited liability company (" LLC" ) registered in Virginia. Humiston and Carr each made initial capital contributions of $2,300,000 and each received a 50% membership interest in the LLC. Route 231's initial operating agreement stated its purpose was " to own, acquire, manage and operate [certain] real property." (J.A. 225.) Consistent
with that purpose, Route 231 purchased two parcels, known as Castle Hill and Walnut Mountain, in Albemarle County, Virginia, for approximately $24 million. Carr and Humiston personally guaranteed the bank loan financing the purchase.
Carr and Humiston were interested in donating some of Route 231's property for conservation purposes and retained a consultant to assist with that process. At that time, Virginia offered state income tax credits " equal to 50 percent of the fair market value of any land or interest in land located in Virginia" donated to a public or private agency eligible to hold such land and interests therein for conservation or preservation purposes. Va. Code § 58.1-512 (2005). Through the consultant, Route 231 discussed the possibility of Virginia Conservation joining the LLC by contributing money to Route 231 and receiving a majority of the Virginia tax credits that would be earned as a result of three proposed conservation donations.
These discussions led to Route 231's first amended operating agreement, signed December 27, 2005, in which Virginia Conservation became a member of Route 231 with a 1% membership interest, with Humiston and Carr's interests each being reduced to 49.5%. The amended operating agreement provided that Virginia Conservation agreed to make an " initial capital contribution" of $500 plus an additional sum " in an amount equal to the product of $0.53 for each $1.00 of [the tax credits] allocated to" it. (J.A. 477, § 2.2.) The first amended operating agreement anticipated that Route 231 would earn Virginia tax credits " in the range of $6,700,000 to 7,700,000" as a result of the proposed conservation donations, and it provided that while Carr would receive $300,000 of credits, Virginia Conservation would receive " the balance."  (J.A. 479, § 3.6.)
Two days later, on December 29, 2005, Virginia Conservation paid $3,816,000 into an escrow account pursuant to three escrow agreements reflecting the three conservation donations Route 231 intended to make. The escrow agreements provided that the funds would be released to Route 231 upon written confirmation by Virginia Conservation that it had received copies of several documents verifying the conservation donations and Virginia tax credits. One item listed was the Virginia Department of Taxation's transaction number for tracking the conservation donations and Virginia tax credits.
The next day, December 30, 2005, Route 231 recorded deeds conveying the following conservation donations of real property: (1) a deed of gift of an easement on Castle Hill to the Nature Conservancy, which was valued at $8,849,240; (2) a deed of gift of an easement on Walnut Mountain to the Albemarle County Public Recreational Facilities Authority, which was valued at $5,225,249; and (3) a fee interest in Walnut Mountain (subject to the above easement) to the Nature Conservancy, which was valued at $2,072,880.
The final value of these conservation donations -- and hence the amount of Virginia tax credits -- was slightly lower than Route 231's consultant had anticipated. Consequently, Carr agreed to defer receiving
approximately $84,000 of the $300,000 in tax credits he had been promised in the first amended operating agreement so as to allow Virginia Conservation to receive tax credits equivalent to the formula for the full amount of money it had paid into escrow.
On January 1, 2006, Humiston, Carr, and Virginia Conservation executed a second amended operating agreement for Route 231. The agreement described the three specific conservation donations the LLC had made and set out the Virginia tax credits Route 231 had earned as a result of those donations. It indicated that those credits " have been allocated as follows: (i) $215,983.00 . . . to Carr and (ii) $7,200,000.00" to Virginia Conservation. (J.A. 508, § 3.5.)
After execution of the second amended operating agreement, Route 231 submitted three Virginia Land Preservation Tax Credit Notification Forms (" Forms LPC" ) to the Virginia Department of Taxation. The forms stated that Route 231 had earned its Virginia tax credits on December 30, 2005 (the date of the conservation donations), and that it allocated those credits to Carr and Virginia Conservation in the amounts reflected in the second amended operating agreement.
In March 2006, the Virginia Department of Taxation provided Virginia Conservation and Carr with the transaction numbers for Route 231's conservation donations and the tax credits. The Virginia Department of Taxation's letter stated that these tax credits were " effective" in 2005.
Soon after Virginia Conservation received these tax credit transaction numbers, the escrow funds were released to Route 231.
In April 2006, Carr -- acting as Route 231's tax matters partner -- filed Route 231's 2005 federal Return of Partnership Income Tax. Schedule M-2 of that form lists total annual capital contributions received in 2005 in the amount of $8,416,000, which includes the amounts Humiston and Carr had provided as capital contributions as well as the $3,816,000 Virginia Conservation paid into escrow. In addition, Schedule K-1 of Route 231's tax form lists Virginia Conservation as a partner that had contributed $3,816,000 in capital " during the [taxable] year." (J.A. 120.) Under the Internal Revenue Code, a partnership is a " pass-through" entity, meaning that although the partnership prepares a tax return, the partnership does not pay federal income taxes. Instead, its taxable income and losses pass through to the individual partners, who in turn are liable for their distributive shares of the partnership's tax items on their own individual returns. United States v. Woods, 134 S.Ct. 557, 562, 187 L.Ed.2d 472 (2013).
The Internal Revenue Service sent Route 231 an FPAA indicating, in relevant part, that Route 231 had improperly characterized the $3,816,000 received as a capital contribution rather than as income from the sale of the Virginia tax credits to Virginia Conservation. Route 231 challenged that determination in a petition for readjustment in the Tax Court. In a detailed memorandum opinion, the Tax Court upheld the Commissioner's determination that the transaction between Virginia Conservation
and Route 231 constituted a " disguised sale" that occurred in 2005, and it adjusted Route 231's 2005 tax return to reflect the $3,816,000 as gross income.
At the outset of its opinion, the Tax Court described our decision in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner,639 F.3d 129 (4th Cir. 2011), as " squarely on point" with the case before it. (Cf. J.A. 1518.) Following much of the same analysis we applied in Virginia Historic, the Tax Court first concluded that Route 231's Virginia tax credits were " property" so their transfer would fall within the scope of I.R.C. § 707. Next, the Tax Court determined that under the applicable tax regulations of § 707, the transaction was a " disguised sale" because the record demonstrated that (1) Route 231 would not have transferred the Virginia tax credits to Virginia Conservation " but for" the fact that Virginia Conservation transferred $3,816,000 to it, and (2) Route 231's transfer of the Virginia tax credits was not dependent on the ongoing entrepreneurial risks of Route 231's operations. In examining the totality of the facts and circumstances relevant to this inquiry, the Tax Court observed that the amended operating agreements set out the timing and amount of the exchange with " reasonable certainty" ; they established Virginia Conservation's binding contractual right to the Virginia tax credits; and they secured Virginia Conservation's rights by an indemnification clause. In addition, the Tax Court observed that Virginia Conservation's share of the Virginia tax ...