June 14, 2011

The Economic Substance of Tax Credits

The Economic Substance of Tax Credits Tax & Business

The Tax Court upholds congressional intent to promote investing in otherwise “unprofitable activities” with respect to passing through rehabilitation credits to investing partners.

Income tax credits are a way for Congress to create incentives for activities it deems beneficial. Such credits can motivate companies to invest money in activities for which no taxable income may be earned for a number of years. However, it is often the case that the entity performing the activities would not benefit from the credits generated. Accordingly, these entities seek out third parties to participate in the activities in return for their ability to use the tax credits.

In a recent case, Historic Boardwalk Hall, LLC vs. Commissioner, 136 T.C. No. 1 (Jan. 3, 2011), New Jersey Sports and Exposition Authority (NJSEA) and an investment corporation created an LLC/partnership to allow the corporate partner to invest in the rehabilitation of a historic/governmentally-owned building and to specifically obtain allowable rehabilitation credits under IRC Section 47. The IRS contended that the transaction, among other things, had no economic substance and the credits should be reallocated to NJSEA. The Tax Court ultimately ruled in favor of the taxpayer, determining that not only did the transaction have economic substance, but that tax credits should be taken into consideration when determining whether the transaction had economic substance.

In reviewing the legislative history of IRC Section 47, the court noted the provision’s primary purpose was to “encourage taxpayers to participate in what would otherwise be unprofitable activity.” The court pointed out that the corporate investor, like many investors, would have not invested in the rehabilitation project without tax credits being part of the transaction. This additional investor provided more capital to the project than would otherwise be available. Using this reasoning and other findings, the Tax Court determined that the transaction had economic substance.

Tax Court’s decision appears to provide additional support for respecting some transactions that have the effect of transferring tax credits between parties as compensation for investing, at least when the transaction appears to be congressionally sanctioned. IRC Section 7701(o) provides clarification of the economic substance doctrine, and while this case was determined for tax years before IRC Section 7701(o) was enacted, it still provides insight to how the economic substance doctrine can apply to these types of transactions.

Please contact your Marcum LLP tax representative today to find out more about these types of transactions.

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