Closeup of assorted coins.

By Sarah Walton

On January 8, 2016, the Fourth Circuit issued a published opinion in the case of Route 231, LLC v. Commissioner of Internal Revenue. The Fourth Circuit affirmed the tax court’s holding that Route 231 should have classified a portion of its capital contributions as gross income.

The IRS Concludes that Route 231 Misclassified a Portion of its Capital Contributions

Route 231, LLC (“Route 231”) is a limited liability company incorporated in Virginia. In 2005, Route 231 reported $8,416,000 in capital contributions on its tax return. Part of this sum included $3,816,000 in tax credits (the “tax credit”) from Virginia Conservation Tax Credit FD LLLP (“Virginia Conservation”), which had recently acquired a one percent membership interest in Route 231. This tax credit originated from a transaction in which Route 231 donated some of its land for conservation purposes.

The IRS audited Route 231 and concluded that it should have classified the $3,816,000 as gross income. Route 231 disputed the determination at the United States Tax Court, arguing that it was a capital contribution. The Tax Court disagreed, holding that the $3,816,000 was considered “property” under I.R.C. § 707. The court reasoned that under I.R.C. § 707, this transaction should have been classified as a “disguised sale,” which is reported as gross income. Route 231 appealed the Tax Court’s judgment.

The Fourth Circuit Rejects Route 231’s Argument that the Transaction Was Properly Classified as a Capital Contribution

On appeal, Route 231 argued that the transaction was a non-taxable capital contribution because it allocated part of the partnership’s assets to Virginia Conservation. The Fourth Circuit started its analysis by describing the tax benefits that a corporation receives when it makes a contribution to a partnership’s capital, as opposed to a sale of assets. Sales of assets are taxable, whereas contributions to a partnership’s capital are tax-free. Thus, companies cannot classify a transaction as a capital contribution when the substance of the exchange would otherwise make it taxable. Further, 26 C.F.R. § 1.707-3 provides examples of instances in which transactions could be considered “sales,” and therefore taxable, rather than capital contributions. The regulation prescribes one of these instances as when “the transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits.”

Ultimately, the Fourth Circuit rejected Route 231’s argument. The court reasoned that Route 231’s operating agreement with Virginia Conservation directly addressed a money transfer and therefore constituted a sale. Further, the court also reasoned that Virginia Conservation had a one percent interest in the company, yet received ninety-seven percent of Route 231’s tax credits for this particular entry. As a result, this transaction should have been classified as gross income, which is taxable.

The Fourth Circuit Rejects Route 231’s Argument that the $3,816,000  Should Have Been Reported as Income in 2006

Route 231 also argued that even if the transaction should have been reported as gross income, this income should have been reported in 2006. The Fourth Circuit reasoned that the income should have been reported in 2005 because the transaction occurred in 2005. Further, because Route 231 already asserted in its 2005 return that the transaction applied to that tax year, it could not argue that the income should have been reported during a different tax year. As a result, the Fourth Circuit rejected this argument.

The Fourth Circuit Affirms the Tax Court’s Holding

The Fourth Circuit affirmed the tax court’s decision, holding that the transaction should have been classified as “gross income” on Route 231’s 2005 tax return.