Taxpayers Had Short-Term Capital Gains On Sale Of State Income Tax Credits

McNeil, TC Memo 2011-109

The Tax Court has again held that transferable Colorado conservation easement income tax credits that a partnership received as a result of its charitable contribution donation and then sold were capital assets. As a result, the partners recognized short-term capital gains on the proceeds of the sale.

Background. Under the “substitute for ordinary income doctrine,” the Supreme Court has concluded that capital gain treatment is not available where the substance of what is sold is the right to receive future ordinary income and the substance of what is received is the present value of ordinary income which the seller would otherwise receive in the future. Instead, there is ordinary income rather than capital gain since consideration is paid for the right to receive future income, not for an increase in the value of the income-producing property. (Com. v. Lake Inc, P.G., (1958, S Ct) 1 AFTR 2d 1394)

Facts. William McNeil and Catherine McNeil were the only members of the partnership McNeil Ranch, LLC (McNeil Ranch). In 2003, McNeil Ranch sold a conservation easement in a bargain sale to the American Farmland Trust (2003 American Farmland Easement) and to the Wetlands America Trust, Inc., a.k.a., Ducks Unlimited (2003 Ducks Unlimited Easement). The sale of the 2003 easements gave rise to a Colorado conservation easement credit of $260,000. On Dec. 18, 2003, McNeil Ranch sold $231,600 of its available $260,000 State conservation easement credit for $178,332 (2003 transferred credit).

In 2005, McNeil Ranch sold a conservation easement in a bargain sale to the Wetlands America Trust, Inc. Colorado (2005 Ducks Unlimited Easement). The sale of the 2005 easement gave rise to a Colorado conservation easement credit of $156,800. On Dec. 15, 2005, the partnership sold all of the $156,800 State conservation easement credit for $133,280 (2005 transferred credit).

All of the income, deductions, and credits reported on the partnership's 2003 and 2005 partnership returns flowed through the partnership to the McNeils' joint 2003 and 2005 individual income tax returns. The net gain from the 2003 and 2005 transferred credits was reported as long-term capital gain.

On audit, IRS determined that the sale of the Colorado income tax credits resulted in ordinary income and not capital gain. (IRS also determined that the McNeils had no adjusted basis in the credits, an issue which they later conceded.) The McNeils sought relief in Tax Court.

IRS's position. IRS argued that the McNeils' gains from the sales of their Colorado tax credits were ordinary because they were merely a substitute for ordinary income, i.e., a substitute for a refund from Colorado that would have been ordinary income.

Court's conclusion. Relying on its previous decision in Tempel (2011), 136 TC No. 15—also dealing with the same Colorado tax credit—the Tax Court held that the tax credits that the McNeils' partnership sold were capital assets. The Court rejected IRS's contention that they should be treated as ordinary income, reasoning that under Code Sec. 1221(a), a capital asset includes property held by the taxpayer other than eight specifically excluded categories (none of which were State tax credits such as those at issue). And, since the Colorado tax credits that were sold didn't represent a right to income, the substitute for ordinary income doctrine was inapplicable.

Holding period. The Court also held that the McNeils' holding period in their Colorado tax credits was insufficient to qualify for long-term capital gain treatment. The holding period in their credits began at the time the credits were granted and ended when they were sold. The capital gains from the sale of the credits were short-term.

As in Tempel, the Court rejected the taxpayers' contention that their holding periods in their land and State tax credits were one and the same because they were both part of the bundle of their real property rights. It reasoned that a Colorado taxpayer had no property rights in a conservation easement contribution State tax credit until the donation was complete and the credits were granted. The credits never were, nor did they become, part of the taxpayers' real property rights.

References: For distinguishing between capital asset and right to receive income, see FTC 2d/FIN ¶I-6824; United States Tax Reporter ¶12,214.65; TaxDesk ¶223,013; TG ¶10775.