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Tax Credit Partnerships: Where Are They Now?

Posted 4:00 AM by

Tax Credit Partnerships

Like Everett McGill from O Brother, Where Art Thou, those in tax credit partnerships for projects that rehabilitate historic buildings want to be perceived as “bona fide.” In the wild west of tax credit syndication (pre-2012), partners did not worry about this Latin term. The Federal rehabilitation tax credit was the oil that freely greased the wheels of rehab projects that otherwise wouldn’t get done, as Congress originally intended.

Impact of Historic Boardwalk

Then came Historic Boardwalk. Thanks to a litany of bad facts, what started out as a taxpayer-favorable Tax Court decision was ultimately reversed by the Third Circuit in a robust, 85-page opinion. Siding with the IRS, the judges felt very strongly that the taxpayers’ economic arrangements effectively prevented the credit investor from having meaningful downside risk and upside potential; necessary characteristics of a “bona fide” partner. As a result, the court disallowed the allocation of tax credits to the investor.

In the immediate aftermath of the Third Circuit’s decision, the tax credit market froze. Since players didn’t know if their economics would be respected by the IRS, new deals were not being started, and others already in progress largely came to a halt. Seeking to provide clarity and relief to the tax credit industry, the IRS issued a safe harbor in the form of Revenue Procedure 2014-12.

Safe Harbor

Fortunately for taxpayers, Rev. Proc. 2014-12 provides ground rules regarding economic arrangements that should pass muster in the eyes of the IRS. Unfortunately for taxpayers, the safe harbor is not void of subjectivity. Provisions of the safe harbor include, in part:

  • Minimum ownership/allocations for the developer and investor of 1 percent and 5 percent, respectively;
  • Distinction between permissible and impermissible guarantees with emphasis that funded guarantees will not meet safe harbor requirements;
  • Limitations on call and put options which aim to prevent the investor’s exit for consideration that is not commensurate with fair market value; and
  • Disallowance of arrangements that reduce the value of an investor’s partnership interest through fees (including developer, management, and incentive fees), lease terms, or other arrangements that are unreasonable as compared to such arrangements for a real estate development project that does not qualify for rehabilitation credits.

Rev. Proc. 2014-12 only applies to the Federal historic rehabilitation tax credits under Internal Revenue Code Section 47. Projects involving any other type of tax credit, including state tax credits, cannot qualify for the safe harbor. Despite this, it is likely prudent to consider the safe harbor guidelines even when dealing with credits outside the scope of the revenue procedure.

Entity Structuring Techniques

Several entity structuring techniques are available to developers and investors in the planning stages of a tax credit deal. The most common arrangements are the traditional/single-tier structure (simpler) and the master tenant passthrough structure (more complex). Each structure has its own benefits and risks and is most effective when tailored to the unique circumstances of a specific project. Rev. Proc. 2014-12 is explicit that both structure types qualify for the safe harbor.

Recent Developments

Disguised Sales & State Tax Credit Partnerships

Partnerships syndicating various types of state tax credits (as distinguished from the Federal historic rehabilitation tax credit discussed above) have also been under attack from the IRS. In at least three cases – Virginia Historic, Route 231 LLC, and SWF Real Estate – the same bad news was delivered to the respective taxpayers – purported allocations of state tax credits were recast as disguised sales under §707(a)(2)(B). This means that otherwise nontaxable capital contributions were now taxable to the partnership as sales proceeds, triggering unexpected income recognition for the partnership and its partners.

The Fourth Circuit’s rationale in Virginia Historic was that the credit investor lacked the true, entrepreneurial risk of a bona fide partner, and as a result decided that the state credits were effectively sold, as opposed to being allocated by a bona fide partnership. Similar facts in Route 231 LLC and SWF Real Estate allowed their judges’ opinions to largely piggyback off of the Virginia Historic rationale. Unsurprisingly, collateral tax consequences result from treating the state tax credits as certificated (i.e., sold) as opposed to allocated, both for the seller (partnership) and the purchaser (deemed non-partner). As a result of these cases, partnerships syndicating state tax credits (especially those which also involve Federal credits) are now weighing the option of proactively reporting the portion of the transaction involving state credits as a taxable sale.

Guidance on Section 50(d) Income

The current, hottest topic to practitioners working in the tax credit industry is the lack of guidance with respect to the tax treatment of §50(d) income, which exists in the master tenant passthrough structure – both in terms of its allocation and its impact to capital accounts and outside basis. Since the issuance of the aforementioned revenue procedure in January 2014, the IRS has informally indicated at tax conferences that guidance on the §50(d) issue is forthcoming, as major players in the industry such as the Historic Tax Credit Coalition have diligently requested. Further technical discussion of this issue is beyond the scope of this article, but is a developing area on which we maintain a watchful eye.

Katz, Sapper & Miller helps clients navigate the murky waters that are unique to the tax credit industry. Leverage our expertise; don’t be a taxpayer of “constant sorrow.”

About the Author
Kent Manuel is the partner-in-charge of Katz Sapper & Miller's Real Estate Services Group. Kent advises clients in a variety of sophisticated real estate matters, including REIT (and UPREIT) transactions and operations, like-kind exchanges, workouts with lenders, and more.

 

About the Author
John Estridge is a director in the Katz, Sapper & Miller’s Real Estate Services Group. In addition to helping clients maximize tax savings opportunities and ensuring their compliance, John is also versed in financial statement compilation and financial modeling. Connect with him on LinkedIn.

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