New Guidance for Tax Credit Investments

 
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Many companies demonstrate their commitment to their communities by investing in projects to rehabilitate historic buildings.  Congress encourages these investments by providing an income tax credit for certain qualified rehabilitation expenditures.  These investments are commonly structured as partnerships managed by a tax-exempt or local governmental entity with the credits generally being allocated to the taxable investors. 

It was thus a surprise to many in the summer of 2012, when a U.S. Court of Appeals agreed with the IRS that the investors in the partnership rehabilitating the Historic Boardwalk Hall in Atlantic City, New Jersey—the historic home of the Miss America Pageant—were not partners for federal income tax purposes and, consequently were not entitled to the tax credit.  In that case, the IRS successfully argued that because the investor’s return was effectively fixed, they lacked a meaningful stake in either the success or failure of the partnership and were, thus, not a bona fide partner.

The result in that case unsettled the historic rehabilitation industry and many deals were put on hold because of uncertainty as to whether the transactions would be respected by the IRS.  Moreover, the theory of the IRS’s case could be used to attack other tax credit deals as well.  So taxpayers were relieved when on December 29, 2013, the government issued guidance providing a safe harbor illustrating how these deals could be structured.

The guidance (Revenue Procedure 2014-12) provides that the IRS will not challenge a partnership’s allocations of rehabilitation tax credits if the partnership and the partners satisfy each of the following requirements:

  • The principal in the transaction must have at least a 1 percent interest in each material item of partnership income, gain, loss, deduction, and credit at all times during the existence of the partnership
     
  • The investor must have an interest of at least 5 percent in each material item of partnership income, gain, loss, deduction, and credit during the period in which it owns an interest in the partnership
     
  • The investor’s partnership interest must be a bona fide equity investment (i.e., the value of the investment must not be fixed) with a reasonably anticipated value commensurate with the investor’s overall percentage interest in the partnership, separate from any tax benefit
     
  • The value of the investor’s interest cannot be reduced through unreasonable fees, lease terms, or other arrangements
     
  • The investor must contribute at least 20 percent of its total expected capital contribution before the building is placed in service and must maintain this contribution throughout the duration of its ownership of its partnership interest
     
  • At least 75 percent of the investor’s total expected capital contributions must be fixed in amount before the date the building is placed in service
     
  • The investor may receive certain enumerated unfunded guarantees for the performance of acts necessary to claim the credit (or avoiding any act or omission that would cause the partnership to fail to qualify for the credit), but certain other types of guarantees (generally involving assurance that the investor will receive the credit) are not permitted
     
  • The investor may not fund its investment by loans from the principal, a developer, or similar persons
     
  • Neither the principal nor the partnership may have a call option or other agreement to purchase or redeem the investor’s interest at a future date
     
  • The investor may not have a put option or other agreement to require any person involved in the transaction to purchase or liquidate its interest
     
  • The fair market value of the investor’s interest may only be determined based on actual arm’s length arrangements
     
  • The investor may not acquire its interest in the partnership with the intent of abandoning it after the partnership completes the rehabilitation
     
  • Allocations of the tax credit must have substantial economic effect

These factors resemble the safe harbor that the IRS had previously announced for wind energy credits (Rev. Proc. 2007-65, revised by Announcement 2007-112).  While the safe harbor is expressly limited to rehabilitation, it nevertheless provides a useful template for testing other types of transactions.

The safe harbor is not intended to provide substantive rules, so taxpayers who fail to satisfy the requirements may still have valid investments.  The guidance is effective for rehabilitation tax credits allocated on or after December 30, 2013.

Action Step—Taxpayers who are considering investing in (or have already invested in) rehabilitation credit transactions (and other types of tax credit deals) should carefully review these guidelines to ensure that they obtain the benefits for which they bargained.  Our federal income tax experts are available to assist you with this important analysis.

Contact Information:

Robert M. Gordon
Managing Director
312.235.3321
Robert.Gordon@TPCtax.com

Robert J. McDonald
Managing Director
312.924.3219
Robert.McDonald@TPCtax.com

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