The IRS has advised that the flip partnership guidelines under Rev. Proc. 2007-65, 2007-2 C.B. 967, do not apply to solar facilities or other projects claiming the Section 48 investment tax credit (ITC). The statement, made in recently released CCA 201524024, was not surprising to practitioners in the solar arena as the revenue procedure expressly does not apply to ITC transactions.
Flip Partnership Structures in Renewable Projects
Taxpayers owning renewable energy projects through a joint venture structure must have a true partnership in order to take the ITC or the Section 45 production tax credit (PTC). Released in 2007, Rev. Proc. 2007-65 issued safe harbor guidelines for determining whether a partnership’s tax allocations to an investor would be respected under the partnership tax rules. Last week, the IRS released internal memorandum CCA 201524024, in which it said that the revenue procedure guidelines are inapplicable to partners or partnerships taking the ITC. The IRS noted that the revenue procedure clearly provides that the safe harbor only applies to partners or partnerships with wind projects taking the PTC.
The typical flip partnership transaction involves an investor partner and a sponsor/developer who jointly own the energy facility through a project company. The investor generally is initially allocated a large percentage of the tax credits and other partnership items. Once the investor’s target return is met, or at a specified time, the partnership allocations “flip” so that the investor receives a lower percentage of the partnership items (at a minimum, 5 percent).
Rev. Proc. 2007-65
Rev. Proc. 2007-65 established the requirements under which the IRS will respect the partnership allocations of wind energy PTCs by flip partnerships in accordance with Section 704(b). PTCs are a tax credit determined based on the amount of energy produced by a facility over a ten-year period. The guidance applies to flip partnerships between a project developer and one or more tax equity investors, with the partnership owning and operating the wind project. The revenue procedure guidelines are only a safe harbor; that is, failure to meet all of the guidelines does not preclude tax treatment as a real partner/partnership.
The safe harbor guidelines include requirements that the developer and investor each have a certain minimum interest in the partnership, and that the investor make and maintain a minimum unconditional investment in the partnership equal to at least 20 percent of its total expected investment. No more than 25 percent of the investor’s contributions can be contingent on future events. Any put or call options must be based on fair market value, and any option of the developer to buy the investor’s partnership interest cannot be exercised until the project has been in operation for five years. The safe harbor prohibits put options with respect to the investor’s partnership interest or put options held by the partnership with respect to the project. No person can guarantee the investor’s ability to take the PTC, and the developer cannot loan funds to the investor to purchase its interest in the partnership.
If the partnership meets all of the safe harbor guidelines with respect to a wind project, then its allocations to the investor and developer (including allocations of the PTC) should be respected by the IRS. Notably, the IRS indicated that the safe harbor applies only to partners or partnerships with PTCs from renewable resources from wind and that it does not apply to any other tax credits.
The IRS in CCA 201524024 confirmed that the Rev. Proc. 2007-65 safe harbor does not apply in the ITC context. The memorandum, drafted last November but only recently released to the public, involves a complex set of transactions using a flip partnership. The project partnership was in part owned by DRE, a limited liability company which was in turn wholly owned by D, an individual. The remainder of the project partnership was owned by an S corporation (S3), owned by individuals A and E.
The project partnership acquired a solar generator from another S corporation (S1) which was owned by individuals A and B. The purchase was in part financed by a loan from S1, with the remainder financed by DRE’s capital contributions to the partnership. The project partnership then entered into a lease of the solar equipment with a third S corporation, which was owned by individuals A and C.
DRE was obligated to make capital contributions to the project partnership in three installments. As a condition precedent to DRE's obligation to contribute the second and third installments, S3 had to certify that (1) the use and operation of the solar generators complied with Section 48 and that the solar generators had been placed in service for purposes of claiming the ITC and had been delivered to the lessee; (2) no default had occurred; (3) no bankruptcy had occurred; (4) S3 was not in breach of the LLC agreement; (5) that DRE would have sufficient basis in the project partnership and capital account balance and share of minimum gain to claim its full proportionate share of the ITC and 100 percent bonus depreciation in the year the solar generators were placed in service; and (6) the project partnership continued to own the solar generators.
The amount of DRE's capital contribution to the project partnership was designed to equal a set amount of the expected ITCs. If the ITCs were less than anticipated, then S3 was required to make a contribution to the project partnership to make up the shortfall, which would be distributed to DRE. Likewise, if the ITCs were greater than anticipated, then DRE would make a contribution to the project partnership for the excess. DRE and S3 were also required to make these contributions in the case of an adjustment of ITCs following an IRS audit or an ITC recapture event. If the solar generators were placed in service prior to DRE's admission into the project partnership, S3 would purchase DRE's interest for an amount equal to DRE's total capital contributions plus interest.
The project partnership allocations flipped on Date 5. Through Date 5, DRE was entitled to a guaranteed preferred annual distribution. If there was insufficient cash to make the preferred distribution to DRE, then S3 would make a loan to the project partnership to cover the shortfall.
S3 had a call option to purchase DRE's interest on Date 6 for its fair market value. DRE had a put option to have its interest redeemed by the project partnership on Date 7 for an amount equal to the lesser of the fair market value of DRE's interest or the positive amount of DRE's capital account.
S3 was the managing member of the project partnership, while DRE’s role was limited to investor. All liabilities of the partnership were nonrecourse to DRE, whose liability was limited to its capital contributions.
In its analysis, the IRS immediately noted that Rev. Proc. 2007-65 applies only to partners or partnerships with Section 45 PTCs from renewable sources from wind. Thus, the revenue procedure does not apply to any other tax credits, such as the Section 48 ITC. The IRS further noted that the PTC amount varies over time based on how much wind energy the partnership produces, while the ITC is an upfront credit. The ITC thus permits the investor to recover its initial investment much more quickly than an investor receiving a PTC. Accordingly, the IRS ruled that the project partnership in CCA 201524024 cannot use the Rev. Proc. 2007-65 safe harbor for support that the IRS should respect its allocation of the ITC to DRE.
The IRS went on to note that the taxpayer would nonetheless have failed to satisfy all the requirements of the safe harbor. First, only the first capital contribution installment by DRE’s was fixed and determinable, which was less than 75 percent of its total expected contribution. Second, DRE had a contractual right to have the partnership redeem its interest. Third, DRE did not bear the risk that the partnership’s activities failed to produce the anticipated ITC amount, because S3 was required to contribute any ITC shortfall to the partnership which would subsequently distribute the amounts to DRE. Further, S3 was obligated to purchase insurance in the amount of the total anticipated ITCs.
Significance of CCA 201524024
The IRS’s position in the new memorandum is not surprising given that Rev. Proc. 2007-65 clearly states that it applies only in the wind PTC context. It is noteworthy that the IRS did not conclude that the structure was not a real partnership for tax purposes, but merely barred reliance on the revenue procedure safe harbor under these facts. In the absence of the safe harbor, tax equity investors are presumably subject to the benefits and burdens analysis under general partnership principles in determining whether a true partnership exists. Although the taxpayer in CCA 201524024 would have failed to satisfy the safe harbor, there is no indication by the IRS one way or another that the arrangement would have failed to pass muster as a true partnership under the application of general partnership principles.
The IRS’s position in CCA 201524024 is unlikely to deter the use of flip partnerships for solar and other ITC projects. Taxpayers entering into solar flip projects have generally viewed the revenue procedure safe harbor as valuable insight into the IRS’s thinking in these types of renewable energy transactions, but have sometimes deviated from meeting all of its requirements where tax law would otherwise support a deviation. The transactions contemplated in CCA 201524024 also fell outside the safe harbor but are generally outside the scope of standard practice in PTC and ITC flip projects. The IRS’s pushback under these facts is not surprising. Accordingly, taxpayers taking the ITC are likely to continue to look to the revenue procedure as helpful guidance – considered alongside general partnership principles – when negotiating the key terms of their flip partnership structures.