The Tax Credit Equity Financing Committee of the American Bar Association Forum on Affordable Housing and Community Development Law provided extensive and thoughtful comments (“Forum Comments”) on the Audit Technique Guide for Section 42 prepared by Grace Robertson of the IRS (“Audit Guide”). The Audit Guide provides support and instruction for IRS revenue agents who audit LIHTC transactions. The Forum Comments highlight a number of issues where LIHTC practitioners disagree with positions that are being advocated by the IRS. This blog post will describe three significant areas of disagreement. First, the treatment of deferred development fees; second, the consequences of the failure of a nonprofit to “materially participate” in a project that received an allocation from the non-profit set aside; and third, the exclusion of bond issuance costs from eligible basis.
Deferred Development Fees
The Audit Guide suggests that a deferred development fee should be evidenced by an interest bearing note. There is no general tax requirement that contractual obligations to pay an amount at a late date must be evidenced by a promissory note to be recognized for federal income tax purposes. Accrual basis tax payers are obligated to include amounts that they are entitled to receive under a contract in income at the time that have performed the service and the payor is obligated to pay, regardless of whether the payor has executed a promissory note. The reverse is also true; an accrual basis payor is required to deduct, amortize or capitalize such an amount at the time that the obligation to pay is fixed. Under Section 467(g) of the Code, Treasury is directed to issue regulations that will establish rules regarding the proper tax treatment of deferred payments for services and the legislative history of Section 467(g) makes clear that the rules should have prospective application. Until Treasury issues such guidance, deferred development fees should not be required to be evidenced by a promissory note or to bear interest at AFR rates.
Recapture arising from the failure of a non-profit to materially participate
In the event that a project receives an allocation of credit from the non-profit set aside, the non-profit is required to “materially participate” in the activities of the project. If the non-profit loses, its tax exempt status, or if the non-profit fails to materially participate, the project would fall out of the non-profit set aside but assuming that the allocating agency still satisfied the minimum requirement that at least 10 percent of its allocations from such year continued to meet the requirement, no adverse consequence should result to the project or its owners. The minimum set-aside requirement is placed upon the allocation agency, not the tax payer owner of the project. Accordingly, failure to comply in this circumstance should not trigger a loss or recapture of LIHTC.
Bond Issuance Cost
Costs incurred by a taxpayer to obtain a loan are amortized over the term of the loan. Under Code Section 263A, amortized loan costs that are attributable to the construction period must be capitalized into the basis of the asset constructed. These general rules are applied in LIHTC transactions to conventional financing. The Audit Guide, however, reaches the opposite conclusion with respect to issuance costs of tax-exempt bond loans. No policy reason supports a different treatment between conventional and tax exempt bond financing, and accordingly, bond issuance costs should be treated the same as conventional loan costs. We note, that such treatment would increase the minimum expenditure that must be financed by tax exempt bonds for purposes of the 50% test set forth in Code Section 42(h)(4)(B).