The Internal Revenue Service (IRS) recently issued Revenue Procedure 2014-12 which contains guidance establishing safe harbor requirements (the “Safe Harbor”) under which the IRS will not challenge partnership allocations of federal historic tax credits (HTCs) by a partnership to its partners. The IRS intends for the Safe Harbor to increase the level of predictability for such allocations following the uncertainty created by the Third Circuit U.S. Court of Appeals in Historic Boardwalk Hall, LLC et al. v. Commissioner, 694 F.3d 425 (3d Cir. 2012).
The Safe Harbor applies to a partnership that validly claims HTCs (a “Partnership”). A “partnership” is commonly understood to be a term of art that includes any legal entity, such as a limited liability company, that is treated as a “partnership” for federal income tax purposes. A Partnership can be structured as either a Developer Partnership or a Master Tenant Partnership. A Developer Partnership is a Partnership that owns and restores a qualified rehabilitated building or a certified historic structure (a “Building”) in a manner that qualifies for HTCs. A Master Tenant Partnership is a Partnership that leases a Building from a Developer Partnership and for which an election is made pursuant to Treasury regulations to transfer the HTCs from the Developer Partnership to the Master Tenant Partnership. The tax credit investor (the “Investor”) invests in the Partnership that is entitled to the HTCs and receives an allocation of HTCs from that Partnership.
The Safe Harbor sets forth rules that distinguish between Investors and Principals of a Partnership. Investors are partners in a Partnership who are not Principals and who meet certain requirements. Principals are managers authorized to act for the Partnership. Although it is not clearly stated in the Safe Harbor, the term “Principal” presumably includes the general partner of a partnership and the managing member of a limited liability company. The term does not appear to apply to a non-member manager of a limited liability company who has no ownership interest in the Partnership.
The Safe Harbor applies to allocations of HTCs on or after Dec. 30, 2013. If the Safe Harbor is met, the IRS will not challenge a Partnership’s allocations of validly claimed HTCs. To satisfy the Safe Harbor, all of its requirements must be met.
Safe Harbor Requirements
Investors are Partnership partners that hold interests in the Partnership that meet certain of the Safe Harbor requirements. If an Investor receives HTCs from a Master Tenant Partnership, the Investor cannot also invest in the Developer Partnership. However, the Master Tenant Partnership may hold an interest in the Developer Partnership. In addition, this prohibition does not prevent the Investor from holding an interest in the Developer Partnership under a separately negotiated, arm’s length arrangement of distinct economic or financial benefit, such as to share in allocations of federal new markets tax credits or low income housing tax credits.
The Partnership Principal (i.e., the general partner or managing member) must always have at least a 1 percent interest in each material item of income, gain, loss, deduction and credit (“Partnership Items”) during the Partnership’s existence.
Minimum Percentage Interest
At all times during which an Investor owns an interest in the Partnership, the Investor must maintain a percentage interest in each Partnership Item that is at least equal to 5 percent of the Investor’s largest percentage interest for each such Partnership Item during such period. In other words, if an Investor’s largest percentage interest in a Partnership Item during its ownership period is 99 percent, the Investor’s interest in such item cannot be reduced below 4.95 percent (99 percent x 5 percent).
Nature of Investor’s Interest
The Investor’s interest in a Partnership “must constitute a bona fide equity investment with a reasonably anticipated value commensurate with the Investor’s overall percentage interest in the Partnership, separate from any federal, state, and local tax deductions, allowances, credits, and other tax attributes to be allocated by the Partnership to the Investor.” An Investor’s interest is a bona fide equity investment only if the interest’s reasonably anticipated value is contingent upon the Partnership’s net income, gain, and loss, and is not substantially fixed in amount. Likewise, the Investor must not be substantially protected from losses from the Partnership’s activities. The Investor must participate in the profits from the Partnership’s activities in a manner that is not limited to a preferred return that is in the nature of a payment for capital.
The value of an Investor’s interest may not be reduced by (1) fees (e.g., developer fees, management fees, or incentive fees), lease terms, or other arrangements that are unreasonable compared to the same for a real estate development project that does not involve HTCs, (2) disproportionate rights to distributions, or (3) issuances of Partnership interests (or rights to acquire such interests) for less than fair market value.
Subleases of the Building from a Master Tenant Partnership to the Developer Partnership (or the Principals of either entity) will be deemed unreasonable unless the sublease is mandated by a third party unrelated to the Principal(s). Also, a sublease will be deemed unreasonable unless the sublease term is shorter than the lease from the Developer Partnership to the Master Tenant Partnership. A Master Tenant Partnership may not terminate its lease of the Building from the Developer Partnership while the Investor is a partner of the Master Tenant Partnership.
Investor Minimum Contribution
An Investor must contribute at least 20 percent of its total expected capital contributions before the date that the Building is placed in service (the “Investor Minimum Contribution”). The Investor Minimum Contribution is determined by the agreements relating to the Partnership as of the date the Building is placed in service. Such amount must be maintained throughout the duration of the Investor’s ownership interest and cannot be protected against loss by any person involved with the rehabilitation, except as provided by any of the permissible guarantees described below. Contributions of promissory notes or other obligations do not count towards the Investor Minimum Contribution.
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.
Guarantees and Loans
The following guarantees are permissible as long as they are unfunded: (1) guarantees for the performance of any acts necessary to claim HTCs, (2) guarantees for the avoidance of any acts (or omissions) that would cause the Partnership to fail to qualify for HTCs or result in a recapture of HTCs, and (3) guarantees that are not impermissible as described below. A guarantee is unfunded if (1) no money or property is set aside to fund all or any portion of the guarantee and (2) neither the guarantor nor any person under the control of the guarantor agrees to maintain a minimum net worth in connection with the guarantee. The Safe Harbor provides the following examples of permissible unfunded guarantees: completion guarantees, operating deficit guarantees, environmental indemnities, and financial covenants. Also, operating reserves are not considered funded guarantees as long as the reserve contains an amount less than or equal to the Partnership’s reasonably projected operating expenses for a 12-month period.
No person involved in the rehabilitation may directly or indirectly guarantee or otherwise insure (1) the Investor’s ability to claim HTCs, (2) the cash equivalent of HTCs, or (3) the repayment of any portion of the Investor’s contribution due to the inability to claim HTCs in the event the IRS challenges all or a portion of the transactional structure of the Partnership. Also, no person involved with the rehabilitation may guarantee that the Investor will receive Partnership distributions or consideration in exchange for its ownership interest, except for the fair market value put rights described below. Should the IRS challenge the Investor’s claim of HTCs, no person involved with the rehabilitation may pay the Investor’s costs or indemnify the Investor. No person involved with the rehabilitation may offer a permissible guarantee if it is funded.
Partnerships and Principals may not lend an Investor funds to acquire any part of the Investor’s interest in the Partnership or guarantee or otherwise insure any indebtedness incurred in connection with the Investor’s acquisition of its Partnership interest.
Purchase and Sale Rights
Partnerships and Principals can no longer have call options to purchase or redeem the Investor’s ownership interest at a future date. Investors can still have put rights, but the put price cannot be more than the ownership interest’s fair market value determined at the time of the put’s exercise.
A determination of the fair market value of the Investor’s interest in the Partnership may take into account only those contracts or other arrangements creating rights or obligations that meet the requirements of the Safe Harbor pertaining to arrangements to reduce the value of the Investor’s Partnership interest (discussed above in “Nature of Investor’s Interest”) and that are on arm’s length terms.
Payment of Preferred Returns, Fees, and Tax Distributions
Nothing in the Safe Harbor prohibits the payment of any (1) accrued but unpaid fees, (2) preferred returns, or (3) tax distributions owed to the Investor.
An Investor may not acquire its interest in a Partnership with the intent of abandoning the interest after the Partnership completes the qualified rehabilitation.
Although much of the uncertainty left in the wake of the Historic Boardwalk decision has been dispelled, the Safe Harbor raises several issues of its own. For example:
- Is an agreement by the Partnership to reimburse the Investor for the loss of HTCs due to the transactional structure of the Partnership an impermissible guarantee or, more to the point, is it a guarantee at all? The legal definition of a guarantee is an agreement by one party to be responsible for the primary obligation of another party, so arguably you do not have a guarantee when you create the primary obligation. For example, a guarantee that an Investor will receive Partnership distributions is impermissible under the Safe Harbor, but you cannot have a guarantee unless the Partnership is obligated to make the distributions in the first instance. So arguably no agreement by the Partnership with the Investor that creates a primary obligation from the Partnership to the Investor should be considered an impermissible guarantee. But this is unclear, particularly as it relates to an agreement to reimburse the Investor from the loss of HTCs.
- Can a person involved in the rehabilitation of the project guarantee the distribution of profits that the Partnership has an obligation to make but fails to make despite having profits? Arguably this type of guarantee should not be prohibited. It is one thing to guarantee that an Investor will receive a return regardless of how the investment performs; it is entirely different to provide assurances that profits that are made will, in fact, be distributed as agreed to by the parties. But it is not clear because the guidance refers to “distributions” instead of “payments,” so it literally seems to cover the failure to make a required distribution of profits.
- Because the general partner of a Partnership generally has unlimited liability for the obligations of the Partnership under state law, does this result in an impermissible guarantee? If the Partnership has an obligation to reimburse the Investor for the loss of HTCs or to make Partnership distributions, must the general partner be exculpated from liability for that undertaking? Presumably, the Safe Harbor is concerned about contractual guarantees, and not liability that otherwise arises under applicable law, but it would be clearer if the Safe Harbor had said that liability that otherwise exists under applicable law does not result in an impermissible guarantee.
- Does the requirement that the Investor must hold a bona fide equity investment with a reasonably anticipated fair market value commensurate with the Investor’s overall percentage interest in the Partnership require that the purchase price in any permitted put agreement be at or near fair market value? The Safe Harbor says that the put purchase price cannot exceed fair market value, and the Treasury Department has informally indicated that a put purchase price at less than fair market value will not be considered to be an abandonment of such interest by the Investor. But the interplay between the put requirements and the bona fide equity investment requirements is unclear. Example 1 in the Safe Harbor includes a put purchase price at fair market value. The example concludes that the Investor’s Partnership interest has a reasonably anticipated value commensurate with the Investor’s overall percentage interest in the Partnership, but does not indicate what importance the put purchase price has in reaching that conclusion.