Written by: Nancy Morton
How do Recent Court Cases Impact Syndication of the LIHTC?
The Low Income Housing Tax Credit (LIHTC) is the nation’s largest and most successful affordable rental housing production program. Since its inception as part of the Tax Reform Act of 1986, the LIHTC has leveraged more than $75 billion in private investment capital, providing critical financing for the development of more than 2.5 million affordable rental units. The program annually supports 95,000 jobs and finances approximately 90 percent of all affordable rental housing. This credit is the fundamental housing vehicle used to transform communities. The program provides housing for working families, to those in the special needs community, to the elderly. The projects associated with the program have typically used partnerships as the main vehicle in which to secure the equity financing needed for these projects. Due to recent court cases regarding the Historic Tax Credits (HTCs) and how these projects were structured, there have been questions and concerns regarding how these decisions will impact the structuring and syndication of various other tax credits, including the LIHTC.
On October 23, 2012, the Third Circuit reversed the Tax Court’s opinion that upheld a claim for HTCs for the Investor Limited Partner. This is the second court case affecting either federal or state HTCs. The first case was the Virginia State Historic Tax Credit Fund 2001 case where the capital contributions for the Virginia state HTCs were deemed a sale of the credits and applied the disguised sale rules under Code Section 707. In the Historic Boardwalk case, the Court determined that the Investor Limited Partner was not a bona fide partner in the enterprise and that the transaction lacked economic substance. The Historic Boardwalk and Virginia State Historic Tax Credit cases may affect the syndication of the LIHTC when analyzing the transactions to verify that the transactions fall within the parameters of the two HTC court cases.
Virginia State Historic Tax Credit Case
In analyzing the Virginia Historic Tax Credit case, the background of the state’s HTCs must be taken into consideration. Virginia provides additional state HTCs for the rehabilitation of historic structures since the costs of renovating these structures often exceed the structure’s fair market value. In order to participate in these credits, an application is presented to the Virginia Department of Historic Recourses (DHR). If the DHR approves the application, then the project is entitled to receive state HTCs up to 25% of eligible rehabilitation costs.
Virginia law allows the partnership to allocate the state’s HTCs among the partners in any manner that the partners agree. The state’s HTCs will only have value to the partners who have a Virginia state tax income liability. These partners may be different than the partners who utilize the federal HTC. It is a common practice that the partners who only receive the Virginia HTCs will receive de minimus limited partnership interest and a disportionately large allocation of the state’s HTCs in exchange for their contribution. One main reason for this is that the federal HTCs must be allocated in accordance with the partners’ interest in the partnership. Besides the federal HTCs, the investor also receives a proportionate amount of the project’s other items of profit, loss and deductions.
In the Virginia State Historic Tax Credit case, the offering memoranda and the partnership agreements explained the investors should not expect to receive more than a negligible allocation of income or losses from the partnership based in the state in which the state’s HTCs were in. The agreement went on to state that the partnership would only invest in completed projects eligible for credits which substantially eliminated the risk that the state’s HTCs would not be allocated to the investor. The partnership would then receive a reimbursement of their investment if any of the projects failed to receive and/or properly allocate the state’s HTCs to the investor. This arrangement allowed for the risk of loss to the investor to be insignificant.
The Court and the IRS argued the payments made to the project were not capital contributions and the investor was not a partner in the partnership. The Court and IRS also went on to state that, even if the investors were partners of the partnership, the transaction should be reported as a taxable sale of state income tax credits to the Investors under Code Section 707. Code Section 707 governs sales and other transactions between the partnership and the partners.
The Court determined that the state’s HTCs were deemed to be property since the credits had value as the credits were used to attract investors and that the partnership controlled the credits and the allocation of the credits. The partnership was not able to override the sale since the treasury regulations have a presumption of a sale because the investor payment to the partnership and the receipt of the credits or property occurred within a two year period. The most significant factor in determining that the transaction was a sale was the fact that the value of the credits received was disproportionately large in comparison with the investor’s continuing interest in the project. In addition, the guarantees that the partnership gave to the investor minimized the entrepreneurial risk to the investor.
The Court did not provide any guidance as to what type of structure could be established in order to avoid the payments being re-characterized as a sale versus a capital contribution. It is very important to realize that Code Section 707 characterizes transactions between a partnership and a partner. The investor can still be a partner in the project and still have the actual transaction re-characterized.
Historic Boardwalk Tax Credit Case
Unlike the Virginia State Historic Tax Credit case, the Historic Boardwalk Tax Credit case determined that the investor was not a bona fide partner in the project. The Court’s analysis was partially based upon the test used in the Commissioner v. Culbertson case that states, “a partnership exists when two or more parties in good faith and acting with a business purpose intend to join together in the present conduct of the enterprise.” The Court determined that a partner must have a meaningful stake in the success or failure of the project. There were three main factors that were used to come to the Court’s conclusion. For an investor to be a true partner, the investor must have a meaningful downside risk, a meaningful upside risk and a meaningful stake in the project. In the case of Historic Boardwalk, the combination of all of the guarantees as well as the put and call provisions made it obvious that the investor lacked both a downward and upward risk potential in this project.
In comparing these court cases with LIHTC projects, it is important to note that HTC transactions are subject to the requirement under Code Section 183 that the taxpayer engage in the activity for profit. The LIHTCs are exempt from this requirement under Regulation Section 1.42-4(a). The LIHTC projects are still subject to other provisions of the law including sham or economic substance analysis and ownership analysis. Another difference between HTCs and the LIHTC is the recapture period. The historic tax recapture period is five years whereas the LIHTC recapture period is 15 years. The difference in the recapture period is not likely to be a factor that would distinguish the HTCs from the LIHTC analysis in the other factors that determine if the investor is a true partner.
One of the main differences between the Historic Boardwalk case and the LIHTC projects is that the LIHTC investors will have typically invested a substantial portion of the equity prior to completion of the project and/or by the end of the 10 year allocation of the credits. In addition, the LIHTC investor usually has substantial exposure to the economic performance of the project and the various legal and compliance requirements regarding the LIHTC. Even though there are guarantees within the partnership agreement, the guarantees are not of the same investment grade nature as the guarantees in the Historic Boardwalk case. It has not been uncommon in LIHTC deals that investors have had to fund additional monies into the project in order to keep the project solvent during the compliance period.
Both the Virginia State Historic Tax Credit case and the Historic Boardwalk Tax Credit case remind us that, even with LIHTC, efforts to remove all practical risk from the transaction may have dire tax consequences. The LIHTC program has proven itself to be a vehicle that has produced safe, sanitary, and affordable housing. The HTC cases provide additional guidance that the LIHTC must still be used in a manner that follows all tax guidance regarding risk and reward.
Nancy Morton is a member at Dauby O’Connor & Zaleski, LLC. Nancy has been in the practice of public accounting for over 18 years, having worked with the international accounting firms of Arthur Andersen and Deloitte & Touche prior to joining Dauby O’Connor & Zaleski, LLC in December 2001.