By Forrest David Milder, Nixon Peabody
As the tax finance pendulum swings from grants to tax credits, it seems a good idea to review the tax issues that can apply to setting up a fund intended to take advantage of energy credits. There’s also been a lot of interest in new markets tax credits (NMTCs) as well, so I’ll address some of relevant NMTC issues. This discussion can be a bit daunting, but I’m not trying to scare anyone off. With preparation and good professional assistance, these hurdles can easily be managed.
- The investor must be a partner when the project is placed in service. Energy tax credits are allocated among the people who are partners when the property is placed in service, in accordance with the partners’ interests in profits at that time. This places a premium on getting the investors into the fund, and your fund into the actual project partnership sooner rather than later. If the fund will invest in more than one project, you’ll have to plan for subsequent investments.
- Very technical rules apply to allocations of tax benefits. For several reasons, one must closely scrutinize the allocation of cash to one class of investors while another class gets the tax benefits. For example: giving one class of partners 99 percent of the tax benefits and 30 percent of the cash flow while the other partner gets 1 percent of the tax benefits and 70 percent of the cash flow. The basic problem with this example is that “cash flow” is generally associated with “profits,” so giving one investor (or the general partner) a larger share of cash flow may also mean that it should have a larger share of profits, and therefore, tax credits, than other partners who are getting smaller shares of cash flow. There is some flexibility here, but any differing allocation should be reviewed carefully.
- Length of investment matters. The energy tax credit has a five-year recapture period. (The amount of recapture declines by 20 percent each year, from full recapture in the first year after placement in service to 80 percent recapture after one year, and so on.) This recapture rule means that an investor will generally have to stay in the deal for at least five years in order not to suffer adverse tax consequences when he leaves. Another technical rule calls for recapture of some of an investor’s tax credits if there is a decline in the investor’s share of the venture below 66-and-two-thirds percent of what it was. This doesn’t have to be caused by a sale of the interest; it could happen because of the admission of new partners and the corresponding dilution of the existing partners’ interests in the company. The NMTC is determined and recaptured differently, in particular, it is taken over seven years, meaning that an investor will want to stay in at least that long to get his full share of the that credit.
- Consider the role of tax-exempt entities, including pension funds, charities, foundations and foreigners. Special tax rules apply to the allocation of tax credits and the depreciable life of property owned by partnerships that have these entities as members. In particular, if one of the members has a varying interest in the partnership (e.g., 1 percent of the profits while the five-year recapture period for energy credits applies and 50 percent thereafter), then the highest interest (50 percent, in this example) will be considered “tax-exempt use” and (a) ineligible for tax credits and (b) required to use far longer depreciation than the five years that normally applies to renewable facilities. It is important to remember that the people who run pension funds have their own tax-exempt use rules that are different from the tax credit rules; sometimes these investors are thinking about one provision of the tax code, and the tax credit community is thinking about a completely different provision. It can be important to have an early meeting to assure that everyone is talking about the same set of tax issues.
- Individual investors are subject to the restrictive rule about passive income. As discussed in a previous article (“The Current: Don’t Worry About Capital–I’ve Got a Rich Friend Who’d Like to Invest in My Energy Project,” February 2012 Novogradac Journal of Tax Credits), the passive loss rules prevent an individual from using the tax credits and deductions from a limited partner investment against salary income, general partner income, and “portfolio” income (e.g., interest, dividends, royalties). Because of this rule, remarkably few high-net-worth investors can use passive tax losses and credits. Remember that this rule also applies to individuals who invest though a “pass through entity,” such as a partnership or limited liability company (LLC), and a similar, but slightly less onerous rule applies to a C corporation that is “closely held” (defined as a corporation that has five or fewer investors owning 50 percent or more of the corporation).
- Individual investors are subject to the restrictive “at risk” rules. There are two at risk rules. An individual can only claim tax credits to the extent of his investment plus his share of certain nonrecourse financing (based on “level payment loans”). An individual can only claim tax losses (i.e., depreciation) to the extent of his investment plus loans for which he is personally liable. In other words, the “level payment loan” rule does not help an individual take losses, only credits. And, remember that these at risk rules are completely different from the passive loss rule, and they can prevent an individual from using credits and depreciation, even if he or she has lots of passive income. Obviously, this means that individual investors require special structuring to take advantage of the credits, and they can’t make as much use of depreciation as large corporate investors. Like the passive loss rules, these rules also apply to individuals who invest though a partnership or LLC, and to C corporations that are “closely held,” as described in the preceding section.
- General partner loan guarantees can be a problem. In general, any investor, regardless of whether it is an individual, a closely held business or a widely held corporation, must have “basis” in its investment in order to take depreciation deductions. Its basis is typically the sum of its cash investment plus its share of the owner’s debt. For example, assume an investor contributes $1 million to a partnership for a 99 percent partnership interest, assume also that the partnership that owns the project borrows $9 million on a nonrecourse basis, and that it uses the investor’s cash and the borrowing to buy a $10 million facility. On these facts, the investor will have just under a $10 million basis in its interest (that’s the sum of $1 million of cash invested and 99 percent of the borrowing), and it can take all the losses associated with depreciating the facility. On the other hand, if the general partner guarantees the $9 million debt, then the investor’s basis will only be $1 million, and it will not be able to use much of the depreciation deductions associated with the project. These rules generally do not affect the allocation of tax credits.
- There are a lot of other technical rules to consider. In general, when an energy credit is claimed with respect to a facility, the facility’s basis is reduced by half the amount of the credit. For example, a $10 million facility will generate a $3 million credit, and the property’s basis for tax purposes will be reduced by $1.5 million. So, it will only be able to claim $8.5 million of depreciation deductions on the $10 million facility. A more complex rule applies if the “lease pass through” method is used to claim the credit, as is often the case with NMTC transactions.
- Recent case law should be studied. Tax benefits cannot be “sold” to the investor. Instead, the investor must be a partner in the transaction, and this requires it to pass additional tests to assure that the transaction is “respected” for tax purposes. In particular, the court of appeals case, Historic Boardwalk Hall v. Commissioner, decided in August 2012, and discussed previously (See “Living in the Post-Boardwalk World,” October 2012 Novogradac Journal of Tax Credits) states that an investor must have a “meaningful stake in the success or failure” of the venture, and it’s important to work with your tax professionals to pass this somewhat nebulous test.
- Plan for the profit motive test. The Internal Revenue Service also applies a “profit motive” test that is nearly inscrutable, but that requires an investor to demonstrate that it expects to make a cash-on-cash profit in order for it to also take tax benefits. Many, if not most, tax advisors will allow tax credits to be included in this computation, but not other tax benefits, such as depreciation. Regardless, different tax advisors have different methods for doing this analysis. The bottom line is that the investor should get some cash — you can’t give an investor all of the tax credits while also diverting all of the project’s cash flow to pay fees to people other than the investor. There is some latitude here, but bear in mind that this is a very, very technical analysis, and one that is significantly affected by recent changes in the Internal Revenue Code and recent court decisions.
- Cash flow varies. It should be remembered that any transaction that needs energy tax credits and NMTCs may not throw off a lot of cash flow anyway. After all, that is why Congress adopted tax credits as a development strategy! Nonetheless, this can vary greatly from deal to deal; some transactions do have a lot of cash, but it is important to run realistic projections to assure that there really is cash flow to distribute to the investors if that is going to be an important part of the investment.
- New markets tax credits can be helpful but complex. NMTC transactions can provide some very real benefits to a project, but they also add complexity and delays. I’ve discussed new markets transactions previously, but here’s a refresher of the issues raised:
The NMTC rules place a premium on using the “lease pass through” structure, because the investor is better protected from certain new markets issues if it does not invest directly in the entity that owns the equipment. Obviously, this adds a lease and other features to the transaction.
Finding a community development entity ( CDE) that wants to invest in renewables is sometimes difficult. Many CDEs feel that such transactions, particularly those associated with solar, don’t generate enough jobs to meet the goals of the NMTC program.
Finally, the NMTC is awaiting a hoped-for extension of the program, or else it will end when existing awards have been expended.
Again, there are a lot of tax and structure issues to remember as you put together a tax credit investment. By working with an experienced tax advisor, you can negotiate a path to a successful closing.