Safe Harbor for Investments in Partnerships Claiming Historic Rehabilitation Credits: IRS Releases Revenue Procedure 2014-12
On December 30, 2013, the Internal Revenue Service ("IRS") released Revenue Procedure 2014-12 (as subsequently revised on January 8, 2014, "the Revenue Procedure"), providing the much-anticipated safe harbor for investors in partnerships claiming historic rehabilitation credits ("historic credits") under the Internal Revenue Code of 1986. The Revenue Procedure addresses a number of issues raised by the U.S. Court of Appeals for the Third Circuit’s landmark August 2012 decision in Historic Boardwalk Hall, LLC v. Commissioner.
Section 47 of the Code provides an investment tax credit against income taxes for qualified rehabilitation expenditures ("QRE") with respect to qualified rehabilitated buildings. Tax equity investors seeking to reap the benefits of historic credits typically do so by purchasing partnership interests in a partnership that owns and rehabilitates the qualified building (a “developer partnership”) or in the lessee of the building owned by the developer partnership (a "master tenant partnership").
Under partnership tax rules, a partner is able to claim a historic credit with respect to its partnership interest if the credit is properly allocated to the partner under Code Section 704. This section provides that a partner’s distributive share of income, gain, loss, deduction or credit shall be determined by the partnership agreement unless the allocation under the agreement to the partner does not have substantial economic effect.
In Historic Boardwalk, the Third Circuit held that because the tax equity investor in the subject partnership was guaranteed to receive both the historic credits and a preferred return, it had neither upside nor downside risk in the venture. Thus, it had not undertaken the risks that a person must bear in order to be a bona fide partner under the prevailing Supreme Court tests. Accordingly, the Court held that the tax equity investor was not a “partner” in the developer partnership for tax purposes, and accordingly was denied its allocation of historic credits under the partnership agreement. Because the ruling did not address what might be sufficient “interest in the success or failure of a partnership” on the part of a tax equity investor to be considered a “bona fide partner,” it created substantial concern among developers and investors in the historic rehabilitation industry, stalling numerous redevelopment projects.
The Safe Harbor
The safe harbor created by the Revenue Procedure applies only with respect to allocations of the historic credit. It does not apply to other federal credits or to state credit transactions – nor does it apply to the determination of whether a given expenditure is a QRE.
Restrictions on the Investor. The Revenue Procedure defines an “Investor” as a partner in a partnership claiming the historic credits (whether a developer partnership or master tenant partnership, a "partnership") (i) other than a “Principal” (a manager authorized to act on behalf of the partnership) and (ii) who is allocated historic credits under the partnership agreement. If the Investor is allocated historic credits through a master tenant partnership, it may not also invest directly in the developer partnership.Partnership Interests.
- The Principal must have a minimum 1% interest in each material item of partnership income, gain, loss, deduction and credit at all times throughout the existence of the partnership.
- The Investor must have at all times during the period it owns an interest in the partnership a minimum interest in each material item of partnership income, gain, loss, deduction and credit of at least 5% of the Investor’s percentage interest in each such item for the taxable year for which its percentage share of such item is the largest.
- The Investor’s partnership interest “must constitute a bona fide equity investment[.]” A “bona fide equity investment” is one whose “reasonably anticipated value is contingent upon the partnership’s net income, gain, and loss, and is not substantially fixed in amount.”
- The Investor must not be “substantially protected from losses from the [p]artnership’s activities,” and the Investor must participate in profits of the partnership “in a manner that is not limited to” a preferred return that is in the nature of a payment for capital.
Other Arrangements with Investors. The value of the Investor’s partnership interest may not be reduced through fees (such as developer or management fees) or other arrangements that are unreasonable when compared to real estate development projects other than historic credit projects, nor can it be reduced through disproportionate distributions or the issuance of interests for less than fair market value consideration.
Minimum Contribution. An Investor must unconditionally contribute before the building is placed in service at least 20% of its total expected capital contribution under the agreements, and must maintain this minimum contribution throughout the term of its partnership interest. Such amount may not be protected directly or indirectly against loss by a person connected to the rehabilitation. Promissory notes and other obligations of the Investor are not counted toward this minimum contribution.
Limitation on Contingent Contributions. At least 75% of the Investor’s total expected capital contribution must be fixed before the placed-in-service date, and the Investor must reasonably expect to meet its contribution obligations as they arise.
Guarantees. The Revenue Procedure sets out permissible and impermissible guarantees. Permissible guarantees include certain unfunded guarantees and any guarantee not described as impermissible by the Revenue Procedure. Impermissible guaranties include:
- guarantees of the Investor’s ability to claim the historic credit, the cash equivalent of the credits, or the repayment of any portion of the Investor’s capital because of an inability to claim the historic credits in the event the IRS challenges the “transactional structure of the partnership[;]”
- guarantees the Investor will receive distributions or consideration in exchange for its partnership interest (except for a fair market sale);
- indemnification of the Investor’s costs in case of an IRS challenge of the Investor’s claim of the historic credits); and
- any guarantee that is otherwise a permissible guaranty (described above) if the guarantee is not an unfunded guaranty.
Puts and Calls. The Revenue Procedure disallows puts or calls other than puts of the Investor’s interest whose exercise price does not exceed the fair market value of the Investor’s interest at the time of exercise. Not considered by the Revenue Procedure is the ability to transfer an equity interest in the Investor itself, a structure sometimes used for an exit strategy. Further, the Investor may not acquire the partnership interest with an intent to abandon it after the partnership completes the rehabilitation, and any later abandonment will be give rise to a presumption that the Investor had such intent unless the contrary is clearly established by the facts and circumstances.
Allocations. Allocations under the partnership agreement must satisfy the requirements of Section 704(b) (generally, that they have substantial economic effect) and the historic credit must be allocated in accordance with the applicable Treasury Regulations (i.e., in accordance with the partners’ respective interests in general profits of the partnership as of the placed-in-service date).
Prior to the issuance of the Revenue Procedure, most practitioners agreed that a safe harbor was needed to address issues left unresolved in the wake of the Historic Boardwalk decision, but many were also concerned that any safe harbor would need to permit a viable structure within which both investors and principals could operate. The new safe harbor does establish clear guidelines that should permit historic credit transactions to proceed with some fairly minor, acceptable tweaks to the current, widely-used structures.
For more information on how the Revenue Procedure’s safe harbor can impact development projects, tax equity investments or your business, please contact your usual Stinson Leonard Street LLP attorney.