Are you an investor or a developer with questions about historic tax credits?
You should be aware that the IRS issued new safe-harbor rules in Revenue Procedure 2014-12 on Dec. 30, 2013, in direct response to the holding in Historic Boardwalk Hall, LLC v. Commissioner 694 F.3rd 425 (3rd Cir 2012).
In the Historic Boardwalk Hall case, the 3rd U.S. Circuit Court of Appeals denied the taxpayer the right to claim historic tax credits on the basis that it was not a true partner in the partnership through which historic tax credits pass. The court found that the investor partner lacked both a meaningful downside risk and a meaningful upside potential.
The IRS, reacting to the impact of the case on the historic tax credit industry, issued Rev. Proc. 2014-12 to provide a safe harbor to give investors and developers comfort in structuring historic tax credit partnerships. The safe-harbor rules apply equally to project-level partnerships and master-lease partnerships, in which the developer has elected to pass the historic tax credits through to a master tenant.
Rev. Proc. 2014-12 is effective for allocations of historic tax credits made on or after Dec. 30, 2013 – that is, with a placed-in-service date of on or after Dec. 30, 2013.
The four key partnership structural provisions required to take advantage of the safe harbor are as follows:
1. Partnership Interests: The minimum requirements are a developer interest of 1 percent and an investor interest of 5 percent. Most deals are structured with 1 percent/99 percent interests, which may “flip” at the end of the five-year compliance period to as low as 5 percent of the investor’s initial 99 percent interest, or to 4.95 percent.
2. Guarantees: The developer may guarantee the investor against recapture of historic tax credits for direct acts or omissions to act that cause the partnership to fail to qualify for historic tax credit. However, a guarantee against recapture based on an IRS challenge of the transaction structure of the partnership is impermissible.
A developer may provide completion, operating deficit, financial covenant breach (but not minimum net worth covenant) and/or environmental guarantees, as long as these guarantees are unfunded. However, cash reserves are allowed as long as they total no more than reasonably projected 12-month operating expenses.
3. Exit Structure: At the end of the five-year compliance period, the developer may not have a call option (an option to buy at a specified price from the investor). Rather, the investor may have a put option, as long as the sales price is less than the fair market value of the investor’s partnership interest at the time of exercise.
4. Bona Fide Investment: This factor has four separate terms:
Equity timing: An investor must contribute at least 20 percent of its total expected equity prior to the placed-in-service date, and at least 75 percent of the investor’s equity must be fixed prior to the placed-in-service date. Note that typical equity adjusters based on milestones are allowed but cannot adjust the investor’s commitment by more than 25 percent.
Bona fide investment: The investor’s interest must be a bona fide equity investment with a reasonable anticipated value that is commensurate with the investor’s overall percentage interest in the partnership, separate from tax attributes (deductions, credits, allowances) allocated by the partnership to the investor, and that is not substantially fixed in amount.
Commensurate value: To have a commensurate value requires that the investor receive the cash and other economic benefits – other than historic tax credits – on a basis equal to its percentage interest. This requirement continues to allow an investor’s interest in the partnership to be determined principally by the amount of anticipated historic tax credits to be allocated.
Value impacts: An investor’s interest may not be depressed through the use of developer fees, disproportionate distributions, lease or other business terms that are not reasonable (and a sublease with a term not shorter than the master lease is deemed unreasonable) relative to arm’s-length development transactions not using historic tax credits. This is really the key requirement in Rev. Proc. 2014-12.
While preferred returns, developer, management and/or incentive fees are allowed, they must be comparable to non-historic-tax-credit development partnerships. This may likely require third-party verification from accountants or appraisers as a condition to a tax opinion from legal counsel.
Rev. Proc. 2014-12 establishes a number of safe-harbor requirements that differ significantly in material ways from customary terms in most historic tax credit transactions closed over the years. These requirements play out most significantly in the value impact requirements, requiring negotiation of business terms (fees, preferred returns and lease arrangements) that previously were fairly well settled.
Because counsel will likely require independent verification of the reasonableness of such business terms as a condition to providing a tax opinion, you should seek the advice of your CPA, who may enlist the expertise of an appraiser, in connection with historic tax credit transactions.