Following Historic Boardwalk Hall LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012), which rejected a partnership's allocation of rehabilitation tax credits to a purported partner, the Internal Revenue Service (IRS) recently published Revenue Procedure 2014-12, 2014-3 IRB 1 (Rev. Proc. 2014-12), which establishes a safe harbor for structuring the allocations of tax credits generated by partnerships that rehabilitate certified historic structures and other qualified buildings. Compliance with the safe harbor ensures that the IRS will not challenge a partnership's allocations of these tax credits. Although Rev. Proc. 2014-12 applies only to credits claimed under Section 47 of the Internal Revenue Code of 1986, as amended (IRC), for the rehabilitation of historic structures, the guidance will likely have an impact on how investors and principals allocate other federal tax credits, including energy credits under Section 48 of the IRC.

Background

Section 47 of the IRC provides a rehabilitation tax credit (RTC) designed to incentivize the preservation and rehabilitation of certain income-producing historic buildings. A historic building's owner or certain lessees may claim RTCs for up to 20 percent of qualified rehabilitation expenditures; the credits are generally taken into account in the tax year in which the rehabilitated building is placed in service.

When an owner—a tax-exempt organization, for example—has little use for the tax credit generated by rehabilitating its historic building, it may partner with one or more investors that can fund a portion of the cost to develop the project and use the credits. Rehabilitation partnerships typically include at least one "principal," which manages the rehabilitation and acts on behalf of the partnership, and at least one "investor," which expects to derive a substantial amount of its return in the form of RTCs. The partnership may own the historic building outright or may lease it pursuant to certain provisions that allow a lessee to claim associated RTCs. The partnership may initially allocate up to 99 percent of the operating income or loss and RTCs from the project to the investor until the investor has received an agreed upon internal rate of return, at which point the allocations in the agreement "flip" such that nearly all of the income, credits (if any are subsequently generated), and cash go to the principal. Following the flip, the investor may have an option to require the partnership to purchase its interest for fair market value. The "flip" partnership, which has its own safe harbor in the context of allocating the IRC Section 45 production tax credit for wind projects, is a common structure for allocating energy credits under IRC Section 48. Rev. Proc. 2007-65 described a safe harbor (the "Wind Safe Harbor") for a partnership's allocation of production tax credits earned from the sale of electricity generated by a wind farm. For further analysis of the Wind Safe Harbor, please see this WSGR Alert.

Recent cases such as Historic Boardwalk and Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011), rejected the allocation of RTCs to investors in rehabilitation partnerships. Historic Boardwalk held that an investor was not a bona fide partner because its interest in the RTCs was guaranteed and it had no further meaningful upside or downside interest in the partnership's business. Similarly, Virginia Historic recast a partnership's allocation of analogous state tax credits to its purported partners as a disguised sale of the credits due to the partners' insulation from the partnership's entrepreneurial risks. The uncertainty in the wake of these decisions hindered the development of rehabilitation partnerships, and Rev. Proc. 2014-12 was promulgated in response.

Rev. Proc. 2014-12 Safe Harbor Requirements

In addition to general compliance with partnership tax and accounting rules IRC Section 704 governing the allocation of credits, Rev. Proc. 2014-12 imposes certain safe harbor requirements. The requirements are similar—though not identical—to those of the Wind Safe Harbor. Certain differences are mentioned where applicable in the following summary:

1. Principal's Minimum Interest. To be respected as a partner in a rehabilitation partnership, a principal must have at least a 1 percent interest in each material item of partnership income, gain, loss, deduction, and credit at all times during the existence of the rehabilitation partnership. This requirement has the effect of placing a 99 percent cap on allocations of tax items to the investors.
2. Investor's Minimum Interest. Each investor must have a minimum interest in each material item of partnership income, gain, loss, deduction, and credit equal to at least 5 percent of its largest percentage interest in such item, as adjusted for sales, redemptions, or dilution of its interest, at all times it holds an interest in the partnership. This requirement has the effect of limiting the reduction in the investor's post-flip interest in partnership items. For example, an 80 percent pre-flip investor must be allocated at least 4 percent of partnership items post-flip (5 percent of 80 percent).
3. Prohibited Reductions of an Investor's Interest. An investor's interest in the partnership can only be reduced through fees, lease terms, or other arrangements that are comparable to those seen in real estate development situations not involving RTCs.
4. Investor's Bona Fide Equity Investment. Each investor's partnership interest must be a "bona fide equity investment." It must have value (separate from the tax credits allocated to the investor) commensurate with the investor's percentage interest in the partnership. And the value of the interest must be contingent on the partnership's income, gain, and loss; it cannot be fixed. This standard is drawn from prior case law and prevents investors from obtaining debt-like partnership interests.
5. Investor's Unconditional Contribution. Investors must have a substantial equity stake in the rehabilitation partnership. Before the date that the rehabilitated building is placed into service, each investor must make a "minimum unconditional contribution" to the partnership, which it must maintain as long as it holds a partnership interest. Each investor's minimum unconditional contribution must be at least 20 percent of that investor's total expected capital contributions to the partnership. Contributions required to be made in the future (such as through promissory notes) are not counted toward the minimum unconditional contribution until they are actually made. Under the safe harbor, and with the exception of a limited set of unfunded guarantees discussed below, the investor cannot be protected against loss of any portion of this minimum unconditional contribution through any direct or indirect arrangement with any person involved with the rehabilitation. Note that the rehabilitation partnership safe harbor requires the minimum contribution to be made before the building is placed into service; the Wind Safe Harbor—which again was in the context of the production tax credit that is earned over a 10-year period based on productivity—permitted investors to join the partnership and make their minimum contribution after the project was placed into service. It is commonly understood in energy credit transactions that the investor must have a substantial equity position prior to a project being placed in service, so this requirement is not a departure from common practice.
6. Contingent Consideration. Some partnership arrangements provide that the investor's obligation to make capital contributions is contingent on the level of tax benefits actually generated, and capital is contributed as those benefits are realized. Rev. Proc. 2014-12 restricts these "pay as you go" arrangements by requiring that 75 percent of the investor's total expected capital contributions be fixed before the building is placed into service.
7. Put and Call Rights. The rehabilitation partnership safe harbor prohibits the partnership or principal from having contractual call rights to purchase an investor's interest at a future date. It does, however, permit an investor to have a contractual put right to sell its interest in the partnership (but only at fair market value) at a future date. These restrictions contrast with those of the Wind Safe Harbor, which permitted certain partnership call rights but prohibited investor put rights.
8. Guarantees and Loans. No one involved in the rehabilitation may guarantee or otherwise insure an investor the right to claim RTCs or the cash equivalent of the RTCs if they are challenged by the IRS, or provide for the repayment of the investor's contribution due to the inability to claim RTCs. Guarantees that the partnership will perform all acts necessary to claim RTCs and will refrain from any acts that would negatively impact the ability to claim RTCs are permitted, as are guarantees not explicitly prohibited above (such as, for example, completion and operating deficit guarantees and financial covenants). Importantly, all guarantees must be unfunded-the guarantor cannot set aside property to meet them and hence minimize the investor's risk. An investor may secure an otherwise-prohibited guarantee from a third party unrelated to the rehabilitation if the investor directly pays the cost of, or premium for, such guarantee. Neither the principal, nor the partnership, nor any related person can lend an investor the funds to acquire the investor's partnership interest or guarantee any indebtedness incurred or created in connection with the acquisition of such investor's interest in the partnership.
9. No Abandonment. An investor cannot join a rehabilitation partnership with the intent of abandoning its interest once the partnership completes the rehabilitation (i.e., once the RTCs are generated). If an investor does abandon its interest in the partnership, there is a rebuttable presumption that the investor joined with the intention of abandoning its interest, therefore disqualifying it from safe harbor protection.

Examples

Rev. Proc. 2014-12 provides an example of a rehabilitation partnership that would qualify for the safe harbor. The partnership, which consists of one principal and one investor, owns a historic building to be renovated and operated as a rental property. The investor acquires its partnership interest in exchange for an expected capital commitment of $100x, of which $20x is payable before the building is placed into service and $80x is to be paid on later milestones. $75x is fixed in amount before the building is placed into service. The principal will manage the rehabilitation and rental operations of the building and all fees paid by the partnership (including those to the principal) are consistent with fees paid by real estate development partnerships outside of the RTC context.

The allocations of partnership profit, loss, and RTCs that satisfy the safe harbor are as follows:

In the example, the principal also provides an unfunded guarantee to meet any partnership operating deficit and repay the investor's capital contribution and associated costs if the partnership fails to meet its obligations. Also, the investor in the example has a put option to sell its interest in the partnership to the principal for its fair market value during the latter six months of year 6.

Observations

Rev. Proc. 2014-12 imposes a blanket prohibition on funded guarantees in the rehabilitation tax credit partnership context. Partnerships that wish to insulate investors from downside risk will have to make a judgment as to how far they can deviate from the safe harbor. We would expect that in energy credit transactions investors will continue to require that certain developers provide financial support for certain obligations of the developer.

The rehabilitation partnership safe harbor notably diverges from the Wind Safe Harbor in its approach to put-and-call rights on investor partnership interests. Investors in rehabilitation partnerships may have put rights to sell their interests, but the partnership cannot have rights to call them. The Wind Safe Harbor takes the opposite position—it permits certain call rights and prohibits all put rights. A developer call right is a significant business term in energy credit transactions, and an investor seeking to eliminate such a right in an energy credit deal will likely face resistance.

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