News, Analysis and Commentary On Affordable Housing, Community Development and Renewable Energy Tax Credits April 2011, Volume II, Issue IV Published by Novogradac & Company LLP Managing the Exit Tax Burden of the QALICB Part One of Two By Neil D. Kimmelfield, Lane Powell PC T he tax credit investor (investor) in a leveraged new markets tax credit (NMTC) financing commonly enters into a put option agreement entitling it to sell its interest in the qualified community development entity (CDE) to an affiliate of a qualified active low-income community business (QALICB) for a nominal amount after the end of the seven-year compliance period (the exit transaction). Once a portion of the qualified low-income community investment (QLICI) loan is used to repay the leverage loan, the affiliate and QALICB have effectively eliminated the burden of paying the remaining portion of the QLICI loan. Although the elimination of this burden creates an economic benefit for the family of entities that includes the QALICB and affiliate (entity family), the full amount of that benefit may not be reflected in their taxable income at the time of the exit transaction. Part One of this two-part article summarizes the reasons that the entity family may realize little or no cancellation of indebtedness (COD) income from the exit transaction. In Part Two, I will discuss planning strategies for reduction and deferral of the COD income recognized in the exit transaction. Example With Dollar Amounts An investor contributes $3 million to Investment Fund LLC (the fund) in exchange for 100 percent of the membership interests in the fund. The fund borrows an additional $7 million (the leverage loan) and uses its combined $10 million of capital to make a qualified equity investment (QEI) in the CDE in exchange for a 99.99 percent membership interest. The leverage loan has a seven-year term. Only interest is paid until the end of the term. The CDE makes two QLICI loans to the QALICB. The A loan has a seven-year term, and the B loan has a 30-year term. Both loans call for interest payments during the first seven years only, generating sufficient interest for the CDE to make the required interest payments on the leverage loan. At the end of seven years, QALICB refinances its property, repaying the A loan. The CDE distributes the proceeds to the fund, which repays the leverage loan. Shortly thereafter, the investor exercises its put option, selling its 100 percent interest in the fund to the affiliate for $1,000. Initial COD Analysis The QALICB family has paid $1,000 to eliminate a $3 million obligation, realizing an economic benefit of $2,999,000. Does the QALICB or the affiliate have COD income in that amount? It is possible that no COD income is recognized in the exit transaction and if COD income is recognized, the amount of income is substantially less than $2,999,000. Because the B loan is not canceled, COD income may arise only to the extent required by Internal Revenue Code (IRC) §108(e)(4), which states, in part: For purposes of determining income of the debtor from discharge of indebtedness, to the extent provided in regulations prescribed by the Secretary, the acquisition of outstanding indebtedness by a person bearing a relationship to the debtor specified in section 267(b) or 707(b)(1) from a person who does not bear such a relationship to the debtor shall be treated as the acquisition of such indebtedness continued on page 2 NOVOGRADAC JOURNAL OF TAX CREDITS continued from page 1 by the debtor. Novogradac Journal of Tax Credits Editorial Board PUBLISHER IRC §§267(b) and 707(b)(1) describe a wide array of relationships. Let’s assume that the affiliate and the QALICB are related. If the exit transaction causes the QALICB to be treated as if it had acquired the B loan for the amount paid by the affiliate, the QALICB will recognize $2,999,000 of COD income under Treas. Reg. §1.61-12. However, IRC §108(e)(4) requires treatment only “to the extent provided in regulations.” What do the regulations say? Treasury Regulation §1.108-2(a) provides that COD income may arise by reason of a related-party acquisition of indebtedness if either the indebtedness is acquired directly by the related party (a direct acquisition), or the holder of the indebtedness becomes related to the debtor in an “indirect acquisition.” Assuming the CDE is respected as a separate entity for tax purposes, the exit transaction is not a “direct acquisition.” Let us consider whether it is an “indirect acquisition.” Michael J. Novogradac, CPA MANAGING EDITOR Alex Ruiz EDITOR Jane Bowar Zastrow TECHNICAL EDITORS Robert S. Thesman, CPA James R. Kroger, CPA Owen P. Gray, CPA Thomas Boccia, CPA Daniel J. Smith, CPA ASSIGNMENT EDITOR Jennifer Dockery STAFF WRITER Jennifer Hill CONTRIBUTING WRITERS Under Treas. Reg. §1.108-2(c)(1), a transaction in which the debtor and the holder of the debt become related is an indirect acquisition only if “the holder acquired the indebtedness in anticipation of becoming related to the debtor.” It is not clear that the CDE “acquired” the B loan when it loaned $3 million to the QALICB. The CDE originated the B loan; before the origination, there was no loan to acquire. www.novoco.comApril 2011 2 Similarly, it is not clear that the CDE made the B loan “in anticipation of” the exit transaction. When the CDE made the B loan, the loan was an economically advantageous investment whether or not the investor ultimately exercised the put option. There is no direct authority on either of the foregoing points. In sum, it is possible that the exit transaction does not give rise to an “indirect acquisition” within the meaning of Treas. Reg. §108(e)(4), and it is possible that the IRS will not argue that the exit transaction causes the QALICB to recognize COD. Nonetheless, because the B loan constitutes more than 25 percent of the CDE’s gross assets on the date of the exit transaction, the QALICB must report COD income as though an indirect acquisition occurred, unless the QALICB attaches a statement to its tax return setting forth certain facts about the B loan and describing facts and circumstances supporting the QALICB’s position that an indirect acquisition did not occur. (See Treas. Reg. § 1.108-2(c)(4).) Thus, it will not be possible for the QALICB to fly safely under the radar. Warning: If, concurrently with the exit transaction, the affiliate acquires the 0.01 percent membership interest in the CDE that is not held by the fund, and the CDE is an LLC treated as a partnership for tax purposes, the CDE will become a disregarded entity, and the affiliate may be treated as acquiring the CDE’s assets. (See Rev. continued on page 3 Ashley Ashleman Kelly L. Beigle Brad Elphick, CPA Glenn Graff Owen P. Gray, CPA Don Holm Jon Kelly Neil D. Kimmelfield Peter Lawrence Forrest Milder Charles A. Rhuda III, CPA Gerald Salzman Shel Schreiberg Daniel J. Smith, CPA Amanda Talbot John M. Tess PRODUCTION Jesse Barredo James Matuszak Novogradac Journal of Tax Credits Information Address all correspondence and editorial submissions to: Alex Ruiz/ 415.356.8088 Address inquiries regarding advertising opportunities to: Emil Bagalso / 415.356.8037 Editorial material in this publication is for informational purposes only and should not be construed otherwise. Advice and interpretation regarding the low-income housing tax credit or any other material covered in this publication can only be obtained from your tax advisor. © Novogradac & Company LLP 2011 All rights reserved. ISSN 2152-646X Reproduction of this publication in whole or in part in any form without written permission from the publisher is prohibited by law. LOW-INCOME HOUSING TAX CREDITS Bud Clarke BOSTON FINANCIAL INVESTMENT MANAGEMENT Jana Cohen Barbe SNR DENTON Tom Dixon continued from page 2 Rul. 99-6, 1999-1 C.B. 432, Situation 2.) In that case, the affiliate will be treated as acquiring the B loan in a “direct acquisition,” and the arguments for not treating the exit transaction as an “indirect acquisition” will be irrelevant. BOSTON CAPITAL Valerie White STANDARD & POOR’S CORPORATION Rick Edson HOUSING CAPITAL ADVISORS INC. Richard Gerwitz CITI COMMUNITY CAPITAL Rochelle Lento Let’s assume that the exit transaction is treated as an “indirect acquisition” and the QALICB is therefore treated as if it had acquired the B loan. How much COD income does the QALICB recognize? DYKEMA GOSSETT PLLC John Lisella U.S. BANCORP COMMUNITY DEV. CORP. Phillip Melton GRANDBRIDGE REAL ESTATE CAPITAL Thomas Morton PILLSBURY WINTHROP SHAW PITTMAN LLP Stephen Ryan COX, CASTLE & NICHOLSON LLP Arnold Schuster SNR DENTON Rob Wasserman U.S. BANCORP COMMUNITY DEV. CORP. PROPERTY COMPLIANCE Rose Guerrero CALIFORNIA TAX CREDIT ALLOCATION COMMITTEE Sharon Jackman SIG SERVICES LLC Michael Kotin KAY KAY REALTY Michael Snowdon MCA HOUSING PARTNERS Gianna Solari SOLARI ENTERPRISES Ruth Theobald Probst Kimberly Taylor THEOPRO COMPLIANCE & CONSULT. INC. HOUSING DEVELOPMENT CENTER HOUSING AND URBAN DEVELOPMENT Sheldon Schreiberg Monica Sussman PEPPER HAMILTON LLP NIXON PEABODY LLP COMMUNITY REINVESTMENT FUND Bruce Bonjour PERKINS COIE LLC Neil Kimmelfield LANE POWELL Marc Hirshman U.S. BANCORP COMMUNITY DEV. CORP. Scott Lindquist SNR DENTON Ruth Sparrow A thorough examination of the determination of the fair market value of the B loan is beyond the scope of this article. Suffice it to say that if the B loan has a below-market interest rate and a long term, the fair market value of the loan will be less than its face amount, but it still should be substantially greater than the $1,000 put price. Deferral Only NEW MARKETS TAX CREDITS Frank Altman Treas. Reg. §1.108-2(f)(2) provides that if the holder did not “acquire the indebtedness by purchase” during the six-month period ending on the “acquisition date,” the amount of COD income is “measured by reference to the fair market value of the indebtedness on the acquisition date.” The “acquisition date” is the date on which the holder and the debtor become related, which is the date on which the exit transaction occurs. Since the CDE did not acquire the B loan by purchase during the six-month period ending on that date, the amount of COD income is the difference between the adjusted issue price of the B loan ($3 million) and the fair market value of the B loan on the date of the exit transaction. (See Treas. Reg. §1.6112(c)(2)(ii).) NOVOGRADAC JOURNAL OF TAX CREDITS Novogradac Journal of Tax Credits Advisory Board Suppose that the fair market value of the B loan at the time of the exit transaction is $2 million. If the exit transaction is treated as an indirect acquisition, the QALICB recognizes $1 million of COD income. If the exit transaction is not treated as an indirect acquisition, the QALICB recognizes no COD income. FUTURES UNLIMITED LAW PC Herb Stevens NIXON PEABODY LLP HOUSING PARTNERSHIP NETWORK Tom Tracy HUNTER CHASE & COMPANY Joseph Wesolowski ENTERPRISE COMMUNITY INVESTMENT INC. HISTORIC TAX CREDITS Don Holm FARRIS BOBANGO BRANAN PLC John Leith-Tetrault Bill MacRostie Donna Rodney John Tess NATIONAL TRUST COMM. INVESTMENT CORP. MACROSTIE HISTORIC ADVISORS LLC BRYAN CAVE LLP HERITAGE CONSULTING GROUP RENEWABLE ENERGY TAX CREDITS Ed Feo USRG RENEWABLE FINANCE Michael Hall BORREGO SOLAR SYSTEMS Jim Howard Forrest Milder Darren Van’t Hof In both cases, the entity family has an additional economic benefit that has not been recognized as COD income, and the tax burden on that benefit is deferred, not avoided. If the exit transaction is treated as an indirect acquisition, triggering $1 million of COD income, the QALICB will still be obligated on the $3 million B loan but will be treated as issuing to the CDE a $2 million obligation with $1 million of original issue discount (OID). (See Treas. Reg. §1.108-2(g)(1).) The OID will give rise to offsetting income and deductions for the CDE and the QALICB. If the B loan is not paid in accordance with its terms, the QALICB will recognize $2 million of COD income at some future time. If the QALICB pays the balance of the B loan, and the proceeds are distributed to the affiliate, the affiliate will recognize a $1,999,000 capital gain. DUDLEY VENTURES NIXON PEABODY LLP U.S. BANCORP COMMUNITY DEV. CORP. If the exit transaction is not treated as an indirect acquisition, and continued on page 4 www.novoco.comApril 2011 Mary Tingerthal 3 NOVOGRADAC JOURNAL OF TAX CREDITS continued from page 3 the CDE is treated as a partnership for tax purposes, the basis of the B loan in the CDE’s hands will be reduced to $1,000 under IRC §743(b)(2) because its basis before the exit transaction ($3 million) exceeds its fair market value ($2 million) by more than $250,000. If the QALICB subsequently pays the balance of the B loan, the CDE will recognize $2,999,000 of gain. The gain would appear to be capital gain, as the reduction of the CDE’s basis in the B loan occurred after the CDE acquired the loan and does not appear to create market discount as defined in IRC §1278(a)(2)(A). Next month: planning strategies for reduction and deferral of the COD income recognized in the exit transaction. Neil Kimmelfield has 30 years of experience as a tax attorney. His practice emphasizes structuring corporate, partnership and real estate transactions (including structured tax financing of energy and community development projects using state and federal tax credits), counseling large and small businesses and exempt organizations in tax matters, litigating tax cases in federal courts, and handling administrative controversies before the IRS. He can be reached at kimmelfieldn@lanepowell.com. This article first appeared in the April 2011 issue of the Novogradac Journal of Tax Credits. © Novogradac & Company LLP 2011 - All Rights Reserved Notice pursuant to IRS regulations: Any U.S. federal tax advice contained in this article is not intended to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties under the Internal Revenue Code; nor is any such advice intended to be used to support the promotion or marketing of a transaction. Any advice expressed in this article is limited to the federal tax issues addressed in it. Additional issues may exist outside the limited scope of any advice provided – any such advice does not consider or provide a conclusion with respect to any additional issues. Taxpayers contemplating undertaking a transaction should seek advice based on their particular circumstances. This editorial material is for informational purposes only and should not be construed otherwise. Advice and interpretation regarding property compliance or any other material covered in this article can only be obtained from your tax advisor. For further information visit www.novoco.com. Special offer for E-newsletter only subscribers: Click here for 20% off an introductory 12-Month Print Subscription to the Journal of Tax Credits. www.novoco.comApril 2011 4