Tax equity transactions are facing tougher vetting by the IRS.

The agency is losing patience with deals where promoters talk about selling tax credits and structure the transactions so that the tax equity investor has little real economic exposure.

A memorandum written by the IRS associate area counsel in Detroit to an agent about a tax equity transaction that is under audit and involves historic tax credits is instructive. The memo is Field Service Advice 20124002F. The agency released it in March.

A 20% tax credit can be claimed on the cost of rehabilitating historic buildings. A real estate developer in the business of renovating historic properties undertook a project. The renovation took at least two years.

The developer arranged for two other entities to be formed. One was a partnership between an affiliated company owned by individuals who also owned the developer and a “fund” of tax equity investors. The partner affiliated with the developer managed the partnership; the fund had no say in management. The other new company formed was a subsidiary of the affiliated company. This subsidiary leased the historic building to the partnership and lent the partnership the money to do the renovations. The partnership hired the developer to do the actual work. The fund of tax equity investors made a small capital contribution to the partnership during construction, but its real capital was not put in until after the renovations were completed.

The partnership paid the developer a developer fee and then hired the developer to manage the property for a fixed fee plus a percentage of monthly gross receipts plus an additional supervision fee of a percentage of any capital improvements that have to be undertaken in the future. The partnership is paying the entity that leased it the building fixed rent plus a percentage of the partnership’s operating income, not to exceed 100% of net cash flow.

The capital contributions by the fund were 90¢ per dollar of historic tax credit. The fund was allocated the tax credit and receives preferred cash distributions that are a percentage of its “paid-in” capital contributions. The IRS said debt service on the loan to finance the renovations, the various fees and the lease rents are set at a level that should vacuum up all the remaining cash flow.

Historic tax credits are subject to recapture for five years. The fund has a “put” option to force the partnership or developer to repurchase the fund’s interest at the end of year five for a percentage of the paid-in capital it contributed plus any unpaid preferred cash distributions. The developer has a “call” option to buy out the fund for fair market value, defined in a manner the IRS said will make it close to nil, plus any unpaid preferred cash distributions, after the exercise period for the put expires.

The developer and three of the individuals who own it guaranteed not only the refund if the tax credit was denied or recaptured but also payment of the put price. They also guaranteed all other obligations of the partnership, including excess development and operating costs and the rent owed on the lease.

The developer hired a promoter who was in the business of syndicating historic tax credits to organize the fund. The computer model the syndicator drew up indicated that the fund investors would pay 90¢ per dollar of tax credit and receive an X% priority return plus an additional Y% return on their investment at the end of the tax credit recapture period. A document describing the structure indicated that the transaction would be structured so that the fund would not receive any cash above the priority return.

The IRS said no real partnership was formed. All the benefits and burdens of the project remained with the developer “through a circular flow of contracts,” with the result that nothing in substance changed. The project remained the developer’s project with a side deal to transfer tax credits. The fund did not put any real capital in until after the rehabilitation job was completed.

“The fund never intended to participate in the rehabilitation of the historic property,” the IRS said. “It simply wanted the historic tax credits. If it was not allowed the credits it wanted its money back . . . . [T]he rehabilitation and operations took place as if no transfer to the [partnership] had occurred.”