Adjustments Needed in Some Partnership Terms
New partnership regulations issued by the Internal Revenue Service in January may require changes in some arrangements used by partnerships.
The regulations are merely proposed at this stage, and the IRS is taking comments. They will apply prospectively once they are reissued in final form.
There are three main effects potentially for partnerships that own power and other infrastructure projects.
Return of Developer Costs
A developer forming a new partnership with a cash or tax equity investor sometimes has the investor make a capital contribution to the new partnership for an interest. The partnership then distributes part of the cash to the developer to reimburse him for his capital spending on the project.
Any such distribution can be received by the developer tax free as long as it reimburses for spending during the past two years. However, if the project is worth more than 120% of the “adjusted basis” the developer has in the project when the partnership is formed, then the amount that can be distributed tax free is limited to 20% of the fair market value of the project on the date the partnership is formed.
This ability of the developer to pull out money tax free is called the “pre-formation expense safe harbor.” Otherwise, the IRS is inclined to view a developer who contributes a project to a new partnership and pulls out cash that the other partner contributed at formation as having made a disguised sale of the project to the new partnership. Any such sale would be taxable.
The IRS has proposed that the safe harbor be applied on a property-by-property basis. Thus, the cash distribution would have to be allocated among each separate “property” based on the spending over the last two years on that property, and a separate calculation would have to be done to determine whether each property is worth more than 120% of the adjusted basis the developer has in it. It is unclear whether a power plant would be considered a single property for this purpose.
In addition, if the developer borrowed money to fund some of its spending on the project and the partnership assumes the debt when it takes the project, then the partner cannot be reimbursed tax free for the capital spending paid for with this debt to the extent the debt is considered borne by the other partners. This situation arises where a project company that borrowed to build a project turns into a partnership because a cash or tax equity investor is brought in. Part of the debt is considered taken on by the new partner.
Partner Debt Guarantees
The next two potential effects of the new rules have to do with how partnership- or project-level debt is shared among the partners in “outside basis.”
Each partner has both a capital account and an outside basis. These are two measures of what the partner put into the deal and what he is allow to take out. Once a partner runs out of outside basis, then the use of any further losses the partner is allocated by the partnership will be suspended until the partner is allocated income by the partnership against which he can use the losses. Any further cash the partner is distributed will be taxed as capital gains. (Partners are not taxed on cash distributions until they run out of outside basis.)
Thus, the more partnership- or project-level debt the partner can put in his outside basis, the more losses can he absorb and the more cash he can receive without having to pay taxes on the cash.
Any “recourse” debt at the partnership or project level for which the partner is liable ultimately goes into that partner’s outside basis. In some deals, a partner may guarantee partnership- or project-level debt so that he can include the debt in his outside basis.
The IRS is proposing to take a harder line on this type of debt. It does not believe many of the guarantees are real. In the future, unless state law makes the partner liable for the debt, the guarantee would have to pass a number of tests.
The terms would have to be commercially reasonable and not designed solely to obtain tax benefits.
The partner must be good for the guarantee. The guarantee will be recognized only to the extent of the partner’s net value. (This rule does not apply to individuals, but the IRS is asking whether it should.) The partner must also maintain at least the net worth that an outside lender would require to rely on the guarantee or be subject to restrictions on asset transfers for less than full value.
The guarantee should be for the full principal amount of the debt. (The IRS is considering whether it also needs to cover all the interest that will accrue on the debt over time.)
“Bottom-dollar” guarantees do not work. An example of a bottom-dollar guarantee is where a partner guarantees $800 of a $1,000 debt, but only after the lender has collected at least $200 from the partnership. An example in the proposed regulations also makes clear that a guarantee will not work where a partner in a partnership of three equal partners guarantees 25% of the debt. However, it would work if each of the partners is “jointly and severally” liable for the full debt, but they have an agreement among themselves that each will contribute its share if any of them is called on to pay the full amount.
The partner should be paid the same amount a third party would require for providing the guarantee.
The guarantee should not require the partnership to hold cash or other liquid assets above its reasonable needs to fund operations, as this would make the partner guarantee less likely to be called.
The partner must provide the partnership and lender periodically with documentation about its financial condition.
The IRS will reduce the amount of debt a partner is considered to have guaranteed by the amount he would be reimbursed by any other person, including other partners, the partnership or third parties, if the partner’s guarantee is called.
Debt in the project finance market tends to be nonrecourse debt: the lender looks solely to the project for repayment. Assuming it remains nonrecourse debt — meaning no partner has guaranteed repayment of the debt — then the debt is shared among the outside bases of the partners according to a waterfall.
An amount of the debt is put first in each partner’s outside basis in the amount of phantom income — called “minimum gain” — that the partner will have to report as the debt principal is repaid. Partners claim depreciation on the project. To the extent the project cost was paid by borrowing from lenders, then that share of depreciation gets reversed later as the debt is repaid. That’s because repayments of principal are not deductible by the partnership. The partnership will have earnings from electricity or other product sales, but no cash to pay the taxes since the cash will have gone to pay debt service.
Next, if when the partnership was formed, the developer was treated as contributing project assets to the partnership and was credited with contributing more value than he spent on the contributed assets, then the assets have a “built-in gain.” The developer will eventually have to report that gain when the assets are resold by the partnership or else the obligation by the developer to report this gain will be worked off by shifting depreciation to which the developer would otherwise have been allocated to the other partners. An amount of debt equal to the remaining built-in gain is put next in the developer’s outside basis.
Finally, the remaining debt is put in partners’ outside bases in the same ratio they share in income or profits. Current IRS regulations allow the parties essentially to set a percentage for sharing the remaining nonrecourse debt in outside basis. The IRS is proposing to eliminate this ability to set a percentage.
In the future, if the partnership does not want to allocate the remaining debt by profits shares, then its only other choice would be to allocate it to partners based on the ratio in which partnership assets would be shared when the partnership liquidates. This ratio would be fixed when the partnership is formed, but then would have to be recalculated each time new capital contributions are made, a partner withdraws, a partner is issued an interest for services or the partnership grants a non-compensatory option to someone to acquire a partnership interest. The recalculations could be burdensome.
These new proposals will not apply until after the IRS reissues them in final form. That could take a year or more. Once adopted, they will apply to borrowings and guarantees entered into after they take effect. Partnerships will have the option to apply them retroactively. A substantial modification in the terms of an existing loan or guarantee after the proposals take effect could bring the new rules into play.
The proposed new rules are being printed in the Federal Register as Reg. 119305-11.
The IRS issued separate proposed regulations in mid-December to address some other technical issues with partnership- or project-level debt. Among the issues they address is what happens if multiple partners have given guarantees in an effort to turn partnership- or project-level debt into “recourse” debt that they can put in their outside bases, and the guarantees add up to more than the total debt.
The IRS said the answer is to allow each partner providing a guarantee a fraction of the debt in its outside basis equal to his guarantee times the sum of all the guarantees.