Partnerships that require the sponsor to fund operating deficits without any promise of repayment or capital account credit risk having to report the funding for deficits as taxable income.
The IRS said that a partnership that earned state tax credits for renovating two historic hotels in downtown St. Louis should have reported income both from sale of the tax credits and from clawing back part of a developer fee to the developer to cover operating deficits.
An experienced developer, Historic Restoration, Inc., formed a partnership with tax equity investors led by Kimberly-Clark Corp. to own two hotels: the Statler and Lennox. The developer did the renovations on behalf of the partnership.
Missouri offers a tax credit for 25% of the amount spent on such projects. The credits are freely transferable, but do not become available until the project is completed. The developer borrowed $18.455 million as a bridge loan at 9.5% interest against the future value of the tax credits and contributed the amount to the partnership to help fund the renovations. The developer then signed an agreement with Firstar Community Development Corp., an affiliate of US Bancorp, to sell it the credits at completion for 82¢ or 83¢ per dollar of tax credit.
The Lennox renovation was completed in 2002, and the tax credits were sold to Firstar.
The Statler renovation cost more than expected and, therefore, the tax credits were greater than expected. The state awarded tax credits of $17.6 million for the Statler job on December 30, 2002, and the credits were immediately sold to Firstar. This was $4.2 million more than originally expected in tax credits.
An accounting firm for the partnership notified the state on January 8, 2003 that the partnership had incorrectly calculated the amount of tax credits to which it was entitled. It asked the state to void the original Statler award and award $16.3 million in tax credits instead. The state did so.
The IRS said that the partnership should have reported income in 2002 from the original sale of $17.6 million in tax credits — and taken an adjustment in 2003 — because it was too late to rescind the original transaction. A rescission must occur in the same tax year. The US Tax Court agreed.
The developer reported the income from the tax credit sales. The IRS said the partnership should have reported the income, since the tax credits were awarded to it. The partnership allocated its income 99% to Kimberly-Clark.
The Tax Court disagreed. It was willing to honor the form of the transaction as a sale of tax credits by the developer directly to Firstar, but said that the sale of $2.9 million in excess credits above what Firstar agreed to buy from the developer should have been treated as a sale by the partnership to Firstar directly.
The developer agreed in the partnership agreement to fund any operating cost deficits. The partnership agreement said that any payments by the developer to cover deficits would not be treated as capital contributions or loans and the sharing ratios would not be affected. The partnership had a deficit from the start in 2003.
The partnership had agreed to pay the developer a developer fee of $9.3 million, or about 8.5% of the cost of the renovations. This fee was to be paid in three installments. The amounts for the last two installments were put into a deferred developer fee fund and could be diverted by the partnership to cover operating costs. The partnership tapped $3.1 million from the deferred developer fee fund to cover the deficit in 2003.
The IRS said the partnership had to report the amount as income. The court disagreed. It said that if the partnership had paid the developer the amount as a developer fee and then the developer made good on its promise to cover operating deficits, the partnership would have had income, but that is not what happened in this case. Here, the partnership effectively had a right to reduce the developer fee to the extent it needed the money to pay for operations.
The case is Gateway Hotel Partners, LLC v. Commissioner. The Tax Court released its decision in January. The case shows the danger of a sponsor agreeing to cover operating deficits without anything in return.
by Keith Martin