The Partnership Flip Guidelines and Solar
The Internal Revenue Service said in an internal memo made public in June that its guidelines for tax equity partnership flip transactions do not apply to solar facilities or other projects on which investment tax credits are claimed.
Instead, the IRS said, transactions involving investment credits should be tested under general partnership principles.
The memo was written by the IRS national office to the part of the IRS that audits taxpayers.
It should not cause the solar market to back away from partnership flip transactions or to alter the core terms of such transactions, but it may require law firms to revise how they analyze the transactions in tax opinions.
Internal IRS Debate
There has been an internal debate within the IRS for a number of years about whether the agency should issue separate guidelines for solar transactions. Some IRS lawyers have wondered whether the fact that the tax equity investor in a solar project is likely to reach its return much more rapidly than in a wind deal, through an upfront investment credit plus possibly a depreciation bonus and utility rebates, and the fact that these elements of the return are not tied to project performance, require that solar transactions be analyzed differently from wind deals.
At the end of the day, the basic question is the same: is the tax equity investor a real partner with meaningful upside and downside risk of a business or is it a bare purchaser of tax benefits or a lender earning essentially a fixed return?
The IRS issued partnership flip guidelines for wind transactions in 2007 after it received several private letter ruling requests that suggested the wind market was adding embellishments to the basic partnership flip structure.
In a partnership flip, a developer brings in a tax equity investor to own a renewable energy project with the developer. The partnership allocates the tax benefits and taxable income largely to the tax equity investor until a set date in the future or when the investor reaches a target yield, after which the investor’s interest drops usually to 5% and the developer has an option to buy out the investor’s remaining interest. Cash flow may be split in a different ratio.
The embellishments that some wind companies wanted to add before the IRS guidelines were issued were things like pay-go features where the tax equity investment is made over time as a percentage of tax credits or the investor is guaranteed a minimum return. The guidelines were an attempt to draw lines and allow the IRS to save on resources by not having to repeat itself in numerous private letter rulings.
The guidelines are in Revenue Procedure 2007-65.
The lines the IRS drew in these guidelines should remain relevant to solar, but, the IRS said in the new memo, they are not a “safe harbor” that ensures that a solar flip transaction will be respected.
The IRS has debated periodically since 2007 whether to issue separate guidelines for solar transactions.
Richard Probst, who wrote the IRS memo, said most of the pressure for such guidelines has come from the IRS field. The new memo was written last November, but only just made public. It is heavily redacted. It is Chief Counsel Advice 201524024.
Probst said he tells IRS agents in the field to apply basic case law going back to a 1949 Supreme Court decision called Commissioner v. Culbertson to determine whether there is a real partnership. He said he hopes that a solar transaction will be referred to the IRS national office by a field agent as part of a request for technical advice so that there can be something for people to read beyond the heavily redacted memo. The national office would then issue a technical advice memorandum, which is a memo written by the national office to settle a legal dispute between a taxpayer and an agent on audit.
The new memo analyzes a solar partnership flip deal with aggressive terms that go well beyond anything that the mainstream tax equity market does.
The transaction had the following features.
An LLC acquired a portfolio of solar systems from an S corporation that was owned by two individuals, A and B. The S corporation took back a nonrecourse note for part of the purchase price. It represented that the LLC would be able to claim the full purchase price, including the note, as basis in the solar systems for purposes of calculating tax benefits.
The LLC then leased the systems to another S corporation owned by A, one of the two individuals that own the seller, and one other related individual. The rent appears to be a fixed amount per month. The length of the lease term is redacted. The rent paid under the lease is the sole source of revenue for payment of the purchase money note that the LLC gave the seller for the balance of the purchase price. If the LLC stops payments on the note, then the seller’s remedy is to take back the systems.
The LLC is owned partly by the same individual, A, that owns both the seller and the lessee of the systems. A owns its interest through yet another S corporation.
The part of the purchase price that the LLC paid for the systems in cash, as opposed to agreeing to pay over time under a nonrecourse note, was paid in three increments: a little at inception, a little more “on the date” the systems are placed in service, and the balance when the LLC files its tax return for the year it claims the investment tax credits on the systems. The second and third cash payments were contingent in amount.
The S corporation through which A owns part of the LLC guaranteed the other investor — the tax equity investor — the amount of investment tax credits that it would receive and that it will have enough capital account and outside basis to absorb the full tax credits and depreciation bonus on the systems. If the tax credits are less than expected, including due to a recapture event or an IRS audit, then the S corporation must make capital contributions to the LLC, plus interest on the shortfall, that are distributed to the tax equity investor. If the tax credits are more than the guaranteed amount, then the tax equity investor must make capital contributions to the LLC that are distributed to the S corporation. If the solar systems were already in service before the sale to the LLC, then the S corporation can buy out the tax equity investor by refunding its money plus interest.
The tax equity investor receives annual preferred cash distributions from the LLC that presumably are a small percentage of the capital it put into the deal plus an annual “asset management fee.” A letter of credit has been posted to ensure the preferred cash distributions will be made each year. The preferred cash distributions stop after the flip date.
If there is an operating deficit in the LLC, the S corporation must fund it by making a non-interest-bearing loan to the LLC that is repayable only out of LLC cash flow after the LLC has made the cash payments to the tax equity investor: the annual preferred cash distributions and management fee and any tax indemnity payments.
The S corporation has a call option to buy the tax equity investor’s interest in the LLC 90 days after the flip for fair market value. If the call option is not exercised, then the tax equity investor has a “put” to force the LLC to buy its interest a year later for fair market value or, if less, the balance in the tax equity investor’s capital account.
By Keith Martin, in Washington