Tax equity and DROs
Tax equity transactions in which the investor agrees to a deficit restoration obligation may need a fresh look.
The Internal Revenue Service said in early October that it has concerns about “whether and to what extent it is appropriate to recognize DROs.”
A deficit restoration obligation, or DRO, is a promise by a partner to contribute more capital to the partnership at liquidation if the partner has a deficit capital account. Each partner has both a “capital account” and an “outside basis.” These are two ways of tracking what the partner put into the partnership and what it is allowed to take out. When a partner’s capital account hits zero, then any further losses that would be allocated to the partner shift to the other partner.
Almost no tax equity investor has a large enough capital account to absorb the full depreciation on a project. One way to deal with this is for the tax equity investor to agree to contribute more capital when the partnership liquidates to cover any deficit in its capital account.
Many tax equity investors today are agreeing to deficit restoration obligations of up to 40+% of the original investment in order to absorb more of the depreciation on a project.
The IRS said in early October that it is concerned about whether promises to restore deficits are real since the obligation is not triggered unless a partnership liquidates. “[S]ome partnerships are intended to have perpetual life and other partnerships can effectively cease operations but not actually liquidate; therefore, a partner’s DRO may never be satisfied,” the IRS said.
The agency released a list of four factors that it said may be a sign that the DRO is not real. The list is in proposed regulations that will not take effect until they are republished in final form. In the meantime, the IRS is looking for comments. Comments are due by January 3.
Many partners may structure DROs as if the proposed regulations are already in effect.
Factors that suggest that a DRO is not real are the partner giving the DRO is “not subject to commercially reasonable provisions for enforcement and collection of the obligation,” the partner is “not required to provide (either at the time the obligation is made or periodically) commercially reasonable documentation regarding the partner’s financial condition to the partnership,” or the DRO ends or can be terminated before the partnership liquidates or while the partner still has a negative capital account.
The practical effect is to impose a net worth test on the tax equity investor to make sure it can satisfy the DRO.