Deficit restoration obligations
Deficit restoration obligations and negative “tax basis capital accounts” are getting more attention from the IRS.
A deficit restoration obligation, or “DRO,” is a promise by a partner to make a capital contribution to a partnership if the partner has a negative capital account when the partnership liquidates.
Each partner in a US partnership has a “capital account” and an “outside basis.” These are two ways to track what the partner put into the partnership and is allowed to take out. If either metric turns negative, then it is a sign that the partner has taken out more than the partner is entitled.
In tax equity transactions in the US renewable energy market, the owner of a project usually brings in a bank or other tax equity investor as a partner to own the project. The partnership allocates tax benefits on the project disproportionately to the tax equity investor. The developer keeps a disproportionate share of cash.
The tax equity investor is likely to exhaust its capital account before it can absorb all the tax benefits. One way around this problem is for the investor to agree to put more money into the partnership in the event its capital account is still in deficit when the partnership liquidates. US tax rules allow the tax equity investor in such a situation to continue to be allocated tax losses (depreciation) by the partnership up to the amount of its DRO.
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 2016 that it has concerns about “whether and to what extent it is appropriate to recognize DROs.” The IRS proposed a list of factors at the time that it said may be a sign that the DRO is not real.
In October 2019, it incorporated them into final regulations.
IRS regulations now say that a DRO will be ignored in two situations. One is where the facts suggest “a plan to circumvent or avoid” the deficit restoration obligation. The other is where the DRO is a “bottom dollar payment obligation” or is not legally enforceable.
Facts that suggest a plan to circumvent or avoid the obligation are 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.
The other situation where a DRO will not be respected is where it is not legally enforceable or is a bottom dollar payment obligation. That is an obligation that is illusory because someone else has promised to reimburse the partner or the real burden is split among other parties by using tiered or upstream entities, legal subordination and other tools.
Separately, in early December, the IRS delayed for another year an effort to require partnerships to report “negative tax basis capital accounts” on partnership tax returns. The IRS announced the delay in Notice 2019-66.
The IRS first tried to require such reporting on 2018 tax returns, but tax advisers were confused about what it had in mind. It planned to try again on 2019 tax returns filed next year, but tax advisers remain confused. The requirement to report negative tax basis capital accounts will now not take effect until 2020 tax returns are filed in 2021.
The agency issued a list of frequently-asked questions and answers in November in an effort to clear up the confusion.
“Tax basis capital accounts” appear to be a hybrid between the two existing metrics — capital accounts and outside basis — that partners already track. They are basically the outside basis a partner has in its partnership interest, but just the remaining equity the partner has in the partnership. Normally a partner’s outside basis also includes its share of any debt at the partnership level. This would be backed out of outside basis to calculate the “tax basis capital account.” The frequently-asked questions and answers sometimes also call this the “tax capital account.”
It is not clear why the IRS feels it needs a new metric in addition the two it already has.
A tax basis capital account can go negative either because a partner is allocated more losses or distributed more cash than it has equity in the partnership or because the partnership takes assets subject to a debt when the partner contributes assets, and the debt exceeds the tax basis the partner has in the assets.
The questions and answers suggest that someone buying a partnership interest inherits the tax basis capital account of the selling partner. This is how regular capital accounts rather than outside basis works. Some other suggestions in the questions and answers about how section 754 step ups affect the calculation of tax basis capital accounts in situations where a partnership interest is sold are contradicted by the instructions the IRS issued with the draft 2018 and 2019 partnership tax returns. The IRS still has some work to do to iron out the lingering confusion.