Revised March 1, 2023
Below is the Q&A based on the questions raised by the audience during our webinar Demystifying capital accounts in tax equity transactions. Here's the video recording of the webinar. I had the privilege of participating in this webinar with Pivotal 180's Daniel Gross and Haydn Palliser.
1. Question: When a partner sells its partnership interest, what happens to the partner’s losses that are suspended pursuant to section 704(d)?
Answer: If a partner with suspended losses sell its partnership interest, the suspended losses neither offset the gain nor transfer to the buyer. That is a sale of a partnership interest results in a “loss” of the selling partner’s suspended losses.
As a general matter, the economics of a tax equity transaction are improved, if suspended losses are limited; however, in many transactions, the creation of some degree of suspended losses is unavoidable.
Explanation: Suspended losses arise under section 704(d) when a partner’s “outside basis”(i.e., its basis in its partnership interest) has reached zero and yet the partner is allocated more losses by the partnership. As the partner’s basis is already zero, the sale of the partnership interest does not allow the partner to use the suspended losses. See, e.g., Internal Revenue Service, MSSP Training Guide, Ch. 5 (revised Dec. 2007).
However, there is something of a silver lining to the loss of suspended losses. If a partner agreed to a “deficit restoration obligation” (DRO) and has suspended losses, it likely also has a negative capital account. In a liquidation of the partnership, a partner that has agreed to a DRO must restore it (i.e., contribute cash to the partnership) subject to its agreed cap. A sale of a partnership interest to a new partner is not a liquidation; accordingly, such a sale neither triggers the DRO nor results in income to the selling partner from the forgiveness of the DRO. See Rev. Rul. 73-301 (clarifying Rev. Rul. 57-318); McKee et al, Fed. Tax’n of Partnerships & Partners ¶ 11.05[b] (4th ed. 2007, supp. 2020-2). Instead, the buyer of the partnership interest steps into the seller’s negative capital account and the associated DRO.
Some business people describe the loss of the suspended losses in a sale as offsetting the seller’s negative capital account; such a shortcut approach is functionally accurate in many but not all instances, and the shortcut mixes what are in fact two separate concepts. For instance, the buyer inherits the negative capital account, but not the suspended losses.
What happens when one partner buys out the other partner(s), and the partnership ceases to have more than one partner, is that the partnership is deemed to have terminated and deemed to have made a liquidating distribution of its assets to the partners and the remaining partner/member is deemed to have purchased assets of the exiting partner(s). See Rev. Rul. 99-6, Situation 2. The blog post discusses this and the associated DRO mechanics.
2. Question: A taxpayer’s basis is reduced by half of the investment tax credit (ITC) claimed with respect to a renewable energy project. If the taxpayer is a partnership, how is that basis reduction reflected in the capital account and outside basis of each partner?
Answer: The basis reduction provided for section 50(c)(3) reduces each partner’s outside basis and capital account balance in the same proportion in which the ITC is allocated to such partner. § 50(c)(5) (outside basis); § 1.704-1(b)(2)(iv)(j) (capital account).
3. Question: Does the application of the section 163(j) interest deduction limitation, effect the partners’ capital accounts or only their outside basis?
Answer: If the section 163(j) interest limitation applies, it only effects outside basis and not capital accounts.
However, this issue is avoided by using “back-leverage” in which borrower is the managing member, rather than the partnership. Many tax equity transactions are structured this way for commercial reasons, but it has the benefit of avoiding this rule.
Explanation: As part of tax reform, Congress in 2017 enacted a limitation on the deduction of interest expense. Section 163(j) limits deductions for net interest expense (i.e., interest expense in excess of interest income) to 30% of an adjusted income amount that is calculated using a tax version of “EBITDA” (through the end of 2021, and thereafter switching to a tax version of the more restrictive “EBIT”). Interest that is disallowed as a result of the application of this limitation can be carried forward to future tax years indefinitely. In the case of partnerships, the limitation is applied at the partnership level. As a result, it applies to each partner, even if the partner is a bank with sufficient interest income to otherwise avoid application of the limitation.
There is small business exemption of $25 million in gross receipts to the application of section 163(j); however, statutorily defined “tax shelters” are excluded from the exemption, and, unfortunately, the typical tax equity partnership would be deemed a tax shelter for this purpose. See § 163(j)(3).
Under section 163(j)(3), the minimum $25 million in average annual gross receipts requirement does not apply to a “tax shelter prohibited from using the cash method of accounting under section 448(a)(3).” For that purpose, the following are considered tax shelters: (i) any “syndicate” within the meaning of section 1256(e)(3)(B), (ii) any “tax shelter” within the meaning of section 6662(d)(2)(C)(ii), and (iii) any enterprise (other than a C-corporation) if interests in the enterprise were offered for sale at any time in an offering required to be registered with any federal or state securities regulator. §§ 448(d)(3), 461(i)(3). The definition of a “syndicate” would include a partnership where in any taxable year more than 35% of the losses are allocated to partners that do not actively participate in management. §§1256(e)(3), 461(j)(4). Therefore, arguably a tax equity partnership with a 99 percent loss allocation to a passive tax equity investor could be a syndicate. Further, a tax equity partnership could potentially be a “tax shelter” as defined in section 6662(d)(2)(C)(ii), as it may have “a principal purpose of . . . the avoidance of federal income tax.” If it were a tax shelter under either definition, it would be subject to the interest limitation rules regardless of its size.
4. Question: When a partner receives a cash distribution that exceeds its outside basis, which triggers a section 731(a) gain for that partner how is the resulting section 734(b) adjustment reflected with respect to the partnership’s assets?
Answer: The resulting increase in basis is allocated to the assets of the partnership, whether tangible or intangible, that would generate a capital gain if sold. Treas. Reg. § 1.755-1(c)(1)(ii) (“Where there is a distribution resulting in an adjustment under section 734(b)(1)(A) to the basis of undistributed partnership property, the adjustment is allocated only to capital gain property.”)
For depreciable personal property to generate a capital gain, it must have a fair market value in excess of its original cost to the partnership. See § 1245. For instance, if the partnership purchased a solar project for $1 million, only that project’s value in excess of $1 million would generate a capital gain (while up to the $1 million in original cost would be “recaptured” as ordinary income). It is very rare for tangible personal property, whether a solar project or a truck, to have a fair market value in excess of its original cost. Therefore, the section 734(b)(1)(A) adjustment is typically modeled as resulting in basis to the partnership that is recovered over 15-years straight-line. That is modelers often assume that the basis attaches to a “section 197 intangible,” whether it is a valuable contract right (such as a power purchase agreement that has appreciated in value) or goodwill.
5. Question: Does curtailment of project’s ability to dispatch electricity reduce the production tax credits (PTCs) that the project generates?
Answer: Yes, it does.
Explanation: When a project is curtailed, there are more projects seeking to dispatch their power than the grid can handle at one time. To avoid damage to the grid or safety problems, the grid operator will “curtail” certain projects (i.e., not allow them to dispatch their power to the gird). That means the power from the curtailed projects is not sold. Unfortunately, for the project owner, section 45(a)(2)(B) requires the generated electricity “to be sold by the taxpayer to an unrelated person” in order for that electricity to result in a PTC.
6. Question: Why is it inefficient for a developer that lacks tax appetite to carry forward tax losses and tax credits?
Answer: The time value of converting tax benefits to cash and the limitation enacted in 2017 with respect to using loss carry forwards.
Explanation: First, there is a question of how far into the future would the developer have to carry forward the tax credits and tax losses before it could use them to reduce its tax liability. If it is one or two years, then the return required by a tax equity investor and the transaction costs associated with a tax equity investment may be more than the present value determinant or waiting to use the tax benefits. However, many developers are not confident that they will have tax appetite in a year or two; rather, they may be concerned that they may not have sufficient tax appetite for many years. In that scenario, the time value determinant becomes more significant.
Second, after tax reform net operating losses can be carried forward indefinitely (and not backwards at all); however, their use is limited to 80% of the current year taxable income (i.e., 20% of any year’s taxable income cannot be offset with a net operating loss carryforward). § 172.
Tax credits can be carried forward 20-years (and back one year). § 39(a).
7. Question: For a tax equity investor’s internal rate of return calculation to determine when the “flip” occurs what are the streams to consider?
Answer: The market has relatively standardized approach for determining when an internal rate of return flip rate has been achieved. Here is typical language included in a limited liability company agreement for an internal rate of return based flip transaction involving the ITC:
“Cash Flows” means solely (A) the Class A Member capital contributions, (B) distributions to holders of Class A Units made or deemed made, (C) the net Tax Costs or Tax Benefits and (D) indemnity payments received by a holder of Class A Units.
“Class A Member” means American Bank Tax Equity Corporation.
“Corporate Tax Rate” means the highest marginal federal income tax rate applicable U.S. corporations (excluding subchapter S corporations), as in effect for any applicable year, which rate is twenty-one 21% as of the execution date.
“Fixed Tax Assumptions” means each Class A Member is taxable at the Corporate Tax Rate and able to fully utilize the Tax Benefits that are allocated to such Class A Member [(i.e., if the Class A Member has insufficient tax appetite to use the Tax Benefits, that is its problem), the other assumptions vary by the facts of the transaction and how the parties negotiate].
“Flip Date” means the date on which the Class A Units have realized an IRR equal to the Flip Rate. [The definition refers to the “units” rather than the “member” so that a transfer does not restart the calculation.]
“Flip Rate” means x.yz%.
“IRR” means, from the initial funding date through the term of which such IRR is being measured, the annual effective discount rate (calculated and compounded on a constant accrual basis) which results in the sum of the present values of the after-tax Cash Flows through such term, with respect to any Class A Unit, being equal to zero, as calculated using the “XIRR” function on Microsoft Office Excel 2007 (or the same function in any subsequent version of Microsoft Office Excel).
“Tax Benefits” means, with respect to a Class A Member, the periodic federal income tax savings resulting from the distributive share of the ITC and the distributive share of tax losses and deductions (except to the extent the Class A Member is unable to use such losses or deductions because of section 704(d), in which case the Member will be assumed to be able to use the tax benefits when section 704(d) allows) reported by the Company to the Class A Member on the Schedules K and K-1 of the federal income tax return filed by the Company, taking into account adjustments as the result of any amended federal income tax return filed by the Company or of a final determination following a federal income tax audit. Absent a breach of representation or covenant by the Class B Member, the Tax Benefits will be calculated in accordance with the Fixed Tax Assumptions.
“Tax Costs” means, with respect to a Class A Unit, the periodic federal income tax liability resulting from (i) the distributive share of taxable income and gain reported by the Company to the Class A Member on the Schedules K and K-1 of the federal income tax return filed by the Company, taking into account adjustments as the result of any amended federal income tax return filed by the Company or of a Final Determination following a federal income tax audit, (ii) any gain recognized by such holder under section 731(a), and (iii) any other reduction, denial, deferral, recapture, disallowance, or loss of the ITC, or a portion thereof. Absent a breach of representation or covenant by the Class B Member, the Tax Cost will be calculated in accordance with the Fixed Tax Assumptions.
8. Question: If the federal corporate income tax rates change during the course of a transaction, what happens to the economic sharing between the tax equity investor and the sponsor?
Answer: In an IRR based flip transaction in today’s market, the IRR would typically be calculated based on the federal corporate income tax rate in effect from time to time. See the definition of “Corporate Tax Rate” in the answer above.
If the transaction is a time based partnership flip, then there is typically no adjustment for changes in tax rates because the flip occurs once the requisite number of years have passed. Time based flips are used in some ITC transactions.
 All references to “section” or “§” are to the Internal Revenue Code of 1986, as amended, or the regulations thereunder.
 This explanation is based on language that originally appeared in David Burton et al, 2018 and Onward: the Impact of Tax Reform on the Renewable Energy Market, 18 Energy L. Rpt. 90, 95-96 (Mar. 2018).