It is 2 a.m. — do you know how the choices your analyst makes will impact your renewable energy deal? The partnership tax code, one of the most complex areas of the tax code, affects the majority of renewable energy financing deals and presents many modeling choices that can have a profound impact on deal economics. The complexity of the tax code and the variety of choices require more time to model and analyze than most deal teams can afford.
Given this time pressure and lack of information about the impact of different scenarios, the most common approach is often implemented. However, understanding these choices better and having the ability to analyze the impact on a deal can improve deal-team competitiveness and performance. To highlight the potential impact of modeling choices, we examine four modeling situations where partnership tax code modeling choices can materially impact a deal.
Contributing Versus Selling Assets into a Partnership
Renewable energy project sponsors have typically completed some stages of their project before negotiating “partnership flip” financing. During the negotiation, the sponsor and the tax equity partner need to decide how the partnership they form will assume the assets of the renewable energy development. The sponsor can either sell or contribute the assets to the partnership at fair market value (FMV). When a sponsor contributes assets rather than selling the assets, complexity increases greatly due to the requirements for implementing Internal Revenue Code Section (§) 704(c) regulations. (For 704(c) regulation definitions, as well as rule definitions, see the Concepts and Definitions section, below.)
Looking beyond model complexity, contributing assets may, in some situations, materially improve the economics of a deal. When a sponsor contributes assets at FMV in excess of the cost basis, benefits arise from deferral of what might otherwise be immediate taxable gain on sale. In addition, asset contributions can add flexibility in achieving yield objectives. Although asset contributions can reduce the amount of cash a sponsor receives up front, sponsors that retain significant equity in the partnership generally find this reduction unimportant.
§ 704(c) Traditional Versus Remedial Allocation Methods
When an asset is contributed into a partnership at a FMV in excess of cost basis, the partnership depreciates the assets based on the full FMV, even though this differs from the actual tax basis of the assets. The disparity between the FMV and tax basis of the contributed assets must be addressed over time. Section 704(c) allows a range of methods for resolving this disparity with tax basis.
The choice of method matters most when the partnership allocates the majority of the project income and loss to the non-contributing partner during the early years of the partnership, as is typical of renewable energy “flipping” partnerships. When we compared the “Remedial” versus the “Traditional” method in one case, we found that the traditional method shifts much of the income adjustment associated with the tax basis differential to the non-contributing partner, whereas the remedial method results in the total of income adjustment going to the contributing partner.
The applicability of the anti-abuse rule will influence the method recommended by a tax attorney. Otherwise, structurers have the discretion to choose the method best suited to the partnership objectives.
Periodic Versus Continuous Yield-based Flip
During the term of a renewable energy project, partner equity positions flip to allow the tax equity investor to exploit tax benefits and the sponsor to secure a substantial residual position. Partnership flip structures achieve these goals by allocating most (e.g., 99%) of tax credits and deductions to a tax-orientated investor during the early part of the project and dramatically “flipping” down to a smaller share (e.g. 5-15%) of the cash and income thereafter.
This flip occurs once the tax equity partner attains a specified minimum after-tax yield. Modeling a yield-based flip, however, can be complex and is often an overlooked component of the deal structure. Because a flip dramatically shifts the flow of cash and income, timing can materially impact the economics of all partners. Models that track flips on a monthly basis assume the flip occurs at the end of the month even when the flip yield is exceeded as of month end. Imprecise flip timing provides a windfall to the tax equity partner at the cost of the sponsor.
Net Versus Gross Income Reallocations
Special allocation partnerships allow disproportionate allocations of cash and income that can drive a partner’s capital account deficit. The partnership may allow a deficit for a period of time but create a deficit restoration obligation (DRO) for a partner.
In the event of partnership liquidation, a partnership agreement obligates the party in deficit to pay any remaining deficit balance in cash to the partnership. This obligation derives from the tax code requirement that allocations have substantial economic effect. To avoid capital account deficits, or to stay within DRO limits, income can be reallocated among partners using either net or gross income reallocation methods.
The net method resolves deficits in excess of DRO limits by reallocating net income between the partners. However, the gross method has greater capacity to resolve deficits by separately allocating gross income and expense. This added flexibility helps tax equity fully utilize tax benefits while limiting the term over which they are exposed to DRO risk.
The ability to optimally structure a deal and to compete more effectively often depends on specialized tax code knowledge and modeling sophistication. Knowing the right questions to ask a tax attorney is a strong first step. However, advanced modeling capabilities are a must. Developing models that allow the structuring choices described in the article to be explored requires a significant resource investment. Third-party partnership flip structuring and analysis applications offer a rapid and cost-efficient alternative approach to internally developing these modeling capabilities.
Concepts and Definitions
§ 704(c) regulations
Section (§) 704(c) regulations apply when a partner contributes assets into the partnership at a fair market value (FMV) different than the tax basis of the assets in order to regulate the possible shifting of tax consequences among partners. A contribution defers the tax consequences that might be associated with the built-in gain or loss. Section 704(c) requires built-in gain or loss to be eliminated over time through tax allocations that put the partners who contribute only cash to the partnership in the same (or similar) tax position as though the partnership had purchased contributed assets at FMV. Section 704(c) allocation methods are provided to resolve this disparity. The choice of method can affect economic results significantly.
Tax code requirements for respecting partnership allocations
Partnerships represent one of the more complex domains of the U.S. tax code. Implementing the regulations represents one of the key challenges associated with modeling and tracking partnerships. The partnership tax code places requirements on a partnership’s allocations of income and loss involving substantial economic effect, capital accounts, liquidation, minimum gain and contribution of assets. Some of the Internal Revenue Service regulations are complex, and their correct interpretation may require highly specialized tax counsel. The consequences of noncompliance with the tax code can be dire — destroying the economics of a deal.
The § 704(c) anti-abuse rule specifies that an allocation method is not reasonable if the contribution of property and the corresponding allocation of tax items are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners’ aggregate tax liability. Many tax lawyers have concluded that the remedial allocation method generally satisfies the anti-abuse rule.
Under the ceiling rule (Reg. § 1.704-3(b)(1)), a partnership cannot allocate more income, gain, loss or deduction to its partners for a taxable year with respect to a property than the total partnership income, gain, loss or deduction actually realized with respect to that property. For example, a partnership may not allocate more depreciation to a partner than may be claimed by the partnership, even though the partner may bear the capital account burden of a larger (book) allocation determined by the property’s FMV upon its contribution. A partnership might be able to remedy problems caused by the ceiling rule by using the remedial allocation method.
Deficit restoration obligation
A deficit restoration obligation (DRO) occurs when a partner’s capital account balance plus its share of any minimum gain becomes negative. Many partnership agreements do not obligate partners to pay a DRO balance in cash to the partnership, but in many transactions, this obligation may be needed to support the tax code requirement for substantial economic effect. DRO risk describes the potential cash payment a partner would have to make in the event of liquidation.
None of this material should replace consultation with a tax attorney.
Dennis Moritz has been a principal with Advantage for Analysts LLC since its founding in 2004. His experience in financial analysis and modeling covers over 20 years in structuring partnerships and other forms of financing for power projects and asset finance. Prior to Advantage for Analysts, he was a senior analyst at Babcock & Brown, where he played a key role in developing the partnership structure now known as “PAPS.” He is a graduate of San Francisco State University and the University of California at Berkeley, where he received his B.A. in Mathematics and M.S. in Computer Science, respectively.