IRS Finally Provides Guidance For Housing Tax Credit Nonprofits, Breaking Tax-Exemption Logjam
By Caitlin Jones & A. J. Johnson
6 min read
Tax Credit Advisor June, 2006: Nonprofit organizations developing low-income housing tax credit projects should now have an easier time obtaining determinations of tax-exempt status from the Internal Revenue Service.
The breakthrough is the result of an April 25 IRS memo that provides new guidance to its agents for processing applications for tax-exempt status under federal tax code Sections 501(c)(3) or 501(c)(4), from nonprofits planning to develop housing credit projects. It covers requests by nonprofits that intend to participate either as the general partner of a limited partnership that has for-profit investors, or as the managing member of a limited liability company.
The memo by IRS official Joseph Urban, which has drawn generally favorable comments from credit industry participants, seeks to resolve a longstanding dilemma that has bedeviled nonprofits serving as general partners in LIHTC limited partnerships, or as managing members of LIHTC limited liability companies.
On the one hand, the IRS has normally required these organizations to provide it with a final LP or LLC agreement as a condition for receiving their tax-exemption. On the other hand, investors in nonprofits’ LIHTC projects have balked at negotiating such agreements without prior assurances that a tax-exemption would be granted. Many partnerships have a nonprofit as general partner because they can qualify for special set-asides of credits and other subsidies.
Written Assurances Acceptable
The new memo allows a nonprofit to apply for tax-exempt status before it finalizes its partnership agreement, as long as it provides written assurances that the final agreement will satisfy 12 separate criteria. (See Box.) Conversely, IRS agents may process applications that have these representations but no final agreement yet. These representations relate to certain deal terms – including permissible operating deficit guarantees – and to past, current, or future actions by the applicant.
The memo adds, “The criteria should be applied with the understanding that applications are processed based on all the information contained in the administrative file. Failure to meet a particular factor may not adversely affect an application where the applicant can otherwise describe how I will satisfy the particular concern.”
The memo augments prior IRS requirements for nonprofit housing sponsors for tax-exempt status. These include Revenue Procedure 96-32, issued in 1996, which provided “safe harbor” guidelines – mainly about the tenant income group targeted by the housing, and nonprofit structural and operational characteristics – plus a facts and circumstances test.
The new memo reiterates that applicants must explain how they will achieve their charitable purpose to provide low-income housing, and describe in sufficient detail their proposed activities, including the housing project to be operated by the partnership.
The memo outlines specific written representations that must be provided to limit the nonprofit general partner’s financial exposure in a project, and limits the size and length of any operating deficit guarantee. It addresses how a nonprofit must balance its dual responsibilities to operate the partnership consistent with its charitable purpose, while maximizing profits for the limited partners, but not providing excessive private benefit.
Industry Reaction to Memo
Housing credit industry participants were generally pleased with the new guidance.
“The memo should break the logjam,” said Washington, D.C. attorney Jerry Breed, a partner at Powell Goldstein LLP. “The IRS has at last provided a roadmap of what should be in partnership agreements provided by nonprofits.” Powell Goldstein partner Michael Sanders termed it “an important first step” that should enable pending and new applications to move forward readily.
Washington, D.C. attorney Herbert Stevens, a partner at Nixon Peabody LLP, said, “The memo makes a big difference because the rules weren’t spelled out before; they always seemed to be changing. Prior to the memo, nonprofits were always risking their tax-exempt status when they reached agreements with investors.”
The IRS, in response to questions, told The Tax Credit Advisor it expects “much improved processing” of applications, and noted there are now less than 100 pending applications. “These applications are being processed rapidly consistent with the guidance,” it said.
The IRS’ past reluctance to issue new determination letters to confer tax-exempt status to nonprofit applicants lacking a final partnership agreement hadn’t just affected new nonprofits seeking initial approval of tax-free status. Perhaps more importantly, it had stalled applications by nonprofits that already had tax-exempt status but wanted to do new credit projects. Sanders said parent nonprofits typically set up a separate new nonprofit for each new project, and seek tax-exempt status for it, in order to limit the parent’s liability.
Breed said the memo deals with two areas of special concern for the IRS: guarantees made by a nonprofit to investors, and a nonprofit’s ability to control the LIHTC project. Investors’ insistence on guarantees and a measure of control over the development of tax credit projects has worried the IRS because of the potential for violations of private-benefit rules governing nonprofits.
The memo says nonprofits must assure they will maintain their commitment to act in a charitable manner, provide affordable housing, and avoid conflicts of interest.
Some Concerns
Some industry experts, though, said some concerns remain.
Washington, D.C. attorneys Kenneth Lore and Harold Levy, of Bingham McCutchen, said two sections are particularly worrisome: one on conflicting obligations, and one stipulating that investor consent may not be unreasonably withheld.
“The requirement that the applicant resolve any conflict between its charitable purpose and its duty to maximize the investor’s profits in favor of the charitable purpose is extremely broad,” the pair wrote in a recent memo. “Read expansively, it could be construed to entitle the general partner to use excess cash flow for ancillary charitable purposes rather than passing the cash flow through to partners. The requirement that the investor not unreasonably withhold consent to major actions establishes a standard that is so vague as to be virtually meaningless, especially in the context of the dual charitable/for-profit nature of the enterprise.”
David Smith, of Boston-based Recapitalization Advisors Inc., worried that the new guidelines reduce investor protection in LIHTC transactions, and could deter equity and debt providers from financing affordable projects. He also said without further clarification the memo might prompt some housing finance agencies to shift credit allocations from nonprofits and give rise to litigation over partnership control rights.
The IRS told TCA the latest guidance was issued as a memo to staff rather than as formal guidance, such as a revenue procedure, because it was felt the most expeditious way to begin processing the pending applications was “by educating staff and providing a road map.” In addition, the IRS said, “we want to give ourselves and the public the ability to reassess these procedures in the light of their practical use.”
(To see memo, go to http://www.irs.gov/pub/irs-tege/urbanmemo42406.pdf)
By Don Yacoe
