Dont Underestimate the Value of a One Page Election: The Importance of the 168(h)(6)(F)(ii) Election

NEW MARKETS TAX CREDIT CONNECTION

Prepared by:

Dan King, Reznick Group

Summer 2011

Dont Underestimate the Value of a One Page Election: The Importance of the 168(h)(6)(F)(ii) Election
When a NMTC deal is paired with Historic Tax Credits (HTC), many new issues and considerations are added to what can already be a complex structure beset with tax issues. One of the additional issues that confront HTC structures is what is known as the Tax-Exempt Use Property rules under Internal Revenue Code (IRC) 168(h). These rules might come into play, subject to certain criteria being met, when there is a Tax-Exempt Organization (TEO) with either ownership in the partnership that owns the historic property or when a TEO is a tenant in the historic property. The significance of these rules lies in IRC 47(c)(2)(B)(v), which basically states that the portion of the historic property rehabilitation expenditures that are deemed to be Tax-Exempt Use Property is ineligible for HTC. For this article, I will highlight the importance of an election that can prevent the taint of Tax-Exempt Use Property that is commonly needed for structures where a TEO has an ownership interest, and how overlooking this simple election could mean the loss of a significant portion of the HTC. For various reasons, a TEO may have an ownership interest in the partnership that owns the historic property. One common example is when the TEO is the owner of the historic property prior to the rehabilitation and contributes the property to the partnership that will own it during the rehabilitation and will lease it once it is in service; in exchange for the contribution, the TEO receives an interest in the partnership. In addition to the TEO having a direct or indirect ownership in the partnership, two other criteria must be met in order for all or a portion of the partnerships property to be deemed Tax-Exempt Use Property. First, there has to be at least one other partner in the partnership that is not a TEO. The second criteria is that the allocation of partnership items to the TEO are not consistent with the TEO being allocated the same distributable share of each item of income, gain, loss, deduction, credit, basis, and such share does not remain the same during the entire period the TEO is a partner in the partnership (commonly referred to as varying allocations). To illustrate the meaning of the preceding sentence, if the partnership agreement calls for the TEO to have a 10% interest in profits and losses, but upon liquidation, the TEO receives an allocation of gain on liquidation other than 10%, the partnership is deemed to have varying allocations. In determining the amount of the partnerships property that would be deemed TaxExempt Use Property, the TEOs highest allocation percentage of income or gain would be applied to the partnership property. In the preceding example, if the TEOs allocation upon liquidation is 90%, and that is the highest allocation of income or gain that the TEO receives under the agreement, then 90% of the partnerships property would be deemed Tax-Exempt Use Property. Therefore, 90% of the rehabilitation expenditures that would give rise to HTC would be ineligible for the HTC. To prevent the taint of Tax-Exempt Use Property, structures that will have a TEO with ownership in the property owner will commonly insert what is referred to as a blocker entity between the TEO and the partnership. The blocker entity can either be a corporation wholly owned by the TEO, or an LLC that is wholly owned by the TEO. If the latter, the LLC must make a check the box election under Treas. Reg. 301.7701-3 to be treated as a taxable C Corporation for federal income tax purposes. In either scenario, the blocker entity would be what the IRC refers to as a Tax-Exempt Controlled Entity (more than 50% of the corporations stock value is owned by a TEO). The IRC treats a Tax-Exempt Controlled Entity (TECE) as if it were a TEO, unless the TECE makes an election under IRC 168(h)(6)(F)(ii) to not be treated as a TEO. The election removes the taint of Tax-Exempt Use Property by requiring any distributions from the TECE to the TEO to be treated as unrelated business taxable income, thus removing any tax exemption

from the income or proceeds from the property. The election must be included with the TECEs 1120 no later than the TECEs tax year that overlaps the partnerships tax year in which the historic property is placed in service. It is a one-time election that is irrevocable. The election can be just a few sentences stating that the TECE elects under IRC 168(h)(6)(F)(ii) to not be treated as a tax-exempt entity for purposes of applying the rules in IRC 168(h)(6), specifying the ownership by the TEO that qualifies the TECE to make the election, and noting that the purpose of the election is not to treat the property owned by the partnership as Tax-Exempt Use Property. The election also should be attached to the Form 990 filed for the TEO. As with many tax elections, the simplicity of the election belies its significance. With HTC structures with a partner that is a TEO, potentially the entire HTC could be lost if the IRC 168(h)(6(F)(ii) election is needed and is not made timely. It is critical that when a blocker entity is needed in a structure, the importance of the blocker entity is not overlooked, and the tax preparer is aware of the need to make this election timely.