Year 15 Dispositions – Who Gets the Cash?
The amount of money each partner is entitled to may vary widely when it is time to dissolve the low-income housing tax credit (LIHTC) partnership that owns an affordable housing property. Partners may be surprised by how much – or how little – they receive, depending on the precise terms of the partnership agreement negotiated between affordable housing developers and their investor/limited partner 15 years ago.
In order to understand how the process will work, the general partner first needs a basic understanding of how income tax basis capital accounts work in a partnership. (All references to capital accounts in this article are income tax basis capital accounts – equivalent to 704(b) capital accounts – and not financial statement basis capital accounts.) Generally speaking, LIHTC partnership agreements are drafted using the safe harbor capital account maintenance rules under Internal Revenue Code section 704(b). Briefly stated, these rules provide that all partners in a partnership have capital accounts. Those capital accounts start at zero, are increased by capital contributions and income allocations, and are decreased by distributions and loss allocations. Finally, and most importantly, these rules provide that upon liquidation of the partnership, all capital accounts must return to zero.
Stated differently, think of a partnership as a zero sum entity. All partnership capital accounts start at zero and ultimately must return to zero. The partnership agreement will have been drafted to ensure this happens. Typically, the applicable provisions within the partnership agreement that ensure this result are contained in three sections: the first deals with the allocation of income from a capital transaction, the second deals with distributions and applications of cash flow from capital transactions, and the third deals with the dissolution and termination of the partnership.
The Danger of Positive Capital Accounts
Partners often assume that cash generated from ending their LIHTC partnership will ultimately be distributed according to the "business deal." However, certain fact patterns may cause disproportionate liquidating distributions to go to the investor/limited partner. For example, in 9% deals where the investor/limited partner has a substantial positive capital account just prior to the sale and liquidation of the partnership, the ultimate liquidating distributions may not occur in the same proportions as the "business deal." Generally speaking, in 4% deals where the investor limited partner has a negative capital account just prior to the sale and liquidation of the partnership, liquidating distributions will occur in the same proportions as the "business deal."
The section of the partnership agreement that deals with the allocation of income from a capital transaction usually first restores negative capital accounts and then allocates income in accordance with the "business deal." When done correctly, assuming the capital accounts have been maintained appropriately during the life of the deal, the sum of the post income allocation positive capital accounts will equal the cash to be distributed. If the investor/limited partner has a positive capital account prior to the income allocation, the resulting liquidating distributions based on relative positive capital accounts will be distorted from the "business deal" by that beginning positive amount.
This unexpected result, although to a lesser extent, may also occur in a partnership where a qualified not-for-profit general partner is relying upon a right of first refusal option to purchase a project under Internal Revenue Code section 42(i)(7). This provision allows a qualified not-for-profit to purchase a project at the end of the compliance period for a purchase price equal to the sum of the investor limited partner's exit taxes plus the principal amounts of the outstanding indebtedness secured by the building. Technically, all this provision does is establish the sales price amount to do the gain calculation. All of the other provisions of the partnership agreement remain in effect. A back of the envelope method for calculating exit taxes is to take the investor limited partner's negative tax capital account and multiply it by the their marginal tax rate (combined federal and state) and then divide this amount by 1 minus their marginal tax rate. If the investor/limited partner has a positive tax capital account, there will be no exit tax component for calculating the sales price. However, if there are substantial cash reserves in the deal that are not part of the security for the existing debt, that cash would be distributable as part of the liquidating distribution and the investor limited partner could be entitled to more than what was expected.
The Anatomy of an Agreement
Generally, the section that deals with the allocation of income from a capital transaction will contain a provision that first allocates income to eliminate negative capital accounts. Next, income will be allocated in accordance with the final allocation provision contained in the section of the partnership agreement that deals with distributions and applications of cash flow from a capital transaction. This provision is sometimes referred to as the "business deal" in that it will contain what the general partner remembers as the negotiated back end splits — for example: 80% to the general partner and 20% to the limited partner. Keep in mind that all the above-mentioned language and cross-referenced sections are only applicable to allocation of income from a capital transaction.
Now we move to the section of the partnership agreement that deals with distributions and applications of cash flow from capital transactions. Typically, this section will include the terms of the "waterfall," which describes the priority of payment of partnership obligations – expenses of the transaction, third party debt, related party debt, any balance owed on the deferred development fee, concluding with any remaining balance distributed in accordance with the "business deal". At this point we have gone through two of the three applicable sections with respect to the liquidation of the partnership.
The final section that must be considered is the section that deals with dissolution and termination of the partnership. Included therein will generally be a description of events that trigger this dissolution and termination, one of which will be the sale or disposition of all or substantially all of the assets of the partnership. When triggered, this section then provides for how liquidating distributions are to be made by the partnership. Often, this section will be cross referenced back to the section that deals with distributions and applications of cash flow from a capital transaction and will include the same cash flow waterfall as before until just before the "business deal". In place of the "business deal" will be a statement that any remaining cash shall be distributed in accordance with positive capital accounts. The purpose of this section is to ensure that partnership capital accounts are maintained in accordance with the aforementioned safe harbor capital account maintenance rules under Internal Revenue Code section 704(b). The reason this is important is that it ensures that all prior year loss and LIHTC allocations will be respected.
What Does CohnReznick Think?
Many partners in affordable housing transactions have been surprised by the distributions at the end of the partnership. To fully grasp how much each partner is entitled to, affordable housing professionals should understand each piece of the agreement. The above calculations can be very complicated and should not be undertaken without consulting with a knowledgeable tax professional. Additionally, there may be some planning opportunities available if you find yourself in this situation.
For more information, please contact Terry Kimm, Partner, at 301-657-7766, or your CohnReznick professional.
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