by Terence Kimm, HCCP, CohnReznick
The partnership agreement you negotiated 15 years ago with your investor limited partner will ultimately control how the partnership unwinds when the project is sold, as well as how liquidating distributions will be made. To understand how the process will work, you first need a basic understanding of how partnership income tax basis capital accounts work. [Note: 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 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.
Typically, the applicable provisions within the partnership agreement that ensure this result are contained in three sections. The first applicable section is the one that deals with the allocation of income from capital transactions. The second deals with distributions and applications of cash flow from capital transactions. The third deals with the dissolution and termination of the partnership.
Generally, the section that deals with the allocation of income from capital transactions 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 capital transactions. 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 applicable only to the allocation of income from capital transactions. 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 contain a long waterfall of 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."
Finally, consider the section that deals with dissolution and termination of the partnership. Included will generally be a description of events that trigger this section, 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. Oftentimes this section will be cross-referenced back to the section that deals with distributions and applications of cash flow from capital transactions, 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.
The interplay of these three sections means that sometimes the "business deal” is how cash will ultimately be distributed; however, sometimes disproportionate liquidating distributions go to the investor limited partner. 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.” However, 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.”
The section of the partnership agreement that deals with the allocation of income from capital transactions 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 their marginal tax rate (combined federal and state) and then divide this amount by 1 minus its 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 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. In an attempt to bring more clarity to this subject, please plan on attending the Sept. 25 HCCP webinar, where sample partnership sale and liquidation calculations for a 4% and 9% deal will be presented.
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This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
Terence Kimm is a partner in CohnReznick's tax practice. He has more than 23 years of experience providing accounting and tax services to syndicators, investors, developers and high net-worth individuals. Kimm works directly with developers and syndicators structuring affordable housing transactions.