The most important calculation in the LIHTC program - at least in terms of credit generation - is qualified basis. Qualified basis is directly related to the amount of eligible basis (Eligible Basis times Applicable Fraction = Qualified Basis). So, it is an owner’s best interest to maximize eligible basis.
A cost incurred in the construction of a tax credit project is includible in eligible basis. This includes both the cost of depreciable residential rental property and the common area costs of such property (as long as the common area is a comparable amenity to all residential rental units).
A recently published IRS newsletter outlined the requirements relative to the inclusion of developer fees in eligible basis. As stated in the Newsletter, "A developer fee represents payment for the developer’s services and at least a portion of the fee is includible in eligible basis."
IRS Audit Issues Relative to the Developer Fee
When examining developer fees, the IRS considers four basic issues:
1. Character of the services to be provided;
2. Services actually provided;
3. Reasonableness of the fee; and
4. The method of payment.
When looking at these issues, IRS examiners will review the development agreement/contract, which outlines developer responsibilities, remedies for non-performance, and payment terms. Any required deferment of the developer fee will also be stipulated. If the developer agreed to defer the fee, the developer note documenting the debt will also be reviewed, and the Service will examine the taxpayer’s books and records to identify payment of the fee.
This article will examine each of the issues relative to including the developer fee in eligible basis.
Character of the Services Provided
Typically, a developer agrees to provide services related to the acquisition, construction, and initial operating phases of a development. Examples of services includable in eligible basis include:
1. Negotiating agreements for architectural, engineering, and consulting services, the construction of the low-income housing or improvements includable in eligible basis, and the furnishing of the associated supplies, materials, machinery or equipment.
2. Applying for and maintaining all government permits and approvals required for the construction and securing the certificates of occupancy once construction is complete.
3. Complying with insurance requirements during construction.
4. Provision of oversight during construction.
5. Implementation of taxpayer decisions made in connection with the design, development and construction of the project.
Examples of services not includable in eligible basis include:
1. Acquisition of the site, including
-Location of the site;
-Performance of economic and feasibility studies;
-Market studies; and
-Negotiation of the purchase price for the land. Note: a portion of the purchase price may be included in eligible basis if the purchase included the acquisition of a building that is subsequently rehabilitated.
2. Maintaining contracts, books and records sufficient to establish the value of the completed project.
3. Advising the taxpayer regarding available sources of financing.
4. Services associated with organization of the partnership.
5. Costs associated with obtaining the tax credits, such as application fees.
Generally, development services end when the project buildings are placed in service. However, the developer may also be responsible for oversight of initial leasing of the units, hiring on-site management, advertising, and maintenance of model units during lease-up. These costs are not directly related to the cost of construction, and are therefore not includable in eligible basis.
Services Actually Provided
The services actually performed by the developer will be analyzed. There are instances where more than one developer is involved in project development. Multiple developers may be involved at the same time. A developer may work with a non-profit organization to develop a LIHTC project that qualifies for an allocation of credits under the Non-profit set-aside. In such cases, determination will have to be made as to how the development responsibilities were divided and whether or not the developer has the skills and expertise required to provide the necessary services and complete the project. In some instances, there are "consecutive" developers, in which case a determination must be made as to why the initial developer could not complete the project and what services were performed by each developer. In all cases, the taxpayer bears the burden of proving that the developer fee constituted a qualified expenditure.
Reasonableness of Fees
State agencies generally limit developer fees to a percentage of total project costs. However, the IRS is not required to accept the developer fee amount allowed by the State and may raise issues regarding the reasonableness of the fee.
Method of Payment
Developer fee payments made during development, or at the completion of development, and which are identified in the taxpayer’s books as payments of developer fees are generally not challenged by the IRS. However, when payment is deferred, the following issues are examined:
1. Performance of Additional Services:
- Payment for services usually associated with the general partner (who often is the developer); or
-Is payment contingent on successful operation of the project?
In either of these cases, if the fee is being paid for services rendered after the end of the project’s development, the fee should not be included in eligible basis.
2. Intent to Pay Deferred Developer Fee: In determining whether there is any intention to actually pay the developer fee, the Service will consider whether:
-The note bears no interest rate or no payment is required for extended periods of time;
-Payment is contingent on events unlikely to occur;
-Payment is subordinate to payment of other debt, and it is unclear that payment would ever be financially possible;
-The developer holds a right of first refusal to purchase to purchase the property for a price equal to the outstanding debt; or
-The GP, who is or is related to the developer, is required to make a capital contribution sufficient to pay the deferred fee if the fee is not paid before a specified date.
If any of the above patterns exist, the deferred developer fee note may not be a bona fide debt, and therefore not includable in eligible basis.
Analysis of Debt
Generally, debt is includable in the basis of property. However, the obligation must represent genuine, noncontingent debt.
Recourse liabilities are generally includable in basis because they represent a fixed, unconditional obligation to pay, with interest, a specified sum of money. However, the obligation will not be treated as actual debt where payment, according to its terms, is too contingent, or repayment is otherwise unlikely. A liability is contingent if it is dependent upon the occurrence of a subsequent event, such as the earning of profits.
Genuine Indebtedness
When considering whether transactions characterized as "loans" are actual debt for federal tax purposes, the courts have set forth a number of criteria. In Fain Hay Realty Co. v. United States, 398 F.2d 694, 696 (3rd Cir. 1968), the court enumerated 16 nonexclusive factors:
1. The intent of the parties;
2. Identity between creditors and shareholders;
3. Extent of participation in management by the holder of the instrument;
4. Ability of the debtor to obtain funds from outside sources;
5. Thinness of capital structure relative to debt;
6. Risk;
7. Specifics of the arrangement;
8. Relative position of the obliges as to other creditors regarding the payment of interest and principal;
9. Voting power of the holder of the instrument;
10. Provision of a fixed interest rate;
11. Contingencies on the payment obligation;
12. Source of interest payments;
13. Presence (or absence) of a fixed maturity date;
14. Provision for redemption by the corporation;
15. Provision for redemption at the option of the holder; and
16. Timing of the advance relative to when the taxpayer was organized.
IRS Notice 94-47, 1994-1 C.B. 357, provides that the characterization of an instrument for federal income tax purposes depends on the terms of the instrument and all the surrounding facts and circumstances. Among the factors considered by the IRS are:
-Whether there is an unconditional promise on the part of the taxpayer to pay a fixed sum on demand or at a fixed maturity date that is in the reasonable foreseeable future;
-Whether the lender has the right to enforce the payment of principal and interest;
-Whether the instruments give the lender the right to participate in the management of the issuer (in this case the §42 project);
-Whether the taxpayer is thinly capitalized; and
-Whether the lender is related to the taxpayer.
The key issue for consideration is not whether certain indicators of a bona fide loan exist or do not exist, but whether the parties actually intended and regarded the transaction to be a loan. An essential element of bona fide debt is whether there exists a good faith intent on the part of the recipient of the funds to make repayment and a good-faith intent on the part of the person advancing the funds to enforce repayment.
In the case of Section 42 projects, it is often the case that both the general partner of the taxpayer (the debtor) and the developer (the creditor) are either controlled by or are the same entity. Such cases are subject to additional scrutiny because the circumstances suggest the opportunity to contrive a fictional debt. In other words, the tax consequences must be determined, not from the form of the transaction, but from its true substance.
Intrinsic Economic Nature
Usually, a deferred developer fee will be structured as a promissory note or other debt instrument. However, given the relationship between the parties, the court may give little weight to the actual form of the transaction. Instead, the court will examine three essential elements relating to whether there is actual debt:
1. Independent Creditor Test: The acid test of economic reality of a purported debt is whether an unrelated outside party would have loaned funds to the borrower under similar circumstances. Is the note due and payable within a reasonable period of time? Are installment payments due in the interim? Is the not subordinate to other debt and only payable after operating expenses have been met? Is the note secured and is there recourse if it is not paid? If these requirements are absent, it is likely that the debt is not real.
2. Debt-Equity Ratios: Courts will look at the thinness of the taxpayer’s capital structure relative to accumulated debt. Thin capitalization adds to the evidence that a deferred developer fee is not genuine debt. Even if a taxpayer’s capital structure is relatively strong, if the debt terms are highly favorable, the deferred developer fee may still not be considered genuine debt.
3. Potential Sources of Repayment: There must be a reasonable ability of the taxpayer to repay the advance and a reasonable expectation of repayment. There are generally four sources of repayment: (1) liquidation of business assets; (2) profits; (3) cash flow; and (4) refinancing with another lender.
Ultimately, the burden is on the taxpayer to demonstrate that the developer fee has been earned and is includable in eligible basis. If the fee has been deferred, a demonstration that the deferred fee is bona fide debt will also be required.