Developer Fees - How They are Viewed by the IRS
Developer fees represent payment for a developer s services and are (at least partly) includable in eligible basis for a Low-Income Housing Tax Credit (LIHTC) project. There are three basic types of developer fees. Turnkey Project Fee The taxpayer (usually a partnership) enters into a development agreement with a developer to pay an amount that includes all hard construction costs and the developer s fee. If the actual costs exceed the budget, the developer fee is decreased. Fixed Amount Developer Fee A fixed amount developer fee occurs when the "hard costs" and the developer fee are separately stated line items in the contract. Unlike a turnkey agreement, the developer fee does not decrease if the hard costs exceed the budgeted amount. Completed Project Developer Fee A completed project developer fee is passed on to the ultimate purchaser of the building as a component of the purchase price. The individual components (land, new construction, acquisition or an existing building, rehab costs, and developers fee) may not be separately stated. Related Parties In many cases, the developer is the general partner of the partnership owning the project. The developer may also be related to the entity that actually constructed the project or the property management company operating the project (in some cases - both). Audit Issues & Techniques There are four basic issues an IRS examiner will focus on when examining a developer fee: Character of the services to be provided; Services actually provided; Reasonableness of the fee amount; and Method of payment. Character of the Services to be Provided The services to be provided will be identified in the agreement entered into by the taxpayer and the developer. Typically, the developer agrees to provide (or may have previously provided) services relating to the acquisition, construction, and initial operating phases of the development. Development Costs Includable in Eligible Basis Examples of services typically includable in eligible basis: Negotiation of agreements for architectural, engineering, and consulting services, the construction of the project or improvements includable in eligible basis, and the furnishing of the associated supplies, materials, machinery or equipment. Applying for and maintaining all government permits and approvals required for the construction of the project and securing the certificates of occupancy when completed. Complying with the requirements imposed by insurance providers during construction. Providing oversight, including inspections, during the course of construction and approving eventual payment for the services rendered. Implementing the taxpayer s decisions relative to the design, development, and construction of the project. Development Costs not Includable in Eligible Basis Development of a low-income project involves services that are not related to the actual construction of the low-income buildings and, therefore, the cost of such services is not includable in eligible basis. Examples include Acquisition of the project site, including locating the site, performing economic and feasibility studies, market studies, and negotiation of the purchase price. Note - a portion of the purchase price may be included in eligible basis if the purchase includes the acquisition of a building that is subsequently rehabilitated for use as low-income housing. A developer may advise the taxpayer regarding available sources of financing, such as federal, state or local subsidy programs, as well as commercial financing. The cost of such services may not be included in eligible basis. Maintaining contracts, books and records sufficient to establish the value of the completed project. Partnership Costs - services associated with the partnership s organization, syndication of partnership interests, or securing the allocation of tax credits, are not includable in eligible basis. Initial Lease-Up Costs - the taxpayer may contract with the developer to complete the initial leasing of the rental units. Typical costs would be Hiring on-site staff; Advertising; and Maintaining model units. These costs are not includable in eligible basis. On-going Management Costs - the developer may also contract to provide on-going management of the day-to-day operations after the initial lease-up. These services may include providing qualified on-site managers, physically maintaining the site, resolving tenant issues, and renewing leases and obtaining new residents. Such costs are not part of eligible basis. Services Actually Provided During an audit, the IRS will work to determine whether the developer actually performed the services covered by the fee. Normally, one developer will initiate development and then provide services throughout the development process until the project is completed. However, there are instances where more than one developer is involved. For example, a for-profit developer may work with a qualified nonprofit organization to develop a low-income project qualifying for a credit allocation from the nonprofit set-aside. When there are multiple developers, there are two basic questions: How were developmental responsibilities divided among the developers; and Did the developer have the skills and expertise needed to provide the developmental services and complete the project? Reasonable Fee As a best practice, the state agencies have limited the developer fee amount that can be supported by the credit. This limit is typically a percentage of total costs. There is no requirement that the IRS accept the developer fee allowed by the state agency, and the Service may raise issues involving the reasonableness of the fee if the facts and circumstances warrant doing so. Method of Payment Developer fee payments made during development, or at the time development is completed, and which are identified in the taxpayer s books as payments of developers fees are generally not challenged by the IRS. Deferred fees however, will get a much harder look. In these cases, the IRS will consider whether the payment is contingent upon providing services usually associated with the duties of a general partner. They will also consider whether payment of the developer fee is contingent on successfully operating the project, or maintaining the project, in compliance with 42. If these conditions exist, separately or in combination, then the deferred portion of the fee is not includable in eligible basis because the developer is being paid for services unrelated to the development of the low-income building. Intent to Pay Deferred Developer Fee A major element in any IRS decision as to whether a deferred developer fee may be included in basis is whether or not the taxpayer intends to pay the deferred fee. This is especially important if the parties to the transaction are related (for business purposes). Consideration will be given to whether: The note and/or other documentation bears no interest rate or no repayment is required for extended periods of time, suggesting that the agreement is not an arm s length transaction; 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 the property for a price equal to the outstanding debt; or The general partner, 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 the above fact patterns exist, separately or in combination, the deferred developer fee note may not be bona fide debt. So, what does the IRS consider to be "bona fide" debt? Generally, debt, whether recourse or nonrecourse, is includable in the basis of property. However, the obligation must represent genuine, noncontingent debt. Nonrecourse debt is not includable if the property securing the debt does not reasonably approximate the principal amount of the debt, or if the value of the underlying collateral is so uncertain or elusive that the purported indebtedness must be considered too contingent to be includable in basis. Recourse liabilities are generally includable in basis because they represent a fixed, unconditional obligation to pay, with interest, a specified sum of money. However, an obligation, whether recourse or nonrecourse, will not be treated as true 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" constitute genuine indebtedness, tax courts have isolated a number of criteria from which to judge the true nature of an arrangement that in "form" appears to be debt. In Fin Hay Realty Co. v. United States (1968), the court outlined 16 nonexclusive factors that bear on whether an instrument should be treated as debt for tax purposes: The intent of the parties; The identity between creditors and shareholders; The extent of participation in management by the holder of the instrument; The ability of the debtor to obtain funds from outside sources; Thinness of capital structure in relation to debt; The risk involved; The formal elements of the arrangement; The relative position of the obligees as to other creditors regarding the payment of interest and principal; The voting power of the holder of the instrument; The provision of a fixed rate of interest; Any contingency on the obligation to repay; The source of the interest payments; The presence or absence of a fixed maturity date; A provision for redemption by the corporation; A provision for redemption at the option of the holder; and The timing of the advance with reference to when the taxpayer was organized. The court stated, "Neither any single criterion nor any particular series of criteria can provide an exclusive answer " The Tax Court also held that the case-enumerated factors are merely aids to determine whether a given transaction represents genuine debt. The weight given to any factor depends upon all the facts and circumstances. No particular factor is conclusive in making the determination of whether an instrument constitutes debt or equity. There is no fixed or precise standard. Among the common factors considered when making this determination are whether: A note or other evidence of indebtedness exists; Interest is charged; There is a fixed schedule for payments; Any security or collateral is requested; There is any written loan agreement; A demand for repayment has been made; The parties records, if any, reflect the transaction as a loan; and The borrower was solvent at the time of the loan. The key issue 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. Related Party Transactions In a typical LIHTC property, both the general partner and the developer are the same entity. When transactions occur between related parties rather than at arm s length, they are "subject to particular scrutiny because the control element suggests the opportunity to contrive a fictional debt." Geftman v. Commissioner, 1998. When examining related party transactions, the Service should determine tax consequences not from the "form of the transaction," but from its "true substance." Thus, as stated in Geftman, "a transaction must be measured against an objective test of economic reality and characterized as a bona fide loan only if its intrinsic economic nature is that of a genuine indebtedness." Intrinsic Economic Nature A deferred developer fee will be structured as a promissory note or other debt instrument. However, courts will rely more on the relationship between the parties than to the form of the transaction. The essential question is whether the instruments "intrinsic economic nature is that of a genuine indebtedness." The critical test of the economic reality of a purported debt is whether an unrelated outside party would have advanced funds to the borrower under similar circumstances. Creditors usually avoid subjecting funds to the risk of a borrower s business as much as possible and seek a reliable return on their investment. For example, commercial lenders impose borrowing terms that limit risks and charge interest rates that reasonably compensate for those risks and provide a reasonable return on the investment. An example of terms that would not represent true debt would be: A note that is due and payable far in the future; No installment payments due; Note is subordinate to other debt an payable only after all operating expenses have been paid; Note is unsecured and nonrecourse; and The note is interest free. A taxpayer s thin capitalization adds to the evidence that a deferred developer fee is not real debt. Even if the taxpayer is reasonably capitalized, if the terms of the debt are highly favorable (as noted above), the IRS could deem the deferred fee as not being genuine debt. The Service will also examine the Taxpayer s ability to repay the advance and the reasonable expectation of repayment. Normally, there are four possible sources of repayment: Liquidation of business assets; Profits; Cash flow; and Refinancing with another lender. In TAM (Technical Advice Memorandum) 200044004, the IRS provided an example of how the totality of circumstances will lead to the determination of whether a deferred fee is true debt. The circumstances were as follows: At completion of construction, the taxpayer did not have the funds to pay the entire developers fee so it issued a note for the balance; The note was payable at maturity, 13 years from completion of the project; The note was unsecured and source-of-payment restrictions were in effect during the term of the note; Payment was subordinate to other debts; The note bore interest which was compounded annually and added to the unpaid principal during the term of the note; The taxpayer was obligated to pay off the note in full at maturity and the general partners were obligated to make additional capital contributions necessary to pay off the note at maturity; and Financial statements indicated that payments had been made on the note. Despite the negative elements of the arrangement (long-term maturity, unsecured and source of payment restrictions, and subordination), the IRS concluded that the amount of the developer fee note was includable in eligible basis. There was an obligation to pay and interest accrued. The general partners were obligated to contribute a sufficient amount to pay the note in full, and the taxpayer had sufficient equity and assets to repay the note. Critical to the determination in the TAM was the fact that the note bore interest to compensate the lender for the various financial risks posed by the note. In the case of deferred developer fees, the ultimate burden to demonstrate that the developer fee was earned and is includable in eligible basis rests with the taxpayer. If the taxpayer has deferred payment, the taxpayer will also need to demonstrate the deferred fee is bona fide debt.