IRC §42(h)(5) requires that a portion of each state’s annual credit ceiling be set aside for allocation to projects involving qualified nonprofit organizations. Specifically, at least 10% of the state’s allocable credit must be set-aside for a nonprofit pool.
In the recently issued draft audit Guide for the Section 42 program, the IRS provides some valuable guidance regarding this nonprofit set-aside requirement. Nonprofit developers and others working with such developers should be familiar with these specific requirements.
In order to be eligible for an allocation from the nonprofit set-aside, a qualified nonprofit organization must own an interest in the project (directly or through a partnership) materially participate (discussed later) in the development and operation of the project throughout the compliance period.
For purposes of §42, the term “qualified nonprofit organization” means any organization if-
I. The organization is a qualified nonprofit for IRS purposes (e.g., a 501(c)(3) organization);
II. It is determined by the State HFA not to be affiliated with or controlled by a for-profit organization; and
III. One of the exempt purposes of the organization includes the fostering of low-income housing.
It is important to remember that even if a nonprofit is a partner is a LIHTC project, unless the allocation of credits came from the nonprofit set aside, the issues outlined here are of no concern to the IRS. Allocations under the nonprofit set-aside are usually made to partnerships for which the general partner is the qualifying nonprofit organization.
When conducting an audit of a project with credits from the nonprofit set-aside, one of the first steps the agent will take is to ensure that the nonprofit is, in fact, a qualified tax-exempt organization. To be tax exempt, the entity must be organized and operated exclusively for one or more of the following purposes:
- Religious
- Charitable
- Scientific
- Testing for public safety
- Literary
- Educational
- Prevention of cruelty to children or animals
Nonprofits participating in the LIHTC program would normally be considered “charitable.”
In addition to 501(c)(3) organizations, 501(c)(4) nonprofits are also eligible to apply under the nonprofit set-aside. These are nonprofit civic leagues or organizations operated exclusively to promote social welfare, or local associations of employees, the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes. As with the 501(c)(3), one of the purposes of these organizations must include the fostering of low-income housing, if they seek credits from the nonprofit pool.
IRS Revenue Procedure 96-32 provides guidance for determining whether a nonprofit involved in low-income housing is serving a charitable purpose by fostering low-income housing. The determination is based on the percentage of low-income units provided and the income level of the tenants. These guidelines are applied continuously throughout the 15-year compliance period. At least 75% of the units must be occupied by residents with incomes of 80% or less of the area median income, and either:
- 40% of the units occupied by residents at or below 60% of the median income; or
- 20% of the units occupied by residents at or below 50% of the median income.
These determinations are made at the time a resident first occupies a unit.
There is also an “ownership test.” The nonprofit must have an ownership interest in the project for the entire compliance period. The interest may be owned directly or indirectly through a partnership. They can also own stock in a qualified corporation that owns a LIHTC project. A qualified corporation must be a corporation that is 100% owned at all times during its existence by one or more qualified nonprofit organizations (i.e., there can be no portion of ownership by a for-profit).
One of the most confusing requirements relating to the nonprofit set-aside is the “material participation” stipulation. A qualified nonprofit organization must materially participate in both the development and operation of the project throughout the 15-year compliance period. IRC §469(h) defines material participation as activity that is regular, continuous, and substantial. The IRS applies the following guidelines to determine if the participation is “material.”
- Is the activity a principle business or activity of the nonprofit?
- Is there involvement in the actual operations of the activity? Services provided must be integral to project operations. Simply consenting to someone else’s decisions or periodic consultation with respect to general management decisions is not sufficient.
- Participation must be maintained throughout the year. Periodic consultation is not sufficient.
- Regular on-site presence at operations is indicative of material participation.
- Providing services as an independent contractor is not sufficient.
If the partnership has one or more for-profit general partners, the nonprofit partner could have less participation in the partnership, which will attract scrutiny from the IRS.
If there is both for-profit and nonprofit general partners, they cannot be related; i.e., share officers or board of directors. These arrangements are subject to intense IRS scrutiny, and may call into question the exempt status of the nonprofit entity. The issue here is whether the nonprofit acts exclusively as a charity or are the actions of the nonprofit furthering the interests of private investors. Some red flags in this area include:
- The nonprofit is not the only general partner;
- The nonprofit’s minority partnership interest provides for minimal participation in the operations of the project;
- The nonprofit makes guarantees to the limited partners against loss of tax credits; and
- Excessive private benefits result from the sale of the property, development fees, or management contracts.
If the IRS determines that an allocation of credits under the nonprofit set-aside was not appropriate, credits may be disallowed in their entirety. Any noncompliance in this area must be corrected as of the end of the taxable year in which the noncompliance occurs. If this does not happen, the IRS will whether noncompliance rests solely with the nonprofit organization, or if other entities share responsibility.
- If responsibility does not rest solely with the nonprofit, the no credit is allowable for the taxable year the noncompliance occurred or any subsequent taxable year until the noncompliance is corrected;
- If responsibility rest solely with the nonprofit, a determination will be made as to whether the noncompliance was corrected with a “reasonable period.”
The IRS has determined that a “reasonable period” for correction of noncompliance caused solely by a qualified nonprofit will be the same as the reasonable correction period for casualty losses. This is no longer than two years following the end of the tax year in which the noncompliance first occurred. If the noncompliance is corrected within this reasonable timeframe, there should be no disallowance of credit. If it is not corrected within this reasonable period, no credit is allowable for the taxable year the noncompliance occurred or any subsequent year until the noncompliance is corrected.
The draft Audit Guide also notes some related issues that nonprofit developers should be aware of:
- Federal Financing: If a nonprofit secures federal funding and loans the proceeds to the project, the loan must qualify as bona fide debt in order to be included in eligible basis;
- Developer Fees: if the nonprofit earns a developer fee for putting the deal together, it must be able to demonstrate that it has the actual expertise to undertake the development;
- Related issues here are (1) private inurement, in which some of the developer fee benefits a for-profit entity; and (2) unrelated business taxable income. If excessive fees are generated for activities not related to a charitable purpose, the entities tax-exempt status could be jeopardized.
Nonprofit organizations considering seeking an allocation of credits from the State’s nonprofit set-aside should be aware of the requirements relating to the nonprofit pool, as should for-profit developers considering partnering with nonprofits on LIHTC projects.