IRC Section 42(h)(5) requires that a portion of each states annual credit ceiling be set aside for allocation to projects involving qualified nonprofit organizations. Specifically, the Code requires that not more than 90% of the state housing credit ceiling for any calendar year be allocated to projects other than qualified low-income housing projects involving qualified nonprofit organizations. The qualified nonprofit must own an interest in the project and materially participate in the development and operation of the project throughout the 15-year compliance period.
Qualified Nonprofit Organization
For purposes of §42, a qualified nonprofit must
- Be exempt from tax under §501(a) of the Internal Revenue Code (IRC);
- Be unaffiliated with or controlled by a for-profit organization; and
- Have as one of its purposes the fostering of low-income housing.
Audit Issues for the IRS
During an audit of a property allocated credits under the Nonprofit set-aside, the following issues will be examined:
- Whether the nonprofit is a qualifying nonprofit organization and satisfies the requirements for its tax-exempt purpose;
- Whether the nonprofit has maintained an ownership interest in the project; and
- Whether the nonprofit materially participated in both the project development and operation throughout the 15-year compliance period.
The Nonprofit Set-Aside
Even if a nonprofit is a partner in the partnership under audit, unless the credits were allocated from the nonprofit set-aside, the taxpayer is not subject to the requirements of §42(h)(5), and the requirements relating to the set-aside will not be an audit issue.
Qualified Tax-Exempt Organization
Allocations under the nonprofit set-aside are frequently made to partnerships for which the General Partner is a qualifying nonprofit organization. One of the issues the IRS will carefully examine is whether one of the nonprofit’s exempt purposes includes the fostering of low-income housing. IRS guidance provides that the fostering of low-income housing serves a “charitable purpose,” which is a requirement for a nonprofit organization.
Revenue Procedure 96-32 provides guidance (including a “safe harbor”) for determining whether a qualified nonprofit organization under IRC §501(c)(3) involved in low-income housing is pursuing a charitable purpose by fostering low-income housing. The safe harbor determination is based on the percentage of low-income units and the income level of the tenants.
- A qualified nonprofit organization must establish (for each project) that at least 75% of the units are occupied by residents whose incomes are 80% or less of the Area Median Income (AMI), and either
- 40% of the units are occupied by residents whose incomes are 60% or less of the AMI, or
- 20% of the units are occupied by residents whose incomes are 50% or less of the AMI.
This determination can be based on the resident’s income at the time the household moves into the low-income unit.
Ownership Test
The nonprofit must have an ownership interest in the low-income housing project throughout the 15-year compliance period. A qualified nonprofit organization can own an interest directly, or through a partnership, or own stock in a qualified corporation that owns directly, or through a partnership, a low-income housing 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.
Material Participation
IRC §469(h) defines material participation as activity that is regular, continuous, and substantial. The test applicable to nonprofit organizations for purposes of material participation is the “facts and circumstances” test. Generally, the IRS will apply the following guidelines in defining material participation:
- Material participation is most likely to be established in an activity that constitutes the principal business/activity of the taxpayer;
- Involvement in the actual operations of the activity should occur. The services must be integral to the operations of the activity. Simply consenting to someone else’s decisions or periodic consultation relative to general management decisions is not sufficient;
- Participation must be maintained throughout the year;
- Regular on-site presence at operations is indicative of material participation; and
- Providing services as an independent contractor is not sufficient.
In many cases, the owning partnership includes both a nonprofit and a for-profit entity. Such partnerships are often structured so that the nonprofit is a general partner with a 1% or less interest in the partnership and the for-profit investor(s) are limited partners with a combined ownership interest of 99% or more.
If the partnership has one or more for-profit general partners, the nonprofit partner may have less participation in the partnership, which raises the issue of whether the nonprofit’s participation is the project is substantial, and thus material.
Exempt Status and Private Inurement
The nonprofit and for-profit general partner should not be related parties, i.e., share officers or board of directors. Such associations may call into question the exempt status of the nonprofit entity. The issue being – whether the nonprofit entity acts exclusively in furtherance of a charitable purpose or to further the interests of private investors. Some indicators that the nonprofit is not acting exclusively to further a charitable purpose are:
- The nonprofit is not the only general partner;
- The nonprofit’s minority partnership interest provides for minimal participation in the project’s operation;
- The nonprofit makes guarantees to the limited partners against loss of low-income housing credits; and
- Excessive private benefits result from real property sales, development fees, or management contracts.
Audit Adjustments
The §42 credit may be disallowed in its entirety if a taxpayer fails to comply with §42(h)(5)(B) requirements. Failure to comply does not, in and of itself, result in an actual (or imputed) decrease in the qualified basis of the building. Therefore, the credit recapture provisions of the Code are not applicable. The taxpayer may claim credit for the taxable year that the violation is corrected.
Compliance will be determined “as of the close of the taxable year.” If a taxpayer is found to be compliant “as of the close of the taxable year” in which the noncompliance first occurred, there is no disallowance of credit.
Correction within a Reasonable Period
If the noncompliance is not corrected “as of the end of the taxable year in which the noncompliance occurred,” when and if credits are reduced will be dependent on who is responsible for the noncompliance.
- If responsibility does not rest solely with the nonprofit organization, no credit is allowable for the taxable year the noncompliance occurred or any subsequent taxable year until the noncompliance is corrected.
- If responsibility rests solely with the nonprofit organization, correction within a “reasonable period” will prevent any credit loss.
- The IRS will apply the same test for “reasonable period” in this case as is applied in the event of a casualty loss.
- 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 period, there is no disallowance of credit.
- If the noncompliance is not corrected within this timeframe, no credit is permitted for the tax year the noncompliance occurred or any subsequent taxable year until the noncompliance is corrected.
Related Issues
- Federal Financing: Nonprofit organizations often secure federal financing and then loan the proceeds to the owning partnership (the taxpayer). In order to avoid potential basis issues, the loan should be bona fide debt and not a grant.
- Developer Fee: If the nonprofit takes a developer fee from the project, the IRS will confirm that the nonprofit has the expertise to develop the project, and did in fact, develop the project.
- Private Inurement: A developer fee paid to the nonprofit that may be used in whole or in part for the benefit of private persons may call into question whether the entity is being operated “exclusively” for an exempt purpose, which in turn, may jeopardize the tax-exempt status of the entity.
- Unrelated Business Taxable Income: the developer fee may be subject to taxation under IRC §512 and if the nonprofit entity has an excess of taxable income, the entities tax-exempt status could be jeopardized.
Summary
When developing LIHTC projects with credits from a States nonprofit set-aside, strict consideration must be given to issues relating to material participation, maintaining the presence of a qualified nonprofit with an ownership interest and private inurement.