United States: IRS Issues Guidance For Nonprofit Organizations Involved In Low Income Housing

The Internal Revenue Service has released guidance for its agents who process applications for federal income tax exemption for organizations which will participate in low income housing tax credit ("LIHTC") projects. The guidance is effective upon its release, and is the result of years of discussion between the IRS and a coalition composed of section 501(c)(3) organizations involved in LIHTC projects. While the guidance is applicable to newly formed entities that are seeking a determination that they are exempt from federal income tax, it also, more significantly, establishes standards for all tax-exempt organizations that participate in LIHTC transactions. Entities whose applications for tax-exempt status are currently being considered by the IRS should supplement their applications by submitting the representations required by the guidelines and discussed below.

Historically, nonprofit organizations which acted as general partner in LIHTC limited partnerships or managing member in LIHTC limited liability companies ("LLCs") were subject to substantial delays in processing their exemption applications. Contributing to the lag in processing time was the fact that the IRS generally requested that an applicant organization produce final documents governing its limited partnerships or LLCs prior to processing the application. Since final documents are the result of the negotiating process, with agreements being reached within days of closing, the requirement that the final documents be reviewed by the IRS inevitably resulted in delayed closings. In some circumstances where the approval of tax-exempt status was a precondition to closing, the mandatory IRS review of final documents created substantial hardships for pending LIHTC transactions. Moreover, the IRS frequently took the position that many of the industry-wide guarantees provided by nonprofits constituted impermissible private benefit.

The new guidance, issued by the Acting Director of the IRS Exempt Rulings and Agreements Division, sets forth clear standards for processing exemption applications for section 501(c)(3) and 501(c)(4) organizations proposing to participate in LIHTC partnerships and LLCs, and provides a "safe harbor" for newly-formed exempt organizations; if the criteria are met, the exemption should be forthcoming. In lieu of final documents, an applicant organization may provide representations with respect to provisions to be included in the final documents.

Specific requirements for exemption applications for organizations intending to participate as general partner in LIHTC partnerships or managing member in LIHTC LLCs include:

1. a description of the applicant organization’s proposed activities, including identification of a specific housing project, and how participation in the project will accomplish the organization’s charitable purposes;
2. a conflicts of interest policy adopted by the applicant organization;
3. in the absence of final governing documents for a LIHTC limited partnership or LLC, a written representation regarding the contents of such governing documents, including representations that the partnerships and LLCs will be operated in a manner that furthers charitable purposes, and that in the event of conflicting obligations, charitable purposes will override any profit motive; and
4. written representations limiting the applicant organization’s financial exposure in the event the housing project does not proceed as planned, including representations regarding the specific terms and conditions contained in final governing documents, and representations regarding actions to be performed by the applicant organization.

When the final governing documents for the limited partnership or LLC are executed, they must be sent to the IRS. Presumably, if the representations made in the exemption application with respect to the final documents were not accurate, the IRS may withdraw a favorable determination letter that it has issued to the organization.

The two key areas of concern for the IRS regarding participation in LIHTC projects by section 501(c)(3) and 501(c)(4) organizations have been certain industry-standard guarantees made by these organizations to investors (which were viewed by the IRS as raising potential private benefit concerns), and the limited ability of the taxexempt organization to control the LIHTC entity. The required written representations for applicant organizations are intended to eliminate these concerns.

LIHTC limited partnerships and LLCs now must enter into a fixed-price construction contract with a bonded contractor, or a contractor that provides a performance letter of credit or adequate personal guarantee. If an operating deficit guarantee is required of the applicant organization, its liability must be limited to a period not more than five years from the date the project achieves break-even operations¹ or limited to an amount equal to no more than six months of operating expenses.

Additionally, any tax credit guarantee made by the applicant organization to investors must be limited. The limitation may be adopted through either of the following approaches: first, if the governing document of the limited partnership or LLC includes separate tax credit adjuster provisions, the guarantee would be limited under each separate adjustable provision to an amount that does not exceed the aggregate amount of developer and other fees (both payable and deferred) that the applicant organization, or any affiliate, is entitled to receive in connection with the project. Alternatively, any payments by the applicant would be treated as capital contributions or loans to the limited partnership or LLC, and their repayment must take priority over any other distribution of residual assets to partners upon sale or refinancing of the property. Tax credit adjuster provisions that combine these two approaches would be permissible.

Applicant organizations must also secure a right of first refusal to acquire the project at the end of the LIHTC compliance period under section 42(i)(7) of the Internal Revenue Code ("IRC"). However, the organization’s board of directors must review any purchase of the project to ensure that the purchase price is reasonable and consistent with the organization’s charitable status. While the requirement provides that the right of first refusal price is the lesser of the minimum right of first refusal purchase price under IRC § 42(i)(7), or fair market value, this does not violate IRC § 42(i)(7). Under general tax principles, the owner of property may grant a right to another party to purchase the property for fair market value, without jeopardizing ownership of the property.

If the applicant organization must guarantee to repurchase the investors’ interest in the limited partnership or LLC in the event of a failure to meet certain fundamental requirements relating to the viability of the project, the repurchase price may not exceed the amount of capital contributions. Under this representation, "mark up" of the repurchase amount to cover syndication costs would not be permitted, regardless of whether the syndicator is a for-profit or a tax-exempt entity.

If the applicant organization is required to obtain the consent of limited partners or investor members with respect to certain matters not involving day to day operations, such consent may not be unreasonably withheld. A number of specific permissible consent rights are identified within the guidance, but additional, nonenumerated consent rights may also be included. However, if those additional non-enumerated consent rights become too extensive, the IRS may object to their inclusion.

Documents governing limited partnerships or LLCs must provide that rights of limited partners or other members to remove the applicant organization as general partner may only be for "cause", and notice must be provided to the applicant organization which states the cause for the action and allows the organization a reasonable period to cure any deficiencies.

Finally, applicant organizations are required to protect themselves from environmental liability by reviewing an independent Phase I environmental report on the proposed project.

We are pleased that the IRS has released guidance in the form of a "safe harbor" for nonprofit organizations planning to participate in LIHTC projects as general partner or managing member. The review by the IRS of exemption applications should be expedited. Applicants need to study the standards set forth in the guidance so that they are able to make the necessary representations to the IRS at the time of filing their exemption applications. In addition to giving the representations, the applicant organization must also ensure that their final documents are consistent with the representations provided. Since many syndication documents will place greater burdens or restrictions on nonprofit general partners and managing members, tax-exempt organizations must be careful to negotiate to include acceptable guarantee and management provisions consistent with the guidance.

Organizations that have previously secured tax-exempt status should use their best efforts to ensure that the documents they execute in the future will comply with these standards. This guidance creates a "safe harbor" in which tax-exempt organizations can ensure that participation in LIHTC transactions will not jeopardize their tax-exempt status. Representatives of the IRS have cautioned that, in cases where the executed documents do not comply with the guidelines, tax-exempt organizations should identify the alternative provisions in the documents that provide equivalent protection for the nonprofit and identify the reasons why the guidelines were not followed. At this time, we do not recommend that tax-exempt organizations apply these standards retroactively or attempt to renegotiate specific provisions in previously executed documents.

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