Considerations When Making Tax Credit Investments
Tax credit investments are an increasingly popular and economically powerful tool to reduce federal and state tax burdens. However, it is important to consider the accounting, tax and regulatory consequences of these investments. Here are some high-level issues to consider when evaluating tax credit investments.
Type of Credit
Typical tax credits available for a retail investor include Historic Tax Credits, New Markets Tax Credits (NMTC), Renewable Energy Credits and Low-Income Housing Tax Credits (LIHTC). Many states have similar credit programs that mirror the federal credit. However, not all credits are created equal.
At the federal level, there’s generally a maximum amount of credits that can be claimed on a single return (approximately 75 percent of your total tax). In addition, some credits may not be eligible to offset against the alternative minimum tax (AMT). Depending on your AMT adjustments and preference items, this may severely limit the credit amount you can claim in a particular year.
On the state level, some credits are limited to which type of tax they can offset. For example, Missouri imposes income, franchise, bank franchise and insurance premium taxes. Some credits are available to offset all of these tax types, while others only are limited to certain state tax liabilities. If investors don’t perform their diligence to make sure their investment generates the appropriate credits to offset their specific taxes, they may be stuck with credits they cannot use or transfer to another taxpayer.
Different credit types require different investment structures to pass the benefits on to an investor.
Some credits, particularly state credits, are “certificated” and can be directly transferred from one taxpayer to another. In these cases, the investment generally involves a straightforward purchase of the tax credit, which is then claimed on a tax return.
However, other credits require investment in a partnership to allow the credit to be “allocated” to the investor. While this isn’t necessarily a bad thing—most federal and state credits require some level of partnership investment—the mechanics of a partnership slightly complicate the process and may delay the filing of your income tax return. In addition, some credits may have a recapture period, requiring you to remain a member of the partnership even if you’re no longer being allocated credits or other tax benefits.
At the state level, you also may receive credits in return for certain charitable contributions. These credits don’t result in a gain to the donor but may reduce the overall financial cost of a contribution. However, other factors discussed below may affect the claiming of the credit.
Accounting Treatment May Vary
For non-individual investors, the accounting treatment of an investment under generally accepted accounting principles (GAAP) or Statutory Accounting Principles (SAP) may affect the decision to make the investment. Depending on the method or credit program chosen, accounting treatment under GAAP and SAP may drastically differ.
Direct purchases of a certificated credit generally are the simplest. These are usually treated as payments of tax—recorded against the taxes payable account as the credits are used—with a gain recognized for any discount received.
Partnership investments for federal or state LIHTCs have special rules requiring amortization of the investment over the 10-year credit allocation period. Recent guidance provides some flexibility in how the investment is amortized; BKD’s whitepaper on ASU 2014-01 offers more information on both the new and old methods. Regardless of the amortization methodology used, the full credit amount is recorded each year as a reduction to the taxes payable account, a portion of the original investment is reduced and the difference is recorded as a reduction in the tax provision recorded in the income statement. Flow-through gain or loss doesn’t affect the book-carrying value of the investment. While accounting for LIHTC investments generally is similar under GAAP and SAP, there are some differences in the method used to determine the fair value of the investment when determining amortization.
Partnership investments for other credit types generally are recorded at cost on the financial statements, carried on the equity method and reviewed periodically for impairment. When tax credits are received, the taxes payable account is reduced with an offsetting gain recorded against the tax provision. Depending on the partnership’s gain, loss and distribution projections, the balance sheet investment often is impaired with a charge recorded to the income statement, as the credits generally do not reduce the investment asset and the residual benefits to be received (tax benefit of losses and cash distributions) will be substantially less than the equity method carrying value of the investment. Again, GAAP and SAP treatments generally are similar, with small differences in valuation and disclosures required.
Note the accounting treatment for each investment is dependent on a number of factors. The accounting treatments discussed above are a high-level view of the applicable guidance. You should discuss the proper accounting treatment with your accounting and tax advisors before committing to a prospective investment.
One of the biggest benefits of using tax credits is the potential financial gain. For direct purchases of certificated credits, the purchase generally is for a fraction of face value. Therefore, you’re able to satisfy your state liability at a discounted price. While actual pricing will depend on your state’s credits and the market for those credits when you purchase, those who make direct purchases of credits on an annual basis can generate significant permanent tax savings over the years.
Credits acquired via a partnership investment also include a discount element. Depending on the specific credit and the syndicator’s model, your investment may be for a fraction of the credits to be received. However, your return also may depend on expected tax losses and cash distributions. Particularly for longer-term investments for credits with multiyear allocations, a syndicator typically will provide projections of tax losses, credits and cash distributions. This is an area with greater potential for due diligence mistakes. It’s important to closely review these projections to understand the inputs used to develop them and recalculate the gain given your specific situation and expected book and tax accounting treatments. Things to consider include:
- Are the projected losses and cash distributions reasonable? Does the model cash flow work or will additional investment from general and/or limited partners be required?
- Are basis limitations considered for tax losses allocated?
- Are the internal rate of return and/or return on investment rates provided accurate? Are they presented on an annual basis or for the full investment horizon?
- Have you considered the character of gains and losses to be recognized? Sizable losses in the final year may be a write-off of your remaining capital account, which generally is a capital loss. If you do not have other capital gains to offset, the benefit of these losses may be deferred or lost entirely.
- What are your options for exiting the partnership? Typically, the partnership agreement includes a mechanism for the investor to exit after the credits are fully allocated; it’s important to understand if that exit is reflected in the models provided and see what other tax consequences an exit would have.
Finally, there are nonfinancial, nontax issues to consider when evaluating a tax credit investment. First, tax credits acquired with partnership interests will produce a Schedule K-1 for your investment in the partnership. Depending on the tax credit fund, these K-1s may not be available until well after March or April 15. If you need to file your return by the original due date, i.e., no extension is filed, consider discussing the timing of the K-1 with the syndicator to see when the K-1s are typically completed or if estimated information is provided prior to your due date.
Second, financial institutions should consider whether the tax credit investment provides Community Reinvestment Act (CRA) credit in addition to the financial benefits. LIHTC and NMTC investments often qualify for CRA credit and may be an added benefit.
In summary, tax credit investments are an increasingly popular way to reduce federal and state tax burden. However, there are a number of financial and nonfinancial factors to consider before committing to a particular structure. By performing the necessary due diligence for your specific circumstance, including the factors discussed in this article, you can reduce your risk of unexpected surprises from your investment. Before committing to a prospective investment, you should discuss the tax, regulatory and accounting issues with your advisors to apply the applicable guidance to your specific situation.
For more information about tax credit investments and their impact on your situation, please consult your BKD advisor.
Note: This article is for general information purposes only and is not to be considered as tax or legal advice. This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your BKD advisor or legal counsel before acting on any matter covered in this update.