Improved Guidance for Nonprofit Organizations Utilizing New Markets Tax Credits to Better Serve Low-income Communities

• Publication year: 2017
• Author: By Julie Treppa

Improved Guidance for Nonprofit Organizations Utilizing New Markets Tax Credits to Better Serve Low-Income Communities1

By Julie Treppa²

EXECUTIVE SUMMARY

New Markets Tax Credits ("NMTCs") issued under Section 45D of the Internal Revenue Code ("Code")³ have been instrumental in supporting private investment in a wide range of businesses and nonprofit organizations located in communities with low-medium incomes and high rates of unemployment. In fact, for every $1 invested by the Federal government, the U.S. Department of Treasury estimates that the New Markets Tax Credit Program (the "NMTC Program") generates over $8 of private investment in low-income and impoverished communities across the United States and its territories.⁴ This paper proposes amendments to the Treasury Regulations ("Regulations") to clarify the types of income that may be used in evaluating whether investments qualify for NMTCs, and what may be properly characterized as a capital investment in a nonprofit.

Nonprofit organizations have been vital to the deployment and use of NMTCs in transactions that have revitalized impoverished communities and assisted those living in poverty. Multiple nonprofit organizations have applied for, and received, an allocation of NMTCs. Others have received cash proceeds from qualified investments made pursuant to the NMTC Program. However, investments in this latter category have generally been limited to organizations involved in the substantial rehabilitation of real estate. While such projects certainly are worthwhile, clarity with respect to how a nonprofit organization can meet the gross income test under Code Section 45D(d)(2) (A)(i) (the "Gross Income Test") in order to be properly characterized as a "qualified active low-income community business" ("QALICB")⁵ would open up NMTC financing to other nonprofits who run operations and programs that are desperately needed in these communities.

This paper recommends that the Treasury Department amend those Regulations promulgated under Section 1.45D-1(d)(4)(i)(A) to clarify that a nonprofit corporation need not generate earned income in order to be a QALICB. Further, this paper recommends that Regulation Section 1.45D-1(d) (4)(i)(A) be amended to include a provision that specifies what type of "income" is included in evaluating the Gross Income Test. Specifically, the recommendation is to include all items included in the definition of "support" under Code Section 509(d) and the related Regulations, without the omission of gross receipts earned from capital gains. Further, this paper suggests that the Internal Revenue Service ("Service") issue guidance similar to that found in the Regulations promulgated under Section 1.45D-1(d) (9) to enable a nonprofit to determine whether income was derived from the active conduct of a qualified business within any Low-Income Community.

In addition, this paper will explain how the Treasury Department can expand the ability of nonprofits to receive funding via NMTC transactions by clarifying that "qualified low-income community investments" ("QLICIs") may include capital investments made in the form of nonshareholder capital contributions. Code Section 45D(d) (1)(A) states that QLICIs include capital and equity interests in, or loans to, QALICBs. Neither this Code Section nor the Regulations under Section 1.45D elaborate on what the difference is between a capital and an equity investment, but presumably there is a difference as statutory construction assumes that each term used in a statute has a distinct meaning.⁶ QLICIs to nonprofit QALICBs are therefore often structured as loans, because a "community development entity" ("CDE") cannot make an equity investment in a nonprofit organization and there is uncertainty as to what constitutes a "capital" investment. As a result, attorneys for investors normally insist on an analysis that requires a QLICI to satisfy a "true debt" test, for fear that the QLICI will be deemed to be a non-qualifying grant to a QALICB. Practically this limits NMTC investments to those nonprofits that can prove that they are credit worthy and can satisfy the true debt test. Such a result is contrary to the purpose of Code Section 45D, whose intent is to provide capital to those who would not otherwise receive it in a commercial setting. However, there is another choice. Regulation Section 1.118-1 and related case law recognize the existence of non-shareholder capital contributions. Including such investments within the definition of "capital investments" would support public policy in that it would open up NMTC financing to those nonprofits who truly could not obtain financing "but for" the existence of the NMTC Program.

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I. DISCUSSION

A. Introduction

Code Section 45D allows certain taxpayers to claim New Markets Tax Credits ("NMTCs"). NMTCs were created as part of the Community Renewal and Tax Relief Act of 2000,⁷ to provide an incentive for private investors to inject capital into geographical areas with at least a 20 percent poverty rate or where the area median family income is below 80 percent of the statewide median family income ("Low-Income Communities"), as well as to provide capital to assist certain persons whose family income is generally not more than 80 percent of the area median family income ("Low-Income Persons"). The NMTC Program has supported a wide range of businesses including manufacturing, food, retail, housing, health, technology, energy, education and childcare. Since 2003, the NMTC Program has created or retained an estimated 197,585 jobs and has supported the construction of 32.4 million square feet of manufacturing space, 74.8 million square feet of office space, and 57.5 million square feet of retail space.⁸In fact, it is estimated that for every $1 invested by the Federal government, the NMTC program generates over $8 of private investment in communities with low-medium incomes and high rates of unemployment.⁹

The rules governing the credit are contained in the Code and the Regulations. The Service is tasked with the enforcement of these rules and the promulgation of regulations and guidance. However, the NMTC Program is administered by the Community Development Financial Institutions Fund (the "CDFI Fund") and it is responsible for reviewing applications for and awarding the credits. The CDFI Fund may issue rules and regulations in addition to those imposed by the Code and Regulations that govern the NMTC Program.

The credit is limited by the amount of allocation authority available each year. Through the first 12 rounds of the NMTC Program, the CDFI Fund has made 912 awards totaling $43.5 billion in NMTC allocation authority.¹⁰ $35.3 billion in NMTCs have been invested in Low-Income Communities since the program's inception through Fiscal Year 2013.¹¹ Under the Notice of Allocation Availability for the Calendar Year 2015 and 2016 Allocation Round of the NMTC Program, up to $7 billion of additional NMTCs may be allocated.

NMTCs are claimed by taxpayers who make a "qualified equity investment" ("QEI") in a "community development entity" ("CDE"), each as defined in Code Section 45D. The credit is equal to 39 percent of the QEI claimed over a seven-year period. A CDE is a domestic corporation or partnership whose primary mission is to serve or provide investment capital for Low-Income Communities or Low-Income Persons and that is accountable to such communities or persons through their representation on the CDE's governing board or on an advisory board. An entity seeking characterization as a CDE must be certified as such by the CDFI Fund.

A CDE may or may not offer NMTCs to investors. A CDE that desires to offer NMTCs to its investors must first compete with other CDEs and apply for authority to allocate NMTCs from the CDFI Fund. The process is extremely competitive. According to the CDFI Fund, in the 2015 and 2016 NMTC round, 238 applicants requested $17.6 billion in allocation authority. The requested amount far exceeds the $7 billion in authority available for this round. Once a CDE is awarded NMTC allocation authority, it enters into a contract with the CDFI Fund that states, among other things, what type of investments the CDE will make and what Low-Income Communities or persons it will serve.

A QEI is a cash equity investment in a CDE that received NMTC allocation authority and that the CDE designates as a QEI. The QEI cannot be redeemed for seven years and, throughout this period, substantially all (85 percent or more) of the proceeds of the QEI must be used to make QLICIs or the NMTCs are recaptured. QLICIs include capital and equity interests in, or loans to, qualified active businesses located in Low-Income Communities ("QALICBs").

A QALICB is a partnership, corporation (including a nonprofit corporation) or multi-member limited liability company that is engaged in an eligible business whereby:

• At least 50 percent of the total gross income is from the active conduct of a qualified business in Low-Income Communities (the "Gross Income Test");
• At least 40 percent of the use of the tangible property of the business is located in Low-Income Communities (the "Tangible Property Test");
• At least 40 percent of the services provided by the business' employees are performed in Low-Income Communities (the "Services Test");
• Less than five percent of the average of the aggregate unadjusted bases of the property of the business is attributable to collectibles (e.g., art and antiques), other than those held for sale in the ordinary course of business (e.g., inventory); and
• Less than five percent of the average of the aggregate unadjusted bases of the property of the business is attributable to nonqualified financial property (e.g. cash deposits and debt instruments with a term in excess of 18 months).

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Nonprofit organizations have been important participants in the NMTC Program. Many nonprofit community development organizations have qualified as CDEs and been awarded...