Issue With a Nonprofit's Participation in
Low Income Housing Tax Credit Deals
What the heck is a "168(h) election" anyway?
In order to score the maximum points in the competition to secure an allocation of Low Income Housing Tax Credit, for-profit developers will typically include a charitable nonprofit entity in their partnership structure.
But, the for-profit is always wary of the manner in which the nonprofit participates in the deal. If one of the direct partners is an exempt nonprofit the partnership's real estate is considered to be "tax exempt use property" and thus not eligible for the most favorable form of depreciation deduction (the property will have to be depreciated over a 40-year recovery period rather than a more favorable 27.5 year period).
To prevent this from happening the participation of the nonprofit must be structured so that distributions flowing to the exempt nonprofit are treated by the IRS as taxable "unrelated business income".
- This can be done by the inserting a taxable “blocker entity” between the tax exempt nonprofit and the partnership.
- a blocker entity is a wholly owned subsidiary controlled by the nonprofit. It can be either a corporation or an LLC. This subsidiary serves as the actual partner in the partnership as opposed to having the nonprofit directly play that role.
If the blocker entity is an LLC it must make an election with the IRS to be taxed as a corporation (because, by default, a single member LLC is considered by the IRS to be a "disregarded entity" and thus would not be able to serve as a taxable blocker entity). The election to be taxed as a corporation is made by submitting IRS Form 8832. If the LLC so chooses it can make a further election to be taxed as an “S corporation” (by default corporations are taxed under Subchapter "C" not "S").
But, regardless of whether the blocker entity is an LLC or a corporation, simply being taxed as a corporation is not enough. An additional step is still needed. Wholly owned subsidiaries of a nonprofit, even if they are being taxed as corporations, will be treated as exempt entities by the IRS UNLESS they make an election under Section 168(h)(6)(F)(ii) of the Code NOT to be treated as exempt entities.
- To make a "Section 168(h) election" you must attach a statement to the tax return of the blocker entity for the taxable year for which the election is to be effective. CLICK HERE go to the IRS regulations describing how to make the election (26 CFR 301.9100-7T). In this regulation the instructions for making the election are found in subsection (a)(3).
- The statement making the election should read something like the following:
Election Not to be Treated as Exempt Entity
Section 168(h)(6)(F)(ii) IRS Code
The taxpayer hereby elects to have any gain recognized by its tax-exempt parent on any disposition of an interest in the taxpayer (and to treat any dividends or interest received or accrued from the taxpayer) as unrelated business taxable income under Code section 511 in order for the taxpayer not be treated as a “tax-exempt entity” (or as a successor to a tax-exempt entity) under section 168(h)(6)(F)(ii) of the IRS. This election is irrevocable
CLICK HERE to view an IRS "Letter Ruling" on this whole topic (it gives a good overview and explanation)
NOTE: In real life the decision to have the distributions to the blocker entity subsidiary be treated as taxable "unrelated business income" will have little negative impact on the nonprofit parent's desired economic benefit so long as the deal is properly structured. The transaction can be set up so that the bulk of the funds transferred to the nonprofit are NOT done so as "distributions" of profits to the blocker entity serving as the partner in the title holding partnership. Instead, either the partnership or the for-profit general partner can enter into a separate agreement with the nonprofit to pay it for services rendered (perhaps to be paid out of the "developer fee" line item in the budget). Thus, in real life most of the income received by the nonprofit from the deal will remain exempt and will not be treated as taxable "unrelated business income" so long as it is paid directly to the nonprofit as a fee for services rendered rather than as a distribution of profits to its blocker entity subsidiary pursuant to the partnership agreement.
CLICK HERE for a sample "Developer Services Agreement" wherein such a nonprofit is retained by a for-profit general partner to provide services to be paid out of the for-profit's share of the developer fee (consult an attorney before using)