Tax Increment Financing: The Developer’s Tax Issues

By Michael R. McGivney, CPA, MSA, and Adam J. Hill, CPA, Cleveland

Editor: Anthony S. Bakale, CPA, M.Tax.

In today's real estate market, large real estate developments and redevelopments are rarely executed without complex layers of debt and equity financing. While nontraditional capital can be obtained from private sources, often a financing gap is bridged by capital provided through federal, state, and local governmental programs intended to provide incentives for meaningful economic development in a depressed area. One tool increasingly employed is tax increment financing (TIF).

TIFs have long been used for financing public improvements, such as public infrastructure (streets, utilities, sewers, etc.), but have become increasingly used by private developers to construct nonpublicly owned property. A TIF is negotiated prior to any proposed improvements on the land and essentially allows the developer to use the real estate taxes on the increased value attributable to the proposed improvements to service debt on the property issued by the local government or development agency. Typically, the county and local municipalities agree to keep the current value of the property as the base value, and the increased value of the property after development over the base value—the incremental value—as the amount available to service the debt. The payments above the base value are considered service payments in lieu of taxes, or PILOT payments.

When a project is proposed, the first step is for a TIF to be authorized by a TIF ordinance adopted by a local governmental body, which creates a TIF district. Taxable or tax-exempt bonds are then authorized to be issued by the local government, and interest and principal payments on those bonds are sourced from and secured by the real estate tax assessments on the incremental value, which is the difference between the agreed-upon minimum value and the base value of the real estate located within the TIF district. Typically, developers guarantee a minimum assessment as security on the bonds. Those assessments are generally in force for a long period (e.g., 30 years). Most states and Washington, D.C., have passed legislation authorizing local governments to adopt TIF ordinances.

When a developer receives proceeds from a TIF bond for private improvements, the tax treatment of those subsidies becomes an immediate issue. Is the subsidy a grant, and, if so, are the proceeds taxable to the developer immediately? And are the increased real estate tax payments fully deductible? Or is the subsidy actually debt, and payments must be trifurcated among real estate taxes, interest, and debt reduction? These questions are not immaterial, as capital provided by TIFs to a project often can range from $10 million to more than $100 million.

As a Grant

When exploring grant treatment, one must first determine whether the grant is taxable or nontaxable, with large amounts of tax dollars at stake. If a taxpayer treats a grant as taxable, it will recognize income under Sec. 61. The taxpayer will use TIF proceeds to acquire, develop, construct, or improve property, and the taxpayer's basis in the property will be equal to the amounts expended, thus allowing for cost recovery through depreciation deductions and a higher tax basis upon sale. In addition, over time, the taxpayer will deduct the PILOT payments as real estate taxes. Ultimately, a taxpayer will realize a large amount of income in the year the TIF proceeds are received and realize deductions over a long period. If a taxpayer cannot offset this income with losses from other activities, the tax bill for such a transaction may be large and must be covered with funds other than the TIF proceeds. This could make TIFs taxed as grants cost-prohibitive, stopping the project from moving forward.

As a Contribution to Capital

Alternatively, treating the subsidy as a nonshareholder contribution to capital under Sec. 118 would allow the taxpayer to avoid recognizing the receipt of TIF proceeds into income. Although it would also result in a lower basis in the improved property, it is a significantly better result. However, any consideration of excluding TIF proceeds from income immediately raises the question of the applicability of Sec. 118 to the TIF transaction. Sec. 118(a) states, "In the case of a corporation, gross income does not include any contribution to the capital of a taxpayer." Sec. 118(b) states that a contribution to capital generally "does not include any contribution in aid of construction or any other contribution as a customer or potential customer." Any property acquired with such proceeds characterized as a contribution to capital under Sec. 118(a) will have zero basis under Sec. 362(c)(2), so a taxpayer must forgo depreciation expense on acquired assets and eventually recognize increased gain (or decreased loss) upon final disposition of the property. As with the first alternative of recognizing the proceeds into income, a taxpayer will preserve its deductions for the PILOT payments.

Various court cases have attempted to clarify the taxability of subsidy payments received from noncustomers. In both Edwards v. Cuba R.R. Co., 268 U.S. 628 (1925), and Brown Shoe Co., Inc., 339 U.S. 583 (1950), the Supreme Court held for the taxpayers and allowed subsidy payments received from noncustomers to be excluded from income. Congress sought to clarify the issue by passing Sec. 118 in 1954; however, a lack of clarity continued until the Supreme Court's decision in Chicago, Burlington & Quincy R.R. Co., 412 U.S. 401 (1973), which laid out a five-part test to determine whether subsidy payments can be considered contributions to capital:

  1. The contribution must become a permanent part of the transferee's working capital structure;
  2. The contribution must not be compensation;
  3. The contribution must be bargained for;
  4. Any asset transferred foreseeably must result in a benefit to the transferee in an amount commensurate with its value; and
  5. The asset transferred ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect.

TIF proceeds seemingly meet each of these five characteristics, so exclusion from income by corporate entities is a strong possibility. However, the major hurdle for real estate developers is that they typically employ noncorporate structures for real estate activities, and Sec. 118 specifically states that the section applies only to corporations.

The question then revolves around the applicability of Sec. 118 to noncorporate taxpayers. Unfortunately, over the past 35 years, taxpayers seeking relief from the IRS on this issue have been met with conflicting rulings, with the IRS's current position being very taxpayer-unfriendly.

Technical Advice Memorandum (TAM) 7950002 concerned the applicability of Sec. 118 to payments received by a partnership from a school board to construct a sewage plant to service a new school. In the TAM, the IRS permitted the exclusion of a portion of the payments that were not connection fees and in its conclusion specifically stated that application of the five-part test of Chicago, Burlington & Quincy R.R. should apply to a taxpayer-partnership in that specific case. However, in 1982, the IRS in General Counsel Memorandum (GCM) 38944 reversed its position, saying that Sec. 118 does not apply to taxpayer-partnerships, and, in TAM 9032001, the IRS revoked TAM 7950002.

The reasons for the revocation are succinctly enumerated by the IRS in an Appeals Settlement Guideline (ASG) issued under the Appeals Technical Guidance Program and effective March 2, 2011. In the ASG's arguments against the applicability of Sec. 118 to taxpayer-partnerships, it cites, among other cases: Kowalski, 434 U.S. 77 (1977); In re Chrome Plate, Inc.,614 F.2d 990 (5th Cir. 1980); and National Alfalfa Dehydrating & Milling Co., 417 U.S. 134 (1974). In citing Kowalski and Chrome Plate, the IRS addresses the fairness argument that taxpayers raise when arguing that taxpayer-partnerships should be permitted to avail themselves of Sec. 118.

The Supreme Court in Kowalski and the Fifth Circuit in Chrome Plate stated that legislative history trumps common law doctrine regarding treatment of an item. Since Sec. 118 explicitly identified corporations as being permitted to exclude from gross income nonshareholder contributions to capital, that treatment is limited to corporate taxpayers, the ASG states. It bolsters this argument by citing National Alfalfa, in which the Supreme Court stated, "This Court has observed repeatedly that, while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not" (National Alfalfa, 417 U.S. at 149).

The IRS states in the ASG, "Appeals concludes that the chances are remote that a court would apply the definition developed through case law of a 'non-shareholder contribution to capital' for corporations to non-corporate entities allowing an exclusion from income." Further, "[T]he type of entity is clearly a choice made by the taxpayer with the associated benefits and burdens." The IRS concludes, "Taxpayer's full concession of the issue is the appropriate resolution." Thus, if a taxpayer-partnership treats TIF proceeds as a nontaxable shareholder contribution, it can reasonably expect the IRS to take a no-compromise position if the issue is raised under audit. Taxpayer prudence is advised, and if a taxpayer (especially an entity taxed as a partnership) claims exclusion from income of the TIF proceeds under Sec. 118, advisers should strongly consider disclosure on Form 8275-R, Regulation Disclosure Statement, to potentially limit penalties.

As a Debt Obligation

A third alternative is to treat the TIF proceeds as a debt obligation. Under Regs. Sec. 1.166-1(c), "A bona fide debt is a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money." This treatment will preserve available depreciation deductions. While Sec. 385 authorizes Treasury to issue regulations regarding treatment of interests in corporations that would presumably further describe debtor-creditor relationships, no regulations have been issued to date. As a result, practitioners must look to the courts for guidance. (Most court opinions addressing bona fide debt seek to determine whether those funds are loans or contributions to capital in closely held corporations, or if a bad debt was actually a valid debt before being expensed.) In the oft-cited Estate of Mixon, 464 F.2d 394 (5th Cir. 1972), the Fifth Circuit identified 13 factors for determining bona fide debt:

  1. The names given to the certificates evidencing the indebtedness;
  2. The presence or absence of a maturity date;
  3. The source of the payments;
  4. The right to enforce the payment of principal and interest;
  5. Participation in management;
  6. The status of the contribution relative to that of regular corporate creditors;
  7. The intent of the parties;
  8. "Thin" or adequate capitalization;
  9. Identity of interest between creditor and stockholder;
  10. Payment of interest only out of "dividend" money;
  11. The ability of the corporation to obtain loans from outside lending institutions;
  12. The extent to which the advance was used to acquire capital assets; and
  13. The failure of the debtor to repay on the due date or to seek a postponement.

These factors seem to indicate that TIF obligations could reasonably be treated as debt, thus avoiding immediate taxation under Sec. 61 or the uncertainty from a position taken under Sec. 118, especially since the TIF bonds usually require a mortgage and declaration of covenants and conditions to be recorded on the property and an agreement with the county not to sell any real estate tax liens or foreclose on the property prior to the bonds' being repaid in full.

Other tax and nontax considerations become relevant when recording a TIF as debt. First, any required financial ratio covenants (such as debt service coverage ratios) with other capital sources must be considered. Those calculations should specifically make allowances within the calculation for the impact of TIF debt and debt service on the balance sheet and income statement. Second, lease terms with lessors must be considered. Very often, leases allow for the passthrough of real estate tax assessments. PILOT payments must be specifically addressed in lease agreements so that tax and book/GAAP treatment does not affect the economics of a lease agreement and the PILOT payments will be considered recoverable real estate taxes. Third, the application of original issue discount should be addressed. Finally, while most TIF bonds are taxable bonds, any depreciable property acquired using proceeds from tax-exempt TIF bonds must be depreciated under the alternative depreciation system per Sec. 168(g)(1).

Conclusion

Great care must be taken when considering the tax effects of TIFs. Advisers should be prepared to recognize and act on the issues created, while considering the full scope of a transaction and historical treatment of nonshareholder contributions to capital. Despite the tax uncertainties, a TIF is a great tool for developers to leverage public finance capabilities to complete private projects.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com. Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

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