4 tax credits that promote social responsibility
By Philip L. Yasenak and Bengi Bala
Banks can purchase tax credits to reduce federal and state tax liabilities and permanently lower their tax burdens — without participating in the activity related to the credit. However, determining which credits to purchase depends on the nuances and circumstances of each bank and how they pay tax.
For example, the desired benefits from different federal credits vary if tax liability is predictable versus the result of a one-time event from a sale. Timing is another consideration — some credits are delivered in one year versus over five, seven or 10 years.
Banks invest in tax credits for more reasons than the resulting reduced effective tax rate. For example, many banks do so to support their social responsibility initiatives, such as contributing to renewable energy or affordable housing. By investing in projects that generate these types of credits, institutions can help satisfy their investment goals without needing to operate the businesses.
CRA as driver
Many large banks have participated in these investments for years. Some regional and smaller banks are starting to or are developing their strategy around purchasing credits. For banks, the Community Reinvestment Act (CRA) is an important driver of whether and how they may invest in tax credits. The CRA requires banks to make investments in low- to moderate-income communities. As a result, it’s common to see all sizes of banks invested in low-income housing tax credit (LIHTC) or historic rehabilitation tax credit (HTC) investments to help satisfy their requirement.
When selecting a tax credit investment, it’s important to consider whether to invest through a syndicator or directly with the project. It’s also important to decide whether to take on investments with diversification in a fund with multiple projects. The four credits described below are general business credits, which means they are limited to reducing federal tax liability by 75%, and can be carried forward 20 years and back one year:
- New markets tax credits
- Low-income housing tax credit
- Investment tax credit
- Historic rehabilitation tax credit
These are all highly complex transactions and are not without risks, making careful planning paramount.
1. New markets tax credit
Congress created the new markets tax credit (NMTC) program, which is a seven-year federal income tax credit and part of the Community Renewal Tax Relief Act of 2000, to encourage investment in low-income communities (predetermined qualifying census tracts). Qualified community development entities (CDE) will apply to the CDFI fund for an award of NMTCs (note that NMTCs are awarded to CDEs and not individuals or businesses).
The CDE will then seek taxpayers to make qualifying equity investments (QEI) in the CDE. The CDE will in turn be required to use substantially all the qualifying equity investments to make qualified low-income community investments (QLICI) in/to qualified active low-income businesses (QALICBs) located in low-income communities. The taxpayer will be eligible to claim a tax credit equal to 5% of its equity investment in the CDE for each of the first three years and a 6% credit for each of the next four years (39% total). In general, NMTC investments can produce:
- Above 20% IRRs (due to an option to leverage the buy-in over multiple years)
- 12%-14% return on investment
NMTCs may be recaptured from investors during the seven-year credit period under the circumstances noted below:
- The QEI fails the “substantially-all” requirement
- Failure to invest 85% of the original QEI; or
- Failure to meet the QALICB requirements; or
- Failure to meet one-year invest/reinvestment requirement
- The CDE redeems the investment
- The CDE ceases to qualify as a CDE
2. Low-income housing tax credit
The LIHTC program, created in 1986 and made permanent in 1993, is an indirect federal subsidy used to finance the construction and rehabilitation of low-income affordable rental housing. Without the incentive, affordable rental housing projects do not generate sufficient profit to warrant the investment.
The LIHTC is equal to 4% or 9% of construction costs and gives investors a dollar-for-dollar reduction in their federal tax liability in exchange for providing financing to develop affordable rental housing. Investors’ equity contribution subsidizes low-income housing development, thus allowing some units to rent at below-market rates.
In return, investors receive tax credits paid in annual allotments, generally over 10 years. Financed projects must meet eligibility requirements for at least 30 years after project completion. In other words, owners must keep the units rent restricted and available to low-income tenants. At the end of the period, the properties remain under the control of the owner.
Developers may claim LIHTCs themselves. However, due to limitations and the lack of enough taxable income, most developers choose to find tax credit investors who provide cash that is channeled into the development. The developer can either work with an investor who invests directly into a partnership (or LLC) and receives tax credits or work with a syndicator who acts as a broker between the developer and investor.
Banks and insurance companies tend to be the most active investors in LIHTC. Investors in LIHTC projects can invest in one of two ways:
- Directly, with a developer entity through a single-tier structure
- Indirectly, though going through a syndicator that pools together multiple projects into a fund or partnership with admitted investors
3. Investment tax credit
Part of the renewable energy tax credit program, the investment tax credit (ITC) is commonly related to solar renewable energy projects eligible for an income tax credit equal to between 10%-30% of eligible costs, depending on when construction begins and when projects are placed in service. Thus, only new solar projects qualify for the ITC. A five-year compliance period begins when the solar project is placed in service.
The credit is delivered in the tax year when the project places in service. Credits can be recaptured if ownership of the project changes or if the project ceases to operate. The credits at risk of recapture reduce 20% of the original credit amount on each anniversary of the placed in-service date. Monetization is typically structured via the partnership-flip structure.
4. Historic rehabilitation tax credit
The HTC program is an indirect federal subsidy to finance the rehabilitation of historic buildings with a 20% tax credit for qualified expenditures. The credit is claimed over a five-year period, 4% each year starting with the year the building is placed in service for a total of 20% over five years. Credits can be recaptured if ownership of the property changes or if the property ceases to historically significant during the compliance period.
It takes longer to earn a return from investing in HTC versus ITC. This is because while both tax credits have a five-year compliance period, the HTC delivers tax credits over five years as opposed to the ITC which delivers tax credits in the year the project places in service.
Like the LIHTC structures, investors in HTC projects can invest in one of two ways:
- Directly, with a developer entity through a single-tier structure
- Indirectly, though a master-lease structure (two-tier structure)
Tax reporting considerations
Claiming the tax credit will depend on the type of corporation of the bank. C corporations will claim the tax credit on their corporate return (Form 1120). S corporation filers will report the credit allocated to their shareholders on the shareholder’s Schedule K-1. The individual shareholder will claim the credit on their individual return (Form 1040). The credit claimed at the individual level will be subject to passive activity rules which could limit the allowable credit claimed.
How Wipfli can help
Our financial services team provides proactive and specialized tax services Wipfli professionals can help you review your approach to ensure you are maximizing your tax planning and lowering your liabilities to the full extent possible. Contact us to learn more about how we can help you evaluate tax credits, tax planning, compliance and audit assistance.
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Wipfli Editorial Team