This webpage describes the inside capital account or the 704(b) capital account or the book basis or the FMV basis that is part of tax equity transactions in the U.S. As with the discussion of the outside basis, the primary importance of the inside basis (704 (b)) is that it can affect the income and the stranded tax of the tax equity investor meaning that the IRR is affected. I find the inside capital account more painful to understand and more difficult to calculate than the outside basis. As shown below on this page there is less consistency in model presentation of the inside capital account than the outside capital account across different models. Further, the manner in which adjustments and balances to this account can affect the ultimate IRR to the tax investor is less obvious. Specifically, the question is how much does the inside basis affect taxable income given a deficit reduction obligation. I believe in part, the analysis is a pain because consultants, lawyers and tax accounts who charge very high fees want to make things confusing for you and then charge you a whole bunch of money. Indeed, what I suggest if you see a fancy model is with a DRO and calculation of the inside 704(b) capital account, is to change the parameters of the DRO and see what happens to all of the IRR’s. I again need to make my disclaimer. I am not a tax accountant; I am not a tax lawyer; I have never charged high fees for consulting on this stuff, and I have not been a financial advisor. This means that if I have some details about the specifics of the minimum gain charge back account in the 704(b) capital account and its effect on the use of the DRO which may affect income re-allocation, please do not sue me.
Two big questions about the inside basis in my opinion are: (1) how does the income allocation in the inside basis account affect the tax equity IRR by virtue of the DRO (e.g. if there is an income re-allocation from the sponsor to the tax investor, does this increase taxes for the tax investor or is it taken account elsewhere); and (2) is the inside basis used for computing the gain on sale for tax purposes or is the tax basis of the plant used when the tax investor exits the partnership SPV? I wish I could say that I know the absolute answer to this one, but have seen different models treat the gain on a sale from the by the tax investor to the sponsor/developer differently. The famous DRO or deficit reduction obligation raises its ugly head when working through the inside capital account or the 704(b) capital account. The DRO can limit the negative balance of the inside capital account, but this can be a bad thing for the tax investor IRR.
Definition of the Capital Account or the Inside Basis
When the tax returns are filed, both the tax basis of assets and the inside basis are submitted to the IRS — I have seen the tax forms (they are simple one page summaries). The inside basis is affected by the deficit restoration obligation, income re-allocations, the minimum gain and other factors. In trying to make sense of the inside capital account I use a few sources — a detailed description by Winston and Strawn; some articles by Deloitte and Claborne; a detailed write-up by a tax accountant; materials from various conferences and other descriptions. I also use interpretation of financial models. To introduce the account, one source states: Section 704(b) income or loss tracks economic income and loss (this means the book income) while assets are held in the partnership. The partnership then allocates these amounts (of income) based on the business arrangement.
Winston and Strawn: A partner’s capital account is the Fair Market Value of partner contributions (net of any related debt assumed by the partnership, implying that the inside account at its core is the equity balance and not the asset balance like the outside basis). This inside capital account or 704(b) account is increased or decreased by the partner’s share of income or loss (like any equity account). It is decreased by the FMV of partner distributions (net of any debt assumed by the partner). For this purpose, income and loss refers to the economic or book definitions under the tax rules of Section 704(b) (which uses tax depreciation and not book depreciation). Note that 704(b) is the book basis. It may not be the same as income or loss determined for income tax if there are asset write-ups or write-downs that are not included in the tax basis. The difference in the book and tax basis may be due to things like developer fees, (developer fees are not an actual outflow of cash) but these items are not included in many renewable financial models.
How does the Deficit Reduction Obligation Work
It is unfortunate, but the amount of money recorded in the inside capital account depends on the deficit reduction obligation. So you should understand what the deficit reduction obligation means and how it works and, most importantly, how it affects the IRR of the tax equity investor. I will explain the modelling in detail below, but here are some of the key points:
- The inside capital account should be computed before the outside basis because it affects taxable income that is subsequently used in the outside basis calculations
- The level of the deficit reduction obligation — the amount of the inside basis deficit that can be reduced — is generally computed as a percent of the tax equity investment
One of the many things I find confusing is that, unlike the outside tax asset basis of the assets, the inside capital account can be negative. But if the account is negative, income may be allocated to the tax investor and from the sponsor/developer. So the question is, does a negative inside account balance result in increased allocations of income and Winston and Strawn: Requirements to avoid negative capital account: The partnership cannot allocate losses to cause the partner’s capital account to be lower than what the partner is actually or deemed obligated to repay (an Adjusted Capital Account deficit); and
If there is an unexpected event that causes a deficit in the Adjusted Capital Account, the partnership must allocate gross income to eliminate that deficit as quickly as possible (referred to as a qualified income offset (QIO)). The DRO is computed from the basis of the tax equity investment. For example, 65% DRO would be the tax investment multiplied by 65%. The DRO is a way to transfer capital from the sponsor/developer to the tax investor to limit a negative closing balance in the account.
Winston and Strawn: Qualified Income Offset. If any Member unexpectedly receives any adjustments, allocations or distributions described in Treasury Regulation Sections1.704-1(b)(2)(ii)(d)(4),(5)or(6) resulting in, or increasing, an Adjusted Capital Account Deficit for such Member, items of Company income and gain shall be specially allocated to each such Member in an amount and manner sufficient to eliminate, to the extent required by the Treasury Regulations, the Adjusted Capital Account Deficit of such Member as quickly as possible, provided that an allocation pursuant to this Section4.3(c) shall be made only if and to the extent that such Member would have an Adjusted Capital Account Deficit after all other allocations provided for in this Article IV have been tentatively made as if this Section4.3(c) were not in this Agreement.
Importance of Inside Basis – Dissolution of the Partnership
Here are some quotes that demonstrate the importance of the inside basis when liquidation of the partnership occurs. When a partnership is dissolved, its assets are either sold or written off. Any gain or loss on the sale (sale price less basis) is allocated to the partners in accordance with the liquidation/dissolution section of the partnership agreement and remaining cash is then distributed. In order to comply with the capital account maintenance rules, the cash must be distributed in accordance with each partner’s positive capital account balance. Liquidating in accordance with capital accounts means the complicated regulatory allocations can have a meaningful effect on the business deal. The agreement allocates book income or loss using a formula that causes the partners’ capital accounts to equal the amounts the partners would receive under the waterfall.
Issue: is the sale of the project from the tax investor to the sponsor a dissolution of the partnership SPV or LLC or is it just a change in the ownership of the partnership (which is no longer really a partnership)
Wiston and Strawn: If the partnership liquidates in accordance with capital accounts, the book allocations drive the economics of the deal.
Account behavior – what happens if cap account or tax basis goes negative?
- Capital Account: one or both partners (tax investor or the sponsor/developer) inside capital accounts are allowed to go negative
- A negative inside capital account does not automatically result in a DRO
- DRO results when the tax investor’s capital account is disproportionately negative
Winston and Stawn: Most of the allocation language in 704(b) and 704(c) relates to the economic / book allocations. Generally, taxable income will follow the book allocations (this means the re-allocation of taxable income from the inside capital account will affect taxes). Net book allocations carry out a proportionate share of underlying tax items. This must mean that there is some kind of tax basis for the partnership — the amount spent on the project. (The inside basis takes this spending of the partnership and allocates it.) However, if a partner contributed an asset with built-in appreciation or depreciation, special rules require that the built-in tax gain or loss be allocated back to the contributing partner.
Excess Distributions and the Inside Capital Account (754 Step-up)
Effects of excess distributions on inside capital account and on the outside tax basis
• On the insider capital account – excess distribution gives rise to an intangible asset that increases the capital accounts (ignoring built-in gain / deemed value)
Examples of Inside Basis
The first example below shows an example of the inside basis for a tax investor. This account includes a step up depreciation and income reallocation in the screenshot below. Note in the examples that the balance can be negative — it is not limited by the suspended loss.
In this example for a wind farm, the inside basis does not go to zero. There is no DRO and the only significant items other than the income, distributions and contributions are the 754 step-up and the depreciation on the step-up. The step-up comes from the excess distribution that was calculated from excess dividends on the outside basis.
The second example demonstrates how the computation of the inside basis is not consistent for different models. Note in this case that there is charge back income and the DRO affects the balance. In the outside basis this does not occur.