This webpage describes the capital account of tax equity transactions named the inside capital account or the 704(b) capital account or the book basis or the FMV basis. I find the inside basis is more painful to understand and more painful 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 is much less obvious. 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. There are three possibilities. First, the IRR may not change. In this case you can put in different DRO’s to protect you in case of liquidation, but you don’t have to worry too much about it. Second, the IRR may go down for the tax investor (because the taxable income is re-allocated to the sponsor and there are more taxes). In this case you may ask why even have a DRO. In the third case, the DRO may increase the IRR (maybe because the gain on the exit for tax purposes is lower). Then you may like a higher DRO.
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 (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.
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 based on the business arrangement.
Definition of the Inside Basis
When the tax returns are filed, both of these accounts are submitted to the IRS — I have seen the tax forms (they are simple one page summaries). The inside basis which is affected by the deficit restoration obligation, re-allocations, the minimum gain and other factors.
Winston and Strawn: A partner’s capital account is the FMV of partner contributions (net of any related debt assumed by the partnership). My note – in the outside basis the debt assumed by the partnership increases and does not decrease the capital account. This account is increased or decreased by the partner’s share of income or loss. It is decreased by the FMV of partner distributions (net of any debt assumed by the partner). My note: this is all clear. For this purpose, income and loss refers to the economic or book definitions under the tax rules of Section 704(b). Note that 704(b) is the book basis. It may not be the same as income or loss determined for income tax. The income for tax is used in the outside basis. Difference in the book and tax basis may be due to things like developer fees. Developer fees are not an actual outflow of cash.
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.
How does the Deficit Reduction Obligation Work
What is clear:
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: 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)).
What in the hell does this mean.
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.