Inside Capital Account (704(b))

This page addresses calculation of the inside capital account and its implications in the modelling of tax equity investments for renewable energy.  The inside capital account (also called the 704(b) capital account or the book basis or the FMV basis) is also associated with the deficit reduction obligation (the DRO) , stop losses and income re-allocations.  The 704(b) inside capital comes from partnership tax law that is central to renewable tax equity transactions in the U.S.  The inside capital separates the partnership equity balance into amounts for the tax investor and the sponsor; it is pre-tax  and is computed for both the developer and the tax equity investor.  The big deal about dividing up the equity balance account among investors is to test whether the balance of the account falls to below zero for the partner.  When the investment balance falls to zero without any mitigation (from the DRO), the taxable income increases and the after tax return goes down. Everything is in this page and the page about the inside basis and the minimum gain is about preventing the inside basis from being negative. The reason for limiting the inside capital is the notion of “Substantial Economic Effect.”  If the inside capital falls below zero, the tax equity investor is not considered a real partner but is a “bare purchaser of tax benefits”

In discussing the inside capital I also review the deficit restoration obligation is associated with this inside basis account and can be used to eliminate deficits in the tax investor’s inside basis. As with the discussion of the outside basis, I discuss inside basis (account 704 (b)) in terms of how things associated with this account can affect the cash flow and IRR to the tax investor. 

Computing the inside basis in a model is important because of the way it affects potential income re-allocation that can increase income to the tax investor and reduce income to the developer. When income is increased to the tax investor, this is bad from the perspective of taxes and thus lowers the tax investor cash flow and IRR.  The tax investor cares about this a whole lot more than the sponsor/developer.

Stylized and Simple Example of Substantial Economic Effect and why the Inside Capital Limit Can Decrease the Tax Investor IRR

In evaluating the tax constraints and whether the tax investor is a bare purchaser of tax benefits, I try to think about why these tax constraints exist. The principal test is whether the equity investment falls below zero.  Think about why the equity balance could go to zero. Perhaps you could pay a lot of dividends.  This is generally not the case with tax equity investments as the cash distribution in dividends is not very large.  But the equity balance can become negative from losses in income.  It may seem that this is a pretty good test as if you put some money into an investment and then the losses are so big that your capital goes down to zero, then you have made an investment other than to get tax losses back. But there are a couple of problems with this theory. 

The investment you make is after-tax.  But the capital calculation where you compute the balance of investment — equity contribution versus income and dividends — is pre-tax.  Think about an example if you put in 1,000 of investment and the income is -500 for three years. Then if the tax rate is 21%, you get back 500 x 21% or 315.  This amount you get back from tax deduction is less than the amount of the investment.  I am not defending tax investors, but this test is really not very fair because to recover your investment, you need more than the losses.  This also does not consider the cost of money as so many other accounting calculations.  An example of the equity capital calculation with horrible details is illustrated in the screenshot below.  These details will be discussed later, but for now note how the equity capital would be negative.

If the capital account becomes negative, the general and simple rule is that your income deductions are limited by the amount of the negative income.  Before you start yelling at me, I of course realise that you can use the deficit reduction (DRO) mechanism to offset this income limit. But, putting aside the, this DRO, if the capital is negative, the income is increased for the tax investor.  This increase in income is bad.  The tax investor has less of a tax deduction.  The manner in which the income is limited is called re-allocation of income where the income for the tax investor is increased and the income for the sponsor/developer is reduced.

Safe Harbor Provisions/ITC Recapture and Some Terms

The IRS issued a letter ruling that allowed assurance of “Substantial Economic Effect” and that the tax equity partner is not a “bare purchaser of tax benefits.”   This letter has been named the safe harbor that can assure that the partnership will not result the IRS considering the tax investor as a bare purchaser of tax benefits.

Some of things the partnership should do according to this IRS letter includes:

  1. Minimum 1% interest for each Partner
    1. The sponsor must always have at least 1% interest of the partnership income; the partnership gain, and; the partnership loss.
  2. Minimum of 5% economic interest in cash flow
    1. Each investor must have a minimum interest in each partnership gain (gain seems to be cash flow or dividends) for each year equal to 5% of its largest gain (cash flow) for any year (e.g. 99% x 5% = 4.95%).
  3. Minimum Investment for Each Partner
    1. Throughout the duration of the project, the investor must have a minimum investment equal to 20% of paid in capital
    2. The investment can be reduced by dividends
    3. Investor must not be explicitly protected against lost
  4. Tax Investor Purchase Rights
    1. The right to purchase must be at fair market value or be reasonably determined up-front
    2. There is no purchase right during the first 5 years

Stylized and Simple Example of Why the Both the Inside Capital and Outside Capital is Computed

The deficit restoration obligation can be used to limit the negative cash flow implications of the inside basis. It increases the capital account of the tax investor so that the income re-allocation will be be less or not even occur.  From this perspective the DRO increases the tax invesor IRR. 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.

  • Capital and Basis
    • 704(b) = inside capital = book capital basis = capital accounts
    • Outside basis = tax basis
  • Purposes of Accounts for IRS
    • Evaluate substantial economic effect and bare purchasing of tax benefits
      • Capital account, 704(b) –> Fair market value
      • Tax basis, outside basis –> Cost basis
      • Capital account cannot be negative without DRO
      • Outside basis cannot be negative
  • Accounts and Debt at Project Level
    • With no debt and not negative capital –> Inside capital = outside basis
    • Levered projects:  Inside capital + debt = outside basis (without minimum gain)
  • What happens when inside capital or outside basis goes negative
    • Computed inside book equity can be negative if the DRO is applied or if there is debt
    • The outside basis (tax basis) cannot be negative because of excess dividend calculations and/or suspended losses

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.

Here are some terms related to the Deficit Reduction Obligations

  • Loss Re-allocation
    • Also called stop losses
    • Can maintain a partnership inside capital 704(b) at zero
    • Can prevent a DRO from being used if there is not enough capital in the sponsor account
  • Deficit Restoration Obligation
    • Allows the tax investor to have a negative capital account and not have to increase taxable income (which is very bad for the tax investor).  You do not want to re-allocate income to the sponsor
    • With the DRO, the tax investor “borrows” equity from the sponsor to claim the negative income that would otherwise be re-allocated.
    • Could also borrow the tax free cash distributions
  • DRO Effect in the case of Liquidation
    • Not very likely
    • Requires the partner borrowing or taking the DRO to contribute real cash capital 
    • This risk of the tax investor actually paying for the DRO is a credit risk for the tax investor and a benefit for the developer/sponsor
  • Stop Losses and Limitations of Stop Losses
    • Loss re-allocations may not always be preventable by the DRO (there may be nothing to borrow).
    • The stop losses (which should be named stop negative capital) can be increased by dividends.

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.

For Inside Capital, How does the Deficit Reduction Obligation Work

It is unfortunate from a modeling complexity standpoint, 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:

  1. 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
  2. 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 is allocated to the tax investor and from the sponsor/developer. The important point about the inside basis is that a negative inside account balance results in increased allocations of income to the tax investor.

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.

How DRO can Push you Into Constraints from the Outside Basis

DRO’s can help you with the re-allocated income or the stop loss that comes from the inside basis.  But this assistance with inside capital problems just often gets translated into constraints from the outside basis.

  • Excess Distributions (also known as Distributions in Excess of Tax Basis; also known as 731(a) Excess Distributions
    • Results when cash distributions plus positive income (excluding current income) pushes the outside basis below zero.
    • This is also called deemed sale — deemed to be a sale of the interest of the tax investor.
    • Requires the tax investor to recognize a gain for tax purposes
    • Cash distributions are like any dividends and do not cause any taxable income if the outside basis is positive
    • Distributions are taxed at the corporate level just like any other dividends and can be classified as capital gains taxes
  • Effects of excess distributions on the outside tax basis account
    • A gain is recognized which brings the outside tax basis account back towards zero.
  • Inside Capital effect of excess dividends

Inside Basis and 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 in Models

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.

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.

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.