Originally published on Forbes.com Aug 6th, 2013
Rhode Island has had a credit for rehabilitating historic buildings. Like similar credits for other things, films for example, both in Rhode Island and other states, it is a transferable credit. The credit is a percentage of the qualified rehabilitation expenditures. This could create a somewhat perverse incentive, since the more costs that you have, the greater the credit. Of course since the credit is only 25 or 30 percent, you won’t come out ahead, if you pay the construction workers a higher rate or buy more expensive sheetrock.
On the other hand, if you can incur the cost without paying it and, even better, maybe even end up paying it to yourself, then you will be getting somewhere. Based on the result in a recent hearing, the Rhode Island Division of Taxation has caught on to that game at least when it comes to transferable historic credits.
On Tax Shelter Accounting
The first time I looked at the general ledger of a tax shelter entity, I was very confused. I had studied the confidential offering memorandum and was expecting to see among other things the development fee, the deficit operatng guaranty fee and the construction supervision fee. None of that was there. My day had already gotten off to a bad start because one of the principals had asked me who I represented and I had no idea what he was talking about. (He was actually the one who didn’t understand what was going on, but that is a different story.)
The controller of the management company took pity on me and sat down and explained to me that all those various fees are “just names” for the money that the principals take. Any actual cash was flushed through an intercompany account and it was up to me to wield my mighty pencil and green analysis paper to make journal entries.
It took quite a while for me to catch on to the bizzaro world that I had entered, where losses were a good thing. I remembered Herb Cohan trying to convince a CFO that under the “losses are good theory”, they should be happier to pay us larger fees. There was a proviso to the losses are good rule. Cash outlays that did not go into the pockets of the general partners were bad. That’s why the real estate gods invented development fees. Most of the deals we were doing were not credit deals, they were 5 year write-off deals, but the same principle applied.
The Audit
The unnamed project in the ruling included a development fee as one of the qualified rehabilitation expenditures subject to the credit. The agent disallowed the development fee. She questioned whether the fee had been incurred at all, noted that it had not been paid and that the owner of building was related to the purported development company. She noted that the development fee was just a book entry and that the development company actually had no employees. The fee was payable out of available cash flow.
The taxpayer argued that there was a binding agreement and that the fee had to be fully paid in 12 years. The taxpayer further argued that there would be sufficient rental cash flow to pay the fee within ten years (I mean there must have been a forecast – right ?) and that there was plenty of equity in the building (That equity would probably be based on the discounted present value of the forecasted income. It gets a little circular sometimes). Here is the main argument:
The Taxpayer argued that even though the fee has not been paid, under the accrual method of accounting, an expenditure is incurred when liability can be established. The Taxpayer argued that the developer fee is a real fee and the Division is treating separate entities as a single entity when the entities are separate and the Taxpayer has a binding obligation to pay the fee.
I wonder if the development company is on the accrual basis of accounting.
The Decision
The ruling did not get into the incestuous nature of the development fee. Rather if focused on the fact that the fee had not been paid:
Even accepting that the fee is now fixed, there has been no expenditure. The Taxpayer admits it has not paid the fee but argued that it will be paying the fee.
However, this matter revolves around the Rhode Island Historic Structures Tax Credit statute. The statute does not provide that the accrual method of accounting for the purposes of IRS income is to be used for determining a QRE. The statute does not provide that tax credits are to be given for liabilities. Rather, tax credits are to be given for actual expenditures.
The Moral
I have made a lot of journal entries in my time. Like most accountants, I will attach a lot of significance to the intercompany accounts of related entities “tying out”. Unlike most accountants, I read lots of decisions. One of the things I’ve concluded is that journal entries don’t mean much to anybody other than accountants. When it comes to taxes, this can give them a great deal of significance, since revenue agents are accountants. Once you get beyond that, they are given little respect, especially by Tax Court judges.
In a situation like this one, journal entries might have been the only way to go if the development company was not on the accrual basis. If it was on the accrual basis, though, it would have been much better to cut some checks.
You can follow me on twitter @peterreillycpa.
Afterword:
I asked Warren Kirshenbaum an attorney who works on credit deals for his thoughts on this ruling:
Based upon our past experience in the industry, a developer fee which is earned because the developer is taking on the financial risk from guaranteeing and servicing the property’s debt obligation, as well as representing and guaranteeing the project’s construction completion, its operating deficit, and the delivery of tax credits to its investor, makes it a QRE. These guarantees and representations are made in order to arrange for and provide the financing that will make this project a reality. When such a developer fee is structured as a long term obligation and amortized over a thirteen (13) year period, thereby holding the developer liable for the operating deficits and financial stability of the project prior to it being able to withdraw the developer fee, it has been deemed an acceptable QRE. I agree that where the developer and the Owner/Investor of the project are related to the extent they were in this case the lines were blurred and the developer fee was not determined to be a QRE. However, it seems that the case was decided on the (bad) facts present in this case rather than invoking a bright-line test of saying that all “accrued” developer fees would not qualify as QRE’s.