E. Wind Partnership Structure
The PTC provides an investment incentive to a taxpayer with taxable income sufficient to use the tax credit. It can take a wind energy project several years to generate taxable income, however, particularly because the projects are eligible for accelerated tax depreciation. In the period during which the project is not generating federal income tax liability, the PTC has limited value to a developer unless it has unrelated taxable income with which to offset the PTC.
The PTC may attract interest from outside investors that anticipate consistent streams of taxable income, however. An entity with ongoing federal tax obligations can invest in a partnership that owns a wind energy facility. As a partner, the investor will have an ownership interest in the wind energy facility and will be able to claim the PTC. Initially, the facility itself will not give rise to any taxable income, so the credits are available to offset the investor’s other income, reducing the investor’s tax liability. Because a wind energy partnership generally produces significant losses in its early years of operation, it also provides an attractive investment opportunity for an investor looking to offset tax liabilities from other sources of income. Thus, the possible benefits to a wind farm investor are twofold: (1) being able to take advantage of the partnership’s losses to offset the investor’s other liabilities, and (2) being able to use the PTC. The financial investor’s interest in the partnership complements the interest of a developer that is generally more concerned with long-term profit. The PTC expires 10 years after the wind energy facility is placed in service; subsequently, the investor’s return is limited to its distributive share of income or loss. The investor’s interest in the wind energy partnership typically ends when the ability to claim the PTC ends.
A partnership ‘‘flip’’ structure addresses these complementary interests and the benefits that shift over time in a wind energy project. A simple
partnership flip structure involves a project developer and an equity investor. The developer and investor enter into a partnership whose purpose is to own and operate a wind energy facility. The project developer constructs and manages the wind energy facility using funds supplied by the equity investor. In return, the equity investor is allocated a
very large part of the income, gains, deductions, losses, and credits from the partnership. This allocation continues until the equity investor achieves a particular return on its investment, which could be projected to occur shortly after the expiration of the 10-year PTC period. At that point, the allocation ‘‘flips’’ and a much smaller proportion of income, gains, deductions, losses, and credits are allocated to the investor, with the remaining allocated to the developer. Cash distributions are allocated 100 percent to the developer until the developer’s capital account is reduced to zero, at which point 100 percent of the cash distributions is allocated to the
investor until the investor’s internal rate of return is reached. After the flip, cash distributions follow income allocations. The typical flip structure provides the developer with a call option to purchase the investor’s interest after the flip point has been reached. The call option is usually set at a predetermined price at the time the partnership is formed so that the developer and investor can plan an exit strategy.
The partnership flip structure could raise several concerns about the partners’ relative tax positions. The investor runs the risk that it will not be respected as an equity partner but rather a purchaser of the PTCs. Also, even if the investor is respected as an equity partner, the IRS may not 70 respect the allocation of the PTC in the partnership agreement. Finally, the structure is costly to implement — both at inception and throughout its life — because of the complex partnership tax compliance work associated with maintaining the structure for up to a decade.
A fundamental characteristic of the partnership structure is that the partnership may allocate, through its partnership agreement, each partner’s distributive share of every tax item incurred by the partnership. These items include income, gain, loss, deductions, and credits. To prevent tax avoidance, the law requires that the distribution of tax items in a partnership agreement have substantial economic effect. If the allocation of tax items to a partner under the partnership agreement does not have substantial economic effect, then the agreement’s distribution scheme will not be respected and the partner’s distributive share of the tax items is determined in accordance with the partner’s interest in the partnership.
An allocation generally will be deemed to have a substantial economic effect if it is consistent with the partners’ economic arrangement. If there is an economic benefit or burden associated with the tax allocation, the taxpayer that receives the tax allocation must also receive the corresponding economic benefit or burden. Generally, this can be accomplished if the partnership agreement requires that: (1) capital accounts be created and maintained in the manner set fort in the partnership regulations; (2) liquidating distributions be made in accordance with the partners’ positive capital account balances; and (3) any partner with a deficit capital account following the liquidation of its interest be unconditionally obligated by the end of the tax year of liquidation to restore the amount of that deficit to the partnership to be paid to creditors, or distributed to other partners in accordance with their positive capital account balances.
Under the regulations, an allocation of credits is not reflected in a partner’s capital account. Therefore, allocations of tax credits cannot have economic effect under reg. section 1.704-1(b)(2)(ii)(b) and must be allocated according to the partner’s interest in the partnership. A credit must be allocated in the same proportion as any corresponding loss, deduction, or receipt.86 For a wind energy partnership, every kilowatt of electricity that it sells gives rise to gross receipts, which results in a corresponding PTC. Because the gross receipts and the PTC both arise from the sale of the same unit of electricity, the income and PTC must be allocated in the same manner in order to be respected under the regulations.
In 2006, the IRS released three private letter rulings involving partnership flip structures with features similar to the flip structure described above. In each ruling, the taxpayer and an investor formed a partnership that acquired a wind farm. The rulings state that the partnership issued class A membership interest to the investor and class B membership interest to the taxpayer. The rulings further provide that based on expected distributions of cash to the investor and taxpayer, the taxpayer would receive a cash-on-cash return, but the investor would not. However, if the PTC had been taken into account as if it were cash, the investor would have been expected to receive a positive economic return on its investment. After the occurrence of certain events, including an anniversary date of the investment, the taxpayer had the option to purchase the investor’s class A membership interest at its then-appraised fair market value. The IRS concluded in the rulings that the PTC attributable to the partnership could be passed through to, and allocated between, the taxpayer and investor under the principles of section 702(a)(7) and in accordance with each member’s interest in the partnership at the time the PTC arose. In so concluding, the rulings suggest that an investor in a wind farm partnership need not demonstrate a pretax profit in order to be treated as a partner in a partnership and that an investor that enters into partnership flip transaction can be treated as a true equity investor and not merely a purchaser of the PTC. However, the rulings explicitly refrain from concluding whether or not the allocations of the PTC were valid.
After the three-letter rulings were issued, the IRS declared in Notice 2006-8888 that it would not rule on issues relating to partnerships claiming the PTC. Investors had to accept the risk that their partnership allocation arrangements might not be respected by the IRS. In such a case, there could be a reallocation of the PTC to the developer, which would result in an increase in the investor’s tax liability. Without concrete guidance from the IRS or the ability to obtain a private letter ruling, the tax treatment of a partnership flip transaction was uncertain.