Using Virginia Historic Tax Credits to Offset the Virginia Bank Franchise Tax

Posted on by Kurt Magette in Tax

The Federal and Virginia governments subsidize rehabilitations of historically significant buildings. Virginia law specifically allows the Virginia Historic Tax Credit (the “Virginia Credit”) to be used to offset the Virginia Bank Franchise Tax (the “Franchise Tax”). Banks may want to take advantage of this opportunity through becoming investor members in entities rehabilitating buildings, which qualify for the Virginia Credit.

Several years ago, the Virginia Credit ceased to be transferable (able to be sold or otherwise transferred to someone not related to the Project). Now the taxpayer taking the Virginia Credit must be an owner, trust, or estate that (or a member, partner, shareholder of an entity that) owns the Project or leases it for five years or more.

Defining the Virginia Credit:

  • The administrative agency issuing the Virginia Credit is the Department of Historic Resources (“DHR”).
  • The Virginia Credit is 25% of the eligible rehabilitation expenditures.
  • Although Virginia does not have a percentage disqualifier on expenditures made to enlarge an existing building, expenditures related to enlargement are not creditable, and the Developer must be careful that the project remains certifiable as consistent with the Standards of Rehabilitation.
  • DHR requires its own Part 1, 2, and 3 for the Virginia Credit:
    • Part 1 basically describes the building and the overview of the project, and its approval indicates that the building is acceptable;
    • Part 2 is the most time-consuming and should be completed with the aid of an architect experienced in dealing with the nuances of historic rehabilitations. It details the contemplated or completed expenditures, and its approval signifies DHR’s general agreement that the expenditures are consistent with the historic nature of the building. However, it is not a certification; and
    • Part 3 is a certification of the completed work. The DHR’s approval includes a certification of the amount, and a confirmation of the validity of, the Virginia Credit.
  • Virginia has no recapture, only audit rights, but the Bank as investor must be careful of securing “true partner” status.

Maximizing the Subsidy:

The two major structures are “Master Lease Deals” and “Pass-Thru Deals.”

  • A pass-thru entity completing the rehabilitation or receiving it as the lessee may allocate the Credit, if an LLC, to its tax partners or, if an S corporation, to its shareholder.
    • Because of numerous advantages, a limited liability company (“LLC”) taxed as a partnership is the entity of choice.
    • The recipient of the Virginia Credit should be a partner or shareholder before the end of the tax year the project is completed.
    • Virginia allows its Credit to be allocated any way agreed. Generally, the Bank will have a 1% membership interest.
    • The Bank can carry any unused Virginia Credit forward for 10 years.
    • Virginia has no at-risk or passive loss limitations analogous to those rules that apply to Federal Historic Tax Credits (“FHTC”) allocated to individual and certain corporations.
  • The Virginia Rules also allow the Developer doing the rehabilitation to elect to transfer the Credits to the lessee of the building. Virginia requires the lease term to be five years or more.
  • This structure allows more control of the economics but is complicated.

Disguised Sale Issues:

Since the Fourth Circuit's decision in early 2011 in Virginia Historic Credit Fund 2001 LP v. Commissioner, Developers have finally realized that if the Virginia Credit Investor has limited upside potential and downside risk as a member, such investor may not be respected as a tax partner. The Virginia Department of Taxation has taken the laudable position that an investor can be allocated the Virginia Credits even if the investor does not qualify as a federal tax partner.

Before this case and another case out of Atlantic City, New Jersey (“Historic Boardwalk”), a Developer felt relatively comfortable that the federal government realized the virtues of rehabbing old buildings. The feds tended to overlook technical business structural issues and would allow Developers to raise capital fairly unimpeded. However, the structures used in Virginia Historic and Historic Boardwalk were thin; the credit investors were granted very little indicia of being a tax partner.

However, the Virginia Credit (as contrasted with the FHTC) allocated to your Bank should not be at risk of invalidation with nominal planning and structuring. Unfortunately, if the arrangement does not vest tax partner status on the investor, the IRS will undoubtedly allege: (i) the capital contribution to acquire the Virginia Credits should be deemed a purchase and (ii) the tax partnership “selling” the credits has a short-term capital gain and has only nominal, if any, tax basis in the Virginia Credits deemed sold.

Recent structures have attempted to allocate 75% of the tax partnership’s gain back to the Virginia Credit Investor. For a variety of reasons, this allocation of the gain from a disguised sale back to the purchaser probably does not work. However, Developers and their tax advisors still use this structure. In fact, if the Virginia Credit Investor agrees to recognize 75% of the disguised sale gain, the required capital contribution per dollar of credit is about $.82; if not, it is about $.90.

The Bottomline:

To examine the impact, assume that your Bank acquires $1,000,000 of Virginia Credits for $900,000 and is not allocated any gain. Your Bank would, in effect, receive an infinite internal rate of return: If you have $1,000,000 in Virginia Bank Franchise Taxes for the year the Project is placed in service. Typically, your Bank only contributes about 10% at signing of the operating agreement ($90,000) while the balance is paid after DHR issues the Part 3 Certification. Therefore, your Bank reduces its tax burden $1,000,000 in Year 1 but does not have to pay the $810,000 balance until about March 30, Year 2. Since: your Bank (i) is receiving $1,000,000 in value on the date that the Franchise Tax would have been paid (“Effective Date”); (ii) does not make $810,000 of its capital contribution until well after the Effective Date; and (iii) only contributes $900,000 for $1,000,000 of value, your Bank has an infinite internal rate of return on its investment.

Your Bank needs to deal only with reputable and knowledgeable Developers, attorneys, accountants, and architects. If your due diligence is satisfied, please consider an investment in Virginia Credits. Your bank not only receives an infinite return, but it helps rehabilitate historic structures in Virginia and to spur economic development.

About the Author

Kurt Magette is a business, commercial real estate, and tax lawyer. His practice focuses on business and commercial real estate transactions requiring significant expertise in federal and Virginia income taxes.

Spotts Fain publications are provided as an educational service and are not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel.