IRS Guidance on Non-Real Estate Operating Businesses

Published by Michael Novogradac on Wednesday, June 8, 2011 - 12:00am

The recent IRS NMTC notices regarding NMTC investing in non-real estate operating businesses are thought provoking exercises that will have limited short-term impact, but may yield significant longer term benefits.  The notices have two key parts.  First, theyPROPOSE a change to the reinvestment rules for investments in non-real estate operating businesses.  Second, they REQUEST COMMENTS on other ways to increase the level of NMTC investment in non-real estate operating businesses.  Let’s start with the PROPOSED rule, and then move to the REQUEST FOR COMMENTS.

Proposed Rule

Simply put, the proposed rule would allow those CDEs who make investments in non-real estate operating businesses to reinvest any repayments in Certified CDFIs.  Such repayments would need to be reinvested with a Certified CDFI within 30 days and there does not appear to be any NMTC related limits on the use of the money by the Certified CDFIs.  However this reinvestment option is limited.  Only a rising portion of investment repayments can be so reinvested, specifically, 0% of the underlying qualified equity investment (QEI) in Year 1; 15% in Year 2, 30% in Year 3, 50% in Year 4; and 85% percent in Years 5 and 6. This rule would not be effective until adopted as either temporary or final regulations, which appears to be 6+ months away.

Who would this help?

This proposal would help CDEs who want to provide amortizing 5 to 7 year financing to non-real estate operating businesses.  Such financing would be helpful, for example, to non-real estate operating businesses seeking longer lived equipment financing. 

This proposal would also help Certified CDFIs as it would provide them a source of rolling financing, as they would be the recipients of the reinvested non-real estate operating business repayments.

Some questions that still need to be addressed, and for which the IRS is requesting comment, include whether other entities, who are not Certified CDFIs, should be eligible recipients of the reinvestment proceeds, and how such a rule would apply to QEIs already made at the time the rule become effective.

Request for Comments

The second part of the recent IRS notices solicit specific comments on whether lessening substantiation requirements in certain structures would facilitate more investments in non-real estate operating businesses.  The notices also have open ended requests for ideas. 

Regarding substantiation, the notices suggest that substantiation rules governing investments would be simplified in cases where a CDE invests in another CDE and the second CDE uses the new markets tax credit proceeds to make smaller-sized loans (for example, less than $250,000) to non-real estate businesses.  The second CDE would need to demonstrate that, at the time of initial investment in the non-real estate business, the non-real estate business receiving the new markets tax credit proceeds met some basic qualifying requirements (for example, the business is in a low-income community).  The Treasury Department and the IRS are asking taxpayers to submit comments as to whether this change would facilitate greater new markets tax credit investment in non-real estate businesses.  They also ask:

  • How should the cap work?
  • What are the minimum substantiation requirements?
  • What other limitations should apply?

The IRS also asks, in the notices, more broadly, what non-statutory requirements can be revised to encourage CDEs to make equity investments in non-real estate businesses?  And if consideration is given to potential changes to the reasonable expectations test, then what modifications would be most effective in encouraging equity investments in non-real estate businesses, while still preserving the purpose of the existing limitations on thereasonable expectations test.

Where do we go from here?

From here, I expect the broader NMTC community to focus on the specific ideas in the notices and to also expand the discussion to other areas.  The NMTC Working Group, for one, will provide detailed comments on the matter and will present its comments at the IRS public hearing in September.