How Partnership or Corporation Status Affects CDE’s Redemption Test for Making Distributions
Question: How would a community development entity (CDE) calculate the redemption test for making distributions if the CDE is treated as a partnership or elects to be treated as a corporation for federal tax purposes?
Answer: Whether the CDE is taxed as a partnership or a corporation for federal tax purposes will affect how the CDE calculates the redemption test. Treasury Regulation 1.45D-1(e)(3) provides the guidance to make these calculations.
Treasury Regulation 1.45D-1(e)(3)(iii) details a safe harbor that a CDE taxed as a partnership can make distribution of cash, without causing redemption, as long as those distributions do not exceed the CDE’s operating income for the taxable year. The CDE’s operating income is defined in these regulations as the sum of:
- the CDE’s taxable income as determined under IRC Section 703, except that
- the items described in IRC Section 703(a)(1) shall be aggregated with the non-separately stated tax items of the partnership, and
- any gains resulting from the sale of a capital asset under IRC Section 1221(a) or IRC Section 1231 property shall not be included in taxable income,
- any deductions under IRC Section 165, but only to the extent the losses were realized from qualified low-income community investments,
- deductions under IRC Sections 167 and 168, including the additional first-year depreciation under IRC Section 168(k),
- startup expenditures amortized under IRC Section 195, and
- organization expenses amortized under IRC Section 709.
Under Treasury Regulation 1.45D-1(e)(3)(i) a CDE taxed as a corporation can make distributions of cash, without causing redemption, only when IRC Section 301(c)(1) applies to cash received by the member. IRC Section 301(c)(1) states that the distribution which is a dividend, as defined in IRC Section 316, shall be included in gross income. Under IRC Section 316, a dividend is defined as any distribution of property made by a corporation to its shareholders (1) out of its earnings and profits accumulated after Feb. 28, 1913, or (2) out of its earnings and profits of the taxable year.
One difference that is important to point out when discussing these calculations is that a CDE taxed as a partnership can only distribute cash based on its current-year operating income and the cash must be distributed within the year the income is earned to meet the safe harbor test. It is important to note that if a CDE fails the safe-harbor test, it does not necessarily mean that a redemption event has occurred. A CDE taxed as a corporation, however, can distribute cash based on its cumulative earnings and profits, so the cash distribution does not need to be distributed to the CDE’s members in the same year that the income was earned.
Let us look at a simple example to illustrate these calculations. We will assume that the CDE has taxable income of $80,000, which includes $10,000 of costs being amortized under IRC Section 167. We will also assume that the CDE does not have any cumulative earnings that have not been previously been distributed. If the CDE is taxed as a partnership, the CDE could distribute up to $90,000 during that year and be within the safe harbor, $80,000 taxable income plus $10,000 in IRC Section 167 amortization costs. If the CDE elects to be taxed as a corporation, the CDE could distribute $80,000 less any taxes owed for that year. When the CDE elects to be taxed as a corporation, the CDE would not get to add back the amortization costs on its books for purposes of making distributions and therefore is limited to its taxable income for the year.
Careful consideration should be taken when making these calculations to determine how much can be distributed out of the CDE, so that the CDE does not have redemption. Please consult your Novogradac & Company LLP tax credit advisor for any questions regarding the calculation for your CDE.
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