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North Carolina ‘Disguised Sale’ Notice Prompts Widespread Concern

Published by Stephen Tracy and Steven Varady on Wednesday, December 5, 2018

Journal cover December 2018   Download PDF

A recent notice from the North Carolina Department of Revenue (NCDOR) has caused concern among developers and investors in state tax credits–and created a potential ripple effect in states with similar incentives.

The NCDOR’s September notice stated that a disguised-sale determination or a transaction which would result in the technical termination of a partnership for federal income tax purposes would result in the NCDOR not recognizing a credit allocation as valid for state income tax purposes. That ruling not only caused concern among those involved in historic rehabilitation and renewable energy transactions, but also may jeopardize the ongoing benefit to the state from such investments.

The historic preservation and renewable energy communities are keeping a close eye on developments. To understand the impact, it’s helpful to consider the context.

State Renewable Energy Tax Credit

North Carolina’s renewable energy tax credit (RETC) for the construction and installation of renewable energy technologies expired Dec. 31, 2015 (a year later if certain criteria were satisfied). The credit was for 35 percent of the cost to purchase and install solar energy equipment, wind energy equipment, geothermal equipment, biomass equipment, combined heat and power system property, or hydroelectric generators located at existing dams or free-flowing waterways. The credit had a $2.5 million cap per installation for a business purpose, although larger projects could be divided into smaller installations for purposes of claiming the credit.

The credit is taken ratably over five years–meaning some taxpayers are still receiving the benefits–by a taxpayer who has an equity interest in the installation at the close of the year in which a credit is claimed. A partner that acquired an interest after the close of the taxable year in which the installation is placed in service can also claim the remaining allocation of the credits after the initial year.

There are no recapture provisions for the RETC, since the credit is taken at the end of each year, but current-year and future credits are lost if the property is taken out of service, moved to another state or disposed of by the taxpayer.

State Historic Tax Credits

North Carolina’s two-pronged state historic tax credit (HTC) for income-producing historic structures expired Dec. 31, 2014–although a new credit was introduced in 2016. The pre-2015 credit was for 20 percent of qualified rehabilitation expenditures (QREs), although if the structure was formerly a facility that served as a state training school for juvenile offenders, the credit was for 40 percent of QREs. Both versions of the pre-2015 credit are taken in five equal installments, beginning in the year in which the property is placed in service.

Members of a limited liability company or partnership could allocate the credit among themselves at their discretion, as long as each member had an adjusted basis in its partnership interest equal to at least 40 percent of the credit they were allocated. Recapture provisions mirror federal HTC provisions, although a taxpayer that disposes of its interest within the five-year period after the property was placed in service forfeits a portion of the credit–if the taxpayer’s interest is reduced to less than two-thirds of what it was in the year the structure was placed in service.

A new state HTC for income-producing historic structures began Jan. 1, 2016. The new credit is for 15 percent of the first $10 million of QREs and 10 percent for QREs of more than $10 million but less than $20 million, with a 5 percent bonus to developments that are in certain areas. The credit has a ceiling of $4.5 million per development and can be taken entirely in the year in which the property is placed in service, although any unused portion can be carried forward nine years.  

There is a third North Carolina HTC for income-producing rehabilitated mill property that satisfies criteria involving the facility’s former use and recent vacancy. That credit is available to taxpayers who submitted an application for eligibility certification for developments before Jan.1, 2015. Those taxpayers are eligible to take the credit through Dec. 31, 2023.  

Both the new HTC for income-producing historic structures and the HTC for income producing rehabilitated mill property may also be allocated among members of a limited liability company at their discretion, so long as each member had a basis in their partnership interest of at least 40 percent of the credit they were allocated.

Tax Credit Benefits to North Carolina

State tax credits provide economic benefits to North Carolina–even beyond the recognized economic benefit of federal credits.

North Carolina’s state historic preservation office says that during the past 20 years–starting in 1998, when North Carolina introduced a state credit–there have been 2,100 historic preservation projects in the state with more than $1.3 billion in rehabilitation costs. Those developments have taken place in 90 percent of North Carolina’s counties, creating jobs and tax benefits for the state.

It’s a similar story for renewable energy development, where North Carolina reaps benefits from the federal as well as state RETC incentives.

The biggest impact came after the state made renewable energy amendments to its tax code in 2006 and 2010. A report by RTI International, an independent, nonprofit research institute, found nearly $2.4 billion in renewables investment in 2016, which was more than 120 times the amount made in 2007. The report said that the state incentives led to an additional $1 billion in state tax revenues, producing an overall positive effect on the state’s bottom line.

Why State Credits Matter

More than 30 states offer state-level HTCs and RETCs and a crucial element for each program is the ability to transfer the state credit to investors who value the credit the most, maximizing the benefit.

Tax credits differ in their transferability. Some credits are directly transferable through transferable, certificated credits. In other cases, tax credits not directly transferrable may be specially allocated to partners in a partnership. Because investors and developers may value the credit more than other partners do, the rules sometimes allow a disproportionate allocation of the credits among members. The ability to transfer the credits to investors in a manner different from the federal tax credits allows developers to generate the maximum value for state credits, which benefits both the state and the taxpayer. Finally, other tax credits are allocated, but are not specially allocable among members.

North Carolina’s previous rules provided this option in a simple form: A claimant of the HTC needed to have a basis in its partnership interest equal to at least 40 percent of its credit allocated, while members of a pass-through entity had flexibility to disproportionately allocate the credit amongst themselves.  North Carolina state renewable energy income tax credits, on the other hand, needed to be allocated in accordance with each member’s distributive share.

NCDOR’s Notice

The NCDOR’s Sept. 10, 2018, document was headlined, “Important Notice: Tax Credits Involving Partnerships.” The notice informed taxpayers of the aforementioned stance that a disguised sale determination for federal income tax purposes results in NCDOR not recognizing the credit allocation to members for state income tax purposes.

The notice appears to imply that an allocation of state tax credits to a partner which is considered a disguised sale for federal income tax purposes would result in nullifying the allocation, thus resulting in the taxpayer being unable to claim the credit. NCDOR also stated in the notice that a taxpayer couldn’t receive an allocation of credits unless that taxpayer is a bona fide partner, since the transfer of the credit can only occur by an allocation, rather than a distribution or sale of property.

This is a quandary: The circumstance above would appear to imply that a disguised sale didn’t occur. It appears that the allocation of state tax credits to a member needs to be respected before one can conclude there is a disguised sale for federal income tax purposes.  The implication above, however, is that the allocation of state credits to a bona fide partner may not be respected.

This is not a new issue for the industry.

Virginia addressed this issue several years ago and concluded that the allocation of state tax credits to a partner for state income tax purposes would be respected, even if the allocation were treated as a disguised sale for federal tax purposes. 

North Carolina appears to be the first state to reach a different conclusion concerning the effect of a disguised sale. Other states have enacted new credits that address the notion of a disguised sale within the statute, including neighboring South Carolina.

The NCDOR notice also said the Department believes that a technical termination of a partnership for federal purposes, before its repeal, would result in the partnership losing its allocable tax credits. However, the Internal Revenue Service has said specifically that such a termination doesn’t trigger the recapture of investment tax credits for federal income tax purposes.

The NCDOR cites the Internal Revenue Code and federal case law in encouraging taxpayers to evaluate their transactions with tax advisers to see if further action is necessary. If so, they may amend prior tax returns, without a late-payment penalty, as long as additional taxes are paid with the amended returns.

Effects of NCDOR Notice

The reaction to the NCDOR notice was profound, swift and ongoing. Law firms and accounting firms notified their clients of the possible ramifications, which will lead to further analysis.

The crux of the concerns is the rationale used by the NCDOR. For federal tax purposes, there are already federal standards for assessing partner status for partnerships primarily formed to avail members of legislatively created federal and/or state tax attributes. Those standards are significantly lower than those for partnerships formed for other purposes. In most cases, partners need only have some risk potential–some risk, not unlimited risk–or some upside potential which can include statutorily intended tax benefits.

NCDOR may update the notice or provide additional guidance. Until then, investors, developers and others must wait to see what action they take.

Impact on North Carolina

North Carolina has received great benefit from historic rehabilitation and renewable energy projects. Despite the sunset of its RETC provision, North Carolina is one of the leading solar markets in the nation–and investors remain engaged despite the end of the credit.

A retroactive clawback of previously claimed credits would potentially jeopardize North Carolina’s position as a solar leader.

In practical terms, should an allocation of the state RETC be deemed a disguised sale of property, that shouldn’t disqualify the allocation of the credit. It merely creates federal and state income tax consequences–and a recharacterization as a disguised sale is not one of the three circumstances that trigger disallowance for state purposes. At worst, the recharacterization of a transaction as a disguised sale should result in the credit being allocated to partners in accordance with the statutory allocation provisions of the state tax code, presumably in accordance with each partner’s capital account or economic interest in the partnership.

The North Carolina HTC market is still active, in the middle of a four-year period for the new state credit. 

A disguised sale determination for an HTC transaction may recharacterize a portion of a partner’s capital contributions as sale proceeds, but that doesn’t disqualify the member’s status as a partner for federal income tax proposes. The federal 40 percent basis requirement could still be met through either an allocation to the partner of income or an allocation of debt in accordance with IRC Section 752.

Similar to the renewable energy industry, a retroactive clawback of previously claimed HTCs based on the NCDOR notice could harm North Carolina’s status and reputation as a national leader in historic preservation and could jeopardize projects currently being proposed and/or  under development.

There have been numerous impact studies about the economic effects of HTCs. State credits obviously encourage development and attract investors, but the attractiveness of those credits depends greatly on the specific rules governing them–including the ability to allocate or transfer credits among investors, particularly in a manner separate from the federal HTC. The NCDOR notice throws a shadow over what partnership structures sponsors can confidently rely on which allow a reliable transfer of state credits to partners (investors). The introduction of this uncertainty will inevitably reduce the pool of investors willing to invest their capital in the state.


North Carolina’s historic preservation and renewable energy communities are reviewing the NCDOR notice and assessing its impact. The notice doesn’t appear to focus on the underlying activity for which the statute was designed nor is the criteria for disallowing the credits tied to actual economic activity or the criteria in the statutes. Nor does there appear to be any safe harbor provisions or detailed rationale for the concerns.

Based on the reaction of industry participants, the North Carolina guidance has created much confusion in the market, dampened investor interest and appears to be undercutting the efficacy of the state’s legislatively-authorized economic development programs. The ruling in North Carolina is being watched nationwide for its implications, both inside and outside of the Tar Heel state. 

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