• IRS Releases Tax-Exemption Standards for Nonprofit Housing Organizations
  • June 22, 2006
  • Law Firm: Bricker & Eckler LLP - Columbus Office
  • In a recent internal memorandum, the Internal Revenue Service set forth standards for processing exemption applications filed by tax-exempt housing organizations. The memorandum is significant because, for the first time, the IRS has provided uniform standards for evaluating these exemption applications. Complying with these standards should substantially shorten the exemption review process, which presently takes several years.

    Lengthy delays in the processing of exemption applications filed by housing organizations are common, as the IRS has struggled to place various aspects of these transactions in the framework of laws applicable to tax-exempt organizations. Of particular concern to the IRS has been the extent to which the nonprofit general partner or manager of the limited partnership (LP) or limited liability company (LLC) owning the housing must provide guarantees to its investors with respect to the amount of credits allocated to the project, losses and other liabilities. The IRS has also expressed concern about uses of the project after expiration of the tax credit compliance period. The new standards address many of these concerns.

    Below, we have summarized some of the more significant requirements of the new standards.

    Governing Documents. The organization is no longer required to provide final governing documents along with the exemption application. However, the governing documents must provide both that:

       

    • Charitable Purposes: The LP or LLC will operate in a manner that furthers charitable purposes by providing decent, safe, sanitary and affordable housing for low-income persons and families (including the elderly or physically handicapped, if appropriate); and

    • Charitable Override: The organization's charitable purposes will take precedence over any duty to maximize profits.

     

    Most organizations will not have difficulty satisfying the first of these two requirements; however, the governing documents of most organizations do not have the "charitable override" provision described above.

       

    • Conflicts of Interest: The organization must adopt a conflict of interest policy for arrangements involving the personal interests of board members, officers and partners similar to that provided in the instructions to Form 1023, Application for Recognition of Exemption.

     

    Guarantees and Indemnification. The standards limit the types of indemnification and guarantees that the nonprofit organization may provide to its investors. These limitations require:

       

    • Environmental Indemnification: The organization obtain and review an independent Phase I environmental assessment on the proposed project and exercise due diligence to minimize any risk before agreeing to provide environmental indemnification;

    • Fixed-Price Construction Contract: The project be constructed pursuant to a fixed price construction contract with a contractor who either is bonded or provides a letter of credit or adequate personal guarantee;

    • Operating Deficit Guarantees: The organization provide operating deficit guarantees for: (i) for a period not longer than five years after the achievement of "break-even operations"; or (ii) no more than six months of operating expenses, including debt service; and

    • Tax Credit Guarantees: The organization provide tax credit guarantees limited to the amount of development and other fees that it will receive. Any payments made under a tax credit guarantee must also be credited to the capital account of the organization or treated as a loan.

     

    Other Requirements. Finally, the standards require that the governing documents also include the following provisions:

       

    • Right of First Refusal: The organization must have a right of refusal to acquire the project at the end of the tax credit compliance period.;

    • Redemption of Investors: Any redemption of the investors' interests in the LP or LLC (such as due to the failure to meet certain requirements or obtain tax credits) will not be for more than the amount of their capital contributions;

    • Management Rights: To the extent that the governing documents require the organization to obtain the consent of the investors for certain matters, this consent may not be unreasonably withheld; and

    • Removal: The organization may be removed as general partner or managing member of the LP or LLC only for cause, and only after a reasonable cure period.

     

    Conclusions. Guidance from the IRS in this area has been long overdue; it has been nearly a decade since the issuance of Revenue Procedure 96-32. These standards are likely to become the guiding provisions for all tax-exempt organizations undertaking housing activities through a syndicated partnership. Organizations with pending exemption applications before the IRS are likely to receive information requests consistent with these standards. Investors, syndicators and developers are encouraged to review these provisions, both in the context of their current transactions and in future transaction. To the extent that a particular transaction cannot satisfy all of these standards, the organization should carefully consider why the standard cannot be met and whether other procedural safeguards may be put into place to achieve a similar result.