Not-for-profit organizations that are looking to expand or build programs to support underserved communities may be missing a significant benefit -the New Markets Tax Credit (NMTC).

Designed to stimulate growth and economic development in low-income communities, the NMTC Program provides federal tax credits to encourage capital investment for projects and businesses into these underserved areas. For not-for-profit organizations working in these communities and wishing to expand their mission, the NMTC Program may be useful in leveraging and subsidizing fundraising efforts. The NMTC program often results in 20 to 25 percent net benefit that could be used for an organization’s capital improvements, operating capital or other costs.

Background

Passed into law as part of the Community Renewal Act of 2000, NMTCs are designed to attract growth capital to low-income communities by allowing investors to receive a tax credit against their federal income tax in exchange for making Qualified Equity Investments (QEIs) in financial intermediaries called Community Development Entities (CDEs). The credit is equal to 39 percent of the investment amount and is taken over a period of seven years.

The Community Development Financial Institutions Fund (CDFI) annually allocates the credits to the CDEs. The CDE then uses the proceeds from the QEIs to make Qualified Low-Income Community Investments (QLICIs). The QLICI may take the form of an equity investment or a business loan, but is typically structured as debt in transactions. The CDEs determine which development projects, businesses, or organizations receive QLICIs in a competitive market based upon a particular project’s impact in a low-income community.

The low-income communities targeted have a poverty rate that is higher than 20 percent and the median income is below 80 percent of the greater of the state or the metropolitan area. Preference is given to projects that serve highly distressed low-income communities (designated by census tracts) where the poverty rate is greater than 30 percent, the median income level is below 60 percent of the surrounding area and unemployment rates are at least 1.5 times the national average. Other criteria may be considered as well in determining whether a specific census tract constitutes a low-income community and many seemingly under qualified areas meet “severe distress” designation through secondary criteria.

Parties, including both for profit and not-for-profit entities, interested in a QLICI must apply, submit intake forms or otherwise present their projects to a number of CDEs for consideration. Recipients of QLICIs must show a community impact for the project that would be funded by the QLICI as well as a targeted focus on a qualifying community. They must demonstrate:

• 50 percent or more of the total gross income from their activities benefits a designated low-income community;
• More than 40 percent of the property is located within the low-income community; and
• More than 40 percent of the services that entity provides are located within the low-income community.

Applicants must establish that the project would not be able to be completed without the boost from the QLICI, in what is known as the “but for” standard. Additionally, funds from the QLICI cannot be used for any “sin” businesses, such as liquor stores or tanning salons.

Benefits for Not-For-Profit Organizations

Opportunities from the NMTC program come in two forms. The first opportunity is to consider applying to become a CDE. Not-for-profit organizations like Habitat for Humanity or the Red Cross have chosen to form CDEs to facilitate investment in their projects. Becoming a CDE, however, is a time-consuming and difficult process to undertake, and there are no guarantees that a CDE will receive an allocation from the CDFI.

The second and more common opportunity is for the not-for-profit organization to apply with one or more CDEs for QLICIs. More commonly, an affiliate of the borrower may facilitate the QEI in the CDE by serving as the leveraged lender by sourcing funds from cash or capital campaign proceeds, senior commercial debt, or from a recapture of recent project costs (within a 12 to 24 month window). A leveraged structure may be used to make the investment in the CDE more attractive to a borrower and an investor. To accommodate the leverage, the investor will form a limited liability entity (referred to as the “Fund”) and make an equity investment into the Fund. The Fund will borrow money from a lender (“Leveraged Lender”) and pool the borrowed funds with the funds from the equity investor in order to make the QEI investment in the CDE. By serving as the Leveraged Lender, the affiliate of the not-for-profit organization borrower effectively subsidizes its capital or borrowing capacity with equity proceeds from the investor, thereby allowing access to equity that otherwise would not have been available. The not-for-profit will generally enter a put-call option arrangement with the investor as a possible unwind option in order to acquire the investor’s interest in the fund whereby the investor’s equity is redeemed at the end of the seven-year credit period. The unwind option would be akin to convertible debt for the not-for-profit organization and the call option would be based on fair market valuation (if the more commonly exercised put is not exercised by the investor).

Applying for a Qualifying Low-Income Community Investment

Competition abounds with the program because the Department of Treasury has a limited number of credits to allocate–$3.5 billion per year. What’s more, every CDE has unique, mission-based criteria for determining the projects it will fund and where it will fund those projects. Some CDEs have targeted investments in businesses with minority leadership, while others place emphasis on stimulating job growth or certain services (such as healthcare) in low-income communities.

Making matters more complicated is that CDEs do not typically use a form application for their QLICIs, which makes applications highly individualized to the CDE. Organizations will have to develop an approach for applying to each CDE in order to demonstrate why their project might be a good fit for a particular CDE’s investment.

If a not-for-profit organization’s project is selected for a QLICI, the process of getting the loan could take an average of six to eight weeks from the time the CDE issues the commitment letter, credit term or letter of intent for the deal to be considered complete. However, outlier projects may be completed in much shorter or longer timelines. Getting to the close of the NMTC-related deal has been known to be difficult, so not-for-profit organizations might want to enlist the help of a professional who is experienced working with CDE intake processes and structuring NMTC transactions in order to complete the arrangement.

Maintaining Compliance

Fortunately, once the investment is in hand, complying with the parameters of the program is not as stringent as many other incentive-based programs. The project or business must demonstrate that it is performing the services it promised by submitting financials, compliance certificates, and other tax information to the CDE during a seven-year compliance period.

Risks for the investment are the same as commercial loans. If an organization can’t meet its premium payments on the loan, it would follow the same remedies as it would for a standard loan. Additionally, the entity would be liable for the investor’s tax position (tax credits, penalties, interest, and other anticipated tax benefits) associated with the transaction if it failed to continue to qualify during the seven-year compliance period and caused the rare triggering of a recapture event of the tax credits. The program possesses a built-in cure period to avoid an event of recapture whereby credits may be placed into another qualifying transaction.

Act Quickly to Benefit from the Program

Most CDEs begin distributing their QLICI in late fall, so not-for-profits should act quickly in order to take advantage of the investments that could be available to them for 2016 and 2017. The Treasury Department recently announced a combination of the 2015 and 2016 rounds of funding, so the allocation in the late fall of this year will be $7 billion. The increased allocation will create an abundance of opportunities for well-qualified, high-impact projects. This next allocation round will be an ideal opportunity to fund deserving projects because of the high availability of credits to be placed in the marketplace.

Not-for-profit organizations should note that the long-term future of the program is uncertain; the PATH Act has guaranteed the program’s funding at $3.5 billion at least through 2019, but whether the program continues beyond that point remains to be seen.

For more information about how you could benefit from the program, please contact us.

Jim Lang is tax credit incentive lawyer with vast experience structuring and closing NMTC transactions for both for-profit and not-for-profit entities. A managing partner at Baynard, McLeod and Lang, P.A., he can be reached at 727.433.0015 or jlang@bmlpa.com.

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