A partnership flip is a “single-tier” partnership arrangement (most often through an LLC) between the solar project sponsor and the tax equity investor, formed to own and operate the solar photovoltaic equipment, and in many ways looks like a conventional real estate partnership, particularly those involving tax credits. Typically, the tax equity investor owns a 99% interest initially and is allocated a majority of the tax credits and taxable losses, along with some operating cash flow distributions. After either the 5-year ITC recapture period has expired or a target yield to the investor has been met, their interest then “flips down” to a 5% or so interest. Once the flip has been triggered, the sponsor has a call option to buy out the investor’s interest for FMV, and the tax equity investor likewise will have an option to “put” their interest to the sponsor for FMV. Due to the availability of bonus depreciation and the majority of the project depreciable assets qualifying as 5-yr property, normally over 100% of the investment is returned within the first 4 – 8 quarters, and significant tax benefits that continue throughout the first 5 years of the investment.
Inverted Lease or Lease Pass Through
An inverted lease is a “two-tier” arrangement where the solar project owner / lessor LLC leases the solar equipment to a lessee LLC that operates the system, pursuant to a long-term operating lease. Lessee sells the electricity and pays a significant portion of the operating revenues to the lessor entity in the form of lease payment/rent. An election is made by the property owner / lessor under IRC § 50(d) to pass thru the tax credits to the lessee rather than claiming them at the lessor LLC entity. Typically, the tax equity investor owns a 99% interest in the lessee initially, and is allocated a majority of the tax credits and taxable losses, along with some operating cash flow distributions. Essentially, the sponsor is the lessor, and the tax equity investor is the lessee through majority interests. This structure had been used extensively in historic rehabilitation transactions prior to being adapted to solar deals. Similar to the partnership flip, after the 5-year ITC recapture period has expired, the investor then “flips down” to a 5% or so ownership interest in the lessee. Likewise, once the flip has been triggered, the sponsor has a call option to buy out the investor’s interest in the lessee for FMV, and the tax equity investor will have an option to “put” their interest to the sponsor for FMV.
The inverted lease structure differs from the partnership flip in several ways in addition to the presence of an operating lease. Instead of the basis reduction required in a partnership flip, the partners of the lessee must recognize income equal to 50% of credits over 5 years or other applicable MACRS depreciable life (see IRC Section 48 (d)(5) and recently issued temporary regulations). The ITC passed through is based on Fair Market Value not cost as in a partnership flip, since the lessee might not know the underlying cost of the equipment and instead must allocates a share of eligible FMV to its owners for use in calculating the credit. Capital raised from the tax equity investor is paid across from lessee to lessor in the form of: (a) prepaid rent for the lease; (b) capital contributions from the lessee for a cross-ownership interest (maximum of 49%) in the lessor; or (c) a combination of prepaid rent and cross-ownership contributions. Due to the availability of bonus depreciation in the cross-ownership scenario, normally over 100% of the investment is returned within the first 4 quarters, and significant tax benefits may continue throughout the first 5 years of the investment. The inverted lease offers more flexible profit & loss and cash allocations than a partnership flip due to the two entities involved, but these are subject to tax counsel’s review and scrutiny. Capital loss upon exit of interest in lessee is more prevalent than in a partnership flip where capital gains recognized upon exit are common. Due to changes in depreciation and tax rates caused by the 2017 federal tax bill, partnership flip arrangements tend to produce superior results for investors.