Tax Planning Pitfalls for Developers in Public-Private Partnerships

Public-private partnerships (P3) are a hot topic in real estate development. With many real estate developers and construction companies often experiencing a lack of liquidity, these cooperative agreements between government and private entities allow the building of many projects that would not happen otherwise.

While most developers recognize the opportunities such partnerships offer, few fully grasp the power that tax planning before striking a deal will have on driving the financial success of the project.

What Are Public-Private Partnerships?

P3 projects commonly involve mixed-use residential/retail redevelopment plans that revitalize downtown areas or unused manufacturing spaces, or spur economic investment in suburban centers. Other instances include projects such as stadiums and other tourist-attracting facilities – and civil projects like bridges.

Lenders also appreciate the P3 model, which encourages their confidence and willingness to invest as projects become less speculative and more secure with the additional equity from public funding. The most common P3 model involves the government entity providing an incentive to the developer, rendering the project financially feasible through financing that becomes available to the well-capitalized project. Incentives may take the form of land or buildings, property tax abatements, tax increment financing or other mechanisms. While this strategy holds great appeal and potential for developers, it carries risk as well.

Tax Considerations of P3s

When assessing the viability of any P3 project, it is critical that developers consider the potential tax effects of the proposed incentives. A careful evaluation of the incentive in terms of future tax liability should be performed early in the process to prevent serious financial problems and ensure that contracts and financing can proceed smoothly. Failure to perform this tax analysis in a timely fashion can result in the project’s cancellation or unanticipated financial implications for the developer.

The key issue is often the taxability of incentives. Absent upfront tax planning, the full value of the incentive is taxed at ordinary rates in the year it is received. However, with effective tax planning, this deal-killing result can be avoided.

Plan of Attack

To maximize the value of project incentives, developers must take a two-pronged approach:

1. Negotiating to receive the incentive that brings the highest tax value
2. Establishing an entity structure to support optimal tax treatment

Negotiating the Deal

Not every incentive is created equal. For example, land, buildings and upfront cash can be structured so they are received tax-free and thus retain their full value. Credits or tax abatements, however, result in a tax-expense reduction that increases taxable income. Therefore, $100 of land typically has a greater tax value than $100 in property tax abatement.

Establishing Structure

Form matters. While partnerships and LLCs are ineligible to receive tax-free incentives, S and C corporations are eligible, provided certain criteria are met. And since real estate projects tend to be formed as LLCs, it is imperative that upfront tax planning creates a structure that contemplates either an S or C corporation in order to receive those incentives. Furthermore, this step needs to occur before negotiating with municipalities and before financing is sought. All too often, taxpayers wait until documents are executed only to find they must undo them in order to receive incentives without a deal-killing tax hit.

P3 projects offer great opportunity for profitable, beneficial development. It is important that developers understand the different tax treatment that accompanies varying types of incentives in order to succeed with public-private partnerships. Developers are strongly encouraged to seek early guidance from tax professionals who understand P3 tax concerns and their impact on the ultimate success and profitability of the deal.