Overview of the tax equity partnership structure
Whether you work with small scale distributed generation assets, or utility scale wind and solar projects, you’ve likely come across the words “tax equity,” “partnership accounting,” or “partnership flip”. What do these words mean? Why are they important? And what can we do once we know how to integrate these into our vernacular?
Let’s start with the notion of tax equity, which is a funny combination of words, mostly because they’re almost deliberately deceiving. Sort of like the first time I heard the words “shareholder loan,” I wondered, well, which is it? Debt or equity? The “tax” in tax equity is certainly appropriate, as wherefore without a tax credit none of this would be important. But we will see over time that tax equity behaves much more like debt in certain instances of a project financing than true equity, much like that shareholder loan behaves more like equity than any debt product.
To set the stage for a conversation about tax equity, let’s pretend that two friends just out of business school create a limited liability company (or LLC) with the stated aim of developing and selling solar projects. One friend knows where they can lease large swaths of land in Texas; the other knows where they can buy solar panels cheaply. They both come to find a large corporate willing to purchase the resulting power. They make arrangements with the local utility to integrate the solar project into the utility’s portion of the grid. And finally, they contract with an engineering, procurement, and construction (EPC) contractor to install the panels. Seems like they have a viable set of contracts and can now proceed to talk with banks about financing structures.
The first thing a bank will look at is all the revenue streams associated with the project. In this instance, the bank would look at the revenues from the power purchase agreement (PPA) and any renewable energy credits (RECs) associated with the project. But lurking just beneath the surface, our two friends might quickly realize they also have other saleable revenue streams in the form of tax attributes, namely the investment tax credit (ITC) and accelerated depreciation (called MACRS, which stands for modified accelerated cost recovery system).
Accelerated depreciation is simply a non-cash charge that impacts cash taxes. By amortizing the capital investment in the renewable project on an accelerated timeframe, our two friends can generate losses that can then be shared within the partnership. Losses result when earnings before tax (EBT) goes negative due to low revenues (early in the cash flow stream) and high depreciation (accelerated depreciation).
However, the big one is the ITC. The history of the ITC dates back to the early 1960s. The credit was initially implemented by the Kennedy administration to incentivize businesses to spend on large capital purchases during the recession of 1960-61. The concept of the ITC was brought back and used to spur investment in solar during the 1990s. However, each congressional authorization of the solar ITC was temporary, usually lasting for a year or two at most. This lack of long-term clarity on how the Federal government would incentivize investment in renewable energy led to the creation of the partnership flip structure as a sort of stop gap. The structure is complicated and involves quite a few moving parts; it was never intended to turn into an industry. It was only created initially to get a few deals done.
The ITC remunerates developers with a tax credit (not cash) sized to 26% of eligible capital costs associated with the solar build. So, think about our two friends from business school: assuming they created a 100MW project, at a cost of $1.20/W or $120 million, 26% of that would equal a tax credit of $31.2 million! I know that business school prepared them well for the business world, but do we really think they’d make $148 million in net income over their lives (the amount required to amortize the ITC of $31.2 million fully)? Maybe a lucky few friends could expect to earn that, but certainly not everyone.
So, what happens to our financing then? Well, it becomes inefficient. Because our two friends can’t monetize the MACRS or ITC, the bank focuses exclusively on the PPA and RECs for purposes of sizing its investment. As a result, our two friends have to inject more cash than they would prefer, which lowers their returns overall, and makes them wonder why they went to the trouble in the first place. It certainly makes them question whether they want to do it all over again, which is exactly what Congress intended by funding the solar ITC in the first place.
So, what can be done? Our two friends can enter into a partnership (there’s that word) with an entity that has A LOT of EBT. Who has a lot of EBT and makes A LOT OF MONEY? Banks, large private equity firms, and Internet companies. But there are other corporates like paper manufacturers or timber companies who also make lots of money and could be tax equity providers, too.
Now those banks and PE firms won’t cover the whole investment required to fund their project. Our two friends will need to participate alongside the tax equity investor as what’s called a sponsor member; they’ll also need to inject some cash into the project’s capital stack, along with tax equity and back leverage (a topic we’ll discuss in subsequent blog posts).
Now, the rules surrounding partnership accounting in the US are some of the most arcane in the developed world. Even tax professionals agree; this stuff isn’t easy. The reason is that partnerships blend the equity method of accounting, where companies report only their proportional share of their investments in other companies, with something called hypothetical liquidated book value (HLBV) accounting. HLBV seeks to understand and report what would happen to the book value of the assets within the partnership if it was collapsed at the end of every year.
The rubber meets the road in the form of what are called capital accounts. These accounts track the inflows and outflows of each partner’s contributions to and distributions from the partnership. Note here that contributions can be either cash or other assets, like land or equipment. We’ll cover capital accounts in a later blog post.
Allocations in a tax equity partnership structure
What we want to focus on is for the purposes of this post are what are called disproportionate allocations, as well as the “flip.”
Stepping back for a second, let’s reacquaint ourselves with the elements of what can be shared between the partners. First, cash can be shared. Cash comes from the initial investment into the partnership, as well as from the PPA and any RECs that get traded for cash. Next there are losses, which are generated due to the fact that solar assets benefit from 5-year MACRS depreciation. That schedule fully depreciates the entire value of the asset in only 6 years, hence years 1-6 of a solar financing are generally ripe with losses for a tax equity partner to absorb. And finally, there are tax credits, namely the ITC, payable by the US Treasury roughly 90 days after commercial operations commence.
Quick question: which does tax equity prefer more: cash, tax credits, or losses? You might think cash – everyone likes that. But you’d only be mostly right. Tax equity providers prefer tax credits and losses over cash. Thinking it through, tax credits count 1:1 against taxable income. Whereas if the tax rate is 30%, losses can only offset the portion of profit that gets taxed (assuming profit of $100, that’s $30 of taxable income). Finally, cash will eventually need to be taxed, which reduces its value by the tax rate.
So, we’ve got cash and tax attributes that need to shared in our partnership. But to what end? Well, tax equity wants to make a return on its investment. So, a partnership is formed between two members to allow the sponsor member (our two friends; also called the managing member) to use the money from tax equity to complete the project efficiently while the tax equity member (also called the investor member) gets a return on its investment. Once that return has been reached, ownership percentages then “flip.”
Why would partners need different ownership percentages? Well, our two guys can’t really use the losses that accrue in the first few years of the solar project. And tax equity certainly can. So, tax equity wants as many of those losses as they can get. 99% is the max allowed by the IRS – they require the sponsor member to retain an interest in the project during this time, in this case just 1%. Tax equity prefers losses to cash, so they take a lower percentage of cash attributes in the first few years, while the sponsor takes more. Which helps our two guys, because waiting 6 years or more to make any money off their investment is a tough road to hoe.
Once tax equity has absorbed enough tax and cash to hit its return, say around 10%, the ownership percentages flip: conceivably, after the flip our two guys have made enough money to be able to use some tax attributes (if any remain after the depletion of the ITC and MACRS).
There’s a lot more to this structure. In subsequent posts, we’ll talk about how the capital accounts are modeled, what happens when losses get too big (they need to be reallocated), and what happens after the flip (an early buy-out option).
Download the Excel file: disproportionate allocations.
What we’ve modeled for you in the download is a simple and straightforward way to think about disproportionate allocations in a tax equity partnership.
We’ve started with an inputs tab that’s loaded with a variety of items required for a tax equity financing. For simplicity’s sake, we’ve hardcoded items like taxable income which would typically require a bunch of assumptions regarding revenues and expenses. For the same reason, we’ve also pre-sized tax equity’s investment in this project. Note that tax equity wants to use a financial model to size its investment to fit its hurdle rate (smaller investment increases returns, and vice versa). So, the size of the investment is usually an output of the model.
On the Partnership tab, we’ve used flags, which are binary modeling elements used to delineate dates, to spell out the various portions of the pre-flip period. We’ve combined those flags with ownership percentages using a SUMPRODUCT formula at the bottom of the calculation blocks in rows 17, 28, 39, 50, etc. SUMPRODUCT is perfect for this application as it uses array logic to combine various elements in a specific order.
We’ve brought the hardcoded cash and tax lines over in rows 54, 55 on the Partnership tab, where we apply the relevant ownership percentage in rows 60, 61, 67, 74, 82, and 83. These cash flows then combine with an initial investment amount to yield a return for the tax equity member (see row 124 of the download).
Once tax equity has achieved its target return, in this case 10% (see Inputs F62), a flag is created telling us that the project is ready to flip (see row 130 on the Partnership tab). Note that the lower tax equity’s return threshold, the earlier the flip occurs. Holding the investment size consistent, changing the required return upwards pushes out the flip, in increments you can view on the Tax equity hurdle rate vs Flip date table on the Summary tab (Summary tab, rows 27 to 37).
But what happens when our flip return isn’t hit exactly at the end of a given time period? In other words, what happens when our return on December 31, 2026 is 9.7%, not 10.00%?
You’ll notice that we’ve used some clever modelling to break that problem down into its component parts. First, in rows 162-171, we’ve used a flag to denote where the return should occur. In other words, the flag is active when the target return occurs between two monthly return values, i.e., 7.50% (target) is between 5.89% (December 31, 2025) and 9.58% (December 31, 2026).
In rows 198 to 207, we use a combination of flags and ratios to decipher which portion of the target return occurs in which period. And in rows 235 to 244, we use Excel’s ability to translate dates into numbers to translate that percentage into an actual flip date.
We’d love to hear from you about how you’re dealing with disproportionate allocations in your own deals. We’d also love your feedback on this blog post as well as the download more generally. If you’d like to know more about our team’s tax equity experience, please feel free to reach out or see our case studies.