Understanding the Reasonable Expectation Test: Why Is It So Important?

The Internal Revenue Code (IRC) generally requires entities involved in the transaction to meet certain criteria throughout the seven-year NMTC compliance period. The entities must meet these requirements for investors to successfully participate in the New Markets Tax Credits (NMTC) program and retain their tax credits.

However, the IRC has created an exception to this general rule called the “reasonable expectations test.” This test permits the entities to remain eligible for the NMTC program as long as they reasonably expect to continue to meet all requirements throughout the seven-year compliance period.

NMTC Entity Requirements

Section 45D of the IRC authorizes community development entities (CDEs) to designate equity contributions from investors as qualified equity investments (QEIs), thus making the investors eligible for NMTCs. The CDEs then must use the QEIs to make qualified active low-income community investments in (QLICIs) in qualified active low-income community businesses (QALICBs).

An entity must remain a QALICB during the seven-year NMTC compliance program. The eligibility requirements for a QALICB are as follows:

  1. At least 50% of the total gross income of such entity is derived from the active conduct of a qualified business within any low-income community;
  2. A substantial portion of the use of the tangible property of such entity (whether owned or leased) is within any low-income community;
  3. A substantial portion of the services performed for such an entity by its employees are performed in any low-income community;
  4. Less than 5% of the average of the aggregate unadjusted bases of the property of such entity is attributable to the collectibles (as defined in IRC §408 (m)(2)) other than collectibles that are held primarily for sale to customers in the ordinary course of such business; and
  5. Less than 5% of the average of the aggregate unadjusted bases of the property of such entity (as defined in IRC §1397C(e)) is attributable to nonqualified financial property.

So, if the QALICB fails to meet any of these tests during the seven-year compliance period, it ceases to be a QALICB, and the NMTCs would be subject to recapture. However, under the reasonable expectations test, if the CED reasonably expects that the QALICB will remain a QALICB during the seven-year compliance period, it will be treated as a QALICB. This is the case even if it later fails one of the eligibility tests.

The Reasonable Expectations Test

Implementing the reasonable expectations test usually requires a two-step inquiry by the Internal Revenue Service (IRS):

  1. Did the CDE expect the entity to remain a QALICB throughout the seven-year compliance period?
  2. Was the CDE’s expectation reasonable?
    • What standard should the CDE’s conduct in forming its expectation be measured against? (the RE standard)
    • Was the CDE’s expectation reasonable in light of the RE standard?

The applicable standard typically is whether the CDE acted reasonably and in good faith in light of the overall facts and circumstances.

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Savage & Associates is an economic development law firm designed to provide clients with the legal and business insights to grow, revitalize, and build their communities. We use individualized strategies for our clients, ranging from large public companies to burgeoning entrepreneurs, to determine the best strategy for achieving their goals.

We are experienced in using New Markets Tax Credits, Low-Income Housing Tax Credits, C-PACE, Historic Tax Credits, and other investment options to help developers, investors, nonprofit organizations, and entrepreneurs change their communities. Our unique qualifications allow us to devise unique plans to carry out your objectives and work toward improving your communities. You can get started today by contacting our offices at 215.880.9441 in Philadelphia or 202.817.3941 in Washington D.C. Set up a session with us to discuss your ideas and learn more about the opportunities that may be available to you. You can also find Savage & Associates online 24 hours a day, seven days a week, for more information about our services.

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