Planning for ‘Flip Dates’ in Tax Equity Partnerships

The U.S. government offers certain benefits to renewable energy projects, primarily in the form of tax credits and depreciation. But the reality is that a growing number of tax-equity partnerships are reaching the end of their lifespan, and the sponsors and tax-equity investors in these projects need to be preparing for the future.

In fact, those groups need to consider a number of factors as they enter these tax structures and reach a targeted return amount or date, more commonly known as the “flip” date. Those include understanding the flip dates based on the type of tax credit, determining the buy-out element of the arrangements, and understanding the future of the structures.

As background, this concept has been written into the tax code for decades. Two of the most commonly used credits are the production tax credit (PTC) and investment tax credit (ITC). The PTC is calculated as a set rate per kilowatt-hour of energy produced from a qualified renewable energy source and the ITC is a credit for dollars spent on construction of a qualified renewable energy facility.

The PTC came first from legislation enacted in connection with the Energy Policy Act of 1992, which was signed into law by President George H.W. Bush. The goal of this legislation was to reduce U.S. dependence on petroleum and improve air quality by addressing all aspects of energy supply and demand, including alternative fuels, renewable energy, and energy efficiency.

The ITC came along more than a decade later from the Energy Policy Act of 2005, which was signed into law by President George W. Bush in August 2005 and aimed to combat rising energy prices and growing dependence on foreign oil. And most recently, much has been made about the Inflation Reduction Act of 2022 signed into law by President Biden, which extended and expanded these tax credits.

Common Structures

The birth of the PTC and ITC created significant growth in the renewable energy industry and left project developers (sponsors) looking for a way to monetize the tax credits that they could rarely use themselves. Enter large insurance companies, corporations, and banks (tax-equity investors) with hefty tax bills looking for a way to reduce their tax obligations (and generate positive press from the market for reducing their reliance on traditional fossil fuels). The developer and tax-equity investor enter into a partnership to own the renewable energy project together. Since partnerships do not pay income taxes, any income/expense and tax credits are passed through to the respective partner per the terms of the operating agreement.

In the early years of a tax equity partnership, the project developer will receive reduced income/loss allocations and the tax-equity investor will receive the majority of the income/loss allocations and tax benefits until a targeted return amount or date is reached. That point is known as the flip date. After the flip date, the income/loss allocations change to where the developer receives the majority of the income/loss allocation. Which brings us to the task at hand, understanding and planning for the flip date and buy-out.

Solar and wind generation has been making up a larger portion of the new generation capacity since 2010. As noted earlier, this means that more tax-equity partnerships are reaching the end of their lifespan. As a result, sponsors are looking to wholly own cash flowing projects, while tax equity investors are looking to recycle capital as part of a larger tax planning strategy.

Step 1: Understanding Flip Dates—ITC Versus PTC Projects

In historical ITC tax equity partnerships, the flip date (or flip point) is based on a stated future date when the partnership is papered. After that date, typically right after the five-year recapture period for the ITC, ownership allocations flip and the developer—through its ownership of the sponsor interest—can wholly own the tax equity partnership via execution of the call option. A tax equity partnership with a fixed flip date is usually less complex than other structures used in practice. Renewable energy developers who have focused on ITC solar photovoltaic renewable energy projects may have only experienced tax equity partnerships with a fixed flip date.

The flip date of a PTC tax equity partnership is almost exclusively based on an internal rate of return (IRR) that the tax equity investor needs to achieve for the owner allocations to flip. The tax equity investor achieves their IRR through a combination of taxable loss benefits, PTCs allocated, and priority return distributions throughout the partnership’s life. At project inception, the project model typically estimates that the tax equity investor will achieve their IRR shortly after the 10-year PTC period. However, since the flip point is based on actual IRR, determining exactly when the flip will occur can be more complicated as the production of the site largely drives when the return will be achieved.

The most important point to remember is to consider the change in income/loss allocations for each partner once the flip date is reached or the IRR is achieved as this has a direct impact on the tax reporting for the year in which the flip occurs. The challenge is that when this flip is triggered, there is no market event or notification sent/received by either party—rather, it’s simply buried in an agreement that may be long forgotten.

Step 2: Buy-Out of Tax Equity

After the tax-equity flip date is reached, the clock is ticking on the buy-out element of the arrangement. The tax-equity flip point is generally a built-in off-ramp that allows for the termination of the partnership where the sponsor can buy-out the other partner’s interest at either the sponsor’s election or the tax-equity partner’s request.

The buyout price is typically the greater of the value of future cash flows or the amount to achieve an all-in target IRR. The buyout price could even be based on an agreed-upon estimated fair value at the time the partnership was established, such as book value. Either way, all parties involved need to know exactly what they are signing up for and the terms so that as the partnership flip date approaches each party is prepared to navigate a successful path forward.

Items to Consider

There are several factors that sponsors and tax-equity partners need to be thinking through as they enter these structures and approach the flip dates. Some important items to consider include:

• For an ITC project with a fixed flip date, who is tracking the flip date? Is it the sponsor, tax-equity partner, someone else, or potentially a combination of involved parties?
• For a project with a flip date based on tax-equity reaching a targeted IRR, who is tracking the IRR? Is it the sponsor, asset manager, tax-equity partner, or a combination or collaboration of all three?
• Are there any other requirements that must be completed to achieve the flip? If so, what are they and who is tracking the completion of those requirements?
• Is there an option or a requirement to buy out the tax-equity investor at some point after the flip has been achieved?
• Can the tax-equity investor require the sponsor to buy them out? If so, what are the conditions around that requirement?
• If a buy-out of the tax-equity investor will take place, does the sponsor have a plan in place to obtain the capital to secure the buy-out? Potential funding options could include cash on hand, a debt issuance or some other form of capital infusion, or a combination of options.

Looking Ahead

As parties on both sides of future partnerships look back on lessons learned, each should be mindful to learn from history and act accordingly in the current market. Interest rates, cost of capital, and direct project costs have changed dramatically. Lead times on materials appear to be near all-time highs, workers continue to be in high demand with limited supply, and site control (particularly for solar projects) continues to require communication, education, and patience.

The economics for both parties must continue to make sense for deals to get papered. Levers to pull include pre- and post-flip ownership percentages, capital to be contributed by the tax-equity partnership, capital from the sponsor, and third-party financing. Tax-equity partners continue to see higher priority returns due to their increasing cost of capital tied to these projects.

As the U.S. continues to shift to a renewable energy future, numerous opportunities arise to employ diverse and often complicated structures to make renewable energy projects financially feasible. Financial modeling for these projects can feel like throwing darts in the dark given all the variables that go into operating and maintaining these projects (see winter storm Uri in February 2021). The key for project developers and tax-equity investors will be to fully grasp the arrangement’s terms, understand the role each party plays, and proactively plan and prepare for the termination of the arrangement far in advance while tracking project performance.

–James Liechty is director/market industry leader for accounting firm FORVIS, and Tyler Baity is a partner at FORVIS.