With an increasing focus on environmental, social and governance (ESG) issues, some organizations are seeking ways to fund various ESG initiatives. Tax credits and incentives have played an important role in subsidizing ESG initiatives, with the Inflation Reduction Act significantly enhancing their impact on environmental investments. However, the often-overlooked social aspect of ESG can also be supported by tax credits and incentives.
The social dimension of ESG focuses on an organization’s relationship with society, including the well-being of employees and the communities the organizations operate in. One mechanism that organizations can utilize to fund initiatives supporting local communities is the New Markets Tax Credit (NMTC)
What is the NMTC?
The NMTC is a federal program established in 2000 to incentivize investment in low-income communities. Codified under Internal Revenue Code Section 45D, the program has been continuously extended through legislative packages. The latest extension provides a $5 billion annual allocation through 2025.
The CDFI Fund, an agency of the U.S. Treasury, administers the program through certified community development entities (CDEs). CDEs use the NMTC allocation to generate a 39% tax credit, which can be monetized by tax credit investors.
Using tax credit equity, the CDEs fund projects in low-income communities, often through loans with flexible features such as below-market interest rates and principal forgiveness.
CDEs help the CDFI Fund allocate funds nationwide, carefully selecting projects that have a significant impact on low-income communities. These projects commonly focus on creating jobs, developing the workforce, providing goods and services to the community, improving healthcare and other community benefits.
The NMTC program requires annual reporting of community outcomes generated by each project, making it an effective tool to support the “S” in ESG initiatives.
Nonprofits and the NMTC
Nonprofit organizations receive a significant portion of NMTC funding each year. The social mission of nonprofits aligns well with the NMTC program’s goal of community development, particularly for underserved populations. NMTC funds often serve as a valuable source of funding for nonprofits to supplement their capital campaigns and other fundraising efforts.
However, nonprofits face challenges in utilizing the leveraged structure commonly used for NMTC funding. In a leveraged structure, tax credit investors create an investment fund that combines their tax credit equity with other financing sources to provide project funding. One challenge nonprofit organizations face is that the leveraged structure typically requires two taxable entities. To address this, many nonprofits establish supporting organizations to facilitate NMTC transactions. Additionally, securing upfront funding sources can create time-value pressure on cash flow, especially for nonprofits that finance their projects over time.
To illustrate how NMTCs can support a project, consider a nonprofit health clinic that aims to expand its facility and acquire equipment to enhance services for disadvantaged individuals in an eligible low-income census tract. The total project cost is $10 million and, despite receiving donations and other funding sources, the clinic can raise only $7.5 million. The clinic can bridge the financing gap through an NMTC loan, which is funded by the tax equity generated from the CDE’s NMTC allocation, enabling the project to move forward. An additional advantage is that the NMTC loan principal is often forgiven after a seven-year term, resulting in a permanent cash benefit to the organization.
Written by Jesse Tsai. Copyright © 2023 BDO USA, P.C. All rights reserved. www.bdo.com