Understanding the Annual CDE Audit

WHITE PAPER

Prepared by:

Reznick Group New Markets Tax Credit Practice

May 25, 2011

Introduction
To maintain New Markets Tax Credit (NMTC) Program compliance, it is crucial to have an annual audit performed on the Community Development Entitys (CDEs) financial statements by an independent accounting firm. While the word audit generally strikes fear in the heart of the taxpayer, in this case the annual audit is an important risk management check on the CDEs operations. Remember that the CDE is exposed to considerably more risk than a traditional financial institution. CDEs, by design, invest in riskier ventures and place less stringent requirements on borrowers and entities seeking equity investments. Furthermore, while banks are now required under various regulations to conduct extensive due diligence on their loans and investments, the community lending activities of CDEs are largely unregulated. As a result, CDEs typically do not have the extensive due diligence infrastructure that is found at traditional financial lending institutions. The annual audit helps address these issues and ensure that the CDE is managing its risk properly.

The Audit Process

The central element of the audit is the valuation of the CDEs loans and equity investments. In the current economic environment, valuations can undergo significant fluctuation in a short period of time, depending on a range of factors. CDEs need to manage their overall risk not only by ensuring that their valuations are realistic, but by making sure that they have accounted appropriately for the possibility of bad loans and investments that decline in value. Experienced outside auditors can assist in providing the right valuations to prevent performance surprises. Avoiding unexpected changes to the income statement is essential for CDEs because of how tightly they are budgeted. Audits also address the CDEs fee structure. When a transaction is being structured, a CDEs fees are estimated based on projections from various aspects of the deal; the actual fee due may vary significantly from the estimated amount. The audit process looks at these discrepancies and checks them against the intent of the deal structure to avoid any performance surprises. How fees are worded and structured can also have important tax implications in terms of the size of the tax liability and when it is incurred. The audit will also include the important issue of safe harbor limitations, ensuring that the CDE is not over-distributing funds to its investors. NMTC Program requirements stipulate that investors must not receive repayment of their initial investment for seven years; even partial repayment can set off a tax credit recapture event. At the same time, however, investors are paid a return on their investment, often in the form of distributions from the CDE; the safe harbor provision protects investors from recapture events so long as the CDEs disbursements do not exceed its taxable income. Should a CDE find itself outside of the safe harbor guidelines, the situation must be caught early so that possible remedies can be applied. While the annual audit process is demanding, it increases the confidence in, and the transparency of, a CDEs financial statements, provides important feedback for management and helps prevent adverse effects that can mar a CDEs track record.

How Reznick Group Can Help

Reznick Group has been active in the New Markets Tax Credit Program since its inception in 2001. As a result, we have unparalleled experience in providing assurance, tax, transactional and consulting services for CDEs. Reznick Groups audit approach for the NMTC industry targets those areas that pose the largest risks for CDEs. We are also able to draw upon the knowledge and experience of Reznick Groups Valuation and Transaction Advisory Group when addressing valuation issues. We can help with the annual NMTC audit in a number of ways, including: Conducting the annual audit Assisting in drafting the financial statements and required disclosures Conducting valuations of Qualified Low-Income Community Investments Advising on risk management and due diligence Monitoring distributions against safe harbor limitations. For more information, please contact Gary Perlow, New Markets Tax Credit Practice Leader, at gary.perlow@reznickgroup.com.

This publication contains only general information and is not intended by Reznick Group to be a rendering of accounting, business, financial, investment, legal, tax or any other professional advice or services. This publication is not a substitute for any professional advice or services.