The historic expansion of clean energy tax credits in the Inflation Reduction Act has received much attention, but the options to monetize those tax credits have received much less. Most buyers into the months-old tax credit transfer market have been large, widely held corporations. Individuals, partnerships, S corporations, and closely held C corporation buyers are restricted in how they can use tax credits by old anti-tax shelter rules, which the IRS says also apply when such taxpayers buy credits.These rules include the passive activity loss, or PAL, limitations that restrict individuals from using tax credits from companies in which they don’t materially participate against active income.For this purpose, active income is broadly defined to include salaries, wages, and portfolio income (meaning interest, dividends, royalties, and gains on stocks and bonds), among others, along with any type of income from businesses in which the taxpayer materially participates. These passive tax credits therefore can only offset taxes on other passive income—also known as passive tax liability—including income from activities in which the taxpayer doesn’t materially participate.According to proposed transferability regulations, credits purchased by taxpayers subject to the PAL rules will be considered per se passive.As a further restriction, the proposed regulations provide that the taxpayer-friendly PAL grouping rules don’t apply, meaning that individuals won’t be able to claim material participation in the activity that gave rise to the purchased tax credit by grouping it with similar activities in which the taxpayer does materially participate.In the preamble to the proposed regulations, the Treasury Department and IRS noted that “allowing a transferee taxpayer to try to change the characterization of an eligible credit based on grouping with its own activities” would be in “conflict with the conclusion that the eligible credit has already been determined.”While these proposed rules may make it difficult for individual investors and small companies to take advantage of purchased tax credits, there are still some opportunities.For example, a high-net-worth individual, who is also a limited partner in multiple businesses in which they don’t materially participate, would be eligible to buy tax credits and use them to offset their passive tax liability. Before doing so, this individual would need to calculate their passive tax liability, which may be a novel concept for them and their tax return preparer.If this individual invested in a closely held C corporation that’s not a personal service corporation, and that C corp purchased tax credits, the PAL rules are less restrictive, and the acquired tax credits can offset all business income of the C corp other than its portfolio income. This could make it easier to purchase tax credits, but investing through a C corp exposes the business’s operating cash flows to corporate-level income tax.Both individuals and corporations need to consider other limitations on credit usage, including an overall limit equal to 75% of total tax liability, the at-risk rules, and, for individuals, the alternative minimum tax.Despite the apparent limitations, proposed regulations are just that—proposed—and stakeholders, including the AICPA in a comment letter, argue that the PAL rules be made inapplicable to credit transfers in the final guidance. Based on statements by Treasury officials, this issue appears to still be under evaluation.More Monetization Options For individuals without other sources of passive income and who don’t want to subject their business earnings to corporate-level tax, the opportunities to invest in tax credits may be limited to equity ownership in the business generating the credits.This planning can be more complex and generally requires material participation, which generally requires the individual to be involved in the operations of an activity on a continuous and substantial basis. An individual can materially participate by spending more than 500 hours in the activity.Let’s say a limited liability company owns a manufacturing plant, and the individual managing member participates in all aspects of the operations for more than 500 hours annually. The LLC acquires a solar facility that’s affixed on top of the plant and generates an investment tax credit.The individual negotiates the contract with the solar developer, supervises the installer, and routinely inspects the system. All the power generated by the solar facility is supplied to the plant. The LLC accounts for the operations of the solar facility in the same books and records as the manufacturing plant operations.Based on these simplified facts, the solar facility is likely part of the manufacturing activity such that the tax credit allocated by the LLC may be used by the individual against taxes from other active income.There are times, however, when the power generated by the rooftop solar facility could be more than the plant needs to operate and the excess is sold either in whole or part to the local utility, thereby providing the LLC with an additional revenue stream. In this case, the activities may be considered to be separate, so the individual would have to consider if they constitute an appropriate economic unit and should be grouped as to offset the solar credits against the active manufacturing income.While the determination of whether activities may be grouped is made based on the relevant facts and circumstances, the IRS highlights the following key factors:Comparisons between types of activities Extent of common control and common ownershipGeographic location of the activities Interdependence among activities Guidance from the Treasury and IRS regarding federal tax credit transferability is minimal and only in proposed form. As the market matures, and more guidance is issued and finalized, the available opportunities for individuals to participate in the tax credit market hopefully will expand.This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.Author InformationJonathan Blitman is a senior manager at Moss Adams, providing federal income tax services to private equity and strategic clients in industries related to domestic and cross-border transactions.Colin Quill is a senior manager at Moss Adams, with cross-industry focus on state and local tax, as well as credits and incentives consulting services.We’d love to hear your smart, original take: Write for us.
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Clean Energy Tax Credits Offer Options for Smaller Investments
