IRS guidance on tax credit transfers reveals risks

The IRS on June 14 released highly anticipated guidance outlining how energy credits can be transferred and refunded, and the rules provide important restrictions that could complicate transactions and create risk.

The Inflation Reduction Act established new mechanisms for taxpayers to monetize the enhanced energy credits. Eleven credits can be sold and transferred to other taxpayers for cash and three of these credits are also effectively refundable for the first five years. Tax-exempt entities can generally elect to receive all 11 as refundable direct payments, plus the credit for clean commercial vehicles.

The new guidance includes FAQs, temporary regulations on registering for the credits (TD 9975), and proposed regulations for transferring energy credits (REG-101610-23), electing direct pay for the energy credits (REG-101607-23), and electing direct pay for the semi-conductor manufacturing credit under Section 48D (REG-105595-23).

The regulations provide helpful clarity for how the elections will operate, but the IRS also interpreted some provisions narrowly in ways that could restrict transactions. Important limitations in the rules include the following:

• Partnerships and S corporations transferring energy credits will be limited to amounts considered “at-risk” to their partners and shareholders under Section 49.
• Purchased credits will be subject to the passive loss limitations under Section 469, limiting their appeal to individuals.
• The IRS provides a strict interpretation of the requirement that the tax credits be purchased only for cash, potentially complicating broader deals.
• Tax-exempt entities will not be able to enter partnerships for credit projects in which they intend to elect direct refundable payments.
• Tax-exempt entities will not be able to purchase credits and then elect direct payments.

Perhaps more importantly, the rules make clear that purchasers of credits will retain significant risk. The transferee essentially becomes the taxpayer for purposes of the credit and will be liable for any recapture or any adjustment after an exam. Adjustments will also incur a 20% penalty unless there is reasonable cause for the excess credit amount.

The temporary regulations apply to tax years ending after June 21, 2023. The proposed regulations are proposed to be effective for tax years ending after the date the final regulations are published, but taxpayers may rely on them for tax years beginning after 2022 provided they rely on them in their entirety and in a consistent manner.

Eligibility

The IRA provided that taxpayers could elect to transfer any of the following credits to another taxpayer:

• Section 45 production tax credit (and the Section 45Y credit that will replace it 2025)
• Section 48 investment tax credit (and the Section 48E credit that will replace it 2025)
• Section 45U nuclear power credit
• Section 48C advanced energy property credit
• Section 45Q carbon oxide sequestration
• Section 45V hydrogen production credit
• Section 45X advanced manufacturing credit
• Section 30C alternative fuel refueling property credit
• Section 45Z clean fuel production credit that will take effect in 2025

In addition, taxpayers can elect to treat the credits under Sections 45V, 45Q, and 45X as payments against income tax for the first five years, essentially making them available as refundable payments from the IRS. This treatment is also available for the Section 48D credit for semiconductor manufacturing. Specific entities can elect to treat any of the energy credits as payments against tax. The entities include (the Section 45W credit is also refundable for a smaller category of tax-exempt entities):

• Any organization exempt from tax imposed by subtitle A
  
• Any state or political subdivision
• The Tennessee Valley Authority
• An Indian tribal government
• Any Alaska Native Corporation
• A rural electric cooperative

The guidance generally defines these categories liberally. Tax-exempt organizations will include all entities exempt from tax by Section 501(a). State and governments and subdivisions will include the District of Columbia and territories, plus any government agencies or instrumentalities. Indian tribal governments will also include any subdivisions, agencies and instrumentalities. The definition of “Alaska Native Corporation” will not include related Alaska Native Settlement Trusts as the IRS said the statute for that category was explicit.

Direct pay

The direct pay election is generally available only for the entities described above, except for the credits under Sections 45V, 45Q, and 45X, which are refundable for other taxpayers for the first five years (the Section 45W credit is refundable only to tax-exempt entities as described in Section 168(h)(2)(A)(i), (ii), or (iv)). The election is made on the annual tax return, such as a Form 1120, Form 1120-S, Form 1065, of Form 990-T. If a taxpayer is not required to file an annual return, it must file the election on the Form 990-T (or the form it would be required to file if it was located in a state and not in a territory). Taxpayers must register before filing.

The election can only be made on an original return and is required by the due date of the return, including extensions. If the taxpayer is not required to file a return, then the election is required by the date the return would be due if the taxpayer was required to file. The election is made separately for each applicable credit property, and each election must include the entire amount of credit related to that property. The guidance provides rules for determining the applicable property. In addition, for the production credits, the election generally applies to subsequent years related to that property. The election is not revocable except for taxpayers electing the five-year direct pay option for the credits under Sections 45V, 45Q, and 45X. Taxpayers are allowed one revocation of those elections.

The regulations provide that taxpayers cannot elect direct payment for a credit that was transferred to them. This question generated significant commentary, as the statute was not clear on the issue. The IRS said such a result was not intended, but asked for comments on whether exceptions should be made for any circumstances, such as when a transferee is involved in the project.

For projects owned by an S corporation or a partnership, the election can only be made at the entity level. No partners or shareholders can make their own election after the credit flows out to them. Because neither a partnership or S corporation can be an applicable tax-exempt entity, the election for these entities is only available for the five-year direct pay option for the credits under Sections 45V, 45Q, and 45X. 

Transferability

Taxpayers can elect to transfer eligible credits to any taxpayer, but only for cash consideration. The cash received is excludable from gross income for the seller and is not deductible for the buyer. For a production tax credit, the election must be made separately for each facility and for each taxable year. For an investment tax credit, the election must be made on a property-by-property basis, with a single property defined to include all components that are functionally independent under the rules in Notice 2018-59.

Unlike the direct pay election, taxpayers can elect to transfer only a portion of a credit, or transfer different portions of a single credit to different taxpayers. Taxpayers cannot, however, separately identify and sell base and bonus credit amounts. The credits generally provide a base amount and then offer bonus rates for meeting certain requirements, such as prevailing wage and apprenticeship rules, energy communities, and domestic sourcing. Transferees receiving a portion of a credit will be deemed to receive a proportionate share of any base and bonus credit amounts.

Taxpayers must register to make the transfer election (discussed more below). The election is made on the annual return for which the credit is determined and must be made by the due date of that return (including extensions). It is not revocable. Taxpayers cannot elect to transfer a carryforward or carryback credit, though the transferee can use the purchased credit as a carryback or carryforward. The transferee must take the credit into account in the first taxable year ending with or after the tax year the seller transfers the credit.

A credit can only be transferred once. In addition, a credit that has already been assigned to another taxpayer under another provision in the code, such a lessee under Section 50 or assignee under Section 45Q, cannot be transferred. 

Credits are transferrable only if all consideration for the credit is “paid in cash.” The proposed regulations define “paid in cash” narrowly to include only U.S. dollars transferred by cash, check, cashier’s check, money order, wire transfer, ACH transfer or other bank transfer of immediately available funds. The payment must be made between the first day of the tax year in which the seller transfers the credit and the due date for making the transfer election. Taxpayers are permitted to enter into a contractual agreement to transfer credits before this, but the cash must be exchanged during this time period.

There are many special rules for S corporations and partnerships. The election to transfer credits must be made at the entity level and cannot be made by a partner or shareholder for a credit flowing from the entity. This also precludes upper-tier partnerships from making an election based on a credit from a lower-tier entity, though disregarded entities are disregarded for the purpose of these rules.

To determine the amount of credit that an entity can transfer, the proposed regulations draw a distinction between rules that impact the credit base and those that impact the ability of a taxpayer to claim a credit against liability. The amount of investment tax credit that a partnership or S corporation can transfer is limited by any reduction in the credit base at the partner or shareholder level under the Section 49 at-risk rules. But the amount of credit that can be transferred is not affected by Section 469 passive activity rules.

The transferee buying the credit, however, will be subject to the passive activity rules. The credit will be considered a passive activity credit and the taxpayer will not be able to change the characterization. The credits will also be subject to the general business credit limitations under Section 38.

There is significant risk borne by buyers of the credit. The statute and regulations make clear that the buyer of the credit is treated as the taxpayer for purposes of the credit. To that end, the statute requires the seller to provide the buyer “required minimum documentation,” presumably so the buyer can document and substantiate the credit under IRS scrutiny. The information must include:

• Information that validates the existence of the property
• Documentation substantiating any bonus credit amounts
• Evidence of the eligible taxpayer’s qualifying costs or production activities

Any recapture of an investment tax credit due to a disposition of the property by the seller is paid by the buyer unless the recapture is due to a partner’s or shareholder’s disposition of an interest in the partnership or S corporation. The transferee is also generally liable for any recapture of a Section 45Q credit due to the release of sequestered carbon emissions. More importantly, the buyer is responsible for paying any adjustment of a credit amount upon examination by the IRS. These amounts are considered “excessive credit transfers” and incur a 20% additional tax. This tax does not apply if the taxpayer can establish reasonable cause.

The proposed regulations provide a list of factors that can demonstrate reasonable cause. The factors are not meant to be exhaustive, nor a list of requirements. They include:

• Review of the seller’s records and documentation for bonus credit amounts
  
• Reasonable reliance on third-party expert reports
• Reasonable reliance on representations that total portions of credits transferred do not exceed the eligible credit
• Review of public company audited financial statements

If portions of a credit are sold to multiple buyers, they are all considered a single buyer for determining if there was an excessive transfer. If there is an excessive transfer, the amount of additional liability is allocated proportionally between the buyers.

Income tax considerations

The statute explicitly excludes the cash consideration received by the seller from gross income and disallows any deduction to the buyer. The proposed regulations also clarify that the buyer does not have any gross income or gain for federal tax purposes when claiming a purchased credit even if the taxpayer has paid less than the amount of credit.

The proposed regulations declined to address the tax treatment of any transaction costs for either the buyer or seller, or whether a buyer is permitted to deduct a loss if the amount of credit claimed is less than the amount paid. The IRS requested comments on these issues.

The basis reduction required for claiming investment tax credits must be performed by the seller of the credit who retains and depreciates the property, not the buyer of the credit.

Any refundable payment or cash for a transfer is treated as tax-exempt income for a partnership or S corporation under Sections 705 and 1366. The proposed regulations generally require the tax-exempt income to be allocated to partners in the same proportion as the underlying credit would have been allocated. The income is not treated as passive for purposes of Section 469. There are no restrictions in the statute or regulations for how an S corporation or partnership can use the cash proceeds or refundable credit.

The proposed regulations also discuss the affect of any grants and forgivable loans on the basis for claiming credits. The IRS did not provide any rules for taxable entities, but in the preamble, it acknowledges that grants and forgivable loans are generally taxable under Section 61 and “thus generally do not result in a reduction of basis.” If tax-exempt amounts are used in the purchase, construction or acquisition of property, the preamble states that Sections 118 and 362 can require a reduction in cost basis.

The IRS acknowledged it is less clear for tax-exempts because grants and forgivable loans are generally exempt from tax. The proposed regulations offer special rules providing that any grants and forgivable loans used by tax-exempts to purchase, construct, reconstruct, erect or otherwise acquire investment credit property can generally be included in the credit base. However, if the value of the tax credit and grants together exceed the cost of the property, then the credit base is limited to the cost.

Registration and reporting

Taxpayers electing to sell a credit or claim a direct pay refund must register before making the election. The registration will take place electronically through an IRS portal that has not yet launched. The registration is required but does not necessarily mean the taxpayer is eligible to receive a payment or transfer their credit.

Taxpayers must obtain a registration number for each separate credit property and the registration number must be included on the return when the direct payment or transfer election is made. In general, a new registration number is required each year with regard to a property, but the IRS plans to offer procedures to renew them.

The registration will require signification information, including:

• Name, taxpayer identification number (TIN), entity type, tax year, and type of return
• Type of credit and type of property
• Physical location of property
• Supporting documentation for construction or acquisition, such as permits, deeds or leases
• Beginning construction date and placed in service date
• Source of funds

For credit transfers, both the buyer and seller must attach a transfer election statement to their returns. This statement must include:

• Name, address, and TIN of both buyer and seller
• Description of the credit, the total amount and the portion transferred
• Tax year the credit will be sold and the tax year the credit will be taken into account by the buyer
• Attestations and representations of compliance with underlying rules

Next steps

The enhanced energy credits and new monetization options under the IRA present enormous opportunities for taxpayers interested in energy projects, including tax-exempts. But the rules are complex, and taxpayers should consider the various credit and monetization options. Traditional tax equity financing structure may still be attractive for projects needing upfront funding, monetizing depreciation, or seeking a step-up in basis to fair market value. The new credit market for direct transfers will also provide a unique new tax savings opportunity for taxpayers who are not themselves pursuing energy projects. Potential credit buyers should carefully assess the potential risks and consider strategies to address them. Taxpayers involved in any aspect of the programs should expect IRS scrutiny. The last time the IRS offered grants in lieu of energy credits (the section 1603 program), it became a major focus for compliance efforts. The IRS currently has a special $60 billion funding allocation to help drive enforcement.