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Closely-Held C Corporations and the Solar Industry: Expanding the ITC Investor Base

Published by Marc Schultz on Wednesday, October 1, 2014

Journal cover October 2014   Download PDF

It’s no secret that the usual suspects in the world of tax credit investing tend to be large financial institutions. One of the reasons for this is that certain limitations in the Internal Revenue Code (IRC) such as the “at-risk” rules and the “passive activity loss and credit” rules don’t apply to these organizations because they are widely-held C corporations for federal income tax purposes (i.e., they aren’t closely-held C corporations (CHCs)). Both the at-risk rules and the passive activity loss and credit rules provide limitations that make it difficult for everyone else in the universe except for these widely-held C corporations to utilize the investment tax credits (ITCs) in IRC Section 48. This discussion focuses only on the passive activity loss and credit rules in IRC Section 469. The application of the at-risk rules results in a reduction in the amount of ITCs available to the taxpayer as well as the disallowance of tax losses that can be used by a taxpayer. The at-risk rules are complex and beyond the scope of this article.

The good news is that there is a special rule located in IRC Section 469 that makes it possible for CHCs to utilize the ITCs (the CHC exception). A CHC is a C corporation where, at any time during the last half of a taxable year, more than 50 percent of the value of the outstanding stock is owned, directly or indirectly, by 5 or fewer individuals. The CHC exception isn’t new. Instead, it has probably been underutilized considering the relatively strong yields for ITC investors.

It should be noted that the CHC exception doesn’t apply to personal service corporation (PSCs). A PSC is generally a corporation that has as its principal business the performance of personal services and such services are substantially performed by employee-owners (i.e., law firms, accountants, doctors, etc.).

Section 469
IRC Section 469 provides that, in a taxable year, individuals, trusts that are separate taxpayers, estates, CHCs, and PSCs can only use the aggregate tax losses from all passive activities against the aggregate taxable income from all passive activities, and the sum of the tax credits from all passive activities against the taxpayer’s regular tax liability allocable to all passive activities. Any excess tax losses or credits described above are disallowed and carried over to the next taxable year. S corporations and limited liability companies and limited partnerships that are treated as partnerships for federal income tax purposes aren’t subject to IRC Section 469 because these entities are pass-through entities and don’t pay income tax. However, because these entities allocate tax losses and credits to their members, partners and shareholders, IRC Section 469 is applicable at the member, partner, or shareholder level of such entities.

A passive activity means any activity that involves the conduct of any trade or business and which the taxpayer doesn’t materially participate. A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis of which is regular, continuous and substantial. The Treasury Regulations provide a number of different ways for a taxpayer to meet the definition of materially participating most of which are based upon the number of hours that the taxpayer spends participating in the activity in a taxable year. The rental of equipment is treated as a passive activity whether or not the taxpayer materially participates.

Essentially, a taxpayer subject to IRC Section 469 that invests in a solar project and isn’t a material participant with respect to such activity will only be able to use the tax losses and the ITCs generated from the solar project in a taxable year against the taxable income and the taxpayer’s regular tax liability from the taxpayer’s other passive activities in such taxable year. However, in the event that the CHC exception applies, the taxpayer will be able to use the tax losses and the ITCs in a taxable year against its net active income and its tax liability from its net active income in such taxable year.

The CHC Exception
The CHC exception can be found in IRC Section 469(e)(2)(A). IRC Section 469(e)(2)(A) provides that if a CHC (other than a PSC) has net active income for any taxable year (or a tax liability from net active income), any excess tax loss from passive activities and any excess credits from passive activities for such taxable year shall be allowed as a deduction against net active income (or against a tax liability from net active income). Net active income generally means the taxable income of the taxpayer determined without regard to all items from passive activities as well as certain other items such as portfolio income and deductions. Simplistically, this means that a CHC (other than a PSC) can offset its tax losses and credits from passive activities in a taxable year against its taxable income and tax liability that isn’t generated from portfolio income in such taxable year. Portfolio income generally means gross income attributable to interest, dividends, annuities, and royalties and not derived in the ordinary course of a trade or business.

Here is another example of how this may apply: A CHC is in the business of selling automobiles. Prior to the placed in service date, the CHC acquires a solar facility subject to a power purchase agreement with a utility. Section 469(e)(2)(A) allows for the tax losses and the ITCs generated from the solar facility to be used to offset the taxable income and regular tax liability derived from the CHC’s selling of automobiles.

Banks as CHCs?
Can a bank that is a CHC take advantage of the CHC exception? Banks have played a major role in the tax credit investment community. Aside from any bank regulatory issues, most banks meeting the definition of a CHC should be able to avail themselves of the CHC exception. This begs the question of whether the interest income from a bank’s loan portfolio is considered to be portfolio income. Fortunately, the related Treasury Regulations provide that interest income on loans and investments made in the ordinary course of a trade or business of lending money isn’t considered to be portfolio income. This means that a CHC bank should be able to use the tax losses and ITCs generated from its acquisition of a solar facility against its taxable income and tax liability derived from its loan portfolio.

Looking Ahead
The dearth of tax equity has been a significant obstacle for the solar industry. Developers have found it quite challenging to obtain financing for distributed generation projects and the solar industry continues to seek a more robust tax equity market. While the CHC exception is nothing new, it has been underutilized. As such, the use of CHCs could be one potential solution to the need for a broader investor base. And as the renewable energy community continues to develop, these kinds of solutions and innovations will be key.

Marc Schultz is a partner in the Phoenix office of Snell & Wilmer LLP and chairs the firm's tax credit finance and renewable energy practice.  Marc can be reached at either [email protected] or 602.382.6358.

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