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Understanding Passive Activity Limits for Individual Investors in Solar Projects
The November issue of the Novogradac Journal of Tax Credits reviewed the tax liability and at-risk limits for individuals related to solar investments. This month, we will review the passive activity limits applicable to individuals investing in solar projects.
Passive Activity Limits
In applying the passive activity rules to individual investors, such investors can be classified into one of three broad categories.
Included in the first category are high-net-worth individuals who have no connection with the solar industry. These individuals might be a doctor, attorney, entrepreneur, etc., but any work they do is outside of the solar industry. The second category is professionals who are advisors to industry participants. These may include individuals who assist in identifying financing or development sources, or work in some other advisory capacity to the solar industry. The third category is individuals who work in the solar industry and are positioned to do their own solar projects.
At the end of this article we will briefly discuss each category of participant and refer to them respectively as “investor,” “industry advisor” and “industry insider.” The ability of individuals to satisfy the hurdles required by the passive activity rules are progressively easier as you proceed through each of the three categories of participants.
The IRC Section 469 passive activity rules were added back in 1986 to curb the proliferation of tax shelters, which were broadly defined to include investments where a significant motive for the investor was the tax benefits of the investment as compared to the economics. These rules limit investors from deducting losses and taking tax credits from passive investments (defined below) except to the extent they have other sources of passive income. Any passive losses that exceed passive income for a year can be carried forward to offset passive income in a later year. When a passive investment is disposed, any prior suspended passive losses are fully deductible.
Any passive tax credits can only be taken to the extent of the tax attributable to passive investments. Any unused credits can be carried forward to future years, subject to the same limit each year (i.e., offsetting only tax on passive investments). In contrast to losses from a passive activity, tax credits related to a passive activity can only offset tax on passive income each year, including the year the investment is disposed, and any excess credit continues thereafter as a carryforward of passive credit still limited to offsetting tax on passive income. Once the credit is allowed, it is subject to the tax liability limitation discussed last month and to the extent not all of the credit can be taken for such reason, it is subject to the one-year carryback and 20-year carryforward rule noted in Part I.
Since 50 percent of the credit reduces the basis of the renewable assets, the statute allows the taxpayer to treat such 50 percent reduction as an addition to basis in the year the asset is disposed, with the trade-off that such treatment results in losing that part of the unused tax credit. This election is less valuable than taking the credit and should be compared to the expected present value of taking the credit in a later year in lieu of reducing the tax on the gain in the year of disposal.
Passive income and losses are the business operating income or loss allocated to a passive investor and does not include capital gain, dividend income or interest income on assets held for investment by a business.
Material Participation Tests for Limited Partners
A passive activity is a trade or business activity where the taxpayer does not “materially participate” each year. Treasury Regulation (Treas. Reg.) 1.469-5T provides seven different tests for satisfying material participation, but only three of them are available to limited partners. For this purpose, a limited partner is defined as a partner of a partnership whose liability is limited under local law or whose interest is designated as a limited partner interest in the partnership agreement. It is not clear how these rules might apply to a member of an LLC who might have different rights and obligations vis-à-vis the LLC compared to a limited partner in a limited partnership.
For purposes of this article, the following discussion is limited to the first (Test 1) and third (Test 3) of the seven tests. Note that pursuant to the discussion in the previous paragraph, Test 3 is one of the tests that is not available to limited partners. Test 1 and Test 3 are probably the most common way that an investor will attempt to satisfy the material participation rules.
Test 1 requires the taxpayer to spend more than 500 hours in the activity during each calendar year. Test 3 requires the taxpayer to spend more than 100 hours in the activity during each calendar year, but such hours cannot be less than any other person who participates in the activity, including non-owners.
Most of the seven tests for material participation are focused on two items. First, how many hours does the individual spend annually in the activity? Second, what is the individual doing with respect to the activity? Both aspects must be analyzed annually to determine if the taxpayer satisfies the material participation requirements.
Hours performed in a management capacity qualify only if no other person is paid to manage the activity and no other person spends more time managing the activity during the year. If the work is not typically done by an owner, it can fail to qualify as participation. In addition, work done in the capacity of an investor does not qualify as participation. This includes studying and reviewing financial statements and reports of operations, and monitoring finances and operations in a non-managerial capacity.
Activity that is involved in a typical solar project, such as site identification, negotiating land use with land owners, obtaining local government permits, negotiating interconnection agreements, negotiating power purchase agreements, negotiating contract terms with an EPC and overseeing their work, managing the project once it is operational and working with contractors for repairs and maintenance, should all qualify as good hours. Note that participation by either spouse is counted toward satisfying the annual hours for both Test 1 and Test 3.
Individuals who own multiple projects directly or in different entities can elect to aggregate the projects for determining their hours of participation to satisfy Tests 1 and 3. The aggregation rules are particularly helpful to qualify under the tests when it would be impossible to do so otherwise because, for example, the taxpayer would not be capable of spending 500 hours annually in 10 separate projects but could spend 500 hours in a group of 10 aggregated projects.
In order to aggregate different projects for satisfying the annual hours of participation, the projects must “constitute an appropriate economic unit for the measurement of gain or loss.” The most significant factors used to make that determination are:
- Similarities or differences in the types of trades or business: Aggregating two solar projects is more likely to pass IRS review compared to aggregating a solar project with an oil and gas or real estate investment.
- The extent of common control and ownership: If the same individuals own controlling interests in the separate projects, they are more likely to be aggregated than ones where the ownership is held by diverse interests.
- Geographic location, which means that projects that are physically located near each other are more likely to be aggregated than ones that are physically distant.
- Interdependencies between or among the activities: Businesses that have products or services that are normally provided together, that purchase or sell goods among themselves and that have the same employees, customers and books and records, are better candidates for aggregation that those that do not.
Note that rental activities cannot be aggregated with non-rental activities. With respect to solar projects, rental of roof-top solar assets will always be considered passive no matter how many hours are spent annually in the project because such rental activity is per se passive. Accordingly, the project must generate its revenue from the sale of electricity and not from rental of solar assets.
A grouping election should be included in the taxpayer’s individual income tax return and updated annually as new projects are added. This election provides that any separate projects are treated as one for purposes of satisfying the hours requirements for either Test 1 or Test 3.
In applying the above requirements to the three categories of individuals noted above, the following are some observations to consider:
- Investor (as described above): Investors will have a difficult time satisfying the material participation standard, since any hours they spend are likely to be considered investor hours under the regulations and not management. Their best approach is to try to spend at least 100 management hours annually with the goal of qualifying under Test 3. However, in that case it is advisable that they own the project directly or as a managing member of a 100-percent-owned limited liability company due to the inapplicability of Test 3 to limited partners.
- Industry advisor (as described above): These individuals have a better argument than investors but query whether their hours will count if not related to particular investments. There is also a risk that the IRS will consider their time spent as not in a management capacity, which is a standard adopted by the regulations. This will be a very fact specific situation with some individuals having better facts and therefore, lower risk of a successful challenge by the IRS.
- Industry insider (as described above): This is typically the “gold standard” with much less risk of IRS challenge, but the taxpayer still must spend sufficient hours to satisfy either Test 1 or Test 3. However, there may be categories of insiders who have better profiles than others. For example, a developer who works with a company that builds and manages its own projects might have a better case than an engineer who works with a solar thermal technology company.
Best practices to support a case of material participation include: (a) maintaining a daily log summarizing the amount and description of hours worked on solar projects; (b) aggregating all solar projects by placing an annual aggregation election in the individual federal income tax return (only needed in the first year or any year where additional investments are added); and, (c) qualifying for the 500 hours test (Test 1) to avoid the risks under Test 3 that someone spends more time in the project than the investor or that the test is not available for limited partners.
Individual taxpayers who can successfully navigate through all of the rules described above are best situated to invest in solar projects generating investment tax credits and related tax deductions.
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