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What do the IRS’s Temporary IRS 50(d) Regulations Mean for the Renewable Energy Community?

Published by Forrest D. Milder on Tuesday, September 6, 2016

Journal cover September 2016   Download PDF

A popular structure for renewable energy investment tax credit (ITC) transactions is the two-tier lease-pass-through (or inverted lease). You’ll remember that in a pass-through transaction, the facility is owned by the landlord and leased to a tenant which operates the facility, collects revenue and pays rent to the landlord. Pursuant to a lease-pass-through election, the landlord “passes” the renewable energy tax credits to the tenant, while keeping the depreciation deductions associated with owning the facility. 

In July, the IRS published “temporary and proposed regulations” (Regulations) that apply to these transactions.  Let’s review them–with specific attention to renewable energy transactions.

First, a recap of the basic rules:  With the simpler single-tier structure, all of the tax benefits stay with the owner of the facility, but there is a basis reduction equal to 50 percent of the credit taken. With the two-tier structure, and the tax credit claimed by the master tenant, there is no basis reduction at the landlord level.  Instead, the tenant recognizes income equal to the credit claimed divided by the shortest depreciable life of the facility. This income is often referred to as 50(d) income after the applicable Code section.

To illustrate, suppose a $1 million solar facility generates a 30 percent tax credit of  $300,000. In the single-tier structure, the owner’s basis in the facility is reduced by one-half of $300,000, or $150,000. The result, $850,000, is subject to bonus depreciation (if applicable) and five-year modified accelerated cost recovery system (MACRS) or (if elected) longer depreciation, yielding smaller deductions than would have been the case if the owner started with the full $1 million.

On the other hand, with the two-tier structure, one-half of the $300,000 tax credit is divided by five, this being the shortest number of years for depreciating the facility, giving the tenant $30,000 of 50(d) income each year. 

Typically, the tenant is a partnership, or a limited liability company that is taxed as a partnership (hereafter, we’ll refer to the entity that is the tenant as the “partnership” and it’s constituents as “partners”). 

Virtually all tenant partnerships have treated the 50(d) income as a partnership item which is allocated among its  partners, increasing their capital accounts and their bases in their partnership interests. This is significant because having a higher basis in its partnership interest means that the investor will have less gain or a larger loss when it sells its partnership interest. 

For example, assume an investor contributes $300,000 for a 99 percent interest in tenant, with  a $300,000 tax credit, so that $297,000 of credit goes to the investor. Assume that all revenue and expenses break even. For the next five years, the tenant will recognize 99 percent of the $30,000 of annual 50(d) income, a total of $148,500. Suppose that the investor then sells its interest for $30,000. Starting with a $300,000 investment, breaking even on annual profits and losses, but then adding $148,500 of 50(d) income, the investor’s basis in its partnership interest will be $300,000 plus $148,500, or $448,500 at the time of sale. Thus, the sale for $30,000 yields a loss of $418,500. Presuming the investor can use the resulting capital loss and is subject to a 35 percent tax rate, this saves about $157,000 in after-tax cash. In particular, adding the $148,500 of 50(d) income to basis reduced the investor’s tax liability by about $52,000. 

Investors generally include this potential savings in computing their return on investment. When compared to a $300,000 investment, this $52,000 savings is about 17 cents per dollar. Of course, this computation should also be adjusted for the time value of money, because the savings occurs about five or six years after the initial investment. Regardless, it can be a significant part of the investment computation. 

The new Regulations call for a different result. Here’s what they provide for energy deals:

The income applies to the partner, not the partnership. The 50(d) income is not a partnership item; as a result, it does not increase the partner’s basis in its partnership interest. Instead, the Regulations refer to the “ultimate credit claimant” as the person who files Form 3468 and claims the credit. The 50(d) income is reported in proportion to the tax credit claimed by the ultimate credit claimant.  The bottom line is that an investor will report the 50(d) income but not get a corresponding loss (or reduction in gain) when it sells its interest.

Adjustments during the recapture period. If during the five-year recapture period, either the property is disposed of or the lease terminates, then there will be a recapture of the unvested tax credits. The Regulations provide rules and examples for computing the adjustment to 50(d) income when this happens. 

Effective Date. The Regulations apply to property placed-in-service on or after Sept. 19.

The Regulations provide a few additional rules with respect to 50(d) income that only affect historic transactions, and they are not discussed here.

The Regulations are almost elegant in their simplicity, but as usually happens when the IRS publishes guidance, taxpayers and their advisors emerge bursting with questions, in particular:

How effective is the effective date? The tax credit community sought “prospective regulations” that would only apply to transactions that closed after the date they were published. While the Regulations are prospective, the choice of a placed-in-service effective date is not what was hoped for. This has created three issues for the tax credit community. 

First, by using an effective date based on the date  the facility is placed-in-service, the IRS is potentially making transactions with long lead times subject to the new rules, even though the parties entered into binding commitments long before these rules were published. 

Second, by using the placed-in-service date, the Regulations leave open the question of how to handle a facility with dates before and after Sept. 19. For example, if a portion of a solar farm is placed-in-service on Sept. 1, and the balance on Oct. 1, is all, some, or none of the facility subject to the Regulations? 

Finally, and perhaps most importantly, the Regulations leave doubt about the state of the law before the Sept. 19 effective date. The introductory language that accompanies the Regulations refers to them being consistent with Congressional intent. While the IRS may have included this discussion purely to establish the legitimacy of its position, the wording is a bit stronger than that:

“The Treasury Department and the IRS are aware that some partnerships and S corporations have taken the position that this income is includible by the partnership or S corporation and that their partners or S corporation shareholders are entitled to increase their basis in their partnership interests or S corporation stock as a result of the income inclusion. The Treasury Department and the IRS believe that such basis increases are inconsistent with Congressional intent as they thwart the purpose of the income inclusion requirement in former section 48(d)(5)(B) and confer an unintended benefit upon partners and S corporation shareholders of lessee partnerships and S corporations that is not available to any other credit claimant.”

Many practitioners fear that an aggressive IRS auditor might cite this language as indicating that facilities placed-in-service years before Sept. 19 should be subject to the “spirit” of the Regulations if not their explicit rules. In other words, there is concern that transactions closed long before the Regulations were published might be examined and denied the opportunity to use the higher basis (and greater tax savings on exit) that they anticipated when deal terms were struck. Thus, investors and developers face the daunting question of whether to continue to use the “include the 50(d) income in basis” technique for those transactions that predate the Regulations. 

What about financial reporting? Whatever the correct answer to the first question,  the accounting community is also concerned with how the tax treatment of pre-effective date transactions should be handled for financial reporting purposes. Without reaching a conclusion on what the law is before the effective date, some leading accounting firms are considering whether investors should include a reserve to cover a larger tax bill if they continue to add the 50(d) income to basis for pre-effective date transactions and are then challenged by the IRS.  

While the new Regulations answer many questions, they also raise some important new ones. Remember that the Regulations are “temporary,” and they have a 2019 expiration date (if they aren’t converted to “final regulations” by then), and there is a 90-day window from July 22 to send comments to the IRS. Many practitioners would like to see an explicit statement that the IRS will not disturb positions taken in good faith before the effective date, as well as an effective date based on closing the investment, as opposed to the facility’s placed-in-service date. If they can’t get that, they would like a broad definition of placed-in-service that grandfathers an entire project once a portion is timely placed-in-service.

Forrest David Milder is a partner with Nixon Peabody LLP. He has more than 30 years’ experience in tax-advantaged investments including the tax credits that apply to affordable housing, energy, new markets and historic rehabilitation, as well as the tax treatment of partnerships and LLCs, tax-exempt organizations, and structured financial products. He can be reached (617) 345-1055 or [email protected]. 

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