The Inflation Reduction Act of 2022 (IRA) introduced the elective pay, aka direct pay election, which allows certain tax-exempt—and in some cases taxable—entities to receive “cash back” for their investments in clean energy. In March, final regulations were released on this topic. While the final regulations largely adopted the previously issued proposed regulations, they also included some key clarifications and changes. This article focuses on some of the significant considerations within this recently released document:
- Eligibility: Who Can Elect for Direct Pay
- Mechanical Rules: Chaining & Structuring Considerations
- Denial of Double-Benefit: Reduction of Income Tax Prior to Cash Back
- Timing of Payments: Cash Back & Estimated Tax Considerations
- Financing Considerations: Grants, Forgivable Loans, & Other Exempt Financing
- Compliance: Return, Extension, & Election Requirements
- Pre-Filing Registration
Eligibility: Who Can Elect for Direct Pay
The final regulations expand upon the proposed regulations’ list of applicable entities (entities eligible for direct pay), and provide details in the preamble of how the listing applies in certain cases. According to the IRS, the listing of applicable entities eligible to make the elective pay election within Section 1.6417-1(c) are:
- Any organization exempt from the tax imposed by Subtitle A of the Code
- By reason of Subchapter F of Chapter 1 of Subtitle A; or
- Because it is the government of any U.S. territory or a political subdivision thereof;
- Any state, the District of Columbia, or political subdivision thereof;
- An Indian tribal government or a subdivision thereof;
- Any Alaska Native Corporation (as defined in §3 of the Alaska Native Claims Settlement Act, 43 U.S.C. 1602(m));
- The Tennessee Valley Authority;
- Any corporation operating on a cooperative basis that is engaged in furnishing electric energy to persons in rural areas as described in §1381(a)(2)(C) of the Code; and
- An agency or instrumentality of any applicable entity which is: (1) a government of any U.S. territory or political subdivision thereof; (2) any state, the District of Columbia, or political subdivision thereof, or (3) Indian tribal government or a subdivision thereof.
Details included in the final regulations’ preamble provide further background and practical implications of this listing. For example, the general rule states that entities described in §§501 through 530 are eligible for the elective payment election. Therefore, homeowners associations, which are exempt under §528, are eligible for direct pay. While outside the scope of the final regulations, the preamble does discuss that Revenue Ruling 57-128 and various court cases have applied a six-factor test to determine what is considered an “agency, instrumentality, or political subdivision.” This six-factor test is outlined in the preamble for taxpayers’ consideration.
The final regulations also spoke to consolidated groups. If the common parent of the consolidated group is an applicable entity, then any of the member entities may be able to elect to be an “electing taxpayer.” Electing taxpayers can make their own direct pay election for the §§45V, 45X, or 45Q credits.
In addition to details of qualifying applicable entities, a number of entities were mentioned that are not eligible for direct pay. The following listing is included in the preamble to the final regulations, but is not an exhaustive list:
- Partnerships or S corps (unless electing taxpayers for the purposes of §§45V, 45X, or 45Q)
- Puerto Rico-registered nonprofits
- Nonprofits under state law but that do not have federal tax-exempt status
- Publicly owned utilities and electric cooperatives other than those in rural areas (unless they are considered agencies or instrumentalities of a state, local, territorial, or tribal government)
- A cooperative that is subject to Subchapter T
- Entities that solely install energy equipment
- Federal agencies, e.g., U.S. Postal Service, federal hydropower agencies, Army Corps of Engineers, Bureau of Reclamation, and power marketing administrations
- ERISA plans investing in pooled investment vehicles if investing through a partnership structure
Likely, the most noteworthy of this listing are partnerships and S corps. These final regulations reinforce an important point: Regardless of the nature of its owners, these pass-through entities are considered entities eligible for the §6418 transfer election, and not the §6417 elective pay election. Therefore, the potential for partnerships and S corps to participate in direct pay is limited to their desire and ability to be considered an “electing entity” for the §§45V, 45X, or 45Q credits. These credits are calculated without regard for any passive activity limitations at the owner level under §469, at-risk limitations under §49, or overall credit limitation under §38(b) and (c). The one exception to a partnership’s exclusion as an applicable entity is if these entities make a “valid election out of Subchapter K under §761(a),” and are thereby no longer considered a partnership but rather a joint venture. Given the interest in this nuance, the IRS issued separate proposed regulations to this point.
Similarly, taxable C corps are not considered applicable entities unless they make the election to be an electing taxpayer for the §§45V, 45X, or 45Q credit. This includes members of a consolidated group. Considering taxable C corps are considered separate from their owner and are not included in the aforementioned listing of applicable taxpayers, they themselves are not applicable taxpayers.
Disregarded entities (DREs) generally are not able to be applicable entities. However, if a DRE is owned by an applicable entity, the regarded owner could make the elective pay election with respect to the credit generated by the DRE’s property.
Mechanical Rules: Chaining & Structuring Considerations
Key Takeaway: The underlying concept cemented by the final regulations is that, with the exception of §45X, entities must own the underlying property generating the credit in order to make an elective pay election.
Chaining
The final regulations confirm that “chaining” is not permitted. Commenters proposed allowing an applicable entity to make an elective pay election on a credit they received via a §6418 transfer election. However, considering direct pay is only available to those who own the underlying credit property (or perform the credit-generating activity for §45X), the recipient of the purchased credit is ineligible for direct pay. In short, the elective payment election cannot be the second election in the “chain.” For example, Partnership A is owned 90% by a C corp and 10% by a tax-exempt entity. Partnership A purchases a tax credit—made possible by the transferor’s §6418 transfer election—to offset the income of the majority owner, i.e., the C corp. The 10% tax-exempt owner cannot now make a direct pay election on their 10% allocated portion of this purchased credit, and, therefore, 10% of the credit’s benefit is “lost” when looking at Partnership A’s purchase holistically.
Structuring Considerations
Many clean energy projects are structured with either a sale-leaseback or inverted lease structure. The guidance did clarify that while a sale leaseback structure would qualify for direct pay, an inverted lease structure would not. A sale leaseback is structured so that the purchaser of the property also is the lessor. Therefore, because the lessor owns the underlying property, they are eligible for direct pay. In an inverted lease, however, even though the lessee is able to claim the credit under §50(d)(5), they do not own the underlying property. Therefore, the lessee cannot make the elective payment election.
Insight: Tax-exempt entities should always consider the structuring of clean energy deals prior to investing in an entity, and avoid investing in those projects structured as inverted leases.
Denial of Double-Benefit: Reduction of Income Tax Prior to Cash Back
Generally speaking, a credit is reduced to zero when an elective payment election is made. That way, entities could not both receive cash back and reduce their taxable income using the same credit, therefore eliminating the risk that they would receive an undue “double-benefit.”
While this rule may seem to be a technicality, a change in the final regulations actually shifts how this general rule is applied. The updated ordering rule essentially requires applicable or electing taxpayers to first reduce any income tax obligations, e.g., generated from unrelated business taxable income, prior to receiving cash back for the direct pay election. This reduction of income tax is only up to the §38(c) limitation, meaning to the extent that a general business credit could offset taxable income. The §38(c)(1) limitation provides that a general business credit cannot reduce income extent past the greater of: 1) the tentative minimum tax for the year, or 2) 25% of the excess net regular tax liability over $25,000. However, this also means that the credit is reduced to zero only to the extent that the clean energy credit exceeds the income tax liability (up to the §38(c) limitation) of the applicable or electing entity.
Timing of Payments: Cash Back & Estimated Tax Considerations
One of the first questions many entities have after making the direct pay election is, “When will I get my cash?” Unfortunately, the IRS declined to provide an estimated turnaround time for when payments will be available. They also declined to provide for “accelerated” payments prior to the filing of the return with which the elective payment election is made, as some commenters requested.
The final regulations also detail whether entities and owners of flow-through entities can take into account applicable credits when calculating estimated taxes for the year. The preamble states that a direct payment “is distinguishable from both an estimated payment made during the taxable year and a refundable credit.” As previously noted, the actual direct pay cash amount could be reduced because of an offset to income tax. Therefore, the final regulations allow the portion reducing income tax as part of the §38 limitation to be accounted for when calculating estimates but does not allow the net elective payment amount, aka the amount to be received in cash to affect the estimate amount. Partners of an electing partnership entity making the direct pay election also cannot reduce estimated taxes for these amounts. This is in contrast to the §6418 transferability election that allows for the anticipated purchased amount to be accounted for with estimates.
Financing Considerations: Grants, Forgivable Loans, & Other Exempt Financing
In general, entities can include tax-exempt debt used to acquire, construct, erect, etc., an asset in basis when calculating an investment tax credit (ITC). However, the final regulations also include a “no excess benefit rule,” which may reduce the applicable credit amount. §1.6417-2(c)(3)(ii) states:
“If an applicable entity receives a grant, forgivable loan, or other income exempt from taxation under subtitle A or otherwise excluded from taxation (tax exempt amount) for the specific purpose of purchasing, constructing, reconstructing, erecting, or otherwise acquiring an investment related credit property (restricted tax exempt amount), and the sum of any restricted tax exempt amounts plus the applicable credit otherwise determined with respect to that investment-related credit property exceeds the cost of the investment-related credit property, then the amount of the applicable credit is reduced so that the total amount of applicable credit plus the amount of any restricted tax exempt amounts equals the cost of investment-related credit property.”
Plainly put, two formulas apply:
1) ITC + Restricted Tax Amount > Cost of Property?
If yes, then:
2) ITC = Cost of Property – Restricted Tax-Exempt Amount
These restricted tax-exempt amounts include forgivable loans and certain grants. Details of the specific terms of the loans, or timing of grant awards, also are included in the preamble. For example, if an amount is received from general funds or a tax-exempt amount is received not for “purchasing, constructing, reconstructing, erecting, or otherwise acquiring” the ITC property, then it is not considered with this “no excess benefit rule.”
After the elective pay amount is paid to the entity, then there are no restrictions of what the entity does with the cash, e.g., the entity can use the cash to meet any grant match requirements present.
Compliance: Return, Extension, & Election Requirements
Return Requirements
The elective payment election should be made on an original tax return, including superseding returns. Therefore, taxpayers cannot make the direct pay election (or withdraw an election) on an amended return or administrative adjustment request (AAR). However, it is possible to correct numerical errors with respect to a properly claimed elective payment election by amendment or AAR, as long as all required information was included in the original filing. The preamble specifically states that this requirement for complete information is not met if entities state that items are “available upon request” instead of included in the filing.
A superseding return is one filed after the original due date but before the end of the six-month extension period. If the superseding return increases the amount of direct pay, then the amount is deemed paid on the date the superseding return is filed. If the superseding return reduces the direct pay amount, interest and penalties could apply unless paid with the superseding return.
For those not required to file a federal return, the original return’s due date is generally due on the 15th day of the fifth month after the taxable year. There is an option to choose a tax year other than a calendar year assuming certain requirements are met.
Extension Requirements
“An automatic [paperless] six-month extension of time from the due date of the return (excluding extensions)” is available to allow for an entity otherwise not able to make an extension to make the direct pay election. Relief under §301.9100-2(b) applies to entities that have not filed an extension within the six-month period after the original due date.
Election Requirements
The election itself can only be made for the whole credit amount. Therefore, an electing taxpayer cannot elect direct pay for part of the credit and elect to transfer for the remaining credit. The election is in place for the specific period defined for each credit. For example, §45 or 45Y has a 10-year period, §45Q has a 12-year period, and §45V applies to all subsequent years of the facility. A special period applies for electing taxpayers, regardless of the credit. For electing taxpayers, the election applies for a five-year period, ending before January 1, 2033, and cannot be “re-elected” following the end of this period. That being said, the preamble to the final regulations clarified that a transfer election can be made for years following the end of this five-year period.
The election made by applicable taxpayers is generally irrevocable. However, electing taxpayers can make one revocation per applicable property, but they cannot alter the revocation once made. The act of not making a direct pay election for one of the years in the five-year “electing taxpayer” period is not considered a revocation and would not allow for a transfer election to be made for that year.
Pre-Filing Registration
The rules within the final regulations related to pre-filing registration are largely similar to those within the proposed regulations. Overall, applicable and electing taxpayers must complete the pre-filing registration process and receive a registration number to receive a direct pay amount. This registration must occur on a property-by-property basis, unless the text of the specific credit allows otherwise.
While taxpayers need not include all information about the project when registering, they must include the documents needed to determine qualification. Publication 5884 includes discussion by credit of what documents are normally needed for this purpose.
Considering these are final regulations, taxpayers can rely on the guidance within them when planning and filing their tax returns. If you are considering making an elective pay election or have questions about the process, please contact a professional at Forvis Mazars.
Forvis Mazars offers a complimentary tool that can help simplify the IRA discovery process. TaxCred PRO™ for Clean Energy is an interactive questionnaire that generates a customized clean energy tax incentive report. Learn about the IRA tax credits and deductions you or your business may be eligible for and your estimated tax benefit amounts.