The historic expansion of clean energy tax credits in the Inflation Reduction Act has drawn a great spotlight, however, the methods for monetizing these tax initiatives could have more exposure. The primary participants of the burgeoning tax credit transfer market have primarily been large, renowned corporations. Meanwhile, potential stakeholders such as individuals, partnerships, S corporations, and closely held C corporations are confined in leveraging these tax credits due to the IRS maintaining the application of antiquated anti-tax shelter rules.
The said constraints include passive activity loss (PAL) limits, which prohibit individuals from using tax credits from businesses where they don’t have substantial participation against active income. This active income comprises wages, salaries, dividends, royalty, among other earnings, along with the income generated from ventures where the taxpayer materially engages significantly. Consequently, these passive tax credits can only counterbalance taxes on other passive income, known as passive tax liability, along with the income generated from activities where the taxpayer doesn’t materially engage.
According to the proposed regulations for transferability, credits purchased by taxpayers subject to the PAL rules will be classified as per se passive. Adding to restrictions, the proposed regulations establish that taxpayer-friendly PAL grouping rules don’t apply. As a result, individuals won’t be able to claim participation in the activity that created the purchased tax credit by combining it with similar activities in which they materially contribute. Nonetheless, the Treasury Department and IRS noted that “allowing a transferee taxpayer to try to change the characterization of an eligible credit based on grouping with its own activities” would conflict with the eligibility of the credit that has already been set.
However, there are still some opportunities for individuals and smaller corporations. For instance, a high-net-worth individual who is also a limited partner in multiple businesses in which they don’t materially contribute, can buy tax credits and employ them to offset their passive tax liability. However, this individual needs to calculate their passive tax liability, which is a new concept for many high-net-worth individuals and their tax return preparer.
Both corporations and individuals must consider other constraints on credit utilization, these include an overall limit set at 75% of total tax liability, the at-risk rules, and for individuals, the alternative minimum tax. Even though these apparent limitations exist, they are just proposals and stakeholders, including the AICPA in a comment letter, argue for the PAL rules to be rendered inapplicable to credit transfers in the final guidance.
The opportunities for those without other sources of passive income and reluctant to subject their earnings to corporate-level tax could be confined to equity ownership in the credit-generating business. This sort of planning can be complex and generally demands material participation.
However, very often the power generated by the standalone solar facility could be more than enough for the plant to operate. The excess is sold either fully or partially to the local utility, further providing the LLC with an additional revenue stream. In these cases, activities could be deemed separate so the individual would have to consider whether they depict a suitable economic unit and should be grouped to offset the solar credits against the active manufacturing salary.
In conclusion, the guidance from the Treasury and IRS regarding federal tax credit transferability is still in a nascent stage and only in proposed form. However, as the market matures, and more guidance is finalized, the potential opportunities for individuals in the tax credit market are expected to grow.
You can access the full article here for more detailed insights.