The Inflation Reduction Act, designed to accelerate the United States’ transition to clean energy, introduced new tax credit monetization options that could provide opportunities for individual investors.
These new IRA monetization options allow individual investors to purchase tax credits, although this opportunity is subject to important restrictions that may or may not be relaxed by future guidance.
Use the following insights to learn how to leverage these tax credit opportunities, as well as other monetization strategies which predate the Inflation Reduction Act.
Credit transfer overview
The federal tax credit transfer market is new and so far, buyers, also known as transferee taxpayers, have primarily been large, publicly held corporations. Individuals and, to a lesser extent, closely held C corporations, are restricted in their ability to use purchased tax credits by old anti-tax shelter rules, like the Internal Revenue Code (IRC) Section 469 Passive Activity Loss (PAL) rules.
The Treasury and IRS are currently reviewing taxpayer comments and may consider changes that would ease these restrictions. Here’s an overview of the PAL rules that must be considered in connection with individual tax credit investments.
How section 469 impacts individuals’ tax credit use
In June 2023, the Treasury and IRS issued proposed regulations stating that purchased tax credits are subject to limitation under the PAL rules, which apply to individuals, trusts, estates, closely held C corporations, and personal service corporations.
Under Section 469, a taxpayer is subject to limitation for losses or credits attributable to a passive activity, such as an activity that the taxpayer didn’t materially participate in or a rental activity. Section 469 doesn’t apply to partnerships or S corporations but does apply to partners and S corporation shareholders when passive activity losses and credits are allocated to them.
Under the proposed regulations, credits purchased by taxpayers subject to the PAL rules would be considered per se passive. This occurs because the purchaser of the eligible tax credits isn’t considered — as a result of the transfer election, as noted in the preamble to the proposed regulations — to have owned an interest or participated in the trade or business at the time of the activity that generated the credit.
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As a result, the purchaser won’t satisfy the material participation standard to treat the purchased credits as active. Therefore, purchasers of the tax credits could only use the credits against passive income, such as income from activities in which the taxpayer doesn’t materially participate or rental activities.
The Treasury and IRS have requested comments “on whether there are circumstances in which it would be appropriate to not apply the passive activity rules under Section 469 to a transferee taxpayer...”
How grouping rules apply to tax credit use
In addition, under Section 469, which applies on an activity-by-activity basis, an individual may treat one or more trade or business activities or rental activities as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss. This is referred to as the grouping rules.
In the proposed regulations, the taxpayer-friendly grouping rules wouldn’t allow an individual to claim material participation in the activity giving rise to the purchased tax credit by grouping it with other similar activities in which the individual does materially participate.
The Treasury has written 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 conclusion that the eligible credit has already been determined.”
Again, the Treasury and IRS have requested comments “on whether there are circumstances in which it would be appropriate… to attribute the participation of an eligible taxpayer to a transferee taxpayer.”
As a result of two of the provisions in the proposed regulations – application of Section 469 to individual purchasers of the eligible tax credits and inapplicability of individuals to utilize the grouping rules to include the trade or business that gave rise to the eligible tax credit – individuals will be dissuaded from purchasing eligible tax credits unless they have sufficient passive income that can be offset by the purchased eligible tax credit.
While these proposed rules make it difficult for individual investors to use purchased eligible tax credits, there are still opportunities for these investors.
Alternate monetization option
For individuals without passive income sources and who don’t want to subject their business earnings to corporate-level tax, tax credit investment opportunities may be limited to equity ownership in a pass-through business generating the tax credits.
This investment option can be more complicated and generally requires material participation. Material participation necessitates the individual to be involved in the operations of an activity on a regular, continuous and substantial basis.
Among other tests for material participation, an individual can materially participate in an activity by spending more than 500 hours in the activity or spending more than 100 hours in the activity with no other individual having greater participation.
Tax credit investment and monetization examples
Leveraging tax credits as an investment channel is a complex process, especially as regulations surrounding their use are still being finalized. Here are three examples of how this investment opportunity could work in practice.
Example: Use of passive tax credits to offset other passive tax liability
Under the proposed regulations, an individual who is a limited partner in multiple businesses but doesn’t materially participate would be eligible to buy tax credits and use them to offset their other passive tax liability from those businesses. Before doing so, however, this individual would need to calculate any passive tax liability, which may be a novel concept for the individual and their tax return preparer.
If this individual invested in a closely held C corporation that isn’t a personal service corporation, and the C corporation purchased tax credits, the PAL rules are less restrictive. The passive activity credits can offset all the C corporation’s tax on business income, other than its portfolio income. This scenario makes it easier to use purchased eligible tax credits; however, investing through a C corporation exposes the business' income to corporate-level income tax.
Both individuals and corporations need to consider other limitations on credit usage, including:
An overall limit equal to 75% of total tax liability
At-risk rules
Alternative minimum tax (for individuals)
Example: Applying grouping rules
A limited liability company (LLC) owns a manufacturing plant. The individual managing member of the LLC participates in all aspects of the operations for more than 500 hours annually.
The LLC acquires a rooftop solar facility that is affixed on top of the plant and generates an investment tax credit. The individual negotiated the contract with the solar developer, supervised the installation, and routinely inspects the system.
All the power generated by the solar facility is supplied to the plant. The LLC accounts for the solar facility operations in the same books and records as the manufacturing plant operations.
Based on these parameters, the solar facility is likely part of the manufacturing activity such that the tax credit allocated by the LLC may be used against taxes from other active income.
In an alternate case, assume power generated by the solar facility is more than the plant needs to operate and the excess is sold in whole or in part to the local utility, thereby providing the LLC with an additional revenue stream.
Under these modified facts, the activities may be considered as separate, whereby the individual would have to argue that they constitute an appropriate economic unit and should be grouped to offset the solar credits against the active manufacturing income.
While the determination of grouped activities is based on relevant facts and circumstances, the IRS highlights the following key factors:
Similarities and differences in types of trades or businesses
The extent of common control
The extent of common ownership
Geographic location of the activities
Interdependence among the activities
Example: Equity investment in energy property
An individual investor is a one percent managing partner in a partnership that owns energy credit eligible property and participates in the partnership’s activity.
The partnership sells its credits to the managing partner. As noted above and in the proposed regulations, a purchaser of the eligible tax credits is not considered (as a result of the transfer election) to have owned an interest or participated in the trade or business at the time of the activity that generated the credit.
Since the managing partner is an actual owner of an equity interest in the activity and materially participates in the activity, there may be a position that using the purchased credits shouldn’t be subject to the Section 469 limitation. However, Treasury should clarify this issue in the final regulations.
In addition, although the proposed regulations don’t permit any grouping, Treasury may want to consider permitting grouping in certain circumstances such as, if, for example, the managing partner participates in the partnership’s activity and materially participates in another similar activity.
Looking forward
The Inflation Reduction Act is still fresh legislation and guidance from the Treasury and IRS is minimal and in proposed form. Despite the apparent limitations on individuals using purchased eligible tax credits, the proposed regulations are just that — proposed. Stakeholders, including the American institute of certified public accountants, argue that the PAL rules should be made inapplicable to eligible tax credit transfers in the final guidance.
Other stakeholders, such as the New York State Bar Association Tax Section, have stated that applying PAL rules should require a balancing of tax and energy policy. It’s argued that applying the PAL rules in the credit transfer context runs counter to the act’s purpose by limiting the investor pool for new clean energy projects. Based on recent statements by Treasury officials, this issue is still under evaluation.
As the market matures and more guidance is issued and finalized, the available opportunities for individuals to participate in the tax credit market will hopefully expand.
