Large solar projects do not seem to have a problem attracting tax credit equity. That is not the case for small commercial and industrial (C&I) projects.
The tax credit equity marketplace is mostly comprised of large financial institutions that are considered to be widely-held C Corporations (WHCCs) for federal income tax purposes. A WHCC is a corporation that is taxed as a C corporation but is not considered to be closely-held. A C corporation is closely-held (a CHCC) where, at anytime during the last half of a taxable year, more than 50 percent of the value of the outstanding stock is owned, directly or indirectly, by five or fewer individuals.
Since large financial institutions have strict underwriting requirements, the transactional costs for a tax equity investment are high enough to make it cost prohibitive to finance small C&I projects. As a result, a dearth of tax credit equity exits for these projects. Many of these smaller projects involve offtakers, such as schools and municipalities, that have been constrained by budget cuts. Solar power provides an enormous opportunity for these offtakers by allowing them to stabilize their long-term energy costs. A tax credit equity market is needed for these projects, and investments by non-WHCCs (which includes individual investors) could provide the solution.
Unlike WHCCs, non-WHCCs are subject to two limitations in the Internal Revenue Code (collectively, the Non-WHCC Limitations) that make it more difficult for them to utilize the tax benefits such as tax losses and federal investment tax credits (ITC). The purpose of this article is to provide a road map to allow a non-WHCC to navigate around these Non-WHCC Limitations.
Please note that these rules are extremely complex, and this article over-simplifies this space. One should seek the assistance of a tax professional with specific knowledge in this area.
The Non-WHCC Limitations
It probably makes sense to start by explaining the difference between a tax loss and an income tax credit. A tax loss results from income tax depreciation taken on the solar equipment thereby reducing the amount of a taxpayer’s income that is subject to income tax. This means that where a taxpayer has an income tax rate of 35 percent, $100 of tax losses is really worth $35. An income tax credit, such as the ITC, reduces the amount of actual tax owed by the taxpayer on a dollar-for-dollar basis. Essentially, $1 of tax credits is worth more than $1 of tax losses.
The Non-WHCC Limitations were enacted in the 1980s to curb the perceived abuse of tax shelters. The first of the Non-WHCC Limitations is referred to as the “passive loss and credit rules,” which generally applies to everyone but WHCCs that are not personal service corporations. A personal service corporation is generally a corporation whose principal business is the performance of services (health, law, engineering, architecture, accounting, actuarial, performing arts, and consulting), where such services are substantially performed by employee owners. Under this limitation, tax losses and ITCs generated from passive activities can only offset a taxpayer’s taxable income and tax liability (collectively referred to as the Taxable Items) generated from other passive activities.
The second Non-WHCC Limitation is referred to as the “at-risk” rules, which generally apply to non-WHCCS. The at-risk rules limit the amount of tax losses that a taxpayer may deduct and the amount of ITCs that are generated. A solar project is usually owned directly by a special purpose entity such as a limited liability company. Accordingly, for purposes of this article, it is assumed that a tax credit equity investor will invest in the project by making a capital contribution to this special purpose entity.
Passive Loss and Credit Rules
For purposes of applying the “passive loss and credit” rules, income should be classified in three different categories:
- Portfolio income (interest, dividends, capital gains, and royalties)
- Passive income
- Active income
Under these rules, tax losses and ITCs generated from passive activities are generally limited to offsetting a taxpayer’s Taxable Items generated from other passive activities.
Determining whether a tax loss or tax credit is generated from an activity that is passive or active generally depends on how many hours a taxpayer actually participates in such activity. Note that certain activities such as leasing are generally considered per se passive whether or not the taxpayer actually participates in the activity. This means that the tax losses and ITCs generated from a solar project and allocated to a passive investor, such as a physician, would not offset the Taxable Items from the physician’s practice of medicine. However, if the physician is a passive investor in another limited liability company that operates a profitable business such as a restaurant, then the tax losses and ITCs generated from the solar project could offset the Taxable Items allocated by the restaurant limited liability company to the physician.
There is a special rule that allows CHCCs to make use of most tax losses and ITCs generated from passive activities (the CHCC Exception). The CHCC Exception generally allows CHCCs to use tax losses and ITCs generated from passive activities to offset Taxable Items generated from activities that are either passive or active (but not portfolio). This means that a CHCC can be a tax credit equity investor in a solar project and utilize the tax losses and ITCs against its Taxable Items from its normal business operations. It should be noted that the CHCC Exception does not apply to personal service corporations.
The CHCC Exception is nothing new but has probably been underutilized in the solar market. CHCCs have historically invested in other tax credits, such as federal Historic Tax Credits.
The application of the at-risk rules both limits the amount of ITCs available to the taxpayer and the amount of tax losses that can be deducted by a taxpayer. With respect to ITCs, the limitations come into play where project level debt is involved (i.e., the special purpose entity obtains a loan) and the debt is considered “nonrecourse financing” under certain complicated rules. With respect to tax losses, the at risk rules provide that a taxpayer can only deduct tax losses up to a taxpayer’s at-risk amount, which is essentially the combined amount of the taxpayer’s investment in the solar project and the taxpayer’s personal liability with regards to any project level debt.
Where project level debt is involved, an investor in a limited liability company that owns a solar project generally needs to personally guaranty the limited liability company’s project level loan or pledge assets with respect to such loan to not be impacted by the at-risk rules. Personally guarantying project level debt or pledging assets is often a non-starter for investors. The good news is that there are exceptions to the at-risk rules for ITCs where project level debt is involved (the At-Risk ITC Exceptions).
One of the At-Risk ITC Exceptions worth noting provides a fairly broad exception. This exception applies where no more than 80 percent of the tax basis of the solar project is attributable to the project level debt that is considered to be “nonrecourse financing” under these rules. Further, the lender cannot be related to the tax credit equity investor, and must either be in the business of lending money or be a governmental entity or instrumentality. Lastly, a seller of a solar project and a tax credit equity investor cannot be related. Note that complicated rules exist to determine relatedness for these purposes. It should also be noted that there is another At-Risk ITC Exception for “level payment loans,” and it is complementary to the exception discussed above.
With respect to the “at-risk” rules that apply to tax losses, the renewable energy industry does not enjoy the same generous exceptions as with the ITCs. Therefore, if the tax credit equity investor tax has not guaranteed the project-level debt or pledged assets with respect to such debt, then such investor’s tax losses will generally be limited to the amount of capital contributed by such investor (as reduced to take into account the mandatory tax basis reduction of the solar equipment by 50 percent of the ITCs).
The limitation on the amount of the tax losses deductible by a tax credit equity investor should not discourage any potential investors. For a number of reasons beyond the scope of this article, many solar transactions are structured whereby the WHCC only obtains the benefit of a limited amount of the total tax losses generated by the solar project and the investment still pencils out for these investors.
With the recent long-term extension of the 30 percent ITC for solar, the potential for growth in the tax credit equity industry for small C&I projects is significant for a number of reasons. First, solar tax credit equity investments have enjoyed strong yields as compared to other tax credit equity investments. Secondly, the maturity of the solar industry has provided investors and lenders with comfort regarding any technology risks. Lastly, an offtaker default is less of a concern because tax credit equity investments are not typically long-term investments as a result of the ITC recapture period being five years.