The federal government provides several valuable incentives to promote alternative energy investments. Many of these incentives take the form of favorable federal income tax benefits.
For example, a solar energy project may entitle its investors to a 30 percent investment tax credit (ITC) and accelerated cost recovery deductions. Together, these benefits often eliminate the taxable income (and with it, the associated tax liability) of a solar installation during the early years of the project’s life. To the extent these deductions and credits exceed the project’s income or tax liability in the current tax year, an investor may be entitled to use those excess deductions and credits to offset income and tax liability from other sources. Simply put, making the alternative energy investment can reduce the investor’s overall tax liability.
Unfortunately, federal incentives encouraging alternative energy investment do not apply uniformly to all taxpayers. For example, because alternative energy investments typically are structured through limited liability companies or limited partnerships in which the investor does not actively participate in project development or management, one particularly challenging obstacle a taxpayer must consider is a limitation commonly known as the “passive activity loss” (PAL) rule.
Components of the Passive Activity Loss (PAL) Rule
The Internal Revenue Code limits the ability of individuals and certain other taxpayers to deduct losses or use tax credits from “passive activities.” For purposes of the rule, a passive activity is defined as any activity that involves the conduct of a “trade or business” in which the taxpayer does not “materially participate.” To be subject to the PAL rule, (1) the taxpayer must be a person or entity covered by the rule, (2) the activity generating the losses or credits must constitute a trade or business, and (3) the taxpayer’s active participation in the activity must fail to satisfy a minimum threshold.
If the PAL rule is triggered, then the taxpayer’s losses and tax credits from the passive activity may be used to offset the taxpayer’s income and tax liability from other passive activities, but may not be used to offset active or “portfolio” income (including dividends and gains from stock investments). Unused losses and credits are carried forward to the next year. When the taxpayer ultimately sells its passive investment, any unused losses that remain with respect to that investment become available to offset income from non-passive sources; unused tax credits are lost (although the Internal Revenue Code provides some mitigating relief).
Taxpayers Subject to the Rule
The PAL rule applies to individuals, estates, trusts, closely held “C” corporations (a corporation more than 50 percent owned, directly or indirectly, by not more than five individuals), and personal service corporations (a corporation that is more than 10 percent employee-owned, if (1) more than 50 percent of the company’s total compensation for the prior taxable year is attributable to the performance of services in certain specified fields and (2) more than 20 percent of such compensation is attributed to the activities of the employee-owners). While partnerships and “S” corporations are not subject to the PAL rule, the rule applies to their partners and shareholders.
The Conduct of a Trade or Business
The PAL rule applies to activities conducted as a trade or business. While not defined by the Internal Revenue Code, the term “trade or business” typically is construed for purposes of the PAL rule as an activity primarily undertaken for income or profit and which is engaged in with continuity and regularity. The guidance in this area acknowledges that the wide variation of potential business opportunities requires careful consideration of the facts to determine whether an activity should rise to the status of a trade or business for purposes of the PAL rule. That said, alternative energy projects organized for commercial purposes will likely be construed as trades or businesses.
A taxpayer is subject to the PAL rule if he or she does not “materially participate” in the trade or business. The Internal Revenue Code defines material participation as being involved in the operations on a basis that is “regular, continuous, and substantial.” An individual establishes material participation by satisfying any one of seven quantitative tests that measure the number of hours he or she participates in the business. For example, one such test is satisfied if the individual participates in the activity more than 500 hours in a taxable year. As a rule of thumb, if the person does not work at least 100 hours in the business or more than everyone else (including nonowners and non-employees), it is unlikely that the individual will satisfy any of these quantitative tests.
Whether a taxpayer is subject to the PAL rule with respect to any given activity requires a careful analysis of the facts and a consideration of the taxpayer’s unique circumstances. Becoming subject to the PAL rule can trigger unpleasant surprises for an uninformed taxpayer. As such, if a person intends not to actively participate in the operations of a business, then he or she should discuss the potential application of the PAL rule with a tax advisor prior to making an investment.
As Applied to Alternative Energy Investments
The PAL rule is not unique to alternative energy investments; it applies to any and all passive activities. However, because alternative energy investments typically are structured to remove an investor from the day-to-day activities of the business, an individual making an investment in an alternative energy project may be subject to the PAL rule. In this case, it is important for the taxpayer to consider carefully its overall income tax profile to determine whether — and the extent to which — the PAL rule will impact the investment.
In the case of a taxpayer with significant passive income from other activities, becoming subject to the PAL rule with respect to an alternative energy investment may not be of any real concern, because the losses and credits from the investment may be used to offset the taxpayer’s income and tax liability from its other passive activities. However, if the investment represents the taxpayer’s primary passive investment and the taxpayer is counting on the income tax benefits the investment would otherwise provide, the limitations imposed by the PAL rule may cause the investment to lose its attractiveness.
John A. Eliason is a member of Foley & Lardner LLP’s Energy Industry Team where he assists clients with completing transactions that rely on tax and other federal and state incentives. He regularly represents both financial institutions and project developers engaged in wind, solar, and other renewable energy transactions. He can be reached at email@example.com
Lead image: Gold coins and plant via Shutterstock