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Chris Brown - Karr Tuttle Campbell Business Lawyer

Direct Pay Funding of Renewable Energy Projects

What’s New for State Agencies, Nonprofits, Tribes and Electric Cooperatives

The U.S. Treasury Department and IRS have issued final regulations governing the new elective payment regime – commonly known as Direct Pay — under the Biden administration’s Inflation Reduction Act (IRA). The final regulations, published on March 11, 2024 and effective May 10, 2024, clarify several uncertain points regarding the application process for Direct Pay along with timing and funding rules. Treasury and the IRS simultaneously issued proposed regulations that would expand Direct Pay to joint operating arrangements, including partnership and LLC structures, where at least one member files an election for Direct Pay benefits. [1]

The Basics of Direct Pay

Section 6417 of the Code creates a new procedure that allows a short list of “applicable entities” to obtain the cash value of federal energy tax credits in connection with renewable energy projects, electric vehicles and manufacturing. Parties eligible for this benefit include tax-exempt entities, state government units and agencies, housing authorities, Indian tribal governments, rural electric cooperatives, Alaska Native Corporations and the Tennessee Valley Authority. Beyond the tax exempt world, Direct Pay also applies to project developers who use clean hydrogen or carbon oxide sequestration as the base technology. Finally, Direct Pay can also apply to U.S. manufacturers of certain renewable energy components, such as U.S. makers of solar panels and batteries.

The Direct Pay benefit applies to a list of energy-focused tax credits, including the investment tax credit (ITC) and the production tax credit (PTC) for electricity generating projects. This list includes tax credits for carbon oxide sequestration, clean hydrogen, electric commercial vehicles, clean fuel production, clean nuclear and domestic manufacturing. [2]

The amount of the Direct Pay benefit will be based on the actual tax credit available on each project. For example, a state agency that builds and owns a non-utility scale solar project would expect to qualify for a basic 30% ITC, but might also receive add-on credits of another 10% to 40% for energy community, U.S. content and low-income beneficiary rules. That state agency would potentially be eligible for Direct Pay for the entire credit.

Regarding timing of payment, the cash from a Direct Pay filing is paid in the year after the project is first operational. This timing lag is illustrated in the following example:

Example: Direct Pay for a state agency project with multiple funding sources.

Assume State Agency wants to build and own a large rooftop solar project for a total cost of $500,000. The $500,000 budget includes $50,000 for roof repairs, which are not eligible costs for the ITC. To finance the project, the State Agency obtains a federal Environmental Protection Agency grant for $200,000 and a forgivable loan from a nonprofit lender for $100,000. The Agency covers the remaining $200,000 of costs (including the $50,000 repair costs) with its own funds and with a market-based loan from an institutional lender. Also, assume the project qualifies for the basic 30% ITC plus a 10% add-on credit due to its location in a low-income community.

Notice several key points in this example: First, the maximum ITC benefit is $180,000, which equals the 40% ITC credit rate multiplied by $450,000 of eligible project costs. Note that in calculating the ITC, project costs funded by tax-exempt grants and forgivable loans are included in eligible tax basis, but certain costs (such as roof repairs) are ineligible for ITC benefits.

Second, the Agency needs to determine whether it can claim a direct pay benefit for the entire $180,000. The final regs include an Excess Benefit Rule that disallows Direct Pay to the extent that (1) project costs covered by grants and forgivable loans, plus (2) the maximum ITC amount, exceed the total eligible project costs. In this example, the total eligible project costs are $450,000, with $300,000 of funding attributable to the EPA grant and forgivable loan. Under the Excess Benefit Rule, the grants and forgivable loan ($300,000) plus the maximum ITC ($180,000) add up to $480,000, which exceeds eligible project cost of $450,000 by $30,000. Therefore, the Excess Benefit Rule imposes a haircut of $30,000, bringing the total Direct Pay benefit to $150,000. Thus, in this example, the Agency’s $450,000 project is paid for by a $200,000 EPA grant, a forgivable loan of $100,000 and ITC credits of $150,000 (received through direct pay). The Agency covers its own costs for the $50,000 of roof repairs. [3]

Finally, notice a key timing point: Direct Pay is late money. In other words, Direct Pay funds do not arrive until after (1) the project is constructed and placed in service, and (2) the Agency has filed a tax return claiming the direct pay amount as a refund. In general, this means that the Agency will need to pay up front all of the money and financing of the project without regard to Direct Pay, and then receive the Direct Pay funds in the next tax year. If the Agency uses the calendar year as its tax year, then a project paid-for and finished in 2024 will yield a Direct Pay refund at some point after May 15, 2025, which is the normal due date of a tax return for a tax-exempt entity. State Agency will file its tax return to claim the ITC credit refund based on the same schedule as a tax-exempt.

A Few Noteworthy Items from the Final Regs

  1. Everyone must pre-register. Prior to filing any tax return, each taxpayer seeking a Direct Pay benefit must first pre-register the relevant energy project using an online IRS portal. In pre-registration the applicant discloses various project details and is required to attach supporting documents such as permits and lease agreements. At this stage, IRS approval is preliminary, but if approval occurs then the IRS issues the applicant a registration number that is specific to the project.
  1. Tax returns and elections. Once the project is finalized and meets the “placed in service” standards to demonstrate completion, the taxpayer is ready to elect a Direct Pay benefit. [4] The election is filed in the next tax year, with the applicant’s timely-filed return (including extensions). The election is irrevocable. Entities that normally do not file tax returns (e.g., state agencies and churches) are required to obtain a employer identification number and file an IRS Form 990-T (Exempt Organization Business Income Tax Return) to make the election. The final regs do not permit a person to correct a missed election (beyond the normal extension period) and are strict in disallowing changes to the claimed credit amount except for math errors.
  1. Timing issues, including fiscal year elections. After filing a tax return, there is no guaranteed or fixed time period before a taxpayer will receive the Direct Pay funding. In a fast case it might take about six months after project completion – i.e., if a calendar year tax-exempt entity finishes a project in December and files its tax return by May 15th of the next year, it might receive the direct pay funding at some point in June. Of course, it could also take longer, especially for projects finalized early in a tax year. Helpfully, the final regs permit new taxpayers (such as state agencies) to elect a fiscal year on their very first tax return when the election is made. That rule should allow state agencies and certain tribes and churches to elect a fiscal tax year soon after a project is completed, thereby speeding up the receipt of Direct Pay funds. [5] Also, there are no specific requirements on the use of Direct Pay funds. Thus, once received, Direct Pay money can be used to repay project costs or non-project costs of the recipient.
  1. Electricity cooperatives. Frequently, mutual or cooperative electric companies are able to qualify as tax-exempt entities under Code Section 501(c)(12). A tax exempt electric cooperative will also qualify for Direct Pay under the broad coverage that treats all tax-exempt entities as “applicable entities” under Code Section 6417 — including churches, 501(c)(3) organizations, trade associations and even homeowner associations under Code Section 528.

In fact, there is another type of taxable rural electric cooperative that will also qualify for Direct Pay, but only if it meets several requirements detailed in the final regs, including: (1) the entity must be a corporation; (2) it must operate on a cooperative basis (e.g.,, as indicated by the sharing of member costs and payment of patronage dividends); (3) it must “furnish” electricity, which means it must “generate, transmit or otherwise furnish electrical energy” to other parties; and (4), it must furnish the electricity to “rural areas,” where a rural area means a region within the United States that is not located within the boundaries of a city or town with over 5,000 inhabitants. Specifically kicked out of this category are taxable cooperatives that are only engaged in the installation of energy equipment (including solar panels) and taxable cooperatives that operate primarily in non-rural areas or that are otherwise subject to Subchapter T of the Code. [6]

  1. The “no chaining” rule. The final regs shut the door on the concept of “chaining” situations, which means, in essence, the ability of a taxpayer to first purchase energy credits from a third party for cash (using the IRA’s new credit transferability regime under Code Section 6418), followed by a prompt Direct Pay election by that credit purchaser to monetize the credits in the form of an IRS Direct Pay refund. Chaining would have expanded the list of eligible participants using both the Direct Pay and credit transferability regimes, but the IRS concluded that chaining would create too many complexities and conflicts. Thus, the final Direct Pay regs are based on the simple rule that the party making the Direct Pay election must own the underlying credit property or, for the manufacturing credit of Section 45X, must conduct the activities giving rise to the credit.
  1. Tax audit and credit recapture considerations. Audit risk exists for Direct Pay participants. Thus, once a Direct Pay election is made and the amount is received, even tax-exempt and government parties remain subject to IRS audit. A party that overclaims a Direct Pay benefit is required to pay back both the overclaimed amount plus an effective penalty of 20% (i.e., 20% of the overpayment), plus interest. The Direct Pay regime permits a reasonable cause defense which, if successful, will erase only the 20% penalty portion.

Separate from tax audit risk, there are also rules that require a recapture (and pay back) of the Direct Pay amount if there is a sale or termination of the underlying project in the 5-year period after the project is completed. The recapture amount is 100% of the Direct Pay benefit in the first full year after the year in which the project is placed in service. After the first year, the recapture percentage diminishes by 20% each year over the next four years. [7]

Something New: Using Direct Pay in a Partnership-Like Structure

One significant limitation under the Direct Pay statute is that a tax partnership generally does not qualify as an “applicable entity” — with a narrow exception for partnerships involving clean hydrogen, carbon oxide sequestration and certain manufacturing. Therefore, for a traditional solar or wind project, a jointly-owned partnership involving multiple tribes as members, or a two-party arrangement involving a government agency and a nonprofit, would generally not qualify for Direct Pay benefits. The same limitation would apply to a jointly-owned solar or wind project involving a for-profit investor and a tax-exempt entity. [8]

The final regs address this limitation by permitting Direct Pay benefits for certain types of co-ownership and partnership arrangements. The final regs achieve this goal by expanding a seldom-used election regime that already exists under the Code Section 761 regulations. That election permits a constructive partnership to “elect out” of the Code’s Subchapter K partnership tax rules that would otherwise apply, and instead operate as a jointly owned business. The new “election out” regime under Section 761 was published as proposed regs on March 11, 2024, with a comment and review period extending into Q2 of 2024. Once finalized, the new Section 761 regs should permit various kinds of partnership-like structures (including multi-member LLCs) to be funded, indirectly, by participants who claim Direct Pay benefits at the member level.

Under the Section 761 proposed regs, a co-owned energy project must meet several requirements. First, the entity cannot be a corporation, but it can be a limited liability company or other unincorporated organization. Second, it must be organized exclusively for the joint production of electricity from a short-list of renewable projects (limited to those yielding ITCs, PTCs and zero-emission nuclear power production credits). Third, at least one member of the unincorporated organization must be eligible for, and elect to use, the Direct Pay benefit. Fourth the members must enter into a joint operating agreement under which each member has a right to take in kind, or sell, a pro rata share of the produced electricity and any related tax credits.

Importantly, the proposed regs permit the entity to appoint a temporary agent with authority to enter into contracts to sell the produced electricity, including under long-term power purchase agreements.

Here is an example that illustrates how a jointly owned project funded by Direct Pay at the member level might be structured under the new “election out” regime:

Example: Direct Pay combined with an “elected out” partnership

A state government agency, a non-profit and a for-profit corporation decide to fund and jointly own a renewable energy project. Assume the project is eligible for the investment tax credit at a 30% level. Each party will fund and own 1/3 of the project.

The three parties form an LLC under state law (where the LLC’s express purpose is to produce electricity from a qualifying tax credit project). They sign a Joint Operating Agreement, under which each member has a separate right to take in kind or dispose of its pro rata share of the produced electricity and related tax credits. They also appoint a third-party advisor and grant this person authority to act for the LLC and to sell each member’s share of the electricity output. This delegated authority is limited to not more than 1 year. During this time the advisor negotiates and executes (on behalf of the LLC) a 25-year power purchase agreement with the local utility. Prior to the end of the 1-year period, the advisor’s role terminates.

The LLC files an election with the IRS to be excluded from the partnership tax rules of Subchapter K. The state agency and non-profit members each register for the Direct Pay benefit and file elections with their tax returns for a Direct Pay refund. This 30% refund will be received in the tax year after the project is completed and will help offset each member’s prior investment in the project. Meanwhile, the corporate member is not eligible for Direct Pay, and will report its co-tenancy share of investment tax credits, depreciation, and net income on its corporate tax return. [9]

The proposed Section 761 regs will be reviewed in a public hearing on May 20, 2024. Comments from the public will likely include requests to clarify whether storage and other non electricity-producing assets can be included in an “elected out” project. Other open points relate to timing issues (e.g., the use of different accounting methods and tax years by the members) and the effect of terminating a Section 761 election. While the election is irrevocable, the final regs will need to address the effects of terminating an “election out” – including due to disqualification or due to a sale by a member of its interest or a specific request by one or more members to revoke the election and opt back in to the partnership tax rules.

For more information or questions about this Legal Alert, please contact Chris S. Brown, 206.224.8008cbrown@karrtuttle.com, or the KTC attorney with whom you typically work.

End Notes:

[1] Code and Section references in this article are to the Internal Revenue Code of 1986, as amended (“Code”). The Direct Pay statute can be found at 26 USC 6417 (Code Section 6417). The final regulations for Direct Pay under Section 6417, together with the preamble, are contained in Dept. of Treasury Decision 9988 (TD 9988) (“final regs” and “Preamble”). The proposed regulations and summary addressing the ability of a partnership entity to elect out of the complex partnership tax rules of Subchapter K of the Code are found at Dept. of Treasury, Reg-101552-24 (“proposed regs”).

[2] Direct Pay applies to these 12 credits: (1) Section 30C (alternative fuel vehicle refueling property); (2) Section 45 (renewable electricity production credit); (3) Section 45Q (carbon oxide sequestration); (4) 45U (zero-emission nuclear power production credit); (5) Section 45V (clean hydrogen production); (6) Section 45W (electric vehicle credit for government units, tax-exempts and tribes); (7) Section 45X (advanced manufacturing production credit); (8) Section 45Y (clean electricity production credit, for post 2024 periods); (9) Section 45Z (clean fuel production credit); (10) Section 48 (energy credit portion of the investment tax credit); (11) Section 48C (qualifying advanced energy project credit); and (12) Section 48E (clean electricity investment tax credit, for post 2024 periods). Section 6417(b).

[3] The treatment of project costs that are paid with tax-exempt grants and forgivable loans, along with the Excess Benefit Rule, is explained at Reg. 1.6417-2(c)(3). This example (illustrating the haircut effect of the Excess Benefit Rule) is based on Example 3 at Reg. 1.6417-2(c)(5). The Preamble to the final Section 6417 Regs contains a useful discussion regarding the calculation of eligible basis and the Excess Benefit Rule. See Preamble, at Part II.C.2.

[4] The terms “beginning of construction” and “placed in service” are defined by various IRS authorities, including Prop. Reg. 1.48-9(b)(5) (placed in service); Prop. Reg. 1.48-14(a) (retrofitted property); IRS Notice 2018-59 (beginning of construction); Rev. Rul. 84-85 (applying multi-factor test to determine “placed in service” date for a solid waste disposal facility). For details on election timing and filing rules, see Reg. 1.6417-2(b).

[5] See Reg. 1.6417-2(b)(3)(i) (entity that does not normally file a federal tax return, and is filing solely to make a Direct Pay election, may choose the calendar year or a fiscal year for its initial tax return, provided that it maintains books and records to support calculations for the chosen year.) See also Reg. 1.6417-1(b) (tax returns used to make Direct Pay election).

[6] Corporations operating on a cooperative basis that furnish electricity in rural areas (per Code Section 1381(a)(2)(C)), but are otherwise excluded from Subchapter T of the Code, are specifically included in the list of “applicable entities” and are therefore eligible for Direct Pay, per Reg. 1.6417(c)(6). The Preamble to the final Section 6417 regs contains a helpful discussion of this category of electric cooperatives, and differentiates this group from other cooperatives that do not qualify for Direct Pay (including, e.g., cooperatives that perform activities beyond the “furnishing” of electricity, such as solar panel installation). The Preamble and final regs do not create a de minimis rule. Thus, it is unclear whether a cooperative that furnishes electricity as its dominant activity, but also performs a minor amount of non-furnishing activities, will qualify. A private letter ruling may be desirable in such a case. See Preamble at Part I.A.5.

[7] See Reg. 1.6417-6(a) (excessive payment and reasonable cause defense) and Reg. 1.6417(b) (basis reduction and recapture).

[8] Code Section 6417(d) is clear that the term “applicable entity” does not include partnerships, except for (1) electing partnerships owning projects in the areas of clean hydrogen (Section 45V) or carbon oxide sequestration (Section 45Q), or (2) manufacturers who qualify for the advanced manufacturing production credit of Section 45X. This means that a tax-exempt, state government agency, Indian tribal government or rural electric cooperative (all of which are “applicable entities” under Section 6417(d)(1)(A), can only own 100% of a project. Forms of joint ownership among two or more “applicable entities,” such as a co-tenancy arrangement, would be theoretically possible in a Direct Pay setting, but also involve uncertainty. For example, under existing partnership tax authorities, a limited liability entity (such as an LLC) would probably be deemed a partnership if it had two or more members and shared profits. If the parties used a co-tenancy arrangements, the co-tenancy rules would significantly limit the use of centralized management.

[9] This example is based on the example included in Prop. Reg. 1.761-2(a)(4)(vi). The existing Section 761 regulations permit an election out of Subchapter K for investing partnership and co-ownership arrangements involving the joint production, extraction or use of property. Reg. 1.761-2(a)(2) and -2(a)(3). The IRS has permitted an election out of Subchapter K in a handful of prior rulings, including Rev. Rul. 68-344 (coal-fired electricity generating plant); Rev. Rul. 78-268 (electricity generating plant operating under a joint ownership arrangement; owned by two investor-owned utilities, a public utility and a tax-exempt cooperative); and PLR 7951006 (co-ownership of pipeline operating under joint operating arrangement).