The Inflation Reduction Act (the “IRA”), signed into law on August 16, 2022, provides significant tax incentives for investments in clean energy. Notably, the IRA provides $216 billion in corporate tax incentives for multiple industries and investments including manufacturing tax credits, transportation and fuel tax credits, hydrogen and carbon capture credits, clean energy production credits, etc. These tax benefits are intended to encourage investments in identified areas of clean energy and development by providing a reduction of corporate tax liability through a credit offset. However, corporate income tax credits lose their value for taxpayers with little or no income tax liability to offset. Unfortunately, many companies eligible for these income tax incentives are unable to utilize them. Previously, taxpayers may have entered into a tax credit financing structure to claim tax credits, but this solution isn’t for everyone. To remedy this issue, the IRA established the ability for direct pay election and a tax credit transfer.
Tax Credit Financing
Historically, taxpayers addressed this problem by developing tax credit finance structures whereby a company involved in the incentivized business activity may partner with a separate investor with sufficient tax liability to utilize the tax incentives. For example, Green Company may form a Limited Partnership with Tax Company. Tax Company, as a limited partner, would provide much needed capital to the partnership and in exchange, would be entitled to any eligible tax credits. Green Company, as a general partner, would benefit from Tax Company’s capital and would receive operating income when the business matures. This arrangement works for some but not all.
In order to address this problem more directly, the IRA introduced IRC §§ 6417 and 6418.
Direct Pay Election
IRC § 6417 allows taxpayers to make a direct pay election for certain tax credits. This effectively permits taxpayers to treat tax credits resulting from eligible investments in renewable energy projects as tax paid on a taxpayers return resulting in a refundable tax credit. This direct pay option is limited to a small amount of “Applicable Entities” such as tax-exempt entities, state/local governments, tribal governments, and a few other limited entities. For limited periods, an Applicable Entity includes any eligible taxpayer with regard to IRC §§ 45V, 45Q, and 45X. For example, for the IRC § 45X, advanced manufacturing credit, any eligible taxpayer may elect direct pay for a five-year period.
Related: Double Your R&D Credit with the Inflation Reduction Act
Inflation Reduction Act Tax Credit Transfer
IRC § 6418 provides an attractive benefit to certain IRA tax credits by allowing eligible taxpayers to sell the credits to unrelated third parties without entering a complex tax credit finance structure as described previously. This tax credit transfer is limited to one transfer. The transferee in the exchange cannot resell the tax credit to another party. The purchase of the credit must be done in cash and receipt of the cash by the transferor is excluded from gross income. Likewise, the expense of the cash payment is not deductible by the transferee. Tax credit transferability is available to eligible taxpayers for tax years beginning after December 31, 2022. Tax credits eligible for transfer is defined in IRC § 6418 and includes, among others, the renewable energy production credit, the clean hydrogen production credit, the advanced manufacturing production credit, and the qualifying advanced energy project credit.
The direct pay and tax credit transfer options introduced by the IRA provide simpler accounting and wider applicability to eligible taxpayers. Tax credit finance structures will continue to be attractive for investments in solar projects, wind farms, and other activities where the tax benefits include tax losses driven by depreciation and other deductions.
Taxpayers should pay close attention to whether their nexus states conform to the most recent version of the IRC and if not, how non-conforming states address an Inflation Reduction Act tax credit transfer or direct pay election.