There are a number of benefits for investing in renewable energy projects. The energy investment tax credits is one such benefit. Given the specialized nature of energy projects, these tax credits are often sold to taxpayers as investments by firms that organize and operate these investments.
After making the investment and receiving allocation notices from the investment entity, taxpayers report these tax credits on their tax returns and use the tax credits to offset their income tax liability. But what happens when the IRS challenges these seemingly legitimate tax credits? Can energy tax credits that require involvement in a business activity be denied by the IRS because the investor wasn’t active enough in that very same business?
Can you have something that is a business or investment for profit under one set of tax rules, and then it not be a business or investment for profit under another set of tax rules? The recent Strieby v. Commissioner case provides an opportunity to consider these questions.
Facts & Procedural History
The taxpayers invested in an Arizona limited liability company that operated solar farms. The LLC was treated as a partnership for federal income tax purposes.
The taxpayers had minimal involvement with the LLC—limited to signing membership agreements and membership funding agreements, and making payments to the LLC. The taxpayers even signed the agreements for these investments after the close of the tax year.
Despite this, the taxpayers reported investment tax credits under Sections 38 and 48 related to these investments on their 2015 and 2016 joint income tax returns.
The IRS audited the tax returns and determined tax deficiencies of $30,337 and $31,926, and imposed accuracy-related penalties under Section 6662(a) of $5,590 and $6,385 for the 2015 and 2016 tax years, respectively. The taxpayers petitioned the U.S. Tax Court, arguing that they were entitled to the claimed credits. The court had to decide whether the passive activity limitations under Section 469 apply to Section 48 credits.
About Section 48 Energy Investment Credits
Section 48 of the tax code provides for an energy investment credit as part of the general business credit framework. These credits incentivize investments in renewable energy projects by allowing taxpayers to claim a percentage of their investment in qualifying energy property as a tax credit.
The credit structure flows through several tax code provisions. Section 38 allows a general business credit against income tax. The amount of this credit includes the current year business credit under Section 38(a)(2), which incorporates the investment credit determined under Section 46. Section 46(2) then includes the energy credit determined under Section 48 as part of this investment credit.
For a taxpayer to claim the Section 48 credit, the energy property must be “placed in service” during the taxable year. When investing through a partnership structure, taxpayers can claim their allocable share of the credit based on the partnership’s qualifying investments.
A requirement that is often overlooked is that the underlying property must qualify for depreciation or amortization. This means the property must be used in a trade or business or held for the production of income as required under Section 167(a) of the tax code. This business use requirement becomes particularly important when analyzing how these credits interact with passive activity limitations.
What Are the Passive Activity Limitations Under Section 469?
Section 469 imposes limitations on passive activity losses and credits. Congress enacted these rules to prevent taxpayers from using losses and credits from passive business activities to offset income from wages, active businesses, or portfolio investments.
Under Section 469, a passive activity is any activity that involves the conduct of a trade or business in which the taxpayer does not “materially participate.” For individual taxpayers, Section 469(a) disallows the passive activity credit for the taxable year, which includes credits from passive activities that would otherwise be allowable under Subpart B or Subpart D of Part IV of Subchapter A.
The definition of passive activity credit in Section 469(d)(2) refers to “the amount (if any) by which the sum of the credits for the taxable year from all passive activities allowable under subpart B (other than section 27(a)) or D of part IV of subchapter A exceeds the regular tax liability of the taxpayer for the taxable year allocable to all passive activities.”
Can Section 48 Energy Credits Escape the Passive Activity Rules?
One of the central arguments made by the taxpayers in this court case was that Section 48 credits should not be subject to passive activity limitations. The argument was that because Section 48 appears in Subpart E of Part IV of Subchapter A, not in the Subparts B or D specifically mentioned in Section 469(d)(2).
The U.S. Tax Court rejected this argument, explaining that while Section 48 determines the energy credit amount, it does not itself allow any credit. Rather, the amount determined under Section 48 is included in the amounts under Section 46, and thus Section 38, and is allowable only under Section 38. Because Section 38 is in Subpart D of Part IV of Subchapter A, the Section 48 energy credit is a credit allowable under that subpart, and therefore potentially a passive activity credit.
This interpretation aligns with previous tax court decisions which confirmed that Section 469 applies to Section 48 credits. The court emphasized that the statutory text is clear, regardless of the taxpayers’ arguments about congressional intent.
Does Business Ownership Through Partnerships Create a Passive Activity Trap?
The taxpayers in this case also argued, based on Revenue Ruling 2010-16, that their minimal involvement with the LLC meant they were not conducting a trade or business, so the passive activity rules shouldn’t apply. This argument created a paradox.
To qualify for Section 48 credits, the energy property must be used in a trade or business (to be eligible for depreciation). However, once it’s established that there is a trade or business, Section 469 applies and requires material participation to avoid passive activity treatment of the credits.
The U.S. Tax Court clarified that for purposes of Section 469, a taxpayer’s activities include those conducted through partnerships. Therefore, if the LLC engaged in a trade or business necessary for the Section 48 credit to be valid, the taxpayers would be treated as engaged in that business for Section 469 purposes as well, regardless of their minimal personal involvement.
The court held that despite the taxpayers’ minimal involvement, they were still treated as participating in the business activity of the LLC – just not materially participating, which is what led to the passive activity credit limitation.
What Level of Participation Is Required to Access Energy Credits?
The taxpayers’ involvement with the LLC in this case was minimal – merely signing documents and making payments. The tax court found that this fell far short of the material participation standards.
The material participation rules are found in Section 469 and are clarified in Treasury Regulation §1.469-5T. The code and regulations say that material participation requires regular, continuous, and substantial involvement in operations. The code and treasury regulations provide several tests to establish material participation, with the most straightforward being participation for more than 500 hours during the year. Other tests include participation for more than 100 hours when no other individual participates more.
This creates a fundamental tension in renewable energy investments. Many investors choose these projects because they don’t require active management – the passive nature is marketed as a benefit. Yet this same passivity can become a significant tax disadvantage if the investor has no passive income against which to apply the credits. This is where tax planning is often needed to help ensure that the intended tax benefits are realized.
The Takeaway
This case clarifies that qualifying for Section 48 energy credits isn’t enough. Investors also have to satisfy the passive activity rules to actually use the tax credits. For renewable energy investments to deliver their promised tax benefits, investors must either materially participate in business operations or have sufficient passive income from other sources to use up the passive credits. Failing to address both sides of this equation may result in disallowed tax credits and substantial penalties, as in this case.