Passive Activity for Tax Equity

Mid-Size CFO: Monetize Your Tax Bill

Companies paying over $200,000 in income tax can turn their tax bill into a profitable short-term investment by becoming a “Tax Equity Investor” in a solar project. Large companies, like Google, have long been able to make tax credit investments. Meanwhile, mid-size companies were kept out because the deal exceeded their tax appetite. Now, that has changed thanks to the proliferation of firms developing tax-advantaged solar projects which demand corporate Tax Equity Investors of all sizes. The trick is figuring out if your company is an eligible investor, and if so, which solar projects are good investments. Below are a few important guidelines.

A. Corporate Tax Equity Investing In A Nutshell

A race is afoot to install solar on as much flat commercial roof space as possible using a financing mechanism called a Power Purchase Agreement (PPA). In a PPA, developers install solar on a building’s rooftop at no cost to the building owner. The building owner, in turn, agrees to pay the developer for all the solar electricity generated over the next 20 years. In other words, the solar developer becomes a utility company. It owns the generating assets and gets repaid over time for the sale of energy. In addition, as the system owner, the solar developer is entitled to take all the tax incentives offered to people who go solar.

When you install a solar electricity system on a commercial rooftop, over 50% of the installation cost is repaid immediately through federal tax incentives. Unfortunately, many solar project developers lack the tax appetite to utilize those tax incentives. As a result, they form a joint venture with a company that has a large enough tax bill to use the tax credits.

The way the joint venture works is the corporate partner buys an ownership stake in the solar project for an amount equivalent to the after tax value of the tax incentives, hence the name Tax Equity Investor. In return the Tax Equity Investor receives essentially all the tax credits and deductions given to the solar system, plus a share of the project cash flows. The Tax Equity Investor can expect returns between 12% to 15% over 5 years, with a 100% return of capital in the first year via tax bill reductions.

B. Which Companies Are Eligible Tax Investors?

The IRS limits which businesses can be Tax Equity Investors through the “Passive Activity Limitations.” (PAL) (See Instructions for Form 8810, and IRS Publication 925). If PAL applies, it may limit the amount of tax credits and deductions the Tax Equity Investor could take in a single year, thus diminishing the investment’s rate of return. The PAL rules apply differently based on the taxpayer’s entity type. Individuals and Pass-Through Entities are subject to the full force of PAL. Closely Held C-Corps face a watered-down version of PAL. Widely-held C-Corps are not subject to it.

 

1. Primer: What Is A Passive Activity?

A Passive Activity is any business for which the taxpayer claims a deduction but the taxpayer does not “materially participate” in the business. Naturally, the IRS test for “material participation” is complex but as a good rule of thumb it requires engaging in over 500 hours of day-to-day management of the business over the year. (See IRS §465(c)(7)(C) for further exceptions.) Tax Equity Investors traditionally do not materially participate in the day-to-day management of the solar project, therefore it may count as a Passive Activity. In that case, the Passive Activity Limitations may apply. The rules work differently based on the business’ entity type. The following sections walk-through how PAL works for each type of entity.

 

2. Pass-Through Entities (S-Corp, LLC, Partnerships, etc.)

As a LLC, Partnership, S-Corp, your business taxable gain or loss is passed through to the owners’ personal income tax return. Therefore, the PAL rules applying to individuals governs your business investment as well. For individuals, the crux of the Passive Activity Limitation says losses from passive activities can only be deducted against taxable income generated by passive activities. (IRS Pub. 925 pg 2). In other words: you cannot deduct losses generated by passive activities against income generated from non-passive business activities, such as the salary from your job. If you do not have sufficient passive income to offset the entire deduction, you carry the remaining deduction forward to offset against future passive income or until you sell your interest in the activity.

To illustrate how this works let’s walk through an example using a law firm set up as an LLP (also a pass-through entity). Bear in mind – the money made from core business activities is considered non-passive income. For the law firm the income generated by providing legal services will be non-passive income to the law firm partners (assuming they practice in the firm). In contrast, if the law firm also rents out an old building that rental income will be passive income. PAL says the law firm owners cannot use deductions from the rental business to offset income generated by the law firm’s legal services. Also note that any money made from investing in public stocks or bonds does not count as Passive Income. The IRS refers to that as Portfolio Income, and says it is not included in the calculation of Passive Income.

 

3. Closely Held C-Corporations

The Passive Activity rules impose less of a limitation on Closely Held C-Corps. A closely held corporation can deduct passive activity losses against all active income except portfolio income. The IRS provides the following definition: “Closely held corporation. A corporation is a closely held corporation if at any time during the last half of the tax year more than 50% in value of its outstanding stock is directly or indirectly owned, by or for not more than five individuals, and the corporation is not a personal service corporation.” Instructions for Form 8810 (2011) pg 1.

Typically, Closely-Held C-Corporations investing in solar projects will not be hindered by PAL because they earn the bulk of their taxable income through core activities, not portfolio income. Even if the solar tax equity investment is deemed a passive activity, the closely-held corporation can use the solar tax incentives to offset the core taxable income. Only income earned from stocks, bonds, and other similar “Portfolio Income” will be restricted from offset by PAL. For most companies, this means PAL will not diminish the tax equity investment returns.

 

4. Widely Held Corporations

Any widely held corporation is free to invest in solar projects without fear of limitation by the Passive Activity rules. The Passive Activity Limitation is expressly limited to Individuals, Pass-Through Entities, and Closely Held Corporations. The IRS does not provide a definition of “Widely Held Corporation.” However, by PAL’s definition, any for profit C-Corp that does meet the Closely Held Corporation definition is not subject to the rule’s restrictions.

C. Risks To Solar Tax Equity Investments

In working with Tax Equity Investors and running our own investment fund, SolRiver Capital, the discussion usually begins by asking “What are the risks?” The answer depends on how the deal is structured (see our Solar Due Diligence Guide on what to look for). However, one risk is common to all deals: Recapture Risk. Below is a quick explanation of what this is, and a few notes on how to evaluate its impact.

The IRS requires the solar system remain in use for 5 years, otherwise a pro-rata amount of the tax credit may be recaptured. (See Instructions for Form 3468 pg 1.) For example, if the tax credit was $100,000, and the solar system was permanently taken out of service in year 4, then $20,000 (plus fees) must be paid back to the IRS. If the same system was taken out of service in year 6, then no money would be owed to the IRS because the recapture period had expired.

In most scenarios, the recapture risk is minimal with rooftop solar systems. Underwriting will identify buildings that can stay in operation for at least 5 years through the recapture period. However, if a customer goes into default, the solar system can stay on the roof. Often foreclosing banks or new building owners continue to use the solar power. Even if they do not, the power can often be sold back to the utility instead of the customer. In the eyes of the IRS, that satisfies the continued operation requirements meaning no recapture is required.

 

About The Author

Brandon Conard is the Director of Zenergy, providing energy finance advisory services to developers and investors. He has more than 16 years of legal and energy experience, with expertise in raising tax equity, early stage project development, commercial energy analysis, solar fund structuring, and project finance. Previously, he was Chief Strategy Officer/VP Structured Finance at HelioPower, CEO of Greenzu, and Director of BlueMap. As former Weil, Gotshal, & Manges attorney, Mr. Conard also understands the changing energy, tax, securities, construction, and environmental hurdles every clean energy project must clear. He’d love feedback on this article. Send it to info@zenergy.com.