On December 17, the Treasury Inspector General for Tax Administration released Review of Section 1603 Grants in Lieu of Energy Investment Tax Credit which is available here. Either there is some confusion associated with the report or the 1603 grant samples included in the study referenced in the report were unusual.

The summary of the report is:

The IRS is currently conducting a Compliance Initiative Project on taxpayers that received Section 1603 grants primarily in 2009. .  .  . The Large Business and International Division selected and examined 16 taxpayers and reportedly identified significant issues in eight.  Similarly, the Small Business/Self-Employed Division selected 83 taxpayers for examination and identified changes in 51.

The report does not tell us what these “changes” are, or if the taxpayer or the IRS appeals functions has agreed with them. 

Without any information about the “changes,” we have no idea of the validity or materiality of the changes. Further, in an audit of 1603 grant applications performed by the office of the Inspector General itself (as opposed to this Compliance Initiative Project performed by the IRS), the results of which were released in 2011, found very little in terms of shortcomings. Client Alert discussing that audit is available here. The apparent divergent results of the Inspector General’s own audit and the IRS Compliance Initiative Project would appear to be cause to proceed with caution in drawing any conclusions based on the results of the Compliance Initiative Project.

The report goes on to make a recommendation that seems misguided:

We recommend that the [IRS] evaluate the feasibility of establishing an indicator on taxpayer accounts that received [Section 1603 grants]. .  .  . This indicator would provide a permanent notice on the IRS files that the taxpayer has received a Section 1603 grant and therefore caution should be taken in processing any amended returns that claim an investment tax credit.

Such an indicator would result in many “false positives.” For example, a taxpayer may claim a 1603 grant for one project and an investment tax credit (ITC) on another project. The taxpayer may even claim a 1603 grant one phase of a project and an ITC on another phase.¹ Thus, merely the same taxpayer claiming a 1603 grant and an ITC, on different properties, could become relatively common, and the IRS would be chasing shadows if it used that as an audit indicator.

Finally, the report provides, “Anecdotes from the IRS staff attending industry and practitioners’ discussions suggest that some practitioners are encouraging the use of leasing transactions because that allows fair market value to be overstated to increase the grant amount.” I think the IRS may be misunderstanding discussions of pass-through and inverted leases.²

In a pass-through or an inverted lease, the lessee (i.e., a party who does not acquire ownership of the asset) is entitled to an ITC (or as applicable as a 1603 grant) based on the asset’s “fair market value.” Thus, there is an apparent element of windfall in that the ITC/grant basis³ is stepped up to fair market value without anyone having to pay tax on the sale of the asset. However, the use of the fair market value, for calculating ITC or 1603 grant amounts, that was not paid by any party in a lease transaction is sanctioned by Congress is section 50(d)(5) of the Internal Revenue Code, which cross-references to old section 48(d), which was repealed by Congress but effectively reinstated by the cross-reference. Old section 48(d) provided: “A person . . . who is a lessor of property may elect with respect to any new [investment tax credit eligible] property to treat the lessee as having acquired such property for an amount equal to . . . the fair market value of such property” (emphasis added).  Therefore, using a notional fair market value to determine the ITC or grant basis is fully consistent with the statutory provision.

In this era of budgetary sequester with limited dollars for the IRS audit function, the IRS and the Inspector General should be sure they are not allocating valuable audit resources to address a purported problem that is actually a result of certain IRS staff misunderstanding practitioners’ references to archaic and highly technical statutory rules.