On July 21, 2016, the IRS released temporary regulations section 1.50-1T under IRC Section 50(d)(5) of the Internal Revenue Code (the "Temporary Regulations") (TD 9776) that provide guidance regarding: (1) the income inclusion rules that are applicable to a lessee that receives a "pass-through" of the investment credit available under IRC Section 46 (including the IRC Section 48 energy credit and the IRC Section 47 rehabilitation credit); (2) the coordination of those income inclusion rules with the recapture rules under IRC Section 50(a); and (3) the election to accelerate such income inclusion upon a lease termination or a disposition, directly or indirectly, of one's entire interest in a lease. The IRS also issued proposed regulations section 1.50-1(a) through (f) which incorporate the text of the Temporary Regulations. Comments on the proposed regulations are due by October 20, 2016.
Gross Income Inclusion Under IRC Section 50(d)(5)
The Temporary Regulations provide that if a lessor of investment credit property elects to treat the lessee as having acquired the property, such that the lessee is entitled to claim an investment credit with respect to the property, the lessee is required to include in gross income an amount equal to 50 percent of the claimed IRC Section 48 energy credit (the "ITC") or, in the case of any other investment credit, 100 percent of the investment credit claimed. The amount required to be included in gross income is recognized over the shortest recovery period applicable to the investment credit property. Such income inclusion is in lieu of the basis adjustment required by IRC Section 50(c), which applies to owners of investment credit property claiming the investment credit.
Under the Temporary Regulations, if the lessee is a partnership or S corporation, the amount required to be included in gross income as a result of a pass-through of the investment credit will not be treated as an item of partnership income for purposes of subchapter K or an item of S corporation income for purposes of subchapter S. Instead, the "ultimate credit claimant" (i.e., the partner or S corporation shareholder that claims the investment credit on its tax return) is treated as the lessee with respect to its allocable portion of the investment credit and, as such, the "ultimate credit claimant" is required to include its allocable portion of the amount required to be included in gross income as a result of the pass-through of the investment credit. This ensures that the taxpayer receiving the benefit of the investment credit bears the burden of the income inclusion.
A result of requiring income inclusion by the "ultimate credit claimant" rather than the partnership or S corporation is that neither IRC Section 705(a) (providing for an increase in the partner's outside basis for items of income) nor IRC Section 1367(a) (providing for an increase in the S corporation shareholder's stock basis for items of income), as applicable, apply to the income inclusion required as a result of a pass-through of the investment credit. The IRS issued the Temporary Regulations in part because it was aware that some partnerships and S corporations were taking the position that this income is includible in outside basis, which the IRS views as inconsistent with the Congressional intent behind the income inclusion rules. This is because, as a result of the basis increase, these partners or S corporation shareholders were able to take a loss, or reduce the gain recognized, upon the disposition of their investment—an unintended benefit not available to any other credit claimant.
Coordination with the Recapture Rules Under IRC Section 50(a)
The Temporary Regulations further provide that upon recapture of an investment credit, an adjustment will be made to the lessee's (or, if applicable, the ultimate credit claimant's) gross income for any discrepancies between the total amount included in gross income for such lessee or ultimate credit claimant under the Temporary Regulations and the Lessee's (or ultimate credit claimant's) total investment credit allowable after recapture. Specifically, if 50 percent of the unrecaptured ITC (or 100 percent of any other unrecaptured investment credit) exceeds the amount previously included in gross income, the lessee's (or the ultimate credit claimant's) gross income will be increased by the amount of such excess. Conversely, if the amount previously included in gross income exceeds 50 percent of the unrecaptured ITC (or 100 percent of any other unrecaptured investment credit), the lessee's (or the ultimate credit claimant's) gross income will be decreased by the amount of such excess. The increase or decrease to gross income, as applicable, will be taken into account in the taxable year in which the recapture rules are triggered.
Election to Accelerate Income Inclusion
Lastly, under the Temporary Regulations, if after the recapture period, but before the expiration of the applicable recovery period, the lease terminates or the ultimate credit claimant, directly or indirectly, disposes of its entire interest in the lease, the lessee or ultimate credit claimant may irrevocably elect to include the remaining amount to be included in income, determined by the Temporary Regulations as described above, to be included in gross income in the taxable year of such termination or disposition.
The temporary regulations will apply to property placed in service on or after September 19, 2016, and are set to expire on or before July 19, 2019.