Summary

On March 5, 2024, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued a notice of proposed rulemaking (the Proposed Regulations) and final regulations (the Final Regulations) regarding the elective payments of credits (Direct Pay) under Sections 761 and 6417, respectively, of the Internal Revenue Code of 1986, as amended (the Code) pursuant to changes authorized by the Inflation Reduction Act of 2022 (IRA). The IRS also updated its Frequently Asked Questions on Direct Pay in light of the updated guidance. The Proposed Regulations and Final Regulations will have a significant impact on existing and future tax credit transactions relating to investments in renewable energy projects.

This alert contains key takeaways, an overview of Direct Pay, and a discussion of the differences between the previously proposed regulations under Section 6417 (discussed here) and the Final Regulations.

Key Takeaways

The Proposed Regulations modifying Section 761 would:

• allow for unincorporated organizations that include applicable entities to co-own certain renewable energy projects and utilize Direct Pay, as long as certain requirements are met (discussed herein). This approach would, for example, allow for municipalities to pool resources and jointly develop renewable energy projects despite partnerships generally being ineligible to utilize Direct Pay; and
• modify certain joint marketing restrictions so that multi-year power purchase agreements (PPAs) would not violate the requirements of an organization to elect out of Subchapter K partnership tax treatment.

The Final Regulations update the previously released Section 6417 proposed regulations. The Final Regulations:

• adopt the proposed regulations’ restrictions regarding “chaining” transactions, confirming that such transactions will not be allowed, while issuing Notice 2024-27, requesting comments for when chaining transactions would be appropriate; additionally, confirms that in general, subject to the Proposed Regulations discussed above, partnerships are not permitted to take Direct Pay elections;
• confirm that applicable entities must own the applicable credit property;
• do not, however, directly address domestic content issues. Applicable entities must comply with domestic content requirements in order to avoid a penalty to the Direct Pay amount; clarifications regarding domestic content will be issued in forthcoming regulations;
• clarify annual tax filing requirements for applicable entities and taxpayers making Direct Pay elections, and provide guidance on making and correcting Direct Pay elections;
• provide updated definitions for applicable entities and applicable credit properties; and
• clarify the application of restrictions on tax-exempt grant amounts used to secure investment-related credit property, and the application of double benefit denial rules under Section 6417(e).

Overview of the Elective Payment Regime

Direct Pay Generally. The IRA created two major credit monetization regimes—the “transferability” regime and the Direct Pay regime—to incentivize taxpayers to pursue renewable energy ventures. Direct Pay allows an “applicable entity”¹ to elect to have the value of an applicable tax credit paid directly to them by the IRS. Congress originally intended for Direct Pay to allow tax-exempt and governmental entities to monetize the value of these tax credits directly, and to bolster specific industries. For-profit companies and certain entities may only use Direct Pay for three credits: 45Q (carbon sequestration), 45V (hydrogen production), and 45X (advanced manufacturing production). Under the prior proposed regulations, partnership entities were treated as ineligible for Direct Pay, regardless of whether any of its partners is an applicable entity. Notwithstanding this, previous Treasury and IRS guidance clarified that an applicable entity may engage with for-profit partners in ownership arrangements that have properly elected out of Subchapter K and make a Direct Pay election with respect to its share of the applicable credits. The Proposed Regulations broaden this exception, as discussed below.

Direct Pay Elections for Partnerships Under the Proposed Regulations

• New Requirements for Direct Pay Elections. The Proposed Regulations would modify Treas. Reg. 1.761-2(a)(3) by introducing an exception for joint ownership arrangements involving unincorporated organizations, allowing such organizations to elect out of Subchapter K partnership tax status and thus access the Direct Pay regime. To qualify under this new exception, an unincorporated organization must meet the following four requirements: 1) the organization must be owned (wholly or in part) by at least one applicable entity; 2) the organization’s members must enter into a joint operating agreement with respect to the credit property in which the members reserve the right separately to either take in kind or dispose of their pro rata shares of the electricity produced, extracted, or used, or any associated renewable energy credits; 3) pursuant to the joint operating agreement, the organization must be organized exclusively to jointly produce electricity from its applicable credit property and for which one or more of the applicable credits listed in Section 6417 is determined; and 4) one or more of applicable entities will make a Direct Pay election under Section 6417(a) for the credits determined by its share of that credit property. The third requirement may be satisfied prior to the applicable credit property being placed in service if necessary, provided that the organization is in the process of completing the credit property and will operate that property once it is placed into service. The Proposed Regulations provide an illustrative example, wherein an Indian tribal government (an applicable entity) and another entity own applicable credit property through an LLC organized under tribal law. This LLC can make an election to be excluded from Subchapter K under section 761(a), and therefore the Indian tribal government (the applicable entity) can make a Direct Pay election for the applicable credits determined with respect to its share of the applicable credit property owned by the LLC, assuming all of the other requirements are met.
• Modification of Co-ownership. The Proposed Regulations would modify the co-ownership requirement in Treas. Reg. 1.761-2(a)(3)(i) to allow members in an unincorporated organization to own the applicable credit property through an organization that is an entity (other than an entity treated as a corporation under the Code). Under the current regulations, the co-ownership requirements are only met when interests in property of an electing unincorporated organization are owned directly by its members, rather than indirectly through ownership of interests in an entity that would otherwise be treated as a partnership under Section 7701 and Treas. Reg. 301.7701-3. The Proposed Regulations would thus allow for applicable entities to invest in renewable energy projects through an entity, which should allow for more manageable financing investments and contract negotiations.
• Modification of Joint Marketing. The Proposed Regulations would modify the joint marketing rule in Treas. Reg. 1.761-2(a)(3), which generally does not allow for members of an unincorporated organization opting out of Subchapter K to delegate authority to sell property on their behalf for periods not longer than as minimally required by the industry and in no case for more than one year. The modification would allow a delegee on behalf of a participant to enter into a PPA to sell electricity generated by the participant’s share of the applicable credit property with a term greater than one year, so long as the delegation of authority to enter into such a PPA on behalf of the participant is no longer than one year.
• Applicability Dates. The proposed applicability dates for the for elections under Section 761(a) for exclusion from Subchapter K treatment would apply to tax years ending on or after the date the Proposed Regulations are published in the Federal Register.
• Modernization of Code References. In addition to the above, the Proposed Regulations would also update certain references to Treas. Reg. 1.6031-1 and internal revenue officers.

Following these Proposed Regulations, Treasury and the IRS request comments regarding:

• revocation procedures under Treas. Reg. 1.761-2(b)(3) and further considerations under Section 761(a);
• the scope and requirements of the Proposed Regulations, including whether similar exceptions are necessary for applicable entities that own applicable credit properties that do not produce electricity;
• the number of entities affected and the impact the Proposed Regulations may have on small entities; and
• considerations on how to prevent abuse under the new election rules.

Updates in the Final Regulations for Section 6417

Annual Tax Filings for Direct Pay Elections. Final Regulation 1.6417-1(b) is updated to clarify the required annual tax filings to include IRS Form 1040 for individuals; IRS Form 1120 for corporations, certain rural electric cooperatives, and certain agencies and instrumentalities; IRS Form 1120-S for S corporations; IRS Form 1065 for partnerships; and IRS Form 990-T for organizations subject to tax under Section 511 of the Code or proxy tax under Section 6033(e) or that are required to file IRS Form 990 pursuant to Section 6033(a). Short year taxpayers are defined as filing a tax return for a taxable year that is less than 12 calendar months. This modification confirms that IRS Form 1120 can be used to make the Direct Pay election.

Applicable Entity Definitions. Final Regulation 1.6417-1(c)(6) now explicitly includes a reference to Section 1381(a)(2)(C) of the Code in reference to corporations operating on a cooperative basis that are engaged in furnishing electric energy to persons in rural areas. In other words, rural electric co-ops that are for-profit are considered applicable entities.

Applicable Credit Property. Final Regulation 1.6417-1(f) clarifies the definition of disregarded entities to mean an entity that is disregarded as separate from its owner for federal income tax purposes under Regulations 301.7701-1 through 301.7701-3. This definition includes a Tribal corporation incorporated under Section 17 of the Indian Reorganization Act of 1934, as amended, or under Section 3 of the Oklahoma Indian Welfare act, as amended, that is not recognized as a separate entity from the tribe for federal tax purposes. In addition, Indian Tribal governments mean a recognized governing body of any Indian or Alaska Native Tribe, band, nation, pueblo, village, community, component band, or component reservation individually identified in the most recent publication of the Federally Recognized Indian Tribe List produced by the Department of the Interior. An Indian Tribal government must be recognized and individually listed prior to the date on which a relevant Direct Pay election is made.

Rules for Making and Correcting Direct Pay Elections. Final Regulation 1.6417-2(b)(1)(ii) provides that an election must be made on an original return, including revisions on a superseding return. No Direct Pay election may be made for the first time on an amended return, withdrawn on an amended return, or made or withdrawn through an administrative adjustment under Section 6227. A numerical error with respect to properly claimed Direct Pay may be corrected through amendment or adjustment if necessary; however, the applicable entity or electing taxpayer’s original return must contain all of the information required by the Final Regulations and signed under penalties of perjury. To correct an error on an amended return or through administrative adjustment, an applicable entity or electing taxpayer must have made an error in the information included on the original return such that there is a substantive item to correct—a blank item or an item described as “available upon request” may not be corrected. Therefore, applicable entities and electing taxpayers should ensure that their original returns are complete. Relief may be available under Treas. Reg. 301.9100-2(b) if the applicable entity or electing taxpayer has not received an extension of time to file a return after its original due date, such return has been filed timely, where corrective action under Treas. Reg. 301.9100-2(c) has been taken within the six-month extension period and meets the procedural requirements under Treas. Reg. 301.9100-2(d).

Pre-filing Registration Requirements. Final Regulation 1.6417-2(b)(2) clarifies that an applicable entity or elective taxpayer must provide the pre-filing registration number for each applicable credit property on its Form 3800, and on any required or completed source forms with respect to applicable credit property, attached to the tax return.

Taxpayers Where No Federal Income Tax Return Is Required. Final Regulation 1.6417-2(b)(3)(i) provides that an applicable entity that is not required to file a federal income tax return pursuant to Sections 6011 or 6033(a) of the Code but is filing solely to make a Direct Pay election may choose whether to file its first return based on a calendar or fiscal year, provided that adequate books and records are maintained to support such an election. This resolved an important issue for entities that had placed assets in service in 2023 but during their 2022 fiscal year, which began prior to December 31, 2022, and thus could have been viewed as ineligible.

No Excess Benefit from Restricted Tax-Exempt Amounts. Final Regulation 1.6417-2(c)(3)(ii) provides modified rules for applicable entities which receive a grant, forgivable loan, or other income exempt or otherwise excluded from taxation for the specific purpose of purchasing, constructing, reconstructing, erecting, or acquiring an investment-related credit property. First, the general rule is that applicable entities and electing taxpayers may not “stack” Direct Pay and funds from sources such as federal grants and loans in an amount that exceeds the total cost of the underlying asset—that is, if one receives a federal grant that covers 100 percent of, for example, a school bus, one cannot elect Direct Pay on that same bus as it was fully subsidized by the grant source. Doing so would result in the applicable entity receiving over 100 percent reimbursement for the cost of the vehicle. Instead, in general, applicable entities must reduce either the amount of the grant or Direct Pay amount to ensure there is no “double dipping.” The Final Regulations clarify that the determination of whether a tax-exempt grant is made for such purpose is made at the time the grant is awarded to the applicable entity. A tax-exempt grant awarded after the investment-related credit property is purchased, constructed, erected, or otherwise acquired, will generally not be deemed restricted unless approval of the grant was a precondition and the amount the amount of the grant was virtually assured at the time of the application. The determination of whether a loan (and its subsequent forgiveness) is made for the specific purpose or purchasing, constructing, erecting, or otherwise acquiring investment-related credit property is made at the time the loan is approved. However, this does not apply if a tax-exempt amount is not received for such specific purposes, as listed above.

Application of the Denial of Double Benefits. Final Regulation 1.6417-2(e) provides modified steps for an applicable entity or electing taxpayer (other than a partnership or S corporation) making a Direct Pay election under Section 6417(e). Where an applicable entity makes an election under Section 6417(e) with respect to an applicable credit, that credit is reduced to zero—eliminating the applicable entity from receiving a double credit benefit. The full amount of the applicable credits for which a Direct Pay election is made is deemed to have been allowed for all other purposes, including basis reduction and recapture under Section 50 of the Code, and calculation of tax, calculation of the amount of any underpayment of estimated tax under Sections 6654 and 6655 of the Code, and the addition to tax for the failure to pay under Section 6651(a)(2), if applicable.

• First, taxpayers should compute any federal income tax liability for the taxable year, without accounting for general business credits (GBC) under Section 38 of the Code, payable on the due date of the return (disregarding extensions), and the amount of the federal income tax liability that may be offset by GBCs pursuant to Section 38 of the Code.
• Second, taxpayers should calculate the allowable GBC carryforwards to the taxable year plus current year GBCs.
• Third, net Direct Pay payments should be calculated for all applicable credits, which should equal the lesser of the sum of all applicable credits for which a Direct Pay election is made or the excess of the total GBC credits over the amount of the federal income tax liability that may be offset by GBCs pursuant to Section 38 of the Code.
• Fourth, excluding the net Direct Pay amount, but including any applicable credits not otherwise part of the net Direct Pay amount, a taxpayer should compute the allowed amount of GBC carryforwards carried to the current taxable year plus the amount of current GBCs allowed for the taxable year and apply these GBCs against the tax liability that was previously calculated.
• Fifth, the final step is to reduce the applicable credits by the net Direct Pay amount and by the amount allowed as a GBC.

[1] Section 6417(d)(1) defines an “applicable entity” as certain tax-exempt organizations, state and local governments, Indian tribal governments, Alaska Native Corporations, the Tennessee Valley Authority, and rural electric cooperatives.