Challenges Individuals face as Tax Equity Investors Flashcards
Why individuals can’t claim ITC or PTC to offset their taxes?
- Passive activity loss rules prohibit individuals from using tax credits and losses from passive investments to offset active income from other sources
- What this means is that passive losses can only be used to offest other passive losses making it hard to tap individuals as potential tax equity investors for solar and other renewable projects.
Passive Activity Loss Rules
- Passive loss rules have been around since 1986 and were enacted as a response to the tax shelters taxpayers created in the 80’s to shelter wages and investment portfolio income from taxes
- As a general matter, passive activity loss rules bar individuals from using depreciation, tax credit and interest (other than your interest created by your home mortage) to reduce taxes on salaries and investment income.
At Risk Rules
- Bar individuals from offseting income taxes by prohibiting individuals from:
1) deducting interest on non recourse loans
2) claiming depreciation deductions funded with non recourse debt
Passive Actvity Loss Rules + At Risk Rules
Between the passive loss limitations and the at-risk rules, it is challenging for an individual to be able to claim energy tax credits, depreciation or interest expense from investing in renewable energy projects
What qualifies as passive income against which passive losses can be offset?
- Active losses can only be used to offset active income.
- Passive losses can only be used to offset passive income. Passive losses cannot offset active income or portfolio income.
- There are two kinds of passive activities:
1) One is renting equipment or other property to others, including equipment leasing and real estate rentals.
2) The other is businesses in which the taxpayer does not materially participate.
The following types of income are considered active income:
salaries, wages, and independent contractor compensation, guaranteed payments, portfolio income (meaning interest, dividends, royalties, gains on stocks and bonds), sales of undeveloped land or other investment property, royalties and income from businesses in which the taxpayer materially participates.
What is “material participation,” and why does it matter?
An individual investor in a power plant would have to participate materially in the business in order to take advantage of tax credits and depreciation.
Material participation requires the individual to be involved in the operations of an activity on a regular, continuous and substantial basis. It is narrowly defined and time sensitive.
Material participation is based on time and not money. An investor can have a significant financial interest in a business, and yet not materially participate.
An investor must meet the narrow material participation definition in order to avoid the passive activity limitations on tax credits and depreciation. There are a number of ways an investor can prove he or she materially participates in a business.
The three most like to come into play are spend more than 500 hours working at the business, spend more time working at the business than any other individual (owner or employee), or spend more than 100 hours working at the business where no other individual (owner or employee) participates more.
Material participation is measured on an annual basis, so it is possible to meet one of these hurdles in one year, then fail the next. Participation by a spouse can be added to the individual’s hours, but participation by children or a significant other cannot. A spouse’s work counts even if the spouse is not a co-owner of the business.
Using a solar facility as an example, if an individual owner of the solar facility wanted to claim the investment tax, that individual would have to spend either more than 500 hours each year working in the solar business (and that’s a lot!), work more at the solar facility than any other owner or employee (so you better learn how to replace those broken panels), or work more than 100 hours with no one — not even part-time employees — working more (again, better learn how to replace broken solar panels)
The IRS Audit Guide encourages agents to review W-2 forms and other non-passive activities to see if it even seems likely that an individual could spend 500 hours on an activity in light of other obligations. It also directs agents to determine the location of each of the individual’s activities to determine if it is likely the individual could physically spend time at the site of the activity.
f you want to claim investment or production tax credits, get ready to do your own operation and maintenance and asset management. It does not count as material participation if the activity is supervised by another individual who is compensated for managing the business or if the paid manager spends more time managing the facility than you do.
Lum v. Commissioner (2012). US Tax Court ruled individuals couldn’t use tax credits from solar heater investments to offset income due to lack of material participation.
Factors:
Compensation for services?
Proximity to activity?
Other full-time job or significant time-consuming activities?
Presence of on-site manager?
Age/health issues affecting involvement?
Essentiality of claimed services to business operations?
Business continuity without individual’s services?
