Transferability rules offer new pathways for governments and tax exempts; limit pool of tax credit purchasers

By Taylor Cranor, Michael Kaercher, and Kyle Sweeney

Treasury and the IRS issued final regulations this week providing the rules for selling clean energy tax credits under section 6418, which will give further certainty to filers planning and implementing clean energy projects. The rules largely finalize the proposed rules that were issued in June of 2023, with limited changes.

We will continue to review this final rule and look for any surprises. In the meantime, we flag two rules of note.

Our first flag relates to who can buy clean energy credits in the transfer markets. As a reminder, the IRA allows entities undertaking clean energy projects to transfer (i.e., sell) the tax credits for the projects to other entities looking to reduce their tax liability, creating transfer markets for the credits. Consistent with the proposed regulations, the final rules apply the “passive activity” rules under section 469 so that individuals and small corporations cannot participate in the transfer markets unless they have “passive” income (i.e., income from business investments in which they have little involvement) to soak up the credits.

As we explained in our monetization comment, Congress enacted section 469 to discourage taxpayers from investing in wasteful ventures that produce economic losses for the purpose of generating tax savings. Section 469 addresses this concern by putting income, credits, and losses into two buckets — a passive bucket and a non-passive bucket. Tax credits and losses flowing from a “passive activity” can only be used against income from passive activities, i.e. activities that (1) involve the conduct of a trade or business, and (2) in which the taxpayer does not “materially participate.” On the other hand, tax credits and losses flowing from a non-passive activity, i.e. a trade or business in which the taxpayer materially participates, can be claimed against their active income. Section 469 applies only to individuals, estates, trusts, closely held C corporations, and personal service corporations, meaning widely-held corporations are exempt from these rules.

Importantly, individual and small corporate taxpayers generate passive income in only limited instances, and most do not generate any. For example, an individual taxpayer might generate passive income as a limited partner in a partnership, where they invest in the partnership and earn income from their investment without materially participating in running the business. Section 469 also specifies that income from rental property is passive per se (unless the taxpayer is in the business of real estate). Otherwise, individuals and small corporations typically only generate active income, meaning they typically cannot use credits that are considered “passive” to reduce their federal taxes.

To illustrate the application of these rules, consider the following taxpayers who may want to purchase tax credits in the transferability markets:

• Taxpayer A, an individual taxpayer, has a $10,000 federal income tax liability from wages and does not have any passive income. Though Taxpayer A can technically purchase credits in the transfer markets, they cannot use those credits because (1) individuals and small corporations are subject to the passive activity limitations, and (2) they do not have any passive income to offset.
• Taxpayer B, a high-income individual taxpayer, has a mix of wage income and passive income. They have a $2 million federal income tax liability, half of which is attributable to wages and the other half to passive activities. Taxpayer B can purchase and use up to $1 million of clean energy tax credits to offset their entire passive activity income tax liability.
• Taxpayer C, a large corporation, has a $100 million federal income tax liability. Because widely-held corporations are not subject to the passive activity limitations under section 469, this corporation can generally purchase credits and offset its entire federal income tax liability (though they may be subject to other limitations, e.g., corporate minimum tax, etc.).

Though Treasury and the IRS could have taken a less restrictive approach to the application of these rules, the selected approach is not unreasonable. It does, however, potentially increase the stakes of other monetization rules. A restrictive approach to the passive activity rules means that, without individual and small corporate taxpayers participating in the transfer markets, there is increased risk that those markets could dry up during economic downturns when large banks and other corporate taxpayers do not have tax capacity to purchase and use credits, limiting monetization options for clean energy credits. Treasury and the IRS should take into account these risks when making decisions on other topics that will influence the thickness of markets, including potentially allowing “chaining” in appropriate circumstances (you can read more about chaining in our previous blog post).

Our second flag on these regulations relates to tax-exempts, governmental entities, rural coops, and other applicable entities claiming production tax credits through direct pay. The final transferability rules make clear that a partnership made up of one or more applicable entities can elect to transfer (i.e., sell) tax credits. This means that when a partnership structure is used, the domestic content phaseout rule for applicable entities claiming direct pay may not apply. This is key, because it provides a pathway for governmental and tax-exempt entities to monetize certain tax credits even if the project does not meet the domestic content requirements.

The domestic content phaseout rule for applicable entities currently reduces (and, starting in 2026, eliminates) direct pay for generation and storage credits if the domestic content requirements are not satisfied unless a statutory exception applies. However, this rule does not apply to credits that are sold in the transfer markets. The final transferability regulations clarify that when one or more applicable entities (e.g., governmental and tax-exempt entities) enter into a partnership, the credits earned through that partnership are not eligible for direct pay, but they are potentially eligible for transferability.

Consider the following example. Two tax-exempt entities partner together to develop a 5MW community solar project in 2028. The entities intend to generate and claim a production tax credit under section 45Y, but they do not meet the domestic content requirements or qualify for a domestic content exception. These entities have at least two structing options:

• Adopt a joint ownership structure where each entity owns a share of the property. These entities will each be eligible for direct pay, but the direct pay amount will be $0 because the project does not meet the domestic content requirements, and a domestic content exception is not available.
• Form a tax partnership and elect transferability. The partnership can sell the credit to a widely-held corporation or a taxpayer with passive income. The domestic content phaseout rule will not apply because the credit is being monetized under the transferability rules (not the direct pay rules), and so the partnership will be eligible to receive the proceeds from the sale of this credit even though domestic content is not used.

Importantly, a tax partnership may only be attractive for applicable entities seeking the production tax credit. A partnership in this scenario would not be an attractive structure for investment tax credit (ITC) projects, because the tax-exempt or governmental entity’s allocable share of the credit would be disallowed due to section 50(b)(3) and (4). The section 50(b)(3) and (4) rules apply to ITC generation credits, energy storage credits, and others.

Treasury should continue to monitor credit transfer market thickness and pricing and provide more flexible monetization rules (e.g., chaining) if necessary to ensure robust demand for IRA tax credits, especially during recessions. In the meantime, we look forward to analyzing forthcoming guidance on other implementation decisions, including proposed guidance on tax credits that depend on emissions analysis (e.g., the technology neutral credit regimes), finalization or update of other key regulations (e.g., the clean hydrogen regulations), and other Phase 3 guidance.

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