Analyzing the Tax Implications of Grants Received for Investment Tax Credit–Eligible Property

Credits Against Tax

The recent availability of grants in lieu of the production tax credit (Sec. 45) and the investment tax credit (Sec. 48) has become a well-documented source of funding for the installation of certain energy property. When structuring the financing for nonutility scale projects, taxpayers often claim the investment tax credit under Sec. 48 as well as additional grants from other federal and state programs, such as the USDA Rural Energy for America Program. The combination of tax credits, grants, and accelerated depreciation reduces out-of-pocket costs for such property and creates very attractive payback periods.

Taxability of Grants

Two recent items in The Tax Adviser discuss issues that arise in structuring the financing of such projects. Holets and Strong, “Treatment of Grants as Nonshareholder Contributions to Capital” (September 2009), p. 575, discuss the taxability of grants. Valentine, “Grants in Lieu of Business Energy Credits” (December 2009), p. 809, outlines the availability of grants in lieu of tax credits under Section 1603 of the American Recovery and Reinvestment Act of 2009, P.L. 111-5 (ARRA). These grants mirror the eligibility rules for the production tax credit and the investment tax credit, with some exceptions. For the purposes of this commentary, note that the use of the Sec. 48 investment tax credit will be addressed because, as of the writing of this item, ARRA Section 1603 grants have not been extended for projects commencing after 2010, and the ARRA Section 1603 grant rules were intended to follow the investment tax credit rules of Sec. 48.

When structuring the financing of renewable energy projects, practitioners are often faced with the question of whether federal and state grants must be recognized as taxable income. When a taxpayer receives a grant under ARRA Section 1603, Sec. 48(d)(3)(a) explicitly states that such grants are excluded from gross income. The only adjustment that the taxpayer must make is to reduce the depreciable basis of eligible property by one-half of the ARRA Section 1603 grant received. The same rule applies to the basis of property when the investment tax credit is received (Sec. 50(c)(3)(A)).

To determine whether grants received from other federal and state authorities are taxable, practitioners are left to the mechanics of Sec. 118, Regs. Sec. 1.118-1, and case law such as Chicago, Burlington & Quincy R.R. Co., 412 U.S. 401 (1973) (CB&Q). Most practitioners will likely try to fall under the five-part test put forward in the CB&Q opinion in order to avoid the taxability of grants. However, a careful analysis of non–ARRA Section 1603 grants, the method of computing the investment tax credit, and the reduction of depreciable basis caused by both non–ARRA Section 1603 and the investment tax credit may reveal that substantial savings can be realized if non–ARRA Section 1603 grants are recognized as income.

Under Sec. 48, the basis for computing the amount of energy property cost that is eligible for a credit is the property’s original cost. If a corporation receives a grant and the grant is treated as a nonshareholder contribution to capital under Sec. 118 and CB&Q, Sec. 362(c) assigns no basis to the cost of the property that was acquired with the grant proceeds. As a result, the corporation is required to reduce the basis of the property for the purpose of computing the investment tax credit and depreciable basis. The advantage of reducing basis is obvious: The corporation avoids taxable income on the grant. However, by reducing basis, the taxpayer could cause highly unintended consequences through the reduction of the allowable tax credit and lower depreciation write-offs. The lower benefits will require a higher capital commitment to the project and may result in the project not meeting the taxpayer’s return on investment requirements.

The effect of reducing basis for a grant received versus recognizing a grant as income is best illustrated through an example.

Example: A, an S corporation, is installing a qualifying wind turbine project at a cost of $500,000 to supply electricity to its existing business. The project meets the requirements for a 30% investment tax credit. Individual B is the 100% owner of A. B’s combined marginal tax rate for federal and state tax is 42%, and B expects to remain in this bracket going forward. A will receive a $200,000 grant from the state for the completion of the project.

Scenario 1: A seeks to fall under the CB&Q requirements and consider the state grant received to be a nonshareholder contribution to capital, and thus not taxable. As a result, the basis for the purpose of computing the investment tax credit is $300,000 ($500,000 – $200,000), and the investment tax credit received is $90,000 ($300,000 × 30%). For depreciation purposes, the basis of the property is $255,000 [$500,000 – $200,000 – ($90,000 × 50%)]. The tax benefit of the allowable depreciation expense is $107,100 ($255,000 × 42%). When all these numbers are combined, the total out-of-pocket cost for the project is $102,900 ($500,000 – $200,000 – $90,000 – $107,100).

Scenario 2: A considers the $200,000 state grant to be taxable, which preserves a higher basis to compute the investment tax credit and depreciable basis. Basis for computing the investment tax credit is $500,000, which results in a tax credit received of $150,000 ($500,000 × 30%). The depreciable basis of the property is reduced by only one-half of the credit received, so depreciation is calculated on basis of $425,000 [$500,000 – ($150,000 × 50%)]. This results in a total tax benefit from depreciation of $178,500 ($425,000 × 42%). The tax that A must pay on the state grant received is $84,000 ($200,000 × 42%). The total of these numbers results in out-of-pocket cost for the project of $55,500 ($500,000 – $200,000 – $150,000 – $178,500 + $84,000).

Under Scenario 2, B will save out-of-pocket costs of $47,400 by simply recognizing the state grant as income and not triggering the basis reduction provisions of Sec. 362(c) and Regs. Sec. 1.362-2. Both the increased tax credit and depreciable basis generate such savings. An argument could be made that the advantages of not paying tax today outweigh the increased tax savings over the depreciable life of the project, but an annual rate of return of 16.53% and steady tax rates would be required to equalize these scenarios. Rising tax rates will increase the annual rate of return required, and with the expected rollback of the Bush tax cuts and recent passage of the Patient Protection and Affordable Care Act, P.L. 111-148, tax rates appear to be increasing for income taxed at the individual level.

Realizing a Tax Benefit

Careful consideration should be given to the taxpayer’s expected income tax rates for each year going forward. Energy property is eligible for MACRS five-year depreciation, so a large depreciation deduction may be realized, especially in the first few years of the project’s life. If the taxpayer can offset other taxable income with these deductions or can realize a net operating loss, the potential tax savings may be substantial, especially for high-bracket taxpayers. Although Sec. 118 is not elective, there are ways to plan around having a grant treated as a nontaxable contribution to capital. Therefore, the taxpayer and his or her advisers should carefully consider the terms of the grant at the outset and to whom the grant will be awarded. In addition, in any payback analysis, practitioners should be wary of various limitations under the Code that may affect the taxpayer’s ability to utilize the credits or deductions generated by investments in qualifying property. Potential limitations that could affect such an analysis are the impact of the alternative minimum tax, the passive loss rules, the general basis limitations, and the at-risk rules applicable to flowthrough entities, to name a few of the more common limitations taxpayers often bump into in their planning. All these areas can affect when a taxpayer may realize a tax benefit. Therefore, even though a taxpayer may be way ahead in the simple analysis provided above, when the time value of the tax benefit is factored in, the resulting answer may be that a bird in the hand is more valuable than two in the bush.

Under the right circumstances, there are significant planning opportunities for practitioners with clients engaging in projects that meet the requirements of the Sec. 48 investment tax credit. A thorough understanding of the mechanics of Secs. 48, 118, and 362 is essential, as are accurate forecasts of a taxpayer’s taxable income and tax rates. Once all the data are assembled, the practitioner should analyze them to determine the best possible structuring in order to maximize the tax benefits that are crucial to such projects.

Editor: Anthony S. Bakale, CPA, M. Tax.

EditorNotes

Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.

For additional information about these items, contact Mr. Bakale at (216) 579-1040 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.