IRS holds investment transaction is sale of refined coal tax credits

By Michael Bernier, CPA, Boston

Editor: Michael Dell, CPA

In Technical Advice Memorandum (TAM) 201729020, the IRS concluded that investors in a partnership that operated refined coal production facilities were not entitled to deduct Sec. 45 refined coal tax credits because the investment transaction was structured solely to facilitate the purchase of the credits.


The taxpayer was a partnership that owned and operated two refined coal facilities. The taxpayer was owned by Operator, Investor 2, and Investor 1, which was owned by Operator and X, an LLC classified as an association. Under a 10-year site lease with an electric company, Operator, through the taxpayer, designed, engineered, developed, and constructed two refined coal facilities that used a proprietary coal-refining process. Operator licensed the technology from a licensor, making royalty payments to the licensor at a set rate per ton during the first three years of production. After the third year, the royalty payments increased to the greater of a certain price per ton or a certain percentage of the available Sec. 45 tax credits per ton. The license expired upon termination of the availability of Sec. 45 credits.

The taxpayer entered into a 10-year agreement to sell refined coal back to the electric company at a rate equal to a price per ton less than the rate at which the taxpayer purchased the unrefined (feedstock) coal under a separate feedstock coal supply agreement with the electric company.

X and Investor 2 purchased from Operator membership interests in Investor 1 and the taxpayer that were, in large part, reimbursements of their proportionate share of Operator's costs for constructing and installing the refined coal production facility. The taxpayer's operating agreement required each member to contribute its pro rata share of the taxpayer's ongoing operating expenses, regardless of whether the taxpayer's facility was in operation and producing refined coal. Members had no right to a return of their capital contributions, although a liquidated damages provision would compensate X for a portion of its initial capital contribution to Investor 1, but not for any ongoing contributions to cover the taxpayer's operating costs. The taxpayer allocated all items of income, gain, loss, deduction, and credit (including the Sec. 45 credit) pro rata among its members.

The taxpayer's operations did not achieve its production expectations, as the facilities were idle for significant periods until the taxpayer halted operations permanently in their fifth year. Nonetheless, the investors received tax benefits (tax credits, losses, and depreciation) that exceeded their capital contributions during those years. Additionally, Operator received amounts from the taxpayer under a sublicensing agreement for the use of the technology that exceeded the amount Operator paid the licensor. Both X and Investor 2 redeemed their interests in the taxpayer back to Operator, either through sale or receipt of liquidated damages, in the fifth year.

Law and conclusion

Sec. 45 allows for a tax credit for qualified refined coal produced at a qualifying refined coal production facility and sold to an unrelated person during the 10-year period after the facility is placed in service. This legislation was intended to incentivize taxpayers to produce refined coal, which significantly reduces harmful emissions during the production of steam by coal-burning utilities to generate electricity. While monetization of tax benefits is not prohibited, taxpayers may not sell federal tax benefits. In Historic Boardwalk Hall, LLC, 694 F.3d 425 (3d Cir. 2012), cert. denied, 133 S. Ct. 2734 (2013), the Third Circuit disallowed the tax credits to an investor who had no meaningful potential in the return from the partnership activity itself, only from the purported tax benefits from the activity.

In the present case, the IRS determined that the facts of the transaction demonstrated a plan to sell refined coal tax credits and other tax benefits, rather than a plan for X and Investor 2 to become producers of refined coal through an investment in the taxpayer. The IRS noted that the agreements guaranteed that the taxpayer would always incur additional financial losses even when the activity was producing refined coal and, thus, the investors' only possible incentive to make additional capital contributions was the prospect of claiming additional tax benefits.

As evidence for its conclusion, the IRS pointed to significant pretax profits to both Operator (through the substantial markup on its sublicense of the technology to the taxpayer) and the electric company (through site lease fees and a guaranteed profit on its sale of the feedstock coal for a higher price than its repurchase of the refined coal). However, the arrangement made it highly unlikely that X and Investor 2 would derive any financial benefit other than from the tax credits received. Further, the arrangement caused X and Investor 2 to suffer small losses of their initial capital contributions restricted to amounts dependent on the amount of tax credits produced, not to amounts attributable to the production of refined coal. Any additional contributions were limited to the amount necessary to keep the taxpayer operating and to continue producing tax credits. The IRS concluded that the contributions from X and Investor 2 were more accurately classified as fees paid to purchase tax credits. Accordingly, X and Investor 2 could not claim the refined coal tax credits.


Even before this TAM was issued, many investors were concerned about the lack of specific guidance as to which financial structures monetizing these types of projects would be respected by the IRS. Wind production tax credits and historic rehabilitation tax credits have their own safe harbors (see Rev. Proc. 2007-65 and Rev. Proc. 2014-12, respectively).The refined coal production tax credits have been monetized for years using similar structures, and, generally, investors have assumed that the IRS would respect them.

The TAM does not dispute the fact that the taxpayer properly produced refined coal and generated tax credits. However, the TAM concludes that the substance of the transaction and the totality of the facts and circumstances supported a finding that the investor and operator entered into the transaction with the taxpayer to purchase refined coal tax credits and not to participate in the business. This finding follows a number of similar challenges in the tax credit industry, most notably, Historic Boardwalk Hall.

The TAM provides little guidance on what type of investment structure the IRS will respect, and until additional guidance comes from the IRS or the courts on these investment structures, taxpayers with such investments should review the fact patterns in light of the TAM to evaluate potential audit risk/exposure.


Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

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