Solar panels: Basis and bonus depreciation

Editor: Mark G. Cook, CPA, CGMA

A recent Tax Court case illustrated several issues common to trades or business but in the unusual context of a taxpayer who purchased solar-powered electricity-generating equipment installed on a third-party “host” property.

The IRS found taxpayers Donald and Sheila Golan responsible for a tax deficiency of $150,694 and an accuracy-related penalty of $30,139 after examining their 2011 income tax return. The taxpayers challenged the assessment in Tax Court. The court’s opinion in the case, Golan, T.C. Memo. 2018-76, addressed issues including whether the taxpayers:

• Established a basis in solar panels and related equipment for purposes of claiming an energy credit under Secs. 46 and 48 and a special allowance for depreciation under Sec. 168(k) (bonus depreciation);
• Satisfied the requirements of then-applicable Sec. 168(k)(5);
• Had sufficient amounts at risk under Sec. 465;
• Materially participated in their solar energy venture under Sec. 469; and
• Were liable for the accuracy-related penalty under Sec. 6662(a).

Background

In 2010, Donald Golan purchased as an investment solar equipment and its related rights and obligations from Solar Energy Equities LLC. The LLC offered discounted electricity to property owners in exchange for permission to install solar panels and related solar equipment on their properties. The LLC temporarily retained the burdens and benefits of ownership (including resulting tax credits and rebates) once contracts with the hosts were finalized. The LLC then sold the equipment to investors. Golan bought the equipment installed on three of the properties.

For all three properties, an application was filed with a local utility company for an interconnection agreement. The LLC entered into a power purchase agreement (PPA) with the owner of each host property; the LLC temporarily retained ownership of solar equipment and was responsible for any servicing or repairs. The PPA prohibited the host property from assigning the PPA to another party without the LLC’s consent, but the LLC could assign its interest in the PPA to another party with 30 days’ notice to the host. Once the solar panels were installed, the utility company informed the host of eligible rebates, which were then assigned to the LLC.

The sale to Golan was effected by: (1) a solar project asset purchase agreement; (2) Golan’s promissory note; (3) Golan’s guarantee; and (4) a bill of sale and conveyance. The purchase agreement specified that the “original use” of the solar equipment “shall commence on or after the Closing Date.” The stated purchase price was $300,000, which was the sum of (1) a $90,000 down payment (due on the closing date in January 2011, but Golan did not pay any part of it in 2011); (2) a $57,750 credit for the rebates the LLC received from the utility company before the sale; and (3) Golan’s promissory note in the principal amount of $152,250 with interest at 2%.

The note required Golan to pay toward the note all monthly revenue generated by the solar equipment. If the accrued interest exceeded the monthly receipts in any month, the difference would be carried forward and owed by Golan in future months. Conversely, monthly receipts exceeding the accrued interest and amortized principal would accelerate the loan’s repayment.

The note was secured by the solar equipment, and, in the event of a default, the LLC agreed to seek recourse against the solar equipment before exercising any rights or remedies against Golan. However, the note also stated that Golan would be liable to pay any deficiency owed to the LLC if, in the event of foreclosure, a sale of the project assets was insufficient to pay all the amounts owed to the LLC under the note. Golan also signed a guarantee for the note and copies of the PPAs.

Basis in the solar equipment

The allowance of depreciation and the energy credit both depend on a taxpayer’s having basis in the property, which under Sec. 1012 generally is the property’s cost. Cost can include a promissory note issued in exchange for property.

In calculating the special allowance and energy credit, the taxpayers reported a basis in the solar equipment of $300,000 ($90,000 down payment, $57,750 credit for the utility company rebates the host property owners assigned to the LLC, and the $152,250 principal amount of the promissory note). The IRS argued that the Golans did not have basis in the solar equipment for 2011 because no money changed hands between Golan and the LLC that year.

The court noted that the $90,000 down payment was not paid in 2011; therefore, under Regs. Sec. 1.1012-1(a), the taxpayers could not add it to their basis for that year. The court also agreed with the IRS about the $57,750 — the record established the host property owners assigned the utility company rebates to the LLC, and as such, Golan did not receive them or report them as income. The court consequently found that the credit was a price reduction based on the LLC’s receipt of the rebates. Because the rebates were not part of the solar equipment’s cost to Golan, the taxpayers could not add the $57,750 credit to their basis in the solar equipment. However, the court further found that the $152,250 promissory note (a recourse obligation) was issued in exchange for the solar equipment, so the taxpayers could include the face amount of the note in their basis. Thus, the court determined that the basis in the solar equipment for 2011 was $152,250.

Bonus depreciation

Under Sec. 168(k)(1)(A), the depreciation deduction provided by Sec. 167 includes a special allowance for qualified property for the tax year in which the property is placed in service.

For 2011, the special allowance was 100% of the adjusted basis of certain qualified property. Qualified property had the following elements under then-applicable Sec. 168(k)(5) (these provisions were later moved, with modifications, into Sec. 168(k)(2)): (1) a recovery period of 20 years or less; (2) the original use of the property commenced with the taxpayer after Dec. 31, 2007; (3) the taxpayer acquired the property after Sept. 8, 2010, and before Jan. 1, 2012; and (4) the taxpayer placed the property in service before Jan. 1, 2012. The IRS agreed that the taxpayers satisfied the first two requirements but contended that they failed to meet the third and fourth requirements. Since the record established that Golan acquired the solar equipment in January 2011 and placed it in service in 2011, the court determined that he met the third and fourth requirements for bonus depreciation.

Sec. 465

Losses are allowed only to the extent of the aggregate amount at risk for an activity (Sec. 465(a)(1)). Any losses disallowed under this section for the tax year are treated as a deduction in the following tax year (Sec. 465(a)(2)). Under Sec. 465(b), a taxpayer is considered to be at risk for an activity with respect to amounts including:

1. The amount of money and the adjusted basis of other property the taxpayer contributed to the activity, and

2. Amounts borrowed for the activity to the extent that the taxpayer is personally liable for the repayment of those amounts, or has pledged property other than property used in the activity, as security for the borrowed amount.

However, if amounts borrowed for the activity are from a person who has an interest in the activity or from a related person to a person (other than the taxpayer) who has such an interest, those amounts are not considered to be at risk. The aforementioned exceptions, however, do not apply to an interest as a creditor in the activity or to an interest as a shareholder (Sec. 465(b)(3)).

Regs. Sec. 1.465-8 provides a detailed definition of a person who has a prohibited continuing interest under Sec. 465(b)(3):

If a borrower is personally liable for the repayment of a loan for use in an activity, a person shall be considered a person with an interest in the activity other than that of a creditor only if the person has either a capital interest in the activity or an interest in the net profits of the activity.

A capital interest in an activity entitles the holder to the distribution of the assets of the activity upon liquidation. An interest in net profits is not limited to the person who has ownership in the activity under Regs. Sec. 1.465-8. For example, an employee or independent contractor whose compensation is determined in any part by reference to the net profits of the activity is considered to have an interest in the net profits of the activity.

The IRS argued that the taxpayers were not at risk under Sec. 465 because the LLC owner retained a continuing prohibited interest in the solar equipment, which excluded the promissory note as a borrowed amount that established risk under Sec. 465(b)(3). Thus, the IRS contended, the taxpayers could not deduct a loss with respect to the solar activity.

The Tax Court disagreed with the IRS’s argument that the promoter of the transaction had a prohibited continuing interest in the transaction under Sec. 465(b)(3) and that, consequently, Golan was not at risk under Sec. 465 for the promissory note. The court reasoned that under the agreement between Golan and the promoter, the promoter neither was entitled to any assets of the solar activity upon liquidation nor had an interest in the net profits of the solar business. The required note payment — all monthly revenue generated by the solar equipment — was a gross-receipts interest rather than a net-profits interest. Furthermore, under Tax Court precedent (Krause, 92 T.C. 1003 (1989)), the fact that a loan in a transaction is made by a promoter of the transaction does not necessarily mean that the promoter has a prohibited continuing interest in the transaction.

Sec. 469

Sec. 469 generally prohibits using a loss from a passive activity to reduce income from nonpassive activities during any tax year. In general, a passive activity is a trade or business in which the taxpayer does not materially participate. A taxpayer materially participates in an activity when he is involved in the activity on a regular, continuous, and substantial basis. A taxpayer can establish material participation in an activity and, therefore, nonpassive status by satisfying any one of seven tests provided in Temp. Regs. Sec. 1.469-5T(a). The taxpayers maintained that Golan met one of the tests: that he participated in his solar energy venture for at least 100 hours in 2011 and that his participation was not less than that of any other individual. The IRS did not prove otherwise; therefore, the court found that the taxpayers were not subject to the passive activity loss limitations.

Accuracy-related penalty

Secs. 6662(a) and (b)(2) provide that taxpayers are liable for a penalty equal to 20% of the portion of an underpayment of tax attributable to a substantial understatement of income tax. For individuals, Sec. 6662(d)(1)(A) provides that an understatement of income tax is substantial if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. The accuracy-related penalty is not imposed on any portion of the underpayment for which taxpayers acted with reasonable cause and good faith, which can be established by showing proper reliance on the advice of a tax professional.

The court determined that the taxpayers relied in good faith on the advice of a tax preparer who had sufficient expertise to justify their reliance and to whom they provided all necessary accurate information. The court also acknowledged that the taxpayers met with the tax professional four times to discuss the solar venture. The court found that the taxpayers made a good-faith effort to establish their proper tax liability and reasonably relied on the advice of their return preparer; therefore, they were not liable for the accuracy-related penalties.

EditorNotes

Mark G. Cook, CPA, CGMA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.