Placing in service the benefits of the Inflation Reduction Act

As the world heads toward a greener future, companies that invest in renewable energy projects within the United States have more opportunities for tax credits and other financial incentives than ever before. The Inflation Reduction Act of 2022, P.L. 117-169, enhanced existing incentives and created new benefits for taxpayers. Many of these credits and deductions are available to taxpayers only in the year in which the eligible property is placed into service, making that determination a crucial factor in properly claiming the benefits provided by the act.

Background

The Inflation Reduction Act added and expanded benefits to taxpayers that make investments in green energy. For example, the maximum credit for alternative fuel vehicle refueling property under Sec. 30C was increased to $100,000 and applied at a single-item-of-property level rather than at a location level. Beginning with property placed in service in 2023, many credits become refundable to tax-exempt organizations, allowing them to claim the credit and receive cash, even if they do not otherwise have a tax liability. The act also extended and enhanced the Sec. 48 credit for certain renewable energy property and created the Sec. 48E clean-electricity investment credit, both available as an investment tax credit (ITC) under Sec. 46. However, to take advantage of these benefits, taxpayers must properly identify when the property is placed in service.

Regs. Sec. 1.48-9(b)(5)(i) provides that:

Energy property is considered placed in service in the earlier of: (A) The taxable year in which, under the taxpayer’s depreciation practice, the period for depreciation with respect to such energy property begins; or (B) The taxable year in which the energy property is placed in a condition or state of readiness and availability for a specifically assigned function, whether in a trade or business or in the production of income.

The second prong of that test is the same as the rule for depreciation under Regs. Sec. 1.167(a)-11(e)(1)(i). Previously, when evaluating the placed-in-service date of energy property, courts have interpreted both the Sec. 167 and Sec. 48 regulations’ placed-in-service tests for depreciation deductions and tax credits, respectively, in the same manner (see Sealy Power Ltd., 46 F.3d 382 (5th Cir. 1995)). Therefore, to better understand some of the factors that need to be considered, taxpayers can and should look to prior case law to assist in that determination.

Sealy Power Ltd.

In Sealy Power, the Fifth Circuit evaluated the placed-in-service date of a waste incinerator generating electricity for purposes of depreciation deductions and a Sec. 48 biomass energy tax credit. Sealy Power initially treated the property as placed in service in 1983 for both depreciation and ITC purposes, but upon review, the IRS determined that the facility was never placed in service. The Fifth Circuit, however, ultimately concluded that the property was placed in service in 1984, based on several factors.

Construction and testing of the incinerator: Sealy Power engaged an engineering firm to design and build a power production facility in Sealy, Texas, in 1983. The facility was designed to generate electricity by incinerating solid waste from a nearby landfill, which could then be sold to Houston Lighting and Power. The construction of the facility began early in 1983 and was substantially completed that same year. Sealy completed an agreement to sell the power in 1984.

Sealy began operating the facility in 1983; however, various critical pieces of equipment experienced deficiencies and were not operating at full capacity. This included major pieces of equipment such as the feed mechanism; the ash conveyor; and, most importantly, the incinerator. The feed mechanism and ash conveyor issues were minor and readily correctible, but the incinerator presented a significant problem.

The incinerator was critical to the operation of the facility because it performed two functions: a primary burn to convert solid waste into gas, followed by a secondary burn to further process the gases into steam used to power the turbines and generate the energy to be sold. These deficiencies in the incinerator resulted in the facility’s generating less than the expected output of electricity because the primary incinerator chamber was not as large as the engineers had planned it to be.

This prevented the facility from generating commercial quantities of electricity, so Sealy tried to find investors willing to provide the additional funds required to correct the facility’s operational problems. Sealy was unable to do so and filed for bankruptcy on July 1, 1988.

The Tax Court originally heard the case and relied on its prior decisions in Oglethorpe Power Corporation, T.C. Memo. 1990-505, and Consumers Power Co., 89 T.C. 710 (1987), to determine that Sealy’s property was never placed into service because it failed to achieve its anticipated electricity output levels, and thus it never operated on a regular basis (Sealy Power Ltd., T.C. Memo. 1992-168). Upon appeal, the Fifth Circuit instead analyzed five factors derived from prior revenue rulings issued by the IRS.

The revenue ruling factors: The IRS has issued several revenue rulings that address the placed-in-service requirement for electricity generating facilities, from which five factors have emerged. The Fifth Circuit noted, as do some of the rulings, that each factor indicates that a facility is operating or placed in service and that not all need to be met for the property to be placed in service for purposes of depreciation or an ITC.

The five factors are whether: (1) the necessary permits and licenses for operation have been obtained; (2) critical preoperational testing has been completed; (3) the taxpayer has control of the facility; (4) the unit has been synchronized with the transmission grid; and (5) daily or regular operation has begun. The court then analyzed Sealy’s facts against each of those factors:

• Permits and licenses: No later than 1983, Sealy had obtained the required permits and licenses to operate legally and effectively.
• Critical preoperational testing: The facility’s design and construction did not involve highly complex components that required a critical testing stage (Rev. Rul. 76-256) or a preoperational testing program (Rev. Rul. 76-428).
• Control of the facility: By 1984, Sealy had both physical and legal control of the facility. Sealy, in fact, had title to the components at all times during construction as well as risk of loss and other legal rights. Both Rev. Rul. 76-428 and Rev. Rul. 79-98 address this factor in terms of physical control and attributes of legal ownership such as title and risk of loss.
• Synchronization into the grid: The court evaluated conflicting testimony as to when the facility was synchronized to the grid and was unable to make a finding on this factor. A number of rulings, however, have addressed this factor for determining the placed-in-service date, including Rev. Ruls. 76-256, 76-428, 79-98, and 79-203.
• Daily or regular operation of the facility: The facility was generating electricity regularly in 1984, even if the output was less than intended. In Rev. Ruls. 76-256 and 79-98, this factor focused on “daily” operation, but in Rev. Rul. 84-85, a facility was operating on a regular basis even though it was experiencing operational problems and unable to generate electricity at its rated capacity.

The IRS stated in Action on Decision 1994-010 that it will not follow Sealy Power, except for taxpayers in the Fifth Circuit. It specifically takes issue with the court’s analysis around the daily or regular operation of the facility and maintains its position that output needs to be at or near capacity, rather than a de minimis level, to meet the test.

(For a more recent case applying this five-factor test, see Ampersand Chowchilla Biomass, LLC, 26 F.4th 1306 (Fed. Cir. 2022).)

Other authorities

In Sealy Power, the Tax Court relied on Consumers Power and Oglethorpe rather than analyzing the five revenue ruling factors.

In Consumers Power, the taxpayer constructed a hydroelectric plant and began testing in 1972. Consumers Power claimed depreciation and an ITC in that year. The Tax Court found, however, that preoperational testing was not completed until 1973, and in fact the power output in 1972 was so low that it could not establish regular operation in that earlier year.

Similarly, in Oglethorpe, a facility finished construction in 1981 and began testing, which was completed the next year. When testing was completed, the facility received the necessary permits, and control was turned over to the taxpayer. The Tax Court also found that the facility was not generating power at its rated capacity until 1982. Accordingly, the court held the property was placed in service in 1982.

In Chief Counsel Advice memorandum (CCA) 200411002, the IRS addressed a placed-in-service issue for property that produced fuel from a nonconventional source under then-Sec. 29, now Sec. 45K. The IRS considered the same revenue ruling factors but clarified that synchronization to the grid is unique to electrical-generation facilities. The CCA addressed a threshold question about a taxpayer being in a trade or business and reminded taxpayers that, in general, business operations must have begun for property to be placed in service, i.e., the taxpayer cannot still be in a startup activity because the property must be ready and available for a specific function in a trade or business. In doing so, the IRS pointed to case law including Piggly Wiggly Southern, Inc., 84 T.C. 739 (1985), and Richmond Television Corp., 345 F.2d 901 (4th Cir. 1965).

Determining the placed-in-service date is crucial

Determining the correct placed-in-service date is crucial for taxpayers aiming to claim energy credits and incentives under the Inflation Reduction Act. The guidance provided by case law and IRS rulings offers a comprehensive framework for making this determination. Taxpayers must consider the revenue ruling factors related to operational readiness, such as obtaining necessary permits, completing critical preoperational testing, and ensuring the property is in regular operation. Additionally, they must address threshold questions about the commencement of business operations to ensure the property is ready and available for its intended function. By carefully evaluating these factors, taxpayers can maximize the benefits available under the Inflation Reduction Act and contribute to the transition toward a greener future.

— Caleb Cordonnier, CPA, is a senior manager in Washington, D.C., and Tony Yorio, CPA, is a tax manager in Charlotte, N.C., both with Grant Thornton Advisors LLC.