Passive Activity Loss Limitation Rules and Solar Project Investment

This is a guest blog post by Mark Vitello of accounting firm BerryDunn summarizing tax rules governing which taxable income can be offset by solar project Investment Tax Credits.

One of the most frequent questions we get from solar project developers is: “Will my investors be able to use the tax credits and the depreciation losses?” The answer is, as with many things related to taxes, “it depends.” One of the biggest hurdles is navigating the passive activity loss rules. While this is a fairly complicated topic, and includes a lot more of “it depends,” we’ll hit some of the major highlights here.

Passive or active?

For tax purposes, activities are grouped as either passive or active activities. Income from these activities are generally treated the same, aggregated as part of the taxpayer’s total taxable income and taxed according to the applicable tax bracket. Losses from these activities are treated very differently, though. Losses from active activities can be used to offset all taxable income, whereas losses from passive activities can only offset passive income. If there is not enough passive income in a given year to fully offset passive losses, the losses become suspended and carried forward. The losses carry forward until there is either passive income to offset or the activity is disposed of (sold or otherwise no longer owned), in which case the suspended losses release in full in that year.

Similarly, the Investment Tax Credit (ITC) takes on the attributes of the activity in which it is being generated. So if the solar project is determined to be an active activity for the investor, the ITC would be active and available to offset tax on all sources of income. But if the activity is determined to be passive, the ITC would be limited to use against tax on passive income. For an investor that has not considered this prior to purchasing a stake in a solar project, a limitation on the credit the investor can use could mean a reduction of the expected return on investment, and an unwelcome surprise.

Portfolio income

It is also important to point out here that a third type of income, portfolio income, is a very common type of taxed income comprised of interest, dividends, and gains from investments. This falls into a separate category from the active/passive analysis, which is often misunderstood.

A classic example is a medical doctor with lots of dividend income from investments who thinks she has passive income but ends up with a rude awakening as that is actually portfolio income and does not allow for the offset of passive activity losses. In this example, barring unusual circumstances, the doctor would likely not be able to offset her portfolio income with passive losses and ITCs from an investment in a solar project. Similarly, the passive losses and ITCs from investing in a solar project would also not be able to offset the non-passive income from her daily medical practice. A different outcome may be possible if the doctor can meet the heavy burden of satisfying the material participation test with respect to the solar project.

Material participation test

IRS Publication 925 details all of the rules surrounding passive activities and includes a set of seven tests to determine material participation. If the taxpayer satisfies at least one of the material participation tests, the taxpayer’s share of the activity is considered active and not passive. The tests are:

You participated in the activity for more than 500 hours.
Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
You materially participated in the activity (other than by meeting this fifth test) for any five (whether or not consecutive) of the 10 immediately preceding tax years.
The activity is a personal service activity in which you materially participated for any three (whether or not consecutive) preceding tax years.
Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

Tests one through six are pretty cut and dried, but the totality of the circumstances test presented in number seven is very open to interpretation. While this allows you to make an argument in your favor, it also gives the IRS more latitude to disagree with you, making it the riskiest test to rely on.

The IRS defines “participation” as “[i]n general, any work you do in connection with an activity in which you own an interest.” This does not include work that would be considered work only done by an investor – such as reviewing operations, preparing reports for your own use, or monitoring the finances or operations of the activity. The work in consideration must also not be work that is customarily done by the owner of that type of activity, nor your only reason for doing the work being to avoid treatment of the activity as passive.

While a contemporaneous log is not required to prove material participation, it is always a good idea to keep track of the work and hours you are performing on behalf of the activity in order to substantiate material participation. This is typically the first thing the IRS asks for in the event of an audit.

As you can see from the seven tests, there is also room to switch between active and passive treatment in any applicable year. So it is important that the investor qualify for the desired treatment in the year the project goes in service and the ITC is generated. If you are passive in year one and end up with suspended credits and or losses, a subsequent switch to active status would not change the attributes of those suspended items―they would remain passive.

So who is a good candidate to target as a passive investor in your solar project? A very common candidate that we see is someone who has a mature real estate holding. The property is generating a nice cash flow for the owner, but the mortgage is paid off and the depreciation is mostly used up. So the real estate owner now has taxable income from a passive investment in real estate. This individual could invest in a solar project LLC as a passive investor and use the passive losses and ITC as offsets against the passive income from the real estate.

Real estate is a very common, but not the only, source of passive income. In fact, any investor/owner in a business who does not satisfy one of the material participation tests would be considered passive. For example – an investor in a restaurant, or a part owner in a gym, who does not participate in the day to day operations of that business (although portfolio income from such a business would still not be considered passive).

Active investors in a solar project are individuals who are actively working on the development and or operation of the project. Solar developers who invest in their own projects are the most common group here – the hours they are spending developing and or constructing the project qualify them for material participation in the project, and then they are allowed to use the active losses and ITC to offset the non-portfolio business income from their other solar activities (or other activities in which they are active).

Lastly, and important to note, this determination is made at the individual taxpayer level. Project investors need to work with their tax advisors and legal counsel to understand their personal tax situation before investing in a project. Depending on the individual situation, an active or a passive treatment may be more beneficial, as everyone’s tax situation is different. The most important thing is knowing ahead of time so that planning can be done and expectations can be set. No one likes a tax surprise!

BerryDunn has worked closely with Klavens Law Group on renewable energy projects in the New England area and is happy to provide this guest blog post. We hope this information is helpful in generating conversations with your project investors, or furthering conversations with your tax and legal team.

FURTHER INFORMATION

For further information about solar project investment matters, please contact Jonathan Klavens at jklavens@klavenslawgroup.com or 617-502-6281 or Brendan Beasley at bbeasley@klavenslawgroup.com or 617-502-6288.

DISCLAIMER

This document, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Klavens Law Group, P.C. or its attorneys. Please seek the services of a competent professional if you need legal or other professional assistance.