May 20, 2024 | By Dorian Hunt, Head of Renewables

On March 11, 2024, the IRS and the Treasury proposed regulations that, if finalized, would provide welcome relief to investors in partnerships owning facilities that generate § 45(a), § 45U, § 45Y, § 48, and § 48E credits (the “Proposed Regulations”).[1] The comment period for the Proposed Regulations ended on May 10. As described below, the Proposed Regulations would accomplish this by extending the availability of the election under § 761(a) to certain of these entities generating certain types of credits. This article describes that election, the provisions of the Proposed Regulations, and the impact on certain credit partnership investors.

Section 761

Under § 761, the term “partnership” is rather broadly defined to include a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not a corporation or a trust or estate. Under this definition, the term partnership can include legal entities with two or more members, as well as contractual arrangements pursuant to which two or more taxpayers engage in a business or financial operation and divided any gains derived therefrom.

If an entity (including one treated as formed for federal tax purposes as a result of contractual arrangement) is classified as a partnership for federal tax purposes, that entity generally is subject to the rules of subchapter K (§§ 701-761) of the Code.[2] Under those rules, the income of the partnership generally is calculated at the partnership level pursuant elections made by the partnership; once allocated, that income is allocated among the partners in the partnership and subject to federal tax at that level.

In certain situations, however, an entity classified as a partnership may elect to be excluded from application of all or part of subchapter K (the “Subchapter K Exclusion”). This technique has long been used in the context of the oil and gas industry to plan around pool of capital and carried interest rules. Under current regulations, for a partnership to be eligible for the Subchapter K Exclusion – (1) the members of the partnership must be able to compute their own income without computing partnership taxable income; and (2) the partnership generally must be availed of for investment purposes only (rather than for the active conduct of a business) or for the joint production, extraction, or use of property (but not for the purpose of selling services or property produced or extracted). For partnerships formed for the joint production, extraction, or use of property, the participants must –(i) own that property as co-owners either in fee or under lease or other form of contract (the “Co-Ownership Requirement”); (ii) reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used and not jointly sell services or the property produced or extracted (although each separate participant may for a limited time delegate authority to sell his share of the property for his account, but not for a period of time in excess of the minimum needs of the industry, and in no event for more than one year) (the “Severance Requirement”).

To be completely excluded from subchapter K, the partnership in question must make an election under § 761(a) not later than the time at which the partnership return would be due for the first taxable year for which the exclusion is desired. When an electing partnership is no longer eligible for the Subchapter K Exclusion, its existing election automatically terminates, and the partnership must begin complying with the requirements of subchapter K.[3]

Section 6417

Section 6417 allows an “applicable entity” to make an election to treat an “applicable credit” (as defined in § 6417(b)) determined with respect to the entity as making an income tax payment for the tax year with respect to which the credit is determined in an amount equal to the amount of the credit. Section 6417 also provides special rules relating to partnerships and directs the Internal Revenue Service (the “IRS”) and the Department of Treasury (“Treasury”) IRS to provide rules for making elections under section 6417.

In June of 2023, the IRS and Treasury issued proposed regulations under § 6417 (the “§ 6417 Proposed Regulations”). Under the § 6417 Proposed Regulations, a partnership is not an applicable entity for § 6417 purposes, regardless of how many of its partners are themselves applicable entities. Accordingly, any partnership making an elective payment election must be an electing taxpayer (as defined in proposed § 1.6417–1(g)). As such, the only applicable credits with respect to which a partnership could make an elective payment election would be credits determined under §§ 45Q, 45V, and 45X for the time periods allowed in § 6417(d). However, the § 6417 Proposed Regulations provide that, if an applicable entity is a co-owner in an applicable credit property through a partnership that validly elected the Subchapter K Exclusion, then the applicable entity’s undivided ownership share of the applicable credit property would be treated as a separate applicable credit property owned by that applicable entity. As a result, the applicable entity may make an elective payment election for the applicable credit determined with respect to its share of the applicable credit property. This echoes the discussion in § 1.48-14(e) of the proposed investment tax credit regulations issued in late 2023 (see our write up on those regulations here). When considering the shared ownership outside of a partnership context, it’s likely important to understand the breakout of energy property between that which is per se energy property and that which is deemed to be energy property by virtual of being integral to per se energy property’s operation.

Following issuance of the § 6417 Proposed Regulations, stakeholders notified the IRS and Treasury that many facilities producing electricity from certain types of property failed to qualify for the Subchapter K Exclusion (and thus the § 6417 elective payment election) because the facility producing the electricity was not owned directly by its members as co-owners, but rather owned by an entity (such as a limited liability company) classified as a partnership in which the members invested. Moreover, under the current § 761 regulations, joint selling of the property produced or extracted by the partnership is prohibited (or at least limited for a period of time). The commentators noted that these requirements put partnerships at a disadvantage that likely would cause investment in applicable credit properties to be reduced. Given the common nature of these types of arrangements and their inability to qualify for the Subchapter K Exclusion, stakeholders requested that the IRS and Treasury adopt rules that would allow property held by an entity to be treated as satisfying the Co-Ownership and Severance Requirements in the existing Subchapter K Exclusion regulations.

The Proposed Regulations

On March 11, 2024, the IRS and Treasury responded to the comments received and issued the Proposed Regulations, which if finalized would extend the availability the Subchapter K Exclusion to certain partnerships that are organized exclusively to produce electricity[4] from certain property. In the preamble to the Proposed Regulations, the IRS and Treasury concluded that it is appropriate to treat certain applicable entities seeking to make an election under § 6417 as satisfying the Co-Ownership and Severance Requirements provided that the other requirements for the Subchapter K Exclusion are met.

Specifically, the Proposed Regulations would amend the existing § 761 regulations to provide an exception to certain rules in the § 761 regulations for partnerships that meet the other requirements in the existing § 761 regulations as well as the following four requirements:

    1. The partnership must be owned, in part or in full, by one or more applicable entities (as defined in § 6417(d));
    2. The partnership’s members must enter into a joint operating agreement with respect to the applicable credit property in which the members reserve the right separately to take in kind or dispose of their pro rata shares of the electricity produced, extracted, or used, or any associated renewable energy credits or similar credits;
    3. The partnership must, pursuant to a joint operating agreement, be organized exclusively to jointly produce electricity from its applicable credit property (as defined in § 1.6417–1(e)) and for which credits under § 45(a), § 45U, § 45Y, § 48, and/or § 48E are determined;[5] and
  1. One or more of the applicable entities will make an elective payment election under § 6417(a) for the applicable credits determined with respect to its share of the applicable credit property.

If a partnership meets these requirements, the Proposed Regulations would modify the Co-Ownership Requirement in § 1.761–2(a)(3)(i) to permit the partners in a partnership formed as a legal entity to satisfy that requirement. Further, the Proposed Regulations would modify the Severance Requirement to provide that a delegation of authority to sell the participant’s share of the property produced may allow the delegee to enter into contacts that exceed the minimum needs of the industry and may be for longer than one year, provided that the delegation of authority to act on behalf of the participant may not be for a period of time that exceeds the minimum needs of the industry, and in no event for more than one year. This feature is likely a practical necessity to enable utilities to negotiate power purchase agreements with a single party offtaker, as opposed to multiple entities who have taken produced electricity in-kind from their share of assets.

Example: X (an applicable entity) and Y invest in PRS, a limited liability company classified as a partnership for federal tax purposes; the partnership will own an applicable credit property that will produce electricity. X and Y enter into a joint operating agreement with respect to the ownership and operation of the applicable credit property in which each of X and Y reserve the right separately to take in kind or dispose of their pro rata shares of the electricity produced and any associated renewable energy credits or similar credits. At the beginning of Year 1, X and Y enter into an agreement with Agent, pursuant to which they each delegate their authority to sell electricity generated by the PRS and their respective shares of the applicable credit property (the “Delegation Agreements”); the term of each Delegation Agreement is one year, which does not exceed the minimum needs of the industry. Later in Year 1, Agent enters into a power purchase agreement (the “PPA”) with a utility on X’s and Y’s behalf. Under the terms of the PPA, X and Y are committed to sell the electricity produced from their shares of the applicable credit property to the utility for a term of 10 years.

In this case, X and Y did not delegate authority for Agent to sell their shares of the electricity produced for more than one year (despite the 10-year term of the PPA entered into by the Agent). Thus, provided that PRS otherwise meets the requirements to elect the Subchapter K Exclusion, PRS is eligible for that exclusion.  Accordingly, X can make an elective payment election for the applicable credits determined with respect to its share of the applicable credit property held by PRS, so long as the requirements of § 6417 are otherwise met.

The IRS and Treasury request comments regarding whether similar exceptions are necessary for applicable entities that indirectly own interests in applicable credit properties that do not produce electricity. We’d expect that addition exceptions would be necessary to enable flexibility for other credit eligible technologies, such as those that produce methane or hydrogen.

Conclusion

Because elective payment elections cannot be made by entities classified as a partnerships for federal income tax purposes (i.e., entities subject to subchapter K) except in the case of credits under §§ 45V, 45Q, and 45X, the Proposed Regulations will expand the circumstances in which joint ownership arrangements may qualify for the Subchapter K Exclusion (and thus be eligible for the § 6417 election).  If the proposed regulations are finalized as written, there may be a significant opportunity for credit-eligible assets to be owned in alternative structures to further leverage direct-pay mechanisms. In the context of investment tax credits in particular, there is a long history of using taxable blockers in fund structures to allow for the participation of tax-exempt entities in those structures. These blockers typically introduce some level of tax drag in exchange for maximizing investment tax credits However, if structures as described in the proposed regulations were allowed perhaps those entities could more directly participate in a way that introduces less overall tax drag into the structure. Of course, electing out of Subchapter K is not without its downside (e.g. such an election would remove the ability to perform special allocations of income and loss under §704(b)). In any case, it’s likely prudent for stakeholders to consider situations when structures similar to those in the proposed regulations might offer the best outcome. Overall, this flexibility is a welcome addition that introduces yet another monetization channel to complement the rapidly evolving landscape which already includes tax credit transfer, tax equity, hybrid tax equity, synthetic tax equity, and others.

[1] See, “Election to Exclude Certain Unincorporated Organizations Owned by Applicable Entities from Application of the Rules on Partners and Partnerships,” 89 Federal Register 17613 (March 11, 2024).

[2] Note that an electing entity is only excluded from subchapter K (relating to the income tax of partnerships); the entity may nevertheless be classified as a partnership for other federal tax purposes.

[3] Although a partial exclusion from subchapter K may be available in certain situations, discussion of that exclusion is beyond the scope of this article.

[4] This excludes properties that do not produce electricity even though such properties might be credit eligible under the relevant code sections

[5] This requirement may be satisfied prior to the applicable credit property being placed in service, provided the partnership is in the process of completing the applicable credit property and will operate the applicable credit property once it is placed in service.