Tax-exempt organizations: Clean energy incentives and direct pay

ARTICLE | March 14, 2023

Authored by RSM US LLP

Direct pay is perhaps the greatest benefit for exempt organizations to come out of the Inflation Reduction Act of 2022 (“the Act”). Section 6417 was added to the Internal Revenue Code, allowing for an elective payment (also referred to as direct pay) of certain federal energy tax credits for “applicable entities,” which includes exempt organizations.  In essence, the Act enables tax-exempt entities to claim energy incentives including solar, wind, combined heat and power, and many others, through the direct pay mechanism that essentially allows for nonrefundable income tax credits to be converted to payments against tax for these entities. In addition to direct pay for applicable credits, the Act also enables tax-exempt entities to allocate a section 179D deduction to the designer of qualifying energy-efficient commercial building property the entity may be installing.

Clean energy incentives – Overview

Energy and climate incentives worth $369 billion are a focal point of the Act through 29 separate provisions that create or modify renewable energy-related credits and incentives. The Act extends and expands the energy investment tax credit which applies to entities placing in service certain renewable energy property at their facility - including solar, geothermal, battery storage, waste energy recovery property, and combined heat and power cogeneration systems. The Act also includes significant changes to facilitate the purchase of passenger and commercial electric vehicles and refueling equipment. The Act also provides new opportunities for monetization of some of the credits by making some of the credits effectively refundable through the “direct pay” provision.

Historically, tax-exempt organizations would not directly engage in the construction of projects related to energy credits, or if they did, they had little use for the utilization of a tax credit.  Instead, these entities would engage in power purchase agreements for clean electricity and indirectly receive the benefit of the credit through reduced costs for green power. These deals had much complexity and, in some cases, leveraged tax equity structuring to monetize the developer’s investments in renewable energy property in exchange for allocating certain tax benefits to an investor through a partnership structure. Tax equity deals are complex in nature and result in a loss in benefit by increasing tax compliance issues and involving outside investors. Direct pay provides a less complex option for tax-exempt entities to directly invest in clean energy projects by providing them with the ability to monetize the clean energy tax credits by converting them to cash through the direct pay mechanism.

Monetization

The Act added section 6417 to the Internal Revenue Code. This provision allows applicable entities to monetize tax credits that would have previously been of little to no monetary value. The use of direct pay unlocks a world of opportunity for tax-exempt entities to benefit from investing in renewable energy property.

Section 6417 defines an applicable entity as any of the following:

• Any organization exempt from tax imposed by subtitle A;
• Any state or political subdivision thereof;
• The Tennessee Valley Authority;
• An Indian tribal government;
• Any Alaska native corporation; or
• Any corporation operating on a cooperative basis which is engaged in furnishing electric energy to persons in rural areas.

Additionally, section 6417 provides that the following credits are available for a section 6417 elective payment:

• Section 30C “Alternative fuel refueling property credit”
• Section 45(a) “Renewable electricity production credit (PTC)”
• Section 45Q “Credit for carbon oxide sequestration”
• Section 45U “Zero-emission nuclear power production credit”
• Section 45V “Credit for production of clean hydrogen”
• Section 45W “Qualified commercial clean vehicles credit”
• Section 45X “Credit for advanced manufacturing production”
• Section 45Y “Clean electricity production credit”
• Section 45Z “Clean fuel production credit”
• Section 48 “Energy credit (ITC)”
• Section 48C “Qualifying advanced energy project credit”
• Section 48E “Clean energy investment credit”

For tax years beginning after Dec. 31, 2022, applicable entities will be able to make elective payments for the applicable credits listed above. Section 6417(a) provides that an applicable entity making the election will be treated as if it made an income tax payment. That payment may be refunded, but may first be required to offset unrelated business income tax. Applicable entities should be thoughtful of placed in service dates or other events that give rise to credits to avoid generating credits in a tax year when the credit cannot be monetized.

Additional guidance is needed to clarify the form(s) and/or process that will be used to make elective payments as this is a new procedure for tax purposes. For applicable entities with tax return filing requirements, an election for direct pay must not be made later than the due date (including extensions of time) for the return of tax for the taxable year for which the election is made, but in no event earlier than Feb. 12, 2023. For applicable entities without a tax return filing requirement, additional guidance is needed to determine the election’s due date.

Exempt organizations may also be shareholders in passthrough entities (e.g., partnerships, S corporations). If an applicable credit is determined with respect to a passthrough entity and an applicable entity is a shareholder, an elective payment could potentially still be available for that shareholder.  

There is no requirement that an applicable entity have unrelated business income to make an elective payment with respect to applicable credits. Additionally, tax-exempt entities do not have to use the potentially qualifying property in an unrelated trade or business for the allowable credits to be eligible for direct pay. Although property used by states and political subdivisions usually cannot generate certain federal income tax credits, this prohibition is disregarded for purposes of direct pay

Base and bonus rates – Apprenticeship and prevailing wage requirements

Applicable to many energy-related incentives, the Act made significant changes by replacing the existing credit regime with a two-tiered system that provides a minimum “base” credit amount and a maximum “bonus” credit amount that is five times the base amount. Both amounts will vary depending on the relevant project. The bonus credit amount will be available only if certain prevailing wage and apprenticeship requirements, as described in Notice 2022-61, are satisfied in connection with the relevant project. RSM issued this tax alert when the IRS published initial guidance on the prevailing wage and apprenticeship requirements.

In general, to satisfy the apprenticeship requirements, the taxpayer must ensure that, with respect to the construction of a qualified facility, qualified apprentices are incorporated into construction, alteration, and repair work through a percentage of total labor hours requirement, a journey worker-to-apprentice ratio requirement, and a participation requirement. Additionally, to satisfy the prevailing wage requirement, the taxpayer must ensure that any laborers and mechanics employed by the taxpayer, their contractor, or their subcontractor for a renewable energy project are paid prevailing wages (as determined by the Secretary of Labor) in the locality in which the project is located. The prevailing wage requirements may be imposed on the construction of certain property, on repairs and maintenance of a facility for a period after it is placed in service, and/or on repairs and maintenance of a facility for each year a facility is generating a credit eligible for a bonus rate.

Credit “Adders” - Domestic content requirements, energy communities, and special rules for solar and wind facilities placed in service in connection with low-income communities

The Act also provides increases to various energy credits that are placed in service after December 31, 2022, and meet certain “domestic content” requirements and/or are located in specified areas or communities.

An increased tax credit rate for qualified renewable energy projects may apply if certain domestic content requirements are met. To meet this requirement, taxpayers must ensure that the steel, iron, or other manufactured products that comprise the project are produced in the United States. Generally, a manufactured product will be considered manufactured in the United States if a specified percentage of the total cost of the components is attributable to components that are mined, produced, or manufactured in the United States.

Additionally, an increased credit rate may apply for certain projects located in an “energy community”.  An energy community is either (1) a brownfield site; (2) an area that has certain levels of employment or local tax revenue related to extraction, processing, transport, or storage of coal, oil, or natural gas and an unemployment rate at or above the national average; or (3) a census tract where a coal mine has closed or a coal-fired electric generating unit has been retired, or a census tract directly adjoining the mine or unit. 

Finally, the Act added an application-based program that increases the energy credit percentage for certain solar and wind projects. Certain solar and wind facilities placed in service in connection with low-income communities may be eligible for an addition of 10 or 20 percent to the energy credit percentage. To earn a credit increase under this program, taxpayers must apply for a capacity limitation allocation.

Recently, the IRS provided guidance to establish a program to allocate amounts of environmental justice solar and wind capacity limitation to qualified solar and wind facilities eligible for the investment tax credit. See our recent RSM tax alert for more information.

Energy credit overview

As discussed above, twelve energy credits now qualify for direct pay if claimed by applicable entities.  Below is an explanation of the credits most likely to be claimed by tax-exempt organizations.

Incentives for investing in property to reduce greenhouse gas emissions and utility costs

The Act modified the section 48 energy credit, a component of the investment tax credit (“ITC”). In general, the credit is calculated as a percentage of the basis in qualifying property. The Act modified the credit to allow for a jump in credit percentage if taxpayers can meet prevailing wage and apprenticeship requirements; the credit rate goes from 2 percent or 6 percent of the basis to 10 percent or 30 percent of the basis in qualifying property if these requirements are met. There are additional credit increases available for domestic content, energy communities, and through the low-income communities bonus credit program. The construction of eligible property must generally begin before Jan. 1, 2025, to qualify for the energy credit. However, the Act added a new technology-neutral credit that may be available for property that is placed in service after 2024.

The following energy properties may be eligible for a credit rate of 30%:

• Qualified fuel cell property
• Qualified small wind energy property
• Qualified waste energy recovery property
• Qualified energy storage technology*
• Qualified biogas property*
• Qualified microgrid controllers*
• Qualified electrochromic glass (dynamic glass)*
• Qualified solar property
• Qualified combined heat and power property
• Qualified geothermal property
• Certain hydrogen production facilities for which the entity elects to treat as energy property*

The following energy properties may be eligible for a credit rate of 10%:

• Qualified microturbine property
• Interconnection property*

*must be placed in service after Dec. 31, 2022, to qualify for the energy credit.

The following types of energy property may be most relevant to exempt organizations: solar property, wind energy property, energy storage property, microgrid controller property, geothermal property, combined heat and power systems, and interconnection property.

Incentives for transportation

The Act added a new tax credit for qualified commercial clean vehicles under section 45W. The credit amount is equal to the lesser of:

• 30 percent of the cost of each vehicle that does not rely on a gasoline or diesel internal combustion engine (or 15 percent in the case of hybrid vehicles), or
• The incremental cost of the vehicle (i.e., the cost differential of the clean vehicle and a comparable vehicle that relies entirely on a gasoline or diesel internal combustion engine)

The maximum credit per vehicle is $7,500 for new vehicles that weigh less than 14,000 pounds and $40,000 for all other vehicles. This credit is available under Section 45W for vehicles acquired after Dec. 31, 2022, and on or before Dec. 31, 2032.

Incentives for EV charging stations

The Act modified and extended the credit for alternative fuel vehicle refueling property under section 30C. EV charging equipment is qualifying property for this credit. For property installed after Dec. 31, 2022, the base credit of such qualifying property is 6%. However, if certain prevailing wage and apprenticeship requirements are met during the construction of such property, the credit increases to 30%. The credit is capped at $100,000 per item of qualifying property and property must be installed in a low-income or rural census tract.

Section 179D deduction – A bargaining chip for tax-exempt organizations

The Act amended section 179D (“energy efficient commercial buildings deduction”) to allow tax-exempt entities to allocate the allowable deduction to the designer of the energy-efficient property, for taxable years beginning after Dec. 31, 2022.

Energy-efficient commercial building property must meet the following requirements:

• The property must be subject to depreciation or amortization;
• The property must be installed in a building located in the United States;
• The property must be installed as part of the interior lighting system, heating, cooling, ventilation, hot water systems, and/or the building envelope; and
• The property must reduce the total energy and power costs by a certain percentage when compared to a reference building meeting standards established by the American Society of Heating, Refrigerating, and Air Conditioning Engineers and the Illuminating Engineering Society of North America).

In general, the deduction is limited to the excess of the product of (i) the applicable dollar value and (ii) the square footage of the building (iii) over the aggregate amount of section 179D deductions during the four taxable years ending with the taxable year a tax-exempt entity is allocating the deduction. The deduction cannot exceed the cost of qualifying property reduced by the aggregate amount deducted in the prior four tax years ending with the year of the allocated deduction. The deduction varies based on a building’s increased energy efficiency. If prevailing wage and apprenticeship requirements are met with respect to the installation of the energy-efficient commercial building property, the deduction can be as much as $5.00 per square foot. The statutory limitation if prevailing wage and apprenticeship requirements are not met is $1.00 per square foot. RSM issued this tax alert when the IRS issued recent guidance on energy efficiency reference standards for purposes of the section 179D deduction.

Opportunities for tax-exempt organizations

State and local governments, Indian tribal governments, and Alaska Native Corporations

State and local governments, Indian tribal governments, and Alaska Native Corporations are key players in the renewable energy space. The Act incentivizes these entities to continue making investments in renewable energy to meet their net zero emissions goals and create a sustainable future for their communities. Transitioning to renewable sources to power public buildings may be more attractive when direct pay is factored into construction costs. Projects such as production of renewable natural gas at landfill or wastewater treatment facilities through anaerobic digestion may also be considered. Further, the electrification of vehicles or transition to clean fuel transportation may also be especially attractive with the use of direct pay.

The Act created a program to allocate additional ITC credit increases for environmental justice solar and wind energy projects for projects located in certain low-income communities and on Indian land. Notice 2023-17 provides initial guidance on the “Low-Income Communities Bonus Credit Program” (the Program) and additional guidance is expected from the IRS and Treasury in the coming months. Applicable entities that intend to develop solar or wind projects in a community that falls within the Program’s guidelines should carefully review application procedures and other program information in upcoming guidance.

Educational institutions and universities

Many universities and educational institutions are deeply focused on setting and meeting net zero carbon emissions goals over the next several years. Universities are looking to meet these goals through a variety of means including the use of electricity from renewable sources, student and faculty EV charging stations on campus, and clean vehicle campus transportation. These may include investments in geothermal, solar, wind, energy storage, dynamic glass, combined heat and power, and microgrid controller property, All these activities may give rise to various credits eligible for direct pay.

Universities seek to innovate with modern, eco-friendly residence halls, student unions, and academic buildings. Section 179D provides an accelerated depreciation deduction for qualified construction or rehabilitation projects for energy-efficient commercial buildings. The Act created an opportunity for tax-exempt entities to allocate this deduction to the designer of such buildings, creating a bargaining chip for exempt organizations as they seek bids from project designers.

Healthcare industry

Over 100 healthcare organizations have joined the White House and Human Health Services (HHS) Health Sector Climate Pledge (the Pledge) to commit to reducing greenhouse gas emissions and building climate-resilient infrastructure. The Pledge is indicative of a strong industry-wide commitment to making changes focused on sustainability and renewable energy. Whether pursuing the goals of this climate pledge or unique goals of the organization, entities in the health sector are investing in new, energy-efficient technologies. Additionally, healthcare organizations are often focused on providing reliable power and are investing in solar, energy storage, and combined heat and power systems in order to take themselves off the grid.  Many of these technologies fit within the policy goals of the Act. As tax-exempt healthcare organizations continue to make these investments, they will want to consider monetizing tax credits for qualified project through the direct pay election. These organization should also consider the bonus credit and other adder program provided in the Act.

Private foundations and other exempt organizations

Many private foundations and other tax-exempt organizations may be focused on reducing their carbon footprint as part of their organization’s mission to better serve their communities. Traditionally, tax-exempt organizations would have had little or no use for a tax credit. However, direct pay may reduce the cost burden of investing in clean energy. Tax-exempt organizations that are looking to electrify their vehicle fleet, install electric vehicle (“EV”) charging infrastructure, or install other green technologies such as solar arrays or energy storage can now take advantage of the available credits to reduce their cost burden and increase their impact for years to come.

Many of these exempt organizations that serve low-income or energy communities may also benefit from the additional credits and credit adders, including the “Low-Income Communities Bonus Credit Program” mentioned above.

Washington National Tax Takeaways

Direct pay opens a world of opportunity for tax exempt entities to facilitate investment in clean energy initiatives and further give back to the communities they serve.

Direct pay is available to applicable entities for taxable years beginning after Dec. 31, 2022. Entities using a fiscal tax year-end must be cautious about triggering credits in a period before direct pay is available to them.  

We are still awaiting guidance from Treasury on administration of the direct pay provisions. Treasury requested comments on implementation of these provisions in Notice 2022-50.  Guidance is expected later this year.

Tax-exempt organizations planning to construct or upgrade energy-efficient commercial buildings should consider their eligibility for a section 179D deduction. Previously of no use to tax-exempt organizations, the ability to allocate the deduction to a designer could now produce an indirect benefit. Prior to the Act, only certain governmental entities were allowed this benefit. This deduction should be considered early in the commercial building construction planning process so the allocation can be considered early in the bidding process.

Applicable entities should carefully consider the modifications and new provisions under the Act, as well as any released and upcoming IRS guidance. Documentation, recordkeeping and substantiation requirements for prevailing wage and apprenticeship requirements will be critical. Applicable entities should work with tax advisors to assist with energy credit planning to ensure the proper credit rates are applied and available bonus rates and other adders are substantiated.