Challenges Facing Individuals As Tax Equity Investors – Tax Authorities

Ever wonder why as an individual, you probably cannot claim the
investment tax credit or production tax credits?

The passive activity loss rules prevent individuals from using
tax credits and losses incurred from businesses in which they are
not materially involved against active income from other sources.
This means that most individuals cannot claim production tax
credits or investment tax credits. The tax credits can only be used
against income from other passive investments in the same
activity.

This makes it hard to tap individuals as potential tax equity
investors for solar and other renewable energy projects.

The passive activity loss rules have been around since 1986,
enacted as a response to the tax shelters of the 1980s that
taxpayers used to generate tax losses to shelter wages and
investment portfolio income from taxes.

As a general matter, the passive activity loss rules bar
individuals from using depreciation, tax credits and interest
(other than home mortgage interest) to reduce taxes on salaries and
investment income. Separate at-risk rules bar individuals from
deducting interest on nonrecourse loans and claiming depreciation
deductions funded with nonrecourse debt. Between the passive loss
limitations and the at-risk rules, it is challenging for an
individual to be able to claim energy tax credits, depreciation or
interest expense from investing in renewable energy projects.

In addition to individuals, the passive activity rules also
apply to estates, business trusts, personal service corporations
and closely-held corporations. Even though the rules do not apply
to grantor trusts, partnerships and S corporations directly, they
do apply to the owners of those entities who are individuals.

Real estate developers, sports team owners, owners of limited
partnership interests and family offices are all likely to have
passive income that cannot be offset by losses and tax credits from
investments in renewables.

What qualifies as passive income for this purpose against which
passive losses can be offset?

Active losses can only be used to offset active income.

Passive losses can only be used to offset passive income, but
not even all passive income. Passive losses cannot offset active
income.

Passive losses can only offset passive income to the extent
there is passive income from the same activity.

There are two kinds of passive activities. One is renting
equipment or other property to others, including equipment leasing
and real estate rentals. The other is businesses in which the
taxpayer does not materially participate.

The following types of income are considered active income:
salaries, wages, and independent contractor compensation,
guaranteed payments, portfolio income (meaning interest, dividends,
royalties, gains on stocks and bonds), sales of undeveloped land or
other investment property, royalties and income from businesses in
which the taxpayer materially participates.

Material Participation

What is “material participation,” and why does it
matter?

An individual investor in a power plant would have to
participate materially in the business in order to take advantage
of tax credits and depreciation.

Material participation requires the individual to be involved in
the operations of an activity on a regular, continuous and
substantial basis. It is narrowly defined and time sensitive.
Material participation is based on time and not money. An investor
can have a significant financial interest in a business, and yet
not materially participate.

An investor must meet the narrow material participation
definition in order to avoid the passive activity limitations on
tax credits and depreciation. There are a number of ways an
investor can prove he or she materially participates in a
business.

The three most like to come into play are spend more than 500
hours working at the business, spend more time working at the
business than any other individual (owner or employee), or spend
more than 100 hours working at the business where no other
individual (owner or employee) participates more.

Material participation is measured on an annual basis, so it is
possible to meet one of these hurdles in one year, then fail the
next. Participation by a spouse can be added to the
individual’s hours, but participation by children or a
significant other cannot. A spouse’s work counts even if the
spouse is not a co-owner of the business.

Using a solar facility as an example, if an individual owner of
the solar facility wanted to claim the investment tax, that
individual would have to spend either more than 500 hours each year
working in the solar business (and that’s a lot!), work more at
the solar facility than any other owner or employee (so you better
learn how to replace those broken panels), or work more than 100
hours with no one — not even part-time employees —
working more (again, better learn how to replace broken solar
panels).

The IRS Audit Guide encourages agents to review W-2 forms and
other non-passive activities to see if it even seems likely that an
individual could spend 500 hours on an activity in light of other
obligations. It also directs agents to determine the location of
each of the individual’s activities to determine if it is
likely the individual could physically spend time at the site of
the activity.

If you want to claim investment or production tax credits, get
ready to do your own operation and maintenance and asset
management. It does not count as material participation if the
activity is supervised by another individual who is compensated for
managing the business or if the paid manager spends more time
managing the facility than you do.

The US Tax Court confirmed the difficulty of individuals proving
material participation in a renewables business in a case called
Lum v. Commissioner in 2012. A group of individuals
purchased solar hot water heaters that were installed in the homes
of third-party customers. The individuals hired a contractor to
collect monthly payments from the customers. The Tax Court held
that the individuals could not use the investment tax credits or
depreciation from the solar hot water heaters to offset their other
income.

The court was unpersuaded by the fact that one of the
individuals solicited customers and managed collections. It said
that the individuals did not materially participate because the
hired contractor collected the majority of the payments, maintained
the books and records, and made tax payments on behalf of the
business.

The IRS listed factors that tend to show whether an individual
has or has not materially participated. These can be reduced to a
series of questions.

Was the individual compensated for services? Most people do not
work significant hours for free.

How far does the individual live from the activity? If the
person lives far away, the IRS questions how many hours can really
be spent working in the business. Travel time does not count.

Does the individual has another full time job? Does the
individual have numerous other investments, rentals, business
activities or hobbies that absorb significant amounts of time?

Is there a paid on-site manager, foreman or supervisor or are
there on-site employees who provide day-to-day oversight and care
of the operations?

Is the individual elderly or does the person have health issues?
Are a majority of the hours claimed for work that does not
materially impact operations? Mere participation is not sufficient.
Activities must be integral to operations.

Would the business operations continue uninterrupted if the
individual did not perform the services claimed? Material
participation is serious business, and the IRS will consider
whether to discount portions of time that relate to investor-type
hours or work not customarily done by an owner.

Indirect Ownership

Investors usually own a solar or other renewable energy project
through a partnership or S corporation. Neither the partnership nor
the S corporation itself can materially participate. Only the
individual partner or shareholder can materially participate. Thus,
material participation is tested at the partner or shareholder
level.

There is a look-through rule for tiered entities. An investor
will be treated as holding an interest in the lowest tiered entity.
This means that if an investor is a shareholder in an S
corporation, and that S corporation owns an interest in a
partnership, if the investor does not materially participate in the
partnership’s activities, he or she would also be treated as
receiving passive income.

Limited partnership interests are presumed to be passive.
Therefore, losses are not deductible by a limited partner unless
the person has passive income from the same activity to offset.

However, limited partner taint can be overcome in one of three
ways. One way is to show the limited partner works 500 hours or
more in the same activity. Another is to show the limited partner
materially participated in the activity in any five of the prior 10
years. Another for activities that involve personal services that
the passive investor materially participated in the same activity
in any three prior years.

Members in limited liability companies are treated like limited
partners, even if the person is a member-manager.

In the case of a business trust, the material participation
standard applies to the trustee. The trustee must satisfy the
material participation standard. Another type of trust — a
grantor trust — is ignored for purposes of these rules, and
the tax owner of the trust must satisfy the material participation
standard.

The passive loss limitations apply to all personal service
corporations, meaning corporations whose core activities are
performed by employee-owners.

Examples of personal service corporations include corporations
through which people do business as doctors, attorneys, engineers,
actors, consultants, accountants or financial planners. The rules
apply to other closely-held C corporations to a more limited
extent. The passive loss rules do not apply to C corporations that
are not closely held and are not personal service corporations. A
corporation is closely held if five or fewer individuals own more
than half the stock during the last half of the year.

Thus, the level of shareholder participation determines whether
a personal service corporation or closely-held corporation
materially participates in its activities. Generally, one or more
of the individuals holding more than 50% of the outstanding stock
must materially participate in each of the corporation’s
activities to meet the material participation standard.

With respect to a personal service corporation, a loss is
passive if the loss stems from renting real estate or equipment to
others.

A loss is passive if it comes from a partnership or S
corporation business in which shareholders holding more than 50% of
the outstanding stock do not materially participate.

Similarly, if the personal service corporation owns interests in
a lower tier S corporation or partnership, material participation
means that shareholders owning more than 50% of the stock in the
personal service corporation must materially participate in the
business of the S corporation or partnership.

For a closely-held corporation that is not a personal service
corporation, passive losses and credits can offset the
corporation’s net income, but not portfolio income. This means
that passive losses can offset corporate earnings, but not
investment earnings.

Separate Activities

What makes things separate activities, and why do separate
activities matter? What if I own or invest in more than one
business? Can I aggregate those activities for purposes of the
material participation tests?

A person must materially participate an activity in order to be
able to use tax credits and losses from that activity against
active income. If the person does not, then the tax credits and
losses are passive, but can still only be used against passive
income from the same activity.

For purposes of the material participation standard, the term
“activity” does not necessarily mean a single business or
separate entity. Activities are not constrained by entity or
organizational lines — IRS rules permit grouping activities
and treating several businesses as one single activity if they form
an “appropriate economic unit.”

On the other hand, a single business entity could contain two
separate activities.

Whether single activities can be grouped into an
“appropriate economic unit” depends on a number of
factors: similarities and differences in types of activities, the
extent of common control, the extent of common ownership,
geographic location of the activities and interdependence among
activities. Factors that tend to show interdependence include the
extent to which activities rely on each other for goods and
services, involve products or services that are normally provided
together, have the same customers, have the same employees, or are
accounted for with a single set of books and records. An example of
two activities that might be treated as a single economic unit is a
retail store and a trucking company that transports goods for the
retail business, if both are under common control.

Any reasonable method of grouping is permissible, and there may
be more than one reasonable method for grouping activities.
However, once activities are grouped together, they must remain
grouped unless there has been a material change in facts and
circumstances.

One thing to keep in mind is that grouping might not always be
favorable. If one activity from a group is sold, prior unused
losses from that activity will be suspended and cannot be used to
offset taxes on gain from the sale until all of the grouped
activities are sold.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.