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Passive activity loss limitation rules and solar project investment

09.14.20

Read this if you are a solar developer or investor.

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, as with many things related to taxes, is “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 either there is 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 taxpayer with lots of dividend income who thinks it is passive income ends up with a rude awakening as that is actually portfolio income and does not allow for the offset of passive activity losses.

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: 

  1. You participated in the activity for more than 500 hours. 
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. The activity is a personal service activity in which you materially participated for any three (whether or not consecutive) preceding tax years.
  7. 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 dry, 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 you take the ITC 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.

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!

If you have any questions about your specific situation or would like to know more, please contact the team. We’re here to help. 

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Read this if you are a renewable energy developer.

Key areas in which developers face critical solar project development stumbling blocks include permitting and environmental matters, site control, interconnection, and preparation for project sale. Here, Mark Vitello and guest co-author Brendan Beasley of Klavens Law Group, P.C. look at preparing for project sale.   

Common pitfalls renewable energy developers encounter when selling projects

Starting from infancy of a project through negotiation of an exit transaction, there are some common―and preventable―missteps developers need to avoid. These include corporate housekeeping and contract missteps; underestimating time to obtain third-party items; striking the wrong balance in a letter of intent; over-reliance on a develop-and-flip business model; undue optimism regarding project assumptions; inadequate protection against payment risk; and not covering bases with a co-developer.

Staying on top of corporate housekeeping

To a developer, the corporate side of project development is low risk and unexciting. Perhaps because of this, developers often neglect corporate matters. This is particularly common for developers without a full-time in-house counsel. Small mistakes can add up. Steps like forming a special purpose project company early in the development process and assigning any pre-existing project contracts or entitlements to the project company can be overlooked or postponed (and eventually forgotten) as a cost-saving measure.  

Here are six common mistakes we see: 

  1. the wrong entity executing a project contract;
  2. misspelling the project company name;
  3. unauthorized signatories (or incorrect title for the right signatory); 
  4. failure to pay state corporate franchise fees; 
  5. losing project documents and signature pages, or not fully compiling project documents; and 
  6. inadvertently allowing liens against a project company or project assets.

These and similar issues can be resolved during the due diligence process, but this typically comes with additional legal costs and delay, is inefficient from a capital perspective, and can jeopardize a buyer’s confidence. There are various approaches to prevent issues and help spot issues in advance. For example, forming a project company is a fairly simple and repeatable process that a good set of forms and checklist can address. As a project moves to development-stage, periodic audits of your organizational and project documents by, for example, maintaining a living data room, will support a smooth transition to marketing your project.

Obtaining third-party items early in the process

Third-party items always take longer to secure than you expect. For example, if you are selling a solar project, you will likely need landlord and offtaker estoppels and, if the deal is structured as a sale of assets, consents to assignment. You will likely need a title commitment and survey. A ground mount project will need a Phase I environmental site assessment, and, often, some sort of permitting report or opinion. An independent engineer report may be required. These are just a few examples of numerous third-party items that are common conditions to closing a sale transaction or part of due diligence. 

Lessen the impact of third-party items, and avoid surprises by attacking these items early. Securing estoppels, consents, reports, and opinions early, even if it becomes necessary to “bring down” or refresh them for the closing date, is immensely better than not initially securing them and leaving your project exposed to third-party risk. It is never too soon to raise third-party estoppels, as that sets expectations. If possible, create incentives or penalties tied to delivery by the third party. For example, estoppels can be addressed in some capacity in your project documents by establishing a covenant to deliver an estoppel within a certain number of days of request and including a form of agreed-upon estoppel. For consents, a project document can identify certain instances where consent is automatic, such as assignment of the document to affiliates, or to third parties meeting certain credit or experience thresholds.

Right sizing the letter of intent (LOI)

Developers should avoid following the middle path in negotiating a letter of intent. Typically, the only two binding terms in an LOI relate to the exclusivity period and confidentiality. Nevertheless, there can be a lot of LOI deal term stickiness when it comes to drafting the definitive purchase agreement. As a result, we usually recommend one of two approaches: (1) no LOI or a very skinny one; or (2) detailed LOIs. 

Factors such as transaction complexity, counterparty risk, potential repetition of transactions, and internal approval processes tend to dictate the right approach in any particular situation. A skinny LOI might have a shorter exclusivity period to extend as the parties coalesce on terms and due diligence progresses. This approach establishes momentum toward due diligence and negotiation of a definitive agreement. One place to avoid ending up, however, is with an LOI that was only lightly negotiated yet covers many deal terms. This scenario can leave a developer (or buyer) in a lurch if certain expected terms of a purchase agreement cannot be agreed upon and were not covered in the LOI or, worse, negotiated deal terms in the LOI are not agreeable to the developer’s management or investors. A project with a commercial operation date deadline, permitting deadlines, and/or a fixed incentive period can ill afford to be stuck in exclusivity with a counterparty unwilling to budge from agreed LOI deal terms.  

Maintaining a Plan B―and a Plan C

Sure, most developers have no tax appetite, limited capital, and want to sell at the first possible opportunity. That’s fine. However, until that exit transaction occurs, the developer owns the project and should have an ownership mentality toward the project. Taking this approach can set the developer in the driver’s seat in purchase agreement negotiations by creating a viable, and perhaps even more valuable alternative path if negotiations stall. Over-reliance on a prospective purchaser that intends to finance construction or insists on procuring key equipment can result in a situation where the buyer exerts leverage if a developer has no Plan B in place. 

Having construction finance capacity or additional equity funding can markedly change the dynamics of post-LOI negotiation. If a developer does walk away from a transaction without having continued development during the period under exclusivity, the developer losses time while often increasing project risk due to outside commercial operation dates and expiring incentives and permits. On the other hand, a developer that has moved forward on a project, and even entered construction, will de-risk a project leading to potential pricing upside.

Correctly pricing transaction assumptions

A typical pre-commercial operation solar M&A transaction involves a purchase price paid in milestones. Frequently, LOI-stage assumptions based on the expected state of the project at the time of signing the definitive purchase agreement turn out not to be accurate. While certain things, such as ultimate project size or property tax burden, are often the subject of mechanisms to adjust the purchase price if later conditions vary from an assumed baseline, it can be risky not to negotiate contingencies with respect to other items, such as whether an executed site lease (still in negotiation) or a key permit (subject to upcoming local board vote) will be in hand at signing. 

Developers tend to be optimistic. However, a developer may wish to agree on pricing or milestones at the LOI stage based on conservative estimates to protect itself if the parties are otherwise ready to sign a definitive purchase agreement. Contemplating both “base case” and “ideal case” pricing and milestones in the LOI can help ensure a developer’s management and investors are on board. It also avoids over-promising and under-delivering, which can be more harmful to reputation and may result in a bigger discounts or deferrals of purchase price than if the base case were negotiated up front.

Ensuring buyer credit quality

A developer must consider the creditworthiness and reputation of a project buyer and put in place necessary protections both to ensure payment of purchase price and continued development and construction of the project. A parent guaranty can not only decrease the general credit risk of the buyer, but, depending on the buyer’s corporate structure, can also result in independent management personnel’s reviewing a milestone payment dispute with fresh eyes. This unbiased perspective may be more realistic and potentially sympathetic to a developer’s claim for payment. 

Other options to protect against risk of non-payment are project entity (or asset) buy-back rights and escrow agreements. In iterative transactions, such as ongoing sales of a portfolio of projects, a developer’s ability to offer future projects from the pipeline to the buyer on similar terms can act as a substantial incentive to the buyer to make payment. A common payment default scenario is a buyer’s unilaterally setting off against the purchase price for claims that may not have any merit. In this case, a buyer rarely has incentive to begin dispute resolution as it is holding the money. 

Developer protections to address this issue, in addition to those discussed above, include restrictions on set-off (which may include requirement of developer written approval or commencement of dispute resolution), litigation fee-shifting, and meaningful deductibles on buyer claims.

Selling co-developed projects

If you have a co-developed project, be sure your development partner is on board before signing an LOI, even if you may have exclusive authority over project sales. Better yet, ensure that each partner signs the LOI. The benefits are two-fold. First, this can protect against a later disagreement with your development partner on deal terms and kick-off discussions regarding allocation of risk between the co-developers in the event of post-closing claims. Second, this will give confidence to the prospective buyer that all necessary parties are in favor of the transaction.

For more information

If you have questions or would like more information about these matters, please contact Brendan Beasley or Mark Vitello.

Please note, this article, 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.
 

Article
Avoiding project development pitfalls: Solar M&A

Read this if you are a solar energy investor, installer, or involved in the renewable energy sector.

One of the benefits to a tax equity investor investing in a renewable energy project is the losses generated by the depreciation of the energy equipment being placed in service. Projects qualifying for the federal Investment Tax Credit are given a five-year MACRS life, providing a cost recovery deduction over five years from the in-service date (typically six tax return filings).  

Investors with eligible income from other sources can offset that income using the losses generated by the depreciation. In some cases the investors have more losses than they can use, which results in a Net Operating Loss (NOL). The rules around NOLs have changed several times recently, and it’s important to know what steps investors should take in order to maximize the benefit from their investment in a renewable energy project.

Historically, individuals could use losses to fully offset their taxable income in the current year. Any excess loss was to be carried back two years to offset taxable income on a previously filed tax return, if available. Any excess NOL carried back and not absorbed would then be carried forward and available for 20 years. This provided a source of immediate funds for investors, as an NOL carryback typically resulted in a recovery of taxes paid in a prior year.

An election could also be made with the original loss return to forgo the carryback and elect to carry forward only. In some cases investors determined that it was more beneficial to have the loss available to offset future income―for example, in cases where the tax rates were set to increase, if the depreciation benefits from a prior project were set to expire, or an anticipated large income event was on the horizon. These losses could also be carried forward for 20 years.

Impacts of Tax Cuts and Jobs Act on NOLs

With the passing of the Tax Cuts and Jobs Act (TCJA) in December of 2017, tax returns filed beginning with tax year 2018 were subject to some changes around NOLs. Some impacts:

  • Losses were no longer allowed to offset 100% of taxable income in the current year, now only being able to offset 80% of taxable income. The remainder was reserved as an NOL available on future returns 
  • The removal of the two-year carryback period 
  • The 20-year cap for NOL’s carried forward was removed, letting them carry forward indefinitely

While most investors were able to use their losses in the first several years surrounding the original loss year, removing the expiration cap on the NOL carryforwards was at least a compromise to losing the other benefits of generating a loss from the investment. The changes from the TCJA shifted the tax strategy focus, as investors who had previously been able to invest in projects and avoid paying federal income tax completely now had to budget for paying tax on at least 20% of their income. The influx of cash from carrying an NOL back to a prior year was no longer an option, as many investors factored that into their ability to repay debt or final construction invoices. While these weren’t completely devastating changes, they were ones that needed to be considered, modeled, and budgeted before any investments were made to ensure proper cash flow.

COVID-19 and its impacts

Then the COVID-19 pandemic hit, and impacted businesses in all corners of the economy. Congress passed the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in March of 2020 with wide-sweeping incentives intended to keep cash flowing to those that needed to continue paying bills while businesses were closed. One of the major tax code changes was to the rules surrounding NOLs. The CARES Act temporarily repealed the 80% limit of the TCJA, once again allowing individuals to offset all of their taxable income with an NOL generated in 2018 through 2020.  

Actions to take

In addition, the carryback was also temporarily re-instated, and expanded to five years for losses generated in 2018-2020. Some considerations:

  • An investor who has already filed their 2018 tax return should look to see if their losses were limited on that filing. If so, an amended return should be filed to retroactively claim the full amount of the losses available in 2018 on that return.  
  • Additionally, an analysis should be done to verify the benefit of carrying back the losses to 2013-2017 returns and potentially claiming additional refunds for those years, depending on the volume of available losses and taxable income.

As the pandemic continues, and project completion is potentially delayed, it will be important for investors to monitor income and losses over the next six months to determine if they will be able to fully utilize NOLs for 2020, or if they will need to plan for a return to the TCJA 80% limitation rule in 2021.

If you have any questions or would like to know more, please contact the team. We’re here to help. 
 

Article
Net Operating Loss rules in renewable energy: COVID-19 changes

Read this if you are a solar investor, developer, or installer.

After a recent article where we highlighted some of the major points of the ITC safe harbor, we received many calls and e-mails looking for clarification on some of the related issues. In working to answer these questions we teamed up with Klavens Law Group, P.C., a Boston law firm that specializes in clean energy. Together with Brendan Beasley and Jon Klavens we have compiled a list of frequently asked questions that may be helpful as you navigate the last few weeks of the year. 

Q: My project is not ready for construction due to a pending decision on a land use permit. How can I minimize capital expenditure while still qualifying the project for the 5% safe harbor?
A: There are a couple approaches you as a taxpayer can take. First, if this project is among several in your portfolio, you can pay or incur expenses prior to December 31, 2019 for enough safe harbor equipment under a single binding contract to qualify each project in your portfolio and retain flexibility to allocate that equipment. Applying the master contract approach (per Section 7.03(2) of IRS Notice 2018-59), you would then transfer equipment, even after December 31, 2019, to affiliate special purpose entities under a second binding contract. Second, you can enter into a binding contract that is subject to a condition, applying section (ii)(B) of the “binding contract” definition at 26 CFR Section 1.168(k)-1(b)(4). In this case, the condition would be the project receiving the land use permits and clearing any related appeals period. Under this approach you would still need to pay or incur―or have your EPC contractor pay or incur under the look-through rule―at least 5% of the project’s depreciable cost basis by December 31, 2019. A limitation on this approach is that, if the condition is not likely to be satisfied within three-and-a-half months of the date of your binding contract, either you or your EPC contractor (applying the look-through rule) must take delivery of the equipment while the condition―and presumably the viability of the project―is still open and uncertain. 

Q: Can I finance a purchase of safe harbor equipment for my project?
A: Yes; however, you can’t use vendor financing. 

Q: I have a project that will be ready to construct in Q2 2020. The project company will execute a binding EPC agreement by December 31, 2019 that includes a procurement component. It will make an initial milestone payment of 7% upon execution. Does my project qualify for the 5% safe harbor?
A: Maybe. There is not enough information here to confirm. As taxpayer you must pay or incur expenses amounting to at least 5% of the total cost of the energy property prior to December 31, 2019, and must take delivery within three-and-a-half months from the date of payment under your binding contract. So the critical question here is what your EPC contractor is doing with that 7% payment. Here are some possible outcomes:

  • The EPC contractor purchases inverters on December 31, 2019 pursuant to a binding contract with a vendor. Applying the look-through rule, the safe harbor is satisfied.
  • The EPC contractor self-constructs a specialized racking system in January 2020, per your EPC agreement, and delivers it to you within three-and-a-half months of the binding contract. The safe harbor is satisfied.
  • The EPC contractor prepares 10% construction drawings and applies for a building permit, each at nominal cost, and holds your 7% payment while waiting for module prices to come down. The safe harbor is not satisfied.
  • The EPC contractor allocates its previously purchased inverters to your project, per your EPC agreement, holding them in its warehouse until May 2020 before delivering them to your site. The safe harbor is likely satisfied. Applying the look-through rule, the EPC contractor’s purchase of the inverters pursuant to a binding contract in 2019 (even if prior to the EPC agreement) will qualify the inverters for safe harbor purposes. The EPC contractor must take steps to identify and segregate the particular inverters within its warehouse.

Q: Can I sell safe-harbored equipment?
A: The buyer of your equipment (unless it is an affiliate) may not utilize the safe harbor unless you are selling the equipment together with the solar project. If, for example, your sale also includes a site lease and a PPA, the purchaser would receive the benefit of the safe harbor. In certain circumstances, you may also be able to become an affiliate of a project LLC by acquiring a membership interest of at least 20% and make an in-kind contribution of the safe-harbored equipment to the project LLC.           

Q: Can I satisfy the physical work test by building roads within my site?
A: Yes; however, the roads must be integral to the energy property. An access road would likely not be interpreted as integral to the property. However, roads used for purposes of operations and maintenance activity―within the area of the facility itself―are considered integral to the energy property.

Q: What constitutes work of a physical nature?
A: This is really open to the facts and circumstances interpretation. The IRS notice instructions referenced previously indicate some specific activities that do not qualify, but there is no quantification of how much of a qualifying activity must be done in order to satisfy the safe harbor requirement. Preliminary planning and site work do not count. But starting construction would, so you could satisfy the requirement with excavation for a foundation, drilling for moorings, pouring concrete, etc. The best bet would be to actually put up a section of panels.

Q: What is the continuing work requirement?
A: There is an additional safe harbor that says if your project is placed in service within four years of the end of the calendar year in which you started it you will have automatically met the continuous work requirement. If your project goes beyond that you will need to show facts and circumstances showing you were taking steps to continue working towards completing the project. For example, if the delay was due to a delay in getting interconnected, be prepared to show documentation that you were continuously working towards resolving that issue.

Unless there are changes to the current tax law, these same provisions will be in effect for each step of the phase-out through the end of 2023. If you have further questions, please contact a member of our renewable energy team

Please note that this Q&A, 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.

Article
ITC safe harbor frequently asked questions

Read this if you are a solar investor, developer, or installer.

With December well under way, thoughts turn to year-end and tax filing preparation. While we get many questions this time of year related to changes in the tax law and what taxpayers can do before the end of the year to minimize their tax burden, different this year is the impending phase-out of the Investment Tax Credit (ITC) and Residential Energy Credit (REC) from 30% to 26%. 

Last month, we gave some pointers on the safe harbor provision available for the Investment Tax Credit which would allow qualifying projects to still be eligible for the 30% credit after the end of the year. No such provision exists for the residential credit, however, and any project not complete by 12/31/19 (and completed in 2020) will receive the reduced 26% credit.

The phase-out was designed to coincide with the projected decline in solar costs, and would help smooth the transition to a market where solar competes directly with fossil fuels for energy production. Since then, we have seen component costs increase due to artificially inflated prices resulting from the tariffs imposed on imported goods. This results in a mismatch on the timing of the phase-out to the cost of the materials, a still immature market for solar, and a missed opportunity. Enter a new bill in the House of Representatives.

Growing Renewable Energy and Efficiency Now Act

On November 19, 2019 Chairman Thompson of the House Ways and Means Subcommittee released a discussion draft of a bill titled the Growing Renewable Energy and Efficiency Now (“GREEN”) Act. This draft bill is not ready for a vote yet, but does promote an extension and/or expansion of tax incentives for taxpayers investing in cleantech. With the GREEN Act, solar investors, installers, and other related businesses would benefit from:

  • Revival and extension of the Production Tax Credit (PTC) through 2024
  • Delay of the ITC and REC phaseout until 2024
  • Expansion of the ITC to include additional technologies, most notably energy storage
  • A provision allowing the taxpayer to receive the ITC or PTC as a refund in the year it is claimed for 15% reduction in the value of the credit

A delay in the phase-out would allow time for the costs of components to return to pre-tariff levels and help achieve the original intention of the phase-out. The expansion of the ITC to include energy storage would be a huge boon to that emerging market, and provide an additional incentive for consumers to install storage on an existing project―creating a more efficient energy grid. 

Currently, due to accelerated depreciation, many taxpayers are not able to take the ITC or PTC in the first year due to not having a tax to offset. Allowing for the option to treat the ITC or PTC as a tax payment (which can be refunded) instead of a credit (which can’t) would help investors realize their return much faster and free up capital to invest in other projects. 

Some of these provisions are fairly aggressive, and it is unlikely that they will all remain as they are now in any future passed legislation. However, it is promising to see the House of Representatives considering these types of extensions and expansions when it comes to clean energy incentives. As renewable energy is still a relatively new and rapidly changing marketplace, this is a prime time for renewable energy professionals to keep representatives informed of what they need to help the industry continue to grow. 

Stay tuned, and please contact Mark Vitello if you have any questions or need more information.
 

Article
The GREEN Act―a ray of hope for the solar carve out and the ITC?

Read this if you are a solar investor, developer, or installer.

The solar carve out of the Investment Tax Credit (ITC) has been a great incentive for taxpayers to invest in solar assets over the last several years. It established an increased 30% tax credit for solar assets placed in service, up from the normal 10%. 

Starting January 1, 2020, the solar carve out will begin to phase out and will return to 10% by January 1, 2024. 

With the first phase-out of the ITC set to drop the credit from 30% to 26% after December 31, 2019, many taxpayers are evaluating ways to make sure their project still qualifies for the 30% credit. The IRS has issued two safe harbor provisions (IRS Notice 2018-59) to allow for projects placed in service after December 31, 2019 and before January 1, 2024 to still qualify for the 30% credit, but timing is key and certain actions must be taken before midnight on December 31, 2019.

Safe harbor methods

The two safe harbor methods are the Physical Work Test and the Five Percent of Cost Test. If a project satisfies either of these tests it can still qualify for the 30% tax credit as long as it is completed and in service before January 1, 2024.

The Physical Work Test requires that the taxpayer performs, or has performed on their behalf, “work of a significant nature” on the project prior to December 31, 2019. This is a little open to interpretation, but generally involves physical construction of the asset, such as the installation of mounting equipment, rails, racking, inverters, or even the panels themselves. Purchasing of equipment generally held in inventory by either the taxpayer or the vendor does not qualify. However, if the equipment is customized or specially designed for the specific project, it might. Preliminary activities do not qualify, which include planning, designing, surveying, and permitting. 

In general, the purpose of this test is to prove that construction has already begun, and is in place to help projects that have been started but won’t be in service before year end still maintain the 30% tax credit. Projects that are substantially complete and waiting for an interconnection or a permission to operate in order to be considered as in service will most easily qualify for this safe harbor test.

The Five Percent of Cost Test is a little more straightforward, and is likely to be more commonly used to qualify projects for the safe harbor provision as the end of the year deadline approaches. This test requires at least five percent of the total project cost be paid or incurred before December 31, 2019. It is important to note that the denominator in this test is the final total cost of the project when it goes in service. The taxpayer may wish to pay more than the five percent to account for project overruns or unanticipated changes to the project in order to make sure they maintain the qualification for safe harbor. 

Another consideration is if the taxpayer files on the cash or accrual method as to whether the project cost needs to be paid or incurred in order to satisfy the chosen filing method.

In either case, the taxpayer should also evaluate the cost of prepaying for equipment that may decrease in cost in the future, compared to the benefit they will receive in maintaining the additional four percent of the tax credit that can safe harbor from the phase out. 

Additionally, an analysis of total project costs and eligible vs. ineligible ITC costs early on in project development can help identify how best to spend the cash before the end of the year, and ensure that the taxpayer receives the return they require once the project goes into service.

Have questions?

If you have questions on these safe harbors or need more information, please contact the green tax experts on our renewable energy team

Article
Safe harbor options for taxpayers as the solar ITC begins to sunset

Read this is you are a business owner or an advisor to business owners.

With continued uncertainty in the business environment stemming from the COVID-19 pandemic, now may be a good time to utilize trust, gift, and estate strategies in the transfer of privately held business interests. 

As discussed in our May 26, 2020 blog post 2020 estate strategies in times of uncertainty for privately held business owners, there may be opportunity to free up considerable portions of lifetime gift and estate tax exemption amounts through transfers due to suppressed values of privately held businesses, and the uncertainty surrounding the impact of the 2020 presidential election on tax rates and future exemption and exclusion thresholds. 

An element to consider when building on this opportunity is the ability to transfer non-controlling interests in a business. These interests are potentially subject to discounts for lack of control and lack of marketability. This may further reduce the overall value transferred through a given strategy, potentially offloading a larger percentage of ownership in a business while retaining large portions of the gift and estate lifetime exemption. Let’s focus on the discount for lack of control (DLOC).

Discount for lack of control

In the context of a hypothetical willing buyer and willing seller, the buyer may place a greater value on an ownership interest with the ability to make changes at their discretion, compared to an alternative ownership interest lacking control. Simply put, buyers like to be in control, and they will pay less for the investment if the interest lacks these characteristics. 

When valuing non-controlling business interests there is an inherent discount to full value recognized to reflect the fact that the subject interest does not hold a controlling position. As a result of this discount, the value of a non-controlling interest in a company will differ from the pro-rata value per share of the entire company. DLOCs alone commonly reduce the value of the transferred interest by 5% to 15%.

All else being equal, a non-controlling ownership position is less desirable (valuable) than a controlling position. This is because of the majority owner’s right to control any or all of the following activities: managing the assets or selecting agents for this purpose, controlling major business decisions, asset allocation choices, setting salary levels, admitting new investors, acquiring assets, selling the company, and declaring/paying distributions.
 
Market-based evidence of proxies for DLOCs can be found within the following subscription-based databases (including, but not limited to): 

  • Control premium studies published in the Mergerstat® Review series by FactSet Mergerstat/Business Valuation Resources
  • Closed-end fund data
  • The Partnership Profiles, Inc. Minority Interest Database and Executive Summary Report on Re-Sale Discounts for applicable entity types

In addition to these resources, to fully assess the degree of discount applicable to a subject interest, consider company-specific factors when estimating the DLOC. The degree of control for a subject interest may be impacted by relevant state statutes and the governing documents of the subject company. These factors are analyzed in conjunction with the current operational and financial policies established and implemented in practice by management to establish a comprehensive view on the applicable degree of discount.

Conclusion

Hypothetical business owners are knowledgeable of the facts and circumstances surrounding a business interest. They take a close look at what they are buying before they make an offer. Like most people, they like to be in charge, and are therefore generally not willing to pay the pro-rata value for a minority interest in a business when the interest lacks control. To assess an appropriate discount for lack of control, consider resources such as those referred to above, then ensure the selected discounts are appropriate based on the factors specific to the company and interest being valued. 

Our mission at BerryDunn remains constant in helping each client create, grow, and protect value. If you have questions about your unique situation, or would like more information, please contact the business valuation consulting team.

Article
Discounts for lack of control and marketability in business valuations

Read this if you are an employer.

Note: The tax deferral situation is very fluid, and information may change frequently. Please check back for updates.

The Treasury Department and Internal Revenue Service released Notice 2020-65 on August 28th, addressing the following questions highlighted in our earlier payroll tax deferral article.

Does the employer or the employee elect to defer taxes?

Notice 2020-65 provides that Affected Taxpayers are defined for purposes of the Notice as the employer, not employee. Therefore, employers will have to choose whether or not to opt-in and defer taxes. Important to note: while the notice doesn’t specifically state that deferral is optional, the IRS press release implies that it is. 

It is unclear if an employee can elect out of the payroll tax deferral, if their employer elects to defer taxes. Absent guidance, it seems that an employer who elects to defer the payroll tax should apply the payroll tax deferral to all employees and not permit an employee to elect out of the deferral. 

The other question for an employer is whether the payroll software will be able to accommodate the deferral feature as of September 1st. It seems highly unlikely that payroll software will be ready for the September 1st effective date. Employers should reach out to their payroll vendor to determine when the system/software will be ready.

How do bonuses, commissions, or other irregular payroll items impact the $4,000/biweekly compensation limit?

Per the Notice, Applicable Wages include wages as defined in Internal Revenue Code (“Code”) Section 3121(a) (i.e., wages for withholding FICA taxes) or compensation as defined in Code Section 3231(e) (i.e., wages for the Railroad Retirement tax) only if the amount of such wages or compensation paid for a bi-weekly pay period is less than the threshold amount of $4,000, or the equivalent threshold amount with respect to other pay periods. Additionally, the Notice states that the determination of Applicable Wages is made on a "pay-period-by-pay period" basis. Therefore, Applicable Wages would include items such as bonuses and commissions. For example, if a bonus of $2,000 caused an employee’s total Applicable Wages to exceed the $4,000 bi-weekly threshold for the respective pay period to which it relates, deferral would not be required for that pay period. In other words, payroll tax deferral applies to Applicable Wages of $4,000 or less for any bi-weekly pay period (or the equivalent threshold for other pay periods) irrespective of amounts paid in other pay periods.

Based on the guidance, an employer’s payroll system will need to be programmed to automatically monitor the $4,000 bi-weekly threshold and accumulate the tax deferral for each employee.

When and how are amounts deferred due to be paid by the employee?

An employer must withhold and pay the deferred taxes ratably from wages and compensation paid between January 1, 2021 and April 30, 2021. Interest, penalties, and additions to tax will begin to accrue on May 1, 2021 with respect to any unpaid taxes.

This means that employers who elect to initiate the payroll tax deferral will double the Social Security tax withholding during the first four months of 2021. The President’s memorandum issued on August 8th states that Secretary of the Treasury shall explore avenues, including legislation, to eliminate the obligation to pay the taxes deferred pursuant to the implementation of this memorandum. However, only Congress can pass legislation to forgive the uncollected taxes, and has thus far been unwilling to do so.

What happens if an employee who is deferring taxes stops working for the employer? Is the employer responsible for collecting the taxes that were deferred?

This question is not addressed; however, the Notice does provide that an employer may make arrangements to otherwise collect the total taxes from the employee, if other than ratably from wages and compensation.

Employers electing to implement the payroll tax deferral may be assuming unnecessary financial risk related to employees who terminate employment during the period of deferral or during the period of repayment. Prior to initiating the payroll tax deferral, an employer will need to determine (and communicate to employees) how it will collect any unpaid tax deferrals when an employee terminates employment. For example, an employer could decide to withhold the deferred taxes from the employee’s final paycheck, if it can do so legally. Further guidance is necessary so an employer can determine the appropriate way to receive payment from employees who terminate employment.

Notice 2020-65 leaves many questions still unanswered.

Most notably, who is responsible for the taxes if an employer is unable to withhold due to an employee terminating employment? The IRS issued a draft version of a revised Form 941 to take into account the deferred payroll taxes.

Additional guidance will hopefully be forthcoming. Until further guidance is issued and payroll systems are updated, it is difficult for an employer to initiate the payroll tax deferral. 
 
 

Article
Payroll tax deferral update

Read this if you are an employer.

President Trump signed a memorandum on August 8 (hereinafter the “Memorandum”) ordering the Treasury Department to defer the withholding, deposit, and payment of the Social Security portion of the payroll taxes during the period September 1 through December 31, 2020. 

We have heard from a few employers who have employees asking them when the tax withholding will stop since September 1st is right around the corner. The short answer for employers and employees is the withholding deferral will begin “when Treasury and/or the IRS issues guidance”.

“Defer” and “deferral” are underlined for a reason. Employees must understand that the Memorandum provides for a “deferral” of the Social Security tax. The tax is not eliminated for the period September 1st through December 31st. This means that while an employee may enjoy some additional take-home pay during the period of deferral, the amounts deferred must still be paid to the IRS at some point. Only Congress can eliminate the payroll tax.

This is what we know so far:

  • The deferral only applies to the employee’s share of the Social Security taxes. It does not apply to the employee’s share of the Medicare taxes.
  • The deferral is only available to an employee with biweekly income of $4,000 or less, which translates to annual income of $104,000. 
  • Amounts deferred pursuant to the Memorandum shall be deferred without any penalties or interest.
  • For example, an employee earning $40,000 annually could potentially defer approximately $825 in payroll taxes and would need to pay that amount at a future date.

There are many open questions for both employees and employers to consider. Therefore, it is nearly impossible to move forward with the tax deferral guidance outlined in the memorandum. 

So, what are the operations questions that employers and employees need answers to before any deferrals can begin? Here are some that come to mind:

  • Does the employer or the employee elect to defer taxes?
  • If it is an employee election, how is that election made?
  • How do bonuses, commissions, or other irregular payroll items impact the $4,000/biweekly compensation limit?
  • When and how are amounts deferred due to be paid by the employee?
  • Are the amounts deferred repaid in a lump sum or in installments?
  • How does an employer report the deferred taxes to the IRS?
  • What happens if an employee who is deferring taxes stops working for the employer? Is the employer responsible for collecting the taxes that were deferred?
  • How quickly can payroll systems be set up to accommodate the payroll deferral?

At the moment, all employees and employers can do is wait for the relevant guidance. Hopefully, guidance is issued soon but it is unlikely any employees can begin the tax deferral on September 1st. 

As soon as guidance is issued, we will be sure to communicate the requirements and timing.

Article
To withhold or not to withhold payroll taxes―The dilemma facing employers