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.
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.
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.
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.