United States

Final regulations limit ITC lessee income inclusion benefits

TAX ALERT  | 

On July 17, 2019, the IRS published final regulations to provide guidance on the income inclusion rules of section 50(d)(5), as they relate to a lessee of investment credit property when a lessor elects to treat the lessee as having acquired the property. These regulations also coordinate the section 50(a) recapture rules with the section 50(d)(5) income inclusion rules, as well as providing rules regarding income inclusion upon lease termination, lease disposition by lessee, or disposition of a partner or S corporation shareholder’s entire interest out of the recapture period. The final regulations are effective July 17, 2019, and are applicable to investment credit property placed in service on or after Sept. 19, 2016. 

Background

The investment credit rules generally require the taxpayer credit claimant to ratably recoup the amount of credit over time. In the case of a taxpayer that owns the investment credit property, this results in reduced cost recovery deductions over the life of the property (or realization of adjusted gain/loss upon disposition of the property). Generally, this realization is caused by the basis reduction provision of section 50(c), which requires the owner to reduce the depreciable basis of the property by 50% of the investment tax credit. Compare this to a lessor that elects to treat the investment tax property as acquired by the lessee, which in turn causes the lessee to recognize the same amount in gross income over the life of the property. Some pass-through lessees subject to this election have characterized this recognized income as items of income from the pass-through, which theoretically entitles the taxpayer to an outside basis increase. The upshot of that treatment is an increased benefit to the lessee upon disposition, through either an offsetting loss or reduction in realized gain. 

Ultimately, the IRS determined that the burden of income inclusion should match the benefits of the allowable credit in these situations. The final regulations, therefore, disallow the lessee basis adjustments that would be allowed under 705(a) or 1367(a) (if the income that is required to be ratably included was characterized as items of income from the pass-through under section 702 or 1366). With this in mind, these final regulations formally adopt the 2016 proposed regulations (REG-102516-15) unchanged and repealed the temporary regulations found in TD 9776.

Key takeaways

The practical effect is a limitation on the basis, increases under section 705, that lessee partnerships and S corporations (the “ultimate credit claimants”) can recognize based on the applicable subchapter K and S provisions. The final regulations also limit the ability of a lessee to accelerate income inclusion outside of the 50(a) recapture period, as well as effectively modify Revenue Procedure 2014-12, naming the circumstances that the IRS will not challenge a partnership’s allocation of rehabilitation credits under section 47. 

The investment tax credit is complex, and many related provisions limit a taxpayer’s ability to recognize the associated benefits. With this in mind, consultation with a tax advisor experienced in energy investment tax credit projects is advised when applying this guidance. 

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