Tax Issues

The tax system often is used to provide incentives for particular types of investments the government wants to encourage. These incentives raise tax planning issues that go well beyond those involved in general structural, choice-of-entity, and other financing considerations, and create the potential for significant economic benefit. The available incentives also have been subject to frequent changes as federal and state energy policies have evolved. The following discussion is only a general summary and is current as of the date hereof. Please contact one of the attorneys listed above for answers to your specific legal questions and to check on any changes that may have occurred since the date of this publication.

I. Federal Income Tax Issues.

A. The Investment Tax Credit. The owner of a qualified solar facility may claim the investment tax credit (“ITC”). The ITC is a one-time credit against income tax that is based on the amount invested in a facility (rather than on the amount of electricity produced and sold). The amount of the ITC for a qualified solar facility depends on the year in which construction begins. If construction begins any time before 2020, the ITC equals 30 percent of the tax basis (generally the cost) of the qualifying property. If construction begins in 2020, 2021, or 2022 the ITC equals 26 percent of eligible costs, and if construction begins in 2023, the ITC equals 22 percent of eligible costs. If construction on an eligible solar facility begins after December 31, 2023, the ITC equals 10 percent of eligible costs. If construction of a solar facility begins before 2024 but the facility is not placed in service before 2026, the ITC is reduced to 10 percent of eligible costs.

  1. Requirements for Claiming the ITC. The ITC applies only to “energy property,” which is defined for purposes of a solar facility to include only property that meets the following requirements:

    a. Solar Equipment. The property must be equipment that uses solar energy to generate electricity, to heat or cool (or provide hot water for use in) a structure, or to provide solar process heat. In addition, equipment that uses solar energy to illuminate the inside of a structure using fiber-optic distributed sunlight may qualify for the ITC. Property used to generate energy for the purpose of heating a swimming pool does not qualify for the ITC.

    b. First Use or Construction by Taxpayer. If the property is acquired by purchase, the original use of the property must commence with the taxpayer claiming the credit. Otherwise, the property must be constructed, reconstructed, or erected by the taxpayer claiming the credit.

    c. Depreciable or Amortizable. The property must be eligible for depreciation or amortization deductions for federal income tax purposes. This requires that the property be used in a trade or business.

    d. Performance and Quality Standards. The property must meet any applicable performance and quality standards prescribed by the Secretary of the Treasury. To date, the Secretary has not prescribed any such standards.

  2. Beginning of Construction. As described above, the amount of the ITC for a solar facility depends in part on when construction of the facility begins. The Internal Revenue Service has issued detailed guidance—Notice 2018-59, Notice 2020-41, and Notice 2021-41—regarding the beginning-of-construction requirement that must be carefully considered, taking into account the specific facts involved. Generally speaking, construction is considered to begin when either (i) physical work of a significant nature begins or (ii) 5 percent of the cost of the facility is incurred. In either case, the owner also must engage in continuous construction or continue to make continuous efforts thereafter, although a safe harbor may be available depending on when the facility is placed in service. Generally, the continuous construction and continuous efforts requirements will be deemed satisfied if a facility is placed in service (1) in the case of a facility the construction of which began in 2016, 2017, 2018, or 2019, by the calendar year that is no more than six calendar years after the calendar year during which construction of the facility began, (2) in the case of a facility the construction of which began in 2020, the calendar year that is no more than five calendar years after the calendar year during which construction of the facility began, or (3) in the case of a facility the construction of which begin after 2020, the calendar year that is no more than four calendar years after the calendar year during which construction of the facility began.
  3. Progress Expenditure Rules. In certain circumstances involving qualified energy property with a normal construction period of more than two years, a taxpayer may be entitled to claim the ITC with respect to progress expenditures incurred in tax years before the property is placed in service.
  4. Basis Reduction. The tax basis of property with respect to which the ITC is claimed is reduced for all tax purposes (including depreciation and calculating gain from a sale) by one-half of the amount of the credit. Thus, the tax basis of the qualifying components of a solar facility with respect to which the ITC is claimed generally will be 85 percent of the cost of those components.
  5. Recapture of the Credit. The ITC is subject to recapture if, within five years after a facility is placed in service, the taxpayer sells or otherwise disposes of the energy property or stops using it in a manner that qualifies for the credit. The amount of recapture depends on when during the five-year period the property is disposed of or ceases to be used in a qualifying manner.
  6. No Cutback for Government Financing. Under prior law, the ITC for a solar project generally was reduced with respect to facilities that were financed in whole or in part with the proceeds of tax-exempt bonds, subsidized energy financing, or other forms of government-supported financing. This restriction generally was removed for property placed in service after December 31, 2008 (and for self-constructed property, to the extent of the basis attributable to the period after December 31, 2008).
  7. Nonrefundable Credit. The ITC is a nonrefundable credit. If a taxpayer entitled to the ITC does not have sufficient income tax liability to use the entire credit for a particular year, the taxpayer is not entitled to a refund of federal income tax on account of the credit. Any unused portion of the credit generally may be carried first back one tax year and then forward 20 tax years from the year the credit arose.
  8. Sunset Date. There is no sunset date for the 10 percent ITC for solar facilities on which construction begins after December 31, 2023.

B. Depreciation. In addition to tax credits or grant payments, solar facilities also can generate significant tax losses that can be valuable to owners with other sources of taxable income that can be offset by the losses.

  1. MACRS Depreciation. Qualifying components of a solar facility are eligible for greatly accelerated depreciation deductions under the Modified Accelerated Cost Recovery System (“MACRS”), typically over a five-year period based on the double declining balance method of depreciation.
  2. Bonus Depreciation. An owner of otherwise qualifying property that is placed in service after September 27, 2017 and before January 1, 2023 generally is entitled to deduct 100 percent of the adjusted basis of the property in that year. An owner of qualifying property acquired after September 27, 2017 is entitled to 80 percent bonus depreciation for property placed in service in 2023, 60 percent bonus depreciation for property placed in service in 2024, 40 percent bonus depreciation for property placed in service in 2025, and 20 percent bonus depreciation for property placed in service in 2026. Bonus depreciation provisions expire for property placed in service beginning January 1, 2027. To qualify for bonus depreciation, property generally must have a recovery period of 20 years or less. Thus, property that otherwise would qualify for five-year MACRS depreciation, for example, generally will qualify for bonus depreciation.

C. Monetizing Federal Income Tax Benefits; Ownership Structuring Issues. A taxpayer that has little or no need for tax credits or losses (e.g., because it has little or no tax liability) may nevertheless be able to obtain the benefit of various tax incentives by entering into an arrangement with an investor that can use credits, losses, or both. For example, in a partnership flip transaction, a taxpayer enters into a partnership with an investor that is willing to contribute cash to help finance a solar facility. The partnership then operates the facility and, within certain limits, the tax credits and losses can be allocated to the partner that can use them. As an alternative, in a sale-leaseback transaction, a taxpayer develops a facility, places it in service, sells it to an investor, and then leases it back from the investor. These and other potential techniques for “monetizing” tax credits and losses (including inverted leases and prepaid power purchase agreements) involve risk and require careful tax planning. These considerations should be taken into account in the very early stages of a project, including when choosing the type of entity that will own a facility and the various financing alternatives available. Analysis of the economic benefits of the various incentives requires, among other considerations, careful financial modeling of the projected costs and output of each specific project and of the full array of potential tax and financing implications. This should include careful consideration of any limitations that may apply to a particular owner’s ability to claim the available tax benefits, such as alternative minimum tax liability, at-risk limitations, and passive activity limitations.

II. State and Local Tax Issues. In addition to federal income tax issues, construction and operation of solar facilities also raise numerous state and local tax issues that should be carefully examined. Following is a general description of the types of issues that may arise, with selected examples. Developers and investors should be careful to obtain very current information about state tax in general, and state tax incentives in particular. States are generally narrowing their incentives for renewable energy projects, either by interpreting existing law narrowly or by legislative change, sometimes with retroactive effect.

A. Net Income Tax States. The vast majority of states impose a net income tax. States generally base their income tax system on the federal system, and many states have adopted relatively uniform rules governing division of the tax base and computation of taxable income. Despite these similarities, however, each state’s tax system is different and must be separately analyzed.

  1. Nexus, Business Structure, and Apportionment. Siting a solar project in a state generally will create “nexus” with the state and generally will allow the state to tax the income of the company that owns or operates the project. Less substantial activities, such as consulting, may create nexus with a state as well.

    One of the most important decisions affecting state taxation is the type of legal entity used when starting a new project. Choices may include corporations (including S corporations and C corporations), LLCs, and limited partnerships. The decision can affect:

    • Whether tax is imposed directly on the project company or on its owners; and
    • Whether taxable income (or loss) is determined on a stand-alone basis or whether state tax will be measured by combining or consolidating the income of affiliates, including the parent company.

    States generally measure the taxable income of a company by apportioning a percentage of overall taxable income to the state. The percentage is determined by a formula that relies primarily on gross receipts attributable to the state divided by gross receipts everywhere. An increasing number of states, including California, Oregon, and Minnesota, generally rely exclusively on gross receipts (“single-factor apportionment”), but additional factors such as property or payroll in the state may apply in some circumstances and are the norm in some states, including Montana. For purposes of attributing sales of electricity among different states, some states follow the traditional approach of sourcing the sale based on where the greatest proportion of income-producing activity related to the sale occurs. Other states may use different sourcing rules. For example, for Oregon apportionment purposes, sales of electricity by public utilities are sourced to the state where delivery occurs, as indicated by the parties’ documented agreement, while sales by nonutilities are sourced to the state of ultimate destination regardless of the place of delivery.

    The choice-of-entity and apportionment rules can sometimes produce surprising results: if the company or group as a whole has taxable income, the company may owe tax to a state even if the activities in that state are not profitable on a stand-alone basis.

  2. Income Tax Incentives. Some income tax states offer incentives to promote the development of solar energy and other alternative energy projects. It is important to understand the nature of each incentive, as there is considerable variation among the states. Also, as noted above, some state incentives may reduce the amount of the federal incentives available for the project.

    a. Hawaii offers an income tax credit for certain alternative energy systems, including solar systems. Hawaii provides a tax credit for the lesser of 35 percent of the cost of a solar system or $500,000 where the system is installed on commercial property for commercial use. The credit applies to the tax year in which the system is placed in service and it may be carried forward until exhausted. For taxable years beginning after December 31, 2019, no tax credit is allowed, subject to limited exceptions, with respect to a solar energy system that is 5 MW in total output capacity or larger and requires a power purchase agreement approved by the Hawaii public utilities commission.

    b. Oregon formerly offered a similar investment-based credit, known as the Business Energy Tax Credit (“BETC”), for development of solar and other renewable energy generation projects. While legacy projects will continue to benefit from the BETC for several years to come, the program has been severely curtailed for new generation projects.

B. Sales and Use Taxes. Nearly all states impose a sales tax. In most states, the tax is imposed only on sales of tangible personal property. Some states also impose use tax on sales of certain kinds of services. In addition, some states impose a transfer tax on the sale (and sometimes the lease) of real property.

  1. Purchase or Use of Equipment. Most states’ sales and use taxes will apply to the purchase or use of equipment within those states.
  2. Generally No Sales or Use Tax on Sales of Power. Most states that impose sales and use taxes do not impose those taxes on sales or use of electricity.
  3. Sales Tax Incentives. A number of states, including Washington, Minnesota and Colorado, have adopted an exemption from sales tax for machinery and equipment used in solar facilities. As noted above, some of these exemptions have recently been narrowed, and states are increasingly assigning sunset dates to tax credits and other incentives, in order to force periodic legislative review of their programs. For example, the amount of the exemption in Washington is dependent on certain requirements being satisfied, such as prevailing wage rates being paid. Likewise, several years ago the legislatures in Nevada and Idaho allowed sales tax exemptions for solar equipment to expire.

C. Property Tax. Virtually all states impose property tax that is assessed annually and is measured, in some fashion, by the value of real property. Most states also tax tangible personal property that is used for business purposes. Intangible property is taxable in some states if the owner is centrally assessed, as discussed below.

  1. “Central” or “State” Assessment Likely. In many western states, such as Oregon, a company that produces electricity is “centrally assessed” for property tax purposes. Central assessment means that the taxable value of the property is determined by the state revenue authority rather than by the county assessor’s office. In Washington, central or local assessment depends in part on whether the company’s property crosses county lines. In California, the facility’s output is a factor in determining whether central assessment applies.
  2. Valuation. States generally accept the three traditional valuation methods for valuing electricity generation property (cost approach, income approach, and comparable sales approach). However, if the property is centrally assessed, the state taxing authority may also be authorized to determine value by combining the property with other facilities owned or used by the same company. In that case, the taxing authority may aggregate property within and without the state, determine the value of the entire “unit,” and allocate some portion of the unit value to the taxing state by means of a formula. Determining the correct value of a particular project is a matter of frequent controversy. Industry efforts to obtain special valuation rules that take into account the unique aspects of solar power have been successful in some states, such as Colorado.
  3. Property Tax Reporting. States typically require owners of centrally assessed property to file annual returns reporting the value of their property. It is good practice to consult a valuation expert before filing the first return with respect to the property, in order to accurately communicate on the return items that could result in tax savings in future years.
  4. Rollback Penalties in Farm and Timber Use Areas. Many states impose property tax penalties when land that is used for farming or timber is dedicated to a different use. In addition to those penalties, property taxes may increase prospectively after the change of use. This issue typically arises when land leases are negotiated. It is best to address this issue as part of financial modeling.
  5. Property Tax Incentives. As part of due diligence in constructing or acquiring a solar facility, it is worthwhile to inquire whether any property tax incentives are available. Property tax incentives can be particularly advantageous because property tax liability typically applies throughout the life of the project. In contrast to income tax, property tax is often highest in the early years before the project is profitable. Nevada and Montana, for example, offer property tax exemptions for certain renewable energy facilities, including solar energy facilities. The Nevada and Montana exemptions may be full or partial exemptions, depending on the characteristics of the applicable solar facility. California offers a property tax exclusion for certain newly constructed solar energy facilities. The California exclusion does not apply to facilities owned by centrally assessed companies or for which there has been a change in ownership for property tax purposes. Oregon’s exemption statute was expanded in 2007 to allow exemption for a greater range of projects when the electricity is used on-site, but this exemption is scheduled to sunset for tax years beginning after July 1, 2023. Also in Oregon, it may be possible to obtain a temporary property tax exemption under the state Enterprise Zone Program or the Strategic Investment Program. The Enterprise Zone Program typically offers an exemption for three to five years, but in rural areas the exemption period may be as long as 15 years. To qualify, state law requires that the company increase its permanent, full-time employment within the zone by at least 10 percent. (Note that one employee may satisfy the minimum hiring requirement if the company has not previously operated within the zone.) Other requirements, such as minimum capital investment size, may apply. The Strategic Investment Program statutes offer a partial exemption for 15 years, with a fee payable to the county and other potential conditions. Negotiations for benefits under both the Enterprise Zone and Strategic Investment Programs generally occur at the county level, sometimes with participation of cities.
  6. Taxes in Lieu of Property Tax. States may impose taxes in lieu of property tax. Minnesota, for example, imposes a solar energy production tax in lieu of personal property tax on solar facilities. The owner of a solar facility must report the annual production (in kWh) of the facility to the Minnesota Department of Revenue by January 15 of the calendar year following production. The Department of Revenue determines the production tax due and notifies the owner and county or counties where the facility is located. The owner of the facility must then remit the tax to the appropriate county or counties. The tax rate is $1.20 per MWh of energy produced. In Oregon, the governing body of a county (and any city) and the owner or lessee of a solar project may enter into an agreement that exempts the solar project from property taxes and allows the payment of a fee in lieu of property taxes imposed on the solar project. Similar to Minnesota, Idaho now imposes a tax of 3.5 percent on gross solar energy earnings, which are defined as the gross receipts of a solar energy generator from the distribution, delivery, and sale of electrical energy generated, manufactured, or produced by means of solar energy within Idaho to a customer for direct use or resale. Annual reporting requirements also are imposed, as well as authorization of liens for unpaid taxes. The Idaho solar energy tax is imposed in conjunction with a property tax exemption for real estate, fixtures, and personal property of a solar energy electricity producer held or used in connection with generating, transmitting, distributing, delivering, or measuring electricity produced by means of solar energy.

D. Excise Taxes. When considering operation of a solar facility, state and local excise taxes also should be taken into account.

  1. Washington Public Utility Tax. The state of Washington and a number of municipalities within Washington impose a public utility tax (“PUT”) on the privilege of engaging in certain utility businesses within the state and those localities. The state PUT is imposed at a rate of 3.8734 percent of gross income derived from certain enumerated public service businesses, including the “light and power business.” The “light and power business” is defined for purposes of the state PUT as “the business of operating a plant or system for the generation, production or distribution of electrical energy for hire or sale and/or the wheeling of electricity for others.” The state PUT is intended to apply only to revenues derived from the retail sale of electricity to consumers. Accordingly, deductions in computing gross revenues may be allowed for revenues derived from the sale of electricity for resale, among other deductions. The Washington business and occupation tax may also apply, depending on the specific activities that the business conducts. Cities and towns also may impose a local PUT or a local business and occupation tax, or in some circumstances both. Local rates can be substantial.
  2. Other State and Local Excise Taxes. Other states and localities may impose other kinds of excise taxes. For example, some California cities impose gross receipts taxes for the privilege of doing business in the locality. California imposes a fee based on gross receipts for the privilege of doing business as an LLC. Similarly, Nevada imposes a commerce tax for the privilege of engaging in business in Nevada. The commerce tax is based on the Nevada gross revenue of the business, and different tax rates apply to different categories of business. All potentially applicable taxes, including state and local excise taxes, should be carefully analyzed in determining the costs and benefits of operating a solar facility.

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