The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 was signed into law in December 2010. This multi-billion dollar tax cut package provides a few key tax incentives for renewable energy projects. The following are some of the favorable provisions impacting renewable energy projects.
1603 Grant extended
Section 1603 of the American Recovery & Reinvestment Act of 2009 allows a cash grant instead of claiming a tax credit on an income tax return for renewable energy projects. Credits provide diminished value when taxable income is low or when tax losses occur. Qualified projects include the production of electricity from sources like wind, solar, landfills, municipal solid waste, industrial waste, biomass, cow manure, etc. This popular provision, which could fund up to 30 percent of a project, was only available on projects begun by December 31, 2010. This caused a flurry of activity at the end of 2010 as developers attempted to do enough to show that their projects had begun. The Tax Relief Act of 2010 extended this deadline to December 31, 2011. In order for projects to qualify for this grant you must show that you have met either the “physical work of a significant nature test" or a “5 percent safe harbor paid or incurred test" by December 31, 2011. This makes 2011 a key year for renewable projects. Although this grant is significant, the Treasury will not approve an application and disburse the grant until the project is complete and in operation.
100 percent bonus depreciation
For the first time in history, Congress passed legislation which allows an immediate deduction for certain fixed assets acquired before January 1, 2012. The law states that qualified property acquired after September 8, 2010 and before January 1, 2012, and placed in service before January 1, 2012, qualifies for a 100 percent bonus depreciation deduction instead of the 50 percent bonus depreciation deduction. The 50 percent bonus deduction applies to 2012 additions. These dates are extended an extra year for certain long-lived property and transportation property.
What type of property qualifies for bonus depreciation? The property must be Modified Accelerated Cost Recovery System (MACRS) property with a recovery period of 20 years or less. The original use of the property must commence with the taxpayer (“used" property does not qualify). Thus the provision generally applies to personal property and not to buildings, although certain components of a building can qualify. A cost segregation study may be warranted where a building is involved.
Whether you claim the 100 percent bonus depreciation in 2011 or the 50 percent bonus depreciation in 2012, the tax benefits are significant. Not only do you accelerate depreciation deductions, but you avoid any type of alternative minimum tax (AMT) problem on those assets. AMT depreciation would be calculated in exactly the same way as regular depreciation, thus no AMT depreciation adjustments result. This immediate depreciation deduction may result in a current net tax loss. This net operating loss might be available to offset current income from other sources, or could be carried back or forward to offset income in other years. Of course your tax advisor should be consulted as to the impact of passive activity, at-risk and basis provisions.
Net operating losses
Generally, non-passive operating losses that arise in the current year can be carried back two years and then carried forward for 20 years to offset income of those years. Thus if these losses cannot be used immediately, they can be used in other years. Losses unused once the 20 years has lapsed simply expire. If, on the other hand, passive losses are suspended in the current year due to at-risk or basis limitations, these can generally be carried forward indefinitely until disposition of the ownership interest.
Of course, entity structure plays an important role and can be the differentiating factor between using these losses currently versus having to carry the losses into future years. An otherwise profitable C corporation business could take these losses currently by developing renewable energy projects in their existing corporation, by using a wholly-owned LLC or by forming an additional C corporation subsidiary and filing a consolidated federal income tax return. LLCs and S corporations could develop renewable energy projects too, but passive loss rules could limit the use of those losses where a member or S shareholder is not materially participating in the business. Basis and at-risk limitations for these types of owners could also impact the ability to utilize losses. Knowledge of the passive activity loss rules, basis and at-risk requirements, and grouping elections is crucial in maximizing the use of net operating losses.
Energy credits
If one chooses to claim an energy credit under IRC section 48 instead of applying for the 1603 Grant, there is some good news in the Tax Relief Act of 2010. Eligible small businesses can use their credits to offset AMT as well as regular tax. Normally, general business credits can only reduce regular taxes down to the AMT level. The Tax Relief Act of 2010 allows credits earned in the year beginning in 2010 to offset AMT during that tax year and for the five previous years. An eligible small business is a non-public corporation, LLC, partnership, or sole proprietor which has annual gross receipts for the three prior years of no more than $50 million.
Code section 179 expensing
The Tax Relief Act of 2010 also increased the ability to use section 179 to immediately write off personal property and certain real property additions. For tax years beginning in 2010 and 2011, a taxpayer can write off up to $500,000 of fixed asset additions if total additions do not exceed $2 million. This can apply to both new and used property (whereas the 100percent bonus depreciation applies only to new property). section 179 has a taxable income limitation whereas bonus depreciation has no such limit. For example, section 179(b)(3) limits the deduction to the amount of taxable income for that year derived from the active conduct of any trade or business. There are also non-corporate lessor rules in section 179(d)(5) which could preclude a taxpayer from claiming a 179 deduction.
Extreme caution must be exercised here as the 1603 Grant and energy credit is based on the tax basis of property as determined under general federal income tax laws. Thus if costs are aggressively expensed and not capitalized, one could waste potential grant dollars. The US Treasury has gone so far as to state that claiming a 179 expense deduction immediately reduces the asset basis of renewable energy property eligible for the 1603 Grant. Thus it would not be advisable to claim a 179 deduction on eligible energy property. On the other hand the Treasury has verbally stated that the 50 percent and 100 percent bonus depreciation provisions can be taken in unison with the 1603 Grant and do not reduce the basis of energy property. We believe the technical reading of section 179 supports the Treasury view, as section 179 allows a taxpayer to treat 179 property as an expense “not chargeable to a capital account." The assets qualifying for bonus depreciation are still recorded as assets– they just get depreciated faster than normal MACRS rules. Thus 179 should be avoided, or only used on property that does not qualify for the grant or credit.
Renewable energy example
How do some of these provisions interact to make a renewable project more feasible? Let’s say you own a plant that processes legumes and beets and you want to add an anaerobic digester and electrical generator to your wastewater stream. The digester will help clean the wastewater stream and create methane, which can be used as a fuel for the generator. Additionally, the local utility wants to enter into a purchase power agreement with you to purchase all the electricity you can produce. Let’s assume that the cost of an anaerobic digester and generator set is $10 million. You intend to finish the project by December 31, 2011, so you can qualify for 100 percent bonus depreciation. You would also qualify for the 1603 Grant in lieu of the energy credits. Thus you would apply for a $3 million grant at the time the property is commissioned, paying for 30 percent of the project. Further, the tax law states that one-half of the credit must reduce the basis of the property. As a result, you would have $8.5 million of depreciable property and an immediate deduction of $8.5 million under the 100 percent bonus depreciation rules. If you are able to use that deduction currently, it would reduce your tax liability by as much as $3.4 million. Of course, the tax benefit of bonus depreciation is merely a timing benefit – claiming a tax deduction more quickly than otherwise possible. Nevertheless, one can see how these provisions favorably impact the decision to produce renewable energy.
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