What instrumentalities need to know about the Inflation Reduction Act

Update June 2023: The Internal Revenue Service (IRS) and Department of the Treasury (Treasury) recently released proposed and temporary regulations, and issued a set of frequently asked questions covering the direct payment option available for certain taxpayers (applicable entities) to monetize energy credits under the Inflation Reduction Act (IRA). Key takeaways include:

• The regulation clarifies agencies and instrumentalities are included in the definition of applicable entities (which also include tax-exempt organizations, state and local governments, the Tennessee Valley Authority, Indian Tribal governments, Alaska native corporations and certain rural electric cooperatives).
• The temporary regulations implement a pre-filing registration process for applicable entities before they can make a direct pay election. More details on the pre-filing registration process are expected to be released.
• The proposed regulations provide that partnerships are not applicable entities eligible to make a direct pay election. If an applicable entity owns property directly, either wholly or through an undivided ownership such as a tenancy in common, the applicable entity can make a direct pay election with regards to the property it owns. Further, in a sale/leaseback situation, the owner of the property would be the one that can take advantage of direct pay or the option of transferability of the credit to another party.

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The Inflation Reduction Act of 2022 (IRA) is the largest energy incentive effort in U.S. history, creating an environment where many energy-related projects are significantly more attractive and easier to fund. The credits offered through IRA represent a financial offset for qualified construction or production costs. The credits start at a base level amount and can be significantly increased if a project employs apprentices and pays prevailing wages.

Certain tax exempt and governmental entities were previously not able to directly take advantage of prior tax incentives for clean energy projects. The IRA added IRC §6417 to allow direct pay provisions for several of the clean energy incentives. State or political subdivisions, tax exempt entities, and Indian Tribal governments, along with others, are now eligible to receive direct pay for IRA incentives. Only entities defined as applicable entities under §6417 are eligible for the direct pay provisions. Instrumentalities are specifically referenced in the IRA under other amendments but were excluded from the definition of an applicable (meaning eligible) entity under the §6417 provisions. This leaves instrumentalities unclear whether they were intentionally left out of the direct pay provision in the IRA or if it was an oversight. Clarification is currently being sought by several associations typically classified as instrumentalities.

Public schools, libraries, hospitals, and other special districts may be considered instrumentalities and are eagerly awaiting guidance from the IRS on the direct pay provision for instrumentalities to determine whether they are eligible. The good news is, instrumentalities can take advantage of IRA energy tax credits, however, their path to claiming credits may not be as straightforward as other entities. At present, before additional expected guidance, instrumentalities appear not eligible for direct pay given the lack of reference under §6417.

Examples of entities often classified as instrumentalities:

• Regional comprehensive universities
• Higher education systems
• Municipalities
• State agencies
• Public schools and school districts

There are several alternative routes for instrumentalities to pursue clean energy projects and claim the expanded energy credits under the IRA:

1. Direct Pay Alternative

The most straightforward route will be if future guidance recognizes instrumentalities as eligible for the “Direct Pay” option.

While guidance is expected in the coming months, entities with current or planned projects should continue to advance eligible energy projects because two additional options can be pursued if instrumentalities are not deemed eligible for “Direct Pay” in future guidance. Those options are described below.

2. Not-for-profit blocker

Often times instrumentalities have not-for-profit organizations within their organizational structural (i.e. public universities). Clean energy projects owned by not-for-profit organizations are eligible for direct pay incentives under §6417.

A clean energy project being developed by an instrumentality can be contributed to a not-for-profit entity with agreements around control and operations to be maintained by the instrumentality. Overall, the design and intention of the clean energy project is not changed. However, by shifting ownership of a project to an applicable entity (not-for-profit), the project can utilize the “Direct Pay” incentives and reduce the capital cost of the project.

3. Corporate blocker

Similar to the structure noted above, instrumentalities can create corporations within their ownership if there are legal limitations around a not-for-profit structure. Corporations are taxable entities and thus are eligible to transfer many of the clean energy incentives for cash proceeds.

A clean energy project being developed by an instrumentality can be contributed to a corporation with similar agreements to maintain the original intention of the project. The clean energy incentives are earned by the corporation and eligible to be sold for cash. Overall, there is limited tax liability at the corporation due to depreciation deductions and the tax exempt nature of proceeds on the sale of credits.

IRA is complex and guidance continues to be rolled out. This is why working with an IRA advisor can help. Baker Tilly’s team of IRA specialists can help instrumentalities and other entities, navigate the complexities of IRA and evaluate how current and planned projects can leverage the credits available.