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Passive Activity For Tax Equity

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Companies paying over $200,000 in income tax can turn their tax bill into a profitable short-term investment
by becoming a “Tax Equity Investor” in a solar project. Large companies, like Google, have long been able to
make tax credit investments. Meanwhile, mid-size companies were kept out because the deal exceeded their
tax appetite. Now, that has changed thanks to the proliferation of firms like Greenzu developing tax-
advantaged solar projects which demand corporate Tax Equity Investors of all sizes. The trick is figuring out
if your company is an eligible investor, and if so, which solar projects are good investments. Below are a few
important guidelines.



A. Corporate Tax Equity Investing In A Nutshell

A race is afoot to install solar on as much flat commercial roof space as possible using a financing
mechanism called a Power Purchase Agreement (PPA). In a PPA, developers like Greenzu install solar on a
building’s rooftop at no cost to the building owner. The building owner, in turn, agrees to pay the developer
for all the solar electricity generated over the next 20 years. In other words, the solar developer becomes a
utility company. It owns the generating assets and gets repaid over time for the sale of energy. In addition, as
the system owner, the solar developer is entitled to take all the tax incentives offered to people who go solar.


When you install a solar electricity system on a commercial rooftop, over 50% of the installation cost is repaid
immediately through federal tax incentives. Unfortunately, many solar project developers lack the tax
appetite to utilize those tax incentives. As a result, they form a joint venture with a company that has a large
enough tax bill to use the tax credits.


The way the joint venture works is the corporate partner buys an ownership stake in the solar project for an
amount equivalent to the after tax value of the tax incentives, hence the name Tax Equity Investor. In return
the Tax Equity Investor receives essentially all the tax credits and deductions given to the solar system, plus a
share of the project cash flows. The Tax Equity Investor can expect returns between 12% to 15% over 5 years,
with a 100% return of capital in the first year via tax bill reductions.



B. Which Companies Are Eligible Tax Investors?

The IRS limits which businesses can be Tax Equity Investors through the “Passive Activity Limitations.” (PAL)
(See Instructions for Form 8810, and IRS Publication 925). If PAL applies, it may limit the amount of tax
credits and deductions the Tax Equity Investor could take in a single year, thus diminishing the investment’s
rate of return. The PAL rules apply differently based on the taxpayer’s entity type. Individuals and Pass-
Through Entities are subject to the full force of PAL. Closely Held C-Corps face a watered-down version of
PAL. Widely-held C-Corps are not subject to it.




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    1. Primer: What Is A Passive Activity?

    A Passive Activity is any business for which the taxpayer claims a deduction but the taxpayer does not
    “materially participate” in the business. Naturally, the IRS test for “material participation” is complex but
    as a good rule of thumb it requires engaging in over 500 hours of day-to-day management of the
    business over the year. (See IRS §465(c)(7)(C) for further exceptions.) Tax Equity Investors traditionally
    do not materially participate in the day-to-day management of the solar project, therefore it may count
    as a Passive Activity. In that case, the Passive Activity Limitations may apply. The rules work differently
    based on the business’ entity type. The following sections walk-through how PAL works for each type
    of entity.


    2. Pass-Through Entities (S-Corp, LLC, Partnerships, etc.)

    As a LLC, Partnership, S-Corp, your business taxable gain or loss is passed through to the owners’
    personal income tax return. Therefore, the PAL rules applying to individuals governs your business
    investment as well. For individuals, the crux of the Passive Activity Limitation says losses from passive
    activities can only be deducted against taxable income generated by passive activities. (IRS Pub. 925 pg
    2). In other words: you cannot deduct losses generated by passive activities against income generated
    from non-passive business activities, such as the salary from your job. If you do not have sufficient
    passive income to offset the entire deduction, you carry the remaining deduction forward to offset
    against future passive income or until you sell your interest in the activity.


    To illustrate how this works let’s walk through an example using a law firm set up as an LLP (also a
    pass-through entity). Bear in mind – the money made from core business activities is considered non-
    passive income. For the law firm the income generated by providing legal services will be non-passive
    income to the law firm partners (assuming they practice in the firm). In contrast, if the law firm also
    rents out an old building that rental income will be passive income. PAL says the law firm owners
    cannot use deductions from the rental business to offset income generated by the law firm’s legal
    services. Also note that any money made from investing in public stocks or bonds does not count as
    Passive Income. The IRS refers to that as Portfolio Income, and says it is not included in the calculation
    of Passive Income.


    3.    Closely Held C-Corporations

    The Passive Activity rules impose less of a limitation on Closely Held C-Corps. A closely held
    corporation can deduct passive activity losses against all active income except portfolio income. The
    IRS provides the following definition: “Closely held corporation. A corporation is a closely held
    corporation if at any time during the last half of the tax year more than 50% in value of its outstanding
    stock is directly or indirectly owned, by or for not more than five individuals, and the corporation is not
    a personal service corporation.” Instructions for Form 8810 (2011) pg 1.


    Typically, Closely-Held C-Corporations investing in solar projects will not be hindered by PAL because
    they earn the bulk of their taxable income through core activities, not portfolio income. Even if the
    solar tax equity investment is deemed a passive activity, the closely-held corporation can use the solar




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      tax incentives to offset the core taxable income. Only income earned from stocks, bonds, and other
      similar “Portfolio Income” will be restricted from offset by PAL. For most companies, this means PAL
      will not diminish the tax equity investment returns.


      4.     Widely Help Corporations

      Any widely held corporation is free to invest in solar projects without fear of limitation by the Passive
      Activity rules. The Passive Activity Limitation is expressly limited to Individuals, Pass-Through Entities,
      and Closely Held Corporations. The IRS does not provide a definition of “Widely Held Corporation.”
      However, by PAL’s definition, any for profit C-Corp that does meet the Closely Held Corporation
      definition is not subject to the rule’s restrictions.



C. Risks To Solar Tax Equity Investments

Tax Equity Investors frequently begin by asking “What are the risks?” The answer depends on how the deal is
structured. However, one risk is common to all deals: Recapture Risk. Below is a quick explanation of what
this is, and a few notes on how to evaluate its impact.


The IRS requires the solar system remain in use for 5 years, otherwise a pro-rata amount of the tax credit
may be recaptured. (See Instructions for Form 3468 pg 1.) For example, if the tax credit was $100,000, and
the solar system was permanently taken out of service in year 4, then $20,000 (plus fees) must be paid back
to the IRS. If the same system was taken out of service in year 6, then no money would be owed to the IRS
because the recapture period had expired.


In most scenarios, the recapture risk is minimal with rooftop solar systems. Underwriting will identify
buildings that can stay in operation for at least 5 years through the recapture period. However, if a customer
goes into default, the solar system can stay on the roof. Often foreclosing banks or new building owners
continue to use the solar power. Even if they do not, the power can often be sold back to the utility instead of
the customer. In the eyes of the IRS, that satisfies the continued operation requirements meaning no
recapture is required.



About The Author

Brandon Conard is the CEO/General Counsel of Greenzu, specializing in financing commercial solar PPAs and
solar leases. His expertise includes commercial energy analysis, solar fund structuring, and project finance.
Previously, he led BlueMap’s energy research and engineering team providing advanced clean-tech purchase
analytics to large commercial properties. As former Weil, Gotshal, & Manges attorney, Mr. Conard also
understands the changing energy, tax, securities, construction, and environmental hurdles every solar project
must clear. He’d love feedback on this article. Send it to info@greenzu.com.




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Contact

To learn more about Greenzu's energy services, please visit our Energy Advisory Services page
(www.greenzu.com/services ) or email us at info@greenzu.com.


To ensure compliance with the requirements imposed by the IRS, please be informed that any U.S. federal tax
advice contained in this communication (including any attachments) is not intended or written to be used, and
cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting,
marketing, or recommending to another party any transaction or matter addressed herein.




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Description: A few guidelines to determine if your company is an eligible investor.