New way of financing clean energy projects

Global Energy Report
17 min read

New rules from the IRS clarify how tax-exempt entities and taxable businesses investing in certain types of clean energy projects can use the option to claim energy tax credits directly from the federal government through a mechanism called direct pay. By Charles H Purcell, partner, Mary Burke Baker, government affairs counselor, Marty Pugh, partner, Michael W Evans, partner and Rebecca Kreiser, associate, K&L Gates.

New rules from the IRS clarify how tax-exempt entities and taxable businesses investing in certain types of clean energy projects can use the option to claim energy tax credits directly from the federal government through a mechanism called “direct pay”.1 Direct pay, also known as elective pay, offers an alternative to traditional financing arrangements such as tax equity, transferring selling the credits, or carrying them over to another tax year. This could be a game-changer for states, cities, tribes, and other entities that normally don’t file income tax returns, and for start-ups and other taxable businesses that may not owe enough tax in a given year to use up their credits.

The Inflation Reduction Act of 2022 added Section 6417, direct pay, to the Internal Revenue Code. Final regulations on direct pay were published on March 11 2024, along with proposed regulations revising Section 761 to provide a work-around to the general prohibition against partnerships with tax-exempt partners electing direct pay. This new way of monetising tax credits can generally be used for facilities placed in service and production after December 31 2022.

Direct pay is intended to incentivise investments in clean energy projects in both the public and private sector by allowing applicable entities (tax exempts)2 and certain electing entities – taxable businesses investing in certain types of projects – to directly receive the full amount of tax credits in the year they are earned from the IRS and without having to partner with a taxable investor or transfer (sell) such tax credits under the IRA’s new Section 6418, where the benefit of the credit will be reduced to account for risk.3 Direct pay effectively makes the tax credits refundable, a new concept for tax exempts that don’t normally pay income tax and for businesses whose ability to use tax credits has been limited to 75% of their income tax liability.4

For applicable entities, direct pay is available for the complete following list of tax credits. For electing entities, the option is limited to the credits in italicised text:

* Section 30C, alternative fuel vehicle refueling property credit

* Section 45, renewable electricity production tax credit

* Section 45Q, credit for carbon oxide sequestration

* Section 45U, zero-emission nuclear power production credit

* Section 45V, credit for production of clean hydrogen

* Section 45W, credit for commercial clean vehicle

* Section 45X, advanced manufacturing production credit

* Section 45Y, clean electricity production credit

* Section 45Z, clean fuel production credit

* Section 48, energy investment tax credit

* Section 48, qualifying advanced energy project credit and

* Section 48E, clean electricity investment credit).5

To qualify for direct pay, an eligible entity, whether a taxpayer or tax-exempt organisation, must follow specific instructions. The most obvious requirement is to have an eligible project or property. After the project or property is placed in service, the electing entity must pre-register with the IRS before filing a tax return to claim the credit.6

A registration number must be received for each item of energy property, annual registration is required, and the number must be reported on the tax return in order to receive the credit. The credit must be claimed on a timely filed tax return, including extensions.7 For a tax-exempt organisation this means filing Form 990-T; for taxable businesses the credit is claimed on the tax return regularly filed. The mere receipt of a registration number does not guarantee eligibility for the tax credit, and the credit is subject to audit by the IRS.

The Section 6417 final regulations confirm and clarify many important rules for direct pay. Direct pay is an election. The election is irrevocable for tax-exempt organisations and applies to the entire term of the credit. Taxable entities may elect direct pay for the first five years of a credit, after which they can use the credit themselves or transfer, sell, it to another taxpayer; although they can revoke their election, the revocation is irrevocable.8 Direct pay elections apply to the entire credit amount. Recipients will receive their payments in lump sums in the form of a tax refund. There are no restrictions on the use of the refunded credits.

Direct pay amounts cannot be double-dipped with the Section 38 general business credit. If the tax credit plus the amount of dedicated loans and grants exceeds a tax-exempt organisation’s basis in the property,9 the credit will be reduced by the amount of the excess.10 Recapture rules apply if an excessive direct pay credit is received.

Chaining, the practice of a taxable entity transferring, selling, a tax credit to an applicable entity, which then would use direct pay to claim a refund for the credit, is not permitted.11 In the case of a consolidated group where the parent is an applicable entity or electing entity, any member of the group that is an electing entity may use direct pay.12 Similarly, an applicable entity or electing entity that owns a disregarded entity can use direct pay to claim a credit earned by the disregarded entity.13

Though the proposed revisions to the Section 761 regulations provide a potential work-around, Section 6417 generally prohibits partnerships and S corporations from qualifying for direct pay unless they are electing entities claiming any of the three types of tax credits available for taxable businesses and electing direct pay at the entity level.14 With respect to this prohibition, a number of commentators on the Section 6417 proposed regulations noted that such a bar limits the ability of tax-exempt organisations to avail themselves of the credit.

Although in some circumstances a tax exempt may be comfortable holding a clean energy asset directly, like an electric city bus or rooftop solar, in many cases an applicable entity will prefer to own an eligible property or project in partnership with a taxable entity.15 A good example of when an entity is needed is when a tax-exempt organisation holds a facility to provide electricity to other tax-exempt organisations or to its beneficiaries. Entities are also useful when renewable energy assets are held as investments by a taxpayer. Furthermore, some tax-exempt organisations that lack experience with alternative energy assets may want to hold such assets in an entity that can be managed by a third party or that provides limited liability to its owners.

Because assets held through disregarded entities (DREs) are eligible for direct pay, DREs may be a good solution for some tax-exempt organisations that qualify as Section 501(c)(3) organisations. However, since single member entities that are owned by states and municipalities are treated as per se corporations under the check the box regulations, there is a question of whether they can avail themselves of the DRE look-through for purposes of direct pay.16 Some large state pension funds have previously addressed this issue in other contexts by holding assets in a partnership, a solution that is of no use here.

The Section 761 proposed regulations provide a work-around to the limitations set on partnerships by allowing tax exempt organisations that invest in entities that elect out of partnership treatment under Section 761 to be eligible for direct pay with respect to electricity-producing assets held in such entities. The current regulations under Section 761 are narrow in their application, prompting the proposed revisions to adapt them to the direct pay regime.

Section 761 has been in the Code since 1954. Regulations were issued more than 50 years ago, amended approximately 30years ago.17 The provision has primarily been used in the energy production context by utilities that jointly operate production facilities. It allows taxpayers to make inconsistent elections with respect to cost recovery and other deductions relating to the property and has also been used to facilitate like-kind exchanges.

Under the current rules, exclusion from Subchapter K may be elected where the participants in the joint production, extraction, or use of property: i) own the property as co-owners, either in fee or under lease or other form of contract granting operating rights; ii) reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used; iii) do not jointly sell services or the property produced or extracted, although each separate participant may delegate authority to sell his share of the property produced or extracted for the time being for his account, but not for a period of time in excess of the minimum needs of the industry, and in no event for more than one year.18

There are aspects of the current rules that may be unattractive to tax-exempt organisations. The requirement to own the property as co-owners precludes a structure where a limited liability entity (LLC) holds the property. In addition, the limitations on sales agreements to less than a year precludes the use of long-term power purchase agreements, which are essential to the financing of renewable energy assets in many cases.

The IRS attempted to address these shortcomings with proposed changes to the Section 761 regulations. The proposed regulations eliminate the co-ownership requirement and allow the use of LLCs to hold an asset. In addition, the proposed regulations provide that the members of such an entity may delegate the right to sell the electricity produced by the facility to a third party who may negotiate long-term (more than one year) power sales agreements or PPAs if the delegation of authority itself is for not more than one year.

The revised rules apply to unincorporated organisations that meet four requirements: i) the entity must be owned, in part or in full, by one or more applicable entity that is a member; ii) the entity’s members must enter into a joint operating agreement where each member reserves the right separately to take in-kind or dispose of their pro rata shares of the electricity produced, extracted, or used, or any associated renewable energy credits or similar credits; iii) the entity must be organised exclusively to jointly produce electricity that may qualify for the 45, 45X, 45U, 45Y, or 48E tax credits and; iv) one or more of the applicable entities will elect direct pay for their share of the tax credit.

Despite their usefulness, the proposed regulations still raise several questions. Going forward, practitioners are likely to make the following points:

* Groups of tax-exempt organisations are permitted to hold electrical generation facilities through LLCs. However, it appears that the tax-exempt organisations may be required to be personally obligated on the power purchase agreement with the offtaker because regulations indicate that the sale of electricity must be by the members, not by the Section 761 entity. Presumably then, a long-term PPA in respect of the electricity produced by the Section 761 entity will be a multiparty agreement with all of the members of the Section 761 entity, the Section 761 entity itself and the offtaker. This will be burdensome.

* How would the delegation to a third party (that cannot exceed one year) to negotiate a PPA (for several years) be crafted? Could a delegation include a longer-term contract with the third party to manage the energy property? Tax exempt entities may be ill-suited to operate and maintain a clean electricity facility.

* To take advantage of the new regulations under Section 761, an entity must be organised exclusively to produce electricity. What if a battery is made part of the generation facility? A fair reading would probably be that a battery that facilitates the production of salable electricity would be permitted, as long as sales of storage do not occur, but it is not certain.

* In the case of investment tax credit property, once the direct payment has vested – that is it cannot be recaptured under rules such as the Section 50 rules – it appears that the terms of the unincorporated organisation may be modified so that it does not have to qualify as a Section 761 entity. If the rules on vesting are the same as Section 50, the credit will vest after five years. The terms of the organisational documents of the unincorporated organisation potentially may incorporate an agreement among the members to force the entity into a more normal LLC structure after five years but it would have to be carefully drafted.

* Importantly, for property where the direct payment is based on the production tax credit, the Section 761 entity would be needed for the duration of that credit.

* While taxable entities may participate in these Section 761 entities, they may be subject to limitations on their ability to claim tax credits and accelerated depreciation if tax-exempt organisations participate.19

The direct pay financing option is an innovative alternative to traditional means of financing clean energy property and projects for tax-exempt organisations and taxable businesses with limited tax liability. In final regulations under Section 6417 and proposed regulations under Section 761,Treasury and the IRS have crafted rules intended to encourage the use of this funding mechanism. As with any complex tax rules, it will be important to obtain good counsel before proceeding with a direct pay claim.


1 – See Treas. Reg § 1.6417-1; Reg § 1.6417-2; Reg § 1.6417-3; Reg § 1.6417-4; Reg § 1.6417-5; Reg § 1.6417-6

2 – See 26 US Code § 6417(d)(1)(A)

3 – See 26 US Code § 6418© Giordano Aita Road in green meadow towards the clean energy system

4 – See 26 US Code §§ 6417, 501(c)(3), 38(c)(1).

5 – Treas Reg § 1.6417-1(d)

6 – This step alone has multiple parts: The eligible entity must have a registration number for each eligible property or project, pre-register after the project or property is placed in service, pre-register annually, and notify the IRS if anything changes about the registration. See Reg. §1.6417-2. Additionally, the registration number must be reported on the tax return claiming the credit – no number, no credit. See id

7 – See Treas Reg § 1.6417-2(b)

8 – See Treas Reg § 1.6417-2

9 – This can occur when the tax credit is added on top of grants received

10 – See Treas Reg § 1.6417-2

11 – See Treas Reg § 1.6417

12 – See Treas Reg § 1.6417-2(a)

13 – See Treas Reg § 1.6417-1

14 – Partnerships and S corporations cannot use direct pay, unless they are taxable entities using direct pay for 45Q, 45V, and 45X. See Treas Reg § 1.6417-4

15 – For example, where a tax-exempt organisation installs generating assets on a rooftop that it owns for its own use or where a municipality acquires electric buses for use in its fleet, it may not be necessary to hold these assets in a partnership

16 – Treas Reg § 301.7701-2(b)

17 – See Treas Reg § 1.761-2

18 – Id

19 – 26 US Code § 50; 26 US Code § 168(h)(6)

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