The Internal Revenue Service and Department of Treasury recently issued final and temporary regulations on income inclusion under Section 50(d) of the Internal Revenue Code as it relates to the tax credit industry. The regulations provide that the income inclusion required under Code Section 50(d) (50(d) income) is recognized by the partner or S corporation shareholder ultimately claiming the credit and cannot be treated as an item of partnership or S corporation income. The regulations were effective as of July 21, 2016, the date issued, and apply to the credits claimed for property placed in service on or after September 19, 2016. Such regulations will have an impact on the tax credit industry.
Prior to the regulations, Code Section 50(d) rules were unclear with respect to lease-pass-through structures for rehabilitation and renewable energy tax credits. For background purposes, these structures allow the owner of the property generating the tax credit to elect to pass through the credit in a lease agreement to the “lessee” who claims the tax credit. While the applicable tax rules provide for a basis reduction in the property when the owner claims the credit, there is no analog rule for lessees. Rather, the lessee must include a pro rata amount as income annually equal to the tax credit (in the case of rehabilitation tax credits) or half of the tax credit (in the case of renewable tax credits). The pro rata amount is based on the depreciable periods for the property (e.g., over 39 years for nonresidential real estate and over five years for solar energy property). The prior rules were unclear when the lessee was taxed as a partnership.
The issue was whether 50(d) income should be treated as an item of partnership income to the lessee. If 50(d) income was a partnership item, it would be allocated among the partners and increase those partners’ basis in their partnership interests. Consequently, the increased basis on account of 50(d) income would result in less gain (or more loss) recognized by the partner upon the sale of its interest in the lessee-partnership. To further complicate the issue, a partner who receives the tax credit will typically exit the partnership before the 50(d) income can fully offset the tax credit amount. Thus, it was unclear whether the departing partner would be required to continue to include annually 50(d) income or to accelerate any unrecovered 50(d) income, or would have no further income inclusion. In prior guidance, the IRS and Treasury did not address this issue and noted that “the [p]artnership’s allocation to its partners of the income inclusion required by § 50(d)(5) shall not be taken into account” when providing safe harbor guidance on lease-pass-through structures. See Rev. Proc. 2014-12, 2014-3 I.R.B. 415.
Regulations on 50(d) Income
With the issuance of the long-awaited regulations, the IRS and Treasury have addressed many of the questions surrounding 50(d) income. First, the regulations provide that 50(d) income is not an item of partnership or S corporation income for purposes of the partnership or S corporation tax rules, respectively. As such, the increase in basis pursuant to Code Section 705(a) (or Code Section 1367(a) for S corporations) does not apply to 50(d) income. In its explanation, the IRS and Treasury noted that such an increase in basis due to 50(d) income is “inconsistent with Congressional intent” and “confer an unintended benefit . . . that is not available to any other credit claimant.” Accordingly, there would be no additional basis to absorb income recognition upon the sale of a partnership or S corporation interest.
Upon concluding that 50(d) income is not a partnership or S corporation item, the regulations provide special rules for the ultimate credit claimant. The IRS and Treasury define an “ultimate credit claimant” as any partner or S corporation shareholder that files (or that would file) Form 3468, “Investment Credit.” If the claimant exits the partnership or S corporation, the claimant may make an election to accelerate any 50(d) income that has not yet been included. Alternatively, the claimant may continue to include his or her pro rata share of the 50(d) income amount. The regulations did not establish a procedure for making such an election.
These regulations will have an impact in tax credit deals where a partner or S corporation shareholder seeks to exit the lessee partnership or S corporation. Because the 50(d) income is not considered a partnership or S corporation item of income, it will be recognized by the partner or S corporation shareholder that receives its share of the tax credit without increasing the basis in its partnership or S corporation interest. Depending on the scenario, such partner or S corporation shareholder could be required to continue to include the required 50(d) income amount after it no longer owns its interest in such partnership or S corporation. Accordingly, this will likely alter the tax credit investment market to adjust for the additional income tax liability for certain investors.