Category: Tax

Preparing For the Return of Dealer Distress

Over the last five years, auto and equipment dealers experienced a period of low inventory levels with high margins on the limited inventory they had for sale and lease. Used automotive and equipment wholesale and retail prices surged. At the same time, merger and acquisition activity drove dealer valuations to record highs especially in the automotive segment.

Dealer merger and acquisition activity has started to cool even though valuations and activity remain elevated above pre-pandemic levels1. New automotive inventory levels have risen during 2024 to the point that Ford’s CFO, John Lawler, expressed worry regarding rising new car inventory levels in June2. Used automotive and equipment wholesale prices have declined from their pandemic era highs as well.

Record profits, low inventory levels, and strong merger and acquisition activity led to low delinquency and default levels in the dealer lending space, but current trends indicate those days may be coming to an end. For floor plan lenders, they should be thinking about dealer distress happening again. While times are still good, there are some steps lenders can take to prepare for distress down the road.

Review Your Documents and Security Interests

It is always easier to fix documentation and security interest deficiencies when times are good. Lenders should be checking to make sure their loan documents are correct and most importantly, their security interest position reflects their expectations. One area of particular concern is making sure no other parties have filed security interests against the dealer including merchant cash advance, factoring and other “short term” funding sources that might not show up as debt on financial statements. Even other lenders providing longer term debt financing secured by other assets like real estate may be taking a security interest in your inventory as well.

Insurance

As part of your documentation review, you should verify the dealer’s insurance meets the requirements of your loan documents, lists your interest properly, and is adequate for the dealer’s exposure. Insurance coverage tied to inventory levels can become insufficient if inventory levels rise faster than the coverage limits increase. Also ensuring the insurance covers all collateral locations is a requirement that might slip through the cracks especially if collateral locations change frequently.

Where is Your Collateral?

One benefit of low inventory levels was that dealers stopped storing inventory at satellite lots. The practice of old is starting to return as inventory levels build. Lenders want to make sure they know of these locations (they should if they are on top of the audits) and obtain landlord waivers if necessary to access the inventory upon a default.

Keeping Up on Audits

Anyone who knows the floor plan business knows the importance of audits. Low inventory levels and well performing dealers made audits easy. With increasing inventory levels, audit complexity is returning to pre-pandemic norms. Audit issues are often one of the first signs of dealer distress. A prominent example of a dealer issue recently being unearthed through audits involves a boat dealer who allegedly sold boats, but stored them for the customers and alleged the boats were still for sale3.

Financial Reporting and Covenants

Financial reporting deficiencies and financial covenant violations are also warning signs of potential distress on the horizon. Dealers rarely go bad overnight. Financial reporting and covenants going downhill are an obvious warning sign.

Taxes

Not just limited to dealers, but tax delinquencies are always a big red flag. Confirming the payment of taxes and the existence of no tax liens should be part of reviewing any dealer relationship especially one showing other signs of distress.

Used Inventory Levels and Advance Rates

During the pandemic when used vehicle and equipment prices shot through the roof, lenders became permissive of advancing beyond their standard advance rates. As used inventory values decline for vehicles4 and agricultural equipment5, dealers can be underwater on used inventory.

Manufacturer Specific Issues

Not all dealers are equal and the same is true for manufacturers. Monthly inventory level data from Cox Automotive6 shows inventory levels being substantially higher among some vehicle brands compared to others. Keeping an eye on your dealer and the average inventory levels of the brands they carry should be on your radar.

Explaining What You Do

As someone who spent a decade as lead counsel at two different financial institutions being lead counsel for floor plan businesses, I spent a lot of time explaining to others outside the floor plan businesses the nuances of floor plan lending. If things start going downhill with a dealer, be prepared for the inevitable basic questions from those not used to the dealer business.

Conclusion – Hope for the Best, Prepare For The Worst

One of the best credit people I ever worked with described a dealer failure as like a war. When a dealer failure occurs, most likely through a selling inventory out of trust, you don’t have time to learn what to do. You got to know what to do. You must have someone ready to take command and quarterback the response. You got to know who will help you accomplish your ends. If you don’t act quickly, your inventory will be gone and your losses can be in the millions within days.

1 “Dealership Buy-Sell Activity and Blue Sky Values are declining, but are elevated well above pre-pandemic levels”, The Haig Report, August 29, 2024 (2024-Q2-Haig-Report-Press-Release-FINAL.pdf (haigpartners.com))
2 “Ford CFO says growing dealer inventory ‘worries me’”, Breana Noble, The Detroit News, June 11, 2024 (Ford CFO John Lawler says growing dealer inventory ‘worries me’ (detroitnews.com))
3 “Lender Alleges Dealer Diverted Millions in Sales Proceeds”, Kim Kavin, Soundings Trade Only, April 16, 2024 (https://www.tradeonlytoday.com/manufacturers/lender-alleges-dealer-diverted-millions-in-sales-proceeds)
4 “Wholesale Used-Vehicle Prices Decrease in First Half of September”, Cox Automotive, September 17, 2024 (Wholesale Used-Vehicle Prices Decrease in First Half of September – Cox Automotive Inc. (coxautoinc.com))
5 “Lower Used Equipment Prices Are Another Sign of the Challenges in the Ag Sector”, Jim Wiesenmeyer, Farm Journal, August 14, 2024 (Lower Used Equipment Prices Are Another Sign of the Challenges in the Ag Sector | AgWeb).
6 “New-Vehicle Inventory Stabilizes as Sales Incentives Increase and Model Year 2025 Vehicles Arrive”, Cox Automotive, September 19, 2024 (New-Vehicle Inventory Stabilizes as Sales Incentives Increase and Model Year 2025 Vehicles Arrive – Cox Automotive Inc. (coxautoinc.com))

Copyright © 2024 Womble Bond Dickinson (US) LLP All Rights Reserved.
For more on Dealers, visit the NLR Utilities Transport section

Energy Tax Credits for a New World Part VII: Low-Income Communities Bonus Credits

What is the Low-Income Communities Bonus Credit?

The Low-Income Communities Bonus Credit available through the Inflation Reduction Act of 2022 (IRA)[1] is designed to increase the siting of, and access to renewable energy facilities in low-income communities, encourage new market participants, and provide social and economic benefits to individuals and communities that have been historically overburdened with pollution, adverse health or environmental effects, and marginalized from economic opportunities.[2]

The Low-Income Communities Bonus Credit supports “a transformative set of investments designed to create jobs, lower costs for American families, and spur an economic revitalization in communities that have historically been left behind.”[3] With the Low-Income Communities Bonus Credit the U.S. government is helping to “lower energy costs and provide breathing room for hard-working families, invest in good-paying clean energy jobs in low-income communities, and support small business growth.”[4]

The Low-Income Communities Bonus Credit is an investment tax credit (ITC) available for certain clean energy investments in low-income communities, on Indian lands, with certain affordable housing developments, and for certain projects benefiting low-income households.[5] It is an ITC for certain clean energy investments in a “Qualified Solar or Wind Facility,” that is, a facility with a net output of less than five megawatts. Unlike most of the other tax credits we have looked at in this Q&A with Andie series, there is a competitive bidding application process. Projects must receive a “Capacity Limitation Allocation Amount” to receive these credits.

What are the eligibility categories for the Low-Income Communities Bonus Credit?

There are four project eligibility criteria to qualify for the Low-Income Communities Bonus Credit:

  1. It is located in a “low-income community” (Category 1)
  2. It is located on “tribal Indian land” (Category 2)
  3. It is installed on certain federal housing projects that are qualified low-income residential building facilities (Category 3)
  4. It serves low-income households as a “qualified low-income economic project” (Category 4)

These eligibility categories are discussed in what follows.

Which tax credits do Low-Income Communities Bonus Credits apply to?

The Low-income Communities Bonus Credit is an additional bonus credit available for ITC-eligible credits at Internal Revenue Code (Code) Section 48, Energy Property ITC, and Section 48E, Clean Energy ITC (CEITC). Section 48 applies to an “eligible facility” (that is, a qualified solar or wind energy facility) for which construction begins before 2025; while the CEITC applies to construction in qualifying clean electricity generating facilities and energy storage technologies that are placed in service after December 31, 2024.[6] The base credit may be increased by 10 percent (for a project located in a low-income community or on Indian land) or by 20 percent (for a qualified low-income residential building project or a qualified low-income economic benefit project).[7]

Because the Section 48 credit expires at the end of 2024 and the Section 48E (CEIT) becomes effective January 1, 2025, we will need to look at Section 48 separately from Section 48E (CEITC) when we address the allocation procedures.

How is the Low-Income Communities Bonus Credit calculated?

The Low-Income Communities Bonus Credit is one of the few IRA energy tax credits that requires an application process and the granting of a “capacity limitation allocation amount.” For allocations in 2023 and 2024, the Section 48(e) ITC provides an increased tax credit for an eligible facility that is part of a “qualified solar or wind energy facility” and that receives a capacity limitation allocation amount. For allocations in 2025 and thereafter, the Section 48E (CEITC) credit applies to a broader group of facilities than those covered under Section 48(e).[8] For both Section 48 and 48E (CEITC), the base credit amount is six percent of a qualified investment (that is, the tax basis of the energy property), and that amount can be increased by 10- or 20-percentage points with the Low-Income Communities Bonus Credit, depending on whether the project meets certain eligibility category requirements.[9] The 10 percent credit is available for an eligible facility in a low-income community or on Indian land, while the 20 percent credit is available for a “qualified low-income residential building project” or a “qualified low-income economic benefit project.”

What is a qualified solar or wind facility?

A Qualified Solar or Wind Facility is an eligible facility if it meets three requirements.[10] First, it generates electricity solely from a wind facility, solar energy property, or small wind energy property. Second, it has a maximum net output of less than five megawatts as measured in alternating current. And third, it is described in at least one of the four Low-Income Communities Bonus Credit project categories.[11]

Because the eligible facility must have a maximum net output of less than five megawatts as measured in alternating current, can applicants divide larger projects into smaller ones to meet the five megawatts requirements?

No. The Treasury has issued Final Regulations on Low-Income Communities Bonus Credit (Final Low-Income Communities Regulations),[12] effective August 15, 2023. The Final Low-Income Communities Regulations provide that the capacity limitation allocation amounts will be made on a “single project factors test.”[13] This is intended to prevent applicants from artificially dividing larger projects into multiple facilities in an attempt to circumvent the requirement for the maximum net output.[14]

When can a Qualified Solar or Wind Facility be placed in service?

A project cannot be placed in service until after it receives the capacity allocation.[15] This is because the Treasury holds that “requiring projects to be placed in service after allocation provides the best way to promote the increase of, and access to, renewable energy facilities that would not be completed in the absence of the program.”[16] This is not viewed as an impediment because Section 48(e)(4)(E)(i) provides a “lengthy window of four years to place a facility in service following an Allocation of Capacity Limitation.”[17] Section 48E (CEITC) also provides a four-year window to place the facility in service.[18]

Definitions

What is a Category 1 low-income community for purposes of the Low-Income Communities Bonus Credit?

A Category 1 low-income community is a community that is located in a census area where the poverty rate is at least 20 percent or more, or the median family income is 80 percent or less than the median family income in the state where the community is located.[19] If the census tract is in a metropolitan area, the median family income cannot be more than 80 percent of the statewide median family income or the metropolitan area’s median family income.

The poverty rate for an eligible Category 1 low-income census tract is generally based on the threshold for low-income communities set by the New Markets Tax Credit (NMTC) Program, as noted in the Treasury Regulations. The NMTC updates its eligibility data every five years based on poverty estimates from the American Community Survey (ACS). New eligibility tables and maps for the NMTC program were released on September 1, 2023, which use underlying ACS estimates from 2016 to 2020.[20] The next NMTC update will include ACS estimates from 2021 to 2025, at which point applicants will have a period of one year following the date that the 2021-2025 NMTC is released to use the 2016-2020 NMTC dataset.[21]

How is Category 2 tribal Indian land defined?

Category 2 Tribal Indian land is land of “any Indian tribe, band, nation, or other organized group or community that is recognized as eligible for the special programs and services provided by the United States to tribes (Indians) because of their status.”[22] To qualify as Indian land, the property must meet the definition of Section 2601(2) of the Energy Policy Act of 1992, which is defined as, “Indian reservations; public domain Indian allotments; former Indian reservations in Oklahoma; land held by incorporated Native groups, regional corporations, and village corporations under the provisions of the Alaska Native Claims Settlement Act[23]; and dependent Indian communities within the borders of the United States whether within the original or subsequently acquired territory thereof, and whether within or without the limits of a State.”[24]

The Energy Policy Act of 1992 was amended by the Energy Act of 2020 to include in the definition of land occupied by a majority of Alaskan Native Tribe members.[25]

How is a Category 3 qualified low-income residential building project defined?

A Category 3 qualified low-income residential building project is a federally subsidized residential building facility “installed on the same parcel or on an adjacent parcel of land that has a residential rental building that participates in an affordable housing program, and the financial benefits of the electricity produced by such facilities are allocated equitably among the occupants of the dwelling units or the building.”[26] Projects must be part of a “qualified program”: one among various federal housing assistance programs as are set out in the Treasury Regulations. For state programs to qualify to receive the 20 percent bonus credit, they must be part of a qualified federal program. To remain a qualified low-income residential building facility, a project must maintain its participation in a covered housing program for the entire five-year tax credit recapture period.

How does a Category 4 qualified low-income economic benefit project assist low-income households?

A qualified low-income economic benefit project is one where at least 50 percent of the financial benefits of the electricity produced are provided to households with income of less than 200 percent of the poverty line, or 80 percent of the area’s median gross income.[27] The financial benefits of a low-income economic project benefiting low-income households can only be delivered in utility bills savings. “Other means such as gift cards, direct payments, or checks are not permissible. Financial benefits for these facilities must be tied to a utility bill of a qualifying household. The Treasury Department and the IRS may consider other methods of determining Category 4 financial benefits in future years.”[28]

Allocation Process

How is the annual Capacity Limitation allocated across the four facility categories?

The annual Capacity Limitation amount is divided across each facility category as is set out in each program year. For the 2023 and 2024 Program Years, for example, we have IRS Notices setting out the Allocation Process. The Applicable Bonus Credit is available at Section 48. For the calendar year 2025 and succeeding years, the applicable bonus credit is available at Section 48E (CEITC). On September 3, 2024, the Treasury issued Proposed Regulations addressing Section 48E (CEITC) (Proposed 48E Allocation Regulations).[29]

For the 2024 Program Year, for example, the annual Capacity Limitation is divided across each facility category “plus any carried over unallocated Capacity Limitation from the 2023 Program Year.”[30]

 Does the Low-Income Communities Bonus Credit have a competitive bidding application?

Yes. The Low-Income Communities Bonus Credit has a competitive bidding application process that applies to each of the four eligibility categories. An annual allocation of up to 1.8 gigawatts (GWs) is available, in the aggregate, to the four categories of qualified solar or wind facilities with a maximum output of less than five megawatts.[32]

How does competitive bidding work?

Since it was introduced for the 2023 program year, competitive bidding has been very successful. The Low-Income Communities Bonus Credit program is extremely popular. The 2023 program—the first year of the competitive bidding process—was significantly over-subscribed with more than 46,000 applications submitted. Applications were for qualified facilities representing 8 GWs of capacity, although only 1.8 GWs of capacity were available for allocation.[33]

For purposes of the Section 48E Low-Income Communities Bonus Credit, we have the Proposed Section 48E Regulations to turn to as to how the competitive bidding process works. The Treasury has provided notice of a public hearing on the Proposed Regulations for October 17, 2024.

What government guidance do we have on the annual Capacity Limitation allocation process for Section 48?

For purposes of the Section 48 Low-Income Communities Bonus Credit, we have the Final Low-Income Communities Regulations. In addition, the IRS has issued revenue procedures and a Notice:

  • Rev. Proc. 2023-27[34] and Rev. Proc. 2024-19[35] provide information and guidance for the 2023 and the 2024 allocations. These revenue procedures both address the reservation of capacity limitations, allocation selection, and application procedures.
  • IRS Notice 2023-17,[36] sets out initial guidance on establishing the program to allocate the environmental justice solar and wind capacity limitation under Section 48(e).

What does the 2024 allocation program look like?

The 2024 capacity limitation allocation opened in May of 2024, with 1.8 GWs of capacity being allocated across the four eligible facility type categories.[37]

Are there any additional selection criteria for 2024?

Yes. For 2024, the Treasury has imposed what it refers to as “additional selection criteria” (ASC) for the 1.8 GWs allocation. The 2024 ASC requires at least 50 percent of the 1.8 GWs to be allocated to applications that meet specified ASC ownership and geographic criteria.

The 2024 ASC ownership criteria is based on applicants that qualify as one of the following: Tribal enterprises, Alaska Native Corporations, renewable energy cooperatives, qualified renewable energy companies, qualified tax-exempt entities,[38] Indian tribal governments, and any corporation described in Section 501(c)(12) that furnishes electricity to persons in rural areas.

The 2024 geographic criteria is based on the facility being located in a persistent poverty county or disadvantaged community as identified by the Climate and Economic Justice Screening Tool.[39] The screening tool is at an official U.S. government website, with an interactive map of census tracts that are “overburdened and underserved” and that are “highlighted as being disadvantaged.[40] For these purposes, Alaska Native Villages are considered to be disadvantaged communities.[41] The datasets used in the Screening Tool’s eight “indicators of burdens” are “climate change, energy, health, housing, legacy pollution, transportation, water and wastewater, and workforce development.”[42]

Where do we look for 2025 allocations and beyond?

The selection criteria for 2025 and beyond is addressed in the Proposed Section 48E Regulations.

Application Process

How are applications reviewed and Capacity Limitations allocated?

The Treasury and the IRS have partnered with the DOE to administer the program. The DOE’s “Office of Economic Impact and Diversity administers the program application portal and reviews applications, with the DOE making “recommendations to the IRS” based on the eligibility of the facility.[43] The Treasury and the IRS can adjust the allocations of Capacity in future years “for categories that are oversubscribed or have excess capacity.”[44] “At least 50% of the capacity within each category will be reserved for projects that meet certain ownership and/or geographic selection criteria. The ownership and geographic selection criteria can be found in §1.48(e)-1(h)(2).”[45]

How does an applicant apply for the Low-Income Communities Bonus Credit Program?

A taxpayer seeking to claim the credit must submit an application to the DOE for an allocation of capacity. The DOE allows one application per project. To begin their process, an applicant must create a login.gov account and register using the “Log In” button located at a DOE’s portal page, https://eco.energy.gov/ejbonus/s/. Before registering, applicants are encouraged to read the handy dandy “DOE Applicant User Guide”[46] available at the same web portal address. Applications are submitted through DOE’s online “Low-Income Communities Bonus Credit Program Applicant Portal” accessible at the same URL. The portal’s applicant checklist sets out rigorous documentation and attestation requirements to demonstrate that ownership requirements are being met.

How does an applicant support its allocation of capacity for its Low-Income Communities Bonus Credit application?

An applicant must submit information for each proposed facility allocation, including the “applicable category, ownership, location, facility size/capacity, whether the applicant or facility meet additional selection criteria, and other information.”[47] In addition, the applicant must complete a series of attestations and must upload to the online portal certain documentation in order to demonstrate project maturity.”[48] An allocation must be received by the taxpayer before an eligible facility can be placed in service.[49]

How are applications considered?

“There will be a 30-day period at the start of each program year where applications will be accepted for each category. Applications received within this 30-day period will all be treated as being received on the same day and time. Once the 30-day period is over, the DOE will accept applications on a rolling basis and recommend applicants to the IRS until the entire capacity limitation within the applicable category is diminished.”[50] In addition, once applications are submitted, “the DOE will review the applications and recommend projects eligible for the bonus to the IRS. The IRS will then award the applicant with an allocation of the capacity limitation or reject the application. The DOE will stop reviewing applications once the entire capacity limitation is awarded. Applicants can reapply for the bonus credit in the next program year if they remain eligible.”[51]

What happens if a facility is not placed in service within the four-year deadline?

A facility can be disqualified after it receives an allocation if the facility is not placed in service within the deadline set in Section 48(e)(4)(E) of four years after the date of allocation. “[P]roviding any type of alternative forms of completion within the four year window apart from ‘placed-in-service’ is inconsistent with the statute and not allowed.”[52]

Can a credit recipient face a recapture event?

Yes. Recapture of the benefit of any increased credit due to Section 48E is provided in Section 48(e)(5). The Treasury noted that “Under the recapture provisions of Section 48(e)(5), Congress provided that the period and percentage of such recapture must be determined under rules similar to the rules of Section 50(a). Section 50(a) generally provides that this is a five year period with differing applicable percentages depending on when the property ceases to qualify. Therefore, under Section 48(e)(5), stricter restrictions related to recapture should not be imposed.”[53]

The final regulations clarify that “any event that results in recapture under Section 50(a) will also result in recapture of the benefit of the section 48(e) Increase. The exception to the application of recapture provided in § 1.48(e)-1(n)(2) does not apply in the case of a recapture event under Section 50(a).”[54] This same recapture possibility applies to Section 48E (CEITC) credit recipients.

The firm extends gratitude to Nicholas C. Mowbray for his comments and exceptional assistance in the preparation of this article.

[1] The Inflation Reduction Act of 2022, Pub. L. No. 117-169, 136 Stat. 1818 (2022) (IRA), August 16, 2022.

[2] “Inflation Reduction Act Guide for Local Governments and Other Tax-Exempt Entities; Solar and Storage Projects,” p. 17, New York State, January 2024, available at https://www.nyserda.ny.gov/-/media/Project/Nyserda/Files/Programs/Clean-Energy-Siting/Inflation-Reduction-Act-Guide-for-Solar-and-Storage-Projects.pdf.

[3] “Low-Income Communities Bonus Credit Program,” Department of Energy (DOE), Office of Energy Justice and Equity, available at https://www.energy.gov/justice/low-income-communities-bonus-credit-program.

[4] “U.S. Department of the Treasury, IRS Release Final Rules and Guidance on Investing in America Program to Spur Clean Energy Investments in Underserved Communities,” Press Release, U.S. Treasury, August 10, 2023, available at https://home.treasury.gov/news/press-releases/jy1688.

[5] “Low-Income Communities Bonus Credit,” IRS, available at https://www.irs.gov/credits-deductions/low-income-communities-bonus-credit.

[6] For a discussion of Sections 48 and 48E (CEITC), see Part II of this series: Production Tax Credits and Investment Tax Credits: The Old and The New.

[7] § 48(e).

[8] § 48E(h). “Elective pay and transferability frequently asked questions: Elective pay,” IRS, Overview, Q15, available at https://www.irs.gov/credits-deductions/elective-pay-and-transferability-frequently-asked-questions-elective-pay#q15.

[9] § 48(e)(1).

[10] Section 48(e)(2)(A) and the Treasury Regulations.

[11] Section 48(e)(2)(A)(iii).

[12] 88 FR 55506, “Additional Guidance on Low-Income Communities Bonus Credit Program,” U.S. Treasury, August 15, 2023, available at https://www.federalregister.gov/documents/2023/08/15/2023-17078/additional-guidance-on-low-income-communities-bonus-credit-program.

[13] Ibid.

[14] Ibid, Preamble, Definition of Qualified Solar or Wind Facility.

[15] 88 FR 55506, August 15, 2023.

[16] Ibid.

[17] Ibid.

[18] Ibid.

[19] “Inflation Reduction Act Guide for Local Governments and Other Tax-Exempt Entities; Solar and Storage Projects,” p. 18, New York State, January 2024.

[20] “Frequently Asked Questions, 48(e) Low-Income Communities Bonus Credit Program,” Q47.

[21] Ibid.

[22] Ibid.

[23] 43 U.S.C. § 1601 et seq.

[24] 106 Stat. 3113; 25 U.S.C. § 3501.

[25] The Energy Act of 2020, Section 8013, As Amended Through Pub. L. 117-286, Enacted December 27, 2022. See also “Energy Act of 2020, Section-by-Section,” Section 8013. Indian Energy, available at https://www.energy.senate.gov/services/files/32B4E9F4-F13A-44F6-A0CA-E10B3392D47A.

[26] “Inflation Reduction Act Guide for Local Governments and Other Tax-Exempt Entities; Solar and Storage Projects,” p. 18, New York State, January 2024.

[27] Ibid.

[28] FAQ#53.

[29] 89 Fed. Reg. 71193 (Sept. 3, 2024).

[30] “Low-Income Communities Bonus Credit Program,” DOE, Office of Energy Justice and Equity, available at https://www.energy.gov/justice/low-income-communities-bonus-credit-program. Also see https://www.energy.gov/sites/default/files/2024-05/48e%20Slides%20for%20PY24%20Applicant%20Webinar.pdf and refer to Rev. Proc. 2024-19 (IRS) and Treasury Regulations § 1.48(e)–1 for the full definitions and requirements of each program category.

[31] Such as rooftop solar.

[32] “U.S. Department of the Treasury, IRS Release 2024 Guidance for Second Year of Program to Spur Clean Energy Investments in Underserved Communities, As Part of Investing in America Agenda,” Press Release, U.S Treasury, March 29, 2024. Proposed Section 48E (CEITC) Regulations.

[33] “The Low-Income Communities Bonus Credit Program: Categories and How to Apply,” Morgan Mahaffey, EisnerAmper, May 29, 2024, available at https://www.eisneramper.com/insights/real-estate/low-income-communities-bonus-credit-program-0524/

[34] Rev. Proc. 2023-27, IRS, August 10, 2023, corrected by Announcement 2023-28, September 11, 2023.

[35] Rev. Proc. 2024-19, IRS, March 29, 2024.

[36] Notice 2023-17, IRS, February 13, 2023.

[37] Treas. Reg. §1.48(e)-1 defines the four categories of facilities for Low-Income Communities Bonus Credit.

[38] Including Sections 501(c)(3) and 501(d) entities.

[39] The screening tool is available at https://screeningtool.geoplatform.gov/en/#3/33.47/-97.5.

[40] Ibid.

[41] Ibid.

[42] Climate and Economic Justice Screening Tool, Frequently Asked Questions, available at https://screeningtool.geoplatform.gov/en/frequently-asked-questions#3/31.77/-95.39.

[43] Ibid.

[44] “IRS releases Guidance on Low-Income Communities Bonus Credit Program, Inflation Reduction Act,” Forvis Mazars, LLP, August 15, 2023, available at https://www.forvismazars.us/forsights/2023/08/irs-releases-guidance-on-low-income-communities-bonus-credit-program.

[45] Ibid. See also, § 1.48(e)-1(h)(2), the Reservations of Capacity Limitation allocation for facilities that meet certain additional selection criteria is available at https://www.law.cornell.edu/cfr/text/26/1.48(e)-1.

[46] “Applicant User Guide,” DOE, available at https://www.energy.gov/sites/default/files/2024-05/2024%20DOE%2048%28e%29%20Applicant%20User%20Guide.pdf.

[47] “Low-Income Communities Bonus Credit Program,” DOE, Office of Energy Justice and Equity, available at https://www.energy.gov/justice/low-income-communities-bonus-credit-program.

[48] Ibid.

[49] “Low-Income Communities Bonus Credit,” IRS, available at https://www.irs.gov/credits-deductions/low-income-communities-bonus-credit.

[50] “IRS releases Guidance on Low-Income Communities Bonus Credit Program, Inflation Reduction Act,” Forvis Mazars, LLP, August 15, 2023.

[51] Ibid.

[52] 88 Fed. Reg. 55537.

[53] 88 Fed. Reg. 55538.

[54] 88 Fed. Reg. 55538.

Read Part I, Part II, Part III, Part IV, Part V, and Part VI here.

by: Andie Kramer of ASKramer Law

For more news on Energy Tax Credits, visit the NLR Environmental Energy Resources section.

Supreme Court Holds Life Insurance Proceeds Paid to Closely-Held Corporation to Fund Buy-Sell Agreement Increases Estate Tax on Deceased Shareholder’s Estate

In Connelly v. U.S., 144 S.Ct. 1406 (June 6, 2024), the United States Supreme Court upheld an estate tax deficiency of $889,914 in a decision that will impact many families and closely-held businesses. A Buy-Sell Agreement is often used to ensure that a closely-held company will remain within the family after the deaths of its owners or otherwise ensure the continuity of the business after an owner’s death. Many Buy-Sell Agreements, such as the one in Connelly, provide that upon the death of an owner, the surviving owner has the option to purchase the deceased owner’s interest in the company, and if the surviving owner declines, the company must redeem the deceased owner’s interest. To ensure that the company will have funds for the redemption, the company will often obtain life insurance for its owners. For years, planners thought it possible to structure such an arrangement so that life insurance proceeds would not increase the value of the company for estate tax purposes. However, in Connelly, the Court held that the life insurance proceeds paid to a corporation upon the death of a shareholder do increase the value of the corporation’s stock for estate tax purposes and that the corporation’s obligation under a Buy-Sell Agreement to redeem the deceased shareholder’s shares does not offset the life insurance proceeds. Under the Court’s decision, the type of entity does not appear to be relevant, and the holding will equally apply to partnerships and limited liability companies. Thus, if any Buy-Sell Agreement is structured as a redemption funded with entity-owned life insurance, the insurance proceeds may increase the value of the deceased business owner’s interest for estate tax purposes.

In Connelly, two brothers, Michael and Thomas Connelly, owned a business supply corporation. Michael owned 77.18% of the company, and Thomas owned 22.82% of the company. The brothers entered into a Buy-Sell Agreement as described above. The brothers ignored provisions under the agreement that required them to value the company annually and obtain an appraisal upon a shareholder’s death. After Michael’s death in 2013, Thomas and Michael’s son simply agreed to a redemption price of $3 million for Michael’s shares. The company used $3 million of life insurance proceeds to redeem Michael’s shares, and Thomas, as Michael’s executor, reported the value of Michael’s shares as $3 million on Michael’s estate tax return without completing an appraisal. Upon audit of the estate tax return, Thomas belatedly obtained an appraisal that determined the fair market value of 100% of the company at Michael’s death to be $3.86 million, excluding the life insurance proceeds. Based on the valuation of the company at $3.86 million, Thomas argued that the value of Michael’s ownership interest was $3 million ($3.86 million x 77.18%).

Connelly rejects the position of the 11th Circuit Court of Appeals in Blount v. Comm’r., 428 F. 3d 1338 (CA11 2005), that the life insurance proceeds paid to a company are offset by the company’s contractual obligation to redeem a deceased owner’s interest. Rather than allowing an offset for the redemption obligation, the Court focused on the value of the company before and after the redemption. If the entire company was worth $3.86 million, as claimed in Connelly, the value of Michael’s 77.18% would be $3 million and the value of Thomas’ 22.82% would be $860,000. The Court reasoned that upon redemption of Michael’s shares, Michael’s estate would receive $3 million, leaving Thomas with 100% ownership of a company worth $860,000. However, Thomas’ argument meant that post-redemption, 100% of the company that Thomas owned was worth $3.86 million. The Court refused to accept that a company which pays out $3 million to redeem shares was worth the same overall amount before and after the redemption. The Court found that the company’s value should be increased from $3.86 to $6.86 million, accounting for the insurance proceeds, increasing the value of Michael’s ownership from $3 to approximately $5.3 million ($6.86 million × 77.18%). The net result was an additional estate tax of $889,914.

Although the implications of Connelly are wide, there are limitations to the Court’s decision. Connelly will have little impact on a business owner whose estate is well under the estate tax exemption, which is currently $13.61 million for each individual and scheduled to be decreased by 50% in 2026. In addition, the Court did not address the application of Section 2703 of the Internal Revenue Code, which provides in relevant part that the value of a deceased owner’s interest in a business may be established by a Buy-Sell Agreement if certain requirements are met. Perhaps the Court did not review Section 2703 because the shareholders did not follow the valuation terms of the Buy-Sell Agreement and arbitrarily determined the redemption price instead. But because Section 2703 was not addressed in Connelly, it may yet be possible to avoid its impact with a properly structured and adhered to, Buy-Sell Agreement.

The Court also explicitly stated in a footnote that the holding does not mean that a redemption obligation can never decrease a corporation’s value. The Court implies that if a company is required to sell an operating asset to redeem shares, the redemption obligation might reduce the company’s value.

The Court acknowledged that a differently structured Buy-Sell Agreement can avoid the risk that insurance proceeds would increase the value of a deceased shareholder’s shares. Specifically, the Court referenced a “cross-purchase agreement” in which business owners, rather than the company, agree to purchase the others’ ownership upon death using proceeds from non-company owned policies. In addition to avoiding the Connelly result, a cross-purchase agreement provides an increased tax basis for the surviving owners who purchase a deceased owner’s interests. However, the more owners a business has, the more complicated a life insurance-funded cross-purchase will be. Other options to avoid the Connelly result may include a life insurance partnership or limited liability company or creatively structured split-dollar arrangements.

After Connelly, all business owners with Buy-Sell Agreements funded with entity-owned life insurance, or with other entity-owned insurance vehicles (split-dollar plans, key-person life insurance, etc.) should evaluate and consider restructuring their arrangements. In some cases, the restructuring of a Buy-Sell Agreement may require the transfer of life insurance policies which raises other tax issues, such as in-kind corporate distributions, S corporation elections, transfer-for-value rules, and incidents of ownership.

© Polsinelli PC, Polsinelli LLP in California
For more news on Life Insurance and Estate Taxes, visit the NLR Estates & Trusts section.

2025: SLATs on the Brink of a Rapid Rise in Popularity?

The 2010 Tax Relief Act temporarily increased the federal estate and gift tax exemption to $5 million per individual, a significant rise from prior years. As the 2012 fiscal cliff approached, concerns grew that these higher exemptions might be reduced, prompting a surge in estate planning activities. During this period, Spousal Lifetime Access Trusts (SLATs) gained popularity as estate planners promoted them as a strategic tool to lock in the increased exemption, allowing one spouse to make substantial gifts to a trust benefiting the other spouse while still retaining some access to the assets.

Figure 1: Google Search Volume Jul 2011 – Aug 2024 for GRATs (yellow) and SLATs (red)

The outlook – Estate tax exemption down to $3.5 Million in 2025?

Since the introduction of a higher gift and estate tax lifetime exemption after 2017, the focus of tax planning for many clients has shifted from reducing estate taxes to minimizing income taxes. In 2024, each taxpayer can pass up to $13.61 million to beneficiaries without incurring gift and estate taxes or $27.22 million for married couples. With the top estate tax rate at 40% for amounts exceeding these limits, many believe that the high exemption eliminates the need for complex end-of-life tax planning. However, these elevated exemption amounts are set to revert to pre-2017 levels in 2026, potentially lowering the exemption to around $5 million per individual.

Adding to this urgency, proposals like Elizabeth Warren’s tax plan (1) could further reduce the estate tax exemption to $3.5 million per individual, with increased tax rates on larger estates. Such changes would significantly broaden the scope of estates subject to taxation, making proactive planning essential. In this context, many savvy taxpayers are turning to strategies like Spousal Lifetime Access Trusts (SLATs) to maximize the current exemption while it remains high, allowing them to lock in tax advantages before the expected changes take effect.

What to do?

Use the higher exemption amounts before they go away by establishing trusts that remove assets from the taxable estate. Spousal Lifetime Access Trusts, or “SLATs,” have emerged as one of the most popular and effective estate planning tools for this purpose.

Type of Trust Purpose Key Features Tax Implications
Spousal Lifetime Access Trust (SLAT) Remove assets from taxable estate while providing spouse access One spouse creates trust for the benefit of the other; assets grow outside estate; irrevocable Assets removed from grantor’s estate; no estate tax on appreciation; spouse can access funds
Grantor Retained Annuity Trust (GRAT) Transfer asset appreciation to heirs with minimal gift tax Grantor retains an annuity for a set period; remaining assets pass to beneficiaries Minimal gift tax on remainder interest; potential to transfer appreciation tax-free
Irrevocable Life Insurance Trust (ILIT) Exclude life insurance proceeds from taxable estate Owns and controls life insurance policy; proceeds not included in estate Life insurance proceeds are estate tax-free; may have gift tax on premiums paid
Charitable Remainder Trust (CRT) Provide income stream to grantor and charity, reduce estate size Income stream to grantor or beneficiaries; remainder to charity; irrevocable Partial estate tax deduction; reduces taxable estate; income stream taxed
Qualified Personal Residence Trust (QPRT) Transfer primary or vacation home out of estate Grantor retains right to live in home for set period; home passes to heirs afterward Reduces estate tax by freezing value of home; gift tax on remainder interest

How do SLATs work?

SLATs allow one spouse, known as the donor spouse, to transfer assets into an irrevocable trust for the benefit of the other spouse, the beneficiary spouse. This transfer uses the donor spouse’s lifetime exclusion amount, effectively removing the assets from their taxable estate, including any future appreciation. The beneficiary spouse can access the trust’s assets as needed, providing flexibility and financial security. Meanwhile, the donor spouse maintains indirect access to the assets through their marriage. The donor spouse also controls how the trust assets will be managed and distributed when the SLAT is created. Additionally, SLATs offer strong asset protection, as the trust structure can help defend against potential creditor claims.

Some Caveats

It’s important to also consider and discuss with clients the potential drawbacks of SLATs. Some of the key disadvantages include:

Risk of Divorce or Death: If the donor spouse and beneficiary spouse divorce or if the beneficiary spouse predeceases the donor spouse, the donor risks losing access to the assets in the SLAT. To mitigate this risk, a “floating spouse” provision can be included in the trust, identifying the beneficiary as the “person to whom the settlor is currently married” rather than naming a specific individual. Additionally, the trust can be drafted to allow the trustee to make loans to the donor spouse for further protection.

Unwanted Tax Consequences: SLATs can lead to unfavorable estate, gift, and income tax outcomes. If the donor spouse retains certain powers over the trust, such as the unrestricted ability to replace the trustee, the SLAT’s assets might be included in the donor spouse’s estate, undermining the trust’s tax avoidance objectives. Contributions to a SLAT are also considered completed gifts, so if the contribution exceeds the annual gift tax exclusion ($18,000 in 2024), it will reduce the donor spouse’s lifetime exclusion. Additionally, because SLAT assets typically do not receive a “step up” in cost basis at either spouse’s death, this can increase capital gains taxes for beneficiaries when the assets are eventually sold.

Application of the Reciprocal Trust Doctrine: Couples must be cautious about creating reciprocal SLATs, as this could lead to the trusts being “uncrossed” and included in each spouse’s estate, defeating the primary purpose of the SLAT. Proper planning and drafting are essential to avoid this pitfall.

Indirect Gift Doctrine: According to Internal Revenue Code (IRC) § 2036, if an individual transfers assets but retains the right to income, possession, or enjoyment of the assets or retains control over who will benefit from them, those assets will be included in their gross estate for estate tax purposes.

This situation can easily occur when creating a Spousal Lifetime Access Trust (SLAT). For example, both spouses may intend to create SLATs with each other as beneficiaries while introducing various differences to avoid the “reciprocal trust” doctrine established in the Grace case, 395 U.S. 316 (1969) (see above). However, if one spouse lacks significant assets, the wealthier spouse might give assets to the less affluent spouse, who then uses those assets to fund a trust that names the wealthier spouse as a beneficiary. If the indirect gift principle is applied, the wealthier spouse could be considered the trust’s grantor for estate tax purposes, thus including the trust’s assets in their gross estate under § 2036. Additionally, if the wealthy spouse is the trustee or holds certain tax-sensitive powers, estate inclusion may also result under § 2036(a)(2) or § 2038. This scenario is common among couples with significant differences in wealth. For this reason, many practitioners avoid reciprocal SLATs.

A practical example

James owns an LLC that he has held for about three or four years. He wants the LLC’s investments to support his wife, Emma, during her lifetime and then pass on to benefit their children and later their grandchildren without being subject to federal estate tax.

To achieve this, James forms an irrevocable SLAT for Emma and the children, naming Emma and their friend, Grace, as co-trustees. James retains the right to replace the trustee of the trust at any time and for any reason, provided the replacement is someone who is not related to him or employed by him.

The trust stipulates that Emma can make distributions to herself based on what is reasonably needed for her health, education, maintenance, and support (HEMS standard). Grace, as an independent trustee who is not a beneficiary of the trust, has the power to distribute any or all of the trust assets to Emma at any time and for any reason, according to her sole and absolute discretion, with no obligation to make such distributions.

The trust also grants Emma the right to redirect how the trust assets will be distributed upon her death, provided they are used solely for their descendants. This is known as a “limited power of appointment.”

In this scenario, James retains the right to replace trust assets with assets of equal value, making the trust “disregarded” during James’s lifetime for federal income tax purposes. Additionally, Emma’s role as both a trustee and beneficiary of the trust also causes the trust to be “disregarded” for federal income tax purposes during James’s lifetime. In other words, James and not the trust pays income taxes (2).

Conclusion

As we look toward 2025, Spousal Lifetime Access Trusts (SLATs) are positioned for a significant surge in popularity. Initially gaining traction during the uncertainty of the 2012 fiscal cliff, SLATs have continued to evolve as a cornerstone of strategic estate planning, especially as clients face the prospect of a reduced federal estate tax exemption. With the exemption potentially dropping to $3.5 million per individual if the Warren tax proposals are enacted, SLATs offer a timely and powerful tool to lock in current tax advantages, allowing couples to transfer substantial wealth while maintaining flexibility and financial security.

However, SLATs are not without their complexities and potential pitfalls. The risks of divorce, death, and unfavorable tax consequences highlight the need for careful drafting and planning. By integrating provisions such as a “floating spouse” clause and adhering to the Health, Education, Maintenance, and Support (HEMS) standard, practitioners can mitigate these risks and enhance the trust’s effectiveness.

Ultimately, as the landscape of estate planning continues to shift, the steady rise of SLATs will likely accelerate, making them an increasingly essential part of the conversation between clients and their advisors. Whether as a means to navigate the complexities of estate tax law or to ensure the financial well-being of future generations, SLATs stand ready to play a pivotal role in the years ahead.

References:

  1. American Housing and Economic Mobility Act of 2024 https://www.warren.senate.gov/imo/media/doc/final_text_-_ahem_2024.pdf
  2. Adapted from an example in Alan S. Gassman, Christopher J. Denicolo & Brandon Ketron, SLAT-OPEDIA: Considering All Options and a Client-Friendly Letter, Tax Mgmt. Est., Gifts & Tr. J. (2021). PermaLink https://perma.cc/5636-T5W5
© 2024 wealthcarelawyer.com. All rights reserved
For more news on Spousal Lifetime Access Trusts, visit the NLR Estates Trusts section.

Energy Tax Credits for a New World Part I: Overview of Energy Tax Credits under the IRA

Signed into law on August 16, 2022, the Inflation Reduction Act (IRA) is the most significant long-term commitment made by the U.S. government to encourage and support a clean energy future. The IRA works through the Internal Revenue Code (Code) in ways that fundamentally change the landscape on how clean energy tax credits and incentives are designed, awarded, and monetized.

The regulation, taxation, and financing of energy projects has been an integral aspect of my law practice for decades. These are exciting times now, as the structuring of energy tax credits under the IRA expands on a number of themes that I first covered in an energy and environmental project finance book I coauthored for Oxford University Press back in 2010. Then, as now, my perspective is shaped by my work for clients in the traditional and emerging clean energy sectors.

Why launch a series now about the energy tax credits that were extended, modified, or introduced by the IRA?

  • Many of the IRA energy credits run until 2032, so project developers still have ample opportunity to get their projects underway while credits remain available.
  • The Treasury and the IRS have yet to provide us with many important details on IRA implementation, with much of the guidance having been provided in Notices and proposed Treasury Regulations. But while the details are being ironed out, taxpayers still need to move forward with their projects, and tax returns need preparation. As project owners and funders continue to seek assistance, it remains critical to remain vigilant and stay on top of the large number of new developments.
  • Two important technology-specific credits expire at the end of 2024. They will be replaced in 2025 by two technology-neutral credits. The technology-neutral credits do not expire until 2032, or until certain greenhouse gas emissions (GHG) are reduced to specific levels set out in the Code (most likely, later).
  • Projects that seek to qualify for IRA energy tax credits and which begin construction in and after 2025 will need to meet statutory requirements not required for earlier projects.

Developers and investors would be well advised to consider the tax consequences to their energy projects during the second half of 2024, which I look at as a transition period.

In this Q&A with Andie, Energy Tax Credits For A New World, I aim to provide an overview of the IRA as it relates to many important energy credits. I will take deep dives into some of the requirements and mechanics of some of these credits, and I will look at the ways in which these credits can be monetized.

Through Summer and Fall 2024, Readers can look forward to reading this extended occasional series presented in the following parts:

Part I: Overview of Energy Tax Credits under the IRA

Part II: Production Tax Credits and Investment Tax Credits: The Old and The New

Part III: Overview of Bonus Credits

Part IV: Prevailing Wage and Apprenticeship Bonus Credits

Part V: Domestic Content Bonus Credits

Part VI: Energy Community Bonus Credits

Part VII: Low-Income Communities Bonus Credits

Part VIII: Monetizing Energy Tax Credits

Part XI: Changes to Traditional Tax Equity Financing

The IRA’s tax benefits are enormous. As a result, when a “qualifying energy project” is properly structured and timed, it can receive tax credits that reduce certain related costs by more than 50 percent.

As I launch this series, I would like to extend my gratitude to Nicholas C. Mowbray for his comments and exceptional assistance.

Part I: Overview of Energy Tax Credits under the IRA

“Dozens of countries are widening the gap between their economic growth and their greenhouse gas emissions. . . . If these trends continue, global emissions may actually start to decline,” observed Umair Irfan writing for Vox.[1]

What is the importance of the Inflation Reduction Act (IRA) to energy tax credits?

The IRA has strengthened the United States’ long-term commitment toward a clean energy economy. It is the most ambitious U.S. effort to date to incentivize the development of renewable energy technologies[2] that can help to reduce greenhouse gas (GHG) emissions. The IRA targets the enormous capital expenditures needed to create, commercialize, and broadly make available renewable energy technologies. The IRA’s goal is to lay out a path toward a net-zero GHG economy by 2050.[3]

How does the IRA affect energy project funding?

The IRA has brought about major changes in the ways in which energy projects are structured and funded. It provides for loans, grants, financial and technical assistance, rebates, and energy tax credits. About $400 billion has been allocated for clean energy innovation, technology, and manufacturing. Of this funding, about $260 billion applies to the extension and modification of existing tax credits and the introduction of new ones. In fact, more than 70 percent of the IRA’s benefits are delivered through tax incentives. Now, more than 20 tax credits allow for monetization that supports clean energy generation, develops related manufacturing capacity, incentivizes the increased use of clean vehicles and energy sources, and increases carbon capture programs.[4]

How does the IRA target GHG emission?

The IRA uses funding and financial incentives to support research, development, and commercialization of low- and zero-GHG emission technologies. It also seeks to steer project developers to locate their projects in “energy communities” or “low-income communities”; to pay prevailing wages and encourage the training of registered apprentices; and to increase the use of domestic content components in project-related manufacturing and construction processes.

Have the IRA initiatives been effective?

Initial IRA success stories are very positive, but we have a long way to go. In 2023, “more solar panels were installed in China […] than the US has installed in its entire history. More electric vehicles were sold worldwide than ever.”[5] As the United States seeks to become a global leader in decarbonization and to compete with other major economies like China, the IRA is creating “new opportunities for workers […] and lower costs for America’s families.”[6]

Congress also seeks to ensure that monies provided by the IRA strengthen domestic supply chains and ensure the nation’s energy security in its transportation modes. The IRA is boosting domestic manufacturing for critical renewable energy components, while partially funding the construction of renewable energy projects through its rigorous domestic sourcing requirements.

In 2023 the American Council on Renewable Energy found that, “One of the most notable impacts of the IRA is how quickly it helped to onshore new advanced green manufacturing. More than 83 new or expanded wind, solar, and battery manufacturing facilities have been announced since August 2022, including 52 plants for solar production, 17 for utility-scale wind production, and 14 for production of utility-scale battery storage.”[7]

Notwithstanding some initial successes, two years after passage of the IRA, there are some serious concerns that some of the credits are unworkable, and that the IRA’s domestic sourcing requirements have fallen short of expectations.[8]

Is it possible that the IRA could be dismantled by future Administrations?

Yes. It is possible. Perhaps, a better question might be should the IRA be dismantled? Is it in our best interests to shut down the onward innovation of a thriving high-growth, high-benefit fledgling U.S. industry segment, substantially underwritten by the government, and made available to the residents of a leading market economy?

What makes the IRA different from prior environmental and climate efforts?

The IRA is fundamentally different from the carrot-and-stick approaches of many prior U.S. environmental and climate laws. It has an incentives-based focus: it does not rely on traditional regulation and enforcement to achieve its desired outcomes. It proactively seeks to encourage long-term commercial investments to decarbonize transportation, manufacturing, and construction. The IRA is popular among early adopters. Kimberly Clausing, the Eric M. Zolt Chair in Tax Law and Policy at the UCLA School of Law, noted in a 2023 interview, “There’s a lot of things to like about these tax credits […] they’re broad, they’re longer lived than prior tax credits, and they don’t phase out as quickly. They’re more flexible than prior tax credits. They’re more transferable and refundable, and that enables them to be ultimately more effective.”[9]

The IRA’s long-term focus on tax credits, financial incentives, and monetization may offer prospective project developers a degree of certainty in their planning; persuade investors to commit to clean energy undertakings; and broaden the pool of capital available to do so. So far, the facts speak for themselves: in the first year after the IRA’s enactment, 280 clean energy projects were announced across 44 states, representing $282 billion of investment.[10]

What deference will be given to Treasury Regulations addressing the IRA provisions?

Since passage of the IRA, the Treasury and the IRS have been carefully moving through the details of its rollout.[11] At the date of this writing, many critical questions remain unanswered. In addition, for many decades, the Treasury and the IRS have enjoyed broad latitude on the administration of the laws. But the legal landscape might be changing. On June 28, 2024, in Loper Bright Enterprises v. Raimondo, the U.S. Supreme Court effectively overturned the so-called Chevron doctrine. Chevron is a 40-year-old Supreme Court case that afforded federal agencies a degree of deference in the reasonable interpretation of a statute that fell within their areas of expertise.[12] As a result, many questions will be raised about many laws, along with the frameworks for their roll out and enforcement. Although the Treasury and the IRS will be able to claim broad expertise in some areas of the tax law, it is likely that there will be disputes and litigation over the deference to be given to climate-related tax regulations.[13]

What is the starting point for the IRA’s focus on tax credits?

Let’s take a walk down memory lane. Federal income tax credits for wind and solar energy were first enacted in The Energy Tax Act of 1978.[14] They were structured as refundable 10 percent tax credits for energy property and equipment that produced electricity using wind and solar sources. Later, The Windfall Profit Tax Act of 1980 extended the expiration through 1985, increased the credit to 15 percent, and removed a taxpayer’s ability to get a tax refund based on the value of the credit.[15] The Tax Reform Act of 1986 reduced solar energy credits from 15 percent to 10 percent and extended them through December 31, 1988. Further energy credit extensions for solar property were enacted between 1988 and 1991.

With The Energy Policy Act of 1992,[16] Congress made solar energy credits “permanent” and named them “investment tax credits” (ITCs). The same legislation also enacted the “renewable electricity production tax credit,” or the PTC. When the PTC expired in 1999, it was subsequently extended and expanded to include additional energy technologies.

The Energy Policy Act of 2005 increased the ITC for solar energy from 10 percent to 30 percent, and it extended the credit to additional types of energy property.[17] It did not, however, extend the PTC for solar and refined coal facilities. This meant that from 2005 until enactment of the IRA, the PTC was not available for electricity that was produced from solar energy.

Does the IRA move away from technology-specific tax credits?

Yes. Before the IRA, the PTC at Section 45 and the ITC at Section 48 were the two principal energy tax credits. They were enacted to encourage the development of U.S. wind farms and solar arrays. Both the PTC and the ITC included technology-specific statutory provisions that had been amended over the years to include additional technologies identified by Congress.

The IRA modified and extended both the Section 45 PTC and the Section 48 ITC through the end of 2024 at which point they will be replaced by the next generation of technology-neutral credits: the Section 45Y Clean Electricity Production Tax Credits (CEPTC) and the Section 48E Clean Electricity ITC (CEITC).[18] The rest of the energy tax credits that the IRA modified or introduced took effect for projects beginning on or after January 1, 2023, with most of those credits expiring on December 31, 2032.

In the next part of this series, we will take a look at the production tax credit (PTC), the investment tax credit (ITC), and their progeny. Many of the IRA tax credits are modifications or expansions of the PTC and the ITC. It is an important next step to consider the underlying framework of the old credits and the new.

The firm extends gratitude to Nicholas C. Mowbray for his comments and exceptional assistance in the preparation of this article.

[1] “We Might Be Closer to Changing Course on Climate Change Than We Realized,” Umair Irfan, Vox, April 25, 2024.

[2] Ibid.

[3] The Inflation Reduction Act of 2022, Pub. L. No. 117-169, 136 Stat. 1818 (2022) (IRA), August 16, 2022.

[4] Treasury, Inflation Reduction Act, https://home.treasury.gov/policy-issues/inflation-reduction-act#:~:text=The Inflation Reduction Act, enhanced, for clean energy and manufacturing. See also, “Elective Pay Overview,”
IRS Pub. 5817 (Rev. 4-2024) Number 941211. https://www.irs.gov/pub/irs-pdf/p5817.pdf

[5] “We Might Be Closer to Changing Course on Climate Change Than We Realized,” Umair Irfan, Vox, April 25, 2024.

[6] “Inflation Reduction Act Tax Credit,” U.S. Department of Labor, Inflation Reduction Act Tax Credit | U.S. Department of Labor (dol.gov), accessed August 15, 2024.

[7] “Celebrating One Year of Progress: The Inflation Reduction Act’s Impact on Renewable Energy and the American Economy,” Greg Wetstone, American Council on Renewable Energy, August 14, 2023.

[8] Press release, www.manchin.senate.gov, June 4, 2024.

[9]  “Why the Inflation Reduction Act Can’t Be Repealed,” Evan George, Legal Planet, April 17, 2023.

[10] “The US Inflation Reduction Act is Driving Clean-Energy Investment One Year In,” Marco Willner,

Sebastiaan Reinders and Aviral Utkarsh, Goldman Sachs, October 31, 2023.

[11] “Here’s What the Court’s Chevron Ruling Could Mean in Everyday Terms,” By Coral Davenport et al., The New York Times, June 28, 2024.

[12] “The Supreme Court’s Elimination Of The Chevron Doctrine Will Undermine Corporate Accountability,” Michael Posner, Forbes, July 8, 2024.

[13] “Tax Pros Discuss Impact of Loper Bright on IRS Regs,” Tim Shaw, Thomas Reuters, July 29, 2024,
“The Supreme Court’s decision […] may have ripple effects on Treasury and IRS rulemaking, though to what extent remains unclear, tax professionals say.”

[14] Pub. L. No. 95-618, 92 Stat. 3174 (1978).

[15] Pub. L. No. 96-223, 94 Stat. 229 (1980).

[16] Pub. L. No. 102-486, 106 Stat. 2776 (1992); H.R. 776, 102nd Congress (1991̵–1992).

[17] Pub. L. No. 109-58, 119 Stat. 594 (2005). I will discuss the term “energy property” in a future article.

[18] The PTC, ITC, CEPTC, and CEITC are discussed in Part V: Domestic Content Bonus Credits of this series.

by: Andie Kramer of ASKramer Law

For more news on Energy Tax Credits under the IRA, visit the NLR Tax section.

Grantor Trusts Rules – Will the Loopholes be Closed in 2025?

While some may see the discovery and use of tax loopholes as a triumph of human ingenuity, others see their exploitation as an abuse of the tax code. The concepts developed here are complex but worth understanding if you want to use them for your clients or participate in the public discourse about related tax law reforms.

When anticipating significant appreciation of an asset, affluent taxpayers typically have two options: 1.  transfer the property now (as a gift) to avoid estate taxes on future appreciation, or 2. transfer the property upon death to avoid income taxes on the appreciation. For each of these options, there is good news and bad news:

If the taxpayer gifts the property today, its value is fixed for transfer tax purposes as of the gift date per IRC Sec. 2512. This avoids transfer taxes on any future appreciation. However, the donee inherits the donor’s basis, often low, under IRC Sec. 1015 and will pay income tax on the appreciation when selling the property.

If the property is transferred at death, its value is determined at the date of death under Sec. 2031, capturing all appreciation for transfer tax purposes. The donee receives a stepped-up basis under IRC Sec. 1014, eliminating income tax on the appreciation that occurred before the donor’s death. However, the property is subject to the estate tax at its current fair market value.

In addition to the above, we need to mention an intermediate situation, the incomplete gift. An incomplete gift occurs when the donor retains certain powers or interests over the transferred property, which prevents the gift from being considered complete for tax purposes. This can have various implications, including the deferral of gift tax liability and the potential inclusion of the property in the donor’s estate.

Tax Planning Conundrum: Wouldn’t it be nice if a taxpayer who has an estate large enough to be subject to estate taxes could do both: avoid capital gains taxes and avoid additions to the taxable estate due to appreciation? In other words, could one obtain a stepped-up basis for income tax purposes while also “freezing” the value of the wealth for transfer tax purposes?

Let’s hold that thought and review the Grantor Trust Rules. They determine when a trust is a grantor trust and when it is not, which in turn determines who pays income taxes. This will be important to solving the tax planning conundrum posed above.

Grantor Trust Rules

The distinction between a grantor trust and a non-grantor trust depends on whether the settlor (grantor) retains any incidents of ownership over the trust. If they do, it is a grantor trust; if they don’t, it’s a non-grantor trust. Incidents of ownership can be any number of things by which control over the trust is exerted, for example, the right to change beneficiaries (Table 1).

As stated, in a grantor trust, the grantor maintains a certain degree of control over the trust’s assets or income. In contrast, non-grantor trusts include irrevocable trusts in which the grantor has relinquished control over the trust assets and does not retain any powers that would cause the trust to be treated as a grantor trust.

Provision Description
Power to Revoke (§ 676) If the grantor has the power to revoke the trust and reclaim the trust assets, the trust is considered a grantor trust.
Power to Control Beneficial Enjoyment (§ 674) If the grantor retains certain powers to control the beneficial enjoyment of the trust’s income or principal, the trust may be treated as a grantor trust.
Administrative Powers (§ 675) If the grantor retains administrative powers that can affect the beneficial enjoyment of the trust, the trust may be considered a grantor trust.
Reversionary Interests (§ 673) If the grantor retains a reversionary interest in the trust that exceeds 5% of the trust’s value, the trust is considered a grantor trust.
Income for the Benefit of the Grantor (§ 677) If the trust income is or may be used to pay premiums on insurance policies on the life of the grantor or the grantor’s spouse, the trust is treated as a grantor trust.

If the trust income can be distributed to the grantor or the grantor’s spouse or held for future distribution to them, the trust is considered a grantor trust.

Table 1: The most important grantor trust rules

The distinction between grantor and non-grantor trusts was made to determine who has to pay income taxes on the trust’s income. In a grantor trust, it’s the grantor; in a non-grantor trust, it’s the trust.

The transfer tax and income tax regimes are closely aligned. When a grantor retains control over transferred property in a trust, they have a grantor trust.  This property is generally considered owned by the grantor at death for estate tax purposes. For instance, if a grantor has the power to revoke a trust, Section 676 treats the grantor as owning the property for income tax purposes, and Section 2038 treats it as owned by the grantor at death for estate tax purposes. However, there is a loophole.

The Loophole – The Intentionally Defective Grantor Trust

An Intentionally Defective Grantor Trust (IDGT) is a type of trust designed to be treated as owned by the grantor for income tax purposes but not for estate tax purposes. This means that the income generated by the trust is taxable to the grantor, but the trust’s assets are not included in the grantor’s estate for estate tax purposes. To draft an IDGT, certain provisions must be included to ensure that the trust is considered defective for income tax purposes. These provisions typically involve intentionally violating one of the above grantor rules so that the trust is taxed on the trust’s income.

A more descriptive name for an Intentionally Defective Grantor Trust (IDGT) could be “Swap Power Grantor Trust”. The swap power is a common feature in the drafting of an Intentionally Defective Grantor Trust (IDGT). It allows the grantor to reacquire trust property by substituting other property of equivalent value. This power is crucial because it helps ensure that the trust is considered a grantor trust for income tax purposes while not causing the trust property to be included in the grantor’s estate for estate tax purposes.

The “Swap Power” in Action:

  • Income Tax Implications:
    • Section 675: The swap power causes the grantor to be treated as owning the property for income tax purposes.
    • No Corresponding Estate Tax Rule: There is no rule that includes this property in the grantor’s estate for transfer tax purposes. Thus, the value of the property for transfer tax purposes is fixed at the time of the gift (Section 2512).

Transferring Property to the Trust:

  • Initial Transfer:
    • When the grantor transfers property to a trust with a swap power, the property is valued for gift and estate tax purposes as of the date of the gift, which freezes its value.
  • Appreciation:
    • Inside the trust, after the transfer, the property may enjoy unlimited appreciation; however, its value for estate tax purposes remains “frozen” at the time of the gift.

Income Tax Treatment of Transactions with the Trust:

  • Disregarded Transactions:
    • Under Section 675, transactions between the grantor and the trust (due to the swap power) are disregarded for income tax purposes.
    • Exercise of Swap Power:
      • When the grantor exercises the swap power (exchanging property within the trust), it is seen as moving assets between the grantor’s own “pockets,” so there are no income tax consequences.

Basis and Tax Implications:

  • Carryover Basis Rule (Section 1015):
    • Normally, the basis of the gifted property carries over to the donee, meaning any appreciation is subject to income tax when the property is sold.
  • Stepped-Up Basis (Section 1014):
    • By using the swap power, the grantor can transfer appreciated low-basis property out of the trust and high-basis property of the same value into the trust.
    • The appreciated property is back in the grantor’s hands. When the grantor dies, it gets a stepped-up basis to its fair market value at death.
    • This eliminates the capital gains tax on the appreciation of the property that occurred before the grantor’s death.
    • In addition, estate taxes are at a lower level because the valuation for estate tax purposes was frozen before appreciation in the trust.

This is all very well, but let’s see how this works out in practice.

Simplified Example

  • Grantor: John
  • Trust Beneficiary: Emily
  • Property: Real estate
  • Initial Value: $2 million
  • Appreciated Value: $6 million

Steps:

See Figure 1.

  1. Initial Transfer:
    • John transfers real estate valued at $2 million to a trust with a swap power. This value is fixed for gift and estate tax purposes.
  2. Appreciation:
    • The property appreciates to $6 million over several years, but its value for estate tax purposes remains “frozen” at $2 million.
  3. Using the Swap Power:
    • John uses the swap power to exchange the $6 million property in the trust for $6 million in cash or other assets.
    • This transaction has no income tax consequences because it is disregarded under Section 675.
  4. Basis Adjustment:
    • Normally, the property in the trust would retain John’s original basis, making any appreciation subject to income tax when sold.
    • By swapping the property out of the trust for $6 Million, John reclaims the house. Upon his death and transfer to beneficiaries, the property gets a stepped-up basis to its fair market value of $6 million.
    • This eliminates capital gains tax on the appreciation that occurred before John’s death.

avoid capital gains and estate taxes with a swap power

Figure 1: How to avoid capital gains and estate taxes with a swap power in a grantor trust (Intentionally Defective Grantor Trust)

John effectively avoids income tax on the property’s appreciation during his lifetime and ensures the property gets a stepped-up basis at his death, providing significant tax advantages for Emily. Our tax planning conundrum from above has been solved.

A number of other techniques have a similar effect, but their discussion goes beyond the scope of this article.

Biden’s Reform Plans

Historical Background

Until 1986, taxpayers aimed to avoid having their trusts classified as grantor trusts to escape the burden of personally paying income taxes on trust earnings. This was crucial in an era with a highly progressive income tax system, exemplified by 1954’s 24 tax brackets ranging from 20% to 91%. In 1954 Congress, codifying judicial decisions and wanting to prevent income shifting from higher to lower tax brackets, enacted the grantor trust rules. However, the 1986 Tax Reform Act and subsequent reforms compressed income tax rates, making grantor trusts more favorable. Today, classifying a trust as a grantor trust often results in better tax outcomes. Moreover, as explained above, careful drafting of grantor trusts can limit both estate and income taxes to an extent otherwise not possible (1).

The current situation subverts Congress’s original intent and is also perceived as societally unfair, as it benefits only the already very wealthy. Reforms are periodically suggested, most recently by the Biden administration in the Greenbook, the Tax Proposal for 2025 (2).

Several reform efforts are aimed at Grantor Retained Annuity Trusts, which we will discuss in a follow-up article but list here for context.

1. Grantor Retained Annuity Trusts (GRATs)

  • Minimum Value for Gift Tax: The remainder interest in a GRAT must have a minimum value for gift tax purposes equal to the greater of 25% of the value of the assets transferred or $500,000.
  • Annuity Payments: The annuity payments cannot decrease during the term of the GRAT.
  • Minimum and Maximum Terms: The GRAT must have a minimum term of ten years and a maximum term equal to the annuitant’s life expectancy plus ten years.
  • Prohibition on Tax-Free Exchanges: The grantor cannot exchange assets held in the trust without recognizing gain or loss for income tax purposes.
  • Impact: These changes aim to reduce the use of short-term and “zeroed-out” GRATs, which are often used for tax avoidance purposes.

2. Sales and Transfers Between Grantor Trusts and Deemed Owners

  • Taxable Events: Sales of appreciated assets between a grantor and a grantor trust will be recognized as taxable events, requiring the seller to pay capital gains tax on the appreciation.
  • Basis Adjustment: The buyer’s basis in the transferred asset will be the amount paid to the seller.
  • Purpose: This proposal aims to prevent tax-free transfers of appreciated assets and ensure that such transactions are treated similarly to sales between unrelated parties.

3. Income Tax Payments as Gifts

  • Gift Treatment: The grantor’s payment of income tax on the trust’s income will be treated as a taxable gift to the trust. This gift will occur on December 31 of the year the tax is paid unless the trust reimburses the grantor.
  • Impact: This change ensures that the grantor’s payment of the trust’s income tax liabilities is recognized as a transfer of value subject to gift tax.

4. Realization of Capital Gains

  • Realization Events: Unrealized capital gains on appreciated property will be taxed at the time of transfer by gift or upon death. This includes transfers to or from most types of trusts and distributions from revocable grantor trusts to persons other than the trust’s owner or their spouse.
  • Impact: This would treat transfers of appreciated assets as taxable events, departing from the current practice of realizing such gains only upon sale. It aims to ensure that high-income taxpayers do not benefit from deferred capital gains taxes indefinitely.

5. Intrafamily Asset Transfers

  • Valuation Discounts: Discounts for lack of marketability and control will be reduced or eliminated for intrafamily transfers of partial interests in assets if the family collectively owns at least 25% of the property.
  • Collective Valuation: The transferred interest’s value will be calculated as a pro-rata share of the total fair market value of the property held by the transferor and their family members, as if a single individual owned all interests.
  • Purpose: This proposal aims to curb the use of valuation discounts to reduce the taxable value of intrafamily transfers.

What if the Republicans Gain Control of Congress?

The Republican proposals regarding grantor trusts largely focus on maintaining the status quo established by the 2017 Tax Cuts and Jobs Act (TCJA). This includes making the increased estate, gift, and generation-skipping transfer (GST) tax exemptions permanent, thus avoiding the reduction scheduled for 2026. Additionally, Republicans are likely to oppose the Biden administration’s suggested reforms, such as treating sales between a grantor and a grantor trust as taxable events and recognizing the payment of income tax on trust income as a taxable gift.

Conclusion

As we anticipate potential changes to the grantor trust rules in 2025, it’s clear that the landscape of estate planning may undergo significant transformations. The Biden administration’s proposals, likely to be adopted in a similar form by Vice President Harris, aim to close loopholes that currently allow for substantial tax advantages through mechanisms like the swap power and GRATs. These reforms would impose stricter requirements and tax consequences, curbing the ability to avoid capital gains and transfer taxes. Conversely, Republican proposals focus on maintaining the current tax benefits established by the 2017 Tax Cuts and Jobs Act. Understanding these proposals and their potential impacts is crucial for tax professionals and affluent taxpayers. Staying informed and proactive will ensure the optimal structuring of trusts and asset transfers, aligning with the evolving tax regulations and maximizing the benefits within the legal framework.

 References:

1  Jesse Huber. The grantor trust rules: An exploited mismatch. The Tax Adviser. November 1, 2021

2  Department of the Treasury March 11, 2024. General Explanations of the Administration’s Fiscal Year 2025 Revenue Proposals. Green Book p.127

© 2024 wealthcarelawyer.com. All rights reserved.

Washington Shake-Up: Vice President Harris to Lead Democratic Nomination for 2024 Presidency

Following President Biden’s withdrawal from the 2024 presidential race on Sunday, the nation’s capital has experienced another political shock, leading to swift mobilization within the Democratic Party. President Biden quickly endorsed Vice President (VP) Kamala Harris as the Democratic nominee, triggering a rapid wave of support from Congressional leaders, governors, stakeholders, and party donors including former Speaker Nancy Pelosi (D-CA), Senate Majority Leader Chuck Schumer (D-NY), House Democratic Leader Hakeem Jeffries (D-NY), all 24 Democratic governors, EMILYs List, and the United Auto Workers.

VP Harris has secured enough backing from Democratic delegates to clinch her party’s nomination to challenge former president Donald Trump in November. With the election a little over 100 days away, we have highlighted VP Harris’ stance on key issues during her tenure in Congress and her 2020 Presidential bid.

Technology

VP Harris is very familiar with the tech industry due to her roots in Silicon Valley as San Francisco’s district attorney, and her subsequent roles as Attorney General and US Senator from California. Although she hasn’t called for the breakup of big tech like some of her former colleagues in the Senate, she has criticized tech CEOs for the data privacy practices and targeted advertising tactics that their companies deploy, and voiced support for general regulation of big tech firms. In the White House, she serves as President Biden’s lead on AI initiatives and has actively promoted policies aimed at mitigating AI risks such as algorithmic bias, disinformation, and privacy concerns, while maximizing its benefits for Americans.

Climate Change

VP Harris has a long history of challenging the oil industry for its role in pollution and is likely to take it a step further than President Biden in tackling climate change. In the 2020 Presidential race, Harris proposed a $10 trillion climate plan aimed at achieving a carbon-neutral US economy by 2045, featuring initiatives such as a climate pollution fee and the elimination of fossil fuel subsidies.

In the Senate, Harris authored legislation that would have authorized grants to fund projects that address the specific climate-related challenges faced by vulnerable communities and invest in critical upgrades to the nation’s water infrastructure.

As California’s attorney general, VP Harris brought lawsuits against major oil companies, including British Petroleum (BP) for failing to stop underground storage tanks from leaking gasoline at 800 sites across the state, and also filed an investigation into ExxonMobil over its climate change disclosures.

Health Care

Maternal health was at the forefront of Harris’ health care priorities during her tenure in the Senate and has continued in her current role as Vice President. She sponsored landmark legislation such as the Black Maternal Health Momnibus Act, aimed at tackling the crisis facing Black maternal health care. This legislation enhances data collection, expands access to prenatal, postpartum, and doula care in underserved communities, promotes implicit bias training for health care professionals, and funds research and innovation to improve health outcomes and reduce disparities for Black women. Although the bill was not enacted, it remained a priority in both chambers of Congress after Harris’ departure from the Senate. It is also the centerpiece bill of the Congressional Black Maternal Health Caucus. Harris also championed legislation aimed at addressing the impact of uterine fibroids on women’s health through initiatives such as research funding, patient support tactics, and health care provider training. Additionally, she supported legislation to establish a loan repayment program for mental health professionals working in areas with critical workforce shortages.

In her 2020 presidential campaign, Harris introduced a health care plan that proposed a gradual transition toward Medicare-for-All over a decade. Her plan allowed individuals and employers to initially buy into Medicare while maintaining strict regulations for private insurance options. She also consistently opposed efforts to restrict access to reproductive health care services.

Tax

With numerous tax provisions under former President Trump’s Tax Cuts and Jobs Act set to expire in 2025, all eyes are on VP Harris’ anticipated tax policy proposals. During her tenure in Congress, she championed a significant tax reform bill that would have introduced the LIFT credit—a refundable tax credit of $3,000 for single filers and $6,000 for married couples—benefiting a large portion of middle- and working-class Americans. Unlike the Earned Income Tax Credit (EITC), this credit’s amount would not depend on the number of children reported on a taxpayer’s return but would phase out as income increased. Harris emphasized that this credit aimed to boost families’ after-tax income to help them cope with rising living costs.

Additionally, she sponsored legislation in Congress aimed at protecting workers from harassment and discrimination, funding earthquake mitigation efforts, and providing housing assistance to low-income families. During her 2020 presidential campaign, Harris advocated strongly for repealing Trump’s tax law. She proposed implementing a financial transaction tax to expand Medicare coverage and advocated for taxing capital gains as part of her broader economic platform.

A Look Ahead

With midterm elections looming in the House and 33 Senate seats up for election, the impact of VP Harris’ nomination on Congressional races will be watched closely. As the first woman of color and the highest-ranking woman in US history to hold the office of Vice President, Harris’ nomination marks a pivotal moment in American politics. It may influence voter behavior, candidate strategies across the aisle, and the broader political landscape leading up to the November elections.

The Democratic National Convention (DNC) is scheduled to be held in Chicago, Illinois, from August 19 to August 22. However, due to upcoming state ballot deadlines which precede the convention date, a virtual roll call where delegates formally select Kamala Harris as the nominee will conclude by August 7. Harris is expected to choose her running mate in the coming days, as her campaign team has sent vetting materials to Arizona Sen. Mark Kelly, Michigan Gov. Gretchen Whitmer, Minnesota Gov. Tim Walz, North Carolina Gov. Roy Cooper, and Pennsylvania Gov. Josh Shapiro.

©1994-2024 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. All Rights Reserved.
For more on the 2024 Election, visit the NLR Election Law Legislative News section

It Ain’t Over ‘til It’s Over: IRS Reminds Taxpayers That Section 280E Applies to Marijuana Companies Until Rescheduling Becomes Law

This is a tax blog. Stay with me – it’s short.

While marijuana advocates celebrate the potential rescheduling of marijuana from Schedule I to Schedule III, the taxman has made clear that marijuana remains a Schedule I substance subject to Section 280E of the Internal Revenue Code. For those who aren’t cannabis tax specialists, 280E provides that:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Marijuana is a Schedule I controlled substance and is subject to the limitations of the Internal Revenue Code. As we previously reported, the Justice Department recently published a notice of proposed rulemaking with the Federal Register to initiate a formal rulemaking process to consider rescheduling marijuana to Schedule III under the Controlled Substances Act. That change would remove marijuana from the purview of 280E.

Predictably, a number of cannabis operators couldn’t help themselves and began filing amended returns seeking to avail themselves of what they apparently felt was a change in the law. The response from the IRS is clear:

Taxpayers seeking a refund of taxes paid related to Internal Revenue Code Section 280E by filing amended returns are not entitled to a refund or payment. Until a final rule is published, marijuana remains a Schedule I controlled substance and is subject to the limitations of Internal Revenue Code Section 280E.

The reasoning is simple – marijuana is a Schedule I substance until it is not. While there is currently in place a process that could lead to the rescheduling of marijuana, it has not actually been rescheduled.

Cannabis operators can dream of a time when they will not be subject to the ravages of 280E, but for now that remains just out of grasp, albeit tantalizingly close.

As usual, stay tuned to Budding Trends. We’ll be monitoring all the impacts of rescheduling, including tax implications like this one.

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© 2024 Bradley Arant Boult Cummings LLP
For more on Cannabis, visit the NLR Biotech Food Drug section.

Supreme Court Rules Against Taxpayers in IRC Section 965 Case

On June 20, 2024, the Supreme Court of the United States issued a 7-2 opinion in Moore v. United States, 602 U.S. __ (2024), ruling in favor of the Internal Revenue Service (IRS).

Moore concerned whether US Congress and the IRS could tax US shareholders of controlled foreign corporations (CFCs) on those corporations’ earnings even though the earnings were not distributed to the shareholders. The case specifically focused on the so-called “mandatory repatriation tax” under Internal Revenue Code (IRC) Section 965, a one-time tax on certain undistributed income of a CFC that is payable not by the CFC but by its US shareholders. Some viewed the case as hinging upon whether Congress has the power to tax economic gains that have not been “realized.” (i.e., In the case of a house whose value has appreciated from $500,000 to $600,000, the increased value is “realized” only when the house is sold and the additional $100,000 reaches the taxpayer’s coffers.)

However, Justice Brett Kavanaugh, joined by Chief Justice John Roberts and Justices Sonia Sotomayor, Elena Kagan and Ketanji Brown Jackson, rejected that position on the ground that the mandatory repatriation tax “does tax realized income,” albeit income realized by a CFC. On this basis, they reasoned that the question at issue was whether Congress has the power to attribute realized income of a CFC to (and tax) US shareholders on their respective shares of the undistributed income. This group of justices ultimately decided Congress does have the power.

The majority went out of its way to avoid expressing any opinion as to whether Congress can tax unrealized appreciation, with Justice Amy Coney Barrett’s concurrence and Justice Clarence Thomas’s dissent asserting that it cannot. Perhaps the Court was signaling a distaste for the Billionaire Minimum Income Tax proposed by US President Joe Biden, which would impose a minimum 20% tax on the total income of the wealthiest American households, including both realized and unrealized amounts, among other Democratic proposals.

Practice Point: We previously noted that certain taxpayers should consider filing protective refund claims contingent on the possibility that Moore would be decided in favor of the taxpayers. In light of the case’s outcome, however, those protective claims are now moot.

© 2024 McDermott Will & Emery
For more news on US Shareholders of Foreign Corporations Taxes, visit the NLR Tax section.

A Tribute to Whistleblowers: Bitcoin Billionaire to pay $40 Million to Settle Tax Evasion Suit

Michael Saylor, the billionaire bitcoin investor, will pay a record $40 million to settle allegations that he defrauded Washington D.C. by falsely claiming he lived elsewhere to avoid paying D.C. taxes. The suit – discussed in of one of our previous blogs – was originally brought by a whistleblower, Tributum, LLC., and the D.C. Attorney General intervened in the lawsuit in 2022. The settlement marks the largest income tax fraud recovery in Washington D.C. history.

Though Saylor claims he has lived in Florida since 2012, the suit alleged that Saylor actually resided in a 7,000-square-foot penthouse, or on yachts docked on the Potomac River in the District of Columbia. Furthermore, the Attorney General alleged that from 2005 through 2021, Saylor paid no income taxes. Saylor first improperly claimed residency in Virginia to pay lower taxes, then created an elaborate scheme to feign Florida residency to avoid income taxes altogether, as Florida has no personal income tax. Court filings state that MicroStrategy, Saylor’s company, submitted falsified documents to prove his residency.

According to a court filing, MicroStrategy kept track of Saylor’s location, and those records show that he met the 183-day residency threshold for D.C., meaning he was obligated to pay income taxes to the District. As we mentioned in our previous blog on the case, the complaint summarizes this tax fraud scheme as “depriv[ing] the District of tens of millions of dollars or more in tax revenue it was lawfully owed, all while Saylor continued to enjoy the full range of services, infrastructure, and other fruits of living in the District.” Despite this, he allegedly made bold claims to his friends, “contending that anyone who paid taxes to the District was stupid,” according to the Attorney General.

About the case, the D.C. Attorney General further stated that “No one in the District of Columbia, no matter how wealthy or powerful they may be, is above the law.” Holding even evasive billionaires accountable is an important part of keeping the integrity of our systems intact and ensuring that we all pay our fair share. Under the District of Columbia False Claims Act , private citizens can report tax evasion schemes , while the federal False Claims Act has a “tax bar,” so tax fraud is not actionable under that law. The IRS Whistleblower program instead offers recourse.

In addition to the $40 million settlement, Saylor has agreed to comply with D.C. tax laws. The amount of the whistleblower award in the case is still being determined, but whistleblowers are entitled to 15-25% of the government’s recovery in a qui tam False Claims Act settlement.

© 2024 by Tycko & Zavareei LLP
For more news on Cryptocurrency Tax Evasion Settlements, visit the NLR Criminal Law & Business Crimes section.