The IRS has issued temporary (T.D. 9776) and proposed regulations on the income inclusion rules for a lessee of investment credit property when the lessor elects to treat the lessee as having acquired the property. The regulations apply to investment credit property placed in service after September 18, 2016.

Background

Section 50 contains special rules applicable to the investment credit. Section 50(d)(5) provides that rules similar to the rules of former Section 48(d)(1) shall apply to investment credit property. Former Section 48(d)(1) permitted a lessor of new investment credit property to elect to treat that property as having been acquired by the lessee for an amount equal to its fair market value. If the lessor made that election, the lessee would be treated for all purposes as having acquired such property. Thus, under Section 50(d)(5), a lessor may elect to treat the lessee of investment credit property as having acquired the property for purposes of calculating the investment credit.

Section 50(a) includes recapture rules under which all or part of the credit is recaptured if investment credit property is disposed of or ceases to be investment credit property during the five-year period after it is placed in service. Section 50(c) states that the basis of investment credit property is reduced by the amount of the credit (50% of the amount of the credit in the case of energy property).

Temporary regulations

The temporary regulations coordinate the Section 50(d)(5) election to treat the lessee as the owner of investment credit property with the basis adjustment rules under Section 50(c). The coordination rules are similar to those of former Section 48(d)(5) (under which the basis adjustment did not apply and the lessee included an equivalent amount in income). The temporary regulations provide that in the case of an election with respect to investment credit property under Section 50(d)(5), the basis adjustment under Section 50(c) will not apply to the property and the lessee must include the credit amount (or 50% of the credit amount in the case of energy property) in gross income ratably over the shortest recovery period applicable under the accelerated cost recovery system. The regulations clarify that the amount to be included in income is divided by the number of years in the recovery period. The resulting fractional amount (for example, one-fifth of the total inclusion amount in the case of five-year property) is included in income in the tax year in which the investment credit property is placed in service and in each succeeding tax year until the entire amount has been included in income. This inclusion is required even if the amount of the credit allowed under Section 38(c) is limited based on the amount of the lessee's income tax.

Special rule for partnerships and S corps

If the Section 50(d)(5) election is made with respect to investment credit property leased to a partnership or S corporation, each partner or S corporation shareholder is treated as the ultimate credit claimant. Accordingly, the partner or shareholder is treated as the lessee for purposes of the income inclusion rules and must include the applicable credit amount in gross income. Because the investment credit and any limitations on the credit are determined at the partner or shareholder level, the temporary regulations provide that the gross income required to be ratably included is not a partnership or S corporation item. Thus, there is no increase in the basis of the partner's partnership interest or the S corporation shareholder's stock basis as a result of the income inclusion. Treasury and the IRS believe this interpretation is necessary to prevent the avoidance of income by taking a loss (in the amount of the basis adjustment) on the disposition of an interest in a pass through entity, which the preamble of the regulations suggests would be inconsistent with Congressional intent.

Coordination of income inclusion and recapture rules

The temporary regulations provide coordination rules that apply when recapture is triggered (including upon a lease termination) for investment credit property subject to the Section 50(d)(5) election. Coordination is necessary because recapture occurs ratably over the five-year period beginning on the date the investment credit property is placed in service while income inclusion occurs ratably over the recovery period for the property. If the allowable credit (determined after recapture) exceeds cumulative income inclusions in years before the recapture event, the excess is included in income in the recapture year. Conversely, there is a negative adjustment to gross income if prior income inclusions exceed the allowable credit (determined after recapture). Finally, if a lease termination, lease disposition by a lessee, or disposition of a partner's or S corporation shareholder's entire interest in a lessee partnership or S corporation occurs after the end of the recapture period and before the end of the applicable recovery period, the lessee (or, if the lessee is a partnership or S corporation, the partner or shareholder) may make an irrevocable election to accelerate any remaining income inclusion to the year in which the disposition occurs.

Implications

The historic and solar industries have long awaited these regulations and clarification of what was always considered a murky area of the tax code. For those industries, the regulations are a mix of the bad, the good and the ugly.

Starting with the bad, the regulations' preamble acknowledges that "some partnerships and S corporations have taken the position that their partners or S corporation shareholders are entitled to increase their bases in their partnership interest or S corporation stock as a result of the income inclusion." The use of the word "some" may be understating the prevalence of this practice; a "vast majority" may be a much more accurate descriptor. As such, the inability to include the income into basis will likely affect numerous historic and solar projects by reducing the value of the benefit and could even prevent marginal projects from moving forward. The benefit reduction could also affect how taxpayers structure transactions utilizing historic rehabilitation tax credits going forward. Before the temporary regulations were issued, the solar industry typically structured its historic rehabilitation tax credit transactions through leases. With the value of that approach reduced, the industry could structure those transactions using pass-through structures instead.

Turning to the good news, the regulations will not accelerate income upon a taxpayer's exit from the partnership, termination of the lease, or any other condition unless the taxpayer elects to do so. This means that the income will be recognized over an extended period, which might offset some of the inability to increase basis with Section 50(d) income. For example, a taxpayer could enter into a transaction that generates historic rehabilitation tax credits on a commercial building in 2017, exit the transaction in 2024 and still be recognizing 50(d) income in 2055 related to the historic rehabilitation tax credit claimed in 2017.

With that benefit, however, likely comes some administrative burden. By continuing to recognize income after exiting the transaction, the taxpayer ultimately claiming the credit will likely become responsible for keeping track of that income and reporting it. Similarly, the taxpayer will also be responsible for tracking for financial statement implications from future taxes due. Depending on the number of years these items would need to be tracked, taxpayers might elect to accelerate income rather than deal with the on-going administrative burden.

Unfortunately, that leaves the ugly, which centers around the regulations' effective date. Although the temporary regulations apply prospectively, the IRS notes that the "temporary regulations should not be construed to create any inference concerning the proper interpretation of Section 50(d)(5) prior to the effective date of the regulation." (emphasis added). With this statement, the IRS effectively reminds taxpayers that the temporary regulations represent its interpretation of the law, not a change in the law. Because the law has not changed, the rationale used by the IRS in the temporary regulations to conclude that taxpayers should exclude income from basis prospectively could also apply to past transactions in open years. Support for this application can be found in long-standing arguments against increasing basis apart from the regulations, which are best illustrated in McKee, Nelson, & Whitmire: Federal Taxation of Partnerships and Partners treatise:

Although the regulations deal expressly with basis adjustments to property where the owner of the property claims the investment tax credit, there is no guidance provided where the lessor passes through the investment tax credit to the lessee under Section 50(d)(5) (which makes the rules of prior law Section 48(d), relating to leased property, applicable). Section 48(d)(1) of prior law allowed the lessor of property to elect to treat the lessee as having acquired the property. In lieu of a basis adjustment where the credit is passed to the lessee, Section 48(d)(5) of prior law required the lessee to include ratably in gross income an amount equal to 50% of the credit allowable to the lessee. The income amortization substitutes for the basis reduction because the lessee does not own the property. Although no provision of law prevents this income inclusion from increasing outside basis under  Section 705 where a partnership is the lessee, such a basis increase is unwarranted given that the income amortization will have no effect on Section 704(b) capital accounts and substitutes for a downward basis adjustment that would have occurred if the partnership had actually owned the leased property.

The ability to apply this rationale to past transactions, regardless of the regulations' effective date, leaves taxpayers with one of two choices: apply the regulations retroactively to transactions in open years or face the possibility of having those transactions challenged upon audit. Though potentially beneficial for taxpayers with excess capital losses from the economic downturn or other sources, applying the regulations retroactively poses several implementation challenges. Applying the regulations only prospectively, however, puts taxpayers in the position of arguing that their past transactions should be respected because the basis for challenging them, which Treasury articulates in the temporary regulations, is incorrect.

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