Treasury Department and IRS Issue Final Regulations and Other Guidance on the Direct Pay Election under Section 6417 of the Internal Revenue Code

In large part, the Final Regulations adopt the Prior Regulations, but some changes were made in response to the comments received by Treasury and the IRS. Additionally, at the same time as issuance of the Final Regulations, new proposed regulations were issued under IRC Section 761 addressing certain matters relating to elections out of subchapter K of the IRC in connection with the filing of direct pay elections (the “761 Proposed Regulations”). Finally, IRS Notice 2024-27, also issued March 5, 2024, requests comments on the possibility of making a direct pay election with respect to renewable energy tax credits purchased pursuant to cash transfer elections under IRC Section 6418 (otherwise referred to as “chaining”).

Certain Definitions
For purposes of the discussion below, a few definitions under the Final Regulations are worth summarizing:

An “applicable entity,” which is eligible to make a direct pay election with respect to the full period for which the relevant tax credits are allowed, generally includes (i) a tax-exempt organization; (ii) a State, the District of Columbia or any political subdivision thereof; (iii) the Tennessee Valley Authority; (iv) an Indian tribal government; (v) an Alaska Native Corporation; (vi) a cooperative, both taxable and tax exempt, furnishing electricity to persons in rural areas. The Final Regulations clarify that all tax-exempt entities that meet the requirements to be tax exempt in sections 501 through 530 are applicable entities, in response to comments requesting the inclusion of homeowners’ associations as applicable entities.

An “electing taxpayer” is a taxpayer, other than an applicable entity, that makes a direct pay election with respect to tax credits available under IRC Section 45Q, 45V or 45X for a single five-year period in accordance with IRC section 6417 and the Final Regulations.

High-Level Overview of Significant Aspects of the New Guidance on Direct Pay Elections

Original Return Requirement. Under the Final Regulations, a direct pay election must be made on an original federal income tax return filed no later than the applicable due date (including extensions) for the relevant taxable year. A direct pay election may not be made for the first time on an amended return or by way of an administrative adjustment request (AAR), and no relief for a late direct pay election is available under Treasury Regulation sections 301.9100-1 through 301.9100-3. Unlike the Prior Regulations, however, the Final Regulations allow for the correction of numerical errors by filing amended returns or AARs (but corrections are not permitted for items left blank or responses of “available upon request”).

First Time Filers. As noted above, a direct pay election must be made on a timely filed tax return. In the case of an applicable entity filing a tax return for the first time solely to make the direct pay election (e.g., a governmental entity that does not pay federal income tax), the Final Regulations allow such entity to choose whether to file its first tax return using its fiscal year or the calendar year, so long as the entity maintains adequate books and records, including a reconciliation of any differences between its regular books of account and the chosen taxable year. In either case, the tax return is due by the 15^th day of the fifth month following the end of the taxable year, and an automatic six-month extension is granted (subject to any future guidance relating to the filing of extension requests).

Financing Investment-Related Credit Property with Grants and Forgivable Loans (Excess Benefit Rule). The Final Regulations, like the Prior Regulations, provide that if a taxpayer receives a grant or forgivable loan for the specific purpose of purchasing, constructing, reconstructing, erecting, or otherwise acquiring an investment-related credit property (a “Restricted Tax Exempt Amount”) and the sum of the Restricted Tax Exempt Amount and the amount requested under the direct pay election exceeds the project’s total cost basis (the “Excess Benefit”), the applicable credit amount will be reduced by such Excess Benefit. The Final Regulations clarify that the determination of whether a Restricted Tax Exempt Amount is received for the specific purpose of purchasing, constructing, reconstructing, erecting, or otherwise acquiring an investment-related credit property is made at the time such amount is awarded. While amounts awarded after the acquisition, construction, reconstruction or erection generally are not considered Restricted Tax Exempt Amounts, the Final Regulations treat such later-awarded amounts as Restricted Tax Exempt Amounts if (i) approval of the award was perfunctory and (ii) the amount of the award was virtually assured at the time of application. The Final Regulations also clarify that the excess benefit rule does not apply to awards that are not specifically tied to a specific project (e.g., unrestricted funds).

Chaining Prohibition. The Final Regulations do not allow for the filing of direct pay elections for tax credits acquired by way of cash purchase under IRC Section 6418, generally on the basis that the relevant applicable entity or electing taxpayer must own the applicable credit property to which the tax credits relate. (Note: for the same reason, a direct pay election is not available for tax credits transferred to another party under IRC Section 45Q(f)(3)(B), or to a lessee pursuant to a lease pass-through election). While acknowledging that nothing in the relevant statutory provisions directly prohibits the chaining of purchased tax credits with a direct pay election, Treasury and the IRS cited concerns as to administrability and potential for fraud or abuse as reasons to deny the use of chaining. Nevertheless, as noted above, IRS Notice 2024-27 requests comments on various questions relating to chaining, including as relates to statutory interpretation of IRC Sections 6417 and 6418, potential impact on the tax credit transfer marketplace, and administrability challenges.

Partnership Election Out. The Final Regulations follow the Prior Regulations in providing that a partnership or S corporation is not considered an applicable entity eligible to make a direct pay election, even if all or some of its members are applicable entities. A partnership or S corporation can be an electing taxpayer, however, for those tax credits (i.e., those under IRC sections 45Q, 45V and 45X) for which a direct pay election can be made for a single five-year period. The inability of applicable entities to access direct payments through a partnership was viewed by many as a major disappointment when the Prior Regulations were issued. Here, the 761 Proposed Regulations provide a possible avenue for applicable entities to access direct pay through joint ownership arrangements that may constitute partnerships for federal income tax purposes, albeit in limited situations. Specifically, an election out from partnership classification would be available under the 761 Proposed Regulations where: (i) an unincorporated organization is owned at least partially by an applicable entity; (ii) the members of the organization enter into a joint operating agreement in which the members reserve the right separately to take in kind or dispose of their pro rata shares of the electricity produced, extracted or used, or any associated renewable energy credits or similar credits; (iii) pursuant to the joint operating agreement, the unincorporated organization operates exclusively to produce electricity from its applicable credit property and with respect to which one or more of the qualifying tax credits is determined; and (iv) one or more of the applicable entities makes a direct pay election with respect to such tax credits. As this “election out” is available only for joint ownership arrangements related to electricity production, only those tax credits related to electricity generation facilities would be accessible under the 761 Proposed Regulations.

Final Points
As described above, the Final Regulations and associated 761 Proposed Regulations include some helpful changes to the Prior Regulations, but do not address other issues raised in comments submitted to Treasury and the IRS. Notably, in the preamble to the Final Regulations, Treasury and the IRS declined to provide guidance on specific timeframes for the processing of direct payments, or for the possibility of accelerated direct payments in advance of the filing of tax returns for the relevant taxable years. The Final Regulations generally apply to taxable years ending on or after March 11, 2024, but taxpayers are permitted to apply the Final Regulations to prior taxable years provided the Final Regulations are applied in their entirety and in a consistent manner. The 761 Proposed Regulations are proposed to apply to taxable years ending on or after March 11, 2024. Comments on the 761 Proposed Regulations are invited until May 10, 2024. Comments under IRS Notice 2024-27 should be submitted by December 1, 2024.