When consulting with clients I hold nothing back. In the first session I lay out all the tax strategies I can in the time allotted. But after several sessions I worry we are only reviewing past strategies and not finding new tools to skin an old hide.
Enter the buying of tax credits. The Inflation Reduction Act (the IRA) has opened one of the most exciting tax strategies in many years. It is now possible for certain individuals and businesses to reduce their taxes to zero or close to it with the purchase of tax credits.
The strategies I outline in this post do not apply to everyone. But those that qualify have a new tool in reducing their federal tax liability. Buying tax credits due to the IRA was first thought to be a $350 billion industry. That number is now estimated to be $1 trillion! The opportunity is vast.
A Short Overview of Buying Tax Credits
The IRA has added numerous tax credits focusing on energy. Large projects will produce large amounts of credits, but many of these companies will not have a tax liability, making the tax credits worthless until they have a tax liability to offset. However, these nascent businesses have a high need for financing. Congress knew this would be an issue so they added provisions to the IRA allowing for the transfer of 11 of these tax credits to unrelated third-parties, therefore providing financing to the businesses in need when it is needed most.
Companies selling tax credits have rules to follow. If the rules are not followed the tax credits could later be denied by the IRS, causing a 20% penalty on top of the repayment of the claimed credit. The buyer would be liable for the recapture of the tax credit. Due diligence is very important.
The IRA tax credits are considered passive. This means only certain individuals will benefit from the buying of tax credits. Corporations do not have passive income so the opportunities are greater for those entities.
Who Benefits from Buying Tax Credits?
Corporations, S-corporations, partnerships, trusts, and individuals can all use tax credits created by the IRA. Unfortunately, the credits are severely limited for all but corporations. Tax-exempt organizations also can use these tax credits, but will not be discussed in this article.
The main issue is passive income. Partnerships and S-corporations pass-through income, along with credits, to the partners or shareholders. On the individual level you need passive income to benefit from buying tax credits. Many times partners and shareholders materially participate, making the income nonpassive.
Real estate is a natural area where buying tax credits can work. But! While real estate is generally considered passive, real estate professionals turn passive income into nonpassive, kicking out the use of these tax credits.
So who can benefit from buying tax credits?
For individuals with large amounts of passive pass-through income there is a possible opportunity. In my office I see several clients with significant investments in partnerships focusing on real estate. The partnership conducts a cost segregation study, generating large losses early in the life cycle of the investment. Of course, nothing happens in a vacuum. Bigger deductions now mean higher profits later. These investors continue ramping up investments with passive losses to offset gains. But that eventually hits a ceiling. Buying tax credits might prove a reasonable way off that hamster wheel.
Business income can also be offset by tax credits, but not any old business income. The IRA purchased tax credits only apply to passive income, and regular corporations, the C-corporation, do not have passive income, allowing for tax credits to offset the corporation’s tax liability.
Closely held corporations, where five or fewer individuals own, directly or indirectly, 50% or more of the corporation the last six months of the tax year can purchased tax credits to offset business income, but not portfolio income (dividends, interest, or capital gains).
Risks from Buying Tax Credits
There are two significant risks when buying tax credits, plus a special risk to partnerships and S-corporations buying tax credits.
The first is not having passive income. Without passive income, or business income in a corporation, the transferred credits will provide no value. You are allowed to carry forward the IRA transferred credits for 22 years. But you still have the outlay of cash to purchase the credits and eventually have a tax liability on passive income for the credit to apply. The best option is to only buy credits as you need them.
The second issue is compliance. For example, for the credits to qualify, there are wage requirements. You will need to verify these and other conditions are met. If the IRS later discovers noncompliance, the tax credits could (almost certainly would) be disallowed. The recapture of the credits will fall on the buyer. Plus there is a 20% penalty for partial or complete disallowance of the credit.
Buyers of large amounts of tax credits will want to handle their own due diligence. Since the risk is high, insurance is recommended. The insurance company will handle their own due diligence, but that doesn’t relieve you of your due diligence. The cost of insurance reduces the value of the tax credits transferred.
There are other risks that each buyer will need to consider based on their facts and circumstances.
The special risk facing partnerships and S-corporations involves recapture of the tax credits. If a partner or shareholder sells part or all of their position in the partnership or S-corporation within five years of the entity purchasing credits, the individual will face recapture.
Cost of IRA Tax Credits
The transferrable IRA tax credits do not have a set transaction price. The price agreed upon between the buyer and seller is the contract price.
In my research it appears 85% or 90% is a common transfer price, before due diligence or transfer costs. That means $10,000 of credits would transfer at $8,500 or $9,000.
As you can see, with small amounts the benefit is small, especially when considering the efforts required to purchase the tax credits.
Many brokers of tax credits only want $500,000 and larger transactions. Smaller amounts are not worth the time or expense for the brokers either. It should be noted that there is no minimum in the tax code. Any minimum transfer size is set by either the seller or broker of the tax credits.
It should also be noted that some sellers of tax credits will set a firm price, while others will use an auction process to sell their tax credits. You will need to research brokers to determine which model each uses and which method benefits you most.
Except for very high income individuals, the minimums set by the seller or broker eliminates most taxpayers. But there is still an opportunity. If you don’t qualify for one of the strategies listed below, it is still wise to understand the process. Listed companies may disclose they are purchasing tax credits. This may increase their profits and stock price. Not all benefits from a tax strategy needs to take place on your personal tax return.
Tax Strategies to Enhance the Buying of Tax Credits
There are a few simple strategies to qualify for buying tax credits, even in smaller amounts.
First, smaller brokers often use a bidding or auction process. Sellers with small amounts of tax credits to sell may welcome smaller bids.
This opens an avenue for income property owners that are not real estate professionals. For example, a doctor with heavy real estate investments is unlikely to qualify as a real estate professional. But years of real estate investments now yields a very high amount of passive income. Tax credits can offset the income tax related to the passive income. $1,000,000 of passive income in the 37% tax bracket is still a lot of tax. Sellers of tax credits may wish to accept an offer to purchase $370,000 of credits. If the discount is 15%, the taxpayer reduced her tax by $370,000 and by $55,500 after including the cost of the tax credits.
Another type of investor may use the same strategy. Investments in partnerships often generate losses early on. As time moves, revenues begin to eclipse the deductions. The investor can buy more similar investments to offset gains from earlier partnership investments. Of course, purchases will need to be bigger and bigger as older investments run out of expenses while throwing off larger and larger amounts of passive income. Buying tax credits can be an avenue off this type of investment treadmill.
Perhaps the biggest and best strategy for the average taxpayer involves business income.
The S-corporation has been the workhorse for small businesses for decades. However, with the new environment, the regular corporation should be given another review.
Not every S-corporation will benefit from terminating their S election. Caution is also warranted, since the S election, once terminated, requires a 5-year waiting period before re-electing S status. Your personal and business facts and circumstances will prevail. Do not terminate your S election unless you have conducted your due diligence!
This strategy does not exist in a vacuum! E.g. Simple math between the S-corporation and regular corporation buying tax credits is not the only considerations. A small business owner may wish to explore the benefits of an ICHRA in a corporation (not allowed to owners of 2% or more of an S-corporation). The corporation has benefits the S-corporation does not. Certain tax-free benefits do not apply to S-corporation shareholders of 2% or more ownership. Your facts and circumstance surrounding health care alone may tip your decision. And there is much more to review before making a decision.
There are a few things to keep in mind when considering an S election termination. As mentioned, there is a 5-year waiting period before you can elect to be an S-corporation again. If you decide to return to an S-corporation after your business was a C corporation, tax issues can be more complicated, increasing costs in the future.
Corporations face double taxation on dividends paid. In an S-corporation, profits are distributed to the owner/s without an additional layer of taxation. Taxes are paid at the owner’s personal tax rate on the owner’s personal tax return. A corporation pays a flat 21% tax rate, but does not get a deduction for distributions (dividends), but the shareholder pays tax on the dividend received, hence a double-tax on those profits.
In short, an experienced tax professional should help you determine the best course with the new options and strategies available. There is a massive opportunity to reduce your tax liability if you have passive income or corporate profits. But due care is required.