The solar tax credit can significantly reduce Federal income taxes. Congress has recently reaffirmed its desire to spur these investments to curb reliance on foreign energy and to help the environment.
As with most tax incentives, such as the research tax credit, there are a number of rules that have to be followed to be able to realize the tax benefits.
One such rule is that the solar investment has to be legitimate–the project has to be viable independent of any tax benefits. This isn’t really a tax standard, but just an entry-level review of the prospects that the solar project will make a profit.
The recent Olsen v. Commissioner, No. 21-9005 (10th Cir. 2022) provides an example of a solar project that failed this preliminary review. Those investing in projects that result in solar tax credits should read this case as it provides a somewhat concise list of facts that investors should strive to avoid with their own investments.
Facts & Procedural History
If the tax court’s opening sentence, in this case, calls the transaction a “tax shelter scheme,” you know the facts are not great. The tax returns fall into the category of “problem tax returns.”
The taxpayer was one of the hundreds of others who invested in light-concentrating lenses. The lenses were to be used as components of a system to generate electricity. The light-concentrating lenses were to be installed on towers to heat liquid that would go to a heat exchanger to create steam to turn a turbine.
The investments were made with a “promoter” who promised tax benefits but did not promise profits.
The structure was set up so that the investors would form an LLC that they owned, the investor LLC would purchase the lenses at a high price, and then the investor LLC would lease the lenses back to the promoter’s entity. The investor entity would then be paid by the promoter entity once the lenses were operational and profitable.
These tax credits and related depreciation deductions were reported on the taxpayer’s income tax returns for four years and, according to the court, they basically eliminated the taxpayer’s Federal income tax.
While the towers were built in 2006, only one of them had lenses installed by 2015. The project basically never made it out of the R&D stage.
The IRS conducted an audit and adjusted the returns for the 200+ investors. Litigation ensued with the U.S. Tax Court concluding that the tax benefits were improper. The above-cited case is an appeal from the U.S. Tax Court.
About Commercial Solar Tax Credits
Commercial solar tax credits are set out in Section 48. They are similar but separate from the residential solar tax credits that are available under Section 25D and enhanced under the Inflation Reduction Act.
The commercial solar tax credits vary in about, but generally, they equal 30 percent of the taxpayer’s basis in energy property.
Energy property includes equipment used to generate electricity using solar energy. The property has to be “placed in service” to qualify.
This property has to qualify for depreciation under the depreciation rules.
The ability to use solar tax credits can also be limited by the passive activity loss rules. These rules look to whether the taxpayer materially participates in the activity.
Whether the Taxpayer Had a Profit Motive
The tax court and appeals court considered whether the taxpayer had a profit motive. This is a requirement to establish a “trade or business.” The courts applied the hobby loss rules to evaluate this issue.
The hobby loss rules set out nine factors that show whether the taxpayer’s activities rise to the level of a trade or business. We have written about numerous hobby loss cases on this site. You can read more about these rules here, here, and here.
The appeals court also considered the factors it announced in its Nickeson v. Commissioner, 962 F.2d 973, 977 (10th Cir. 1992) opinion. This opinion identifies five characteristics of activities suggesting the absence of a profit motive:
(1) the marketing materials focus on expected tax benefits,
(2) the taxpayer buys the item for a grossly inflated price without negotiating,
(3) the taxpayer doesn’t ask the seller about potential profitability,
(4) the taxpayer lacks control over activities, and
(5) the taxpayer uses nonrecourse debt.
The short version of the court’s analysis is that the taxpayer did not conduct this activity like a business. He apparently did not really ever visit the site where the lenses were, knew nothing about solar energy or its generation, and did not take the time to educate himself about this type of business endeavor. In an even shorter form, the taxpayer made an investment in exchange for tax credits and depreciation deductions.
The commercial solar credit is a legitimate credit and, as intended by Congress, can reduce one’s tax liability. Investors have to do their due diligence as part of their tax planning.
This court case is instructive on what to avoid with respect to commercial solar credits. The investor has to be knowledgeable and should take steps to learn the business, the business should legitimately be carried out in earnest, and, preferably, the persons offering the business should be knowledgeable in solar and have a strong track record of success and the marketing materials should clearly explain the profit motive and not just the expected tax benefits.