Purchasers of State Tax Credits
Purchasers of state tax credits can deduct the state taxes they pay with the credits on their federal tax returns.
However, they can only deduct what they paid for the credits — not the full taxes paid with them.
The IRS made this comment in a private ruling it released in late December. The ruling is Private Letter Ruling 200951024.
The ruling involved an investor in a venture capital fund. The state guaranteed the investor it would earn at least a minimum return. If its return fell short, the investor was given transferable tax credits to make up the difference. A regulated utility in the state signed a forward purchase agreement to buy up to a certain amount of tax credits from the investor.
The IRS said the investor had to report the sales proceeds as gain on the sale.
The utility bought an asset. It had a basis in the asset equal to what it paid for it. When it turned over the asset to the state to satisfy state tax liabilities, it could deduct the taxes it paid in this fashion; state income taxes are deductible at the federal level. However, to the extent the state gives it credit for more than it paid for the asset, then it has a gain equal to the difference. The net effect is the utility will end up with tax deductions equal to what it paid for the tax credits it uses.