Revised March 1, 2023
Below are the questions asked by the audience during our webinar of June 22 Capital Account Implications for Renewable Energy Tax Credits with our answers and explanations. For reference, a PDF of the presentation from the webinar is available here.
The questions are divided into the following five categories:
DRO/Negative Capital Account Questions
Could a “book-up” of a partnership’s capital accounts due to a “reevaluation” of the project result in the reduction or elimination of a partner’s deficit restoration obligation (DRO)?
Answer: Yes, it could.
Explanation: The section 704(b) regulations permit a book-up of capital accounts when a new or existing partner makes a capital contribution “(other than a de minimis amount)” to the partnership in exchange for an interest in the partnership. See Treas. Reg. §1.704-1(b)(2)(iv)(f)(5). The contribution must be made for a non-tax business purpose in order for the capital contribution to qualify as a revaluation event. If such a contribution is made, the partnership is permitted to revalue or “book-up” its assets to fair market value. The “book-up” of the partnership’s assets allows the partners to restate their capital accounts to reflect the increased value of the partnership’s property and can serve to eliminate or reduce a DRO.
2. Question: In deals structured with a DRO, the partnership agreement typically caps the applicable partner’s DRO at a percentage of the partner’s capital contributions. Do the tax rules provide for a limit on how large a DRO may be?
Answer: The tax rules do not have an objective limit on the size of a DRO.
Explanation: The concept of a DRO traces its roots back to the principle that a general partner had unlimited personal liability for the obligations of the partnership. Given general partners had unlimited personal liability, the tax law does not provide for an objective limit for how large a DRO may be.
We have seen tax equity deals in which 12-year straight-line depreciation is elected and the tax equity investor’s DRO cap is as little as 15% of its capital contributions. We have also seen tax equity deals in which bonus depreciation is elected and the DRO cap is more than 100% of the tax equity investor’s capital contributions.
3. Question: What are the risks of sizing a DRO cap with a large cushion to make sure the negative balance of the tax equity investor’s capital account does not exceed the DRO cap?
Explanation: There is not a tax risk with such a strategy; however, there is a commercial risk: if the partnership were to liquidate, the partner with the DRO would have to fund its negative capital balance up to the cap with large cushion. Given that commercial risk, partners generally opt to not provide DROs larger than necessary to cover their reasonably projected negative capital account balance (after adjustment for any “minimum gain” attributable to any “partnership nonrecourse debt”), which is what the section 704(b) regulations require.
4. Question: What happens when an investor exits a deal and has an outstanding DRO? Is there gain recognized on the deficit capital account or does the investor need to contribute cash at that point? If gain is recognized, are the suspended losses released to cover the gain?
Answer: Assuming the exit is a sale of the investor’s partnership interest, the buyer inherits the DRO. The seller/investors recognizes gain for the difference between its outside tax basis in its partnership interest and the purchase price. However, the investor’s suspended losses are eliminated and do not get transferred to the buyer, so the investor avoiding the DRO is not as much as a windfall as it seems at first.
Explanation: If you are thinking of a typical tax equity partnership with the only members being the managing member and investor, the result is that the partnership terminates as it only has one partner. In this termination scenario, the buyer/managing member does not inherit the DRO from the seller/investor because there is no longer a partnership for tax purposes.
The exercise of a buyout that results in there being only one partner/member is known as a Revenue Ruling 99-6 transaction. What that ruling deems to happen is that the partnership makes a “liquidating distribution of all of its assets” to the managing member and the investor, and following such distribution the managing member is deemed to acquire the assets distributed to the investor. See Rev. Rul. 99-6, Situation 2.
There is not any guidance that excludes this deemed liquidation provided in Revenue Ruling 99-6 from being a “liquidation” for purposes of Treas. Reg. § 1.704-1(b)(2)(ii)(g) that would trigger the DRO. However, most partnership agreement expressly provide that upon the exercise of the buyout the investor has no obligation to make any further capital contributions (other than possibly for IRS “imputed underpayments”). Therefore, the exercise of the buyout by the managing member excuses the investor from having to satisfy its DRO in the liquidation that Revenue Ruling 99-6 deems to occur.
However, the investor being excused from satisfying the DRO does not mean it has taxable income equal to the cancelled DRO. There are two reasons for this. First, the IRS has ruled that a typical DRO is not a debt obligation of the partner that agrees to it:
there was no unconditional and legally enforceable obligation that required the taxpayer [(an individual general partner (i.e., effectively a partner with an uncapped DRO)] to repay any of the amounts withdrawn to the partnership on or before a determinable date. Therefore, it is held that the withdrawals … that created a deficit in his capital account are not loans governed by section 707(a) of the Code but are partnership distributions received by him in his capacity as a partner. Rev. Rul. 73-301, 1973-2 CB 215.
Second, the investor has achieved no tax advantage by the exercise of the buyout effectively cancelling its DRO. The lack of tax advantage is because the negative capital account is typically accompanied by corresponding suspended losses under section 704(d). That is the losses that created the negative capital account were never deducted:
where a partner who disposes of his interest is relieved of a deficit capital account liability created by prior partnership distributions. Prior cash distributions will have either (1) decreased the basis of his interest under § 733(1) if the partner had sufficient basis at the relevant times or (2) been taxed to him under § 731(a)(1) if he did not. … In all of these situations, because the ‘liability’ has not produced a basis increase or generated untaxed cash or property for the partner, the liability should not constitute an amount realized on disposition of the partner's interest. McKee et al, Fed. Tax’n of Partnerships & Partners ¶ 11.05[b] (4th ed. 2007, supp. 2020-2).
Another way to state is that if the investor were, hypothetically, burdened with taxable income from the cancellation of its DRO in the buyout, then that taxable income should be able to be offset by the investor’s suspended losses.
5. Question: Can depreciation that is capitalized into inventory be specially allocated as a separable line item? Or once depreciation is capitalized into the basis of the inventoriable item, that depreciation deduction cannot be allocated as a separable item and must be allocated in the same ratio as all costs of goods sold.
Answer: It cannot be separately allocated. It must be capitalized into cost of goods sold.
Explanation: In the power generation , depreciation is only separately allocable if the project is leased. If power is sold pursuant to a power purchase agreement (or scheduled directly into a power market), the IRS requires cost of goods sold accounting, which means depreciation is capitalized into cost of goods sold, which results in only a bottom-line profit or loss to allocate. See GCM 38337 (Apr. 4, 1980); GCM 37352 (Dec. 21, 1977); Announcement 86-65, 1986-19 I.R.B. 19; TAM 200543050 (Oct. 28, 2005); PLR 200146009 (Nov. 19, 2001).
6. Question: To determine depreciation schedules for wind and solar projects, do you look to section 168, or are there more detailed rules for wind and solar?
Answer: Yes, the general depreciation rules apply to wind and solar property.
Explanation: Section 168 and the regulations thereunder provide rules for depreciation of all property, including wind and solar projects. IRS Publication 946 is also useful in determining depreciation schedules. The ITC regulations (i.e., Treas. Reg. § 1.48-9) provide some guidance with respect to depreciation. The U.S. Treasury’s section 1603 grant guidance can be applied by analogy and may provide helpful background. A number of PLRs have been issued over the years and while not precedential, provide helpful guidance.
7. Question: If transmission equipment with a 15-year recovery period is placed in service in the same year as a wind or solar power generation equipment with a 5-year recovery, can the owner claim bonus depreciation on the 15-year recovery period equipment and 12-year straight-line on the wind or solar power generation equipment?
Explanation: Depreciation elections apply taxpayer-by-taxpayer, depreciation class-by-depreciation class and placed in service year-by-placed in service year. I.R.C. §§ 168(g)(7), (k)(7). Since 15-year transmission equipment is a different deprecation class than 5-year renewable energy generation equipment, a taxpayer can make different depreciation elections, even if they are placed in service in the same year.
Further, if one wind turbine (or solar project block) is placed in service in year X and another wind turbine (or solar project block) is placed in service in year Y, a taxpayer can make different elections for the different placed in service years.
Further, the same corporation can be a partner in two separate partnerships that each own separate solar projects, and one partnership can elect bonus depreciation and the other partnership can elect 5-year MACRS (or 12-year straight-line) depreciation. These depreciation election rules are discussed further on page 4 of the article available at https://www.projectfinance.law/media/5552/2018-01-19-elfa-tax-reform-article-by-d-burton-and-a-levin-nussbaum.pdf
8. Question: Consider an example in which a partner contributes $100 and is allocated a $200 credit with $100 basis reduction and $150 loss, resulting in a negative $150 capital account at year end. The partner has a negative outside basis. Since the negative basis was created from a combination of both the credit reduction and the losses, are both “suspended” in proportion, or can the partner apply the ITC basis reduction FIRST and attribute the entire negative capital account balance to the loss only? That is does the ITC adjustment always come before the loss?
Answer: There is no clear guidance directly on point. However, the conventional wisdom in this area is that the basis adjustment attributable to the ITC necessarily has to occur first. It would have to occur first because the adjustment is necessary to calculate the depreciation available with respect to the project for the year in question. That is the project’s basis is reduced by the ITC basis adjustment and the balance of the basis is then subject to the depreciation rules of section 168.
Explanation: As there is no clear guidance on point, it is rare to see reliance on this logical ordering inference. Typically tax equity investors prefer a high degree of comfort and would rather make an optional contribution than rely on inference without direct guidance.
9. Question: Are a losses of a partner that are suspended pursuant to section 704(d) subject to a limit on the ability to use them in future years comparable to the 80% limit on net operating losses (NOLs) that are carried forward?
Answer: No. There is not limit on the ability to use losses that that are suspended under section 704(d) in future years once the losses are released.
Explanation: In tax reform enacted in 2017, section 172 was amended to allow only 80% of taxable income for any year to be offset by the carry forward of net operating losses. This rule is discussed on page 4 of the article available at https://www.projectfinance.law/media/5552/2018-01-19-elfa-tax-reform-article-by-d-burton-and-a-levin-nussbaum.pdf. There is no comparable limit on the use of losses that are released after being suspended pursuant to section 704(d).
Tax reform completely eliminated the ability to carryback NOLs. However, it is still possible to carryback general business credits, like the ITC and the PTC, one year. General business credits can be carried forward 20 years.
10. Question: Has the production tax credit (PTC) for onshore wind expired?
Answer: Projects that “began construction” prior to statutory deadlines can still claim PTCs.
Explanation: The PTC has a 10-year credit period, so operating projects can continue to claim PTCs. Additionally, projects placed into service after the expiration of the credit that “began construction” in earlier years can still claim the credit (in later years at a reduced amount):
If Construction Begins:
PTC Amount Reduced by
During 2020 or 2021
No PTC Available
The PTC rate is currently $26 a mWh. Accordingly, for an onshore wind project to claim the full $26 a mWh, it must have begun construction in 2016 or earlier. A wind project may opt for the investment tax credit (ITC); however, the ITC amount would be subject to the same level of reduction as the PTC. The begun construction rules for wind are provided for in IRS Notice 2013-29 and its progeny.
11. Question: Why is there a basis reduction, with a corresponding capital account and outside basis adjustments, for 50% of the ITC but no corresponding adjustment for the PTC?
Answer: That is how Congress wrote the rules. Specifically, section 50(c)(3)(A) provides for the basis reduction of half of the ITC, and there is no corresponding basis adjustment rule for the PTC. (Rehabilitated historic buildings also qualify for an ITC, and that basis adjustment is 100% of the ITC.)
12. Question: If ITC claimed on a partner's share of ITC eligible basis is recaptured, does the partnership increase its basis in the energy property by 50% of the amount recaptured by the partner?
Answer: Yes, it does.
Explanation: The partner will have an increased tax liability in the year of the recapture by the amount of the recapture, and the partnership will adjust its basis in the energy property by 50% of the amount recaptured by the partner. I.R.C. § 50(c)(2).
13. Question: How does a project casualty impact ITC recapture?
Answer: If the project is permanently removed from service, the ITC would have to be recaptured. I.R.C. § 50(a)(1)(A).
Explanation: The amount of the ITC that must be recaptured declines by 20% a year (i.e., if the casualty occurs more than five years after the placed in service date, there is no recapture).
14. Question: What are the recapture rules for qualified production expenditures (QPE), which allow ITC to be claimed while a project is being constructed?
Answer: If the project is not ultimately placed in service, the ITC claimed based on QPE must be recaptured.
Explanation: In general, ITC may not be claimed until the project is placed in service. However, in some cases taxpayers investing in projects that take more than two years to construct need not wait until the property is in service to claim the ITC. In the case of “progress expenditure property,” a taxpayer can elect to claim ITC before as the project is being constructed. See Treas. Reg. § 1.46-5(b).
Progress expenditure property is property being constructed by or for the taxpayer that has an estimated normal construction period of two years or more. In this context, “construction” means building or manufacturing property from materials and component parts. “Normal construction period” starts on the day when the physical work begins or, if later, on January 1 of the year in which the QPE election is made. Treas. Reg. § 1.46-5(b).
If the project is never placed in service, the QPEs must be recaptured. I.R.C. § 50(a)(2)(A).
A QPE election is rarely (if ever) made in practice. This is because it entails construction risk. That is it requires owning the project during construction and suffering recapture if the project is not placed in service. The banks, insurance companies and public corporations that are the efficient users of ITC generally do not want to take construction risk. Therefore, they will rarely entertain QPEs. In contrast, developers that are comfortable with construction risk generally do not have sufficient tax appetite to use QPEs efficiently.
 All references to “section” or “§” are to the Internal Revenue Code of 1986, as amended, or the regulations thereunder.
 Further, if the DRO was a debt obligation, the investor could take the position that distributions to it that exceeded it outside basis when viewed in conjunction with the DRO amounted to a loan (rather than a taxable distribution pursuant to section 731(a)). Seay, TCM 1992-254 (rejecting an individual general partner’s argument that distributions in excess of his outside basis combined with his uncapped DRO, as a general partner, constituted a loan to the partnership and did not result in taxable income under section 731(a) because a DRO is not a debt obligation: “We believe that petitioner should have known the distributions were taxable. He used the money to live but did not pay tax on it.”).
 I.R.C. § 50(a)(1)(B): "(i) One full year after placed in service 100%
(ii) One full year after the close of the period described in clause (i) 80%
(iii) One full year after the close of the period described in clause (ii) 60%
(iv) One full year after the close of the period described in clause (iii) 40%
(v) One full year after the close of the period described in clause (iv) 20%"