The IRS has taken the position that in the course of an audit of a taxpayer’s return, it has the authority to challenge the amount of a Section 1603 Treasury cash grant previously paid to the taxpayer in the year under audit. This comes as a surprise to many taxpayers who believed that once paid by Treasury, the IRS did not have audit jurisdiction over a cash grant payment.
Section 1603 of the American Recovery and Reinvestment Act of 2009, as amended (Section 1603), allows a taxpayer to elect to receive a cash grant payment, instead of claiming the 30% energy tax credit, with respect to an investment in certain renewable energy generation projects (so-called “specified energy property”). Generally, property qualifies as specified energy property if it would otherwise qualify for the Section 48 energy investment tax credit (ITC). The amount of the cash grant is 30% of the eligible basis of the property which qualifies for the ITC. The election to obtain the cash grant and forgo the ITC is made by application to Treasury. In general, Treasury is directed by the statute to pay out qualifying cash grants within 60 days after the application is complete and the project has been placed in service.
The amount of any Section 1603 cash grant payment is not includible in gross income. However, the tax basis of the property for purposes of depreciation deductions is reduced by one-half of the cash grant payment (as is also the case with the ITC). Like the ITC, all or a portion of the grant must be recaptured and paid back to Treasury in the event a specified disqualifying event occurs, such as a disposition of the project to an ineligible recipient or a change in the qualification or use of the property.
The Section 1603 cash grant program is available to applicants who place specified energy property in service during 2009, 2010 or 2011. Grant payments can be made for qualifying projects placed in service after 2011 if construction began during 2009, 2010 or 2011 and the property is placed in service by a specified date (December 31, 2016 for solar projects and December 31, 2012 for wind projects with respect to which the taxpayer has elected the ITC in lieu of the production tax credit). For more information about the cash grant program generally, see our summaries and alerts here and here.
Whether the taxpayer claims the ITC or elects the cash grant, the tax basis for the property determines the amount of the credit or grant. The Treasury Department has reviewed literally thousands of applications under the Section 1603 program and has paid out billions of dollars in grant money. Congress encouraged a rapid application turn-around time and a 60-day payment deadline. Due to the volume of applications, Treasury has had to evaluate whether a project is eligible for the grant, and whether the tax basis claimed by the taxpayer is accurate, in a much shorter period of time than is available to IRS auditors in the field examining returns on which the ITC has been claimed.
Most taxpayers and their advisors have been under the impression that once Treasury completes its review of a grant application and pays out a grant, the IRS does not have the authority to subsequently challenge on audit the qualification of the project as “specified energy property” or the amount of the tax basis on which the 30% grant was claimed. However, a recently issued IRS internal memorandum (available here) upsets this expectation. The IRS takes the position that the IRS may review in the course of an audit whether the amount of a Section 1603 payment was appropriate, and any portion of a Section 1603 payment that was “excessive” is required to be included in the grant recipient’s income.
In the memorandum, the IRS Chief Counsel responded to questions raised by IRS counsel and field agents concerning projects for which Section 1603 grant payments were made, but where the IRS determines on audit that all or a portion of the grant paid was not eligible for the grant. The key question raised was: “In the event the Service determines that a taxpayer’s project did not qualify for all or part of a section 1603 payment, is the excessive amount of the payment includible in the taxpayer’s gross income … notwithstanding … that section 1603 payments shall not be includible in the taxpayer’s gross income?”
The IRS concluded that, notwithstanding the amount paid out by Treasury, only the portion of the grant claimed by the taxpayer that actually qualifies for the grant on the merits can be excluded from gross income. The excludable amount does not include the portion of any payment that a taxpayer receives under the Section 1603 program that exceeds the amount of the payment that applies to the cost of property that qualifies for the payment under section 1603. Thus, if the IRS determines, on examination, that a taxpayer’s property did not qualify for all or part of the payment that the taxpayer received under the Section 1603 program, the excess over the amount of the correctly determined Section 1603 payment is not excludible from the taxpayer’s gross income. The IRS also concluded that the excessive amount of a Section 1603 payment cannot be excluded from income under any other principle of tax law (e.g., as a non-taxable gift, contribution to capital).
As a corollary to the rule that “excessive” grant payments are income, the amount of the “excessive payment” that is includible in income does not reduce the taxpayer’s basis for the property for depreciation purposes.
For example, assume a taxpayer claims a grant payment of $300 on a project with a claimed tax basis of $1,000. Treasury pays the $300 grant to the taxpayer. Taxpayer’s basis for depreciation is reduced by one-half the grant amount, to $850. Absent a special disqualifying event, the grant money cannot be recaptured by Treasury. However, on the regular audit of the taxpayer’s return, the IRS examines and challenges the taxpayer’s claimed basis as excessive. The IRS determines that the taxpayer overstated its basis for the property and that the proper basis amount was $900, and the proper grant amount was $270. The taxpayer has an income inclusion of $30 (the “excessive payment”). In addition, the taxpayer’s basis re-adjusted: it is reduced from $1,000 to $865 ($1,000 less one-half of $270). Thus, the income inclusion is partially offset by a basis increase, but on a net basis, the economic loss caused by the adjustment on audit is still substantial.
What will surprise most taxpayers is not the IRS’ calculations, but the fact that the IRS has the authority on audit to challenge the amount of the taxpayer’s Section 1603 payment at all. By characterizing the portion of a grant payment that exceeds the allowable amount as an unreported item of gross income, the IRS essentially is asserting audit jurisdiction over every Section 1603 payment that Treasury has ever made. For taxpayers that have applied for and received a grant payment, the Treasury cannot recapture and require repayment of the grant money absent a disqualifying event. However, the IRS has another opportunity to review and challenge the taxpayer’s claim upon audit of the taxpayer’s return for the year the grant was paid. A significant portion of the economic benefit of the grant can be lost if the IRS determines on audit that all or a portion of the grant claimed exceeds the proper amount.
One challenge that the IRS may make on audit is that the taxpayer’s project fails to qualify as “specified energy property.” Another more likely challenge is that the taxpayer has overstated the tax basis on which the 30% grant is calculated. Treasury apparently is concerned that taxpayers have attempted to game the Section 1603 system by claiming unrealistic and unsupported amounts as tax basis. Clearly, Treasury is concerned about potential taxpayer abuse in the Section 1603 program. This concern is reflected in the recently issued Treasury guidance describing how Treasury evaluates the tax basis for photovoltaic (PV) solar energy projects (discussed here). Treasury identified the opportunity to artificially step up basis through excessive developer premiums, transfers between related parties, sale-leasebacks, and in lessee “pass-through” lease transactions (also called “inverted leases”) where basis is deemed to be “fair market value.” Thus, if a lessor passes the Section 1603 payment through to a lessee and that payment to the lessee is based on an amount in excess of the true fair market value of the property, the lessee has received a partially excessive Section 1603 payment. These are the kinds of transactions which may be susceptible to greater IRS scrutiny on audit, with the potential for an unanticipated income inclusion and a reversal of a part of the overall economic benefit of the transaction.