August 2, 2025
Investment

Tax-exempt investment in partnerships holding energy properties


Editor: Christine M. Turgeon, CPA

The Inflation Reduction Act of 2022, P.L. 117169, significantly amended and expanded the investment tax credit (ITC) under Sec. 48, including making additional types of energy property eligible for the ITC, and providing increased credit amounts for energy projects that satisfy prevailing wage and apprenticeship requirements and domestic content requirements, or are located in energy communities. The Inflation Reduction Act also established the technologyneutral zero greenhouse gas (GHG) emission electricity investment credit under Sec. 48E, which replaces Sec. 48 as the primary tax incentive for investment in cleanenergy facilities placed in service after 2024.

The amount of the ITC under these provisions generally is calculated as (1) the applicable percentage of the basis of the Sec. 48 crediteligible energy property or (2) the applicable percentage of the Sec. 48E creditqualified investment with respect to any qualified facility and energystorage technology.

Approaches to sharing the ITC and other tax benefits

Investments in energy projects offer two primary tax benefits: the ITC and accelerated depreciation. Some developers cannot use these tax benefits themselves but can use them to incentivize tax equity investors that provide bridge financing until the projects receive cash payments.

The most common traditional tax equity structure for monetizing ITCs and depreciation is the partnership flip structure. Under this arrangement, the partnership that owns the project allocates a tax equity investor a large portion of the tax benefits (e.g., 99%) and a lower share of cash for an agreedupon period — generally five years, to avoid ITC recapture under Sec. 50. After this period, the allocation to the investor “flips” down to a lower percentage (e.g., 5%), and the sponsor typically has an option to purchase the tax equity investor’s interest.

The Inflation Reduction Act introduced two additional avenues to monetize ITCs by allowing (1) applicable entities, including taxexempt entities, that directly hold the energy projects to elect direct payments under Sec. 6417, and (2) eligible taxpayers — excluding applicable entities — to transfer ITCs to third parties under Sec. 6418. However, these options do not facilitate the monetization of depreciation, which can be claimed only by the tax owner of the project, and typically require sponsors to sell the ITCs at a discount to reflect substantiation and recapture risks for the transferee.

Hybrid structures are now emerging that allow a tax equity investor to direct the partnership to sell tax credits that would otherwise be allocable to them, while retaining the corresponding depreciation — thereby combining the benefits of the traditional partnership flip structure with the directtransfer option.

Limitation of tax benefits for tax-exempt organizations

A notable limitation of both traditional and hybrid tax equity structures arises when energy property, which is otherwise eligible for the ITC and accelerated depreciation, is held by a partnership that has indirect taxexempt partners. This is because the taxexempt partner’s indirect proportionate share of the property is treated as taxexemptuse property that is ineligible for these tax benefits.

Under Secs. 50(b)(3) and (4), property used by certain taxexempt organizations, governmental units, or foreign persons or entities is — subject to specific exceptions — ineligible for the ITC under Secs. 48 and 48E. If the property is held by a partnership, then under Sec. 50(b)(4)(D), rules similar to Secs. 168(h)(5) and (6) apply. These rules deny accelerated cost recovery on taxexemptuse property and require the taxpayer to apply the applicable alternative depreciation system (ADS) method instead.

For purposes of Secs. 50 and 168, taxexempt entities generally include the United States (including any state or political subdivision thereof), organizations exempt from tax (other than cooperatives described in Sec. 521), and foreign persons or entities (with exceptions for certain property subject to U.S. taxation). A taxexempt controlled entity— generally, any corporation if 50% or more of the value of its stock is held, directly or indirectly (taking into account the attribution rules of Sec. 318), by one or more taxexempt entities (other than a foreign person or entity) — is also treated as a taxexempt entity for this purpose (Sec. 168(h)(6)(F)(iii)).

A reading of the statute suggests that for purposes of applying Sec. 50, the ownership of a U.S. corporation by a foreign person or entity is not considered when determining whether the U.S. corporation is a taxexempt controlled entity. If the corporation’s stock is publicly traded, only 5% shareholders are taken into account.

A taxexempt controlled entity can elect out of taxexempt treatment under Sec. 168(h)(6)(F)(ii), thereby enabling the entity to claim the ITC and accelerated depreciation tax benefits. This election requires both the taxexempt controlled entity and its shareholders to recognize income and gain from its interest in a partnership (and any dividend or interest received or accrued by the taxexempt controlled entity from such partnership). That income is treated as unrelated business taxable income (UBTI) to the taxexempt controlled entity for purposes of Sec. 511. This election is irrevocable and binding on all taxexempt entities holding interests in a taxexempt controlled entity. It is unclear whether the election is valid if the U.S. corporate blocker is owned by a super taxexempt entity that is never subject to UBTI, although a literal interpretation of the statute may support the election in that case.

Tax-exempt-use property held by partnerships

As a general rule, if property is owned by a partnership that has both a taxexempt entity and an individual or nontaxexempt entity as partners, and any allocation to the taxexempt entity of partnership items is not a qualified allocation, then the taxexempt entity’s proportionate share of that property is treated as taxexemptuse property under Sec. 168(h)(6)(A) (and thus ineligible for the ITC and accelerated depreciation).

Under Sec. 168(h)(6)(B), an allocation to a taxexempt entity is qualified if it (1) is consistent with that entity’s allocation of each item of income, gain, loss, deduction, credit, and basis throughout the entire period during which the entity is a partner in the partnership, and (2) has substantial economic effect within the meaning of Sec. 704(b)(2).

There is limited guidance under Sec. 168(h)(6)(B) (and the temporary regulations issued under the predecessor to Sec. 168(h) in 1985 and amended in 1992) describing qualified allocations, so common partnership allocation provisions such as targeted allocations, preferred returns, fillup allocations, and tracking allocations may not be qualified allocations. Allocations made under Sec. 704(c) are not taken into account when determining whether the partnership has made qualified allocations. Allocations that are not governed by the substantialeconomiceffect rules (e.g., an allocation of basis of an oil and gas property, which generally is governed by Sec. 613A(c)(7)(D)) and allocations that cannot have substantial economic effect (e.g., nonrecourse deductions) also must comply with provisions governing those items.

These rules apply in the case of any passthrough entity and in the case of tiered partnerships and other entities under Sec. 168(h)(6)(E). As a result, if a taxexempt entity owns an interest in a lowertier partnership through one or more uppertier passthrough entities, its indirect ownership could result in the property being treated as taxexemptuse property — unless qualified allocations are made.

Sec. 168(h)(1)(D) provides that taxexemptuse property does not include any portion of the property that is predominantly used by a taxexempt entity (directly or through a partnership) in an unrelated trade or business subject to tax under Sec. 511 (i.e., UBTI). However, super taxexempt entities (e.g., state and local governments or state pension funds) do not have UBTI, and thus partnerships with these partners may need to classify the portion of partnership property deemed owned indirectly by super taxexempt investors as taxexemptuse property, absent a rule that the interest is excluded from the taxexemptuse property classification.

Consequences of investments in partnerships without qualified allocations

If a partnership with taxexempt partners does not make qualified allocations, the indirect taxexempt owner’s proportionate share in property will be treated as taxexemptuse property that is not eligible for the ITC. Additionally, that share of the otherwise eligible property must be depreciated using the ADS under Sec. 168(g)(1)(B) instead of the general depreciation system (GDS), denying accelerated recovery.

Generally, a taxexempt entity’s proportionate share of any property owned by a partnership is determined under Sec. 168(h)(6)(C)(i) on the basis of that entity’s share of partnership taxable income or gain (excluding gain allocated under Sec. 704(c)), whichever results in the largest proportionate share. If the entity’s share of partnership items of income or gain varies during the period that entity is a partner in the partnership, that share would be the highest share that entity may receive. For example, in a partnership flip structure, the sponsor typically has a 95% share of income after the end of the flip period, so a sponsor indirectly held by a taxexempt entity would be required to exclude 95% of the indirect taxexempt investor’s share from qualification for the ITC and accelerated depreciation.

If the property is held through a tiered partnership structure, then the share of partnership items of income or gain must be determined with respect to each tier to ultimately determine the extent to which the taxexempt entity’s investment in the toptier partnership results in a portion of the otherwise eligible property held by the lowesttier partnership being treated as taxexemptuse property, rendering that portion of the property ineligible for the ITC or accelerated depreciation. It should be noted that it is often difficult to determine the total interest held by taxexempt entities and super taxexempts in openendtype partnership investments and publicly traded partnerships.

Partnership allocations are critical

If taxexempt entities invest in energy projects through partnerships, careful consideration should be given to allocations under the respective partnership arrangements to avoid any detrimental impact on the eligibility of the energy property’s basis for ITC and accelerated depreciation. Proper qualified allocations of partnership items to the direct and indirect taxexempt partners could allow the partnership to continue to claim ITCs and accelerated depreciation. Given the limited guidance and the complexity of tieredownership structures, it can be challenging to determine whether specific allocations should be treated as qualified.


Editor

Christine M. Turgeon, CPA, is a partner with PwC US Tax LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Turgeon at christine.turgeon@pwc.com.

Contributors are members of or associated with PwC US Tax LLP.



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