Year-End Planning for the Solar Energy Investment Tax Credit
Solar energy is a popular choice for businesses looking to reduce their carbon footprint through alternative energy sources. In addition to supporting a company’s environmental, social and governance (ESG) strategy, converting to solar energy can potentially lock-in lower energy rates. Further, Section 48 of the Internal Revenue Code provides businesses that invest in solar energy a 26% Investment Tax Credit (ITC) on qualifying solar property placed in service before January 1, 2026 — but only if construction begins on the property before January 1, 2023. Otherwise, the credit is phased down to as low as 10%.
The IRS has provided special rules to determine when construction begins on solar energy property for ITC purposes. Businesses seeking to maximize the available tax credits should consider beginning solar projects before the end of 2022 to be able to take advantage of the 26% ITC rate.
Phasedown of ITC for Solar Energy Property
Under current rules, the ITC percentage for qualifying solar energy property is determined based on when construction begins, and the credit is taken in the year the qualifying property is placed in service.
For property placed in service prior to January 1, 2026, the credit is as follows:
26%, if construction begins after December 31, 2019, and prior to January 1, 2023;
22%, if construction begins after December 31, 2022, and prior to January 1, 2024; or
10%, if construction begins after December 31, 2023.
For property placed in service after December 31, 2025, the credit is 10% regardless of when construction begins. Unused credits may be carried back one year and carried forward 20 years.
The Biden Administration has indicated its support of clean energy incentives. While the Build Back Better proposals approved by the U.S. House of Representatives in 2021 would have modified the ITC and extended the credit to qualifying solar projects for which construction begins before 2027, the legislation was not passed by the Senate. Therefore, the above phasedown of the credit remains in force. Solar energy developers and businesses planning to invest in solar energy projects should continue to monitor potential legislative developments in this area.
Determining When Construction Begins
The IRS issued Notice 2018-59 to provide specific guidance on when construction begins for purposes of determining the solar ITC percentage. The notice provides two methods a taxpayer can use to establish when construction begins: (i) the physical work test, or (ii) the 5% safe harbor. Both methods include a continuity requirement.
Physical Work Test
Construction begins under the physical work test when the taxpayer begins physical work of a significant nature on the project. The analysis is based on the nature of the work performed — not the amount or cost of the work — with no minimum requirements. Physical work can occur on-site or off-site and includes, for example, manufacturing components, inverters, transformers or other power conditioning equipment. The notice clarifies that physical work does not include preliminary activities (as defined) or work to produce components of energy property that are included in existing inventory or that are typically held in inventory by a vendor.
Five Percent Safe Harbor
Under the 5% safe harbor, construction begins when the taxpayer pays or incurs 5% or more of the total cost of the solar energy property. Whether a cost has been incurred for this purpose is based on the taxpayer’s method of accounting. The notice provides special rules for solar energy projects consisting of multiple qualifying properties.
Both the physical work test and the 5% safe harbor include a continuity requirement, under which the taxpayer must show continuous progress toward completing the project. This means maintaining a continuous program of construction under the physical work test and satisfying a continuous efforts test under the 5% safe harbor. Whether the continuity requirement is satisfied under either method is determined based on the relevant facts and circumstances.
Notice 2018-59 also provides a continuity safe harbor, which allows solar projects to satisfy the continuity requirement if the project is placed in service by the end of the calendar year that is no more than four calendar years after the year construction began. In response to the pandemic and associated supply chain issues, the IRS issued Notice 2021-14 to extend the continuity safe harbor to six years for projects for which construction began during calendar year 2016, 2017, 2018 or 2019 and to five years for projects where construction began in 2020.
Solar energy developers and businesses investing in solar energy projects are on a tight timeline to determine whether they want to begin construction on projects in their pipeline before the end of 2022 to be able to take advantage of the 26% ITC rate. Given the persistence of supply chain and workforce issues and the potential rush to begin construction prior to the end of the year, taxpayers should keep in mind that contractors and equipment may not be available or could be difficult to secure in time to meet the year-end beginning of construction deadline. In addition, supply chain and inventory issues may drive cost increases and thus cost overruns that must be considered when analyzing when construction begins using the 5% safe harbor.
If you have questions, contact HFM today. Our professionals are well versed on the latest issues to provide our clients with professional, personalized services.