Historically, neither tax-exempt organizations nor state and local governments were eligible to directly receive any significant benefit from clean energy tax credits. The Inflation Reduction Act of 2022, however, rewrote the eligibility rules for many federal clean energy tax credits. Now, tax-exempt organizations and governmental entities who invest in qualifying clean energy projects and properties may receive direct federal payments for many federal clean energy tax credits — incentivizing investment and making eligible projects more affordable. In many cases, direct pay, also called elective pay, offers significant financial incentives for tax-exempt and governmental organizations. Direct pay allows eligible organizations to receive payment of the energy tax credits even if an eligible organization does not have any corresponding tax liability nor is required to file a Form 990. However, to take advantage of the benefits afforded by clean energy tax credits, these newly eligible entities must understand the direct pay rules and pre-filing registration requirements, in addition to the rules underlying clean energy tax credits more generally.

The Inflation Reduction Act of 2022 created Section 6417 of the Internal Revenue Code¹ to allow tax-exempt organizations, state and local governments, and other specified organizations – such as tribal governments and rural electric cooperatives – called applicable entities under Section 6417, to benefit from clean energy tax credits. Under Section 6417, eligible organizations can receive direct payments for certain clean energy tax credits available under Sections 30, 45, and 48 of the Internal Revenue Code, including:

• Alternative Fuel/Electric Vehicle Charger Credit (Section 30C).
• Production Tax Credit (Sections 45/45Y).
• Tax Credit for Carbon Sequestration (Section 45Q).
• Nuclear Power Production Credit (Section 45U).
• Clean Hydrogen Production Credit (Section 45V).
• Advance Manufacturing Production Credit (Section 45X).
• Clean Fuel Production Credit (Section 45Z).
• Energy Credit (Section 48).
• Advanced Manufacturing Tax Credit (Section 48C).
• Clean Electricity Investment Credit (Section 48E).

This alert does not address the availability of direct pay for applicable entities in connection with advanced manufacturing investment tax credits available under Section 48D for the manufacture of semiconductors and semiconductor manufacturing equipment, which was added pursuant to the CHIPS and Science Act of 2022 (CHIPS Act).

After the creation of Section 6417, there was some question about whether applicable entities could benefit from direct pay. The Department of Treasury (Treasury) and Internal Revenue Service (IRS) released proposed regulations on June 14, 2023, guiding various aspects of the direct pay election. On March 11, 2024, the IRS and the Treasury published final rules clarifying what kinds of applicable entities are eligible for direct pay and providing more details on the process for claiming direct pay for clean energy tax credits. These final rules are available here and will be codified in Treas. Reg. Sections 1.6417-0 through 1.6417-6.

Under the final rules, qualifying tax-exempt organizations include federally recognized tax-exempt organizations. Nonprofit entities that have not obtained tax-exempt status are not eligible for the direct pay program. State and local governments, and their subdivisions, agencies, and instrumentalities are also eligible for direct pay under Section 6417. Additionally, these eligible organizations can claim direct pay on behalf of their disregarded entities. Entities that file under partnership or S corporation taxation rules are not eligible for direct pay under Section 6417, even if all of the partners or shareholders are entities that are individually eligible. Certain unincorporated organizations may be eligible for direct pay for certain tax credits.

The final rules also make clear that certain tax credit rules applicable to most taxpayers – such as taxable entities – are different than those for applicable entities under Section 6417. For example, applicable entities under Section 6417 do not have to reduce the tax basis of the property for which certain investment credits are claimed, unlike most other taxpayers, and under Section 6417(d)(2), credits claimed by applicable entities are not subject to the recapture rules under Section 50. Even so, the final rules include a provision intended to ensure that applicable entities do not receive an excess benefit from investment credits claimed. Under this provision, if an applicable entity receives a grant, forgivable loan, or other exempt income to purchase, construct, or otherwise acquire an investment-related credit property, the organization could not claim an applicable investment credit in excess of the organization’s cost of the investment property credit. Any claimed credit must also be used to offset any tax liability owed by the applicable entity before any refund under direct pay may be made.

Organizations considering a direct pay election for clean energy credits should review and understand Section 6417 and the rules for the applicable credit, and obtain the advice and assistance of legal counsel and tax advisors, as early as possible in the clean energy project planning. Organizations eligible for direct pay under Section 6417 must not only satisfy eligibility requirements under Section 6417 but also must satisfy the substantive requirements for each credit claimed. In many cases, an organization’s claim for one type of clean energy tax credit may preclude other credit options. However, organizations may be able to structure their clean energy projects in ways that allow them to claim multiple credits or different credits for different portions of their projects, producing a more advantageous result. Thus, organizations must carefully review potential projects and activities, as well as consider which clean energy tax credits may be most advantageous in their circumstances.

Additionally, prior to making an election for direct pay, applicable entities must complete a pre-filing registration process and receive a registration number from the IRS. Pre-filing registration requirements generally include providing the IRS with general organizational information, identifying the tax credits to be claimed, and providing details and documentation about the property or project for which tax credits are being claimed. More information on the IRS’s pre-filing registration tool can be found in IRS Publication 5884, available here.

The final rules also clarify that the election for direct pay of the applicable credits must be made on an organization’s annual – or original – tax return. Applicable entities will make this election using a Form 990-T, even if the entity would not otherwise need to file a return. Under the final rules for Section 6417, organizations cannot retroactively make a direct pay election on an amended return. Certain corrections may be made to a previously filed election and previously filed returns may be made revised before that return’s applicable due date. Thus, organizations seeking to harness the direct pay opportunity will be generally best served by involving their tax and legal teams as early as possible in any planned project to decrease the risks of missing out on a potential direct pay election.

While the publication of final rules related to Section 6417 is an exciting development for applicable entities interested in clean energy projects and properties, other clean energy tax credit-related issues are still developing. For example, rules pertaining to clean energy credits purchased in transfers – sometimes called “chaining” – are still being reviewed and finalized. Likewise, the IRS is considering rules that would exclude certain unincorporated governmental energy producers from partnership taxation rules, allowing them to make direct pay elections under Section 6417. Moreover, Section 6417 may not be the only way for an applicable entity to avail itself of clean energy tax credits. Depending on the organization’s structure and monetization needs, an organization may be better off engaging in the tax credit generating activities via a for-profit subsidiary or engaging in a “tax equity investment” transaction. Depending on the particular facts and circumstances, these transactions may allow the organization to monetize not only the federal tax credits but also avail itself of – or otherwise monetize – state tax credits that do not have a direct pay mechanism, tax losses arising from depreciation and other state and local renewable energy incentives that remain unavailable to tax-exempt or governmental entities.

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¹All future references to a “Section” refer to Sections of the Internal Revenue Code of 1986, as amended.