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What Is Elective Pay (aka Direct Pay)? Here's How It Makes Clean Energy Tax Incentives More Accessible

Thanks to one key IRA provision, tax-exempt and governmental entities will for the first time be able to take advantage of credits for clean energy projects

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Wednesday, June 28, 2023

Editor's Note:

Passing the Inflation Reduction Act (IRA) ushered in the largest investments in climate and clean energy in our nation’s history. But our work isn’t done yet. Effective and equitable implementation will be key to ensuring we realize our climate goals, cut greenhouse gas pollution, advance environmental justice, and create good-paying jobs that propel the clean energy economy. In order to assist federal agencies, states, local communities, Tribal governments, businesses, and other partners take full advantage of this historic funding, Evergreen Action is writing a series of blogs breaking down several key programs in the IRA. This blog was written in collaboration with our partners at Center for Public Enterprise (CPE).

Everyone should be able to benefit from and support the transition to a clean energy future. The Inflation Reduction Act (IRA) is the largest down payment on addressing the climate crisis that this nation has ever seen—and the most powerful tools within the IRA are tax credits that incentivize the nation to build and use cleaner technologies to accelerate the path to a zero-emissions economy.

But historically, the problem with relying on tax credits to make big changes is that not everyone can access the credits because not everyone has tax liability. In other words, you can’t count a subsidy credit against your taxes if you don’t pay any taxes.

In fact, some of the most important players in the energy transition don’t have a tax liability, including local governments, nonprofits, state agencies, Tribes, rural co-ops, schools, and community-based organizations.

That’s where a key provision called elective pay (previously referred to as “direct pay”) comes in. It expands access to tax credits beyond private businesses, allowing tax-exempt entities to qualify for the full value of the tax credit and receive it as a direct payment from the government (rather than relying on tax equity markets to claim the entire credit like private businesses do). Expanding access to clean energy developments will accelerate the transition to zero-emissions energy and allow for more local initiatives to grow clean energy and allow more communities to benefit from this historic funding

Watch now: Evergreen Collaborative and Center for Public Enterprise hosted an expert panel for a public briefing, discussion, and Q&A on the elective pay features contained within the IRA.

Earlier in June 2023, the Department of Treasury (IRS) released proposed regulations that describe which tax-exempt entities qualify for the credits. This is great timing because public and nonprofit entities have opportunities to cut climate pollution and expand clean energy development all over the country, especially as key EPA and state rules roll out. Elective pay can help get communities across the country ready to accelerate the ramp-up of clean energy so that fossil fuel plants can be retired earlier.

The most important questions that the proposed rule addressed are who exactly is eligible for elective pay, how it would interact with other grant and loan opportunities, how elective pay works in the context of wage and procurement requirements, as well as how private businesses and investment institutions can interact with elective pay recipients.

Who exactly is eligible for elective pay?

The more entities that can access clean energy incentives via elective pay, the faster we can transition away from dirty fossil fuels to a zero-emissions grid. IRS knows this and created a broad definition of which tax-exempt entities qualify.

The proposed rulemaking covers all tax-exempt government entities including state, local, and Tribal that can now develop clean energy projects and receive the tax credits those projects qualify for. IRS also includes cities, counties, other local governments, and even water districts, school districts, and economic development agencies. This also includes governments of U.S. territories (for specific credits), the District of Columbia, and Alaska Native Corporations.

Importantly, some of the energy producers that currently rely heavily on dirty fuels like coal and gas are also eligible. This means rural electric co-ops and the Tennessee Valley Authority now have the opportunity to make great strides and promote clean energy technology. Some big energy consumers are also eligible, including public universities and hospitals.

Blog Post Image - Electric Buses — Elective pay gives states, cities, Tribes, and local governments more control over clean energy developments within their borders. Pictured: New York Gov. Hochul announcing a new fleet of zero-emission buses. (© *2022 MTA/Flickr CC BY 2.0)*

For tax-exempt organizations, eligibility includes 501(c) organizations that operate for religious, charitable, scientific, educational, literary, and other specified purposes. The rule also covers 501(d) organizations, which are religious entities with a common treasury.

The only thing that remains unclear from this rulemaking is whether federal agencies can receive elective pay, including federal power marketing administrations, which operate and sell power from federally owned dams in 34 states, accounting for over 40 percent of the nation's hydroelectricity. The same question of qualification remains for other important federal entities that build big projects across the nation like the Army Corps of Engineers and the Bureau of Reclamation. The goal of elective pay is to encourage as many tax-exempt entities as possible to support the clean energy transition. As major players in this process, federal entities should be able to access elective pay, and the guidance should be updated to clarify this issue.

How to maximize elective pay credits

There’s more good news: Tax-exempt entities can maximize elective pay credits by stacking them on top of other IRA grants and loans to optimize for the maximum reduction in climate pollution. IRS clarified that the use of other grants and loans would not impact the amount of credit eligible entities could receive via elective pay. With the elective pay tax credits, eligible entities will get back a baseline tax credit at 30 percent of the value of the project, and this important clarification from IRS confirms that grants or loans will not decrease that baseline credit amount. In fact, credits can be used to purchase, construct, reconstruct, erect, or otherwise support applicable properties. There are some caveats to this, including if the total of grants and loans exceeds the cost of the investment property, or in cases where the financing itself is tax-exempt, such as tax-exempt municipal finances. The use of tax-exempt financing sources may result in a reduction of the credit value.

Elective pay boosts American products and jobs

This IRS also clarified in this proposed rule that tax-exempt entities who wish to use elective pay must meet domestic content requirements to avoid a penalty on the credit amount. The purpose of the domestic content requirement is to encourage the use of American-sourced materials and industries to produce them.

Not only that, but IRS confirmed that meeting domestic content requirements will also qualify a project for the 10 percentage point bonus on the Investment Tax Credit (ITC). This is a win-win by providing materials and jobs sourced from the U.S., while also increasing the value of the credit. Now tax-exempt entities can qualify for a credit that is 40 percent of the project value rather than 30 percent.

Blog Post Image - Clean Energy Jobs — The domestic content requirement will help build a pipeline of clean energy jobs in America. Pictured: A technology company and nonprofit installing a solar array in Walden, Colorado. (© 2018 NREL/Flickr CC BY-NC-ND 2.0)

How partnerships work under elective pay

Another major question the rulemaking answered was whether entering into partnerships, joint ventures, or other common ownership arrangements would affect eligibility for elective pay. This was particularly concerning because state and local entities would likely need to partner with tax-liable entities to afford project planning, construction, or even operation. For the most part, IRS says that elective pay eligibility is for entities that directly own the applicable project, which means partnerships are ineligible for elective pay.

However, different ownership structures are eligible for elective pay in cases where there is joint production, use, or investment in the applicable property. Further engagement with IRS is needed to understand if this would allow public power organizations to create investment arrangements with other organizations and businesses needed to develop, construct, and operate projects.

Transferred credits or “chaining”

IRA’s proposed rule doesn’t allow for “chaining,” or the ability of eligible tax-exempt entities to transfer elective credits to other entities for them to claim. This means that green banks and similar investment institutions aren't able to buy up elective pay-eligible projects from tax-exempt or local government partners and then claim elective pay. IRS has the authority to make further exemptions to this rule—and it should do so—to promote more clean energy projects.

Elective pay is available now. Here’s how to apply.

Starting in 2023, entities that do not usually file tax returns will still have to file in order to make the “elective payment election.” State and local government entities in particular will have to:

1. Determine the credit(s) they want to use.

2. Select the tax year.

3. Complete a pre-registration process with IRS and secure a registration number for each applicable credit property. This pre-registration should be complete in time to file a return by the regular tax deadline.

4. File a Form 990-T Exempt Organization Business Income Tax Return (for governmental entities and Tribal governments) and note the property’s registration number on that form.

5. Disbursement will follow specific credit rules. For the ITC, this means a lump sum disbursement.

While these steps listed above are also applicable to tax-exempt organizations, different forms and/or more specific instructions may apply to different types of eligible entities.

For more specifics on each organization type, IRS published a series of factsheets instructing eligible entities on applying for the credits with applicable forms for state and local governments, territories, tax-exempt organizations, cooperatives, tribal governments, and Alaska Native Corporations.