Claims for investment tax credits under the Inflation Reduction Act (IRA) will require a level of documentation beyond the mere collection of receipts. An investment tax credit study can provide a greater level of confidence in the calculated benefit.
The clean energy tax incentives included in the Inflation Reduction Act (IRA) offer significant tax benefits (and in some cases, even direct monetary benefits) to taxpayers that meet certain criteria. However, many of the tax credits created or enhanced under the new rules, including the Investment Tax Credit (ITC) under IRC Section 48, require careful analysis of amounts spent on potentially qualifying projects for several key reasons, including:
Not every dollar spent on a project that includes energy property will qualify for the credit as some ancillary or soft costs aren’t deemed eligible.
The timing of when construction begins — as well as the date the project is placed in service — can impact credit eligibility details.
Some of the incentives have multipliers if the taxpayer can show that certain requirements have been met, like percentage of components manufactured in the United States and prevailing wages paid to employees and contractors as well as use of qualified apprentices.
Many taxpayers that claim ITCs must rely on records provided to them by contractors that contributed to the qualifying projects. Taxpayers should carefully consider what information is available from contractors and how it will be collected, as it will be exponentially more difficult to generate that documentation after the fact if the parties don’t agree to share it upfront.
There is considerable complexity and variety of moving parts in play when computing tax credits under the IRA, especially the ITC. Accordingly, taxpayers that are looking to file a return claiming these benefits or who may be considering monetizing the benefit by selling their credits to another taxpayer should consider an ITC study to thoroughly document and support the calculation.
An ITC study provides a taxpayer claiming an ITC with a higher level of confidence in the initial amount claimed on the return, but it also serves two additional purposes:
An ITC study thoroughly documents the calculation of the credit using the most recent guidance from the IRS, giving a taxpayer comprehensive support in the event the tax credit is questioned on exam.
The ITC study serves as a detailed record for any due diligence efforts in the event that the taxpayer seeks to monetize the credits via a credit transfer.
An ITC study provides a taxpayer claiming an ITC with a higher level of confidence in the initial amount claimed on the return.
What investments may qualify for an Inflation Reduction Act ITC?
The law allows an ITC for several types of energy property investments, including:
Solar energy used to generate electricity or to heat or cool a structure.
Geothermal energy to make electrical transmissions.
Qualified fuel cell property or qualified microturbine property.
Combined heat and power system properties.
Wind energy property.
Geothermal heating and cooling systems.
Waste energy recovery.
Energy storage technology.
Qualified biogas property.
Microgrid controllers.
One area of complication that typically arises in ITC projects is the fact that each type of energy property has specific requirements to be considered eligible for an ITC. On top of that, each type of property has a different set of related expenses that may be included in the eligible basis calculation for the credit. The determination of the tax basis for an eligible project might not always follow cost classifications that seem most logical to those not familiar with relevant tax authority and guidance. Consequently, one of the key features of an investment tax credit study is an ITC-focused cost segregation study that provides a more accurate breakdown of the costs in each project that are eligible for the credit.
How an ITC study identifies costs that qualify for the Inflation Reduction Act tax credit
In general, a targeted cost segregation study closely examines the overall costs of a project that has credit eligible energy property to ensure that a taxpayer accurately claims only those costs eligible for the credit. For example, consider a university that builds a new gymnasium that includes a geothermal heating system. The entire cost of the gym wouldn’t qualify for the ITC just because it has geothermal heating; rather, only those components that are integral to the geothermal heating system would qualify. An ITC-focused cost segregation study identifies those components that qualify for credit treatment. Unlike the traditional cost segregation studies many taxpayers are accustomed to, this study not only focuses on accelerating depreciation in certain classes of assets with shorter useful lives but also on determining the basis of credit eligible property. Due to the complexity, a construction professional with expertise in both clean energy technology and the IRS fixed asset rules should perform this kind of analysis. Ultimately, an ITC-targeted study is focused on accurately identifying all costs that qualify for an immediate credit against the taxpayer’s current year liability, potentially resulting in a much more significant tax impact in the year it is performed.
In general, a targeted cost segregation study closely examines the overall costs.
Documenting qualifications for minimum thresholds as well as higher tax credit rates
Several provisions in the IRA set minimum standards that a taxpayer must meet to qualify for the credit, as well as additional criteria that, if met, entitle qualifying projects to significantly increased credit benefits. At a baseline level, a taxpayer that places in service qualifying energy property is eligible for a credit equal to 6% of the cost basis in such property. The taxpayer then may be eligible for a 5-times multiplier on the credit if the taxpayer can show that the nameplate capacity of their energy property is less than 1 megawatt of alternating current or equivalent thermal energy or, if more than 1 megawatt, that the wages paid to workers on the project met a “prevailing wage” standard and apprenticeship requirements (PWA).
Prevailing wage and apprenticeship
Meeting the PWA requirements relies on a comparison of project worker information to Department of Labor (DOL) information on prevailing wages for laborers in those job classifications in the area; and requirements that the taxpayer must use registered apprentices for a certain percentage of all labor hours. To meet the PWA requirements, taxpayers claiming the credit must document:
Payment of wages at rates not less than those determined by the DOL under the Davis-Bacon Act (DBA) to laborers and mechanics employed by the taxpayer, contractor, or subcontractor. This standard applies to wages paid with respect to the construction, alteration, or repair of a facility.
The different types of workers under DOL classifications, in order to verify compliance with the prevailing wage rate for each class of worker.
Participation of qualified apprentices under rules established by the DOL or a recognized state apprenticeship agency.
Note, failure to use qualified apprentices may potentially be mitigated with proper documentation of a good-faith effort to employ qualified apprentices.
Furthermore, the Treasury Department and the IRS expect that taxpayers will report at the time of filing a return the following information:
The location and type of qualified facility.
The applicable wage determinations for the type and location of the facility.
The wages paid (including any correction payments) and hours worked for each of the laborer or mechanic classifications engaged in the construction, alteration, or repair of the facility.
The number of workers who received correction payments.
The wages paid and hours worked by qualified apprentices for each of the laborer or mechanic classifications engaged in the construction, alteration, or repair of the facility.
The total labor hours for the construction, alteration, or repair of the facility by any laborer or mechanic employed by the taxpayer or any contractor or subcontractor.
The total credit claimed.
If these requirements weren’t challenging enough, many taxpayers who qualify for the credit rely on contractors to perform the construction and installation of the qualifying energy properties.
Unfortunately, a simple representation of compliance with these rules from the contractor won’t be enough to prove actual compliance in the event of an exam. Therefore, the taxpayer claiming the credit bears the responsibility for maintaining records that demonstrate these requirements have been met throughout the project. In some cases, this may also require some difficult discussions, as many contractors aren’t accustomed to sharing this level of detail on a project. There are also some areas where the PWA requirements vary from DBA classifications, so taxpayers may need to consult with their contractors to make sure that all the classifications, prevailing wage calculations, and apprenticeship hours meet the IRS standards where those differ from the DBA rules.
Taxpayers should anticipate IRS examination of ITC claims either before refunds are issued or anytime within the statute of limitations. In the event of an IRS challenge, it’ll be up to the taxpayer claiming the credit to produce documentation that the workers were paid at a qualifying level. To the extent possible, taxpayers who engage contractors should attempt to write into the respective contracts and agreements with contractors that such documentation will be made available to the taxpayer during the project rather than simply relying on a good-faith representation. Processes for how this information will be shared and how frequently it will be shared should also be established upfront. The IRS rules allow for some opportunities to cure errors in this area, but there is a strict timeline as well as an interest component. As such, taxpayers looking to claim the significant additional benefits that accrue to those who meet the PWA requirements should set up systems at the outset that monitor and track compliance with these requirements closely throughout the duration of the project.
Taxpayers should anticipate IRS examination of ITC claims either before refunds are issued or anytime within the statute of limitations.
Domestic content
Several provisions in the IRA entitle taxpayers to additional bonus credits if they meet particular standards. Under the domestic content bonus, a taxpayer’s applicable credit amount may be increased by up to 10% (or 2% if the project capacity is over 1 megawatt and the PWA requirements aren’t met.) Under those rules, the 10% bonus will apply if a taxpayer can demonstrate that 100% of iron and steel as well as a certain percentage of the manufactured components used to construct the energy-efficient property are domestically produced.
Generally, taxpayers must show that the cost of U.S. components as a percentage of the total cost of all components meets the applicable threshold. Therefore, it can be a challenge to document the domestic content of a project when various materials and components are being purchased or fabricated and installed by contractors and other vendors. Contractors will be reluctant to provide this information as it could disclose the producer’s cost and margins as well as revealing potentially proprietary information about the components themselves. Taxpayers undertaking these projects may therefore want to include provisions in construction agreements requiring the contractor to document origin and cost of the materials in order to support the increased credit claims.
Additionally, some taxpayers have made arrangements with third-party services providers, such as their legal advisors or CPAs, to collect information from contractors related to domestic content percentages and provide representations that ITC domestic content requirements are met without sharing the details behind the component costs with the taxpayer. While final regulations related to the domestic content requirement are still pending, this practice may or may not be accepted under final guidance. In the meantime, however, this may be a useful approach to the domestic content documentation concerns.
Additionally, recently issued guidance would provide some flexibility for proving domestic content of a project through a safe harbor rule. On May 16, Treasury published Notice 2024-41, which includes a new elective safe harbor that helps taxpayers determine cost percentages for the domestic content-adjusted percentage rule. Under that notice, taxpayers must determine if specific components are domestically produced or manufactured by applying fixed percentages provided for by tables within the Treasury notice. If a project meets such a standard, no further information is required from contractors or vendors. Ultimately, final rules have yet to be published, so taxpayers should proceed with caution and document all information meticulously.
Finally, the documentation of domestic content takes on additional significance for those taxpayers recognizing a credit through the direct pay election, as they could be subject to a 10% reduction in their credit if the applicable energy property’s capacity is greater than 1 megawatt and they fail to meet certain criteria.
Energy and low-income community
Location of the qualifying property can also increase the amount of the available credit. If a project is undertaken in certain “energy community bonus credit” areas described by the Department of Energy, as well as a solar or wind project in certain low-income communities, Native American lands, and other listed communities, the value of the credit can increase by 10–20%.
Inflation Reduction Act due diligence and monetization options
As noted above, much of the work associated with creating the properties that will qualify for the IRA’s energy investment tax credits will be performed by contractors that are hired by taxpayers who will claim appliable credits. The fact that the taxpayer bears the risk of any tax adjustment by the IRS puts a premium on upfront efforts to document compliance with all of the credit’s requirements. Taxpayers simply can’t rely on verbal assurances and handshake deals in this area — they must get documentation and keep it in their files. Given the significance of these credits to some taxpayers, those who expect to claim these benefits often might want to assemble a specialized team of legal and accounting professionals focused on negotiating contracts with suppliers that require them to provide the required information about compliance with PWA and U.S.-based materials requirements and other critical criteria.
Taxpayers simply can’t rely on verbal assurances and handshake deals in this area — they must get documentation and keep it in their files.
Another component that puts additional pressure on the documentation requirements is the ability for taxpayers to sell these credits. In a secondary market, it’s reasonable to expect that buyers will come to demand the same kind of due diligence documentation typical in the mergers and acquisitions deal space. A taxpayer looking to sell credits in order to accelerate the financial benefit could find that poor documentation could significantly lower the value of the transaction or even cause it to fall through altogether. The buyer of the credits would be well advised to require an ITC study as a regular part of due diligence procedures. Those involved in the secondary market for these credits also have an option to purchase insurance for them, but the underwriters who provide that insurance are likely to require an ITC study or similar documentation before signing off on any policy.
An investment tax credit study can resolve a lot of issues upfront
Generally speaking, to qualify for these specialized ITC benefits, projects must be placed in service on or after Jan. 1, 2023, and begin construction on or before Dec. 31, 2024. For those projects beginning construction on or after Jan. 1, 2025, generally new rules under IRC Section 48E will apply. If your organization is considering a project that may qualify for the energy ITC provisions in the IRA, the best time to reach out to a tax credit professional for support is during the project planning, but wherever you may be in the process, be sure to consider how an investment tax credit study could provide a clearer picture of the potential benefits available.
