On July 21, 2016, the IRS released temporary and proposed regulations that address income inclusion with respect to lessees of investment tax credit property when owners treat the lessees as having acquired the property for investment tax credit purposes. The rules apply when a partnership or an S corporation¹ leases property from the owner and the owner passes the credit through to the lessee. These regulations are particularly noteworthy with respect to historic rehabilitation tax credits.

Under current rules, if an owner makes an election to pass the credits through to the lessee, the lessee is entitled to the credits. However, instead of reducing the basis of the property, which would be the case if the owner retained the investment credits, the lessee is required to ratably include over the life of the investment credit property an amount equal to, or one-half of, the credits as gross income.² There was, however, uncertainty surrounding the income inclusion that the regulations clarify in two notable ways. 

First, the regulations clarify that the investment credits and related limitations should be determined at the partner level rather than at the partnership level. This conclusion has the following consequences:

• Each partner that is the “ultimate credit claimant” must include in gross income their pro rata portion of the historic rehabilitation credit (or 50% of the energy tax credit) claimed.³

•  Since the income is not earned by the partnership and allocated to the partners, the partners are not entitled to increase their outside basis in their partnership interests under § 705(a) as a result of the purported allocation of § 50(d) income. Similarly, the partners are not entitled to increase their capital accounts per § 704(b). 

Many partnerships previously took the position that the § 50(d) income inclusion was a partnership item and entitled the partners to increase their bases in their partnership interest and to increase their capital accounts by the amount of the § 50(d) income allocated to each partner. The IRS notes that such basis increases are inconsistent with Congressional intent and thwart the purpose of the § 50(d) income inclusion requirements. 

Second, the regulations provide that a tax credit claimant may elect to accelerate the § 50(d) income inclusion when a lease termination occurs outside the tax credit recapture period.⁴ The regulations provide that a lease termination is deemed to have occurred in the taxable year in which the ultimate credit claimant terminates its direct or indirect interest in the lessee of investment credit property. Accordingly, the ultimate credit claimant may make an irrevocable election to include in gross income any of the remaining income required to be taken into account under § 50(d) when the ultimate credit claimant terminates its direct or indirect interest in the lessee. 

The temporary and proposed regulations were released and became effective on July 22, 2016, upon publication in the Federal Register, and will apply to property placed in service on or after September 19, 2016. Taxpayers are permitted to submit written comments on the temporary regulations by October 20, 2016.

_{1. The temporary and proposed regulations apply rules to S corporations and their shareholders similar to those discussed herein for partnerships and their partners. The following is written with a focus on partnerships considering the prevalence of partnership structures in this arena.} 

_{2. For example, with respect to historic rehabilitation tax credits, the income inclusion is 100% of the amount of the credits. With respect to the renewable energy tax credits, the income inclusion is 50% of the amount of the credits.} 

_{3. The “ultimate credit claimant” is any partner or S corporation shareholder who ultimately claims the credits (i.e., the taxpayer that files Form 3468 – Investment Credit).}   

_{4. The election to accelerate the § 50(d) income inclusion is not available when § 1.50-1T(b)(2) requires the “ultimate credit claimant” to include ratably in gross income with respect to property that is subject to § 168 depreciation rules (the modified accelerate cost recovery system, also known as MACRS). In such cases, the “ultimate credit claimant” must include in gross income the amount equal to the credit determined under § 46 over the shortest applicable recovery period pursuant to § 168.}