What You Should Know About Credits & Tax Shelters
Although I am not located in a state that has an individual income tax, I know it is standard practice in certain ones to eliminate an individual’s state tax liability if they purchase state tax credits. For example, say you have a client in California, and they owe $5,000 in state income tax. They can buy certain credits for pennies on the dollar to mitigate their state tax obligations. However, these credits do not transfer to the client’s federal ones.
Recently, I had a phone call with someone promoting something that at first sounded alluring, but it turned out to be anything but.
First, let’s go into some helpful background information. The federal solar tax credit, also known as the investment tax credit (ITC), allows you to take a 30 percent credit of the cost of installing a solar energy system from your federal taxes. The ITC applies to both residential and commercial systems, and there is no cap on its value. It’s meant as an incentive for home and business owners to go green and is also for solar water heaters, small-wind energy properties, geothermal heat pumps and fuel cells.
In the event a taxpayer does not have the income necessary to redeem the full amount in a single calendar year, the IRS, as of 2014, allows a carryover to help taxpayers monetize as much of the solar tax credit as possible. This regulation was passed as part of the 2009 American Recovery and Reinvestment Act.
Recently, Congress agreed to extend the solar ITC at the current 30 percent rate through 2019, after which it will fall to 26 percent in 2020, 22 percent in 2021 and, finally, 10 percent in 2022.
Now, to the phone call: I spoke with a gentleman who was involved with a company that had amassed a sizable solar tax credit. The business was continuing to construct green buildings and was looking to sell its federal tax credit to investors for $0.90 on the dollar.
As I said earlier, there is no way to sell a federal tax credit, but that didn’t stop this company from its pursuits. They tried to get around it by offering limited membership units in their limited liability company (LLC). For example, for an investment of $90,000, you would get a special allocation of $100,000 of the tax credit. If you wanted the credit in the next year, you would have to pay additional monies.
Immediately, this sounded like it was too good to be true. I needed more details, so I asked for the LLC’s Operating Agreement (OA), which is used to spell out special allocations, different levels of membership and other relevant information. The gentleman I talked to referred to the investment as “Class B shares” in the LLC.
If you have a limited interest in a company, be it through a membership in an LLC or a Limited Partnership, the income or loss received from operations is passive. Additionally, any credits that pass through to the limited partner can only be used to offset passive income. Forget for a second that the only reason someone would invest in this LLC would be to offset income with the solar credit.
Upon examining the OA, I found there was nothing about Class A or B membership. Further, it didn’t discuss any special allocations given to any members. This was a huge red flag and an indication the offer might really be about an unlawful tax shelter.
A tax shelter is a financial arrangement made to avoid or minimize taxes, and there are a number of legitimate ways to go about doing it. The simplest example is participation in a 401k plan, in which the individual contributes to a 403b plan, IRA, Roth IRA, etc. Claiming deductions for retirement savings (less a Roth IRA) is a perfectly legal tax shelter. Others could be mortgage interest, property taxes, contributions to a health savings account (HSA) and the like.
To help taxpayers recognize potential schemes, or illegal tax shelters, the IRS has compiled a list of transactions that qualify as “abusive.” If a tax shelter even resembles a listed transaction, it is considered unlawful, and the users may face penalties.
For example, one of the more common schemes in recent years has been a micro-captive insurance tax shelter where an entity forms its own insurance company to protect against certain risks. This structure allows the entity to claim a deduction for premiums paid, and, in turn, allows the captive insurance company to exclude portions of premiums from its declared income.
It is one thing to invest in a company with the goal of making money. However, it is a whole other animal to invest with the objective of achieving a tax credit. In this situation, it would be passive in nature anyway, unless the investor was given a managing interest in the LLC. Furthermore, the promoter of this LLC would have to register with the IRS as a tax shelter, and the investors would be scrutinized by the Service.
My response to the caller? Thanks, but no thanks.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...