Final Regulations on Taxpayers Eligible for Direct Pay Electing Out of Subchapter K
On November 20, 2024, the US Department of the Treasury and the Internal Revenue Service (“IRS”) issued final regulations (the “Final Regulations”) to allow certain unincorporated organizations owned by specified “applicable entities” to elect out of the partnership tax rules under Subchapter K of the Internal Revenue Code (the “Code”).1 The Final Regulations (effective January 19, 2025) and adopt—with modifications—the proposed regulations issued March 11, 2024 to carry out the purposes of Section 64172 (the “Prior Proposed Regulations”).3 In addition to releasing the Final Regulations, the Treasury Department and the IRS also released proposed regulations (the “Proposed Regulations”) that outline administrative requirements that work in tandem with the Final Regulations.
Section 6417, enacted in 2022 as part of the Inflation Reduction Act, allows certain applicable entities to elect for certain tax credits to be treated as making a payment against income tax equal to the amount of the credit (an “Elective Payment Election”). An applicable entity can thereafter claim a tax refund for the amount deemed to be paid. Applicable entities include: tax-exempt organizations; the District of Columbia; state and local governments; Native American tribal governments; Alaska Native corporations; the Tennessee Valley Authority; rural electric cooperatives; and certain agencies and instrumentalities of the foregoing.
Final regulations issued with the Prior Proposed Regulations4 provide that partnerships are not “applicable entities.” As a result, partnerships generally cannot make an Elective Payment Election except with respect to credits under Sections 45Q, 45V, and 45X. However, these regulations provide a rule for co-owners of an applicable credit property through an organization that has made a valid election under Section 761 to be excluded from the application of the partnership tax rules of Subchapter K. Under this rule, such applicable entity's undivided ownership share of the underlying property will be treated as a separate applicable credit property owned by such applicable entity, with respect to which an Elective Payment Election can be made.
Section 761(a) authorizes the Treasury Secretary to issue regulations permitting an unincorporated organization to exclude itself from application of Subchapter K if all the organization’s members so elect. To qualify for this election, the organization must also be “availed of” the following purposes: (1) for investment purposes, rather than for the active conduct of a business; (2) for the joint production, extraction, or use of property, but not for the sale of services or property; or (3) by dealers in securities, for a short period, to underwrite, sell, or distribute a particular issue of securities. Additionally, the owners’ income must be adequately determinable without computation of partnership taxable income.
Treasury Regulations Section 1.761-2(a)(3) required that participants in the joint production, extraction, or use of property (i) own that property as co-owners in a form granting exclusive ownership rights; (ii) reserve the right separately to take in kind or dispose of their shares of any such property; and (iii) not jointly sell services or the property (subject to exceptions). The Prior Proposed Regulations would have modified certain aspects of these requirements to address ways that these requirements might not have been compatible with applicable entities owning property jointly with third parties.
The Final Regulations retain most of what was included in the Prior Proposed Regulations, and provide guidance on the definition of applicable entity, eligibility and procedures for making the election under Section 761, and the reporting and withholding requirements for the electing entity and its owners.
Final Regulations
The Final Regulations adopt the proposed definition of “applicable unincorporated organizations” contained in the Prior Proposed Regulations without changes. These are unincorporated organizations owned, in whole or in part, by one or more applicable entities as defined in Sections 6417(d)(1)(A) and Treasury Regulations Section 1.6417-1(c) (i.e., partnerships that produce, extract, or use certain fuels or energy property that qualify for tax credits).
The Final Regulations clarify that a valid Section 761(a) election removes an organization from being classified as a partnership for purposes of Subchapter K. As a result, the unincorporated organization ceases to be a partnership, and each member of the unincorporated organization is generally treated as a co-owner directly owning its proportionate share of the organization’s assets.
The Final Regulations significantly broaden the scope of organizations eligible to elect out of partnership rules. Under the Prior Proposed Regulations, only unincorporated organizations created exclusively to jointly produce electricity from its applicable credit property were eligible to make the election under Section 761(a).
The Final Regulations modify the co-ownership requirement so that the participants in the applicable unincorporated organization are permitted to own applicable credit property through an unincorporated organization that is a legal entity, as long as that organization is not treated as a corporation under any provision of the Code. To qualify, an unincorporated organization must satisfy the following conditions:
- The organization is wholly or partially owned by one or more applicable entities.
- The members of the organization have entered into a joint operating agreement concerning the applicable credit property. Under this agreement, members retain the right to take in kind or dispose of their pro rata shares of any property produced, extracted, or used, as well as any associated renewable energy credits or similar credits.
- The organization is established exclusively to own and operate applicable credit property under the terms of the joint operating agreement.
- One or more applicable entities will make an elective payment election under Section 6417(a) for the applicable credits associated with their share of the credit property.
- Members are able to compute their income without needing to calculate partnership taxable income.
- The organization is not a syndicate, group, pool, or joint venture classified as an association, nor does it operate under an agreement that would result in classification as an association.
The Final Regulations also finalize the agent-delegation rule in the Prior Proposed Regulations with respect to the joint-marketing requirement allowing a participant’s delegee to enter into contracts—of longer than a year in duration—that bind a participant to sell its share of the property produced from the applicable credit property, as long as the participant is not bound to the agency relationship with the delegee for longer than one year.
The Final Regulations also add new examples to illustrate (1) a rule that the determination of the members’ shares of property produced, extracted, or used be based on their ownership interests as if they co-owned the underlying properties; and (2) details of the agent delegation rule described above.
The Treasury and IRS also clarify in the Final Regulations that “partnership flip structures,” in which allocations of income, gains, losses, deductions, or credits change at some point after the partnership is formed, violate existing statutory requirements for opting out of Subchapter K, and thus are, by existing definition, not eligible to make a Section 761(a) election. This should not be surprising in light of the requirements of Section 761.
While the Final Regulations clarify several aspects of the elective payment process and Section 761(a) elections, they do not provide information about audit procedures or any additional guidance. However, the Treasury Department and the IRS indicated that they will continue to monitor the elective payment process to determine whether there are areas that could be further streamlined.
Direct Pay Administrative Requirements: Proposed Regulations
The Proposed Regulations clarify that a Section 761(a) election must be made by including a statement with a properly executed partnership return, Form 1065, US Return of Partnership Income. This statement must provide:
- the name or other identification of the organization and its address, along with information either on the return or in the attached statement identifying the names, addresses, and identification numbers of all the organization’s members;
- a declaration that the organization qualifies under Treasury Regulations Section 1.761–2(a)(1) and either Treasury Regulations Section 1.761–2(a)(2) or a statement confirming that all members of the organization elect to be excluded from the provisions of Subchapter K; and
- an indication of where a copy of the agreement governing the organization can be accessed, or—if the agreement is oral—from whom the details of the agreement can be obtained.
The Proposed Regulations also provide that a specified applicable unincorporated organization’s Section 761(a) election terminates as a result of a “terminating transaction.” A terminating transaction is the acquisition of, or disposition of an interest in, a specified applicable unincorporated organization, other than as the result of a transfer between a disregarded entity and its owner, since such transfer does not change the identity of the applicable entity for purposes of Section 6417.
The Proposed Regulations also clarify that a request to revoke a Section 761(a) election must be made by submitting a private letter ruling request.
Conclusion
While largely following the Prior Proposed Regulations, the Final Regulations provide additional certainty and flexibility for tax-exempt entities seeking to enter into arrangements with taxable entities and make an Elective Payment Election, in order to monetize tax credits arising from their proportionate share of tax-credit generating property.
2 References to “Section” refer to the Code unless otherwise specified.
3 References to “Section” refer to the Code unless otherwise specified. REG-101552-24. For Mayer Brown’s coverage of the Prior Proposed Regulations, please see Final Regulations Issued on Direct-Pay Elections and Transfer of Tax Credits | Insights | Mayer Brown.
