Direct Pay: How Local Goverments Can Leverage Tax Credits

As local governments face growing pressure to combat climate change and promote sustainable energy, funding innovative projects remains a challenge.
The Inflation Reduction Act of 2022 (IRA) includes an elective pay option (direct pay) that presents an opportunity for municipalities and other governmental entities to directly benefit from new and existing clean energy tax credits.

Although the continued federal commitment to the IRA is uncertain, a full repeal of the IRA may prove difficult. While certain parts of the IRA may be repealed or amended in the 119th Congress, local governments should be aware of the benefits of direct pay to take advantage of any available energy-related tax credits and position themselves for potential future benefits.

What is Direct Pay?

Through direct pay, local governments can receive cash payments equivalent to the value of specific clean energy tax credits. Historically, these tax credits could only reduce federal tax liabilities – a benefit inaccessible to nontaxable entities. Direct pay bridges this gap by turning tax credits into cash payments by treating local governments and other nontaxable entities as having overpaid their taxes. Direct pay effectively enables cash payments that help offset expenditures by the local government related to clean energy generation, energy storage, and electric vehicles.

The Tax Credits Most Relevant to Local Governments

While there are 12 IRA tax credits that are available under direct pay, some are less relevant to local governments. The four that are most relevant to local governments include the credits for alternative fuel vehicle refueling property, qualified commercial vehicles, renewable electricity production, and renewable energy investment.

Alternative fuel vehicle refueling property (IRA section 30C). Section 30C applies to vehicle refueling properties for various alternative fuel sources, but the most common application of section 30C is likely electric vehicle charging stations. The credit applies to costs incurred for purchasing and installing alternative fuel vehicle refueling equipment, as well as upgrading or retrofitting existing equipment to support qualifying fuels. Costs related to general site preparation (e.g., paving or unrelated construction) are typically excluded.

Local governments within Wisconsin that are planning to invest in electric vehicle charging stations should be aware that the Wisconsin Legislature recently implemented a new regulatory scheme related to public EV charging and implemented a new tax on electricity supplied at public electric vehicle charging stations. Electric vehicle charging stations will be exempt from sales tax but will be subject to an excise tax at a rate of three cents per kilowatt-hour (kWh). The tax applies even if the charging station is free for public use. The two exemptions are charging stations at residences and any “Level 1” or “Level 2” charger installed prior to March 22, 2024.

Qualified commercial clean vehicles (IRA section 45W). Local governments can receive a tax credit for up to 30% of their cost basis in fully electric or fuel cell vehicles under Section 45W (plug-in hybrids can receive up to 15%) provided that the vehicles battery meets specific size requirements. This credit could be used for electric garbage trucks, public transit, and other governmental uses like school buses. The credit has a maximum limit of $7,500 for vehicles less than 14,000 pounds, and otherwise, the limit is $40,000. The credit is also limited by the incremental cost, the price difference between the clean vehicle and a similar conventionally fueled vehicle. The credit will be equal to the percentage of basis, the maximum limit, or the incremental cost, whatever figure is
lowest.

Renewable electricity production tax credit (IRA section 45). Section 45 provides for a production tax credit for projects employing the “qualified energy resources” listed in the IRA, including wind, solar, and geothermal energy projects. The tax credit ranges from 0.3 cents to 2.75 cents per kWh depending on the size, type, date of construction, and the in-service date of the particular project. For projects that will be in service starting in 2025 or later, the clean electricity production credit (section 45Y), will apply. Section 45Y is a “technology neutral” credit that makes qualified zero-emission energy technologies eligible. Section 45Y ranges from 0.3 cents to 1.5 cents per kWh depending on whether certain requirements are met. Both the 45 and 45Y tax credit also have numerous bonus credit incentives available.

Energy investment tax credit (IRA section 48). Section 48, commonly referred to as the Energy Investment Tax Credit, is a federal tax incentive that supports the development and installation of renewable energy projects by providing a credit based on the upfront costs of eligible energy property. Eligible projects include wind and solar farms as well as battery energy storage. The credit ranges from 6% to 30% of cost basis depending on whether certain requirements are met. Numerous bonus credits are also available that can potentially increase the available credit up to 70%. Relevant costs include equipment and materials directly related to energy production, installation and labor costs, and some related soft costs, such as permitting and site preparation. Similar to section 45, section 48 will be replaced by section 48E, the clean electricity investment credit. Section 48E, like section 45Y, applies to projects placed in service in 2025 or later, and applies to any clean electricity generation technology that achieves zero emissions or energy storage.

Important note on section 179D deductions. Tax deductions for energy efficiency upgrades under section 179D are
not eligible for direct pay. However, the IRA did allow governmental entities to allocate section 179D deductions to architects, engineers, and contractors that install qualifying systems in government buildings. Local governments could consider this when planning energy efficiency projects in order to secure reduced pricing.

Bonus credits and additional requirements. Local governments can take advantage of bonus incentives to maximize their credits and ultimate direct payment. There are also additional requirements that must be met to avoid a reduction in the available tax credit. The relevant bonuses and requirements include domestic content, prevailing wage and apprenticeship (PWA), energy communities, and low-income communities bonus (LICB).

Domestic content.The domestic content bonus credit is available when a qualified facility, energy project, or energy storage technology has been certifiably built with certain percentages of steel, iron, or manufactured products that were mined, produced, or manufactured in the United States. The domestic content bonus applies to both the production and investment credits. For projects put in service in 2024 or later, the domestic content bonus requirements must be met to avoid a
reduction in the total available tax credit. The domestic content bonus and requirements only apply to projects greater than 1.0 megawatt (MW).

Prevailing wage and apprenticeship (PWA). The PWA requirements impose a floor on the wages of workers employed in the construction, alteration, or repair of green energy projects. They also set a minimum standard for apprenticeship hours spent on the construction. The PWA requirements apply to any investment and production credits on projects greater than 1.0 MW. The requirements also apply to refueling properties constructed in 2024 or later.

Energy communities. Both investment and production tax credits are eligible for a 10% bonus when the energy project is located in:

• a “brownfield” site;

• an area employed by coal, oil, or natural gas with an unemployment rate above national average; or

• a census tract in which coal mine closed after 1999 or coal-fired power plant has been retired after 2009.

The
IRA Bonus Mapper will provide eligibility information by zip code. Additional information on energy communities can be found atenergycommunities.gov.

Low-Income Communities Bonus Credit (LICB). The LICB only applies to investment tax credit projects with a max net output under 5 MW. The credit adds 10% if the project is located in a low-income community or on Tribal land. The credit adds 20% if the project qualifies as a low-income residential building project (affordable housing programs) or a low-income benefit project (financial benefits to low-income/affordable housing). The LICB has a separate application process that can take a considerable amount of time, so local governments should apply before the relevant project is completed.

The Direct Pay Process

Local governments should identify qualifying projects for the current taxable year and begin planning for future years by working with key stakeholders. Once projects are identified, they will need to be registered with the IRS after gathering the appropriate documentation to prove their qualification, such as, ownership documentation, domestic content, and compliance with prevailing wage laws. Registration with the IRS is required prior to filing a return claiming these credits.

Conclusion

By offering refundable tax credits, direct pay empowers municipalities, school districts, and other nontaxable entities to significantly reduce project costs while advancing sustainability goals. However, the complexity of direct pay – including its eligibility criteria, compliance requirements, and interaction with various financing mechanisms – necessitates careful planning and collaboration.

By embracing a proactive and multidisciplinary approach, local governments can position themselves to effectively leverage direct pay to update and improve local infrastructure. However, because of the complex regulatory regime proposed by the IRA, and the rapidly evolving governmental support for the IRA, it is critical that local governments engage with legal counsel and tax and finance professionals who are experienced in federal energy tax credits.

This article was originally published on the State Bar of Wisconsin’s
Taxation Law Section Blog. Visit the State Bar
sections or the
Taxation Law Section webpages to learn more about the benefits of section membership.

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