IRC Section 179D deduction clarified 

The Inflation Reduction Act of 2022 (IRA) enacted more than $200 billion in tax incentives for clean energy. Included in the legislation were amendments to enhance IRC Section 179D, which provides a deduction for energy efficient commercial buildings. The IRS issued Notice 2022-48, requesting comments on what should be addressed in forthcoming guidance to implement changes made by the IRA to IRC Section 179D and other provisions.

Crowe observation

Though the IRC Section 179D deduction was enacted in 2005 and extended several times, it was not made permanent until 2021. As a result, there are no regulations, and guidance has been limited.

The Tax Court’s January decision in Johnson v. Commissioner (160 TC 2 (2023)) clarifies a number of issues related to IRC Section 179D. Generally a taxpayer-favorable decision, the amount of the allowable deduction in the case was significantly less than the amount claimed. In addition, though these clarifications of IRC Section 179D rules are welcome, the vitality of this decision might be short-lived once new guidance is published.

Section 179D

IRC Section 179D(a) allows a deduction for the cost of depreciable energy efficient commercial building property (EECBP) placed in service during the taxable year, including property installed as part of the heating, ventilation, and air conditioning (HVAC) system. The rules under IRC Section 179D were amended by the IRA. However, following are the rules that were in effect for 2013, the year at issue in the Johnson case:

• The deduction under IRC Section 179D(b) is limited to the excess (if any) of the product of $1.80 and the square footage of the building over the aggregate amount of the deduction taken with respect to the building for prior years.
• Among other qualifying elements, IRC Section 179D(c)(1)(D) provides that property qualifies as EECBP if it is certified by a person unrelated to the taxpayer as having been installed as part of a plan to reduce the total annual energy and power costs of the building. These costs must be reduced by 50% when compared to a reference building that meets the minimum requirements of the American Society of Heating, Refrigeration, and Air Conditioning Engineers’ applicable energy efficiency standard, Standard 90.1.

Crowe observation

The IRA reduced the total annual energy and power cost savings requirement from 50% to 25% for property placed in service on or after Jan. 1, 2023.

 

• IRC Section 179D(d)(2) authorizes the secretary of the U.S. Department of the Treasury to prescribe the rules for calculating and verifying energy and power consumption and cost.
• Under IRC Section 179D(d)(6), the Treasury secretary is required to prescribe how to make certifications, including procedures for inspection and testing by qualified individuals. IRC Section 179D(d)(5) requires that the certification include an explanation to the building owner regarding the energy efficient features of the building and projected annual energy costs.
• IRC Section 179D(d)(4) provides that instead of claiming the deduction, a government owner of EECBP can allocate the deduction to the “person primarily responsible for designing the property,” who can claim the deduction.

While there are no IRC Section 179D regulations, Notice 2006-52 provides rules for certifications and calculating and verifying energy and power cost and consumption, and Notice 2008-40 provides rules for allocating the deduction.

Tax Court decision in Johnson

The Johnson case centered around the engineering firm Edwards Engineering, Inc. (Edwards), which is an S corporation that designs and installs HVAC systems. In 2013, Edwards entered into contracts with the U.S. Department of Veterans Affairs (VA) to provide HVAC services at a VA hospital, including updating air handlers and emergency replacement of temperature controls. Edwards performed services in 2013 and 2014. Edwards received payment from the VA and paid invoices to subcontractors in 2013 and 2014.

The VA allocated the deduction to Edwards in a letter. Edwards reported a $1,073,237 Section 179D deduction on its 2013 return. Edwards shareholders claimed their allocable share of the deduction on their 2013 returns. Upon examination, the IRS disallowed the deduction in full based on the following grounds:

1. The certification requirement was not met because the property was not installed as part of a plan to achieve the energy saving targets because there was no intent and specific forethought.
2. The computed energy savings was derived not from the property installed but rather from property installed in a prior year and by another contractor.
3. The certification and notice to the building owner were insufficient.
4. The deduction was not properly allocated to Edwards.
5. The property was not placed in service in 2013.

Each of the shareholders received a deficiency notice and timely filed petitions with the Tax Court. The Tax Court issued its opinion in Johnson on Jan. 25, in which it disagreed with the IRS that the IRC Section 179D deduction should be disallowed in full. However, the Tax Court did agree with the IRS that the amount of the deduction was overstated.

Specifically, the court found that the certification requirements in Notice 2006-52 do not require intent and forethought, that the broad definition of the property used to compute energy savings includes property that was installed in a prior year by another contractor, and that the certification and notice to the building owner met the requirements of Notice 2006-52. The court also concluded that the allocation of the deduction was proper. Edwards was the entity primarily responsible for designing the property, and the allocation letter met the requirements of Notice 2008-40. Finally, the court held that the property installed by Edwards was placed in service in 2013, disagreeing with the IRS that invoices issued in 2014 and services performed in 2014 meant that the property was not placed in service in 2013.

Despite these findings in favor of the taxpayer, the court agreed with the IRS that the amount of the deduction was overstated. The court concluded that the costs used to determine the amount of Edwards’ IRC Section 179D deduction are those related to the property installed by Edwards in the year the property was placed in service. As a result, the court determined that Edwards’ allowable IRC Section 179D deduction was only $304,640. Thus, the allowable deduction for each shareholder was far less than the amount initially allocated.

Looking ahead

Guidance under IRC Section 179D is likely to be issued soon. Those drafting the guidance surely will have the Johnson decision in mind as they craft the new rules. In the meantime, Johnson provides clarification of some of the more complicated issues surrounding Section 179D that taxpayers can rely on until further guidance is issued.