Regs Provide Rules for Unincorporated Organizations to Elect Out of Subchapter K

(Parker Tax Publishing December 2024)

The IRS issued final regulations that modify existing regulations under Code Secs. 761(a) to allow certain unincorporated organizations that are owned in whole or in part by applicable entities to be excluded from the application of partnership tax rules in order to access elective clean energy tax credits through elective payments under Code Sec. 6417. The IRS also issued proposed regulations that provide additional administrative requirements for unincorporated organizations that opt out of partnership treatment under the modified rules. T.D. 10012; REG-116017-24.

Background

Code Sec. 6417 was added to the Code by the Inflation Reduction Act of 2022 (IRA) (Pub. L. 117-169). Code Sec. 6417 allows an "applicable entity" (including tax-exempt organizations, the District of Columbia, state and local governments, Indian tribal governments, Alaska native corporations, the Tennessee Valley Authority, rural electric cooperatives, and certain agencies and instrumentalities) to make an election to treat an "applicable credit" (as defined in Code Sec. 6417(b)) as making a payment of income tax by such entity for the tax year for which such credit is determined, equal to the amount of such credit. Code Sec. 6417 also provides special rules relating to partnerships and directs the IRS to issue rules for making elections under Code Sec. 6417. Code 6417 applies to tax years beginning after December 31, 2022.

On March 11, 2024, the IRS published final regulations (T.D. 9988) that provide guidance on the Code Sec. 6417 elective payment election (Section 6417 regulations). The Section 6417 regulations provide that partnerships are not "applicable entities" described in Code Sec. 6417(d)(1)(A), regardless of how many of their partners are themselves applicable entities. Accordingly, any partnership making an elective payment election must be an electing taxpayer (as defined in Reg. Sec. 1.6417-1(g)), and, as such, the only applicable credits with respect to which the partnership could make an elective payment election would be the credit for carbon oxide sequestration under Code Sec. 45Q, the credit for production of clean hydrogen under Code Sec. 45V, and the advanced manufacturing production credit under Code Sec. 45X.

Also on March 11, the IRS issued proposed regulations (REG-101552-24) under Code Sec. 761(a) to carry out the purposes of Code Sec. 6417 (proposed regulations). Generally, the proposed regulations amend Reg. Sec. 1.761-2 to provide that unincorporated organizations meeting certain requirements (i.e., "applicable unincorporated organizations") are eligible for certain exceptions to the existing requirements for making a Code Sec. 761(a) election.

Code Sec. 761(a) and Reg. Sec. 1.761-2(a)(3) provide that, at the election of all of its members, an unincorporated organization may be excluded from the application of the Subchapter K partnership rules if the organization is availed of: (1) for investment purposes only and not for the active conduct of a business; (2) for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted; or (3) by dealers in securities for a short period for the purpose of underwriting, selling, or distributing a particular issue of securities, provided that the income of the members of the organization may be adequately determined without the computation of partnership taxable income. According to the IRS, unincorporated organizations seeking to be excluded from the application of subchapter K so that one or more of their members can make a Code Sec. 6417 election are likely to be availed of for the purposes listed in Code Sec. 761(a)(2); that is, for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted.

Under prior Reg. Sec. 1.761-2(a)(3), additional requirements apply in order for an unincorporated organization to make an election under Code Sec. 761(a)(2) to be excluded from subchapter K. Specifically, prior Reg. Sec. 1.761-2(a)(3) requires that the participants in the joint production, extraction, or use of property: (1) own the property as co-owners, either in fee or under lease or other form of contract granting exclusive operating rights (co-ownership requirement); (2) reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used (severance requirement); and (3) do not jointly sell services or the property produced or extracted (joint marketing requirement), although each separate participant may delegate authority to sell the participant's share of the property produced or extracted for the time being for the participant's account, but not for a period of time in excess of the minimum needs of the industry, and in no event for more than one year (one-year exception).

Final Regulations

On November 20, the IRS published final regulations in T.D. 10012 that adopt the proposed regulations issued in REG-101552-24 with modifications is response to practitioners' comments.

The final regulations modify the co-ownership and joint marketing requirements in Reg. Sec. 1.761-2(a)(3). Under the final regulations, an applicable unincorporated organization is defined as an unincorporated organization:

(1) that is owned, in whole or in part, by one or more applicable entities, as defined in Code Sec. 6417(d)(1)(A) and Reg. Sec. 1.6417-1(c);

(2) the members of which enter into a joint operating agreement in which the members reserve the right separately to take in kind or dispose of their pro rata shares of any property produced, extracted, or used, and any associated renewable energy credits or similar credits;

(3) that, pursuant to the joint operating agreement, is organized exclusively to own and operate applicable credit property (as defined in Reg. Sec. 1.6417-1(e));

(4) for which one or more of the applicable entities will make an elective payment election under Code Sec. 6417(a) for the credits determined with respect to its share of the applicable credit property;

(5) the members of which are able to compute their income without the necessity of computing partnership taxable income; and

(6) which is not a syndicate, group, pool, or joint venture which is classifiable as an association, or any group operating under an agreement which creates an organization classifiable as an association.

Under the proposed regulations, an organization was considered an applicable unincorporated organization if it "is organized solely to produce electricity from its applicable credit property (as defined in Sec. 1.6417-1(e)) and with respect to which one or more applicable credits listed in section 6417(b)(2), (4), (8), (10), and (12) is determined." Practitioners generally recommended that this definition be broadened to include organizations formed to own applicable credit property with respect to which any other applicable credit listed in Code Sec. 6417(b) is determined. The IRS agreed, and revised the definition of an applicable unincorporated organization in final Reg. Sec. 1.761-2(a)(4)(iii) to include organizations organized exclusively to own and operate applicable credit property (as defined in Reg. Sec. 1.6417-1(e)).

The final regulations generally apply to tax years ending on or after March 11, 2024. An applicable unincorporated organization that validly made a Code Sec. 761(a) election meeting the requirements of the final regulations for a tax year ending on or after March 11, 2024, will be treated as having made a valid election even if it was made prior to the publication of the final regulations in the Federal Register.

Proposed Regulations

In REG-116017-24, the IRS issued proposed regulations under Code Sec. 761(a) that set forth certain administrative requirements for unincorporated organizations taking advantage of the modifications to the requirements for Code Sec. 761(a) elections provided in the final regulations.

Observation: The IRS explained that, after an unincorporated organization makes a Code Sec. 761(a) election, each member may increase or reduce (even to zero) its interest in the unincorporated organization without affecting the validity of the Code Sec. 761(a) election. As a result, the information submitted to the IRS in connection with an organization's section 761(a) election, as required under revised Reg. Sec. 1.761-2(b), can become inaccurate at any time without notice to the IRS. According to the IRS, this lack of reliable and accurate information about the applicable entity owners (if any) of an applicable unincorporated organization constrains the IRS's ability to ensure that the amount of payments or deemed payments made under Code Sec. 6417 are commensurate with the amount of applicable credits that would otherwise be allowable, as directed under Code Sec. 6417(h).

Under the proposed regulations, a specified applicable unincorporated organization's Code Sec. 671(a) election will terminate as a result of a "terminating transaction." A terminating transaction is the acquisition or disposition of an interest in a specified applicable unincorporated organization, other than as the result of a transfer between a disregarded entity (as defined in Reg. Sec. 1.6417-1(f)) and its owner, since such a transfer does not change the identity of the applicable entity for purposes of Code Sec. 6417.

The proposed regulations provide that terminating transactions do not terminate an applicable unincorporated organization's Code Sec. 761(a) election if the organization meets the requirements to make a new Code Sec. 761(a) election and makes such an election no later than the time prescribed by Reg. Sec. 1.6031(a)-1(e) (including extensions) for filing a partnership return with respect to the period of time that would have been the organization's tax year if, after the tax year with respect to which the organization first made the Code Sec. 761(a) election, the organization continued to have tax years and such tax years were determined by reference to the tax year in which the organization made the Code Sec. 761(a) election (hypothetical partnership tax year). Such election will protect the organization's Code Sec. 761(a) election against all terminating transactions in a hypothetical year only if it contains, in addition to the information required by Reg. Sec. 1.761-2(b), information about every terminating transaction that occurred in the hypothetical partnership tax year, including the parties and the interest(s) transferred. If a new election is not timely made, the Code Sec. 761(a) election terminates on the first day of the tax year beginning after the hypothetical partnership tax year in which one or more terminating transactions occurred.

For a discussion of elective payment elections under Code Sec. 6417, see Parker Tax ¶104,220. For a discussion of Code Sec. 761(a) elections, see Parker Tax ¶20,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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