When it comes to claiming tax credits (and the related tax consequences), it makes a big difference whether the credit is structured as an allocated credit, a certificated credit, a refundable credit or a hybrid of one or more of these types.
Allocated credits may be claimed only by the entity that earned the credit or by its members or partners to whom the entity has “properly” allocated the credit. As such, an allocated credit generally cannot be transferred to third parties, although some state tax credits are structured as hybrid credits that can be treated, at the taxpayer’s option, as either allocated or certificated or as allocated or refundable. Many allocated state tax credits, such as the Louisiana historic tax credit, permit “special” (or disproportionate) allocations, allowing, for example, an entity to specially allocate 100% of the state tax credit to a member than holds a minority ownership interest (often 1% or less) in the entity. Other allocated state credits and most federal credits impose limits on how the credit may be allocated. For example, the federal historic rehabilitation tax credit (the “FTHC”) generally requires that the allocation be made in the same manner as profits are allocated among the members or partners. Where a taxpayer has insufficient tax liability to use an allocated tax credit in a particular tax year, in some instances, the tax credit can be carried back and/or carried forward to other tax years. The FTHC, for instance, may be carried back for one year and carried forward for 20 years. In all instances, in order for an allocation of a tax credit, which is generally a non-taxable event, to be respected for federal income tax purposes, the allocation must be made by to one or more “true partner(s)” of the entity. (Look for an upcoming posts regarding what constitutes a “true partner” for federal income tax purposes and where a purported allocation of state credits could be treated as a taxable “disguised sale” for federal income tax purposes.)
Many state credits are structured as certificated credits, whereby the entity earning the credit is awarded a certificate, specifying the type and amount of credit awarded. In stark contrast to allocated credits, certificated credits are generally freely transferrable to third parties, enabling a taxpayer that has insufficient tax credit liability to donate or sell the awarded certificated credit to a third-party for its use. In some instances, a limit is placed on the number of times that a certificated credit may be transferred. In all instances, a transfer of a certificated credit does not extend any applicable carryback or carryforward periods for the credit. The sale of a certificated credit is a taxable event. Further, a sale of certificated credits by the entity that earned the credit is generally taxable at the full amount of the sales price because the earning entity has no basis in the certificated credit for federal income tax purposes.
Refundable credits are treated as if the taxpayer that earned (or was allocated) the credit made a payment against its tax liability in the amount of the awarded credit. Thus, when the taxpayer files its tax return, if the amount of the refundable credit (along with any other withholdings and payments made by the taxpayer) exceed its tax liability, the excess will be treated as an overpayment and the taxpayer will receive a refund in the amount of the excess. The amount of any refunded state tax credits are generally included in taxable income for federal income tax purposes.