Tuesday, October 21, 2014

If You Get Too Bright, I’ll Tax The Sun: Solar Rooftop Electricity Exchanges and Potential Income Tax Liability

By Kyra Hill, Energy Fellow
Austin, Texas and the state of Minnesota recently established Value of Solar Tariffs (VOST) that aims to pay the true “value” that distributed solar power offers to the electricity grid. These policies are somewhat related to Feed-In Tariffs (FITs), which similarly pay a customer at a rate different from the one they would receive under net metering. Under both a VOST and a FIT, the customer must sell all electricity produced to the utility, and the customer must buy all electricity needed from the utility. This is arguably quite different from net metering, under which a customer consumes electricity on-site and purchases additional power from the utility. 
But just as net metering faces substantial opposition, VOSTs face serious criticism as well. In fact, one rooftop solar advocacy group, The Alliance for Solar Choice (TASC), believes that the forced sale of power under the VOST scheme is problematic because it may expose the homeowner to unforeseen income tax liability. Concerned about this potential exposure, an Austin homeowner, with the enthusiastic support of TASC, recently filed an Information Letter Request with the Internal Revenue Service (IRS) seeking guidance as to whether electricity sales under a VOST structure are taxable income. TASC and the homeowner have two main concerns. First, payments under a VOST structure expose the homeowner to income tax liability. And second, they may disqualify the owner from taking advantage of certain tax credits available to homeowners provided they consume the vast majority of electricity produced by the panels on-site. 
The IRS determination could have implications in several states currently investigating the possibility of adopting some form of VOST, such as California and Oregon. Although VOSTs can incite heated debateover appropriate methodologies, there is some evidence that when done well, VOSTs could be a forward-thinking way to account for the value that solar energy could provide to the grid (including environmental benefits, avoided transmission, and congestion management costs). Some suggest it could even make solar financing easier. I am therefore concerned that the decision to ask the IRS to rule on the status of those sales may be tactically nearsighted. Not only could it impose tax liability on owners of rooftop solar, but it also ignores the underlying reasons a well-crafted VOST could be beneficial to solar proponents in the future.
This myopia takes several forms. First, asking the IRS to offer some guidance on an issue it seemed otherwise content to ignore seems unwise. In fact, this issue looks similar to a Citibank controversy involving frequent flyer miles that the bank issued to customers for opening credit card accounts with the bank. Citibank began sending out 1099 notices and treating the miles as taxable income. Although the definition of taxable income under the Tax Code is broad—“all income from whatever source derived”— the IRS had until that point not treated the points as taxable income. With prodding from Citibank, though, the IRS began treating them as such. Yet, the IRS still treats the points customers receive when they make purchases on their credit card as nontaxable, the difference being that the points connected to actual purchases constitutes a “reimbursement of your membership fees” as part of a reward program (i.e. nontaxable), whereas the one-time point disbursement looks more like income.
Commentators argue that the distinction between those two is contrived. But even if it is, the VOST arguably looks more like the membership reimbursement points than the taxable exchange of points for signing up for a new credit card. The owner of solar panels is required to purchase electricity from the utility under the VOST structure, and the credits she receives on her bill is directly tied to the value she gives to the grid through her solar array’s production. In fact, the VOST scheme is in essence a structure designed to reimburse a homeowner for her solar panels’ contribution to the power grid. If the IRS is willing to treat points received for membership in a credit program as nontaxable, it might be willing to do the same under a VOST.
The second type of tactical nearsightedness results from TASC’s likely misunderstanding that VOST exchanges do in fact result in taxable income. In support of its position, TASC cites to a memorandum written by the leading tax firm Skadden, Arps, Slate, Meagher & Flom. The memo argues that the VOST structure results in taxable income because the VOST requires a homeowner to sell electricity to the utility in exchange for either cash or an on-bill credit. However, several arguments could reasonably lead to the opposite conclusion. For instance, a tax law doctrine called the “step transaction doctrine” seems to suggest that power exchanges between a customer and a utility should not be viewed as taxable income. In 1989, the United States Supreme Court explained in Commissioner v. Clark, that when a transaction is “integrated” and composed of interdependent components, the analysis of its taxable nature must take into account the “character of the exchange as a whole, and not simply its component parts.” Particularly where the parties are formally obliged to complete each part in a series of steps, this doctrine counsels against treating each as a separate transaction. Because the VOST scheme requires a homeowner to sell her power onto the grid and to purchase electricity from the utility at a different rate, each step of the transaction is both interdependent and obligatory. Taking the entire exchange as a whole, rather than simply as component parts, the transaction does not appear to result in taxable income under the test established in Clark.
Finally, an IRS determination that these exchanges result in taxable income is logically inconsistent with the Federal Energy Regulatory Commission’s (FERC) interpretation of net metering exchanges. Although I see no legal reason that the IRS’s interpretation would have to follow FERC’s, the federal government should avoid taking internally conflicting positions, particularly in an area as crucial as promoting renewable energy.  FERC does not treat customer-end electricity flowing onto the grid under net-metering programs as wholesale power sales, so long as the homeowner is not selling excess power onto the grid. A similar exchange where the customer is not sending more power back onto the grid than she consumes should, if at the very least for administrative ease, receive similar treatment under the Tax Code.
Ultimately, an IRS ruling that exchanges under VOST structures do in fact result in taxable income could open up a proverbial Pandora’s box of problems. First, VOST schemes are not perfect, but they do represent an attempt by solar advocates to work with utilities to craft a policy that accurately reflects the value distributed solar power provides to the grid. Subjecting payments under VOSTs to income tax would undermine the financial feasibility of distributed solar. Second, TASC is a proponent of net metering programs because they reimburse the homeowner at retail rate for the power her panels produce. I am not convinced that if VOSTs constitute taxable income, net metering payments would not.
Forcing homeowners with residential PV to pay income taxes on the power their panels produce could create additional and unnecessary financial hurdles and potentially pose significant problems for residential PV customers. For this reason, the IRS should avoid embroiling itself in an already contentious debate and decline to respond to the Information Letter Request at all, thereby avoiding issuing a ruling as to the taxable status of these payments until solar advocates and utilities are prepared to face the consequences. 

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