For many years, states have allowed taxpayers to transfer certain tax credits, effectively selling a tax break for cash. Now, federal tax law offers a similar—but not identical—opportunity to businesses with respect to certain tax credits. Companies operating at a loss or those in their infancy may not be able to use or maximize the use of tax credits and, where applicable, might want to transfer the credits in the year they are earned.
The rules aren’t simple and making the decision on whether to transfer isn’t easy. It requires not only an understanding of whether you have a credit transfer opportunity, but also whether to make the transfer, and then, how to do it.
What to know about state tax credit transfers
Transferable tax credits allow businesses that qualify for credits but can’t use them on their state income tax returns because they exceed their tax liability to get cash for the tax breaks they’ve qualified for. The credits typically relate to investments in real estate (e.g., historic property rehabilitation credits), R&D, jobs, and alternative energy. Some states permit transferable credits related to the film industry and low-income housing. Businesses that buy the credits don’t have to be in the same industries as the sellers in order to use the credits on their state returns.
Among the states offering transferable tax credits are Connecticut, Georgia, Illinois, Massachusetts, Montana, New Jersey, New Mexico, Pennsylvania, and Rhode Island. The rules in each state vary considerably and transferability may come and go over time, so work with a knowledgeable tax adviser.
Here’s how a state credit transfer works:
The seller is the party qualifying for the credit; the buyer is the business that obtains the credit—directly from the seller or through a broker or online exchange (e.g., Tax Credit Marketplace for South Carolina sellers and buyers). Depending on state law, the credit is sold to a single party or can be parsed to multiple buyers. Typically, credits are sold at a discount (e.g., 90¢ for each $1 of credit). One blog has a great description of how film credit transfers operate in Georgia.
For partnerships, a credit transfer can also be arranged by strategically allocating credit amounts to partners.
Caution: For federal income tax purposes, a transfer of state credits may be viewed as a deemed sale of a capital asset to the buyer when the credits are obtained as a discount. The deemed sale date is the date when the buyer files the state tax return and applies the credits. Again, this is complicated but worthwhile to pursue in many instances.
What to know about federal tax credit transfers
The Inflation Reduction Act of 2022 introduced the concept of credit transfers into federal law. The credits transferred are treated as a direct payment. The tax credit transfers apply to 9 credits in 2023. Although most of them have no applicability to small businesses, a few nonetheless may apply, either now or in the immediate future.
If successful, Congress may expand the concept of transferable credit within more “green energy” areas … and beyond, so it’s important to begin to understand how transferability works under the general rules and where it specifically may come into play. There’s some IRS guidance on the matter that already has been released, but proposed regulations are expected to flesh out the details, expected in time for use later this year.
Here are some key considerations we know so far:
- The cash or price reduction you receive for the transfer is not taxable to you (and it’s not deductible by the seller who buys the credit). A transfer of a tax credit is limited to one time; there cannot be multiple transfers of the same credit.
- The transfer is voluntary. The election to make the transfer must be done by the due date (including extensions) of the return on which the election is made.
- The credit buyer can claim the credit for the first year ending with, or after, the tax year of the credit seller. The credit buyer can carry back credits for 3 years and forward for 20 years.
- The credit transfer option applies to a number of tax credits. Some of them are unlikely to relate to a small business, such as the zero-emission nuclear power production tax credit. However, some other credits subject to transfer may be applicable to small businesses. These include the alternative fuel vehicle refueling property credit (beginning immediately), the commercial clean vehicle credit (beginning in 2024), clean vehicle credit (beginning in 2024), the used clean vehicle credit (beginning in 2024), and the advanced energy investment tax credit (beginning immediately).
Note: The transfer of vehicle-related credits at this time is limited to transfers solely to dealers selling the vehicles.
Many credits—state and federal—that can’t be used currently can be carried forward to produce tax savings in the future for the taxpayer that earns the credit. Weigh the current benefit from transferring a credit now against the future benefit from a carryforward.