Tax Implications of NEM Successor Policies

The Clean Coalition recently published a report titled "Net metering & feed-in tariffs: Understanding the tax implications of distributed generation policies."¹ Here I address some concerns related to the analysis in this report. And explain how the Internal Revenue Service, IRS, should be expected to analyze the potential tax consequences of a Net Energy Metering arrangement, NEM, and a Feed-In-Tariff, FIT.

The IRS understands that residential solar customers are delivering electricity to their utilities under several NEM and FIT transactional patterns. However, they have not issued any guidance addressing the taxability of such arrangements. At this time it is uncertain whether they will choose to issue guidance. 

Proponents of NEM attempt to use the pricing distinctions between NEM and FIT arrangements to support different tax results. They argue that a FIT produces a taxable transaction and a NEM arrangement does not. 

This outcome is unlikely. Both transactions result in delivery of electricity produced by a residential customer to a utility for consideration in the form of a credit for future electricity, cash, or a combination of both. 

 The IRS has not addressed any of these issues. If they do, it will be difficult for them to distinguish the facts of a FIT from a NEM arrangement. 

Either both will give rise to some form of a taxable transaction or neither will. The only distinction is in the quantity of electricity sold to the utility, which is dependent on how the system is engineered. It is not dependent on the price at which the various transactions occur or the crediting or billing arrangements.

While the form of a transaction can have implications for federal income tax treatment, generally the substance of the transaction will control. If the IRS chooses to review the federal income tax treatment of these transactions, the substance of the transactions will be paramount in their analyses.

For federal income tax purposes, the IRS has long adhered to the position that the sale of electricity is the sale of a good (tangible personal property). The transfer of ownership of a good for consideration constitutes a sale or exchange for federal income tax purposes. It is unlikely that the IRS will analyze solar transactions under any other characterization, such as a loan or the provision of a service.

When comparing NEM to FIT, the terms must first be defined, not only by the various pricing and billing practices, but also by the flow of the electricity. 

In what might be called a true FIT, the residential customer produces electricity and delivers all that electricity to the utility at a price. This price is received by the customer either as:

1. a credit to the customer to offset future deliveries of electricity from the utility to the customer;
2. a cash payment to the customer; or
3. a combination of credits and payments.

Another transaction, called a Value of Solar Tariff, VOST, is commonly mistaken for a FIT. Under a VOST, two electric meters are used. The first meter measures the solar generation. The second meter measures the net deliveries of electricity between the customer and the utility. 

Under a VOST, for billing purposes only, all the solar generation measured by the first meter is totaled as if the solar generation had been sold to the utility at a predetermined price. The customer bill then contains a charge to the customer for the electricity measured by the first meter at a retail price, plus any net deliveries by the utility to the customer, or minus any net deliveries by the customer to the utility, as measured by the second meter.

However, unlike a FIT, under both NEM and VOST arrangements, solar power generated at the residence is consumed at the residence to the extent needed for the residence's load. Only excess solar production is delivered to the utility. 

As in the case of a FIT, the price is received by the NEM or VOST customer either as:

1. a credit to the customer to offset future deliveries of electricity from the utility to the customer;
2. a cash payment to the customer; or
3. a combination of credits and payments.

Under a FIT, VOST, or NEM mechanism, the net electricity used by the customer (total usage less total generated) is the same. Therefore, the tax treatment of the delivery of the electricity to the utility under a FIT or a VOST should be no different than the tax treatment of the delivery of electricity under a NEM. 

This is particularly the case for a VOST where much of the electricity produced at the residence is consumed at the residence, just as it would be under a NEM arrangement. 

The only distinction in the transactions is that, in a true FIT, the customer is delivering all the electricity produced at the residence to the utility. In a NEM arrangement and a VOST, the customer only delivers the electricity to the utility that is in excess of what is consumed at the residence. 

Thus, a true FIT potentially produces more gross taxable income than a NEM or VOST only because the customer is delivering more electricity to the utility. In the true FIT, the customer is not taking advantage of consuming his own production, but rather selling that production in a potential taxable sale, and using the after-tax income to purchase electricity.

This phenomenon is not unique to solar electric production. For example, if a person grows her own food and cooks it at home, there is no tax burden on the benefit of the meal. However, if the person eats the same meal at a restaurant, she pays for the meal with after-tax dollars, and therefore the meal comes with a tax burden. Similarly, a major benefit of producing one's own electricity is to reap the benefit of the electricity without paying for it with after-tax dollars.  

The federal income tax treatment discussed above has nothing to do with the pricing of the sale of electricity to the utility or to the customer. If a customer's sale of electricity for a credit toward the future purchase of electricity or cash is taxable under a FIT or a VOST the same should be true under a NEM arrangement.

Endnote:

1. The Clean Coalition's report, dated December 10, 2015, is available through its website: http://www.clean-coalition.org.