Tax Court permits limited energy tax deduction for engineering firm

by | Feb 3, 2023

TAX ALERT | February 03, 2023

Executive summary: 

In Johnson v. Commissioner, the Tax Court brought some welcome guidance on several requirements under section 179D. The court held that a taxpayer does not need to install the property with the specific intent to reduce energy consumption, and a taxpayer may derive energy savings from components not installed by the taxpayer. The Tax Court also provided additional clarity on what kinds of services qualify a taxpayer as a designer. 

Tax Court permits limited energy tax deduction for engineering firm

In Johnson v. Commissioner, the Tax Court reversed the IRS’ disallowance of an engineering firm’s Energy Efficient Commercial Building Property (EECBP) deduction under section 179D. The Tax Court addressed several issues important to qualifying for the section 179D deduction, including the ability to derive energy savings from components not installed by the taxpayer.  

Section 179D allows a taxpayer who owns or leases a commercial building to deduct either the cost or a portion of the cost to install EECBP. If the EECBP is installed in a government-owned building, the deduction can be allocated to the entity primarily responsible for designing the EECBP, the designer. EECBP must meet certain energy savings targets and be part of at least one of three systems: (1) interior lighting; (2) heating, cooling, ventilation and hot water; or (3) the building’s envelope.

In Johnson, the Department of Veteran’s Affairs (VA), a federal-government entity, engaged an engineering firm to service a VA hospital’s HVAC system, and modified its contract to include the engineering firm installing a replacement air control system. The engineering firm commissioned a section 179D study from a tax consulting and lobbying firm to certify the required energy savings. The taxpayer also obtained an allocation letter signed by a VA authority providing the engineering firm with the full deduction available under section 179D attributable to the HVAC and hot water systems. At the conclusion of the study, a professional engineer employed by the tax consulting firm signed a certification of compliance. Additionally, the tax consulting and lobbying firm sent a letter to the VA indicating the amount of the section 179D deduction, $1,037,237, the projected annual energy costs and a listing of the energy efficient building features. 

The engineering firm claimed the section 179D deduction on its 2013 tax return. The IRS disallowed the entire $1,037,237 section 179D deduction, asserting a variety of arguments, including: (a) the engineering firm did not make the installations as part of a plan to achieve an energy savings target; (b) the control system installed by the engineering firm did not create the energy savings and instead, the savings resulted from an HVAC upgrade in 2011; (c) the certification and notice to the building owner were deficient by failing to list the energy-efficient features of the building; and (d) the taxpayer was not a ‘designer’ of EECBP because it did not create any technical specifications for the installation of the property, and the scope of its work was limited to installing, repairing and maintaining the HVAC systems.

The court disagreed, holding that the engineering firm was entitled to a section 179D deduction, but limited the amount of the deduction to $304,640 (the amount actually paid to the engineering firm during the tax year at issue). In so doing, the court observed that Notice 2006-52 does not require intent or forethought to achieve an energy savings target. Moreover, the court provided that the engineering firm did not need to certify that any of the computed energy savings resulted specifically from the components that it installed, because it was able to establish that the VA hospital’s total annual energy and power costs had been reduced by 50 percent or more in comparison to the annual costs of the reference building. Lastly, the court noted that the certification of compliance and the notice to the building owners listed both the components and energy efficient features of the building.  Accordingly, the court concluded that the engineering firm was entitled to a deduction of $304,640 rather than $1,037,237 (the product of $1.80 by the square footage of the building) as that was the amount paid to the engineering firm for its services for the taxable year.

The Johnson case also addressed the type of work that qualifies a taxpayer as a ‘designer’ for purposes of the deduction. Notice 2008-40, section 3.02 supplements section 179D and defines a ‘designer’ as “a person that creates the technical specifications for installation of [EECBP]” and may include, for example, an architect, engineer, contractor, environmental consultant or energy services provider who creates the technical specifications for a new building or any addition to an existing building that incorporates energy efficient commercial building property. Mere installation, repair or maintenance does not qualify taxpayers as designers. In Johnson, the Tax Court held that work modifying the sequence of operations to better operate the systems and programming the operations into the control system of the HVAC was enough to qualify as a designer.

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This article was written by Tracy Watkins, Jason Belbot, John Charin and originally appeared on 2023-02-03.
2022 RSM US LLP. All rights reserved.

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP 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. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. 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.

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