Tax credit investing: Rules on passive activity for tax credit buyers (updated 2026)

Prior to the Inflation Reduction Act of 2022 (IRA), tax equity was the primary mechanism available for transferring the financial benefits of clean energy tax credits to another taxpayer. Because tax equity transactions are complex and require substantial tax liability to justify the investment, the overwhelming majority of tax equity came from large corporations investing in large projects — limiting the pool of eligible buyers to a small number of large institutions.

The IRA introduced tax credit transferability, which permitted clean energy project developers and manufacturers of all sizes to sell their tax credits to another unrelated taxpayer for cash, opening a new channel for clean energy finance and investment. The streamlined transaction process of direct transferability has enabled small and mid-sized developers to monetize their clean energy credits to a greater extent than before and has significantly widened the pool of eligible tax credit buyers. That said, not every taxpayer can use purchased clean energy tax credits in the same way.

Under IRS regulations, transferred Section 6418 tax credits are classified as "passive activity" tax credits and are subject to rules described in Section 469 of the Internal Revenue Code. These rules govern the ability of different types of taxpayers to utilize tax credits for certain types of income, and depending on how a buyer is organized, tax credit transactions may be more or less practical for their tax planning objectives.

Passive activity rules under Section 469

Section 469 of the Internal Revenue Code restricts certain taxpayers’ ability to use losses and credits from "passive activities” to offset income from active business operations and portfolio investments. Under final Internal Revenue Service (IRS) regulations, transferee taxpayers subject to Section 469 must treat purchased tax credits as passive activity credits, usable only to offset passive income tax liability.

“Passive activities” refer to trade or business activities where the taxpayer does not “materially participate,” as well as rental activities. For a taxpayer to qualify for material participation in an activity, they must meet one of the following criteria:

1. The taxpayer participates in the activity for more than 500 hours during the taxable year.
2. The taxpayer’s participation in the activity constitutes substantially all of the participation of all taxpayers in the activity.
3. The taxpayer participates in the activity for more than 100 hours and no other individual participates more.
4. The activity is a significant participation activity for more than 100 hours for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours.
5. The taxpayer materially participated in the activity for any five of the preceding 10 taxable years.
6. The activity is personal service activity (such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor) and the taxpayer materially participated in the activity for any three taxable years preceding the taxable year, whether or not consecutive.
7. The taxpayer has regular, continuous and substantial involvement in the activity, based on all relevant facts and circumstances. 

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How passive activity rules apply by taxpayer type

Widely held C-corporations

Widely held C-corporations are not subject to passive activity limitations under Section 469; they can use transferred tax credits to offset tax liability from sources other than passive income and do not need to demonstrate material participation in the underlying project to use the tax credits. For this reason, widely held C-corporations represent the most straightforward buyer type in the transferable tax credit market.

Closely held C-corporations

Closely held C-corporations (where more than 50% of stock value is owned by five or fewer individuals during the last half of the tax year) are subject to modified passive activity rules under Section 469. Under these rules, transferred tax credits are treated as passive activity credits and therefore generally can only be used to offset passive income.

However, closely held C-corporations that are not personal service corporations (corporations whose principal activity is performing personal services, where such services are substantially performed by employee-owners who own more than 10% of the stock) can use transferred tax credits to offset both passive activity income tax liability and “net active income” tax liability, which in most cases constitutes income from business operations. This means that many closely held C-corporations can use purchased tax credits against their regular business income, not just passive income. However, closely held C-corporations of this kind cannot use transferred tax credits to offset liability attributable to portfolio income.

Net active income offset requirements:

Non-personal service closely held C-corporations must meet the following requirements to use transferred tax credits against net active income:

1. Material participation: To prove material participation in an underlying activity, one or more individuals owning more than 50% of the outstanding stock of the corporation must meet one of the qualifications for material participation listed above, or the corporation must have at least one full-time employee and three full-time, non-owner employees who spend substantially all their time actively managing the trade or business.
2. Active business operations test: The amount of deductions attributable to the business that are allowable under Section 162 (ordinary and necessary business expenses) and Section 404 (employer contributions to employee benefit plans) must exceed 15% of the gross income from that business for the taxable year.

Personal service corporations exception

Personal service corporations face more restrictive rules and generally can only use transferred tax credits to offset passive income tax liability. 

Closely held C-corporations should consult with a tax advisor to determine whether they qualify as a personal service corporation and whether they meet the requirements to utilize transferred tax credits against net active income.

S-corporations

S-corporations are treated as pass-through entities for federal income tax purposes. Under this designation, transferable tax credits would flow through to shareholders, which are then subject to the appropriate rules for individuals. Because individuals are subject to the passive activity limitations under Section 469 (see more below), and transferred tax credits are treated as passive activity credits, individual shareholders of S-corporations can only use these tax credits to offset tax on passive income (except in very limited circumstances).

Individuals

Individual taxpayers are subject to passive activity limitations under Section 469. Transferred tax credits are treated as passive activity credits and can only offset tax on passive income (except in very limited circumstances).

In practice, this means the individual buyer opportunity is concentrated among those with substantial passive income streams. Individuals with substantial investments in real estate, passive interests in private companies, and pass-through partnerships (such as master limited partnerships) may report passive income and have the opportunity to offset it by purchasing clean energy tax credits.

Key considerations for prospective tax credit buyers

Crux recommends that all prospective buyers — particularly individuals and closely held C-corporations — consult with a tax advisor to identify how much tax they can offset with purchased tax credits. Key questions to discuss with an advisor include: 

• How is the buyer organized and which Section 469 rules apply?
• Does the buyer have sufficient passive income or net active income to absorb tax credits? 
• Can the corporation (if applicable) demonstrate material participation in its business activities?

Crux's team of finance, tax, and development experts works with buyers to curate a selection of pre-vetted tax credits from leading developers and manufacturers, tailored to match each buyer's tax appetite, risk preferences, and deal size. With access to our $55 billion transaction dataset and industry-specific workflows validated by 40+ top-tier legal and accounting firms, buyers can evaluate opportunities against proven market benchmarks and move forward with confidence.

Contact us to learn more about working with the Crux team.

Disclaimer

This post is for informational purposes only and should not be construed as tax, legal, or accounting advice. Crux does not provide tax or legal advice. You should consult with your own tax, legal, and accounting advisors before engaging in any transaction or strategy discussed herein.