Federal Tax Incentives for Alcohol Fuels

Salvatore Lazzari
Specialist in Public Finance
Economics Division

Updated April 2, 1997

97-416 ERN

Summary

The federal tax code contains five tax incentives for alcohol fuels: the 5.4¢ per gasohol gallon excise tax exemption, the 54¢ per alcohol gallon blender's tax credit, the 10¢ per gallon small ethanol producers' credit, the tax deduction for clean-fueled vehicles, and the §29 tax credit for the production of unconventional fuels. Rules against "double-dipping" prevent taxpayers from claiming more than one incentive. The tax incentives were enacted to 1) encourage substitution of alternative renewable transportation fuels for gasoline and diesel fuel, which would reduce petroleum consumption and importation, 2) help support farm incomes by expanding the markets for corn, sugar, and other agricultural products that are the basic raw materials for nearly all of the actual ethanol production in the United States, and 3) more recently, to reduce smog and improve air quality.

As part of the 105th Congress's work on reauthorizing the federal highway program, the House Ways and Means Committee has been examining the current structure of transportation fuels excise taxes,(1) including the complicated structure of excise taxes on alternative fuels, and the exemptions and tax credits for alcohol fuels. Committee chairman Archer supports current proposals (such as the English-Lewis bill, H.R. 161) to end the 5.4¢ per gallon alcohol fuels tax exemption, and the tax credits for alcohol fuel (gasohol) used in transportation, which benefit primarily ethanol from biomass.(2)

Excise Tax Exemptions

The most important tax incentive for alcohol fuels -- the one most responsible for the development of the alcohol fuels market -- is the 5.4¢ per gallon exemption from the excise taxes on gasoline. The Internal Revenue Code (IRC) imposes a tax of 18.3¢ per gallon of gasoline, composed of an 14.0¢ highway trust fund rate (which finances the Federal Highway Trust Fund), and a 4.3¢ deficit reduction rate (which is designated to the general fund for deficit reduction).(3) In addition, the IRC imposes tax on diesel and a variety of other motor fuels used in highway transportation, with the tax rates varying by type of fuel and its use. Diesel fuel, for example, is taxed at 24.3¢ per gallon.(4)

The excise tax exemptions for alcohol fuels apply to both blended fuels (mixtures) and straight (neat) alcohol fuels. Mixtures of motor fuels and biomass-derived alcohols (either methanol or ethanol produced from plants and other renewables) are partially exempt from the 18.3¢-tax, with the amount of the exemption depending upon the fraction of alcohol that is in the mixture and the type of alcohol. Gasohol mixtures - blends consisting of 10% ethanol(5) and 90% gasoline - are taxed at 12.9¢ per gallon (or are exempt from 5.4¢ of the tax). Blends that are 7.7% or 5.7% alcohol (either ethanol or methanol) receive an exemption prorated from the 5.4¢ exemption for ethanol blends. Thus, 7.7% ethanol blends qualify for a 4.158¢ exemption (they are taxed at 14.142¢ per gallon); mixtures that are 5.7% ethanol quality for a 3.078¢ per gallon exemption (they are taxed at 15.222¢ per gallon). In all these cases, the exemption equates to 54 cents per gallon of ethanol used. The 5.7% and 7.7% blends correspond, respectively, to the 2.0% and 2.7% oxygen content standard for gasoline sold in ozone nonattainment areas and carbon monoxide nonattainment areas under the Clean Air Act.

Alcohol blended with diesel fuel or one of the other special motor fuels is also partially exempt from tax. The exemption for gasohol blends also applies to blends of diesel and biomass-derived alcohol and blends of a special motor fuel and biomass-derived alcohol, whether ethanol or methanol. Alcohol blended with diesel - sometimes called "dieselhol" - is taxed at the rate of 18.9¢ (the exemption is 5.4¢, the same as for gasoline) if the alcohol is ethanol and 18.3¢ per gallon is the alcohol is methanol.

In order to qualify for the exemptions, the alcohol must be at least 190 proof (95-percent pure alcohol, determined without regard to any denaturants). Second, for the blended fuels, the alcohol cannot be derived from petroleum, natural gas, or coal (including peat). Legally, both ethanol and methanol qualify for the exemption. In practice, however, most of the economically feasible alcohol produced is ethanol from corn; most of the economically feasible methanol is derived either from natural gas or coal, which does not qualify for the exemption for blended fuels.(6) Thus, methanol produced from wood, urban waste, and other biomass would qualify for the exemption, but very little methanol is actually produced from these sources because it is generally uneconomic.(7)

Under IRS (Internal Revenue Service) regulations, mixtures of gasoline and ETBE (ethyl tertiary butyl ether) also qualify for the 5.4¢ excise tax exemption. ETBE is a chemical compound derived from a chemical reaction between ethanol and isobutylene, a byproduct of both the petroleum refining process and natural gas liquids. In this reaction, the ethanol is chemically transformed and is not present as ethanol in the final product. The IRS regulations permit mixtures containing 12.7 percent ETBE (equivalent to 5.7-percent alcohol) to qualify for the 3.078¢ exemption. Straight (or neat) alcohol fuels -- mixtures that contain a minimum of 85-percent alcohol -- also qualify for the excise tax exemption at varying rates. For biomass-"thanol, the tax rate after the exemption is 12.9¢ (a 5.4¢-exemption); for biomass-methanol, the tax rate after the exemption is 12.3¢ per gallon, (a 6.0¢ exemption); for 85 percent alcohol (ethanol or methanol) derived from natural gas, there is a separate motor fuels tax exemption of 7.0¢ per gallon [the tax rate is 11.3¢ per gallon (§4041(m)).(8)

Blender's Tax Credit

The current federal tax code provides for an income tax credit for alcohol used or sold as a fuel, which is available in place of the excise tax exemption. This credit is available for both alcohol blended as a motor fuel (mixture) and for straight alcohol used as fuel. Whether the alcohol is a blend or straight fuel determines who qualifies for the tax credit.

The alcohol mixture (blender's) credit is a tax credit available to the blender for alcohol blended with gasoline or any other liquid motor fuel. The credit is 60¢ per gallon of alcohol if the alcohol is methanol and if the alcohol is at least 190 proof and 45 cents if the methanol is between 150 and 190 proof. No credit is available for methanol that is less than 150 proof. This credit is equivalent to a 6.0¢ per gallon of methanol mixture. If the alcohol is ethanol, the credit is 54¢ per gallon if the alcohol is at least 190 proof and 40¢ if the alcohol is between 150 and 190 proof. This credit is equivalent to a 5.4¢ per gallon of ethanol mixture. This mixture credit is available only to the blender, who must not only produce the mixture but must either use the mixture as a motor fuel in a trade or business or sell it for use as a fuel. The blender may be the producer, the terminal operator or the wholesaler.

The blender's tax credit is also available for straight (unblended) or neat alcohol fuels. The amount of the credit is the same as above, depending upon whether ethanol or methanol is used, and depending upon the proof of the alcohol. This alcohol fuels tax credit is a credit to either the user of the fuel in a trade or business or to the retail seller of straight alcohol fuels, as long as it is placed in the fuel tank of the buyer's vehicle. The two blender's tax credits have been available continuously since 1980, and they are scheduled to expire on January 1, 2001.

The alcohol fuels tax credits apply to ethanol and methanol derived from renewable energy resources such as vegetative matter, crops, and other biomass, including methanol derived from wood and other biomass sources (such as waste disposal sites). It does not apply to alcohol derived from petroleum, natural gas, or coal (including peat). Thus ethanol produced as a byproduct of ethane-derived ethylcellulose is considered to be a derivative of natural gas or petroleum and does not qualify for the tax credit.

In March 1990, after nearly two years of urging from various members of Congress and several interested parties, the IRS ruled that blends of ETBE and gasoline (or other motor fuels) would be treated as alcohol fuels mixtures and, therefore, would qualify for the blender's tax credit. Allowing ETBE, which is about 42% ethanol, to qualify for this tax credit is designed to stimulate the production of ethanol for use in reformulated gasoline, which would reduce the growth of methyl tertiary butyl ether (MTBE), another fuel additive that enhances fuel oxygen content. Before 1990, ETBE was not considered a qualified mixture of ethanol and isobutylene, but rather a compound of these two chemicals.

There are a number of restrictions on the use of the blender's credit. First, as with the excise tax exemptions, the alcohol cannot be derived from petroleum, natural gas, or coal (including peat). And as with the exemptions, this limitation effectively means that the credits are currently available only to ethanol, since most economically feasible methanol is made from natural gas. Second, and most important, the credits are offset by any excise tax exemptions claimed on the same fuel. Taxpayers must choose between the exemption or the credit; they cannot claim both incentives on the same quantity of blended fuel. Third, under IRC §87, the alcohol fuels tax credit is itself taxable as gross income for the tax year in which the credit is earned. Thus, a taxpayer that claims the credit has to add it back as income subject to tax and the value of the credit is reduced. Fourth, the alcohol fuels tax credit is a component of the general business tax credit under IRC §38 (which includes the targeted jobs tax credit, research and development tax credit, low-income housing tax credit, and other credits) and is subject to the carryforward and carryback rules of §39. Fifth, the credits are not refundable; they may be used only against a positive tax liability; they are of no value if the producer has no tax liability.

Small Ethanol Producer Credit

Current law provides for an income tax credit of 10¢ per gallon ($4.20 per barrel) for up to 15 million gallons of annual ethanol production by a small ethanol producer, defined as one with ethanol production capacity of less than 30 million gallons per year (about 2,000 barrels per day). This credit, which was enacted as part of the Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508), is strictly a production tax credit available only to the manufacturer who sells the alcohol to another person for blending into a qualified mixture in the buyer's trade or business, for use as a fuel in the buyer's trade or business, or for sale at retail where such fuel is placed in the fuel tank of the retail customer. Casual off-farm production of ethanol does not qualify for this credit. The small ethanol producer credit is limited in the same way as the blender's tax credit. The amount of the credit is reduced to take into account any excise tax exemption claimed on ethanol output and sales.

Tax Deduction for Clean-Fuel Vehicles

The Energy Policy Act of 1992 (P.L. 102-486) created a new federal tax deduction for clean-fuel-burning vehicles, including vehicles that run on alcohol fuels. This tax deduction has two components: a tax deduction for individuals or businesses that purchase vehicles that run on alternative fuels; and a tax deduction for businesses that invest in equipment for storing and dispensing the clean fuel and otherwise refueling clean fuel burning vehicles.(9)

With the first incentive, taxpayers can deduct from adjusted gross income a portion of the costs associated with the purchase of dedicated alternative fuel vehicles (AFVs), or the costs of converting vehicles so that they can operate on clean-burning alternative fuels (dual fuel AFVs) in addition to gasoline. Dedicated AFV's are new vehicles designed to run on an alternative fuel only. For dedicated AFVs, costs up to $2,000 for qualified property can be deducted for a vehicle up to 10,000 lbs., up to $5,000 for a truck or van of 10,000 to 26,000 lbs., and up to $50,000 for a truck or van over 26,000 lbs. Qualified property for a dedicated AFV includes the full cost of the engine, the fuel delivery system, and the exhaust system. For a dual-fuel vehicle, the qualified cost is limited to the incremental cost of the same components compared with the systems for conventional fuels.

With the second incentive, installation of refueling equipment for alternative fuels is provided with an annual tax deduction of up to $100,000 for the costs of installing alternative fuel storage and dispensing equipment. Qualifying property includes equipment usually purchased by retail service stations and associated with the storage and dispensing of the alternative fuel into the AFVs.

For both of these tax incentives, alternative fuels are defined as compressed natural gas, liquefied petroleum gas, liquefied natural gas, hydrogen, electricity, and any other fuel that includes 85-percent alcohol fuels, ether, or any combination of these. In addition, all of the property that qualifies for the deduction -- the new vehicle, the conversions equipment, or the refueling equipment -- must be new. Qualifying vehicles must meet any applicable federal and state environmental standards. For business taxpayers, the basis of the property for purposes of the depreciation deduction is reduced by the amount of clean-fuel-vehicle deduction. In general, each of these deductions terminates at the end of 2004. But there is a phase-out provision in the case of new clean-fuel burning vehicles or retrofit equipment. The deduction is phased-out evenly over a three-year period beginning in January 2002.

Production Tax Credit for Unconventional Fuels (The §29 Credit)

Production of certain types of alcohol fuels may qualify for a non-refundable income tax credit. The credit is also available for a broad variety of fuels derived from various alternative energy resources (such as oil from tar sands or shale, gas from coalbeds, brine or tight formations). This is the alternative fuels production tax credit, also known as the section 29 tax credit.

Certain types of alcohol fuels -- alcohol produced from coal and lignite -- could qualify for this credit. Thus, both ethanol and methanol could technically qualify for this credit, although, in reality, there is little if any production of synthetic fuels from coal in the United States. Moreover, alcohol fuels produced from coal or lignite may be used as feedstocks, unlike other fuels, without invalidating the tax credit. Alcohol fuels produced from biomass do not qualify for this credit, although gas produced from biomass does qualify for the credit.

Every barrel of qualifying fuels (including alcohol fuels) receives a credit of $3.00 in real terms (using 1979 as the base year and the GNP deflator as the price index).(10) For 1996 production, the credit was about $6.00 per barrel of oil (equivalent to about $1.07 per thousand cubic feet of gas).

The availability of the credit depends on the price of oil and is determined by comparing the average wellhead price of domestic crude oil (called the reference price) with a trigger or base price. When oil prices are "low" the credit is available; when oil prices are high the credit is phased out. More specifically, when the reference price of oil is below a base 1979 price of $23.60 adjusted for inflation, the tax credit becomes available; when the oil price reference price is between $23.50 and $29.50, the credit is phased-out proportionately; when the oil reference price is above the inflation adjusted price of $29.50, no credit is available. These trigger or threshold prices are adjusted for inflation so that in any year a comparison is made between the market price of oil in that year (using West Texas Intermediate at the wellhead) and the inflation adjusted trigger prices. For example, in 1996, the market price of crude oil (the reference price in nominal terms) was about $18.00 per barrel, and the phase out trigger range was $47.00-$59. Thus the alternative fuels credit was available and would have been completely phased out had oil prices been above $59 per barrel.

The alternative fuels production credit is generally available for fuels produced before year 2002. However, except biomass gas and synthetic fuels, the production facilities (or wells) must be placed in service (or drilled) after 1979 and before 1993. This is the placed-in-service rule. The credit is reduced in proportion to any subsidized energy financing (grants, loans, tax-exempt financing) which may be used. This is done to prevent "double dipping." The credit is also reduced "dollar-for-dollar" by the enhanced oil recovery credit of section 43 and by any business energy tax credits claimed for equipment which is used to produce the fuel to the extent that this credit is still being claimed.

Endnotes

1. On the complex structure of transportation fuel taxes see: U.S. Library of Congress.Congressional Research Service. Transportation Fuel Taxes Early in the 105th Congress. CRS Report 97-326 E by Bernard A. Gelb, March 17, 1997. Washington.

2. The Bureau of National Affairs, Inc. Daily Tax Report. Lawmakers Launch Drive Against Ethanol Credit. March 14, 1997. p.G-1.

3. A 0.1¢ Leaking Underground Storage Tank (LUST) trust fund rate expired on January 1, 1996. The LUST trust fund is a federal program that finances the cost of cleaning up spills from underground tanks.

4. The expiration dates for the two excise tax components vary by type of fuel. See U.S. Congress. Congressional Research Service. Alcohol Fuels Tax Incentives and EPAs Renewable Oxygenate Requirement. CRS Report #94-785E, Oct. 7, 1994, by Salvatore Lazzari. Washington. p.3.

5. Although blends of gasoline with biomass-derived methanol would also qualify under the IRC, such blends are disqualified under the Clean Air Act because of the associated increase of emissions of ozone-forming pollutants.

6. However, as discussed below, methanol from natural gas when used as a straight fuel (at least 85% methanol) qualifies for a 7.0¢ per gallon exemption.

7. As a practical matter, there is little if any production capacity in the United States for methanol produced from biomass resources.

8. 0n the structure of excise tax on the various alternative transportation fuels such as ethanol, methanol, and the various gases see: U.S. Library of Congress. Congressional Research Service. The Tax Treatment of Alternative Transportation Fuels. CRS Report 97-195 E by Salvatore Lazzari, February 7, 1997. Washington.

9. For a more detailed discussion of these provisions see: U.S. Library of Congress. Congressional Research Service. Energy Tax Provisions of the Energy Policy Act of 1992. CRS Report # 94-525E, by Salvatore Lazzari. Washington, 1994.

10. Technically, the amount of the credit is linked with the BTU (British Thermal Unit) content of oil. Each 5.8 million BTU's of fuel qualifies for the $3.00 credit.