United States: Prohibition Pitfalls in an Ethanol Economy

Against the backdrop of record oil prices, geopolitical instability in the Middle East and the war on terror, last year the U.S. Congress passed significant new incentives for ethanol production. In addition to substantial subsidies, tax credits and protective tariffs already in place, the Energy Policy Act of 2005¹ imposes an escalating mandatory target for U.S. consumption of renewable fuels (mostly ethanol by default) that reaches 7.5 billion gallons in 2012.² The Act effectively doubles the market for ethanol, which stood at 3.4 billion gallons in 2004.³ In 2006 alone, projections call for ethanol consumption to rise by nearly 50 percent.⁴ The industry is poised to continue its brisk growth.

As companies and investors respond to government inducements by pouring money into alcohol fuel plants (AFPs), they must remember that ethanol is alcohol, and alcohol is a highly-regulated substance. Thus, the same regulatory agencies that regulate alcohol beverages also exercise jurisdiction over the production and distribution of ethanol to ensure that alcohol destined for use as fuel is not diverted for use in beverages. This overlay of alcohol regulations on the establishment and operation of AFPs puts an obscure but important legal compliance burden on AFP operators.

Because Congress and the states want to encourage ethanol production, regulations related to ethanol production are less stringent than those applied to the alcohol beverage industry. It is relatively easy, for example, to obtain a federal license as a "small" producer—one making 10,000 "proof gallons"⁵ of ethanol per year or less. Like producers of distilled spirits for other uses, ethanol producers that do not qualify as "small" must obtain a surety bond to safeguard the potential revenue from the excise taxation of alcohol created by an AFP. Certain AFP applicants also benefit from an unusual presumption of approvability not enjoyed by other producers of alcohol: If federal regulators do not act within a 60 day window to deny an application, the proposed plant receives automatic approval.

Notwithstanding the relatively favorable regulatory regime compared to the one applied to other alcohol producers, AFP operations require attention to legal details in order to comply with the law. For example, amendments or new filings are required when the status of an ethanol producer changes—often after a transfer of ownership. Other regulatory filings may be triggered upon an upgrade of the plant’s production capacity, thereby changing the plant’s federal regulatory classification. An AFP must keep good records as well, especially of production, shipments and of rendering the alcohol unfit for human consumption. Purchasers of an AFP should pay particular attention to potential regulatory pitfalls. For example, federal law generally allows a new AFP owner to operate under the old owner’s permits in limited circumstances, and only if the new owner submits a new application within 30 days of the change in ownership. Moreover, the new owner may find that the plant’s previous owner was not in compliance in the first place.

Noncompliance carries potentially ruinous penalties. Most significantly, AFP owners risk being taxed at the excise tax rate that would apply to alcohol destined for human consumption on past production. Federally, that rate of $13.50 per proof gallon translates to almost $27 per actual gallon for the almost pure alcohol normally created during ethanol production. While the federal and state governments generally do not want to drive an AFP into bankruptcy, they might exact stiff penalties and, in any case, it is hardly desirable to place your investment entirely at the government’s mercy.

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