Tax Provisions of the Economic Stimulus Act
The American Recovery and Reinvestment Act of 2009 (the “Act”), signed into law by President Obama on February 17, is the federal government’s greatest exercise of its fiscal might in the face of an economic recession since World War II. The Act authorizes spending $507 billion on infrastructure, energy, education, state medicare costs, unemployment benefits, and a host of other projects, including what some have labeled Congressional pork. In this newsletter we will examine the Act’s $282 billion in tax cuts and tax incentives, focusing on provisions aimed at business taxpayers.
Tax relief in the Act is heavily weighted towards individuals, especially middle- and lower-income taxpayers. The members of our Tax Practice Group have also prepared separate discussions of other parts of the Act that may be of more specialized interest.
Businesses will also be affected by what isn’t in the Act, especially its lack of action on the looming sunset of the Bush tax cuts. Not only will the federal estate tax spring back to pre-2002 levels after having disappeared for a single year in 2010, but the 15% maximum rate on corporate dividends and long-term capital gains will revert to 20% on January 1, 2011 unless Congress does something before then.
The principal business provisions of the Act are discussed in the following sections:
PROVISIONS TARGETED AT PROVIDING TAX RELIEF FOR BUSINESSES
- Extension of Bonus Depreciation
Under prior law, taxpayers were allowed “bonus” depreciation equal to 50% of the costs of certain depreciable property (e.g., property with a recovery period of less than 20 years, water utility property, computer software and leasehold improvements) placed in service during 2008, in addition to the normal first year depreciation allowance under the Code. The Act extends bonus depreciation for qualifying property placed in service during 2009.
- Extension of Section 179 Expensing
Section 179 allows certain taxpayers to elect to immediately deduct the cost of qualifying property placed in service during the taxable year, rather than recovering the cost of such property through depreciation or amortization deductions over time. Qualifying property generally includes tangible personal property used in a trade or business (including canned software). The taxpayer’s section 179 deduction may not exceed the taxable income derived from the applicable trade or business, and any excess section 179 deduction may be carried forward to subsequent tax years. With respect to taxable years beginning in 2008, the maximum amount that a taxpayer could expense under section 179 was increased to $250,000. However, the maximum expense allowance was reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeded $800,000. The Act extends both the temporary $250,000 maximum and $800,000 threshold for taxable years beginning in 2009.
- 5-Year Carryback of Net Operating Losses (“NOL”) for Small Businesses
Prior to the Act, a NOL incurred by a taxpayer generally could be carried back to the two taxable years before the year that the loss arose, and carried forward to each of the succeeding twenty taxable years after the loss year. Certain NOLs were also eligible for three or five year carryback periods, e.g., President declared disasters for small businesses or businesses located in the Gulf Opportunity Zone. The Act provides an election for eligible “small businesses,” i.e., those having average annual gross receipts of $15 million or less for the prior three tax years, to extend the NOL carryback period from two years up to a maximum of five years for NOLs incurred in tax years that end in 2008.
To expedite the refund process, taxpayers should consider filing applications for tentative carryback adjustments when claiming refunds with respect to the extended NOL carryback period. Fiscal year taxpayers also may elect to apply the extended carryback period to NOLs incurred in a tax year that begins in 2008 (but the extended period can apply to only one taxable year). Several transitional rules may also apply to NOL elections made before the effective date of the Act, such as elections to forgo the normal two-year carryback period, most of which may require taxpayers to act by April 18, 2009 in order to take advantage of the extended NOL period. Taxpayers that had NOLs in 2008 should study the various options available under the Act carefully to determine whether an election will be beneficial, and if they do decide to file an election, whether extending the carryback period to 3, 4 or 5 years will produce the greatest benefit.
- Temporary Reduction of S Corporation Built-In Gains Holding Period From 10 Years to 7 Years
An S corporation is generally not subject to income taxes; rather the income or losses pass through to its owners. However, if an S corporation was once taxed as a C corporation (or acquired assets from a C corporation in a carryover basis transaction), the S corporation may be subject to the built-in gains tax. On the date the corporation elects S status, a “snapshot” is taken of the corporation’s assets, and the amount of any built-in gain (or loss) that may exist in each asset – including goodwill or going-concern value – is determined by comparing the fair market value of the assets to their adjusted basis on the effective date of the S election. Prior to the Act, the amount of built-in gain realized on an S corporation’s disposition of built-in gain assets within the 10-year period following the date of the election was subject to corporate-level tax at the highest marginal tax rate.
The Act temporarily reduces the built-in gain recognition period from 10 to 7 years for certain dispositions that take place during 2009 and 2010. Accordingly, if a corporation elected S status (or acquired assets from a C corporation) on January 1, 2002, that corporation will not be subject to the built-in gains tax for asset dispositions in 2009 or 2010. If a corporation elected S status (or acquired assets from a C corporation) on January 1, 2003, the corporation will not be subject to the built-in gains tax for asset dispositions in 2010. The Conference Report indicates that the original 10-year recognition period should not apply after 2010 for S corporations that meet the shortened 7-year period for 2009 or 2010; however, the language of the Act doesn’t support this reading. A technical correction may be necessary to clarify whether certain dispositions in 2011 or 2012 are still subject to the built-in gains tax.
- Special Rules Applicable to Qualified Small Business Stock for 2009 and 2010
The Act increases the exclusion for qualified small business stock (“QSBS”) sold by an individual to 75% of the seller’s gain, but only for stock issued after February 17, 2009 and before January 1, 2011.
To qualify as a small business the stock of which is eligible for QSBS treatment, a corporation’s gross assets cannot exceed $50 million when the stock is issued and the corporation must meet certain active trade or business requirements. Under prior law the exclusion was 50% for QSBS held for more than five years; the new law increases the exclusion percentage to 75%. The 25% portion of gain includible in taxable income is taxed at a maximum rate of 28% (i.e., it isn’t eligible for the lower long-term capital gain rate of 15% or the 20% rate due to come into effect in 2011).
In order for gain on the sale or exchange of QSBS to be excludible, the taxpayer generally must have acquired the stock at original issue. The amount of gain eligible for the exclusion is the greater of (i) ten times the taxpayer’s basis in the QSBS, or (2) $10 million for single taxpayers and taxpayers filing joint returns; $5 million for married filing separately, less the total amount of eligible gain taken into account by the taxpayer on dispositions of QSBS issued by the corporation in earlier tax years.
- Deferral of Cancellation of Indebtedness Income for Reacquisition of Debt Instruments
The Act allows a taxpayer that reacquires the taxpayer’s own debt instrument at a discount during the 2009 or 2010 calendar years to elect to recognize the cancellation of indebtedness (“COD”) income ratably over a five-year period beginning in 2014. Prior to the passage of the Act, a taxpayer that acquired its own debt at a discount would have been required to recognize the entire amount of the discount as COD income in the year of acquisition absent an exclusion under Section 108(a) (e.g., the bankruptcy or insolvency of the debtor).
The provision applies to any debt of C corporations and to debt of other persons and entities if the debt is issued in connection with the conduct of a trade or business. Almost all types of debt instruments come within the parameters of the deferral provision, including bonds, debentures, notes, and any other instrument representing true debt. The new deferral provision also applies to any reacquisition of debt by a person related to the debtor, and treats the following types of transactions as reacquisitions:
- Debt-for-Cash Exchange – reacquisition of a debt instrument in exchange for cash.
- Debt-for-Debt Exchange – reacquisition of a debt instrument in exchange for another debt instrument (including a deemed exchange resulting from a modification of the debt instrument).
- Equity-for-Debt Exchange – reacquisition of a debt instrument in exchange for an ownership interest in the taxpayer (i.e., stock of a corporation, a partnership interest in a partnership or a membership interest in a limited liability company).
- Contribution to Capital – reacquisition by a debtor corporation from a shareholder as a contribution to capital.
- Complete Forgiveness – cancellation of the debt without consideration.
The Act restricts deductibility of any original issue discount in debt-for-debt exchanges (including a deemed debt-for-debt exchange). Under the new provision, a taxpayer who elects to defer COD income must also defer deducting that portion of OID that doesn’t exceed the amount of COD income deferred. In these cases, OID will be deductible only as the COD income is recognized. If the OID deduction exceeds the COD income realized and deferred in the debt-for-debt exchange, the OID deduction is not affected by the new provision to the extent of such excess.
If a taxpayer elects to defer the recognition of COD income under this new provision, none of the Section 108(a) exclusions can apply to the COD income. The exclusions under Section 108(a) allow for complete nonrecognition of the COD income rather than mere deferral; however, the “price” of exclusion under Section 108(a) is the reduction of certain tax attributes such as net operating losses, tax credits, and tax basis. The new deferral provision thus gives debtors who qualify for a Section 108(a) exclusion another option to consider in workouts and other debt restructuring situations.
- Modification of Rules for Original Issue Discount on Certain High Yield Obligations
The Act suspends the “applicable high-yield discount obligation” (“AHYDO”) rules for debt obligations issued after August 31, 2008 and prior to the end of 2009 that are exchanged for debt obligations that are not AHYDOs and are issued by the issuer of the AHYDO. The relief does not apply to certain contingent interest obligations and to obligations issued to a person related to the issuer.
The AHYDO rules apply to debt instruments issued by C corporations where (i) the maturity date is more than five years from the issue date; (ii) the yield to maturity equals or exceeds the sum of the applicable federal rate in effect for the calendar month of the issuance plus five percentage points, and (iii) the instrument is deemed to have significant original issue discount. If the AHYDO rules apply, the issuer gets no deduction for that portion of the OID deemed to be a return on equity and only gets to deduct the remainder of the OID when paid. In the absence of the AHYDO rule, the OID would generally all be deductible by the issuer as interest, amortized over the life of the instrument.
For all debt obligations issued on or after January 1, 2010 (i.e., once the temporary suspension period described above has terminated), the Act provides that the IRS will be able to use a rate higher than the applicable federal rate in making AHYDO determinations if the IRS determines that the higher rate is appropriate in light of distressed conditions in the debt capital markets.
- Pass Through of Credits from Tax Credit Bonds
The Act allows regulated investment companies (mutual funds) to elect to pass through to its shareholders the tax credits from certain tax credit bonds (See Tax-Exempt Bonds for details). Tax-credit bonds include qualified forestry conservation bonds, new clean renewable energy bonds, qualified energy conservation bonds, qualified zone academy bonds, and Build America Bonds.
- Withholding Tax on Government Contractors Delayed
A 3% withholding tax on government contractors was scheduled to go into effect in 2011. The Act delays the effective date of this tax for a year so that it does not become effective until 2012. The tax applies to payments made by federal, state, and local governments or governmental agencies, and also applies to government vouchers or certificates that effectively function as payments for property or services. Several exceptions apply, which contractors and vendors should review closely. Under the House bill, the withholding tax would have been repealed completely; under the final Act, government contractors and vendors at least will not have tax withheld until 2012.
- Treatment of Certain Ownership Changes Under Economic Stabilization Act of 2008
The Act provides that Section 382 limitations on the use of NOLs and built-in losses by loss corporations undergoing ownership changes will not apply when the ownership change (i) occurs under a restructuring plan required under a loan agreement or a commitment for a line of credit entered into with the Department of the Treasury under the Economic Stabilization Act of 2008 and (ii) is intended to result in rationalization of the costs, capitalization, and capacity with respect to the manufacturing workforce of, and suppliers to, the taxpayer and its subsidiaries. This special rule, however, does not apply to an ownership change if, immediately after the ownership change, any person (other than a voluntary employees’ beneficiary association) owns 50% or more of the stock (by vote or value) of the post-ownership change corporation. For these purposes, related persons are treated as a single person and members of a group of persons acting in concert are treated as related persons. This provision applies to ownership changes that take place on or after February 17, 2009.
- Revocation of IRS Notice 2008-83
Code section 382 limits the ability of a loss corporation to use NOLs and built-in losses carried forward when the loss corporation undergoes an ownership change. In October 2008, the IRS issued Notice 2008-83, which allowed unlimited use of losses on loans or bad debts incurred by a bank following its acquisition.
The Act repeals IRS Notice 2008-83 prospectively (i.e., transactions completed prior to January 17, 2009 will continued to be covered by the Notice). For ownership changes occurring after January 16, 2009, financial institutions will be unable to rely on the Notice. However, taxpayers may rely on the Notice with respect to ownership changes occurring after January 16, 2009 that were made (i) pursuant to a written binding contract entered into on or before January 16, 2009, or (ii) pursuant to a written agreement entered into on or before January 16, 2009 and which was described on or before such date in a public announcement or in a filing with the Securities and Exchange Commission required by reason of such ownership change.
- Work Opportunity Credit Expanded to Include Unemployed Veterans and “Disconnected Youth”
Under current law, businesses may claim a work opportunity tax credit equal to 40% of the first $6,000 of wages paid to employees who are in certain targeted groups. The Act creates two new targeted groups that will qualify for the credit if they are hired in 2009 or 2010. The first is “unemployed veterans.” Individuals qualify as unemployed veterans if they were discharged or released from active duty within five years of being hired and have received unemployment compensation for more than four weeks in the year before being hired. The second group is “disconnected youth.” Individuals qualify as disconnected youths if they are between the ages of 16 and 24, have neither been regularly employed nor attended school in the past 6 months, and are “not readily employable by reason of lacking a sufficient number of basic skills.” Both unemployed veterans and disconnected youths must be certified as such by the local state unemployment agency.