Tax Credits for Small Wineries. Winery and Wine Distribution Law

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1 Tax Credits for Small Wineries Winery and Wine Distribution Law Marc R. Greenough Foster Pepper PLLC Quincy, Washington August 5, 2008

2 Tax Credits for Small Wineries Under the Internal Revenue Code of 1986, as amended (the Code ), the following two tax credits are available for wineries: New Markets Tax Credits and Rehabilitation Tax Credits. 1. New Markets Tax Credits (Code Section 45D) A. What is the new markets tax credit? A credit that certain taxpayers can claim on a dollar-for-dollar basis against the federal income tax. Section 45D of the Code provides that a taxpayer can claim a new markets tax credit on each of seven annual credit allowance dates in an amount equal to the applicable percentage of the taxpayer s qualified equity investment in a qualified community development entity ( CDE ). The first credit allowance date is the date on which the investment is first made. The remaining credit allowance dates are the six anniversaries of such date. The applicable percentage is 5% for the first three credit allowance dates and 6% for the remaining credit allowance dates. (Sometimes the new markets tax credit is referred to as a 39% tax credit. Due to the effect of present valuing, this is a misnomer. The tax credit is approximately a 30% credit on a present value basis.) B. What are qualified equity investments (or QEIs )? A qualified equity investment is any equity investment in a CDE that meets the following requirements:

3 (1) the CDE has entered into a credit allocation agreement with the U.S. Treasury Department s Community Development Financial Institutions ( CDFI ) Fund, (2) the CDE designates the investment as a qualified equity investment for purposes of Section 45D of the Code, (3) the taxpayer acquires the equity investment at its original issue, (4) the taxpayer pays cash for the investment (i.e., the investment cannot be obtained in exchange for a promissory note), and (5) the CDE uses at least 85% of the cash received by the CDE to make qualified low-income community investments (the substantially all requirement). In most cases, the CDE is set up as a partnership for federal tax purposes (e.g., either a limited partnership or a limited liability company). The taxpayer makes its equity investment by acquiring a limited partnership or membership interest in the CDE. As a passthrough entity for tax purposes, the tax credits flow through the CDE to the CDE s partners/members, one of which is the entity that received the tax credit allocation from the CDFI Fund and the other of which is the taxpayer/investor. The substantially all requirement must be satisfied for each of the seven years the tax credit can be claimed. This means the CDE must be continually invested in qualified low-income community investments (as described below). This requirement causes most qualified low-income community investments to be structured such that there is no return of equity (if an equity investment) or repayment of principal (if a loan) on the investment during the seven-year credit period. A special rule provides the

4 CDE with a one-year window to reinvest any such return of equity or repayment of principal. While this may seem to provide some flexibility, most investor do not want the CDE to bear the reinvestment risk that accompanies return of equity or loan repayment. The substantially all requirement also tends to cause CDEs to be structured as single-asset entities, which reduces the administrative burden of tracking multiple investments. Reserves not in excess of 5% of the taxpayer s cash investment in the CDE maintained by the CDE for loan losses (or for additional investments in existing qualified low-income community investments) are treated as invested in a qualified low-income community investment. This provides some cushion with respect to meeting the substantially all requirement. C. What are permissible qualified low-income community investments (or QLICIs )? Qualified low-income community investments generally consist of equity investments in, or loans to, qualified active low-income community businesses. A qualified active low-income community business ( QALICB ) is a corporation or a partnership if for the taxable year: (1) at least 50% of the total gross income of the entity is derived from the active conduct of a qualified business within any low-income community; (2) at least 40% of the use of the entity s tangible property is within a lowincome community; (3) at least 40% of the services performed for the entity by its employees is performed in a low-income community; (4) less than 5% of the average of the aggregate unadjusted bases of the property of the entity is attributable to certain collectibles (e.g., artwork, gems, metals, antiques); and (5) less than 5% of the average of

5 the aggregate unadjusted bases of the property of the entity is attributable to certain nonqualified financial property (e.g., debt, stocks, partnership interests, futures). The 50% gross income test will be deemed to be satisfied if the either of the tests described in (2) and (3) can be satisfied at a 50% threshold. If the entity will have no employees, then the 50% gross income test and the test described in (3) will be deemed to be satisfied if the test described in (2) can be satisfied at an 85% threshold. To the extent a QALICB is structured as a single-asset entity that owns its assets in a low-income community, the test described in (2) usually will be satisfied at the 100% level. An entity will be treated as engaged in the active conduct of a trade or business if, on the date the CDE makes its investment in (or loan to) the entity, the CDE reasonably expects the entity to generate revenues within three years of the investment (or loan). A qualified business means any trade or business other than: (i) the rental of property that is residential rental property; (ii) the rental of real property on which there are not located substantial improvements; (iii) the rental of real property to a lessee that does not separately qualify as a qualified business ; (iv) a business consisting predominantly of the development or holding of intangibles for sale or license (e.g., a software company); (v) a golf course; (vi) a country club; (vii) a massage parlor; (viii) a hot tub or suntan facility; (ix) a racetrack or other gambling facility; (x) a liquor store; or (xi) a large farming operation.

6 Low-income communities are census tracts in which the poverty rate is at least 20% or the median family income for such tracts is 80% or less than the area median income. To the extent 5% or more of the aggregate unadjusted bases of an entity s property represents holdings in debt, stocks, and certain other nonqualified financial property, it will not be considered a QALICB. This rule generally prohibits banks from being QALICBs. However, it also prohibits a QALICB from holding capital reserves or debt service reserves in an aggregate amount of 5% (or more) of the QALICB s aggregate basis in property. One exception to this general prohibition exists for working capital reserves, so long as the reserve is not invested in instruments that have terms greater than 18 months. There is a special rule for QALICBs that intend to use the proceeds of the QLICI to finance construction. The rule allows a QALICB to hold proceeds of the QLICI in an amount equal to 5% (or more) of the QALICB s aggregate unadjusted bases in its property if those proceeds will be expended on construction of real property within 12 months after the date the QLICI is made. An entity will be treated as a QALICB throughout the seven-year credit period so long as the CDE reasonably expects, on the date of the investment, that the entity will qualify as a QALICB during such period. This rule does not apply if the CDE owns or controls the voting or management rights of 50% or more of the entity.

7 D. Are new markets tax credits subject to recapture? Yes. A recapture event i.e., an event requiring the investor to recapture credits previously taken can occur for an equity investment in a CDE if the CDE (1) ceases to be a CDE, (2) fails to meet the substantially all requirement for being continuously invested in QLICIs; or (3) redeems or otherwise cashes out the investor s equity investment in the CDE. The investor s federal income tax for the year in which the recapture occurs will be increased generally by the sum of new markets tax credits taken by the investor during all previous years plus interest at the underpayment rate (i.e., the federal short-term rate plus 300 basis points). Properly drafted QEI documents will treat a recapture event as an event of default. However, unlike the standard low-income housing tax credit recapture provisions, CDEs have been effective at limiting their recapture liability to the fees they collect. Since these recapture guaranties generally do not exceed the 15% bad money allowance (i.e., the amount available after meeting the substantially all requirement), an investor generally encounters some recapture risk in a new markets tax credit transaction. Assuming the CDE is structured as a partnership for federal tax purposes, a redemption of the investors partnership interest will not occur if the CDE makes pro rata distributions based on capital interests during a taxable year and such distributions do not exceed the CDE s operating income (as defined by the regulations) for that year. Also, a non-pro rata cash distribution by a CDE to a partner during the taxable year will be not treated as a redemption so long as the distribution does not exceed the

8 lesser of 5% of the CDE s operating income for that taxable year or 10% of the partner s capital interest in the CDE. The bankruptcy of a CDE is not a recapture event. Further, the investor can continue claiming the tax credit after the CDE becomes bankrupt. If a qualified equity investment fails the substantially all requirement, the failure is not a recapture event if the CDE corrects the failure within six months after the CDE becomes aware (or should have become aware) of the failure. Only one correction is permitted for each qualified equity investment during the seven-year credit period. E. How do the credits affect an investors basis in its investment? An investor s basis in a qualified equity investment (i.e., the investment in the CDE) will be reduced by the amount of the new markets tax credit. This reduction occurs on each credit allowance date and can affect the back-end tax liability of the investor when the investor is cashed out of the CDE. Most investors will want to liquidate its investment soon after the seven-year credit period expires. They will look to the manager/general partner to cash out the investor for an amount equal to the investor s tax liability, if any. The developer s accountant (or the accountant retained by the CDE) should be able to perform sensitivity analyses regarding the back-end tax liability in various financing structures.

9 2. Rehabilitation Tax Credits (Code Section 47) A. What are rehabilitation tax credits? The rehabilitation tax credit is a two-tiered credit against federal income tax liability. A 20% credit is available for rehabilitations of certified historic structures, and a 10% credit for rehabilitations of non-historic, non-residential buildings that were first placed in service before A certified historic structure is a building that is either: (1) listed individually in the National Register of Historic Places; or (2) located in a registered historic district and certified by the National Park Service ( NPS ) as contributing to the historic significance of that district. The rules pertaining to rehabilitation tax credit are more complex than those relating to new markets tax credits. The NPS maintains a useful internet web site relating to rehabilitation tax credits ( brochure2.htm). The IRS also publishes an audit guide, the Market Segment Specialization Program Rehabilitation Tax Credit (Rev. 2/2002) (the Audit Guide ), that has a comprehensive analysis of the relevant tax laws pertaining to the rehabilitation tax credit. B. Is the 10% credit available for the rehabilitation of certified historic structures? No. I.R.C. 47(a)(1). This rule forces the taxpayer to decide earlier on whether to pursue the 10% credit or the 20% credit. C. What scheduling challenges are raised by the 20% credit? First, the owner must seek listing on the National Register of Historic Places. An owner seeking

10 the 20% credit can commence rehabilitation after it receives a preliminary determination of significance from the NPS. (However, this can be somewhat risky if the taxpayer expects to substantially alter the existing internal structural framework of the building or change external walls, as such activities could disqualify the building for the 10% credit if the NPS ultimately denies a listing on the National Register of Historic Places.) Second, the owner must file with the state historic preservation office (e.g., Washington s Office of Archaeology and Historic Preservation) a completed Part 1 (Evaluation of Significance) and Part 2 (Description of Rehabilitation) of the NPS s Historic Preservation Certification Application. These should be filed before the rehabilitation is commenced. Third, Part 3 (Request for Certification of Completed Work) must be filed with the state historic preservation office when the rehabilitation is completed. The Audit Guide, at pages 3-2 through 3-4, describes the adverse consequences if Part 1 of the application is not submitted before the building is placed in service (i.e., the building would not qualify for the 20% credit) or the NPS does not certify the completed work within 30 months after the owner files its tax return claiming the credits (i.e., the credits might be subject to recapture). D. When are the tax credits taken? The tax credits generally are taken in the year the rehabilitated building is placed in service. If the building is never taken out of service (e.g., a multiple-floor building that is rehabilitated on a floor-by-floor basis while the other floors remain occupied), then the placed in service date(s) for the various portions of the building will occur when the substantially rehabilitated test of Section 47(c)(1)(C) is satisfied for such portion(s). If the taxpayer cannot use all of the tax credits

11 in that year, the credits can be applied as a carryback to the prior taxable year and carried forward for up to 20 years. E. Who can take the tax credits? Both the 10% credit and the 20% Credit are taken by the entity that is able to charge the expenditures to a capital account. F. What expenditures form the basis of the rehabilitation tax credit? The tax credit is a percentage (10% or 20%) of qualified rehabilitation expenditures. These are capital expenditures for property that is subject to depreciation (and is either nonresidential real property, residential rental property (for 20% credits), or property with a class life longer than 12.5 years) that are made in connection with the rehabilitation of a qualified rehabilitated building. These include costs associated with the work undertaken on the historic building and reasonable architectural and engineering fees, site survey fees, legal expenses, development fees, and other construction-related costs, so long as the costs are added to the property s basis. G. What expenditures are excluded from consideration? Excluded from the definition of qualified rehabilitation expenditures are: expenditures for which straight-line depreciation is not used; amounts paid to acquire the building; expenditures related to the expansion of an existing building, new building construction, parking lots, sidewalks, landscaping and other facilities related to the building; expenditures for furniture, appliances, cabinets, moveable partitions, tacked (and not glued) carpeting, and other furnishings; expenditures for the rehabilitation of tax-exempt use property (i.e., property subject to certain leases or ownership by government entities and nonprofit entities); and expenditures made by a lessee if the remaining term of the lease (upon

12 completion of the rehabilitation) is less than the recovery period for depreciation purposes. H. What are the minimum expenditure requirements? During any 24- month period selected by the taxpayer, the taxpayer s qualified rehabilitation expenditures (as described above) must exceed the greater of $5,000 or the adjusted basis of the building and its structural components as of the start of such 24-month period (the substantially rehabilitated test). The 24-month period can be extended to 60 months if architectural plans and specifications completed prior to the rehabilitation reflect that the rehabilitations will occur in phases. The adjusted basis of a building is generally the purchase price, minus the cost of land, plus improvements already made, minus depreciation already taken. A special rule requires that the adjusted bases of the owner of the building, the owner of any condominium unit (if the building is a condominium) and of lessees in the leasehold and leasehold improvements be aggregated for purposes of the substantially rehabilitated test. I. How does the 10% credit differ from the 20% credit? The 10% credit is not available for rehabilitations of certified historic structures. The 10% credit is not available for residential rental property. The 10% credit can be claimed only for buildings first placed in service before The 10% credit can be claimed only if: (1) at least 50% of the building s walls existing at the time the rehabilitation began remain in place as external walls at the work s conclusion; and (2) at least 75% of the building s existing external walls remain in place as either external or internal walls; and (iii) at least 75% of the building s internal structural framework remain in place. A taxpayer claiming the 10% credit is not required to file Part 1, Part 2 or Part 3 applications, or to obtain a final

13 NPS certification, and is not at risk of having the NPS revoke its certification after the credit has been claimed (e.g., if the rehabilitation was not completed properly or if unapproved alterations were made within five years after the rehabilitation was certified). J. How are rehabilitation tax credits claimed? Both the 10% credit and the 20% credit must be claimed on IRS Form 3468 for the tax year in which the rehabilitated building is placed in service. For 20% credits only, the NPS certification of completed work (based on the Part 3 submittal) must be filed with the tax return claiming the tax credit, if received. Otherwise, a copy of the first page of the Part 2 submittal (showing evidence that it has been received by either the state historic preservation office or the NPS) must be filed with the tax return. If the taxpayer then fails to receive final certification within 30 months after claiming the 20% credit, the taxpayer must agree to extend the statute of limitations for claiming back taxes. If the NPS subsequently denies certification, the 20% credit will be disallowed (thereby triggering recapture of the credits). K. What is the five-year hold period? The taxpayer must own the building for five full years after completing the rehabilitation (i.e., the fifth anniversary of the placement in service date) or suffer recapture. If the building is disposed before the first anniversary of the placement in service, 100% of the credit claimed must be paid by the taxpayer as additional income tax. This percentage decreases by 20% on each subsequent anniversary of the placement in service date. Recapture also can occur if the building is owned by a partnership for federal tax purposes (e.g., an LLC or limited partnership). A disposition of the partnership s property may be deemed to occur if within a 12-month period there is a transfer of 50% or more of the interests in partnership

14 capital and profits. Therefore, an investor partner in a tax credit partnership likely will be required to maintain its partnership interest until at least the fifth anniversary of the placement in service date. Recapture also will occur if the building is destroyed by a casualty within the five-year hold period. L. How does the rehabilitation credit affect depreciation? The depreciable basis of a rehabilitated building must be reduced by the full amount of the tax credit claimed. This prevents taxpayer s from double-dipping by claiming losses and tax credits upon the same expenditures.