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1 TaxUpdate Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington June 2010 Follow Us on Twitter Speakers Corner On July 12, Todd B. Reinstein will be speaking on Recent Developments Affecting Section 382 at the Tax Management Corporate Tax and Business Planning Review Luncheon in Washington, D.C. On July 16, Lance Jacobs will speak on Sales and Use Tax at a seminar hosted by Lorman Education Services at the Wyndham Hotel Pittsburgh-University Place in Pittsburgh, PA. Pepper Hamilton s Independent Contractor Compliance Practice Group and Marcum llp are pleased to present a series of Breakfast Briefings highlighting the legal and legislative challenges facing employers that use independent contractors, and focusing on ways businesses can continue to use independent contractors in compliance with applicable labor, tax and employee benefit laws. Lisa B. Petkun will be speaking in Pepper s Berwyn office ( July 13), Philadelphia office ( July 14) and Princeton office ( July 22). Visit for more information. Ms. Petkun will be speaking in Pepper s New York office on July 20. Visit events.aspx?announcementkey=626 for more information. The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please send address corrections to phinfo@pepperlaw.com Pepper Hamilton LLP. All Rights Reserved. Notice Formalizes Hold Constant Principle Found in Recent Section 382 Rulings Annette M. Ahlers ahlersa@pepperlaw.com In t r o d u c t i o n, No t i c e The Internal Revenue Service (IRS) released Notice on June 11, 2010, which provides guidance on fluctuations in value between different classes of corporate stock when measuring owner shifts for Section 382 purposes. The notice outlines two separate methods for applying the Section 382(l)(3)(C) fluctuation in value rules. Section 382, In General Congress enacted Section 382 to prevent trafficking in federal tax net operating losses (NOL). Section 382 generally limits a loss corporation s ability to use its historic NOLs against future taxable income if such loss corporation undergoes an ownership change. An ownership change occurs when one or more of the loss corporation s 5-percent shareholders increase their interest in the loss corporation by more than 50 percentage points. Section 382(l)(3)(C), Fluctuation in Value Statute Section 382(l)(3)(C) states that [e]xcept as provided in regulations, any change in proportionate ownership which is attributable solely to fluctuations in the relative fair market values of different classes of stock shall not be taken into account. For many years controversy has existed as to how to interpret the fluctuation in value rules found in Section 382(l)(3)(C), with respect to determining how much of the ownership percentage is carried by each class of stock on each testing date, in order to determine if an ownership change has occurred under Section 382. This publication may contain attorney advertising. in this issue... 1 Notice Formalizes Hold Constant Principle Found in Recent Section 382 Rulings 4 Quotable 5 It s Not Easy Being Green: A Survey of Green Incentives and Credits in the Mid-Atlantic Region 8 Pepper Hamilton s Tax Practice Group

2 Without this special rule, a loss company could presumably undergo an ownership change as its fortunes gradually changed for the worse and the preferential terms of preferred classes of stock kick in to cause the preferred stock to represent a larger portion of the overall equity of the loss company, as compared to the common stock. Given that the policy behind Section 382 focuses on not allowing new shareholders to benefit from the losses of the company that were accumulated before they were owners, there is no reason to cause an ownership change and impose a limitation when no shareholders change and no equity changes hands. While the IRS has issued rulings to specific taxpayers over the past few years clarifying how Section 382(l)(3)(C) should be interpreted for the taxpayer s situation, 1 Notice provides more general guidance that will be helpful to loss companies that do not obtain a private letter ruling on their specific facts. Two Methods of Application In interpreting the fluctuation in value rules, Notice adopts two methodologies with one methodology allowing for two alternative approaches. FVM Fu l l Va l u e Me t h o d o l o g y The first methodology is the Full Value Methodology (FVM), which is close to a strict interpretation of the statutory language. Under the FVM the ownership interest of each shareholder is determined on a pure valuation approach on each testing date, regardless of whether a particular shareholder or group of shareholders does anything to affect their equity ownership. For example, if a testing date is triggered because of the issuance of stock under an employee stock purchase plan, then each class of stock of the loss corporation is valued and compared to the overall value of the loss corporation. The FVM approach would require the loss corporation to take into account any fluctuations in value that occurred since the loss company s last testing date in determining the percentage ownership shifts among the 5-percent shareholders. The notice provides that the FVM is essentially a mark-to-market approach for all shares on each testing date. Under this approach, there would be no mark-tomarket until an equity event occurred to trigger a testing date. HCP Ho l d Co n s t a n t Principle The second methodology is more complicated. The Hold Constant Principle (HCP) is the approach taken by the IRS in several recent private letter rulings. 2 The HCP essentially allows the As with most Section 382 issues, the benefits of the FVM or the HCP methodologies will require significant information gathering on historical pricing, terms, and sales and other dispositions of the loss corporation stock over a significant period of time. relative value of each class of stock to be set at the time the stock is issued by holding constant the value of the new class of stock compared to the existing classes of stock at the issuance relative value for purposes of valuing such stock on subsequent testing dates. The HCP is applied by issuance and by shareholder. In addition, dilutive adjustments are made for subsequent issuances and accretive adjustments are made for subsequent redemptions. HCP, nevertheless, takes into account value fluctuation for actual acquisitions of stock. Notice includes an example of the Hold Constant Principle. In the example in the notice, on Date 1 Shareholder A purchased one share of preferred stock for $20 and Shareholder B purchased two shares of common stock for $80 (80 percent). Two years later the common stock of X is worth $2.50 a share and the preferred stock is worth $20. B sells one share of common stock to C. For purposes of determining whether X has an ownership change, the percentage changes will be calculated as follows: SH P C Date 1% Testing Date % % Change Increase A 1 20% 20% 0% B 1 80% 70% 0% C 1 0% 10% 10% 2

3 TaxUpdate Thus, only a 10-percent increase in percentage ownership has occurred because of this sale. The IRS will not challenge a taxpayer s application of the HCP (or the FVM) as long as such method is reasonable and applied consistently. Specifically, the IRS mentions two separate alternatives that can be used to apply the HCP, and that both of the described HCP alternatives are considered reasonable. Alternative one calculates the percentage interest represented by a tested share on a testing date beginning with the value of such share on the testing date and then adjusting such percentage of value based upon changes in the relative value of the subject share to other stock of the loss corporation that has changed in value since the tested share s acquisition date. Once a particular shareholder sells its stock, the percentage owned by him is adjusted to take the disposition into account. Thus, it appears that in order to take advantage of the HCP, the relevant shareholder cannot have participated in any transaction in its stock that adjusted the value or percentage interest in the tested shares, or sold or disposed of the relevant shares in a transaction occurring on a testing date. Therefore, if the shareholder holds constant, there is no percentage change adjustment with respect to his particular ownership percentage. Under the second alternative in the HCP approach, the percentage interest in the loss corporation that is represented by the tested share is determined on its date of issuance, adjusting for subsequent dispositions and for the subsequent issuances or redemption of other stock. If the holder of these shares does not buy or sell additional stock, their percentage increase in the loss corporation associated with the stock will not increase because of another shareholder s actions, except for redemptions by the corporation. The IRS observes that alternative two may result in fewer calculations by the loss corporation on subsequent testing dates. Because of the timed approach of the HCP methodology, dispositions of shares held by shareholders that acquired their stock at various points in time may create differing percentage ownerships. In determining which shares are being disposed of on a particular disposition date, the loss corporation may take the shares pro rata from all owned shares or use a LIFO method or FIFO method to determine which shares must be taken into account in calculating the percentage interest that is being transferred. Whichever methodology is chosen must be applied consistently by the loss corporation on subsequent testing dates. Disallowed Method The IRS will not treat certain methods as reasonable under Notice For example, the notice states that the IRS intends to challenge a methodology that fixes the relative fair market value of a class of preferred stock to common stock on the issue date of the preferred stock, regardless of the actual value of either class on the subsequent date that a shareholder whose percentage ownership is being computed acquires a share of either such class of stock. Thus, a corporation taxpayer may not freeze the relative values of common and preferred classes of stock notwithstanding fluctuations in value and additional transactions in such stock. Reliance on Notice As mentioned above, Notice specifically allows loss corporations and their shareholders to apply reasonable methods of measuring increases in ownership where fluctuations in value of various classes of stock are present. In this regard, the IRS will not challenge any reasonable application of either an FVM or an HCP, provided that a single methodology (i.e., if using HCP applying LIFO conventions for share dispositions, etc.) is applied consistently as required in the notice. The IRS believes that both alternative one and alternative two of the HCP methodology are reasonable applications of HCP. Taxpayers may rely on Notice prospectively until additional guidance is issued under Section 382(l)(3)(C). In addition, taxpayers may apply the notice retroactively to any past tax year that is still an open year not barred by the statute of limitations. Notwithstanding this permitted retroactive application, taxpayers may not employ a methodology under the notice for an open year if employing such methodology for that open year would have changed the taxpayer s federal income tax liability for a closed year barred by the statute of limitations. Pepper Perspective These rules represent an administrative acknowledgement of a ruling position that has been consistently applied by the IRS over the past few years and provides welcome operating procedures for taxpayers seeking to apply the fluctuation in value rules of Section 382(l)(3)(C). It cannot be used, however, to change a tax liability in a closed tax year or to nullify the effects and stock values from actual sales or dispositions of the loss corporation stock. In addition, the IRS states that it intends to issue regulations under Section 382(l)(3)(C) and would like comments on 3

4 the approach these regulations should take given the approaches sanctioned in the notice and the overall policy and administrable concerns underlying Section 382 in general. Thus, as is the case with most Section 382 issues, the benefits of the FVM or the HCP methodologies will require significant information gathering on historical pricing, terms, and sales and other dispositions of the loss corporation stock over a significant period of time. Without these factual records the methodologies available to address fluctuation in value issues may not be as beneficial. In addition, a modeling exercise also will likely be required to determine the more optimal outcome using either methodology. En d n o t e s 1 See e.g., PLR ( January 11, 2010); PLR ( January 11, 2010); PLR ( January 11, 2010); PLR (December 30, 2009); PLR (December 4, 2009); PLR (October 27, 2009); PLR (September 23, 2009). Quotable Todd B. Reinstein was quoted in BNA s June 14 Daily Tax Report and in CCH s June 17 Federal Tax Weekly on Section 382 guidance in newly issued IRS Notices and On June 29, Todd B. Reinstein was quoted in BNA s Daily Tax Report, CCH s Federal Tax Day and Tax Notes Today with his comments from a Federal Bar Tax Section webinar on newly enacted Section 48D. 2 Id. RSS on Subscribe to the latest Pepper articles via RSS feeds. Visit today and click on the RSS button on the publications page to subscribe to our latest articles in your news reader. 4

5 TaxUpdate It s Not Easy Being Green: A Survey of Green Incentives and Credits in the Mid-Atlantic Region Lance S. Jacobs Over the last ten years, the search for energy efficiency in the form of cleaner, more sustainable forms of energy has made its way into both the federal and state tax laws. Especially at the state level, these incentives can take many different forms and have a bearing on the differing tax liabilities a business faces. This article will survey select incentives and credits that are available to businesses operating in the Mid-Atlantic region. Ma r y l a n d Green Buildings Credit Individuals or corporations can claim an income tax credit for green buildings and green building components in Maryland. To the extent that the credit remains unused because the amount of the credit exceeds the income tax liability, the credit can be carried forward for up to ten years after the taxable year for which the credit is allowed. The amount of the credit varies depending on the nature of the expenditure. One of the available credits is 8 percent of allowable costs for the construction or rehabilitation of a green whole building. A green whole building is a building for which the base building is a green base building and all tenant space is green tenant space. A base building is all areas of a building not intended for occupancy by a tenant or owner, such as structural components, exterior walls, floors and the like. In order to be a green base building, this part of the building must, for new construction, meet certain specified standards of the American Society for Heating, Refrigerating and Air-Conditioning Engineers (ASHRAE), certified as Silver under the Leadership for Energy and Environmental Design (LEED ) criteria, and meet certain other LEED accreditation standards. Allowable costs are capital expenditures, other than for land, incurred after July 1, 2001, for construction or rehabilitation, commissioning costs, interest, architectural, engineering and other professional fees, recording taxes and fees, and certain finishing and furnishings (including lighting, plumbing, electrical and ventilation costs). Telephones, computers (other than electrical wiring), legal fees, site costs, other finishings and furnishings, or the cost of purchasing or installing fuel cells, wind turbines, Especially at the state level, these incentives can take many different forms and have a bearing on the differing tax liabilities a business faces. or photovoltaic modules are not allowable costs. For purposes of the 8-percent credit, allowable costs are capped at $120 per square foot for the base building and $60 per square foot for that portion that comprises tenant space. A separate 6-percent credit is available to owners for allowable costs paid or incurred for the construction of a new green base building or the rehabilitation of an existing building into a green base building. This 6-percent credit is likewise capped at $120 per square foot. A 6-percent credit also is available for owners or tenants for the construction or completion of green tenant space or the rehabilitation of space into green tenant space. The credit for tenant space is capped at $60 per square foot, and is allocated between the owner and the tenant according to specific ordering rules if both incurred costs. In order to qualify for the tenant space portion of the credit, an owner must occupy at least 10,000 square feet, and a tenant must occupy at least 5,000 square feet in order to claim the credit. Additionally, there are credits available for certain costs incurred for the installation of fuel cells that are qualifying alternate energy sources (integrated or non-integrated photovoltaic modules, wind turbines and fuel cells that meet certain requirements). The credits begin in the credit allowance year, which is the later of (1) the year the property for which the credit is sought is placed in service, (2) the year the alternative energy source is 5

6 fully operational, or (3) the earliest taxable year that the initial credit certificate granted by the state permits the credit to be used. The total amount of the green credits granted by the state under the green buildings program is limited to $25 million. The program expires on December 31, The taxpayer can claim the credit by applying for and obtaining an initial credit certificate from the Maryland Energy Administration. Solar Grant Program The Maryland Energy Administration administers a solar grant program. The amount of the grant is equal to the lesser of $2,500 per kilowatt of installed electricity generation capacity of photovoltaic property, or $10,000; or $3,000 or 30 percent of the total installed cost of solar water heating property. Photovoltaic property is solar energy property that uses a solar photovoltaic process to generate electricity and that meets applicable performance and quality standards and certification requirements that are in effect at the time the property is acquired. Solar energy property is equipment that uses solar energy to generate electricity, to heat or cool a structure or to provide hot water for use in a structure, or to provide solar process heat. Similar to the language contained in the energy tax credit found in Section 48 of the Internal Revenue Code, it does not include a swimming pool, hot tub, or any other energy storage medium that has a function other than storage. Solar water heating property is solar energy property that, when installed in connection with a structure, uses solar energy to provide hot water and must meet applicable performance and quality standards and certification requirements in effect at the time of acquisition. Credit for Qualified Energy Resources Corporations can claim a Maryland income tax credit of $0.85 for each kilowatt hour of electricity it produces from qualified energy resources at a qualified Maryland facility over a fiveyear period specified in the credit certificate granted under the program by the Maryland Energy Administration and sold to an unrelated party. If the facility uses qualified energy resources that are co-fired with coal, the credit is limited to $0.05 per kilowatt hour of electricity the corporation produces from qualified energy resources at a qualified Maryland facility during the period. The credit is limited to one-fifth of the maximum amount of the credit granted in the initial credit certificate. Qualified energy resources has the same meaning as it does under Section 45(c) of the Internal Revenue Code, which includes energy produced from wind, closed and open loop biomass, geothermal, solar, small irrigation power, municipal solid waste, qualified hydropower production, and marine and hydrokinetic renewable energy. Various other resources qualified for Maryland purposes are not included in the federal tax provision, including methane or any combustible gas resulting from anaerobic or thermal decomposition resulting from an agricultural operation as well as from a landfill or wastewater treatment plant. A qualified Maryland facility is located within the state, primarily uses qualified energy resources to produce electricity, and is originally placed in service on or after January 1, 2006 but before January 1, The credit is based upon certificates issued upon the approval of a particular project by the Maryland Energy Administration, which can offer no more than $25 million in the aggregate. Credits can be carried forward for up to ten years after the tax year in which the credit arose. Virginia Green Job Creation Tax Credit Virginia has recently enacted a new green job creation tax credit applicable for tax years after January 1, 2010 but before January 1, Taxpayers are allowed a credit for each new green job created in Virginia. A green job is employment in industries relating to the field of renewable, alternative energies, including manufacturing and operation of products used to generate electricity and other forms of energy from alternative sources that include hydrogen and fuel cell technology, landfill gas, geothermal heating systems, solar heating systems, hydropower systems, wind systems and biomass and biofuel systems. The statute allows the Secretary of Commerce and Trade to develop a detailed definition and list of eligible jobs. To qualify, the taxpayer must demonstrate that, after July 1, 2010, the green job was created by the taxpayer and that such job was continuously performed in Virginia during the taxable year. To be considered a job, the job must entail at least 35 hours a week, 48 weeks a year, or at least 1,680 hours per year. A job will not be considered new if it is merely the shifting of responsibilities from one Virginia location to another. The credit is $500 for each new green job with a salary of at least $50,000, and each qualifying taxpayer is allowed a credit for up to 350 jobs created. The credit is taken in $100 increments per job created, starting in the taxable year in which the job has been filled for at least one year and for each of the four succeeding taxable years provided the job is continuously filled during the taxable year. The credit is not refundable, and any excess credit can be carried over for five 6

7 TaxUpdate taxable years. Additionally, the credits granted to a pass-through entity such as a partnership or S corporation pass through to the owners, allocated in proportion to their ownership interests. Clean Fuel Vehicle Job Creation Credit Through December 31, 2011, a corporation is allowed credit for each job created for the following: (1) manufacture of certain major mechanical components for vehicles fueled by clean special fuels; (2) manufacture of components used to convert vehicles designed to operate on gas or diesel to operate on clean special fuels or biofuels; (3) the conversion of vehicles designed to operate on gas or diesel to operate on clean special fuels or biofuels; (4) the manufacture of vehicles designed to operate on clean special fuels; (5) the manufacture of components designed to produce, store and dispense clean special fuels or advanced biofuels; or (6) the production of advanced biofuels. The credit is equal to $700 per job created, taken ratably over three years, from the taxable year in which the job is created and in each of the two successive taxable years. For purposes of this credit, a job is one that requires 40 hours of work a week for at least 40 weeks a year. In order to qualify for the credit, the corporation must demonstrate that the job was created during the taxable year for which the credit was claimed or was continued from the previous taxable year for which the credit was claimed and the employment level in the relevant job or jobs has increased when compared to the previous taxable year. This particular credit has a five-year carryover, and is not refundable. It can be taken by a pass-through entity and passed through to the owners, allocated in proportion to their ownership interests. The credit cannot be taken by an employer who is already taking advantage of Virginia s other major employment credit, the major jobs facility tax credit. Pepper Perspective In Maryland and Virginia, the credits seem to break down across clear lines. Virginia s green jobs credit is closely related to the Virginia major jobs facility tax credit, and is designed, like that credit, to spur employment in the state. Businesses in the targeted segments would be well served to consider basing or expanding their operations in Virginia as this would provide significant tax incentives. The major Maryland credit, on the other hand, encourages green real estate development, and may provide tax advantages to real estate developers considering various locations throughout the region. We anticipate that credits like these, despite the relatively short time frame to take advantage of them, may be extended by the legislature, especially in light of the need for jobs for this economy, as well as the highlighted focus on minimizing our carbon footprint that has resulted from the world s focus on the environmental damage being sustained in the Gulf of Mexico from the oil spill. 7

8 Pepper Hamilton s Tax Practice Group Federal and International Tax Issues Annette M. Ahlers ahlersa@pepperlaw.com Joan C. Arnold arnoldj@pepperlaw.com James W. Barson barsonj@pepperlaw.com Steven D. Bortnick bortnicks@pepperlaw.com Gordon R. Downing downingg@pepperlaw.com W. Roderick Gagné gagner@pepperlaw.com Howard S. Goldberg goldbergh@pepperlaw.com Bryan D. Keith keithb@pepperlaw.com Timothy J. Leska leskat@pepperlaw.com Ellen McElroy mcelroye@pepperlaw.com Marc D. Nickel nickelm@pepperlaw.com Michelle Parten partenm@pepperlaw.com Lisa B. Petkun petkunl@pepperlaw.com Todd B. Reinstein reinsteint@pepperlaw.com Joan M. Roll rollj@pepperlaw.com Laura D. Warren warrenl@pepperlaw.com State and Local Tax Issues Philip E. Cook, Jr cookp@pepperlaw.com Lance S. Jacobs jacobsls@pepperlaw.com Employee Benefits Issues Jonathan A. Clark clarkja@pepperlaw.com David M. Kaplan kapland@pepperlaw.com Andrew J. Rudolph rudolpha@pepperlaw.com 8