Tax Alert. The American Recovery and Reinvestment Act of February 20, 2009

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1 February 20, 2009 The American Recovery and Reinvestment Act of 2009 On February 17, 2009, President Obama signed into law the much publicized American Recovery and Reinvestment Act of 2009 (ARRA) which contained $787 billion worth of tax incentives and spending provisions intended to help revitalize the economy. The provisions range from significant relief for businesses that restructure their debt, to those that encourage individuals to make investments in houses and cars. Notable incentives are provided for energy investments it is truly the time to become clean and green. Below are highlights of key elements of the act, organized in three sections - business, energy and individual provisions. BUSINESS PROVISIONS I. General Deferral of Debt Cancellation Income When debt is cancelled or repurchased at a discount, cancellation of indebtedness income may be generated. Under the new law, if a corporation or any entity that issues debt in its business has the debt discharged or reduced in 2009 or 2010, rather than having the income included in the year of the transaction, the taxpayer can elect to be taxed on the cancellation of indebtedness income ratably over a period of years. For income arising in 2009 or 2010 the income inclusion rules are the same, and the income is included in each year from 2014 to 2018, inclusive. The discharge can occur by: the debtor or a related party acquiring the debt for cash or for another debt, the complete forgiveness of the debt, the contribution of the debt to capital, or the exchange of the debt for stock or a partnership interest. Suspension of Rules for High-Yield OID Obligations For certain high-yield OID obligations, the yield is divided into an interest component that is deductible only when paid and a return on equity component that is not deductible as interest but may entitle the holder to a dividend received deduction. The ARRA suspends these rules for obligations issued in a debt for debt exchange that occurs on or after September 1, 2008 and before January 1, The rules are not changed for new issuances of debt for cash. Extension of Bonus Depreciation The Economic Stimulus Act of 2008 amended Section 168(k) by providing for a 50 percent bonus first-year depreciation for regular tax and alternative minimum tax purposes for qualified property purchased and placed into service before January 1, The ARRA extended application of this 50 percent bonus deprecation to any qualifying property placed in service during Qualifying property means: (1) tangible property with a recovery period not in excess of 20 years, (2) purchased computer software, (3) water utility property, and (4) qualified leasehold improvement property. The placed-in-service deadline is extended until January 1, 2011 for property with a recovery period of 10 years or longer and certain transportation property (including certain aircraft). Additionally, a taxpayer may choose to forego the bonus depreciation of Section 168(k) in order to accelerate pre-2006 alternative minimum tax (AMT) or research and development (R&D) credits under Section 168(k) (4). Although only AMT or R&D credits not in excess of 20 percent of the foregone bonus depreciation amount may be accelerated, for taxpayers unable to benefit from bonus depreciation due to excess NOLs, for example, these refundable credits may provide a more beneficial tax result on a present value basis. New Market Tax Credit Section 45D provides taxpayers with a new market credit equal to a percentage of the amount paid to a qualified community development entity for a qualified equity investment. A qualified equity investment is a cash investment in a qualified community development entity, as defined by the Code, that is used to make qualified lowincome community investments.

2 Before enactment of the ARRA, the new markets tax credit was available through 2009 subject to a national $3.5 billion limitation. The ARRA increased the limitation to $5 billion for 2008 and Sale of S Corporation Assets and the Built-In Gains Holding Period C Corporations that elect to be S Corporations are subject to the built-in gains tax for assets held at the time of the election if the assets are sold within the 10-year period after the election is made. For assets sold by an S corporation in 2009 or 2010 the applicable recognition period is reduced from 10 to seven years. For example, if a corporation elected S status as of January 1, 2001, a sale of the assets before January 1, 2011 would normally trigger the built in gains tax. If, however, the sale occurs in 2009, no builtin gain tax will be due because the applicable recognition period is only seven years, and it will have expired on January 1, This provision may help S corporations that made the C-to-S election in 2000, 2001, 2002 and, for sales in 2010, elections made in Incentive to Hire Unemployed Veterans and Disconnected Youth The ARRA amends Section 51 which provides a 40 percent credit for the first $6,000 of wages paid to an employee hired in a targeted group. The ARRA adds two new targeted groups for which a credit of up to $2,400 is available if an employee in such group is hired in 2009 or The two new targeted groups for which the credit is available are Disconnected Youth and Unemployed Veterans. Disconnected Youth are those individuals certified by the local designated agency to be between the ages of 16 and 25, who have not been employed in the last 6 months, who have not been in any type of school in the last six months, and who do not have basic skills. An Unemployed Veteran is an individual certified by the local designated agency to have been discharged from the armed forces within the last five years and who has received unemployment compensation for not less than four weeks in the year preceding the date of hire. Withholding on Government Contractor Payments Delayed Under current law, governmental entities were to have begun withholding 3 percent on payments made to government contractors on January 1, The withholding rule requirements have been delayed under the ARRA and now apply to payments made after December 31, Employer-Provided Transportation Under the ARRA the amount that an employee may receive as a tax free fringe benefit for van pool arrangements and transit passes for the years 2009 and 2010 is increased from $100 to $175. In 2011, the amount of the tax-free fringe benefit drops back to $100. Regulated Investment Companies (RICs) Pass-Through of Bond Credits Under the ARRA, RICs may elect to pass through tax credits on tax credit bonds to their shareholders. Tax credit bonds are essentially Build America Bonds, Qualified Forestry Conservation Bonds, or any other bonds for which a tax credit is allowed. If the election is made to pass through the credits to the shareholders, the RIC may not use the credits. The ARRA Clarifies Application of Section 382 to EESA Bail-Outs The ARRA clarified the application of the Section 382 limitation on the use of net operating losses by corporations that have undertaken restructurings that are within the scope of the Emergency Economic Stabilization Act of 2008 (EESA). In general, restructurings that are within the scope of the EESA include modifications to an organization s capital structure and business operations implemented to achieve long-term financial viability and competitiveness. The ARRA makes it clear that the Section 382 limitation does not apply when the ownership change is pursuant to a restructuring plan of the taxpayer which (1) is required under a loan agreement or a commitment for a line of credit that is within the scope of the EESA and (2) is intended to result in a rationalization of the costs, capitalization, and capacity with respect to the manufacturing workforce of, and suppliers to, the taxpayer -2-

3 and its subsidiaries. Thus, a corporate taxpayer meeting both prongs of the exception may utilize its pre-change net operating losses against its post-change income without applying the Section 382 limitation. The exception, however, does not apply to a subsequent ownership change that does not fall within the ARRA provisions. In addition, the ARRA exception does not apply if any person owns 50 percent or more of the corporation immediately after the ownership change. Finally, the ARRA exception does not modify any other operative rules under Section 382. Stimulus Law Revokes Relief for Banks Attempting to Utilize Net Operating Losses The ARRA revokes tax relief for banks regarding the utilization of net operating losses that was granted in Specifically, the ARRA revokes IRS Notice , issued by the IRS in September Notice provided that any deduction properly allowed to a bank after an ownership change with respect to losses on loans or bad debts would not be subject to limitation under Section 382(h). The Notice applied to situations in which bad loans had been acquired pursuant to the purchase of another bank. Such acquisitions triggered an ownership change and the imposition of a net operating loss limitation under Section 382 with respect to the acquired bank s net operating losses. Furthermore, the purchase would otherwise limit the post-acquisition utilization of built-in losses inherent in the acquired bank s impaired assets, such as bad loans, under Section 382(h). The ARRA is prospective, so there is a window of opportunity to apply Notice It applies to transactions that occurred on or before January 16, 2009 or from transactions under a binding contract or written agreement entered into on or before January 16, For changes of ownership that occur after those dates, banks lose the favorable treatment and will be subjected to the same rules as other corporations. Thus, banks will be required to consider the potential Section 382(h) limitation on losses triggered by loans or bad debts after an ownership change under Section 382. II. Small Business Enhanced Expensing of Certain Expenditures Section 179 allows small businesses to elect to deduct as a current expense a portion of the cost of Section 179 property rather than recovering such cost over several years. Section 179 property is either (1) tangible property (to which Section 168 applies), or (2) computer software (to which Section 167 applies). The Economic Stimulus Act of 2008 amended Section 179 by increasing from $128,000 to $250,000 the amount a small business may elect to deduct of the cost of Section 179 property placed in service during The amount allowed as a deduction pursuant to Section 179, however, is reduced by the amount by which the cost of all Section 179 property placed in service by the taxpayer during 2008 exceeds $800,000. The ARRA extended these provisions to Section 179 property that is acquired during Increased Exclusion of Gain from Qualified Small Business Stock Section 1202 generally provides that a noncorporate taxpayer that sells qualified small business stock (QSBS) which was held for at least five years may exclude 50 percent of the gain from the sale or exchange of such stock. The ARRA increases the gain that may be excluded to 75 percent for stock acquired after February 17, 2009 and before January 1, Among other requirements, QSBS is stock of a corporation which (1) has had assets not in excess of $50 million since August 9, 1993, and (2) will not have assets in excess of $50 million immediately after issuance of the stock. The remainder of the gain from the sale of QSBS is taxed at a 28 percent rate such that the effective rate of tax on the gain on the sale of QSBS acquired after February 17, 2009 and before January 1, 2011 (and otherwise satisfying the requirements of Section 1202) is 7 percent. Net Operating Loss (NOL) Carryback for Small Businesses The ARRA permits certain small businesses to elect to increase the current two-year NOL carryback to a carryback for a number of years as selected between two and six for certain 2008 NOLs. For calendar year taxpayers, a 2008 NOL is the net operating loss generated in For non-calendar year taxpayers, a 2008 NOL -3-

4 is defined as a taxpayer s net operating loss in any year ending in 2008, or, if elected (and the option for tax years ending in 2008 is not used), the net operating loss for the tax year beginning in The election is irrevocable and only applies to the one year. The election must be made, as prescribed by Treasury, on a timely filed tax return for the 2008 tax year in which the loss is incurred. A small business is a corporation or partnership that has gross receipts of less than $15 million. Some important issues have already arisen, such as how gross receipts will be measured from collective pass through entities, and whether the IRS will provide relief on previously made NOL carryback waivers. The limitation of the NOL carryback provision to small businesses is a great disappointment to many since both the House and Senate bills would have permitted all corporations to utilize a five-year carryback of NOLs. III. Financing/Bond Provisions Build America Bonds The ARRA creates a new category of tax credit Build America Bonds for bonds issued before 2011 that otherwise would meet the rules for governmental bonds (e.g., private use restrictions, arbitrage rules). The interest on these Build America Bonds is taxable, but the holder in general is allowed a tax credit equal to 35 percent of that taxable interest. The issuer of the bonds may elect to receive the credit as a direct subsidy rather than pass it through to the holder, but only for bonds issued solely for capital expenditures, costs of issuance, and reserve funds. Recovery Zone Facility Bonds The ARRA authorizes up to $15 billion of Recovery Zone Facility Bonds, a new category of tax-exempt private activity (exempt facility) bond. In general, proceeds of these bonds must be spent in areas (Recovery Zones) designated by the issuer as having significant poverty, unemployment, rate of home foreclosures or general distress. The bonds must be issued before 2011 and generally must finance depreciable property. The $15 billion limit is allocated to states and localities in proportion to their 2008 jobs losses. Recovery Zone Economic Development Bonds Up to $10 billion of this new category of taxable bonds is authorized. Generally, these bonds must be issued before 2011 to promote development or other economic activity in Recovery Zones. Issuers of these bonds would receive a direct subsidy from the federal government of 45 percent (as compared to 35 percent for Build America Bonds) of the interest paid. The volume limitation would be allocated to states and localities in the same manner as Recovery Zone Facility Bonds. Qualified School Construction Bonds Up to $11 billion of this new category of bonds in each of 2009 and 2010 is authorized, in general for the construction, rehabilitation and repair of public school facilities. The bonds are taxable, with the holder receiving a tax credit that is set by the Treasury at a rate that permits the bonds to be issued without discount and interest cost to the issuer. In general, 60 percent of the authorized amount will be allocated to states in proportion to the amounts they are entitled to receive under the Elementary and Secondary Education Act of 1945, and the remaining amount will be allocated to certain large, local educational agencies. Tribal Economic Development Bonds The ARRA authorizes the Treasury to allocate $2 billion in tax-exempt Tribal Economic Development Bonds among Indian tribal governments. Tribal Economic Development Bonds generally may be issued for the same purposes as other state and local governmental bonds. The current law rules that restrict the purpose of tribal bonds to essential governmental functions would not apply to these bonds, and the bonds could be issued as tax-exempt private activity bonds. However, certain gaming facilities and facilities outside an Indian reservation could not be financed with these bonds. Modification of Existing Tax-Favored Bonds The ARRA extends the authorization for and/or increases the amounts of certain types of existing tax-favored bonds that may be issued, including: (1) Clean Renewable Energy Bonds, (2) Energy Conservation Bonds, and (3) Qualified Zone Academy Bonds. Also, for bonds issued before 2011, the definition of manufacturing for purposes of the tax-exempt small issue (manufacturing) bond rules has been expanded to include the manufacture, creation, or production of intangible property (any patent, copyright, formula, process, design, know-how, format -4-

5 or other similar item), and facilities that are functionally related and subordinate to a manufacturing facility (and on the same site) may be financed with the bonds without restriction as to the amount of bond proceeds that may be used for such functionally related and subordinate facilities. AMT Changes Under the ARRA, for alternative minimum tax purposes, interest on tax-exempt private activity bonds issued in 2009 and 2010 is not a preference item, and interest on all tax-exempt bonds issued in 2009 and 2010 is not included in a corporation s adjusted current earnings. Generally, refunding bonds are treated as issued when the refunded bonds were issued, except for refunded bonds issued in 2004 through 2008, in which case the issue date of the refunding bonds is determinative. These AMT changes should increase the potential investor pool for tax-exempt bonds and possibly lower the cost of capital for issuers/ borrowers. Bank Deductibility of Interest on Debt Incurred to Carry Tax-Exempt Obligations Generally, banks and other financial institutions are denied an interest deduction in proportion to the ratio of their tax-exempt bond holdings to their total assets. However, 80 percent of a bank s interest expense allocable to carrying qualified tax-exempt obligations (bank qualified bonds) is deductible. The ARRA extends to banks an administrative safe-harbor rule currently applicable to other taxpayers by permitting banks to deduct 80 percent of the interest allocable to carrying tax-exempt obligations issued in 2009 and 2010 to the extent those obligations don t exceed 2 percent of the bank s assets. For this purpose, refunding bonds are treated as issued when the refunded bonds were issued or, for a series of refundings, when the original bonds were issued. In addition, the ARRA increases from $10 million to $30 million the annual amount of bonds an issuer can designate as bank-qualified bonds, for bonds issued in 2009 and For this purpose, the ARRA provides that qualified 501(c)(3) bonds are treated as issued by the 501(c)(3) borrower organization for whose benefit the bonds are issued, rather than by the actual issuer of the bonds, and that, in certain circumstances involving pooled or composite issues, the annual limitation is applied at the borrower rather than issuer level. These bank qualification changes should increase the potential investor pool for tax-exempt bonds and possibly lower the cost of capital for issuers/borrowers. Labor Standards Importantly, federal prevailing wage requirements under the Davis-Bacon Act apply to projects financed with proceeds of the following bonds issued after the date of enactment of the ARRA: (1) Clean Renewable Energy Bonds, (2) Qualified Energy Conservation Bonds, (3) Qualified Zone Academy Bonds, (4) Qualified School Construction Bonds, and (5) Recovery Zone Economic Development Bonds. ENERGY PROVISIONS Extension of Placed-In-Service Date for Wind Developers Section 45 generally allows a credit, known as the PTC, based on the amount of electricity sold to an unrelated taxpayer that is produced at a qualified renewable energy facility over a 10-year period beginning on the date the facility is placed in service. Over the 10 years, the owners of the qualified facilities are able to offset these federal taxes due with the credits generated from the sale of this electricity. To qualify for the PTC, the facility must be placed in service before a specified statutory date. The ARRA extends the placed-in-service date for qualified wind facilities placed in service before January 1, 2013 and for qualified facilities placed in service before January 1, 2014, in the case of other renewable sources. By allowing the placed-in-service date to be extended, Congress has given developers more time to seek financing for various renewable energy projects that may have been stalled due to the current credit crunch and down turn in the economy. ITC Credit Now Available to Renewable Sources Other Than Solar Section 48 provides a purchaser of qualified solar property a credit equal to 30 percent of the cost of the property purchased (ITC). Typically, commercial solar projects are owned through investment partnerships where investors are allocated the beneficial credit that they can utilize on federal tax returns leaving the developers as the effective operator of the energy property. The ARRA added an important provision allowing taxpayers an irrevocable election to claim the ITC in lieu of the PTC. -5-

6 This may be a significant boost to wind developers who have stalled projects for two reasons. First, it allows these developers to provide a higher degree of certainty of cash return since the ITC is based on initial cost instead of the variable PTC. Secondly, the ITC provides a more immediate benefit since it is claimed in the first year the property is placed in service unlike the PTC which is based on electricity production over a 10-year period. Wind developers, however, must carefully analyze the effects of making the election as they may still prefer to claim the PTC. There also may be a secondary benefit to other renewable energy producers, such as biomass facilities, since they are only allowed half of a PTC credit under the current rules. This new provision may allow these developers to pass through a larger credit and essentially provide more tax equity for their projects. New Federal Grants In Lieu of Energy Credits Importantly, the ARRA adds a new provision authorizing the Treasury Secretary to provide grants in lieu of the PTC or ITC for certain property placed in service in 2009 and To obtain a grant in lieu of the PTC or ITC, taxpayers must file an application with the Department of Treasury before October 1, Depending on the type of equipment purchased and placed into service, the grant is equal to either 30 percent or 10 percent of the tax basis in tangible property used as an integral part of a qualified facility. The requirements for qualifying for the grant are intended to mirror those of the ITC with grant recipients excluding the amount of the credit from their gross income. In the past, financial institutions were purchasers of PTCs and ITCs, effectively providing much of the equity funding for these projects. The recent economic downturn among financial institutions has caused much of the tax credit market to dissipate. This new provision has the potential to jump start a number of renewable energy projects by providing refundable credits, precluding the need to rely on the tax credit market to fund these projects. New Credit for Investment in Advanced Energy Facilities As another step in creating our green economy, the ARRA establishes a new investment tax credit for qualified tangible personal property placed in service at manufacturing facilities which are qualifying advanced energy projects. The federal credit is equal to 30 percent of qualified property placed in service. A qualifying advanced energy project is a project which re-equips, expands or establishes a manufacturing facility for the production of property that is used in the production of: certain renewable energy, advanced battery technology, property used in electric grids to support and store renewable energy, and certain other property used in green technologies. Unlike the ITC and PTC, taxpayers must receive a certification from the IRS that they have a qualifying advanced energy project before they claim the credit on their returns. Although the Treasury has 180 days from enactment to draft regulations on the grant application process, we would advise developers to start the application process early as there is a finite amount of funds available for disbursement and it will likely be competitive. INDIVIDUAL PROVISIONS Sales Tax Deduction Allowed for Purchase of New Vehicles For an individual who buys a new vehicle in 2009 after February 17, any state or local sales or excise tax is deductible as part of the standard deduction or as an itemized deduction. The deduction is phased out ratably for taxpayers with modified adjusted gross income between $125,000 and $135,000, and the deduction is limited to the amount of taxes attributable to the first $49,500 of the purchase price. AMT Short Term Fix The AMT has been patched again by increasing the amount of income exempt from the AMT to $46,700 for an individual and $70,950 for a married couple filing joint returns (an increase of $500 per person from 2008). In addition, the ARRA permits certain nonrefundable personal tax credits to offset the AMT in Making Work Pay Tax Credit The ARRA adds a new Section 36A, providing an income tax credit to individuals, who are not: (1) claimed as a dependent by another, (2) an estate or trust, or (3) a -6-

7 nonresident alien. The credit is equal to 6.2 percent of earned income, but not in an amount that exceeds $400 for an individual and $800 for married couples filing jointly. The credit is available for both the calendar year 2009 and 2010, but not thereafter. The credit is phased out by 2 percent of the amount that exceeds $75,000 for an individual and $150,000 for a married couple filing jointly. The credit can be claimed on a timely filed tax return or by a reduction in the income tax withheld. The reduction in income tax withholding for 2009 is about $13 a week and will be about $9 a week in Increased First-Time Homebuyer s Credit The limit on the First-Time Homebuyer s Credit, which is equal to 10 percent of the purchase price of the home, has been increased from $7,500 to $8,000 for a first-time purchaser of a home before December 1, The Credit passed last year was only available until July 1, 2009 and was repayable over 15 years (or upon sale of the home), making it really an interest free 15-year loan as opposed to a pure credit. The ARRA waives the repayment provisions for first-time homebuyers, who purchase a home after January 1, 2009 and before December 1, 2009; provided the first-time homebuyer holds the house at least 3 years, otherwise the credit is to be repaid to the IRS. The Credit phases out for taxpayers with adjusted gross income in excess of $75,000 ($150,000 in the case of a married couple filing a joint return). Computer Technology and Equipment as Qualified Education Expenses ARRA amends Section 529 to provide that qualified educational expenses from a 529 Plan include purchases of computer technology or equipment and internet access in the calendar years 2009 and 2010 so long as the beneficiary of the 529 Plan or his or her family uses the technology, equipment or services while the beneficiary is enrolled at a qualified educational institution. Computer software for games, sports, or hobbies will not qualify. This is a recognition of the need for students to have computer equipment at college. These summaries are general in nature and not intended to be a comprehensive discussion of the provisions. Members of Pepper Hamilton s Tax Practice Group who assisted in preparing these summaries include Gordon R. Downing, W. Roderick Gagné, Bryan D. Keith, Michelle Parten, Lisa B. Petkun and Todd B. Reinstein. The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, 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. Please send address corrections to phinfo@pepperlaw.com. Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington 2009 Pepper Hamilton llp. All Rights Reserved. This publication may contain attorney advertising. -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 Benjamin M. Hussa hussab@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 Leonard Schneidman schneidmanl@pepperlaw.com James H. Stevralia stevraliaj@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 Charles L. Potter, Jr potterc@pepperlaw.com Employee Benefits Issues Jonathan A. Clark clarkja@pepperlaw.com David M. Kaplan kapland@pepperlaw.com Andrew J. Rudolph rudolpha@pepperlaw.com *Admitted in the Commonwealth of Virginia only; supervision by principals of Pepper Hamilton llp who are members of the DC Bar. -8-