TAXATION

Renewal Communities

Tax Benefits for Distressed Areas

By Ann Burstein Cohen

Congress enacted three tax bills between 1993 and 2000 that provided tax incentives for businesses operating in designated distressed areas:

In January 2002, five cities in New York State became “Renewal Communities,” eligible for the federal tax benefits afforded the 40 Renewal Communities authorized by the Community Renewal Act of 2000.

Overview of the Tax Benefits

The Community Renewal Act creates four tax incentives that reward businesses operating in a designated Renewal Community (RC) that employ community residents and invest in plant and equipment, as well as taxpayers investing in such businesses. These incentives apply to qualifying events from January 1, 2002, through December 31, 2009, although some benefits may be realized later if the qualifying investment occurred during this period. The tax incentives consist of the following:

The employment credit and the commercial revitalization deduction are available to any business in the RC meeting the criteria of the specific benefit. The enhanced section 179 deduction and the capital gain exclusion apply only to “qualifying RC businesses” or their investors. Certain businesses are disqualified from the four RC tax benefits because of their line of business: golf courses, country clubs, massage parlors, hot tub facilities, tanning salons, racetrack or gambling facilities, and liquor stores. New York State tax law does not modify these tax benefits, so New York taxpayers will enjoy state tax savings as well, due to the accelerated deductions and the capital gain exclusion.

The Renewal Communities

Congress authorized the Department of Housing and Urban Development (HUD) and the U.S. Department of Agriculture to designate 40 RCs, specifying a mix of urban and rural areas. The determination took into account poverty rates, household incomes, unemployment rates, general distress, and incidence of crime. Applications from geographic areas used 1990 census tracts, so contiguous sections of a city that meet the standards are eligible, rather than an entire city. Applying communities also had to commit to some or all of the following: reduced tax rates or fees; increased efficiency of local services; reduced crime; streamlined governmental requirements; involvement of community and private groups; gift or bargain sales of surplus real estate; and minimized licensing, zoning, and similar restrictions.

On January 24, 2002, HUD announced five RC communities in New York: Buffalo/Lackawanna, Jamestown, Niagara Falls, Rochester, and Schenectady. In addition, Syracuse was named an Empowerment Zone. Neighboring states also received some RC designations, including Newark and Camden in New Jersey and Philadelphia in Pennsylvania.

Some RC communities have found that the 2000 census would have allowed an expansion of their boundaries, and legislation has been proposed to allow use of the 2000 census data. HUD has posted area maps that provide a broad overview of the boundaries of each RC, an address locator, and contact information for local officials overseeing the program, at www.hud.gov/offices/cpd/economicdevelopment/programs/rc/index.cfm.

There are important differences between the RC program and New York’s Empire Zones. The RC program gives federal tax benefits, whereas the Empire Zone provides New York State tax benefits. The geographic areas are not necessarily the same, although in some communities there will be overlap. A business “self-certifies” for the RC benefits (other than the commercial revitalization deduction), but it must apply for the Empire Zone benefits. The New York State tax benefits include property and sales tax savings in addition to income tax savings.

Renewal Community Employment Credit

The Act added IRC section 1400H to provide a 15% credit on the first $10,000 of wages of qualifying employees, resulting in a maximum annual credit of $1,500 for each qualifying employee. The actual calculation of the credit appears in IRC section 1396, the Empowerment Zone Employment Credit, with modifications. The business does not have to be a qualifying RC business to enjoy this benefit. Key criteria for a qualifying employee are:

There is no guidance about the efforts an employer must undertake to verify a principal residence in the RC. In some RCs, the local unemployment offices issue special cards identifying individuals as qualifying residents, but this is not a requirement. Employers should urge potentially eligible employees to obtain these cards, if available, or ask for other identification, such as a driver’s license, to confirm the address listed on the Form W-4. One requirement that could negatively affect regions with more than one RC is that the employee must live and work in the same RC.

A more elusive requirement is that substantially all of the employee’s services be performed in the RC. “Substantially all” is not defined in either the law or committee reports of IRC section 1400H or section 1396 (Empowerment Zone Employment Credit), which uses the same language, or in the regulations under section 1396. IRC section 45D, the New Markets Tax Credit, provides an 85% safe harbor for its “substantially all” cash investment criteria within the IRC section itself. Section 45D was enacted as part of the Community Renewal Act of 2000, along with the RC tax incentives. The only written guidance specific to the RC employment credit appears in the related IRS publication, which quantifies the term “substantially all” as at least 85%. Such guidance does not provide authoritative support. On the other hand, the IRS ruled that “substantially all” means at least 80% in the context of qualifying employee services for the New York Liberty Zone Employee Credit. This substantially-all requirement will clearly limit the ability to earn the credit for employees in service businesses where they go to customers’ homes or businesses, unless the services are very local, and will also limit the credit for employees performing delivery services. There is guidance available if an otherwise eligible employee regularly performs some services within and without the RC. Treasury Regulations section 1.1396-1 allows either a calendar-year or a pay-period method to determine if the location-of-services requirement is satisfied. If the potentially qualifying employee also performs services for an employer outside the RC, the pay-period method may be more beneficial. This method may be particularly useful where employees rotate to different business locations or temporary job sites, such as in the construction industry. The same method must be used for all employees. Timesheets or other employment-reporting mechanisms may require modification to incorporate this information.

The 90-day requirement will be troublesome for seasonal businesses. There are exceptions to the 90-day requirement in the case of disability and termination for misconduct. Part-time employment qualifies, as does employment of high-risk youth (ages 18 to 24) and summer youth (ages 16 and 17) living in the RC.
Business owners and their dependents or relatives do not qualify for the employment credit, which could reduce its appeal to small, family-owned businesses. In the case of businesses organized as corporations or partnerships, the constructive ownership rules of IRC section 267 apply to disqualify the credit of substantial owners and their relatives and dependents.

Neither IRC section 1400H nor section 1396 defines wages for this purpose, other than mentioning “paid or accrued.” The committee reports to section 1396 refer to wages for FUTA purposes (without the dollar limits), plus qualifying training and educational expenses paid to an unrelated party, and, for employees under age 19, expenses of a youth training program operated with local education officials. IRS Publication 954 and the instructions to Form 8804, Empowerment Zone and Renewal Community Employment Credit, repeat this definition. Given the reliance on FUTA wages, leased employees likely will not qualify. The credit also reduces any deduction for wages on the employer’s tax return. For businesses using a tax year other than the calendar year, the calendar year ending within the tax year will be the wage base year for the credit.

The RC employment credit is 15% of the first $10,000 of qualifying wages, resulting in a maximum credit of $1,500 per employee per year. Unlike the other job credits, current employees are eligible, not just new hires, and they generate credits each year they qualify through 2009. The RC employment credit generally follows the application criteria of the general business credit in IRC section 38, with two exceptions. First, it cannot be carried back to a year preceding the area’s designation as an RC (i.e., to 2001 or earlier). Second, while the general business credit is unavailable in a year that the taxpayer is subject to the alternative minimum tax, the RC employment credit is allowed to offset up to 25% of the alternative minimum tax. The RC employment credit is claimed on Form 8884.

New employees that qualify for the RC employment credit may also qualify for the work opportunity tax credit (WOTC) or the welfare-to-work credit (WTWC). The same wages cannot qualify for more than one credit, but with careful comparison of wage definitions and coordination, it may be possible to enjoy the benefits of more than one credit. If the employee is eligible for both the RC employment credit and the WOTC during the first year of employment, the employer would normally maximize tax savings by applying the WOTC first, earning a $2,400 credit (40% of the first $6,000 of wages), and then applying the 15% RC employment credit rate to the $4,000 adjusted ceiling (the $10,000 statutory ceiling reduced by the $6,000 of wages applied to WOTC), generating a $600 RC employment credit. If the employee qualifies for both the RC employment credit and the WTWC, the employer will generally be better off with the WTWC for the two-year credit, but wage definitions are not exactly the same. The WOTC is available for only the first year of employment of a new employee and the WTWC for the first two years of employment, but the RC employment credit continues to be available each year. The RC employment credit also applies to employees of any income level that meet the residence and service tests.

To qualify for the employment credit, the business itself need not meet the standards of a qualified RC business, nor does it even have to have a permanent business location in the RC. For example, a construction company with headquarters outside the RC would be able to claim credits for qualifying employees working on a construction site in the RC if the project lasts at least 90 days.

Commercial Revitalization Deductions

The Commercial Revitalization Deduction (CRD) encourages businesses and developers to construct new buildings and substantially rehabilitate older structures in the RC by allowing a vastly accelerated deduction in lieu of the normal 39-year straight-line depreciation. Businesses do not have to be qualified RC businesses to enjoy this benefit, but this is the one RC incentive that must be applied for and for which allocations are limited. The states are allowed $12 million of CRDs per year for each RC to allocate to worthwhile projects. New York State, with its five RCs, has $60 million to allocate each year from 2002 to 2009, which is administered by the Empire State Development Corporation (ESDC).

Qualifying revitalization expenditures include capital expenditures for nonresidential real property other than land. Other real property will qualify if functionally related to and subordinate to a qualifying property. For example, an apartment in a structure that primarily houses shops may qualify. The qualifying expenditure has to be for a new building or substantial rehabilitation of an existing property that is placed in service in the RC after its rehabilitation. The “placed in service” requirement prevents businesses currently operating in an older structure from taking advantage of the accelerated deduction. IRC section 47(a) (the rehabilitation credit) determines “substantial rehabilitation,” essentially including rehabilitation expenditures incurred over a 24-month period that exceed the greater of $5,000 or the adjusted basis of building. The cost of the building itself can be included up to 30% of qualifying rehabilitation expenditures. The taxpayer cannot include costs taken into account for any tax credits, such as the rehabilitation credit.

The ESDC has proposed reliance on the recommendations of the local coordinating responsible authority. Contact information for the local coordinating responsible authorities is in Exhibit 1. In accordance with IRC section 1400I and the related committee reports, when determining allocations, the ESDC must consider a project’s conformity to the RC’s strategic plan, job creation and retention, resident and community support, and likelihood of success and completion. No more than $10 million can be allocated to a project, but there is no limitation on how many projects a taxpayer can have. If the full $12 million annual allotment is not allocated, the balance does not carry over.

The ESDC was told by HUD in 2002 that it had some flexibility to reallocate among RCs within the state for worthy projects. Exhibit 2 provides a brief summary of the 2002 allocation. The IRS has overruled this “flexible” interpretation for 2003 with Revenue Procedure 2003-38. The $12 million ceiling now applies strictly to each individual RC. The revenue procedure does provide a limited ability to make a binding commitment of an allocation to a project not yet placed in service, if certain criteria are satisfied. For RCs outside of New York that did not fully allocate their $12 million in 2002, the revenue procedure gave an opportunity to allocate the unused 2002 portion in 2003.

A taxpayer can deduct the CRD allocation by electing to either (1) deduct 50% of the qualifying expenditure in the year the building is placed in service, with the remainder depreciated in the normal manner, or (2) amortize 100% of the qualifying expenditure over 120 months. The marginal tax rate of the taxpayer in future years, the time value of money, and the expected holding period of the property will all factor into the decision. The election is made on Form 4562 (the depreciation form). Revenue Procedure 2003-38 provides further guidance on making this election.

The Community Renewal Act specifically provides that the CRD is allowed for alternative minimum tax purposes, and the act amended IRC section 469, the passive loss limitations, so that the phaseout of the $25,000 ceiling on rental property losses for adjusted gross income exceeding $100,000 will not apply to the deduction of the CRD. These provisions will be particularly valuable for real estate development projects operating as pass-through entities, such as limited liability companies, where investment capital comes from “active” participants that are not material participants.

Qualified Renewal Community Business

The remaining two tax incentives, the additional section 179 deduction and the capital gain exclusion, are only available to qualified RC businesses and their owners, as defined in the criteria of IRC section 1397C, the Enterprise Zone business. There are no regulations proposed or issued at this time under either section 1400G or section 1397C. The criteria cover three categories: line of business testing, asset testing, and employee testing.

Line of business testing. Every trade or business of the corporation or partnership must be a qualifying business in the RC. For purposes of these last two tax incentives, it will also rule out businesses whose predominant activity involves the development or holding of intangibles for sale or license. This prohibition could eliminate many high-tech businesses as qualifying RC businesses. At least 50% of the entity’s gross income must arise from a qualifying business in the RC.

Asset testing. A substantial portion of both the owned and leased tangible property of the qualifying RC business must be located in the RC, and the intangible property must be substantially used in the qualifying active business. In Temporary and Proposed Regulations section 1.45D-1T, relating to the New Markets Tax Credit and its asset use and employee service testing for purposes of defining a “qualified active low-income community business,” substantial portion is defined to mean at least 40%. Other property-related tests include the requirement that less than 5% of the business’s unadjusted bases of property be composed of collectibles (unless inventory) or nonqualified financial property. Nonqualified financial property is essentially investment assets other than short-term investments held for working capital purposes. A traditional bricks-and-mortar business involved in manufacturing, merchandising, or local services will normally satisfy the asset test.

Employee testing. The employment portion of the qualified RC business will probably be the most difficult of the standards for many businesses to meet. It requires that at least 35% of employees be residents of the RC and that a “substantial portion” of employee services generally occur in the RC. It is not clear how part-time employment affects the 35% test. These tests will essentially favor local shops and small manufacturing businesses.

The same standards apply to sole proprietors, focused on the assets used in and the gross income derived from the business activity itself. The sole proprietor is treated as an employee for testing purposes.

Some additional criteria apply to rental businesses. In the case of real property rentals, only nonresidential property qualifies, and at least 50% of gross rental income must come from qualifying RC businesses. Section 1397C provides that a lessor can rely on a lessee’s certification regarding its status as a qualified RC business. For rentals of personal property, the property must be tangible, and at least 50% of the property rentals are to qualify as RC businesses or RC residents.

While the standards for a qualifying RC business may appear to be unattainable for all businesses other than small, local shops, Congress left the door open for some planning opportunities. Neither section 1400G nor section 1397C, upon which 1400G relies for virtually all of its definitions and operating rules, requires application of the tests on a controlled group basis. In fact, the committee reports under section 1397C specifically provide that activities of legally separate entities are not to be aggregated for testing purposes, even if related. While regulations have not yet been issued, it appears that separate subsidiaries or limited liability companies could be established within the RC by larger business entities, making it more likely that this smaller unit could satisfy the various business, asset, and employment tests. For many businesses, the toughest hurdle will be the 35% resident test.

Additional Section 179 Deduction

IRC section 1400J provides two enhancements to the section 179 deduction for investments in qualified renewal community property (RC property) by qualified RC businesses: (1) an additional expensing allowance of $35,000, and (2) a more gradual phaseout of the section 179 expensing provision once the investment limit has been reached.

The additional allowance provided in IRC section 1400J will result in a total section 179 deduction of up to $135,000 for qualifying taxpayers for tax years beginning in 2003, 2004, and 2005. Unless future legislation extends the general section 179 $100,000 allowance created by the Jobs and Growth Tax Relief Reconciliation Act of 2003, the maximum deduction will revert to $60,000 in 2006 (the $35,000 additional RC allowance plus the $25,000 section 179 allowance available to all taxpayers).

The qualifying assets are the normal IRC section 179 property acquired (by purchase) between January 1, 2002, and December 31, 2009. For tax years beginning in 2003, 2004, and 2005, the 2003 Tax Act also included “off-the-shelf” software in the definition of qualifying section 179 property. Assets acquired from a related party or through a transaction where basis is determined by reference to the transferor’s basis (such as section 351 transactions or gifts), or by inheritance, will not qualify. While otherwise qualifying assets may be used, their first use in the RC must commence with this taxpayer and during the specified period. For example, a pizzeria located in the RC and meeting the standards of a qualified RC business may purchase two-year-old pizza ovens from a business outside the RC and the purchase will qualify for the additional section 179 deduction, but if the pizzeria purchased used ovens from inside the RC, the purchase would not qualify. Limited special provisions are provided for substantial rehabilitation of existing property and sale-leaseback arrangements. A further condition, which could limit the additional deduction for some assets, is the requirement that substantially-all use must occur within the RC. “Substantially all” is not defined, but may be covered by the IRS’ 85% unofficial rule of thumb. This requirement could eliminate the additional deduction for many vehicles, such as delivery or other service vehicles, to the extent that the business serves customers outside of the RC. This requirement could also limit assets shared by different locations and may require documentation for portable assets. The additional section 179 deduction is subject to recapture if the property ceases to qualify.

Consistent with the general section 179 deduction, the additional amount is limited to net income and thus cannot create a loss. The deduction is elective, so while a taxpayer may be eligible for the extra deduction, if current-year marginal tax rates are low, the taxpayer may choose to forgo it and instead enjoy higher depreciation deductions over the life of the asset. Both the additional and normal section 179 deductions are allowable for alternative minimum tax purposes. To retain this deduction for small to medium-size businesses, the expensing is subject to phaseout when total qualifying additions exceed an investment limit similar to the provisions of the general section 179 deduction. For tax years beginning in 2003, 2004, and 2005, the general section 179 deduction phaseout range is $400,000 to $500,000. Qualifying RC property is discounted by 50% for purposes of this limitation, however, so qualifying additions in these the 2003 Tax Act–affected years will not totally phase out until they exceed $670,000. Assuming the section 179 benefits of the 2003 Tax Act are not extended, in 2006 the section 179 general phaseout range will revert to $200,000 to $225,000, but the qualifying RC additions will not totally phase out until they exceed $520,000 because of the 50% discounting factor.

If new qualifying property is acquired before January 1, 2005, it probably also will qualify for the 30% or 50% bonus depreciation of IRC section 168(k), and the two provisions will need to be coordinated. The ordering is as follows:

Capital Gain Exclusion

IRC section 1400F excludes from income any qualified capital gains realized by RCs and their owners. This benefit has been publicized as a “0% capital gains rate” because many of the operating rules of IRC section 1400B are incorporated by reference, but it actually excludes from gross income gains on “qualified community assets.” Essentially three types of assets qualify: stock in a qualified RC business, a partnership interest in a qualified RC business, and certain tangible business property used by a qualified RC business.

The exclusion potentially creates a significant incentive to invest in risky businesses and real estate in RCs. There are nonetheless significant criteria to satisfy before realizing this tax incentive, and substantial carve-outs, so that in many circumstances some tax will still be due. No regulations have yet been issued under either IRC section 1400F or section 1400B (the D.C. Zone exclusion on which section 1400F is based), and many issues about its practical applications remain uncertain.

Qualifying stock and partnership interests. For owners of and investors in qualified RC businesses operating corporations (qualified community stock) and partnerships (qualified community partnership interest), the following criteria have to be satisfied in order to exclude the gain realized upon the sale or exchange of ownership interests:

Both capital and profits interests of partnerships qualify, as do limited liability companies. IRC section 1202–type redemption prohibitions apply to both corporations and partnerships, to prevent churning pre-RC investments into qualifying investments. Unfortunately, sole proprietors contributing business assets into a corporation will not qualify because of the cash investment requirement.

Special consideration is required of gains on the sale or exchange of otherwise qualifying S corporation stock and partnership interests, which may result in taxation of some portions of an otherwise excludable gain. By reference to the operating rules of IRC section 1400B (the D.C. Zone exclusion provisions), a “look-through” to the inside assets is required, and any portion of the realized gain attributable to real property or an intangible asset that is not integral to the RC business will be recognized. While not specifically referenced in the RC provisions, IRC section 751 will presumably require recognition of ordinary income for the portion of any partnership gain attributable to hot assets; that is, appreciated inventory and unrealized receivables (which includes depreciation recapture).

Qualifying community business property. In addition to excluding gain on equity interests, IRC section 1400F also excludes gains realized on qualified community business property. The qualifying property is essentially tangible section 1231 property, primarily property, plant, and equipment. Realistically, only real property is likely to be eligible, as it would be unusual for equipment or furniture and fixtures to result in a section 1231 gain after application of depreciation recapture. Additional requirements are as follows:

Preexisting real property, including land, will qualify if it is substantially improved. To be substantially improved, additions to basis must exceed the greater of $5,000 or the adjusted basis before improvement, and such improvements must have occurred during a 24-month period after December 31, 2001. Any qualifying land must be an integral part of the RC business, so land held solely for investment purposes would be subject to tax. If the taxpayer realizing the gain is a partnership or S corporation, the exclusion will pass through to the partners or shareholders, which must have held the interest throughout the holding period of the qualifying asset.

The exclusion is not available for any portion of the gain requiring recapture under IRC sections 1245 or 1250. Section 1250 recapture for this purpose will apply to total accumulated depreciation, not just “additional” depreciation. For individual taxpayers, this taxable portion of the gain will be treated as “unrecaptured section 1250” gain, taxed at the 25% rate. It appears that any commercial revitalization deductions claimed will also be treated as accumulated depreciation requiring recapture.

Both equity interests and business property. The acquisition (or rehabilitation) dates are very important in determining eligibility for the exclusion, and all assets require a minimum five-year holding period. Assuming the five-year holding period is satisfied, any appreciation after December 31, 2014, after the business ceases to be a qualified RC business, or after the business asset fails the “substantially all” test, will not qualify, so a valuation would be advisable. No part of any gain from a sale to a related party qualifies for exclusion.

The exclusion applies to the alternative minimum tax, although in the case of a corporate taxpayer, an adjusted current earnings (ACE) adjustment may be required. In transfers of equity interests or business assets in certain tax-free transactions, the transferee will step into the shoes of the transferor. The relevant transfers include transfer by gift or bequest, partnership distribution, and certain section 351 (exchange of assets for stock in a controlled corporation) and section 368 (reorganization) transactions. Under limited circumstances, subsequent purchasers of qualifying stock, partnership interests, or business assets will later qualify for the exclusion.

Other Potential Tax Incentives

The Community Renewal Act of 2000 also created the New Markets Tax Credit (IRC section 45D). This provision authorizes the creation of qualified Community Development Entities (CDE) that make equity investments in and make loans to qualified active low-income community businesses. Investors in CDEs receive tax credits over seven years equal to 39% of their investment in the CDE. For investors that do not want the risk of investing in a business in an RC or other low-income community, the CDE provides a vehicle similar to a mutual fund with professional management and risk spreading, and the 39% investment credit provides some government insurance. If a taxpayer or the business does not qualify for the capital gain exclusion, IRC section 1202, “Partial Exclusion for Gain from Certain Small Business Stock,” provides a 50% exclusion for gain on the sale of qualifying investments. An alternative for tax deferral is IRC section 1045, “Rollover of Gain from Qualified Small Business Stock.” This provision will help taxpayers that do not satisfy the five-year holding requirement of IRC section 1202 and are willing to invest the sales proceeds in another start-up corporation.