By Kevin F. Powers, CPA, and Sheryl Vander Baan, CPA
Signed into law on Feb. 17, 2009, the American Recovery and Reinvestment Act of 2009 (ARRA) is designed to stimulate the economy, in part through tax relief to businesses and individuals. Authors Kevin Powers and Sheryl Vander Baan explain the impact certain tax provisions in the section of the bill known as the American Recovery and Reinvestment Tax Act of 2009(ARRTA) could have on financial institutions.
Carryback of Net Operating Losses
ARRTA provides a carryback period of up to five years for net operating losses (NOLs). It is limited, however, to companies with average annual gross receipts of less than $15 million.
The $15 million gross receipts test is applied on a consolidated basis, including the bank, the bank holding company, and any other subsidiaries reported on the bank’s consolidated federal tax return. It is likely that only banking groups with $300 million or less in total assets would satisfy the test.
Gross receipts for this purpose include interest (including tax-exempt interest), dividends, rents, and service fees. For sales of capital assets or depreciable business assets, gross receipts are reduced by the adjusted tax basis in the property. Gross receipts do not include the repayment of the principal of a loan or similar instrument held by a bank.
The extended carryback period applies only to NOLs generated in calendar year 2008 (fiscal-year taxpayers may opt to apply the period to the fiscal year either beginning or ending in 2008). A company can choose to carry back the NOL three, four, or five years.
Investments in Tax-exempt Obligations
Banks investing in tax-exempt loans and bonds are required to disallow a portion of the interest expense associated with carrying these obligations. This limitation, sometimes referred to as the TEFRA1 disallowance, is computed by multiplying a bank’s cost of funds (that is, the total interest expense divided by total average assets) by its average investment in tax-exempt obligations and then multiplying the result by a percentage – either 20 percent or 100 percent. If the tax-exempt obligations are “bank-qualified,” the 20 percent disallowance percentage applies; if not, the 100 percent disallowance percentage applies.
The “bank-qualified” designation generally refers to a limitation imposed on municipalities issuing debt in the form of either bonds or loans. A municipality issuing $10 million or less in obligations during the calendar year is referred to as a “qualified small issuer” and can issue bank-qualified debt. Under no circumstances, however, will a private activity bond be treated as bank-qualified, even if issued by a qualified small issuer. Generally, banks will purchase obligations issued by (or make loans to) only qualified small issuers because of the reduced TEFRA disallowance that applies to these obligations.
The following provisions of ARRTA should encourage continuing bank investment in municipal obligations issued in 2009 and 2010:
- The $10 million qualified small issuer threshold is increased to $30 million.
- Banks investing in nonbank-qualified tax-exempt obligations can treat those obligations as bank-qualified issuances subject to the 20 percent (not 100 percent) disallowance percentage. This reduced percentage applies to nonbank-qualified obligations not exceeding 2 percent of the bank’s total average assets for the year.
- The alternative minimum tax (AMT) preference items for tax-exempt interest, including interest on private activity bonds, is suspended, thus providing banks already subject to AMT an opportunity to continue purchasing municipal obligations without adding to their AMT liability.
Although these favorable provisions apply only to obligations issued in 2009 and 2010, there are no restrictions on the date of purchase. The provisions should make municipal obligations issued during 2009 and 2010 more attractive in the secondary markets well beyond 2010. To claim the appropriate benefits on tax returns, banks purchasing such obligations must adequately identify these bonds for tax return preparers.
S Corporation Built-in Gains
An S corporation is required to pay a corporate-level tax on any built-in gains that existed on assets held on the date it converted from a C corporation if those assets are sold during the recognition period – generally, the 10-year period from the date of the conversion. ARRTA temporarily reduces the recognition period to seven years for built-in gains realized in 2009 and 2010, but only if the seventh taxable year in the recognition period precedes either 2009 or 2010.
This rule is applied as follows, based on the tax year in which the bank or bank holding company converted to an S corporation:
- Converted in 2001 or earlier – built-in gains tax is no longer applicable;
- Converted in 2002 – built-in gains tax will apply only to asset sales in 2011;
- Converted in 2003 – built-in gains tax will apply to sales in 2009, 2011, and 2012 (not 2010);
- Converted in 2004 or later – built-in gains tax will apply to all years during the 10-year recognition period.
This provision could eliminate a barrier that sometimes exists when an S-corporation bank (or bank holding company) is a target of an acquisition. It is common for an acquisition involving an S corporation to be structured as an asset sale. For the seller, such a structure might give rise to built-in gains tax, which could be a significant cost, depending on the size of the company. The reduction of the recognition period under ARRTA might expedite a sale that otherwise would have been delayed until the pre-ARRTA 10-year recognition period expired to avoid a corporate-level built-in gains tax.
Loan Losses From Acquisitions
On Oct. 1, 2008, the IRS published controversial guidance (Notice 2008-83) in which banks that were “loss corporations” and undergoing an ownership change would not have to apply certain deduction limitations to losses on loans occurring after the date of the ownership change. ARRTA repeals this notice for any ownership change that occurred after Jan. 16, 2009. Notice 2008-83 will, however, continue to apply to an ownership change occurring on or before Jan. 16, 2009, or to an ownership change occurring after Jan. 16, 2009, if the change is pursuant to a written binding contract entered on or before that date.
Tax Credit Programs
Many banks invest in various community projects that provide tax credits and other tax incentives, often via their Community Reinvestment Act commitments. These tax incentives can catalyze investment in projects that might not otherwise be economically feasible. ARRTA provides numerous tax credit and bond provisions designed to further stimulate such economic activity, including:
- New Markets Tax Credit (NMTC). Bank investors receive a tax credit, over a seven-year period, equal to 39 percent of capital invested in low-income communities via specialized community development entities. The tax credits are awarded each year through a competitive application process. ARRTA increases the 2008 NMTC investment authority by $1.5 billion, which will be reallocated to prior-year applicants. ARRTA also provides an additional $5 billion of NMTC investment authority that will be awarded under the 2009 application round.
- Qualified Zone Academy Bonds (QZABs). QZABs are used to finance renovations, equipment purchases, and curriculum development for certain public schools in distressed areas. Bank investors receive a tax credit in lieu of interest payments. The tax credit can be used to offset both regular and alternative minimum tax. ARRTA allows an additional $1.4 billion of QZAB issuing authority in 2009 and 2010.
- Qualified School Construction Bonds (QSCBs). This is a new form of tax credit bond for constructing, rehabilitating, or repairing public school facilities or for acquiring land on which a public school facility will be constructed. ARRTA provides a $22 billion national limitation on the amount of QSCBs that may be issued by state and local governments – $11 billion each for 2009 and 2010. As with QZABs, bank investors receive a tax credit in lieu of interest payments, and the tax credit can be used to offset both regular and alternative minimum tax.
- Build America Bonds (BABs). This is a new form of tax credit bond that can be issued before Jan. 1, 2011. Municipalities that would issue an otherwise tax-exempt bond (excluding private activity bonds) can elect to treat that bond as having taxable interest, but providing a nonrefundable tax credit to the holder in the amount of 35 percent of the interest payable by the issuer on the bond. Further, the municipality can elect to forego the credit to the investor and instead receive a cash payment from the federal government equal to the credit that would otherwise have been offered to the investor.
Accelerated Deductions for Fixed Assets
Companies (including banks) are allowed to claim an additional first-year depreciation deduction equal to 50 percent of an investment for qualified property acquired and placed in service during 2008. Qualified property includes tangible property such as banking equipment and office furniture, computers and computer software, and certain leasehold improvements. ARRTA extends this “bonus” depreciation deduction to qualified property placed in service during 2009. Companies can elect out of this bonus depreciation. Banks in a net operating loss position should consider this election to minimize loss carryforwards or use losses that would otherwise expire.
ARRTA also extends the increased small-business expensing election, sometimes referred to as “Section 179 expense.” For tax years beginning in 2009, banks are allowed to expense up to $250,000 of qualified property placed in service during the 2009 tax year. Qualified property is generally the same as that eligible for the bonus depreciation, with the exception of leasehold improvements. The Section 179 expense is reduced dollar for dollar if the total value of qualified property exceeds $800,000, so that no benefit exists under this provision when total qualified expenditures exceed $1.05 million.
ARRTA also extends through 2009 a provision that allows companies to accelerate the recognition of AMT credit carryforwards in lieu of claiming bonus depreciation. The amount of accelerated AMT credits that can be claimed is limited to 20 percent of the bonus depreciation that would have been allowed but to no more than the lesser of $30 million or 6 percent of AMT credits accumulated from tax years beginning before Jan. 1, 2006. In other words, AMT credits generated during 2006 or later are not eligible. This provision could allow a bank generating losses in 2008 or 2009 to receive a partial refund of AMT credits rather than claim the bonus depreciation, which could just add to an NOL carryforward.
Deferral of Cancellation of Debt Income (CODI)
ARRTA contains a favorable provision that could affect a bank’s business clientele. Companies generally are required to recognize CODI at:
- The acquisition, at a discount, of their own debt for cash;
- The exchange of one debt instrument for a new debt instrument at a lower issue price;
- The substantial modification of a debt instrument;
- The exchange of a debt instrument for corporate stock or a partnership interest; and
- The complete forgiveness of debt.
ARRTA allows companies to elect to defer the recognition of CODI from such transactions that take place in 2009 and 2010. If this election is made, the income is deferred and recognized ratably over a five-year period starting in 2014. The recognition of the deferred income is accelerated upon bankruptcy filing, the cessation of business, or other similar circumstances. For partnerships and S corporations, the sale or exchange of an interest in the pass-through entity or the redemption of a partner or shareholder in the entity accelerates recognition of the CODI. Companies with NOLs or unused tax credits should consider including the CODI in taxable income rather than making the election.
Kevin Powers is an executive with Crowe Horwath LLP in the Oak Brook, Ill., office. He can be reached at 630.586.5140 or kevin.powers@crowehorwath.com.
Sheryl Vander Baan is an executive with Crowe Horwath LLP in the Grand Rapids, Mich., office. She can be reached at 616.752.4255 or sheryl.vanderbaan@crowehorwath.com.
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Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer.
