Capital gain exclusions expanded for empowerment zone and renewal community investments.

The Community Renewal Tax Relief Act of 2000 (the Act) significantly expanded incentives for taxpayers investing in businesses located in distressed communities. Beginning with the Omnibus Budget Reconciliation Act of 1993, empowerment zones have been the target of several tax benefits, including an employment credit, an increased Sec. 179 deduction and tax-exempt bond financing. Along with other incentives, the Act added a 60% gain exclusion on the sale of qualified small business stock (QSBS) for empowerment-zone businesses under Sec. 1202(a)(2) and, in Sec. 1400F, a 100% capital gain exclusion on the sale of certain assets located in renewal communities.

Tax legislation encouraging investment in distressed areas has been helping to revive neighborhoods and communities. Early responses to other legislation for distressed communities are encouraging. In 1996, businesses took over $15 million for empowerment-zone employment credits. The ostensible success of earlier legislation has spurred Congress to expand incentives for investors and entrepreneurs to invest in the poorest neighborhoods and communities. The expansion of benefits to empowerment zones and the creation of community renewal statutes for the most distressed areas in the Act are examples of this trend.

Empowerment Zones and Renewal Communities

The Secretary of HUD has the authority to designate empowerment zones and renewal communities. Designated empowerment zones appear in IRS Pub. 952 (June 2001). Currently, 23 urban areas and eight rural areas have this designation. The Act allows for an expansion of nine more empowerment zones and 40 renewal communities. When added together, it appears there will be 40 empowerment zones and 40 renewal communities. However, current empowerment zones also qualify for recharacterization as renewal communities. The Secretary of HUD has until Dec. 31, 2001 to determine the 40 communities based on detailed criteria set forth in Sec. 1400E. Many are interested in which renewal communities will become new targets and which ones will be reclassified from empowerment zones. Up to 20 empowerment zones can be reclassified. Sec. 1400E(e) states that when the HUD Secretary reclassifies an empowerment zone as a renewal community, he terminates the original zone designation. It is stated in the Committee Reports that once the Secretary redesignates an empowerment zone, another area can take its place.

Capital gain benefits for empowerment zones and renewal communities differ substantially. Empowerment zone businesses can exclude 60% of the gain on the sale of the stock of C corporations that qualify as an enterprise-zone business. Renewal communities can exclude 100% of the capital gain from the sale of an interest in an enterprise-zone business or a tangible asset used in one. While the 60% exclusion applies only to C corporations, the 100% exclusion applies to all forms of business as long as they qualify as an enterprise-zone business under Sec. 1397C. This exclusion also applies to the gain on the sale of tangible assets from a renewal community trade or business.

Gain Exclusion on the Sale of QSBS

Exhibit 1 presents criteria that businesses can use to defer gain on QSBS under Sec. 1202. When a noncorporate taxpayer sells QSBS, it can exclude 50% of the gain from Federal income taxation. To qualify, the stock must be original issue and held at least five years. Since its inception, tax experts have criticized the ineffectiveness of this statute. The government taxes gain on the sale of QSBS stock at 50% of the 28% tax rate, resulting in a 14% rate. For nonqualified stock, the capital gain rate is only 20%. Thus, the 50% exclusion rate is only 6% (20%-14%) lower. If applicable, the alternative minimum tax (AMT) could effectively eliminate any Sec. 1202 benefit. For taxpayers subject to the AMT, the current 50% exclusion benefit may not be enough to entice them to invest in distressed communities.

Exhibit 1: Qualifications for Gain Deferral of QSBS

Sec. 1202(b)(1): Limit caps the eligible gain to the greater of
$10 million, less all gain subject to this provision in previous
years or 10 times the adjusted basis of all QSBS disposed of
during the current year.

Sec. 1202(c)(1): Stock is C corporation original-issue stock,
issued after Dec. 31, 2001 in exchange for cash, property
or services.

Sec. 1202(c)(2): Business meets the active business requirement
during substantially all of the taxpayer's stockholding period.

Sec. 1202(d)(1):Aggregate gross assets of the corporation cannot
exceed $50 million at any time during which the taxpayer holds
the stock.

Sec. 1202(e)(1):To qualify as an active business, the
corporation uses at least 80% of its assets in the active
conduct of one or more businesses.

Sec. 1202(e)(3): Exclusion specifically applies to almost all
service corporations, such as the professions, insurance
and farming.

Increased Capital Gain Exclusion on Empowerment-Zone Stock

The increased exclusion of gain on the sale of empowerment-zone stock is effective for investments purchased after 2000. Given the five-year holding period, investors will not realize any benefits before 2006. This empowerment-zone incentive is merely an expansion of the Sec. 1202 partial exclusion of gain from QSBS. Sec. 1202(a)(2) lists the requirements for the empowerment-zone business exclusion. There are very few differences in the rules between the 50% exclusion and the 60% exclusion.

To be eligible for either benefit, stock must qualify as small business stock under Sec. 1202(c). However, to garner benefits from the 60% exclusion, a corporation must also be an enterprise-zone business as defined under Sec. 1397C. Exhibit 2 presents the qualification criteria for an enterprise-zone business. The only other attribute differentiating the two provisions is the termination of the benefit. The 50% gain exclusion is permanent; the 60% exclusion terminates on Dec. 31, 2014 under Sec. 1202(a)(2)(C). However, Sec. 1400B(b)(7) provides a safe-harbor rule. If the property qualifies for the 60% exclusion on the cessation date, a sale that occurs after that date does not preclude the taxpayer from realizing the benefits of the 60% exclusion on gain accrued up to that date.

Exhibit 2: Characteristics of an Enterprise-Zone Business

Sec. 1397(b)(1): Business is qualified within an empowerment
zone or renewal community (e.g., corporation, partnership
or proprietorship).

Sec. 1397(b)(2): At least 50% of total gross income is from
the active conduct of a trade or business within the empowerment
zone or renewal community.

Sec. 1397(b)(3) and(4): If the business has intangible assets, a
substantial part of the assets would be used within the empowerment
zone or renewal community and in the active conduct of the business.

Sec. 1397(b)(5): A substantial amount of the employees' services
are performed within the empowerment zone or renewal community
(including the proprietor).

Sec. 1397(b)(6): At least 35% of the business' employees are
residents of the empowerment zone or renewal community
(including the proprietor).

Sec. 1397(b)(7) and (8): Nonqualified financial property and
collectibles not held primarily for sale to customers are less
than five percent of the average of the total unadjusted
bases of the assets owned by the business.

The 60% gain exclusion results in an effective rate of 11.2%, rather than the 14% rate on the original Sec. 1202 exclusion. The savings could be substantial, as long as the AMT does not apply. The AMT adds back 42% of the excluded gain, resulting in a 19.88% tax rate for the 50% exclusion and an 18.3% tax rate for the 60% exclusion. If a taxpayer has a $20,000 capital gain from the sale of stock, his tax liability will depend on which statute applies and whether he is subject to AMT. As shown in Exhibit 3, the 60% exclusion provides a substantial tax savings as long as the taxpayer is not subject to AMT. Under Sec. 1202, the 50% exclusion is virtually eliminated when the AMT applies. The tax benefit left in the aftermath of the AMT for the 60% exclusion is hardly enough to change the investing behavior of the taxpayer subject to AMT. As Exhibit 3 shows, if Congress intends to encourage all taxpayers to invest in distressed communities, it needs to eliminate the AMT for investments in enterprise-zone businesses.

Exhibit 3: Taxpayer with $20,000 Capital Gain from a Stock Sale

                Effective regular   Regular tax
                  tax rate (%)       liability

No exclusion            20            $4,000
50% exclusion           14             2,800
60% exclusion         11.2             2,240

                Effective tax
                 rate after     Tax liability
                   AMT (%)        after AMT

No exclusion           20          $4,000
50% exclusion       19.88           3,976
60% exclusion        18.3           3,660

Tax planning is available for the 60% exclusion. In addition to the gain exclusion, Congress passed a rollover provision for stock in empowerment-zone businesses. If the taxpayer purchases QSBS in the same zone within 60 days of the sale of the original stock and meets the enterprise-zone business criteria, he can roll over the gain into the new stock. Thus, if the taxpayer makes such a sale in a year in which he is subject to AMT, he can roll over the gain into the new stock to avoid paying AMT.

Exclusion of Capital Gains on Renewal-Community Investments

Renewal communities are a new designation beginning in 2002. They benefit from an employer wage credit, an increased Sec. 179 deduction, a commercial revitalization deduction for the renovation of real property and a capital-gain exclusion. Unlike empowerment zones and enterprise communities, taxpayers can exclude all capital gain from taxation if they meet the requirements. The 100% exclusion has been part of the District of Columbia enterprise zone incentives since enactment in 1997.

To qualify for the 100% capital-gain exclusion, a taxpayer must hold a qualified community asset for more than five years. A qualified community asset includes an enterprise-zone business (see Exhibit 2) and tangible assets or property that a taxpayer uses in a trade or business located in a renewal community, purchased after 2001 and held for more than five years.

Sec. 1400B rules on the zero-percent capital-gain rate specifically exclude intangible assets and land from gain exclusion if they are not an integral part of a qualified renewal-community business. Also, taxpayers must keep accurate records on the fair market value of qualified assets for assets placed into service prior to the renewal-community designation and that remain in service on termination of the statute. Under Sec. 1400B(g)(2), the taxpayer cannot include gain attributable to periods before the enactment date and after the termination date in the capital gain subject to the 100% exclusion.

Overview

Exhibit 4 presents a comparison of the three provisions. Sec. 1400F is much broader in scope, because it includes all types of businesses and tangible assets used in a trade or business. Given that the scope of Sec. 1400F goes beyond stock, a taxpayer must specify the character of the allowable gain. Sec. 1400B (e) (3) specifically excludes any gain that would be treated as ordinary income under Sec. 1245 or 1250. For purposes of this statute, Sec. 1250 gain includes all previous depreciation, rather than just additional depreciation. This exclusion is not necessary for the other two provisions, as only C corporation stock qualifies for the tax benefit.

Exhibit 4: Criteria for Excluding Capital Gain by Statute

                                      Sec. 1202      Sec. 1202(a)(2)
                                     50% capital      60% capital
                                    gain exclusion   gain exclusion

Allowable assets:
C corporation                       [check]          [check]
S corporation, partnership
  and proprietorship
Tangible assets used in qualified
  business

Qualification criteria:
Must be a qualified
  small business                    Yes              Yes
Must be an enterprise-
  zone business                     No               Yes
Effective capital-gain rate         14%              11.2%
Is original-issue stock             Yes              Yes
Earliest date to acquire asset      Aug. 11,1993     Jan. 1, 2001
Holding period for tax benefit      >5 years         >5 years
Qualifying taxpayer                 Noncorporate     Noncorporate
Maximum gain exclusion              $10 million      $10 million

                                     Sec. 1400F
                                    100% capital
                                    gain exclusion

Allowable assets:
C corporation                       [check]
S corporation, partnership
  and proprietorship                [check]
Tangible assets used in qualified
  business                          [check]

Qualification criteria:
Must be a qualified
  small business                    No
Must be an enterprise-
  zone business                     Yes
Effective capital-gain rate         zero
Is original-issue stock             No
Earliest date to acquire asset      Jan. 1, 2002
Holding period for tax benefit      >5 years
Qualifying taxpayer                 N/A
Maximum gain exclusion              N/A

The taxpayer has to jump through the most hoops to qualify for the 60% gain exclusion; the stock must be QSBS and enterprise-zone business stock. The empowerment-zone stock must meet all of the criteria in Exhibits 1 and 2, along with other criteria not specified in the exhibits. It remains to be seen how many taxpayers will take advantage of the 60% exclusion, given the AMT and all of the qualification criteria.

Although Secs. 1202(a)(2) and 1400F were both enacted in 2000, the HUD Secretary needed an extended period of time to select the 40 renewal communities. Hence, Sec. 1400F becomes effective one year after Sec. 1202(a)(2). The effective date is merely the first date in which a taxpayer can purchase the qualifying property. To actually accrue any benefit, the taxpayer has to hold the property for more than five years. Taxpayers will not receive any Sec. 1202(a)(2) benefits until 2006 and, for Sec. 1400F, not until 2007. That gives Congress several years to modify the provisions and to revisit the impact of the AMT on Sec. 1202(a)(2).

Conclusion

Congress has truly put the plight of America's poorest communities and neighborhoods on the top of its tax reform agenda. The creation of enterprise communities, empowerment zones and renewal communities is a vital part of this growing trend. Sec. 1400F is by far the strongest capital-gain exclusion incentive for entrepreneurs and investors to invest in the neediest communities. It is questionable whether Sec. 1202(a)(2) provides taxpayers with enough incentive to affect their investor behavior, but only time will tell.

FROM LINDA NELSESTUEN, PH.D., CPA, CMA, CLEVELAND STATE UNIVERSITY, OH (NOT AFFILIATED WITH SUMMIT INTERNATIONAL ASSOCIATES, INC.)