Will the new markets tax credit stimulate low-income communities?

Part I of this two-part article, in the last issue, explained the goals of and qualifications for new markets tax credits (NMTCs).

Part II discusses uses of taxpayers' capital contributions, credit recapture, other Federal tax incentives and limits on NMTC use.

In the last issue, Part I of this two-part article addressed new markets tax credit (NMTC) status, allocations and investments. The second part, below, discusses uses of taxpayers' capital contributions, recapture, other Federal tax incentives and limits on use.

Permissible Investments

For equity investors in a community development entity (CDE) to qualify for NMTCs, the CDE must use 85% (substantially all) of contributed capital to make qualified low-income community investments. Sec. 45D(d)(1) defines "qualified low-income community investments" to include any:

1. Capital investment in a qualified active low-income community business (qualified business).

2. Loan made directly to such a qualified business.

3. Equity in (or loan to) another CDE.

4. Loan to a qualified business or CDE originated by another CDE and purchased from the originating CDE.

Sec. 45D (d)(1) also includes financial counseling to businesses in (and residents of) low-income communities.

Qualified Business

To generate NMTCs for its equity investors, a CDE making loans to or investing equity in a non-CDE entity (or buying from another CDE a loan originally made by that CDE to a non-CDE entity) must generally ensure that the non-CDE entity is a "qualified active low-income community business" (defined in Sec. 45D(d)(2)). Sec. 45D(d)(2)(A) permits a qualified business to be organized as a partnership (including a multiple-member limited liability company (LLC)), a nonprofit corporation or a for-profit C or S corporation.

In addition, Sec. 45D(d)(2)(B) states that businesses organized as proprietorships (presumably including single-member LLCs (SMLLCs)) can qualify, if the proprietorship would meet the requirements if separately incorporated. Similarly, Sec. 45D(d)(2)(C) provides that a portion of a qualified business conducted in several locations can qualify. Apparently, borrowers that are qualified subchapter S subsidiaries and SMLLCs with a corporation or partnership sole owner can be qualified active low-income community businesses if their sole owner qualifies under Sec. 45D(d)(2)(A) or if they separately qualify under Sec. 45D(d)(2)(C).

Sec. 45D(d)(3) permits most types of businesses to qualify. While commercial rental buildings (e.g., shopping centers, offices and warehouses) meet the requirements regardless of the business's commercial tenants, unimproved real estate holdings do not qualify. Sec. 45D(d)(3), incorporating Sec. 1397C(d), makes certain types of businesses ineligible, including rental housing, developing or holding of intangibles for license (thus excluding some software businesses), firms valued in excess of $500,000 and liquor stores and other facilities described in Sec. 144(c)(6)(B).

Percentage Tests

Under Sec. 45D(d)(2)(A) and Temp. Kegs. Sec. 1.45D-1T(d)(4), a business must have certain links to low-income communities to be a qualified active low-income community business. At least 40% of the tangible real or personal property owned or leased by the business (valued at original cost for owned property and any reasonable valuation for leased property) must be located within any low-income community. At least 40% of the wages paid to employees must be for services performed by the entity within any low-income community. Moreover, unless either the low-income community tangible property percentage or wages percentage is at least 50%, at least 50% of gross income must be derived from the active conduct of a qualified business within any low-income community.

The 40% tests may be difficult to meet for many businesses whose headquarters and employees are located within a low-income community, but which provide services outside such communities (e.g., construction, guard, janitorial, home healthcare and catering businesses). On the other hand, the fact that Temp. Regs. Sec. 1.45D-1T(d)(4) does not impose a gross-income test when the low-income community tangible property or wages percentage is at least 50%, apparently accommodates pure cost centers such as production and distribution facilities and situations in which cost of sales exceeds sales, notwithstanding the possible existence of some nonqualifying income that otherwise could cause the 50%-gross-income test to be failed.

In addition, Sec. 45D(d)(2)(A) provides that 5% or more of the qualified business's assets cannot consist of collectibles held for investment, financial assets in excess of working capital needs or debt instruments with a term longer than 18 months. The 18-month restriction generally excludes banks and other financial institutions.

Low-Income Community

Sec. 45D(e) defines a "low-income community" to include any census tract with median income at least 20% below the metropolitan-area or statewide median income, or with a poverty rate of at least 20%. Treasury can designate as a low-income community a smaller low-income contiguous area lacking adequate access to investment capital, but located within a non-low-income census tract.

Transactions Between CDEs

If a CDE invests equity in (or makes loans to) another CDE, Temp. Regs. Sec. 1.45D-1T(d)(1) generally treats such amount as a qualified low-income community investment of the first CDE only to the extent the second CDE invests the proceeds in (or loans to) a qualified business in a manner that would constitute a qualified low-income community investment if made directly by the first CDE. Thus, CDEs making investments in (or loans to) other CDEs must ensure that the recipient CDEs use the proceeds for qualified investments.

Under Temp. Regs. Sec. 1.45D-1T(d)(1), if a CDE purchases a loan to a qualified business from another CDE, the loan is a qualified low-income community investment if it so qualifies either when the selling CDE made the loan or when the loan is purchased from the selling CDE. Under Temp. Regs. Sec. 1.45D-1T(c)(5), the CDE's basis, for purposes of applying the 85% tests to the purchasing CDE, appears to be the loan's cost to the purchasing CDE; this reflects any premium or discount over the selling CDE's cost basis.

Recapture

Under Sec. 45D(g), a recapture event occurring within seven years of a CDE issuing a NMTC-designated equity interest, triggers an additional tax equal to the tax savings from the prior NMTCs claimed, and interest at the underpayment rate. Under Sec. 45D(g)(3) and Temp. Regs. Sec. 1.45D-1T(e)(2), a recapture event occurs if a CDE loses its status as such, redeems equity investments or no longer uses "substantially all" of the proceeds of its investments for qualified low-income community investments.

Temp. Regs. Sec. 1.45D-1T(c)(5) applies the 85% tracing and overall tests based on original cost basis under Sec. 1012, it ignores fair market value, thereby minimizing the need for appraisals. Favorably, the cost basis of any qualified low-income community investment that becomes worthless continues to be treated as a qualifying investment; thus, the financial risk does not create recapture risk. The temporary regulations' preamble states that issuance costs or CDE overhead expenses do not count toward the 85% tests. However, Temp. Regs. Sec. 1.45-1T(d)(3) does allow CDE reserves (not in excess of 5% of the taxpayer's cash investment) for loan losses or for additional investments in existing qualified investments to be treated as qualifying assets in applying the tests.

Repayments

Temp. Regs. Sec. 1.45D-1T(d)(2) addresses how to treat repayments (or the selling price) of equity or principal on a qualified low-income community investment in applying the 85% tests. Generally, amounts a CDE receives in payment of (or for capital, equity or principal on) such an investment must be reinvested no later than 12 months from the date of receipt to qualify as continuously invested. This places the CDE under some time pressure to locate a potential investment, perform due diligence and close. However, in the case of "periodic" amounts received as principal payments on a loan qualified as a low-income community investment, the reinvestment period is extended to the end of the following calendar year. Periodic payments are not defined; it is unclear whether balloon repayments, voluntary prepayments, prepayments due on breach of a borrower's financial covenants or payments on a due-on-sale clause are periodic.

According to Temp. Regs. Sec. 1.45D-1T(d)(6), whether a business uncontrolled by a CDE at the time of testing is qualified is determined by the timing of the CDE'S investment in (or loan to) the business, based on the CDE's reasonable expectations for the business throughout the investment's (or loan's) term. One concern for investors is that recapture may be triggered by an investment in (or loan to) a noncontrolled business being excluded from the numerator of the 85% tests, merely because the business successfully expanded outside low-income communities (or contracted within low-income communities) so that less than 40% of its tangible assets are located (or less than 40% of its wages are incurred) within low-income communities.

Under Temp. Kegs. Sec. 1.45D-1T(d)(6), recapture relief may not be available if a CDE cannot show such expansion (or contraction) was not reasonably expected at the time of its investment or loan. To mitigate investor fears of recapture, perhaps the Service will view reasonable expectations as established by a written business plan, presented at the time of the CDE's investment, that reasonably forecasts continued future qualification as a qualified active low-income community business throughout the seven-year period.

Other Rules

Temp. Regs. Sec. 1.45D-1T(e)(3) provides that a CDE's bankruptcy is not a recapture event; Temp. Regs. Sec. 1.45D-1T(e)(4) grants the IRS discretion to waive a requirement or extend a deadline to avoid recapture. A Temp. Regs. Sec. 1.45D-1T(g)(1) anti-abuse rule provides that the IRS can trigger recapture if a transaction is undertaken to achieve a result inconsistent with Sec. 45D and Temp. Regs. Sec. 1.45D-1T.

Some rules facilitate winding down during the seventh year of the credit period without recapture. Amounts received in the seventh year in payment of (or for capital, equity or principal on) a qualified low-income community investment do not have to be similarly reinvested by the CDE to qualify as continually invested. In addition, the 85% substantially all test is reduced to 75% in the seventh year.

Double Dipping

Under Sec. 45D(i)(1), future IRS regulations will limit NMTCs for investments directly or indirectly subsidized by other Federal tax benefits. Both the preamble and Ann. 2001-49 (1) request comments on such regulations' scope.

Disqualifications

Sec. 45D(i)(1) specifically authorizes Treasury to treat as a NMTC-disqualifying subsidy the Sec. 42(a) low-income-housing tax credit. The preamble observes that residential rental property is not a qualified business; it concludes that a taxpayer, even without regard to Sec. 45D(i), cannot receive both Sec. 42(a) credits and NMTCs on the same investment.

Sec. 45D(i)(1) likewise authorizes Treasury to treat the Sec. 103 exclusion for interest on tax-exempt bonds (e.g., qualified small-issue and redevelopment bonds, exempt facilities bonds (including enterprise-zone facilities bonds) and qualified Sec. 501(c)(3) bonds) as a NMTC-disqualifying subsidy. The preamble concludes that the tax-exempt interest subsidy referred to in Sec. 45D(i)(1) is that received by the borrower (not the bond purchaser) under a tax-exempt bond financing. Thus, the IRS apparently views Sec. 45D(i) as authorizing regulations that bar an allocation of NMTCs to a CDE'S equity investment in a qualified business that is the ultimate obligor on tax-exempt bond financing.

Further, the preamble states that a loan by a CDE directly to a business cannot be a tax-exempt bond, because the loan is not a state or local government obligation. This may mean that the IRS will not allow conduit-type revenue bonds (issued to a CDE through a state agency by a qualified business) to be included as loans to a qualified business in the numerator of the 85% tests.

Public Comments

Commentators have requested that the IRS not apply Sec. 45D(i)(1) to disallow NMTCs in connection with a CDE's investment in commercial rental building projects that generate a historic tax credit or rehabilitation tax credits. Commentators have also requested that NMTCs be available to a CDE that invests in a business that generates Sec. 51 work-opportunity tax credits, Sec. 51A welfare-to-work tax credits, Sec. 1396 empowerment-zone wage tax credits and Sec. 1400H renewal-community wage tax credits. They have also requested that the Sec. 1202(a) reduction-of-capital-gain tax granted to investors who invest in qualified small businesses stock, the Sec. 1397B deferral of gain on rollover of empowerment-zone investments, the Sec. 1400B exemption from capital-gain tax for DC zone assets and the Sec. 1400F exemption from capital-gain tax for renewal-community assets, be permitted in connection with NMTCs, a result suggested by Sec. 45D(h). Another possible subject for Sec. 45D(i)(1) regulations is the extent to which an NMTC is available for investments made in corporate CDEs that result from tax-deferred sales of public company stock (Sec. 1044) or qualified small business stock (Sec. 1045).

An equity investment by a CDE with an NMTC allocation in another CDE with a NMTC allocation is not characterized by Temp. Regs. Sec. 1.45D-1T(c)(4)(i)(B) as an NMTC-eligible qualified equity investment of the first CDE. This rule precludes the first CDE's investors from claiming both direct and duplicative indirect NMTCs on the same cash equity investment.

Limits on NMTC Use

Depending on many technical and mathematical limits, taxpayers can generally use NMTCs to offset any tax otherwise payable on income from a CDE; excess credits beyond those needed to shelter CDE income may shelter the investor's other income. According to Temp. Regs. Sec. 1.45D-1T(g), NMTCs are claimed by filing Form 8874, New Markets Credit, with a tax return.

Sec. 38(b)(13) characterizes the NMTC as a general business tax credit. Sec. 38(c)(1)(A) provides that general business credits are not creditable against the alternative minimum tax. Under Sec. 38(c)(1)(B), general business credits cannot exceed the excess of net income tax over 25% of the portion of the taxpayer's net regular tax liability that exceeds $25,000. Sec. 39(a)(1) provides generally that noncreditable general business credits may be carried back one year and forward 20.

The relationship of various pre-2001 technical limits on tax credits to NMTCs is unclear. For example, Sec. 469 generally provides that tax credits from passive activities (in excess of the tax liability generated therefrom) cannot be used by an individual and certain other classes of taxpayers to offset a tax liability on nonpassive income. Temp. Regs. Sec. 1.469-1T(e) indicates that holding loans or C stock is not a passive activity. However, under Regs. Sec. 1.469-4(d)(5)(i), owning an interest in a passthrough entity that holds partnership interests in operating partnerships that either rent property or operate a business in which the taxpayer does not materially participate is a passive activity to the extent of those holdings. Accordingly, if an individual owns an interest in a passthrough-entity CDE, and the CDE owns partnership interests in rental or operating businesses, the excess of the individual's NMTCs attributable to such partnership interests owned by the CDE, over his pre-tax liability from such partnership interests or other passive sources, may not be available to offset non-passive income.

Other novel technical issues arise in connection with NMTCs that the IRS might address in future regulations. For instance, is there any reduction in the NMTC under Sec. 49(a)(1) for CDE equity investments financed by nonrecourse financing, given that the credit base requiring reduction under that section does not cross-reference Sec. 45D? Similarly, future regulations might address whether the IRS will apply a pre-tax profit-motive requirement to NMTCs. In an analogous area, Regs. Sec. 1.42-4 states that the Sec. 183 not-for-profit rules do not apply to disallow low-income-housing credits, although the IRS can use economic substance or similar tax law principles in appropriate circumstances to deny such credits.

Economic Evaluation

The Community Development Financial Institutions Fund's (Fund's) policies of allocating NMTCs based on its review of CDE applicants' business plans and the CDEs' operational policies, will influence whether low-income residents of low-income communities benefit from the NMTC program. The NMTC program's mechanical tax requirements provide no incentives to benefit low-income residents of low-income communities.

The NMTC program itself provides no credit enhancement; thus, to minimize their investors' risks, CDEs may be motivated to offer zero- or low-interest-rate loans to high-credit publicly traded corporations for facilities that these corporations would locate in such tracts in any event.

The definition of low-income community in Sec. 45D(e) is based on residential rental income. Accordingly, commentators have observed that many of the wealthiest prosperous-by-day downtown areas in the U.S. qualify as low-income communities. By contrast, the definition of qualified business in Sec. 45D(d) requires NMTC-eligible funds to be invested in nonresidential facilities. As a result of these definitions, luxury downtown office buildings with commercial tenants and high-income employees residing in high-income areas (e.g., CPA and law firms) qualify for NMTC financing. Temp. Regs. Sec. 1.45D-1T(d)(5)(i) confirms "there is no requirement that employees of a qualified business be residents of a low-income community."

Although the NMTC program is large in absolute terms, it is relatively small. For example, if NMTC-allocated CDE equity was invested uniformly nationally, in a major metropolitan area with about three million people (about 1% of the U.S. population), the volume of new NMTC-allocated CDE equity funds invested there would be about $25 million annually (1% X ($15 billion/6 years)) during the remaining six years of the NMTC program.

On June 10, 2002, the Fund announced it is accepting applications for the 2002 allocation of about $1 billion of NMTCs (corresponding to $2.5 billion of equity investment). Its NMTC application guidelines and forms are available at www.cdfifund.gov. CDE certification applications must be received by July 25, and NMTC applications must be submitted by August 29. In evaluating NMTC applications, the Fund will consider a CDE's business strategy. In accordance with Sec. 45D(f)(2), it will give more points to CDEs with controlling entities that have a successful track record of assisting low-income communities and to CDEs that invest in businesses unrelated to the CDE. The Fund will also examine capitalization strategies, including past syndication success and an ability to raise funds, as well as NMTC equity. A CDE's management capacity and projected community impact will also be reviewed.

Conclusion

Qualified businesses, lenders, investors, financial intermediaries and their advisers are likely to find several opportunities in the NMTC program, despite its modest relative size. Private syndicators and nonprofit organizations can form--and seek NMTC allocations for--CDEs that will sell equity interests directly to taxpayers and use the proceeds to invest in or make loans to qualified businesses or other CDEs. Taxpayers can obtain NMTCs that will shelter their yield from investment in the CDE and, depending on technical and mathematical limits, possibly shelter some of their other income from tax. Qualified businesses can find low-cost equity partners and low-interest-rate lenders in the form of CDEs. Private syndicators and nonprofit organizations can sponsor CDEs that do not compete for NMTCs, but rather raise equity or debt from NMTC-allocated umbrella CDEs and invest the funds in low-income community businesses. Non-NMTC-allocated CDEs can also be formed to originate loans to qualifying businesses on a revolving basis and sell them to NMTC-allocated CDEs. Moreover, the NMTC program will no doubt provide significant marketing opportunities for professionals as well.

(1) Ann, 2001-29, IRB 2001-20, 1183.

Alan S. Lederman, P.A., MBA, J.D., CPA
Partner
Broad and Cassel
Miami, FL