Credits Against Tax
On Dec. 5, 2011, the IRS published final regulations (T.D. 9560) relating to how an entity serving targeted populations can meet the requirements to be a qualified active low-income community business (QALICB) under the provisions of the new markets tax credit (NMTC) program. In addition, on May 1, 2012, the Community Development Financial Institutions (CDFI) Fund, the division of Treasury that oversees the NMTC program, announced that it completed the first stage of its transition to updated program eligibility based on new census data. Both of these recent changes were important steps in expanding the impact of the NMTC program, giving more businesses access to the “gap” financing provided by private investors under the program.
Note: The new markets tax credit expired at the end of 2011 (Sec. 45D(f)); however, the carryover period for unallocated credits runs through 2016 (Sec. 45D(f)(3)), and Congress is expected to renew the credit.
Background of the NMTC Program
The NMTC program was created in December 2000 by the Community Renewal Tax Relief Act of 2000, P.L. 106-554, to spur new or increased investments into operating businesses and real estate projects located in low-income communities throughout the United States and its territories. The NMTC program attracts investment capital to low-income communities by permitting individual and corporate investors to receive a tax credit against their federal income tax return in exchange for making an equity investment in a specialized organization called a community development entity (CDE). The credit totals 39% of the original investment amount and is claimed over a period of seven years—5% for each of the first three years of the investment period, and 6% for each of the last four years of the investment period. If the investment in the CDE is redeemed before the end of the seven-year investment period, then 100% of the tax credit is subject to recapture.
Since the NMTC program’s inception, the CDFI Fund has made 664 awards allocating a total of $33 billion in tax credit authority to CDEs through a competitive application process. Based on data provided in a report by the CDFI Fund on Nov. 22, 2011, through the fiscal year 2010 reporting period, CDEs disbursed a total of $20.9 billion in equity investments to 3,060 QALICBs—financing real estate developments and operating businesses in low-income communities. These investments supported a wide variety of projects including, among others, charter schools, health care facilities, timberlands, grocery stores, restaurants, child care providers, and pharmacies.
The technical provisions of the NMTC program are contained in Sec. 45D and Regs. Sec. 1.45D-1. Sec. 45D(a)(1) provides a tax credit on certain credit allowance dates with respect to a qualified equity investment (QEI) in a CDE, as described in Sec. 45D(c). Under Sec. 45D(b)(1), an equity investment in a CDE is a QEI if (1) the investment is acquired by the taxpayer at its original issue solely in exchange for cash; (2) substantially all the cash is used by the CDE to make qualified low-income community investments (QLICIs); and (3) the investment is designated for purposes of Sec. 45D by the CDE. Sec. 45D(d)(1)(A) further defines a QLICI as any capital or equity investment in, or loan to, any QALICB.
The definition of a QALICB is contained in Sec. 45D(d)(2) and Regs. Sec. 1.45D-1(d)(4). In general, among other requirements (only some of which will be covered in this item), a QALICB must generate at least 50% of its total gross income from the active conduct of a qualified business within any low-income community; at least 40% of the tangible property of the QALICB must be used within any low-income community; and at least 40% of the services provided for the QALICB by its employees must be performed within any low-income community.
The determination of whether a business qualifies as a QALICB is made on a separate-company basis. Thus, even a large, multinational corporation can be eligible for NMTC financing by forming a subsidiary entity to qualify as a QALICB. Regs. Sec. 1.45D-1(d)(4)(iii)(A) also allows portions of a business to qualify as a QALICB as if the trade or business (or portion thereof) were separately incorporated, provided that a complete and separate set of books and records is maintained for that trade or business (or portion thereof).
In addition to the technical requirements under the Code and regulations, the CDFI Fund provides a set of rules to which each CDE must adhere. The rules are incorporated into an allocation agreement between the CDFI Fund and the individual CDEs that have been granted tax credit authority via the competitive application process discussed above. The allocation agreement specifies, among other items, the eligible investment activities of the CDE, the low-income communities (LICs) the CDE is eligible to serve, and the flexible financing terms of the investments the CDE will make in the LICs it serves. Thus, the specific terms of an allocation agreement can limit the types, and locations, of QALICBs in which CDEs are eligible to invest.
As originally enacted, Sec. 45D, and the regulations thereunder, defined LICs as: (1) any population census tract if the poverty rate for the tract is at least 20%; or any population census tract if the median family income for the tract does not exceed 80% of statewide family median income (or 80% of the greater of statewide median income or metropolitan area median family income, in the case of tracts located within a metropolitan area); and (2) certain “Targeted Areas” specifically designated by Treasury as an LIC if the boundary of the area is continuous, the area would satisfy the poverty or median family income requirements as previously described, and inadequate access to investment capital exists in the area.
The American Jobs Creation Act of 2004, P.L. 108-357, amended the definition of LICs. Specifically, it removed Treasury’s authority to designate targeted areas and instead created three new categories of LICs: (1) high out-migration rural county census tracts; (2) low-population/empowerment zone census tracts; and (3) “targeted populations.” The IRS published Notice 2006-60 to provide guidance on how an entity meets the requirements to be a QALICB when its activities involve targeted populations. T.D. 9560 was issued on Dec. 5, 2011, finalizing new regulations. As a result, Notice 2006-60 is obsolete for tax years ending on or after Dec. 5, 2011, and the final targeted populations rules are now contained in Regs. Sec. 1.45D-1(d)(9).
There are two categories of eligible targeted populations under the NMTC program: (1) low-income targeted population (LITP); and (2) GO (Gulf Opportunity) Zone targeted population (GZTP). The LITP comprises individuals, or an identifiable group of individuals including an Indian tribe, who are low-income persons. For this purpose, “low income” means having an income, adjusted for family size, of not more than: (1) for metropolitan areas, 80% of the area median family income; or (2) for nonmetropolitan areas, the greater of 80% of area median family income or 80% of statewide nonmetropolitan area median family income. The regulations allow an individual’s income to be determined using household income as measured by the U.S. Census Bureau, as determined under Section 8 of the Housing Act of 1937, P.L. 75-412 (as reported by HUD), or based on adjusted gross income (AGI) as reported on IRS Form 1040, U.S. Individual Income Tax Return. AGI must include the AGI of any family member of the individual’s family if that family member resides with the individual, regardless of whether the family member files a separate return.
The GZTP comprises individuals, or an identifiable group of individuals, including an Indian tribe, who otherwise lack adequate access to loans or equity investments and that were displaced from their principal residences and/or lost their principal source of employment as a result of Hurricane Katrina in 2005. To meet this definition, an individual’s principal residence or principal source of employment, as applicable, must have been located in a population census tract within the GO Zone that contains one or more areas designated by the Federal Emergency Management Agency (FEMA) as flooded, having sustained extensive damage, or having sustained catastrophic damage as a result of Hurricane Katrina.
Regs. Sec. 1.45D-1(d)(9) specifies how an entity serving targeted populations can meet the requirements to be a QALICB. In general, a business (i.e., potential QALICB) may be able to satisfy the requirements if (1) at least 50% of its total gross income for any tax year is derived from sales, rentals, services, or other transactions with members of the targeted population; or (2) at least 40% of its employees are members of the targeted population; or (3) at least 50% of the entity is owned by members of the targeted population. The determination of whether an employee is a low-income person is made at the time the employee is hired and continues throughout the time of employment, regardless of any increase in the employee’s income after the time of hire. The determination of whether an owner is a low-income person is made at the time the QLICI is made or at the time the ownership interest is acquired by the owner, whichever is later.
Contrast the requirements of a QALICB serving targeted populations with the general QALICB requirements under Regs. Sec. 1.45D-1(d)(4). First, the tests for serving targeted populations are “or” tests. A QALICB does not have to meet all of the tests, as QALICBs are required to do under the general requirements of Regs. Sec. 1.45D-1(d)(4). In addition, the 40%-tangible-property test under the general requirements has been replaced with an ownership test (i.e., at least 50% of the entity is owned by members of the targeted population). This makes sense, given that the location of the business property is generally not relevant—in other words, the QALICB does not have to be located in an LIC. Rather, the focus is on the LIC residents (or displaced residents, in the case of a GZTP) benefiting from the activities of the QALICB. As a result, the targeted populations tests ensure, and encourage, the hiring of employees from LICs; the provision of critical-need services to residents of LICs; and/or local ownership of businesses serving the needs of LIC residents.
The targeted populations regulations also provide for various other limitations. With respect to QALICBs serving an LITP, the QALICB must be located primarily in census tracts for which median family income does not exceed 120% of the applicable median family income—though exceptions are provided for low-population census tracts in nonmetropolitan areas and for low-population census tracts zoned for commercial or industrial use. A median family income ratio between 81% and 120% is considered to be moderate income. Thus, as stated in the previous paragraph, the QALICB does not have to be located in an LIC (i.e., with a median family income ratio at or below 80%), but it also cannot be located primarily in high-income census tracts, with certain exceptions.
For QALICBs serving a GZTP, only those CDEs with a significant mission of recovery and redevelopment in the GO Zone that received a special allocation of NMTCs pursuant to the GO Zone Act of 2005, P.L. 109-135, may serve this population. The QALICB must also be located in census tracts within the GO Zone that contain one or more areas designated by FEMA as flooded, having sustained extensive damage, or having sustained catastrophic damage as a result of Hurricane Katrina. In addition, the QALICB must be located primarily in census tracts for which the median family income does not exceed 200% of the applicable area median family income, with similar exceptions applicable to an LITP (as discussed in the previous paragraph).
Data regarding census tracts, median income, GO Zone qualified areas, and other demographic data can be found on the CDFI Fund’s website. Keep in mind, however, that identification of the census tracts in which the QALICB is operating (or is going to operate) is less than half the battle. More importantly, the CDE will have to ensure that proper documentation is obtained from the QALICB regarding gross income derived from members of a targeted population, employees who are members of a targeted population, and/or owners who are members of a targeted population. This can be a daunting task, requiring affidavits and signed certifications from members of these applicable groups, as well as tax opinions issued by attorneys or other professional service providers. As a result, this can be not only a daunting task, but also an expensive one.
Updated Census Data
On May 1, 2012, the CDFI Fund released updated LIC eligibility data for the NMTC program. The new LIC eligibility data is based on income and poverty data provided by the Census Bureau’s 2006–2010 American Community Survey (ACS) for the 2010 census tracts. CDEs can use the updated census data to determine if a QALICB is located in an NMTC-eligible 2010 census tract. The CDFI Fund also released a list of 2010 census tracts that are eligible because they are located in high out-migration rural counties. During the transition phase from the 2000 census data to the 2010 census data, the CDFI Fund will allow current NMTC recipients to use either data set to qualify QLICIs closed between May 1, 2012, and June 30, 2013.
As of the date this item was written, the CDFI Fund had not yet updated its mapping system for the 2006–2010 ACS data. The CDFI Fund anticipates this data to be available for mapping by the fourth quarter of calendar year 2012, when it is expected to launch a redesigned and improved mapping system. In the meantime, CDEs and QALICBs can use the Federal Financial Institutions Examination Council Geocoding System to identify the census tract in which a particular QALICB is located. The identified census tract can then be matched to the tabular eligibility file for 2006–2010 ACS low-income communities, which is available on the CDFI Fund’s website.
CDEs that intend to apply for NMTC allocation authority in the 2012 allocation round are required to use the 2006–2010 ACS data to identify qualified projects for their applications to the CDFI Fund. CDEs that receive allocation authority under the 2012 allocation round are required to use the 2006–2010 ACS data to qualify QLICIs. On July 13, 2012, the CDFI Fund formally announced the opening of the 2012 application round. However, as of the date this item was written, Congress had not yet passed an extension of the NMTC for 2012, and, in fact, an extension of the NMTC by Congress may not occur until after the presidential election in November.
The NMTC program has become an important tool in the financing of commercial projects located in low-income and highly distressed communities throughout the United States and its territories. These recent changes are welcome additions to the ongoing efforts by both the IRS and the CDFI Fund to ensure that the NMTC program remains relevant and to further support the revitalization and rehabilitation efforts aimed at reversing the economic downturn experienced over the past several years.
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, Ill.
For additional information about these items, contact Mr. O’Connell at 630-574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.