Community Renewal Tax Relief Act's Incentives for Investors—Form Over Substance?

Before completing its session at year-end, Congress passed, and President Clinton signed, the Installment Tax Correction Act of 2000 (HR 3594) and the Community Renewal Tax Relief Act of 2000 (Act) (HR 5662). While the Act includes various other provisions, it essentially provides tax incentives for businesses to locate in urban and rural areas that did not experience the economic expansion enjoyed by much of the nation during the 1990s, and to hire residents of those areas. The Act also provides various tax incentives to investors. The question is whether the alternative minimum tax (AMT) will allow the realization of some of the incentives designed to encourage investment in disadvantaged communities.

Business Incentives

Briefly, the Act creates or extends and expands three vehicles to encourage business development in designated areas. First, it creates 40 renewal communities, entitling qualifying businesses to a zero capital gain rate on the sale of qualifying assets, expanded Sec. 179 expensing of fixed assets, accelerated deductions for revitalizing qualified buildings and enhanced jobs credits. Secondly, the Act creates a new markets tax credit for investment in stock in community development entities. Finally, the Act extends the life of the empowerment zones (originally created under the Omnibus Budget Reconciliation Act of 1993 and expanded under the Taxpayer Relief Act of 1997), authorizes the creation of nine additional empowerment zones and expands some of the incentives for businesses in these zones.

Benefits of Empowerment Zones

Qualifying businesses located in empowerment zones will enjoy expanded jobs credits and Sec. 179 expensing of fixed assets, deferral of gain on qualifying assets if the proceeds are reinvested in appropriate replacement assets and easier access to tax-exempt financing. For the most part, the tax incentives for operating a business in an empowerment zone function at the entity (rather than the investor) level, although if a business is a partnership or S corporation, the benefits will pass through to the owners. In addition, the deferral of gain on disposition of certain assets, followed by a reinvestment of proceeds in qualifying assets, can apply to stock and partnership interests in a qualifying business if the investor is willing to reinvest the proceeds in another qualifying business in an empowerment zone. There is one provision specifically directed at potential investors: Act Section 117 increases the 50%-exclusion-of-gain provisions of Sec. 1202 to a 60% exclusion for eligible shareholders of qualifying businesses under the empowerment zone rules—in effect, a super-sized Sec. 1202 exclusion. It is this provision, designed to encourage investors to provide capital to start-up businesses in distressed communities, that may be all form and no substance. Further, qualifying for the exclusion precludes investors from enjoying the tax benefits of other business forms and may possibly limit the use of tax credits.

Value of the Investor Incentive

Sec. 1202 was originally part of the Revenue Reconciliation Act of 1993. It provides an exclusion for 50% of the gain realized by noncorporate shareholders of qualified small business stock issued after Aug. 10, 1993 and held for more than five years. Numerous eligibility criteria apply to the corporation, including a ceiling on the maximum value of gross assets held and restrictions on the use of the assets, the nature of the business activities, limits on redemptions and the business form itself (i.e., it must be a C corporation). Various restrictions also apply to the shareholder, including the requirement that he acquire the stock on its original issuance and the lack of eligibility by corporate shareholders.

Sec. 1202 encourages investors to invest in small, start-up companies, which often have difficulty raising capital, by offering reduced taxes as a tradeoff for additional risk incurred on investing in such a company. However, the 50% exclusion is not as valuable an incentive as it may first appear; if a taxpayer avails himself of the Sec. 1202 50% gain exclusion, he forfeits the 18% capital gain rate (for investments made after 2000 and held more than five years) and pays instead a 28% tax rate on half of the taxable gain. The investor also increases his AMT exposure, because 28% of the exclusion (usually 14% of the total gain) becomes an AMT preference item. Further, this AMT preference is an exclusion preference and the taxpayer cannot recover any resulting AMT through the minimum tax credit. For example, for a $1 million gain, the incremental tax savings that an investor realizes on gain qualifying under Sec. 1202 would be only $800, compared to a comparable gain on a traditional investment held more than five years.

The application of the AMT essentially eradicates any benefit from the traditional application of Sec. 1202. Does it also negate the additional incentives that an empowerment zone business might offer an investor?

To qualify for the 60% exclusion, a business must meet the requirements of both Secs. 1397C(b) and 1202. An investor must (1) have acquired stock after Dec. 21, 2000 and held it for more than five years and (2) satisfy the empowerment zone requirements during substantially all of the holding period. Assume an individual acquires stock in a corporation on Jan. 2, 2002 and sells it on Jan. 3, 2007 for a $100,000 gain. Exhibit 1 compares the after-tax return under three different scenarios: (1) a traditional long-term capital gain, resulting in application of the 18% capital gain rate; (2) a gain qualifying for the Sec. 1202 50% exclusion but not a qualifying empowerment zone business entity; and (3) a gain qualifying for the 60% Sec. 1202 exclusion that allowed an investment in a qualifying empowerment zone business entity.

Assuming the taxpayer is not subject to AMT, he can reap, under Sec. 1202, an additional $4,000 return (an extra 4.9%) relative to the traditional after-tax gain. If that investment also satisfies the location, employment and other requirements of Sec. 1397C, he can earn an extra $6,800 (8.3%) in comparison to the traditional long-term capital gain or $2,800 (3.3%) in comparison to investing in a business not limited to the empowerment zone. Given that the Sec. 1202 benefit is the major incentive, the question is whether the additional conditions that an investor must satisfy and the additional risk are worth the added return that the tax incentives provide. If the taxpayer is subject to AMT, the extra reward is immaterial. For an AMT taxpayer, the reduction in the additional after-tax return of nonzone Sec. 1202 stock is reduced to only $80 (or 1%) in comparison to the traditional long-term capital gain. The after-tax return on "zone" stock for an AMT taxpayer is reduced to $2,096 (2.6%) in comparison to a traditional long-term capital gain of $2,016 (2.5%) on nonzone Sec. 1202 stock. Further, for each layer of extra tax savings, the investor has to deal with a narrowing field of investment choices (due to the multitude of eligibility requirements), extra complexity and additional risk. In particular, for a taxpayer subject to the AMT, the extra return is probably not worth the risk and extra effort.

Who are the investors that would have the capital to invest and would be willing to accept the risk of investing in a start-up company, particularly one in a depressed area facing numerous limits on asset placement and use and employment pools, or in funds specializing in such start-up companies? These incentives would probably appeal to upper-income individuals. As has been discussed at length in recent years, the reach of the AMT has been expanding at rapidly increasing rates, particularly in upper-income groups. According to a June 2000 report issued by the Treasury Office of Tax Analysis, by 2005, 28.6% of taxpayers with adjusted gross incomes exceeding $200,000 will be paying AMT, and by 2010, 56.4% of such taxpayers will be paying AMT. A taxpayer considering an investment in an empowerment zone-qualifying business entity will have to assess his likelihood of being subject to the AMT five years into the future. Even if the Sec. 1202 benefit does not subject a taxpayer to AMT or increase his AMT liability, related costs exist; the spread between regular tax and tentative minimum tax will narrow, reducing the taxpayer's ability to use general business credits (including the new markets tax credit) and the minimum tax credit.

Additional Considerations

For taxpayers who are confident of avoiding the AMT, the additional return that the zone-enhanced Sec. 1202 allows is still not substantial, given the risk and complexity; in the best case, it is only 8.3% over five years. As noted, the gap between tentative minimum tax and regular tax narrows, limiting other tax benefits, the use of tax credits in particular. There is an additional cost to consider—the loss of flexibility in the choice of business entity. To qualify under Sec. 1202, a business must be a C corporation from the date of stock issuance. Business owners and investors are therefore forgoing passthrough benefits, such as those from a limited liability company treated as a partnership for tax purposes. Specifically, individual taxpayers face the effects of double taxation and give up the benefits of the passthrough of start-up losses, the expanded jobs credits and the enhanced Sec. 179 expense.

Conclusion

In evaluating the risks and rewards of tax incentives for investing in distressed areas, businesses and investors cannot simply accept the superficial promise of lower capital gain rates, without factoring in the direct and indirect costs associated with the AMT and the forgone benefits of other entity choices.

From Ann Burstein Cohen, MBA, CPA, Visiting Associate Professor of Accounting, University at Buffalo, State University of New York, Buffalo, NY (Not affiliated with KPMG)