Employment-Zone Empowerment and Renewal- Community Tax Incentives

An often overlooked and misunderstood tax-reduction strategy is the tax incentives associated with businesses located in economically distressed areas such as designated empowerment zones and renewal communities.

The Community Renewal Tax Relief Act of 2000 (Act) extends empowerment-zone status for existing zones through 2009, provides additional tax benefits to businesses located in empowerment zones and authorizes nine new zones.

One of the principal tax incentives is the empowerment-zone employment credit, which is up to 20% of $15,000 of qualified-zone wages paid during the year to a qualified-zone employee. The credit is available for wages paid to part-time and full-time employees, provided they have worked for the employer at least 90 days. Nonqualifying employees include related taxpayers, dependents and five-percent owners. The employee not only must work and live in an empowerment zone to qualify, but substantially all the employee's service must be performed within the empowerment zone. Businesses such as country clubs, golf courses, gambling establishments and certain farming operations do not qualify.

As the credit is a general business credit for Federal tax purposes (taken from Form 8444), passthrough entities such as S corporations and partnerships may be eligible for the credit, which in turn the owner takes on his individual returns. The "price" of the credit is that the taxpayer must reduce its salary and wage deduction on its Federal return by the amount of the employment credit.

Another tax incentive for businesses located in an empowerment zone is an increased Sec. 179 deduction. Taxpayers may be able to claim up to $20,000 ($35,000 for 2002 and later years) as an additional Sec. 179 deduction, in the year the taxpayer places the property in service. To qualify, the property must be qualified-zone property, placed in service in an empowerment zone by an enterprise-zone business. Qualified-zone property is any depreciable tangible property that:

• The taxpayer did not acquire from a related party or member of a controlled group;
• The taxpayer is the first person to use in the empowerment zone;
• The basis of which is not determined by the property's adjusted basis in the hands of the person from whom the property was acquired, and the basis cannot be determined under the stepped-up basis rules for property acquired from a decedent;
• The taxpayer acquired after the empowerment-zone designation went in effect; and
• 85% or more of its use is in an empowerment zone (delivery equipment usually does not qualify).

In addition, the taxpayer's business must be an enterprise-zone business that involves the active conduct of a trade or business within the empowerment zone. Generally, any business qualifies, except one in the development or holding of intangibles for sale or license, and specific businesses (such as golf courses, country clubs, race tracks and certain farming trades). Special rules apply to businesses that rent real or tangible personal property. Qualifying businesses must obtain at least 50% of their gross revenue from within a zone, and a substantial part of the employee's services must be performed within it. Taxpayers often overlook the requirement that at least 35% of the taxpayer's employees must be residents of the empowerment zone (this rule does not apply to the District of Columbia Zone).

If the amount of qualified Sec. 179 property purchased exceeds $200,000, the amount eligible to be expensed would be reduced. Recapture rules would apply if the property was no longer used in an empowerment zone.

Tax practitioners should also be aware that Sec. 1202 could apply to entities located in empowerment zones. While taxpayers must satisfy various requirements, those who qualify could exclude up to 60% of their gain on the sale of the stock.

The tax incentives connected with renewal communities are similar to empowerment-zone tax incentives. The Act authorizes up to 40 renewal communities in which businesses are eligible for various tax credits and incentives. These incentives are available Jan. 1, 2002Dec. 31, 2009. The Office of Housing and Urban Development (HUD) will designate the renewal communities by the end of 2001.

The tax incentives available for qualifying businesses include the renewal-community employment credit, increased Sec. 179 expense deduction, commercial revitalization deduction and capital gain exclusion.

The renewal-community employment credit is available for businesses within the designated distressed area that hire individuals living and working in the renewal community. The credit is 15% of the first $10,000 of qualified wages for each qualified employee per year. However, the employer must reduce deductions on its Federal return by the amount of the renewal-community credit.

A business is also eligible for an increased Sec. 179 expense deduction, provided it places in service qualified renewal property and qualifies as a renewal-community business. Specific requirements for the increased Sec. 179 benefit are similar to those of the empowerment-zone requirements.

Another tax incentive for a business to locate in a renewal community is the commercial revitalization deduction (Sec. 1400I). Taxpayers can choose to treat revitalization expenses in one of two ways:

• Amortize the entire expenditure over 120 months, beginning with the month a taxpayer places a building into service, or
• Deduct half of the revitalization expenses for the tax year in which a taxpayer places a building into service.

Qualified revitalization expenses are those chargeable to a capital amount for depreciable property, which is generally nonresidential real property that a taxpayer places into service in a renewal community before 2010. If the building is a new structure, the original use must begin with the taxpayer; if it is not new, the taxpayer must substantially rehabilitate the building before placing it in service. Most expenditures qualify, with the exception of those used to figure any other allowable credit. In addition, for a building acquired and rehabilitated, the acquisition cost is treated as a qualified revitalization expenditure, only to the extent that it does not exceed 30% of the aggregate qualified revitalization expenditures (determined without regard to such cost) for such building. The overall dollar limit for any qualified building is the lesser of $10 million or the amount allocated to the building by the state revitalization agency.

Under Secs. 1202 and 1400F, a capital gain exclusion is available on the sale or exchange of qualified community stock, partnership interest or business property held for more than five years. A qualified community stock or partnership interest is any stock in a U.S. corporation or interest in a U.S. partnership that the taxpayer acquired after 2001 at its original issue for cash. At the time of stock issuance or acquisition of partnership interest and during its holding period, the corporation or partnership must have been a renewal-community business. Qualified business property is tangible property acquired after Dec. 31, 2001 and before June 1, 2010, but not from a related person or member of a controlled group. Its basis cannot be determined by its adjusted basis in the hands of the person from whom the taxpayer acquired it, nor can basis be determined under the stepped-up basis rules for property acquired from a decedent. The business must be the original user of the property and the use must have been in the renewal community during substantially all of its holding period.

As can be seen, there are numerous tax incentives for businesses located in economically distressed employment and renewal communities. A clear understanding of the specific requirements is necessary to advise clients properly.

From Bernard K. Fleishman, Ellin & Tucker, Chartered, Baltimore, MD