Business Tax Provisions of Economic Stimulus Act
Corporate & Finance Alert
March 3, 2009
The American Recovery and Reinvestment Act of 2009 (the “2009 Recovery Act”) which was signed into law on Tuesday, February 17, 2009, contains a number of tax relief provisions for businesses. As discussed more detail below, these provisions include:
- Extending Bonus Depreciation Through December 31, 2009
- Extending Section 179 Expensing Through December 31, 2009
- Deferral of Income Tax from Cancellation of Debt
- Extension of NOL Carryback Period to five years for Small Businesses
- Suspension of OID Rules for High Yield Debt Obligations
- S Corporation Built-in Gains Relief
- Expansion of Work Opportunity Credits for Employers
Extending Bonus Depreciation Through December 31, 2009
In 2008, Congress temporarily allowed businesses to recover the costs of capital assets made in 2008 faster than the regular depreciation schedule. The accelerated depreciation permitted businesses to immediately write off 50% of the cost of depreciable assets acquired in 2008 for use in the United States. Examples of depreciable assets are equipment, tractors, wind turbines, solar panels, and computers.
The 2009 Recovery Act extends the acceleration for capital expenditures incurred in 2009. For example, under the 50% accelerated depreciation, a taxpayer deducts half the cost of an asset purchased in the year of purchase. The remaining 50% is depreciated under the regular depreciation schedule. For an asset with a five year life, the taxpayer recovers 60% of the asset cost in the first year. The 60% results from the 50% bonus depreciation, and one-fifth of the remaining 50% for the year of purchase.
Extending Section 179 Expensing Through December 31, 2009
To assist small businesses in recovering the cost of capital expenditures, small businesses may elect to write off the cost of these expenditures in the year of acquisition, instead of recovering the cost over the regular depreciation schedule. Until the end of 2010, small businesses were allowed to immediately expense up to $125,000 (indexed for inflation) of capital expenditures subject to a phase-out once the capital expenditures exceed $500,000 (indexed for inflation). In 2008, Congress increased the amount that small businesses could write off for expenditures incurred in 2008 to $250,000, and increased the phase-out threshold for 2008 to $800,000. The 2009 Recovery Act extends these increases for capital expenditures made in 2009.
Deferral of Income Tax on Cancellation of Debt Income
Normally, taxpayers recognize ordinary income upon recognition of cancellation of debt income (“COD”). The 2009 Recovery Act adds new Code Section 108(i) to allow an election to defer the payment of tax on the recognition of COD from a “reacquisition” of an “applicable debt instrument” that occurs in 2009 or 2010 over the five-taxable-year period beginning in 2014.
A “reacquisition” means any acquisition of a debt instrument by either the debtor or a related person as defined in Code Section 108(e)(4), which is basically a 50% test. An “acquisition” is defined broadly to include the acquisition for cash, the exchange for a new debt instrument, a modification of the outstanding debt instrument, an exchange of the debt instrument for corporate stock or a partnership interest, and the contribution of the debt instrument to capital. An “acquisition” also includes the complete forgiveness of the indebtedness by the holder of the debt instrument.
An “applicable debt instrument” means any debt instrument issued by a C corporation or “any other person in connection with the conduct of a trade or business by such person.”
Critically, the tax payment deferral is accelerated in the case of a “liquidation or sale of substantially all of the assets of the taxpayer (including in a title 11 or similar case), the cessation of business by the taxpayer, or similar circumstances.” This acceleration rule also applies for pass-thru entities “in the case of the sale or exchange or redemption of an interest in a partnership, S corporation, or other pass-thru entity by a partner, shareholder, or other person holding an ownership interest in such entity.”
In summary, new Code Section 108(i) does not provide for an exclusion from income, unlike the other provisions of Code Section 108. It instead allows the taxpayer to defer paying the tax on the COD income until the tax years of 2014 through 2018. The present value of deferring the payment of the tax for an average of seven and a half years is significant, and may allow a debtor to restructure debt when the tax bill would otherwise have made the restructuring prohibitively expensive.
Extension of NOL Carryback Period to 5 Years for Small Businesses
Under current law, taxpayers can carry back net operating losses (“NOLs”) to the two prior tax years and then carry the NOLs forward for the next twenty years. The 2009 Recovery Act allows eligible small businesses to elect to carry back an “applicable 2008 net operating loss” for up to five years, rather than two. An applicable 2008 net operating loss is an NOL generated by any taxable year ending in 2008, or alternatively, any taxable year beginning in 2008.
Eligible small businesses mean a corporation or partnership with average annual gross receipts for the prior 3-year period of less than $15,000,000. Treasury is to issue anti-abuse rules including anti-stuffing rules, anti-churning rules, and wash sale rules.
Temporary Suspension of OID Rules for High Yield Debt Obligations
The 2009 Recovery Act includes a provision that suspends the operation of an important limitation on the deductibility of interest on certain high yield debt obligations. The suspension should assist in the restructuring of corporate issued debt in the current market.
Since 1989, Code Section 163 has included limitations on the deductibility by C corporations of original issue discount (“OID”) on applicable high yield discount obligations (“AHYDOs”). An AHYDO is a debt instrument that:
- has a maturity date of more than five years;
- bears interest at a rate of 5 percent or more than the applicable federal rate (AFR); and
- has “significant” OID.
If a debt instrument is characterized as an AHYDO, several adverse results occur. First, the OID is treated as a (nondeductible) dividend to the extent of the total OID or the “disqualified yield.” The disqualified yield is the excess of the total return on the debt instrument over the AFR plus 6 percent. Second, that portion of the OID that is not treated as a dividend is not deductible by the corporation until actual cash payments are made. Of course, at the same time that the issuer’s interest deduction is limited, the holder must report the OID as interest income on an accrual basis.
One commonly used technique to avoid AHYDO status is to structure a debt offering so that it is not considered to have significant OID. A debt instrument is treated as having significant OID if the aggregate amount that would be includible in gross income as of the close of a period ending more than five years after issuance is greater than the sum of the actual interest paid prior to such period plus the product of the issue price of the debt instrument and its yield to maturity. To avoid being considered to have significant OID, debt instruments have often been structured to provide for a large cash payment or payments at the end of the fifth year after issuance.
As the financial press has reported, the current financial crisis has boosted market yields on non-investment grade debt to levels that were unheard of only a few years ago, especially in comparison to the yield on Treasury securities, which approximates the AFR. The premise of the AHYDO rules is that when a debt instrument accrues a relatively high interest rate, the instrument is more akin to equity rather than debt, so that a deduction for interest should be limited as a matter of policy. In the current financial market debacle, this premise is unfounded.
Under the 2009 Recovery Act, the AHYDO rules are suspended and thus do not apply to a debt instrument that would otherwise be characterized as an AHYDO issued after August 31, 2008 but before January 1, 2010, in exchange for an obligation which is not an AHYDO. Such an exchange includes a significant modification of an outstanding non-AHYDO instrument that is treated as an exchange for federal income tax purposes. The new exception does not apply to debt instruments (i) with certain contingent payment features (i.e., interest is based on receipts, cash flow, or asset valuation changes), and (ii) issued to related parties as defined in Code Section 108(e)(4).
The AHYDO suspension amendment in the 2009 Recovery Act also includes a provision that allows the Secretary of the Treasury to extend the suspension period to exchanges after December 31, 2009 “if the Secretary determines that such application is appropriate in light of distressed conditions in the debt capital markets.” Finally, the 2009 Recovery Act also allows the Secretary to temporarily define an AHYDO by reference to an implicit interest rate higher than the AFR if distressed conditions in the debt capital markets continue.
S corporation Built-in Gains Tax Relief
Currently, when an existing C corporation with C corporation earnings and profits elects S status, any built-in gain recognized during the 10-year recognition period after the S election is initially made triggers a 35% built-in gains tax. This provision is designed to prevent C corporations from electing S status shortly before a major asset sale transaction to avoid the C corporation level tax.
The 2009 Recovery Act provides that for taxable years beginning in 2009 or 2010, if the taxpayer is in the eighth, ninth, or tenth year of the 10-year recognition period, no built-in gains tax will apply to asset dispositions that otherwise would have triggered the built-in gains tax.
Work Opportunity Credits
Code Section 51 currently provides a Work Opportunity Credit of up to 40 percent of the qualified first-year wages paid or incurred by an employer to individuals who are members of a targeted group. The maximum annual amount of an individual employee’s wages that can be taken into account is $6,000 ($12,000 in the case of a qualified veteran). Targeted groups currently include disabled veterans, food stamp recipients, and a long-term family assistance recipient, among others.
The 2009 Recovery Act expands the list of target groups to include unemployed veterans and disconnected youth. These amendments to Section 51 apply to hires who begin work after December 31, 2008 and during 2009 and 2010.