Credits Against Tax
The new markets tax credit (NMTC) was enacted under the Community Renewal Tax Relief Act of 2000, P.L. 106-554, and was incorporated into the Internal Revenue Code as Sec. 45D. The NMTC aims to encourage capital investment in economically depressed areas by private investors in exchange for federal income tax credits. Treasury has used data collected over the past 10 years to analyze the program’s overall effectiveness in stimulating the local economy and promoting job growth. The results have shown that the NMTC has been effective in spurring investment in real estate development, but it has failed to attract a significant amount of investment in other types of businesses.
Earlier this year, the Obama administration introduced the Startup America initiative, a national campaign aimed at increasing U.S. worldwide competitiveness in high-growth, job-creating industries, such as clean energy, medicine, advanced manufacturing, and information technology. As a part of the plan, President Barack Obama proposed to expand the NMTC to encourage private-sector investment in startups and small businesses operating in lower-income communities. To that end, Treasury has proposed revisions to the NMTC regulations, primarily to make the program more attractive to investors in non–real estate businesses in low-income communities. The proposed regulations were published in a notice of proposed rulemaking (REG-101826-11) issued in June 2011.
Legal Framework of the NMTC
Sec. 45D(a) provides that taxpayers who hold a qualified equity investment (QEI) can claim an NMTC equal to 39% of the original investment amount in a qualified community development entity (QCDE). Taxpayers claim the credit over a seven-year period at a rate of 5% of the investment amount for each of the first three years and 6% for each of the remaining four years. Sec. 45D(h) requires taxpayers to reduce their basis in the QEI by the amount of the credit claimed. Taxpayers that redeem their investment during the seven-year period are subject to recapture of the credit plus interest.
A QEI is defined in Sec. 45D(b) as any investment in a QCDE if:
- The investment is acquired at its original issue solely in exchange for cash;
- Substantially all of the cash is used by the QCDE to make qualified low-income community investments (QLICIs); and
- The investment is designated by the QCDE as a QEI on its books and records using any reasonable method.
Sec. 45D(c) defines a QCDE as any domestic corporation or partnership whose primary mission is serving, or providing investment capital for, low-income communities or low-income persons. The entity must be accountable to the residents of the low-income communities through residents’ representation on its board. The IRS must also certify the entity as a QCDE.
A QLICI, as defined by Sec. 45D(d), is:
- Any capital or equity investment in, or loan to, any qualified active low-income community business (QALICB);
- A purchase from another community development entity of any loan made by such entity that is a QLICI;
- Financial counseling and certain other services to businesses located in, and residents of, low-income communities; or
- Any equity investment in, or loan to, any other QCDE.
A QALICB is any corporation (including a nonprofit corporation) or partnership that:
- Derives at least 50% of its total gross income from the active conduct of a qualified business within any low-income community;
- Uses a substantial portion of its tangible property and performs a substantial portion of its services in a low-income community; and
- Holds less than 5% of the unadjusted basis of such property as collectibles (other than those held for sale in the ordinary course of business) or nonqualified financial property (as defined in Sec. 1397C(e) for enterprise zone businesses—generally stocks, bonds, notes, partnership interests, certain other securities and contracts, and similar assets).
A qualified business, including a QALICB, includes any business not specifically excluded by Secs. 45D(d) and 1397C(d). A qualified business does not include one that primarily develops or holds intangibles for sale or license, or one operating a golf course, country club, or certain other recreational or gaming facilities. It can be a farming activity, but only if the basis of its business assets and value of leased property combined do not exceed $500,000. The rental of nonresidential real property is generally a qualified business if the property is located in a low-income community and is substantially improved. A QALICB can be a sole proprietorship or portion of a business that would otherwise qualify as a QALICB if separately incorporated.
A low-income community is described in Sec. 45D(e) as a census tract in which the poverty rate is at least 20% or the median family income does not exceed 80% of the state’s or metropolitan area’s median family income, with special rules for areas not in census tracts, tracts with low populations, those in rural counties with high population migration, and certain other targeted populations.
The nationally allocable dollar limit for the NMTC is set for each calendar year by Sec. 45D(f). For 2011, the maximum available credit is $3.5 billion. Treasury allocates that amount among applying QCDEs. The deadline for submitting allocation applications for the 2011 credit was July 27, 2011. Recipients of allocations of the credit are generally announced early the following year.
At the time of this writing, Congress has not extended the credit beyond 2011. However, the Obama administration’s 2012 budget proposes to extend the NMTC through 2012, with an allocation of $5 billion.
Implementation of the NMTC Program
The Community Development Financial Institutions (CDFI) Fund, an agency within Treasury, administers the NMTC program. The mission of the CDFI Fund is to “expand the capacity of financial institutions to provide credit, capital, and financial services to underserved populations and communities in the Unites States.” Under this mission, the CDFI Fund directly invests in and supports community development financial institutions working in underserved communities. Besides the NMTC, the CDFI Fund also oversees the Bank Enterprise Award and Native Initiatives programs.
Since the NMTC program’s inception, the CDFI Fund has awarded a total of $29.5 billion in tax credit authority to 594 QCDEs (U.S. Department of the Treasury, Community Development Financial Institutions Fund, 2010 New Markets Tax Credit Program Allocations 23 (July 24, 2011)). The CDFI Fund announced in August 2011 that it had received 314 applications from QCDEs requesting $26.6 billion in credit allocations for 2011—more than seven times the amount available. In 2010, 99 QCDEs were selected from among 250 applicants to receive the $3.5 billion in available credit for the year (id.). The types of organizations receiving allocations of the credit include CDFIs, nonprofit organizations, government-controlled entities, banks, publicly traded institutions, real estate development companies, and minority-owned or controlled companies. The eligible investment activities carried out by these organizations include loans to, or equity investment in, businesses and real estate projects, capitalization of other community development entities to fund other NMTC-eligible activities, and purchase of NMTC-eligible loans originated by other QCDEs.
The CDFI Fund reported that more than 98% of NMTC recipients have invested in low-income communities through preferential rates and terms on loans, such as below-market interest rates, lower origination fees, and longer-than-standard periods of interest-only payments (id. at 28–29). However, only 35% of the NMTC investment has been in non–real estate businesses, and much of this portion has gone to support real estate–related projects (REG-101826-11).
Promoting Non–Real Estate Business Investment
The proposed regulations revise the reinvestment rules to increase the program’s ability to benefit non–real estate businesses in low-income communities. QCDEs are required by Sec. 45D(b) to invest substantially all of the cash they receive in QLICIs. Regs. Sec. 1.45D-1(d)(2) currently requires amounts received as returns on QLICIs within the seven-year qualification period (including repayments of principal from amortized loans) to be reinvested in QLICIs within a 12-month period. The preamble to the proposed regulations notes that this continuous reinvestment requirement “makes it difficult for [QCDEs] to provide working capital and equipment loans to non-real estate businesses because these loans are ordinarily amortizing loans with a term of five years or less.”
The proposed regulations offer an alternative reinvestment rule for QCDEs that make QLICIs in non–real estate businesses. The proposed regulations define a non–real estate QALICB as any QALICB whose predominant business activity “does not include the development (including construction of new facilities and rehabilitation/enhancement of existing facilities), management, or leasing of real estate.” A predominant business activity is one that generates more than 50% of the business’s gross income. Furthermore, the purpose of the money invested in the business cannot be connected to the development, management, or leasing of real estate.
As an alternative to the current reinvestment rule, if a QCDE makes a QLICI in a non–real estate business and receives a payment of, or for, capital, equity, or principal from that business during the seven-year credit period, the QCDE may reinvest the money in an unrelated certified CDFI that is recognized as a community development entity for purposes of the NMTC. The reinvestment into the CDFI must occur within 30 days from the date of receipt of the payment for the monies to be treated as continuously invested.
However, the total amount a QCDE may reinvest in a CDFI for purposes of the continuously invested requirement is limited. The total amount reinvested in a CDFI cannot exceed an escalating percentage of the maximum aggregate portion of the non–real estate QEI within the seven-year credit period: 15% in year 2, 30% in year 3, 50% in year 4, and 85% in years 5 and 6. QCDEs are not required to reinvest payments received in the seventh credit year.
The IRS appears committed to increasing the ability of the NMTC program to provide access to credit in low-income communities. The revisions to the regulations provide an alternative means of reinvesting returns during the seven-year credit period and appear to be a promising step in that direction.
Mark Cook is a partner at SingerLewak LLP in Irvine, CA.
The editor would like to offer a special thanks to Christian J. Burgos, J.D., LL.M., for his assistance with this column.
For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or firstname.lastname@example.org .
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.