Tax Incentives for Businesses in Distressed Communities

Executive Summary

• Businesses in designated EZs and RCs may be eligible for an employment credit, increased Sec. 179 expensing, tax-exempt bond financing and other tax incentives.
• A capital gain deferral applies to purchased EZ assets; a 60% exclusion applies to small business EZ stock.
• Enterprise zone facility bonds may be available to finance property acquisitions.

Businesses in designated distressed areas are entitled to various tax incentives. This article provides an overview of the incentives available in designated empowerment zones and enterprise and renewal communities.   Since 1993, Congress has enacted a number of tax provisions that offer tax incentives for businesses operating in distressed communities. The various incentives provide for credits and enhanced deductions and exclusions, depending on an area’s particular designation. The Community Renewal Tax Relief Act of 2000 (CRTRA 2000) highlighted the continued importance that Congress places on investment in low-income and economically disadvantaged areas.   The Department of Housing and Urban Development (HUD) has a well-constructed website with detailed information and links to various incentives for economic development; see Exhibit 1. The HUD website¹ states that there are $5.3 billion in “empowerment zone” (EZ) tax incentives and $5.6 billion available in “renewal community” (RC) incentives (these terms are discussed below). However, many of these dollars may be unclaimed due to the nature of the deductions and credits. Tax incentives for distressed communities apply only to certain geographic areas. For example, employees must also reside in the designated geographic area to qualify for the Sec. 1396 employment credit. The definitions for qualified businesses, assets or employees are detailed and specific. Unclaimed credits can result from tax practitioners and business owners being unaware of these less-publicized tax incentives.

This article highlights the tax incentives available for businesses and, in some cases, individual investors, in EZs and RCs. Businesses looking to set up new operations, or to expand or relocate existing ones, may benefit from locating their business in an economically distressed community for which tax incentives are available. Tax practitioners need to be aware of these incentives as they consult with clients on tax-saving opportunities. See Exhibit 2 for a summary of the incentives; many are available through 2009.

EZs

Certain economically distressed communities were designated as EZs in the Revenue Reconciliation Act of 1993 (RRA ’93).² Businesses in the designated EZs are entitled to various tax incentives, including a wage-based employment credit for hiring employees living in the EZ, increased Sec. 179 expensing and expanded tax-exempt bond financing.³ In addition to EZs, certain economically distressed communities were designated as enterprise communities, entitled to fewer tax incentives than are EZs.

Designated Zones

EZs are nominated by state and local governments. Under Sec. 1392(a), distressed communities submitting an application for EZ designation must have a strategic plan and meet eligibility criteria, including population, general economic distress and poverty rate.

Various tax acts since the RRA ’93 have expanded the number of EZs. However, each “round” of designation has required different eligibility criteria, along with different tax incentives over different dates of coverage. Round I under the RRA ’93 allowed the HUD Secretary to designate six urban EZs and the Secretary of Agriculture to designate three rural EZs, effective as of Dec. 21, 1994. The RRA’93 also authorized the designation of 65 urban enterprise communities (ECs) and 30 rural ones. The Taxpayer Relief Act of 1997 (TRA ’97) authorized two additional EZs as Round I EZs, with a Jan. 1, 2000 effective date.⁴

The TRA ’97 also authorized the HUD Secretary to designate 15 additional urban EZs and the Secretary of Agriculture to designate five additional rural EZs. These Round II EZs have different eligibility criteria from their Round I counterparts. Also, Round II EZs are not eligible for the Sec. 1391 credit for EZ wages paid or incurred on or before Dec. 31, 2001, under Sec. 1391(g).

The CRTRA 2000 authorized the HUD Secretary and the Secretary of Agriculture to designate nine additional EZs, with not more than seven in urban areas and not more than two in rural areas, in Sec. 1391(h)(1). These EZs are generally designated as Round III EZs.

Because Round I and II EZs were authorized by different tax legislation, they had different beginning and ending dates. Originally, they expired at the end of the tenth calendar year beginning on or after the date of designation. The CRTRA 2000 extended the expiration date for Rounds I and II to match the expiration date of Round III (Dec. 31, 2009).

Sec. 1391(d)(1) allows for an earlier expiration date if so designated by the local or state government or if the Secretary of HUD or Agriculture revokes the designation. Also, the modification of the designated area’s boundary or nonadherence to a submitted strategic plan can result in revocation of the designation and an earlier expiration date.

Tax Incentives

EZ businesses may take a 20% credit on the first $15,000 of wages paid or incurred to an EZ employee, under Sec. 1396. Sec. 1397A allows them an increased Sec. 179 expensing deduction, up to an additional $35,000. A capital gain deferral is available for assets purchased after Dec. 21, 2000, under Sec. 1397B. A seller can elect to roll over or defer recognition of realized capital gain from the sale of certain EZ assets. Sec. 1202 allows a 60% capital gain exclusion for sellers of small business EZ stock acquired after Dec. 21, 2000 and held for more than five years. Both EZs and ECs may finance property purchases using special tax-exempt-facility private-activity bonds, under Sec. 1394. For tax planning based on these incentives, see Exhibit 3.

Employment Credit

The EZ employment credit, in Sec. 1396(b) and (c), entitles employers in an EZ to take a 20% credit on the first $15,000 of qualified wages paid to either full- or part-time employees who reside in the EZ, with a maximum $3,000 credit per year per employee. The employee must perform substantially all of his or her work in the employer’s trade or business in the EZ. Form 8884, Empowerment Zone Employment Credit, is used to compute the credit for the year. The credit is not available to ECs.

The phrase “substantially all” is not defined in the Code or regulations. However, other provisions on EZs define it as 85% or more.⁵ Also, if an employee does not work substantially all of his or her time in the EZ, the credit is not prorated, so none of the wages may be allocated to qualify for the credit.

The eligibility criteria and tax incentives vary depending on the legislation that designated the EZ. Prior to 2002, the credit percentages varied depending on whether the designated EZ was in Round I or II. For the nine urban and rural Round I EZs, the 20% credit decreased after 2001. The later two EZs that were to be considered Round I carried a 20% credit that decreased after 2004. The CRTRA 2000 repealed these decreases for wages paid or incurred after 2001. Round II EZs were not eligible for the EZ employment credit for wages paid or incurred before 2002. Secs. 1396(b) and 1391(g)(3) apply the current 20% credit to qualified wages paid or incurred after 2001 in any EZ, whether designated as Round I, II or III.

Under Sec. 1397(a), qualified wages are generally defined as salaries and wages for FUTA purposes, including training and educational expenses paid on behalf of an employee that would be excludible under Sec. 127. Also included are employer expenses incurred for youth-training programs held in conjunction with local officials for employees under age 19. However, wages paid to employees related to their employer under either Sec. 267 or 707(b)(1) are not qualified.⁶ Also, wages paid to employees related to a person who owns more than 50% of the corporation or partnership are not qualified. In addition, under Sec. 1397(b), all employers of a controlled group of corporations, or partnerships or proprietorships under common control, are deemed to be a single employer for purposes of the $15,000 qualified-wage limit. Under Sec. 1396(c)(3)(A), the same wages may not be used for multiple credits; thus, qualified employment credit wages may not be used to compute the Sec. 51 work opportunity credit.

For controlled groups, Sec. 1397(b) provides that any employment credit is divided proportionately among the group members, based on wages paid.

Sec. 179 Expensing

Sec. 179 allows for the immediate expensing of certain tangible assets used in a trade or business. The election allows a purchaser to expense the cost of an asset up to a maximum dollar amount, rather than capitalizing and depreciating the property. The 2007 limit is $112,000, reduced dollar-for-dollar for qualified asset purchases over $450,000. Both the dollar limit and the purchase limit are adjusted annually for inflation.

Sec. 1397A(a) increases the $112,000 2007 Sec. 179 dollar limit when a qualified enterprise zone business purchases qualified-zone property for use in an EZ. The increase is the lower of $35,000 or the cost of the Sec. 179 qualified-zone property placed in service during the tax year. The dollar limit is reduced by 50% of the cost of Sec. 179 qualified-zone asset purchases over $450,000 in 2007, rather than the general dollar-for-dollar reduction for asset purchases over $450,000. Part I of Form 4562, Depreciation and Amortization, is used to record the election to expense property under Sec. 179.

Planning: Under Sec. 1394(b)(3)(D), a qualified enterprise zone business includes any trade or business that would qualify as an enterprise zone business if it were separately incorporated. Thus, a business belonging to a national chain would qualify as an enterprise zone business if it would meet the requirements had it been separately incorporated.

Capital Gain Rollover

In certain situations, under Sec. 1397B, a taxpayer can elect to roll over or defer recognition of capital gain realized from the sale or exchange of any qualified EZ asset purchased after Dec. 21, 2000 and held for more than one year. To qualify, the seller must use the proceeds from the sale to purchase other qualifying EZ assets within 60 days of the original sale. The replacement asset must be used in the same EZ as the sold asset.  The holding period of the replacement asset includes the holding period of the sold asset. However, the replacement asset itself must be held for more than one year for the gain to qualify for deferral.

The deferred gain recognition is postponed until the sale of the replacement asset, by reducing the replacement asset’s basis by the amount of realized gain not recognized. When more than one replacement asset is purchased, their bases are reduced in the order in which the assets were purchased. The deferred gain rules do not apply to any gain treated as ordinary income, for example, due to recapture under the general depreciation recapture rules.

The realized gain is recorded in Part I of Schedule 4797, Sales of Business Property, without regard to the deferral election. On the line below the line reporting the gain, the phrase “Section 1397B Rollover” should be entered in column (a). The gain that the taxpayer elects to postpone is entered as a loss in column (g). The ordinary income portion of the gain computed on Part II of Form 4797 and reported on Part II cannot be deferred.⁷

A qualified EZ asset is one that would be a qualified community asset if the EZ were an RC (discussed below) and purchased after Dec. 21, 2000. A qualified community asset is defined in Sec. 1400F.

Exclusion of Gain from QSBS

Generally, noncorporate investors can exclude up to 50% of the gain on the sale or exchange of QSBS held for more than five years and issued after Aug. 10, 1993. For EZ stock sales, the exclusion of gain percentage from the sale or exchange of QSBS is increased from 50% to 60% under Sec. 1202(a)(2).

To qualify for the 60% gain exclusion under Sec. 1202(a)(2), the QSBS must be (1) stock in a corporation that is a “qualified business entity” during substantially all of the taxpayer’s holding period, (2) acquired after 2000 and (3) held for more than five years. If a corporation ceases to be a qualifying business after the five-year holding period, the higher exclusion percentage applies only to gain accrued to the date the corporation was no longer a qualifying business. The increased exclusion does not apply to gains incurred after 2014.

Under Sec. 1397C(b), a “qualified business entity” is a corporation meeting the requirements of a qualifying business under the EZ rules during substantially all of the taxpayer’s holding period. The corporation must actively conduct its business activities in the EZ, must derive at least 50% of its total gross income from the businesses operated in the EZ and at least 35% of its employees must be residents thereof.

Enterprise Zone Facility Bonds

A form of tax-exempt private-activity bonds, called enterprise zone facility bonds, may be used to finance property acquisitions by qualified businesses operating in EZs and ECs.  These bonds may be issued only while the EC designation remains in effect.

The bonds are also subject to the particular state’s private-activity-bond volume limits. However, bonds issued to finance property acquisitions in EZs are subject to different rules from bonds issued to finance property acquisitions in ECs. Bonds issued before 2001 by Round I EZ businesses are subject to the state private-activity-bond volume limits. Under Sec. 1394(c), these bonds have a $3 million limit for each business and a $20 million limit for each principal user. Bonds issued after 2001 by Round I, II or III EZ businesses are not subject to the state private-activity-bond volume limits under Sec. 146. Also, they are not subject to the Sec. 1394(c) limits noted above for each business and principal user.

However, bonds issued after 2001 by Round I, II or III EZ businesses are subject to the EZ volume limits, under Sec. 1394(f)(2)(B). The maximum aggregate face amount of bonds issued for an urban EZ with a population of under 100,000 is $130 million per EZ. The maximum aggregate face amount of bonds issued for an urban EZ with a population of 100,000 or more is $230 million per EZ. For rural EZs, the maximum aggregate face amount of bonds issued cannot exceed $60 million.

To qualify as tax-exempt enterprise zone facility bonds under Sec. 1394(a) and Regs. Sec. 1.1394-1(j)(2), 95% of the net proceeds must be used to finance the acquisition of qualified-zone property. The principal user of such property must be a qualified enterprise zone business. The “principal user” is the owner of the property; a lessee may be treated as the principal user if the property is commercial real estate and the rental is a qualified business under Sec. 1397B(d)(2).

RCs

In 2002, 40 economically distressed areas were designated as RCs.⁸ Sec. 1400E RC businesses are awarded tax incentives similar to those for EZs. Also, the criteria for RCs are similar to those for eligibility as an EZ. General characteristics are high unemployment and a high poverty rate. RCs are designated through the Secretaries of HUD and Agriculture.

Under Sec. 1400G, an RC business is any entity or proprietorship that would be a qualified business entity or qualified proprietorship for enterprise zone business purposes under Sec. 1397C. Generally, an entity or proprietorship must receive at least half of its income from the active conduct of a business in an RC, must use a substantial portion of its property in the RC or in the active conduct of the business, a substantial portion of its employees must live in the RC, a substantial portion of the employees’ services must be performed in the RC and no more than a minimal amount of its property is attributable to collectibles or certain financial property.

Tax Incentives

RC businesses may take a 15% credit on the first $10,000 of wages paid or incurred to an EZ employee, under Sec. 1400H. They may also take a Sec. 179 deduction of up to an additional $35,000, under Sec. 1400J. A CRD is available for taxpayers that construct or rehabilitate nonresidential buildings in RCs under Sec. 1400I. Also, an exclusion under Sec. 1400F applies to qualified capital gain resulting from the sale of certain qualified RC assets held for more than five years. For tax planning based on these incentives, see Exhibit 4.

Employment Credit

The employment credit for RCs has a different credit percentage and wage base from the one available to EZs. For RCs, the employment credit is 15% of the first $10,000 of qualified wages. The qualified wages must be paid to full- or part-time employees whose principal place of residence is in the RC and who perform substantially all their work in the employer’s trade or business in the RC. For employment credit purposes, RCs are treated the same as EZs, except for the difference in credit percentage and wage base under Sec. 1400H. Under Sec. 1400E(b)(1), qualified wages must be paid or incurred after 2001 and before 2010.

Sec. 179 Expensing

The increased dollar limit for the Sec. 179 election for EZ tangible depreciable asset purchases also applies to RCs, under Sec. 1400J. RC businesses are treated as enterprise zone businesses and qualified renewal property is treated as qualified-zone property.

CRD

The Community Renewal Tax Relief Act of 2002 created the CRD under Sec. 1400I(a) for taxpayers who construct or rehabilitate nonresidential buildings in RCs. Taxpayers have the option of either deducting (1) half of the qualified revitalization expenditures generally capitalized on a qualified building in the tax year it is placed in service or (2) 100% of such expenses over 120 months, beginning with the month in which the building was placed in service.

If the election is made to amortize such expenditures, the amortization is reported on Part VI of Form 4562. If the election is made to deduct half of these costs, the deduction is reported as “Other Deductions” or “Other Expenses” on the tax return. The deduction is allowed for both regular and alternative minimum tax purposes. Form 8582, Passive Activity Loss Limitations, is used to report the $25,000 special allowance if the CRD is from a passive rental real estate activity.⁹

Planning: Because the modified accelerated cost recovery system’s recovery period for nonresidential buildings (39 years) is longer than the 120-month (10-year) amortization period, the election to amortize 100% of qualified revitalization expenditures would generally be the preferred choice. With this election, 100% of qualified revitalization expenditures are eventually allowed as a deduction. The other choice is to deduct half of the qualified revitalization expenditures in a single year. A depreciation deduction is not allowed for the other half of the revitalization expenditures not deducted under the election. The election to deduct half of the revitalization expenditures in one tax year may result in a net operating loss carryback or carryforward if the taxpayer does not have sufficient income to absorb the immediate write-off.

Capital Gain Exclusion

For RCs, Sec. 1400F allows a 0% capital gain tax rate for qualified capital gains resulting from the sale of certain qualified RC assets held for more than five years. A qualified capital gain is any gain recognized on the sale or exchange of a capital asset or property used in a trade or business under Sec. 1231(b). The exclusion applies to capital gain resulting from the sale or exchange of corporate and partnership interests held for more than five years in an RC business. The exclusion also applies to capital gain resulting from the sale or exchange of tangible property held for more than five years and used in an RC business. The exclusion applies to qualified gains occurring after 2001 and before 2015.

State Tax Incentives

Many states offer tax incentives associated with, or independent of, the Federal tax incentives for EZs and RCs. State revenue or economic development department websites generally list the various tax incentives available to encourage investments in economically distressed areas and communities.

Conclusion

Congress has enacted a number of provisions that offer tax incentives for distressed communities. These provide tax credits and enhanced deductions and exclusions, depending on the applicable zone or community. Tax practitioners should be familiar with these Federal tax incentives to determine if any apply to their clients or communities. Tax advisers and businesses should also investigate any similar state tax incentives.

Notes

¹See www.hud.gov/offices/cpd/economicdevelopment/programs/rc/
index.cfm.

² See Sec. 1391.

³ See Secs. 1394, 1396 and 1397A.

⁴ See P.L. 105-34 (8/5/97) and Sec. 1391(b).

⁵ See, e.g., Regs. Sec. 1.1394-1(l).

⁶ In Secs. 267 and 707(b)(i), “10%” is substituted for “50%.”

⁷ See Form 4797, Sales of Business Property, and the related instructions.

⁸ See www.hud.gov/offices/cpd/economicdevelopment/news/taxincentives
2003.pdf

⁹ See the instructions to applicable forms.

For more information about this article, contact Dr. Garrison at garrisonl@umkc.edu.