Capital Construction Funds: Sec. 7518

Editor: Neal A. Weber, CPA

Special Industries

The Capital Construction Fund (CCF) program was authorized in 1936 by the Merchant Marine Act (46 U.S.C. §§1177 and 1177-1). This program was created to help owners and operators of U.S. flag vessels accumulate the large amounts of capital needed for the modernization and expansion of the U.S. Merchant Marine. The program allows this accumulation of capital by deferring federal income taxes (increasing cashflow due to no income tax) on certain deposits of money or other property placed into the fund.

The program is the responsibility of two agencies within the federal government—the Department of Transportation’s Maritime Administration and the Department of Commerce’s National Oceanic and Atmospheric Administration (NOAA). NOAA administers the program that is related to the vessels used in the fisheries of the United States, and the Maritime Administration handles the programs for vessels that are not related to the fishing industry. The IRS administers the fund under Sec. 7518.

Before opening a CCF account, a taxpayer must request an application kit from either agency. This kit will help the taxpayer produce a document that will establish the following:

• Agreement vessels: Eligible vessels named in the agreement that will be the basis of the deferral of income tax;
• Planned use of the withdrawals for acquisition, building, or rebuilding of the vessel; and
• A CCF depository, where the funds will be held.

Once the agreement is approved by the secretary of the agencies, the fund provides that any U.S. citizen owning or leasing one or more eligible vessels may establish this fund. The fund is established to provide replacement vessels, additional vessels, or reconstructed vessels built in the United States and documented under the laws of the United States for operation in the United States, foreign regions, the Great Lakes, or the noncontiguous domestic trade or the fisheries of the United States. Once the agreement is approved, Sec. 7518 then applies to the mechanics and investment activity of the fund.

“Eligible vessels” are defined as vessels that weigh more than five tons. They must be built or rebuilt in the United States and must be documented under U.S. laws. They must either be used for U.S. fisheries or be operated in the foreign commerce or domestic commerce of the United States. Eligible vessels are also allowed under the five-ton weight requirement if the vessel:

• Is built or rebuilt in the United States;
• Is owned by a U.S. citizen;
• Has a home port in the United States; and
• Is used commercially in U.S. fisheries.

Once approved, a taxpayer must keep three important accounting records to maintain the CCF account activity: a capital account (no tax has been deferred), a capital gain account (long-term capital gain has been deferred), and an ordinary income account (ordinary income has been deferred). Sec. 7518 sets a ceiling on deposits and stipulates requirements as to the investments, the nontaxability for deposits, and the establishment of accounts.

In general, the amount of deposits the taxpayer makes to the fund is deductible from income (to the extent of taxable income before net operating losses). The earnings from the fund are excludible from income, including capital gains, interest, and dividends. If the taxpayer makes a qualified withdrawal (i.e., a withdrawal made for the acquisition, reconstruction, or capital improvements to a vessel covered by the CCF agreement), the taxpayer must reduce basis in the vessel because no income is recognized. The basis reduction will vary depending on the account from which the monies are withdrawn.

If, however, a nonqualified withdrawal is made, it is taxed in accordance with ordering rules that treat the withdrawal as being made first out of the ordinary income account, then from the capital gain account, and finally from the capital account (Sec. 7518(g)); hence the importance of maintaining the three categories of accounts as required for the fund. The penalty for making a nonqualified withdrawal is onerous. Tax on nonqualified withdrawals is due based on the maximum individual or corporate marginal tax rate (Sec. 7518(g)(6)). In addition, interest is computed for every year that the monies were in the fund and taxes were deferred (Sec. 7518(g)(3)(C)). In 1986, a 25-year limit was imposed on the amount of time in which money may remain in the fund without being withdrawn for qualified purposes (Sec. 7518(g)(5)).

For C corporations, amounts deposited in this fund are not deductible for alternative minimum tax (AMT) purposes, and earnings as well as capital gains of the fund are not excludible when calculating AMT. There is no basis reduction of the vessels for AMT purposes for qualified withdrawals. Note that Form 4626, Alternative Minimum Tax—Corporations, for C corporations contains a specific line as well as specific instructions for this calculation.

The fund may be invested in interest-bearing securities approved by the commerce or transportation secretary, or up to 60% of the amounts held in the fund may be invested in stocks of domestic corporations, with the secretary’s approval (Sec. 7518(b)(2)). Fund investments may include common or preferred stocks that are currently fully listed or registered on a national exchange registered with the Securities and Exchange Commission, but cannot include over-the-counter securities.

EditorNotes

Neal Weber is managing director-in-charge, Washington National Tax, with RSM McGladrey, Inc., in Washington, DC.

For additional information about these items, contact Mr. Weber at (202) 370-8213 or neal.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.