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American Recovery and Reinvestment Act of 2009
President Obama signed into law the American Recovery and Reinvestment Act of 20091 (the “Stimulus Bill”) on February 17, 2009. On February 26, 2009, President Obama released his proposed budget (the “Budget”), which generally outlines the President’s budget goals over the next ten years. Both the Stimulus Bill and the Budget contain numerous provisions relating to taxation of individuals and businesses, and understanding the consequences (or potential consequences) of these provisions is vital to making effective tax planning decisions over the next year. This article will focus only on certain specific provisions in the Stimulus Bill and the Budget which we think are particularly important to our clients.
The Stimulus Bill
Generally, the Stimulus Bill contains spending provisions in education, healthcare, and infrastructure. The Stimulus Bill also contains a number of federal tax incentives and changes. This article will highlight only certain of the more relevant tax provisions. For a more complete discussion, please speak with your tax advisors.
1) Deferral of Certain Cancellation of Indebtedness Income. The first provision in the Stimulus Bill includes an elective provision regarding the delayed recognition of certain cancellation of debt income.2
A brief background of cancellation of debt income is necessary in order to determine the scope of this provision’s application. Generally, gross income includes income from the discharge of indebtedness.3 Income from the discharge of indebtedness generally arises when a creditor forgives some or all of an outstanding debt owed to such creditor by the taxpayer, either through a negotiated “workout” with the taxpayer or through some legal action such as a foreclosure.
A common example of discharge of indebtedness income in the real estate area arises from a foreclosure. For instance, assume a taxpayer issued a recourse debt which is secured by a piece of real property, and the creditor agrees to accept a transfer of the taxpayer’s entire interest in the property in complete satisfaction of the debt. This exchange is bifurcated into two transactions: first, the taxpayer will be treated as having sold the real property in exchange for a partial discharge of the debt, to the extent of the fair market value of the real property on the date of transfer, and second, the taxpayer will have discharge of indebtedness income to the extent that the debt exceeds the fair market value of the property. It is important to differentiate between gain (or loss) from the sale of the real property and income from the discharge of indebtedness, because only discharge of indebtedness income is eligible for the non-recognition provisions discussed below. Particularly, if the debt attaching to the property were a non-recourse debt (i.e. if the taxpayer had no personal liability on the debt beyond the property itself), then the entire exchange of the property in satisfaction of the debt would be treated as a sale, and the taxpayer would have no discharge of indebtedness income.
The primary exception to the general rule that gross income includes discharge of indebtedness income is contained in Section 108 of the Tax Code, which provides for various situations in which a taxpayer may not recognize the discharge of indebtedness income. Many of the Section 108 provisions are already familiar to taxpayers, such as the bankruptcy and the insolvency exceptions (which provide that certain discharges of indebtedness are not fully taxable to the debtor). The Mortgage Forgiveness Debt Relief Act of 20074 enacted an additional exception for a discharge of qualified principal residence indebtedness.
The Stimulus Bill added an additional provision to Section 108 which allows for the delayed recognition of certain discharge of indebtedness income. The new provision allows a taxpayer who has discharge of indebtedness income as a result of a partial or full write-off of his debt by the lender to make an election to defer recognition of the discharge of indebtedness income for five years (four if the reacquisition occurs in 2010) and recognize the income ratably over the five years following the deferral period. This new election to defer the discharge of indebtedness income is only available to C corporations or to other taxpayers who issued the debt instrument in connection with the conduct of a trade or business. Additionally, the election is only available for qualifying debt of the taxpayer which is discharged after December 31, 2008 and before January 1, 2011. For taxpayers considering electing the new deferral provision, it is especially important to consider that the provision is exclusive, and if the taxpayer elects to defer the income with respect to a particular debt instrument, then the other exceptions under Section 108 (such as the bankruptcy and insolvency exceptions) will no longer be available for that debt instrument.
2) Extended Carryback of Certain Net Operating Losses. Another significant provision of the Stimulus Bill is the extension of the maximum net operating loss carryback period from two years to five years for certain small businesses.5 Under this new provision, small businesses with receipts of less than $15,000,000 would be eligible for the extended carryback period. However, the election to use the five year carryback period only applies to net operating losses that occur in a taxable year ending or beginning in 2008. Therefore, taxpayers who may be eligible for the election will need to take action immediately, especially calendar year taxpayers who will need to make the election on their 2008 tax returns. 3) Shortened S Corporation Built in Gain Period. Currently, an S Corporation which has converted from C corporation status has a holding period of 10 calendar years for assets subject to the built-in gain tax. The Stimulus Bill shortens the holding period to seven tax years.6 Although the express language of the statute appears to provide that the shortened built-in gain recognition period applies only if there is a sale of assets in 2009 or 2010, and if the seven tax year period has expired prior to the beginning of the tax year in which a sale is made, some commentators believe that based on the committee reports, the new seven tax year holding period may also apply to sales occurring after 2010 (if the seven tax year period expired prior to the beginning of 2009 or 2010). Further clarification is needed on this provision. 4) Decrease in Capital Gains Rate for Small Business Capital Gains. Under this provision, stock of a small business that is issued after February 17, 2009 but before January 1, 2011, which the taxpayer has held for more than five years, may be eligible for a seven percent tax rate. 5) The Making Work Pay Tax Credit. Although the “Making Work Pay” tax credit is targeted at individuals, business owners need to be aware of it because the effect is a reduction in the amount of withholding for the affected individuals. The credit is a refundable tax credit of up to $400 for working individuals ($800 for married couples filing joint returns.) The credit is phased out for individuals with an adjusted gross income exceeding $75,000 ($150,000 for married couples filing jointly). The IRS has released adjusted withholding tables to reflect this credit, and employers must start using the new withholding amounts by April 1, 2009.
The Proposed Budget
In addition to the Stimulus Bill, we also believe a brief summary of certain pertinent provisions in President Obama’s Budget is relevant. The Budget contains barebones proposals for tax changes with minimum details, some of which are highlighted below.
1) The Bush Tax Cuts. The Budget proposes to make the Bush tax cuts from 2001 and 2003 (which are currently set to expire in 2010) permanent with regard to low or middle income taxpayers, while limiting or ending those provisions that benefit higher income individuals. Specifically, the Budget proposes the permanent extension of the 10 percent tax bracket, the marriage penalty relief, and the Child Tax credit. Additionally, the Budget proposes to extend the 25 percent and 28 percent brackets, the adoption tax credit, and the dependent care tax credit. However, for individuals with income over $200,000 ($250,000 for married couples), the Budget proposes to reinstate the top two income tax brackets (36 percent and 39.6 percent), phase out the benefit of itemized deductions, and phase-out the personal exemption. Additionally, the Budget would set the top long term capital gains and dividends preferential rates at 20 percent for individuals with income over $200,000 ($250,000 for married couples). The maximum marginal rate imposed upon long term capital gains and dividends for lower income levels would continue to be 15 percent. 2) AMT Relief. The Budget assumes that the annual AMT “patches,” which adjust the AMT to reflect inflation, will be made permanent. 3) Carried Interest. The Budget proposes to tax so-called “carried interests” as ordinary income. A carried interest is generated when a partner who contributes services to a partnership (in lieu of cash or property) receives in exchange a partnership interest entitling the partner to a share of the profits. Currently, all partnership income is passed through to the partners including service partners who have a carried interest, and the character of this income is determined at the partnership level. The proposal would convert all partnership income allocated to the partner holding a “carried interest” to ordinary income. 4) Economic Substance Doctrine. The Budget proposes to codify the economic substance doctrine, a judicial creation which generally requires that a transaction have a real economic purpose or investor risk in order to be respected for tax purposes. 5) Repeal of LIFO Inventory Method. The Budget proposes to repeal the inventory accounting method known as “last-in-first-out” (LIFO).
About the Author:
Christine Weingart is a member of Dean Mead’s Tax Department. She provides tax and business planning counsel to business owners on all types of business matters. She regularly represents large landowner clients and has gained considerable knowledge of Florida’s emerging Carbon Credit Trading program.
About Dean Mead:
Dean Mead is a commercial law firm that provides full-service legal representation to businesses and individuals throughout Florida. The firm has 48 lawyers practicing in Orlando, Fort Pierce and Viera.
1 P.L. 111-5.
2 Section 1231 of the Stimulus Bill.
3 Code § 61(a)(12).
4 P.L. 110-142; the exception in Section 108(a)(1)(E) applies to debt discharged before January 1, 2013.
5 Section 1211 of the Stimulus Bill.
6 Section 1232 of the Stimulus Bill.
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