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American Recovery and Reinvestment Act of 2009

February 19, 2009

 

On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Act (the “Act”)--the highly anticipated $787.2 billion economic stimulus package. The Act provides a number of significant tax incentives for businesses, as summarized below.

Delayed Recognition of Certain Cancellation of Debt Income

Generally, a taxpayer incurs “cancellation of debt income” (“COD income”) when its debt is forgiven, reduced or repurchased at a price lower than the debt’s issue price. COD income can arise in situations becoming increasingly common in the current marketplace, including when debt is modified or exchanged.

The Act allows certain businesses to elect to defer recognition of COD income when an applicable debt instrument is repurchased for cash, exchanged for debt (including a modification that is treated as an exchange for tax purposes), exchanged for stock or a partnership interest or contributed to capital (each such instance a “reacquisition”) by the issuer or a related person, or is forgiven by the debt holder, during calendar years 2009 and 2010. Under this rule, the COD income, and some or all of the related deduction for original issue discount (“OID”) if debt is exchanged for new debt deemed issued at a discount, is deferred completely for the first four or five taxable years following the taxable year in which the reacquisition occurred (depending on whether the debt was reacquired in 2010 or 2009) and is then recognized ratably over the five taxable years following the grace period. An applicable debt instrument is any debt instrument issued by a C corporation or any other person in connection with the conduct of such person’s trade or business.

To illustrate this deferral rule, suppose Company, a calendar year taxpayer, has a debt outstanding with a principal amount and adjusted issue price of $1,000, and a fair market value of $900. Prior to the Act, if Company were to repurchase the debt for $900 (assuming exceptions such as insolvency did not apply), Company would have been required to recognize COD income of $100 in the year of the debt repurchase. However, under the Act, if Company were to purchase the debt for $900 in 2009 or 2010, it would instead recognize $20 of income in each of the five taxable years beginning in 2014. This same result would occur under the Act if instead of a cash repurchase, Company issued $900 worth of stock or new debt with an issue price of $900 in exchange for the existing debt. If, instead of a repurchase of the debt by the Company, a related party (e.g., a majority shareholder) were to purchase the debt, the transaction would be treated as though Company issued a new instrument to the related party. The new instrument would have a face amount of $1,000 and an issue price of $900 (and would thus have OID of $100) and, under the Act, the issuer would be treated under the deferral rule in the same way as discussed above. However, all or a portion of Company’s OID deductions on the new instrument would be deferred until 2014 and then the deferred OID would be deducted ratably over the next five taxable years. The related party would be required to include the $100 of OID in income over the term of the new debt.

This deferral rule provides a significant benefit for struggling businesses by allowing them to defer recognition of COD income and thereby retain cash now that would otherwise be required to fund tax payments. This provision is especially helpful because most transactions that cause a business to incur COD income do not generate cash to cover the corresponding tax liability.

Suspension of the Applicable High-Yield Discount Obligation Rules

The Act suspends the rule deferring or disallowing interest deductions with respect to certain “applicable high yield discount obligations” (“AHYDOs”) issued between September 1, 2008 and December 31, 2009 in exchange (including modifications that are treated as exchanges for tax purposes) for debt instruments that are not AHYDOs. The issuer of both the original and new debt instrument, however, must be the same, and the suspension does not apply to certain contingent interest obligations or obligations issued to a related person. An AHYDO is a debt instrument issued by a corporation that has a term of more than five years, a yield to maturity 5% or more in excess of the applicable federal rate (“AFR”), and has significant OID (as defined). The deferral and disallowance rule does not apply to AHYDOs issued by S corporations.

For example, suppose Company is a C corporation and has an outstanding debt that is not an AHYDO. In exchange for the outstanding debt, Company issues a new zero-coupon debt instrument in 2009. The new debt instrument has a term of 10 years, a yield to maturity equal to the AFR plus 6%, and significant OID. Prior to the Act, the new debt instrument generally would have been subject to the interest deferral or disallowance rule for AHYDOs. Under the Act, however, the new debt instrument will not be subject to the interest deferral or disallowance rule applicable to AHYDOs if it does not have certain contingent interest features and is not issued to a related person.

This suspension provides relief for C corporations that are forced to restructure their existing debt (especially publicly traded debt) by borrowing at a higher rate of interest from being penalized by the AHYDO rules, and thus removes a potential obstacle to debt workouts and restructurings during the economic downturn.

Extension of Bonus Depreciation for 2009

Pre-Act law provided for accelerated or “bonus” depreciation by allowing an additional first-year depreciation deduction of 50% of the adjusted basis of certain qualified property acquired and placed in service in calendar year 2008. The Act extends this temporary benefit for qualifying property purchased in calendar years 2008 or 2009 and placed in service in calendar year 2009. The additional first-year depreciation deduction is allowed for both regular tax and alternative minimum tax purposes for the taxable year in which the property is placed in service. The basis of the property and the depreciation allowances in the year the property is placed in service and in subsequent years are adjusted to reflect the first-year bonus depreciation deduction.

In order to be eligible for bonus depreciation, the property must be (1) property subject to the modified accelerated cost recovery system (generally most tangible property) and that has a recovery period of 20 years or less, (2) water utility property, (3) non-custom-made computer software, or (4) qualified leasehold improvement property. The taxpayer must be the original user of the property, and in general acquire the property in calendar year 2008 or 2009 and place it in service in calendar year 2009. Certain property may be eligible for bonus depreciation even if not placed in service until calendar year 2010.

5-Year Carryback of Net Operating Losses for Small Businesses

Under pre-Act law, net operating losses (“NOLs”) of a company can generally only be carried back to the two taxable years before, and carried forward to each of the succeeding twenty taxable years after, the year in which the loss arises.

For NOLs that would otherwise have a maximum carryback period of two years, the Act generally extends the maximum NOL carryback period to three, four or five years for certain small businesses if they so elect. In order to qualify for this extension, a business must have average gross receipts of $15 million or less in a specified period, typically three years. The extension applies to NOLs that arose in the taxable year ending in 2008 or, at the election of the taxpayer, for NOLs that arise in its taxable year beginning in 2008 (but not both).

The temporary extension of the NOL carryback period effectively allows qualifying small businesses that generate NOLs (as a result of the current economic downturn or otherwise) to increase available cash by obtaining income tax refunds for prior years that would otherwise have been beyond the reach of the NOL carryback period. 

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In addition to the tax incentives described above, there are several other new provisions for certain businesses, including the following: (1) the Act extends the enhanced small business expensing provision that applied for taxable years beginning in 2008 to taxable years beginning in 2009, and generally permits certain qualifying small and medium-sized businesses to elect to expense and currently deduct (instead of depreciating over a period of years) up to $250,000 of the cost of qualifying property placed in service in their taxable years beginning in 2009, subject to certain reductions and limitations; (2) the Act broadens the Work Opportunity Tax Credit, which offers subsidies to businesses that hire certain disadvantaged workers by expanding the target groups of the credit to include a broader category of youth (i.e., “disconnected youths”) and unemployed veterans; (3) the Act provides a temporary reduction of the S corporation built-in gains (i.e., the potential gains existing at the time a C corporation converts into an S corporation) holding period from 10 years to 7 years for sales that occur in S corporations’ taxable years beginning in 2009 and 2010; and (4) the Act increases the income exclusion from 50% to 75% for individuals on gain from the sale of certain qualified small business stock held for more than five years if such qualified small business stock was acquired after February 17, 2009 and before January 1, 2011.

Finally, the Act includes a number of tax incentives for investment in and development of alternative energy, such as an extension of the production tax credit and the availability of a grant and investment tax credit election. For more information, please see our related alert issued Monday, February 16 by clicking here.