The New Markets Tax Credit program provides an incentive to stimulate private investment in low-income communities. Attorneys whose clients are seeking additional tax advantaged investments should consider bringing the NMTC to the attention of their clients. In addition, the clients of attorneys representing low-income community businesses may benefit from the investment capital provided by community development entities that are able to raise funds from investors seeking the NMTC. This article sets forth the basic NMTC rules.
Section 1(a)(7) of Public Law 106-554, 114 Stat. 2763 (Dec. 21, 2000) added Section 45D to the Internal Revenue Code of 1986, as amended, which code section provides for the NMTC. The mechanism of enactment was to incorporate by reference (as appendix G to Public Law 106-554) the provisions of H.R. 5662, the Community Renewal Tax Relief Act of 2000, as introduced on Dec. 14, 2000. Section 121 of the CRTRA contains the NMTC provisions, 114 Stat. 2763A-605 through 2763A-611.
Basic NMTC rules
The NMTC is one of the general business tax credits of Section 38 of the code, and is thus subject to the rules governing the use of general business credits. For example, under Section 38(c)-(d) of the code, the NMTC is a non-refundable tax credit and is subject to the general business tax credit ordering rules. The NMTC does benefit from the one-year business credit carryback and 20-year business credit carryforward provisions of Section 39 of the code.
To be eligible for the NMTC during a taxable year, a taxpayer must under Section 45D(a)(1) of the code hold a “qualified equity investment” on a “credit allowance date” of such investment. The amount of the NMTC under Section 45D(a)(1) of the code equals the “applicable percentage” of the “amount paid” to a “qualified community development entity” for such investment at its original issue. The “amount paid” includes underwriter’s fees. Section 1.45D-1(b)(4) of the regulations promulgated by the U.S. Department of the Treasury under the code. Pursuant to Section 45D(a)(2)-(3) of the code, the “applicable percentage” is 5 percent for the first three “credit allowance dates” (a “credit allowance date” being the date of initial investment and each of the next six anniversary dates), and 6 percent for the next four credit allowance dates.
Section 45D(b) of the code sets forth the parameters for determining whether an investment is a “qualified equity investment.” These parameters are as follows:
- The taxpayer must acquire an “equity investment” in a “qualified community development entity” at its original issue (directly through an underwriter) solely in exchange for cash, or, in the case of a taxpayer who is a subsequent purchaser that would qualify under these rules except for failing the original issue test, such taxpayer must acquire an investment that was a “qualified equity investment” in the hands of the seller.
- Substantially all of such cash must be used by the “qualified community development entity” within 12 months of the date of receipt of the cash to make “qualified low-income community investments.” Section 1.45D-1(b)(5)(iv) of the Treasury regulations. “Substantially all” means at least 85 percent for each of the first six years of the credit period and at least 75 percent for the final year of the credit period. See Section 1.45D-1(b)(5)(v) of the Treasury regulations.
- The “qualified community development entity” designates such investment for code Section 45D purposes on its books and records using any reasonable method. See Section 1.45D-1(c)(1)(iii) of the Treasury regulations.
- An “equity investment” means any stock (other than nonqualified preferred stock as defined in Section 351(g)(2) of the code) in a corporation and any capital interest in a partnership. The investor may derive the funds to make an equity investment from a loan including without limitation a nonrecourse loan. Revenue Ruling 2003-20, 2003-1 C.B. 465. Under Section 1.45D-1(c)(2) of the Treasury regulations, the general entity classification rules of Sections 301.7701-1 through 301.7701-3 of the Treasury regulations are used to determine whether an entity qualifies as a corporation or a partnership. However, the “qualified community development entity” may not issue more equity investments than the amount allocated to said entity by the Treasury secretary or the Treasury secretary’s designee. In addition, if a “qualified community development entity” issues an investment more than five years after the date of allocation receipt, such investment will not qualify for the NMTC. An equity investment by a “qualified community development entity” in another one does not qualify for the NMTC if the investing entity has received an allocation. See below for a discussion of the allocation procedures.
- The redemption limitations of Section 1202(c)(3) of the code apply to redemptions by “qualified community development entities” of stock of investors seeking the NMTC.
Under Section 45D(c)(1) of the code, a “qualified community development entity” is a domestic corporation or partnership if (i) its primary mission is serving or providing investment capital for “low-income communities” or low-income persons, (ii) it maintains accountability to residents of “low-income communities” through representation on any entity governing board or entity advisory board, and (iii) it is certified by the Treasury secretary or the Treasury secretary’s designee for purposes of code Section 45D as a qualified community development entity. These requirements are treated as met by any specialized small business investment company (as defined in code Section 1044(c)(3)) and by any community development financial institution (as defined in Section 103 of the Community Development Banking and Financial Institutions Act of 1994). Section 45D(c)(2) of the code.
The four types of investments, each of which constitutes a “qualified low-income community investment,” are set forth in Section 45D(d)(1) of the code. These types are as follows:
- Any capital or equity investment in, or loan to, any “qualified active low-income community business.”
- The purchase by a qualified community development entity of a loan from another CDE, which loan itself is a “qualified low-income community investment.”
- Financial counseling and other services specified in Treasury regulations to businesses located in, and residents of, low-income communities. Under Section 1.45D-1(d)(7) of the Treasury regulations, such services consist of advice provided by the CDE relating to the organization or operation of a trade or business.
- Any equity investment in, or loan to, any CDE.
Pursuant to Section 45D(d)(2) of the code, any for-profit or nonprofit corporation, any proprietorship and any partnership may constitute a “qualified active low-income community business” if for the taxable year in question the following standards are met (either with respect to all trades or businesses carried on by the entity in question or with respect to any trade or business which if separately incorporated would qualify under the following standards):
- The entity derives at least 50 percent of its total gross income from the active conduct of a “qualified business” within any “low-income community.”
- A substantial portion (under Section 1.45D-1(d)(4)(i)(B)(1) of the Treasury regulations, a substantial portion being at least 40 percent) of such entity’s use of owned or leased tangible property is within any “low-income community.”
- A substantial portion (under Section 1.45D-1(d)(4)(i)(C) of the Treasury regulations, a substantial portion being at least 40 percent) of the services performed for such entity by its employees are performed in any “low-income community.” For an entity with no employees, such entity is deemed to meet both this test and the 50 percent total gross income test if at least 85 percent of such entity’s use of owned or leased tangible property is within any “low-income community.” Id.
- Less than 5 percent of the average of the aggregate unadjusted bases of such entity’s property is attributable to collectibles (as defined in code Section 408(m)(2)) other than collectibles held primarily for sale to customers in the ordinary course of said business.
- Less than 5 percent of the average of the aggregate unadjusted bases of such entity’s property is attributable to “nonqualified financial property” (as defined in code Section 1397C(e)). Thus, “nonqualified financial property” means debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities and other similar property. Section 1.45D-1(d)(4)(i)(E) of the Treasury regulations. Reasonable amounts of working capital held in cash, cash equivalents or debt instruments with a term of 18 months or less, and accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of inventory or inventory-type property, are not classified as “nonqualified financial property.” Id. Under this definition of nonqualified financial property, banks and other financial institutions generally would not constitute qualified active low-income community businesses.
A “qualified business” means (i) any trade or business that is not (A) a real property rental business (with the exception noted in “(ii)” below), or (B) the operation of any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other gambling facility or liquor store (any activity described in this clause “(i)(B)” constituting a “prohibited activity”), or (C) farming, and (ii) a real property rental business as long as (A) the property is not residential rental property (as defined in code Section 168(e)(2)(A)) or the rental to a lessee engaged in a prohibited activity and (B) there are substantial improvements located on the real property. Sections 45D(d)(3) and 1397C(d) of the code, and Section 1.45D-1(d)(5) of the Treasury regulations.
An entity is treated as engaged in the “active conduct” of a trade or business if, at the time of the CDE’s investment in or loan to such entity, the CDE reasonably expects that the entity will generate revenues (or, for a nonprofit corporate entity, engage in an activity furthering its nonprofit purpose) within three years after the making of said investment or loan. Section 1.45-1(d)(4)(iv) of the Treasury regulations.
In general, a “low-income community” means any of the following: (i) a population census tract with a poverty rate of at least 20 percent, (ii) a non-metropolitan area population census tract in which the median family income does not exceed 80 percent of statewide median family income, (iii) a metropolitan area population census tract in which the median family income does not exceed 80 percent of the greater of (A) statewide median family income or (B) metropolitan area median family income, and (iv) certain targeted populations treated as low-income communities pursuant to Treasury regulations. Section 45D(e)(1)-(2) of the code. For areas not tracted for population census tracts, equivalent county divisions are used for purposes of determining poverty rates and median family income. Section 45D(e)(3) of the code. There are special rules for population census tracts with populations of less than 2,000 and for census tracts within high migration rural counties. Section 45D(e)(4)-(5) of the code.
The NMTC is subject to recapture if at any time during the seven-year period beginning on the date of the original issue of a qualified equity investment in a CDE, (i) such CDE ceases to so qualify, (ii) less than substantially all of the cash received from said investment is used to make qualified low-income community investments, or the entity redeems said investment. Section 45D(g) of the code. Other than for the purpose of determining the partial gain exclusion for gain from the sale or exchange of qualified small business stock under Section 1202 of the code, and for determining qualified capital gain for purposes of the zero qualified capital gain rate from the sale or exchange (A) of any DC Zone asset held for more than five years pursuant to Section 1400B of the code or (B) of any qualified community asset held for more than five years under Section 1400F of the code, the basis of a qualified equity investment is reduced by the amount of the NMTC determined under code Section 45D. Section 45D(h) of the code.
Taxpayers claim the NMTC on Form 8874. A CDE must notify a taxpayer acquiring a qualified equity investment in the CDE at its original issue that the taxpayer is entitled to claim the NMTC. Section 45D(i)(4) of the code and Section 1.45D-1(g)(2) of the Treasury regulations. The notice must be provided no later than 60 days after the investment date and must include the amount paid to the CDE for the qualified equity investment and the CDE’s taxpayer identification number. Id.
Section 45D(i)(1) of the code authorizes the promulgation of Treasury regulations limiting the NMTC for investments that are directly or indirectly subsidized by other federal tax benefits including the low-income housing tax credit under code Section 42 and the tax-exempt bond exclusion under code Section 103. However, the current Treasury regulations prohibit “double dipping” only with respect to the low-income housing tax credit. Section 1.45D-1(g)(3) of the Treasury regulations.
Credit allocation limitation and CDE designation
The amount of investments that CDEs may designate as qualified equity investments is subject to a calendar year limitation under Section 45(f) of the code. The limitation for 2007 is $3.5 million. Section 45(f)(1)(D) of the code. The Treasury secretary or the Treasury secretary’s designate is required to allocate the limitation among CDEs selected by the Treasury secretary or the Treasury secretary’s designee, who is required to give priority to any CDE (i) with a record of successful provision of capital or technical assistance to disadvantaged businesses or communities, or (ii) which intends to satisfy the requirement that substantially all of the qualified equity-generated cash acquired by the CDE be used to make qualified low-income community investments by making said investments to one or more businesses in which persons unrelated to such CDE (within the meaning of code Section 267(b) or 707(b)(1)) hold the majority equity interest. Section 45D(f)(2) of the code. Unused limitation increases next year’s limitation amount, except that no carryover is allowed to a calendar year after 2014, Section 45D(f)(3) of the code.
The Treasury secretary has delegated to the Community Development Financial Institutions Fund (CDFIF) in the U.S. Treasury Department the responsibility for certifying organizations as CDEs and for allocations to CDEs of the national investment limitations. See Guidance, New Markets Tax Credit Program, 66 Fed. Reg. 21846 (May 1, 2001). For information on the application process to be designated as a CDE, and on amounts allocated to existing CDEs, go to the following Web address: www.cdfifund.gov/what_we_do/programs_id.asp?programID=5.
The CDFIF Web site includes the necessary CDE certification and allocation application materials, a frequently asked questions document, U.S. Government Accountability Office reports on the NMTC, notices of recent NMTC developments, IRS materials and other materials that will be helpful to investors seeking NMTCs, to community development organizations seeking CDE certification and to community-based businesses seeking capital or organizing and operating advice.