1. Income tax rates for married couples filing jointly on income in excess of $450,000 increase from 35% to 39.6%;
2. Marginal income tax rates on capital gains and qualified dividends increase from 15% to 20% for married couples filing jointly to the extent their income is in excess of $450,000; and
3. Itemized deductions are phased out for married couples filing jointly by 3% of every dollar of income in excess of $250,000 ($200,000 for heads of household and singles) limited to a maximum phaseout of 80% of itemized deductions.

In addition, 2013 begins the futile attempt to fund Obama Care by imposing a 3.8% Medicare tax on unearned income to the extent it exceeds $250,000 for married couples filing jointly ($200,000 for heads of household and singles).  The cumulative impact of these provisions is to significantly increase the complexity of the tax code and resulting planning.

In general[1], the beneficial impact of tax credits is unchanged for taxable incomes at or below $250,000.  For taxpayers with incomes between $250,000 and $450,000 their tax rates increase by the 3.8% new Medicare tax but only on unearned income.  However this is a Medicare Tax and since its not an income income it does not alter the cost or benefits of state tax payments or state tax credits.  On all taxpayers with incomes between $250,000 and $450,000 tax credits will be even more valuable because the cost of paying state income taxes goes up due to the 3% phaseout of itemized deductions.  This makes buying state tax credits even more advantageous.

The effects of the new tax rates on incomes above $450,000 becomes increasingly complex and beyond the scope of this discussion.  However, the net after-tax benefit to the taxpayer is roughly 55% of the discount on the purchased credits assuming the state tax deduction is fully deductible.  To the extent incremental current deductions are disallowed the benefit of purchasing credits will increase.  Often the benefits of acquiring state tax credits will be greater in situations where incomes are unusually high (for example when a large asset or business is sold) because the phaseout of the state tax deduction is higher in the current year, and since the federal taxation of single year state tax credits pushes the deduction for state income tax payments out to the subsequent year when the phase out will typically be significantly less, the net benefit of purchasing those credits is enhanced.

As always, the efficacy of the credits must also be assessed in light of the potential impact of the Alternative Minimum Tax (“AMT”) both in the current and subsequent years.  However, due to the phaseout of itemized deductions the impact of the AMT should be less now for taxpayers with incomes in excess of 250,000 and significantly less for taxpayers with incomes in excess of $450,000.

The structure of the proposed tax credit transfer in Virginia Historic was not uncommon, though its facts were horrible.  The basic structure involved a partnership holding the credit property which was owned by three members, the GP developer, the federal credit investor and the fund for the state credit investors.  The state credit investors basically enjoyed less than .01% of the economics of the project but 99.99% of the state tax credits.  This is fairly standard deal structure. With respect to some of the credits in question, state law provided that the credits could only be allocated to partners of the partnership.  In fact, under an unusual state law, some but not all of the credits in question could be transferred by the partnership to taxpayers who were not members of the partnership.

All of the contributions of the state credit investors were treated by the recipient fund as capital contributions.  Meanwhile the recipient fund expensed the contributions made to the fund holding the credit property to acquire the credits.  Not exactly sound accounting theory.  The state credits investors also possessed put rights, which they exercised, allowing them to put their interests for a nominal amount back to the partnership approximately a few months after their admission to the partnership but in the following calendar year.   The fund’s prospectus stated that the credit investors would expect to receive insignificant allocations of cash flow, profit and loss from the underlying historic tax  project. The state credit investors also received guaranties relating to the validity of the credits they were to receive and were not required to make the capital contributions until the credits were certified by the sate of Virginia.

The Tax Court in Virginia Historic found that the substance over form doctrine didn’t result in the credit investors not being partners under the analysis of Culbertson5 — whether ‘‘the parties in good faith and acting with a business purpose intended to join together in the present conduct of an enterprise.’’ In reaching those holdings, the Tax Court looked to several factors, including: (1) the agreement between the parties; (2) the conduct of the parties in executing its provisions; (3) the parties’ statements; (4) the testimony of disinterested persons; (5) the relationship of the parties; (6) the parties’ respective abilities and capital contributions; and (7) the actual control of income and the purposes for which the income was used. None of those factors were cited as controlling; The Tax Court looked at the totality and did not conduct a factor-by-factor analysis. The Tax Court found that the documents characterized the investors as partners and characterized their payments as capital contributions. The agreements gave the investors a right to share in the profits and liquidation rights.

In its analysis, the Fourth Circuit assumed that the credit investors were partners in the fund under state and federal tax law.  Its analysis focused on whether the relationship of the credit partners and the credit partnership fit under the notion of a disguised sale under Section 707 as the IRS had argued.  The Court noted that 707 applied when there is a transfer of property either shortly before or after the recipient transfer cash to the partnership.  It wasted little time in determining that state tax credits are property for tax purposes.  It didn’t matter to the Court that the property (i.e. the tax credits) could only be transferred by allocation by the partnership to its members.  The court felt this was sufficient transferability to constitute property.

Next, the Court turned to IRS regulations to shape its analysis. It stated that in determining the applicability of Section 707, Section 1.707-3 calls for an evaluation of “all the facts and circumstances” surrounding the transaction to determine whether (i) The transfer of money or other consideration would not have been made but for the transfer of property; and (ii) In cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations. Id. § 1.707-3(b)(1) (emphasis added). The regulation listed ten factors, five of which were determined to be of relevance here and were required to be considered: (i) the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer; (ii) That the transferor has a legally enforceable right to the subsequent transfer; (iii) That the partner’s right to receive the transfer of money or other consideration is secured in any manner, taking into account the period during which it is secured; . .(ix) That the transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits; and (x) That the partner has no obligation to return or repay the money or other consideration to the partnership, or has such an obligation but it is likely to become due at such a distant point in the future that the present value of that obligation is small in relation to the amount of money or other consideration transferred by the partnership to the partner. Id. § 1.707-3(b)(2).

The Court followed up by stating that, § 1.707-3 also sets forth a presumption that all transfers “made within two years” of each other are sales, “unless the facts and circumstances clearly establish that the transfers do not constitute a sale.” Id. § 1.707-3(c). This presumption places a high burden on the partnership to establish the validity of any suspect partnership transfers. The Court then concluded that the transfers were effectively simultaneous or at least not dependent upon the entrepreneurial risks of the partnership.  The partnership guarantees and protections offered the state credit partners effectively eliminated any entrepreneurial risk of the state credit partners.  Finally, the value of the state tax credits dwarfed the value of the state credit partners’ share of the partnership’s income.  This latter amount was guaranteed to be virtually zero because of the minimal call right the partnership had on the interests held by the state credit partners.  Given this analysis, the Court concluded that the capital contribution be re-characterized as a disguised sale under Section 707.

The practical ramifications of this decision are limited but important.  The section 707 analysis is limited to scenarios where the credits are transferred within one or two years at most, otherwise, the transfer wouldn’t be simultaneous with the transfer to the contribution to the partnership.  The case would apply to most funds which attempt to transfer one-year credits.  In particular, in those scenarios where the value of the one-year credits are greatly disproportionate in value to the remaining economic interests the credit partner receives this analysis should apply.  This would further be reinforced to the extent of guaranties of the credits which extend to the credit investor or otherwise protect the credit investor minimizing the risks of the credit investor. The presence of partnership put and call rights resulting in the liquidation of the credit partners’ interests at minimal values further supports the analysis.  The absence of these put and call rights probably does not change the conclusion of the court.

However, if instead the issuing partnership allocates the capital contribution between 707 proceeds and capital contribution such allocation would likely be respected.  A 90-10 to 99-1 allocation should suffice.  The IRS’s beef in Virginia Historic was that the partnership didn’t recognize income upon the contribution, but did recognize an expense when it paid for the credits.  That would not be present if the aforementioned allocations were made.  Moreover, allocations in rough approximation with the value of the credits and the value of the partnership interest should be respected.  In many instances the partnership has value from an administrative, compliance and recapture avoidance perspective in addition to any cash flow or profit and loss allocations which may be derived.  So, in every case that value is not zero.

Structuring the transaction so the credit investor is recognized as a partner for tax purposes is crucial. In many state statutes, the allocation of credits must be to a partner of the partnership.  Many states also follow the federal tax characterization of the partner’s status as a partner.  By making a relatively small allocation to partnership capital and a disproportionately large allocation to Section 707 credit proceeds which better reflects the substance of the transaction where partnerships attempt to allocate one year credits to credit investors will result in the reporting of the transaction consistent with the Virginia Historic decision.

From the credit investor’s perspective, the IRS’ treatment of the transaction has been clear and consistent for many years.[iv]  For transferable credits, which includes those sold under Section 707, the IRS considers them an intangible asset.  It has also been established that transferable credits are a capital asset in the hands of the purchaser.[v]  The taxpayer’s basis is equal to the portion of the contribution which is allocated to the credits. The credit is deemed to be sold by the investor when the investor files a tax return which uses the credit to offset their state tax liability.  The investor is deemed to receive proceeds equal to the face value of the credits used on their return.  The investor then reports a capital gain equal to the difference between the deemed proceeds and their basis in the credits.  At that same point, the credit investor is deemed to have made a state income tax payment to the state equal to the deemed value of the proceeds (i.e. the face value of the credits used).  So, if you assume a state credit investor on August 1, acquires 100,000 credits for $80,000 in the Fourth Circuit, under this allocation approach $79,200 is allocated to the investor’s basis in the credits and $800 to its capital account in the credit partnership.  The following April 15 the investor claims and uses the credits on their state tax return.  On April 15 of the following year the investor recognizes a $20,800 (100,000 – 79,200) short-term capital gain.  On that same April 15, the investor is deemed to have made a state income tax payment of $100,000 deductible under Section 164.  Upon the ultimate liquidation of the partnership the credit investor would recover their remaining $800 basis in the credit partnership.

Say a client buys 100 2012 Georgia low income housing credits for  $80.  That taxpayer is deemed to have acquired intangible property (ie the tax credits) and has a basis in that property equal to $80.  When the taxpayer files their Georgia 2012 income tax return and claims and uses the 100 Georgia tax credits on their return, the IRS considers two things as having occurred.  First, the taxpayer is deemed to have sold their credits in exchange for eliminating $100 of Georgia tax liability on the day the return is filed with the state of Georgia.  Since the taxpayer had a basis of $80 in the credits, the taxpayer recognizes a $20 capital gain from the use of the credits.  Second, the IRS considers the use of the credits as a tax payment of $100 to the state of Georgia qualifying for a deduction as a state income tax payment.  With respect to the $20 gain, the taxpayer will pay tax under short term capital gains rates of 35%, or $7, if the credits were acquired within twelve months of the taxpayer filing their Georgia return, or 15%, or $3, if the credits were acquired more than twelve months prior to the taxpayer filing their tax return.

This difference in the capital gains rate is why taxpayers should be buying their Georgia tax credits now.  Many clients hesitate to do this because they don’t want to forgo the $80 any sooner than they have to.  But the tax savings of $4 on an $80 dollar investment represents at least a 5% after-tax rate of return to the taxpayer.    In most instances it will represent an even higher annualized after-tax rate of return since Georgia low income housing credits must be acquired before December 31 of the calendar year.  No one makes 5% after-tax on their cash balances in today’s economy!

Obviously, taxpayers owing significant amounts of Georgia income tax shouldn’t withhold Georgia income tax or make Georgia estimated income tax payments.  Rather, they should reduce their tax obligations buy acquiring Georgia tax credits.  Its now clear that such acquisitions of Georgia tax credits should be made prior to April 15 of the calendar year if the taxpayer cannot be persuaded to extend their Georgia income tax return, or October 15 if the taxpayer extends and files their Georgia return on October 15 of the following year.  BUY YOUR 2012 TAX CREDITS NOW!!!!

Prior to the the revised regulations, production companies could only sell film credits of a particular vintage once a year.  The transaction could have multiple buyers, but it had to be part of one consolidated transaction.  Paragraph 10 of the revised regulation now permits multiple sales of credits during the year.  Each sale of credits, other than the final sale of credits created in a particular year, must be sold in multiples of 100,000.  There can be multiple purchases of these blocks.  And the individual multiple purchasers don’t have to acquire credits in increments of 100,000 but the sum of their purchases in each sale must be a multiple of 100,000.  In the final sale of film credits from a vintage or year, the sum of the purchases in that final sale do not have to equal a multiple of 100,000.   The requirement remains that the seller must file Form IT-TRANS “Notice of Tax Credit Transfer” with both the Department of Economic Development and the Georgia Department of Revenue within 30 days of each transfer or sale of Georgia film credits.

This change in the regulations will significantly ease the sale of Georgia film credits.  Production companies will no longer have to corral multiple buyers into agreeing to purchase credits all at the same time.  This has proved difficult because buyers often want to file their tax returns at different times or have available funds to purchase credits at different times.

In a more subtle change, it is clear that Paragraph 10 and 11 to the revised regulations also make the purchase of credits more flexible for the purchaser.  It was previously thought, for example, that if someone bought 2008 Georgia film credits in 2011 and wanted to report them on their 2010 return that the purchaser first had to report the credit on their amended 2008 return and amend their 2009 and 2010 Georgia tax returns to use the credit on their 2010 return.  It is now clear that the purchaser can simply report the credit directly on their 2010 return.  The revised regulation makes it clear that the purchaser can claim and report the purchased Georgia film credits in the tax return which is the same year as the credit was created or any of the five succeeding years.  This eliminates the need to file amended returns to simply carry forward purchased credits to a year where they are needed.

Once more, The Georgia Department of Revenue has acted in a very constructive manner with respect to the Georgia film credits.  The revised regulation both makes it easier for production companies to sell film credits and for purchasers of Georgia film credits to report those credits on their tax returns.

What the court specifically ruled was as follows.  This case involved investors investing in a partnership whose sole assets were one-year Virginia historic tax credits or partnership interests where the only expected benefit was the flow-through of Virginia historic tax credits.  The investors were redeemed out of the fund within 2-3 months of their admission and in the same calendar year as their admission to the fund based on put rights contained in their subscription documents.  The Court  accepted the status of the investors as partners in the partnership.  However, since most of the value of the partnership was attributable to the credits and there was no expectation of other economic benefits, the Court ruled that the investors (outside of their status as partners) purchased the credits for federal income tax purposes from the partnership.

The Court ruled that the credits were tangible property (just like film credits) and the purchaser and seller would treat them according.  The Service will say that the seller has a capital gain at that point and the buyer has a tangible asset.  The IRS will then take the position that the investor has a state income tax deduction in the year a tax return is filled using the credits equal to the full value of the credit as well as a capital gain equal to the difference in the face value of the credit and what the investor paid for the credit.

This judicial rationale should apply to any short-term partnership where the sole asset is a state tax credit.  Arguably, its scope could be far broader.  While the decision is only binding on the Fourth Circuit, since it also represents the IRS’ position, it is expected to ultimately be the rule in every jurisdiction.  Certainly, taxpayers who adopt this position will be safe from challenge by the IRS since it’s the IRS’s position.  Consequently, all taxpayers will now find state low income housing credits an attractive alternative to other state credits.  Obviously, please contact your personal accountant to see how this decision impacts your state income tax liability payment options.

The legislature notes that the state is facing tremendous budgetary stresses so the bill is intended to be revenue neutral.  To achieve revenue neutrality the legislature is proposing to  sharply limit if not eliminate itemized deductions for individual taxpayers.  These deductions are typically interest expenses (mostly home mortgage interest) , state and local taxes, charitable gifts and in the case of the elderly and poor medical expenses.

In order for this bill to be revenue neutral, the middle class, and in this case, the lower middle class will pay more in taxes to fund the tax cut from 6% to 4.5% for the wealthy.  As most people understand, persons making more than a million dollars a year could care less about itemized deductions: they normally have medical insurance hence limited out of pocket medical expense, they tend to not be overly  in debt so they have modest if any interest expense and they may or may not give to charity.  But the reduction in tax rate from 6% to 4.5% saves them significant amounts of Georgia income tax.   However, the loss of itemized deductions to families making 50,000 or even 100,000 would result in larger tax liabilities for those families.

So one two facts is true.  Under  Georgia HB 387 either the tax bills of the middle class (and predominantly the lower middle class) will go up under the proposal or the bill will cost Georgia valuable tax dollars at a time Georgia can least afford the loss of revenue.  A sober assessment of the proposal tends to cause people to suspect both alternatives are likely to be true.

This author is convinced that this is not what Governor Deal had in mind when he ran for Governor.  Several targeted tax reform proposals could be made which could encourage business growth in Georgia without providing a windfall to millionaires with large passive, non-business incomes. Please contact your local Georgia state senator and representative to  oppose HB 387 and its take from the poor to give to the rich approach to tax reform.

While the Georgia Department of Revenue has not yet amended their regulation, they have announced that they intend to amend the regulation to permit multiple sales during the same year.  Moreover, production companies are being allowed to make more than one sale/transfer before the regulation is amended/published.

The Georgia Department of Revenue has indicated that the new regulation will permit film tax credits to be sold in more than one installment.  However, if the credits are sold in more than one installment the following guidelines must be met:

1. Each sale or transfer, except the final sale or transfer, must be for at least $100,000.  The final sale is the sale that results in the remaining balance of credits for a particular year being sold.  The existing requires of a minimum sales price of 60 cents per credits and that the Form IT-Trans be filed within 30 days of each sale will still apply.

2. Each sale can include more than one party and each party can purchase an odd dollar amount as long as the total for the sale equals a multiple of $100,000 (with the exception of the final sale).

This is much needed relief as it will permit multiple closings for a production company.  For example, it could now close transactions before before and after April 15 of a particular year, better accommodating the varying needs of purchasers.

Caution is still required.  since the modification to the applicable regulation has not yet been published, production companies would be wise to obtain written confirmation from the the Georgia Department of Revenue blessing multiple sales of their credits.  The Georgia Department of Revenue has been very prompt and helpful in providing written informal guidance for taxpayers.

The Georgia film tax credit has been extremely effective.  Reportedly almost 300,000 jobs have been created by it.  Critics argue that the jobs may not be full time jobs. Probably true with respect to film productions, but that is the nature of this industry.  People move from project to project.  On the other hand long term jobs and business development has also occurred with respect to gaming productions (a huge opportunity for technology jobs and education…just look at SCAD) and TV productions which can run for years.    Pay is normally quite generous to compensate for the down time between projects.  Several movies have switched locations to Georgia because of the Georgia tax credit.  Numerous television series are now being filmed in Georgia because of the credit.  But the tax reform proposal has already begun to damage Georgia.  This author is aware that at least one very prominent public company has halted the filming of any new pilot for a television series in Georgia until the status of the Georgia film credit is clarified.  The company is unwilling to film a pilot in Georgia and then switch the filming of the series to another state if Georgia repeals its film tax credit.

Likewise, Georgia’s Low Income Housing Tax Credit has been extremely effective in the development of affordable housing in Georgia.  Most of these projects are quite attractive with assorted amenities.  Without the Georgia low income housing credits, most of the projects built in the past ten years would not have been completed.  This is doubly true now given the current difficulty in obtaining bank financing for projects.  The availability of the transferable Georgia Low Income Housing Credits allow developers to sell the credits up front to use the proceeds to finance the projects.  The commission mentions the amount of funds actually provided to developers is not enough given the amount of credit but it fails to understand the 10 year nature of the resulting credit flow and how the time value of money impacts the credits’ value.  Given the current status of the housing market and the surge in unemployment, expanding the supply of affordable housing should be a priority for the state.  Repealing the Georgia low income housing tax credit would immediately halt the construction of most affordable housing projects in Georgia.

While tax reform and the closing of many perceived corporate tax loopholes is a desirable outcome, the current tax reform proposal before the Georgia Assembly is overly broad in its application.  Preserving the Georgia Film Tax Credit and Low Income Housing Credit is important to stabilizing and reinvigorating the Georgia economy for all its citizens.  Please contact your Georgia representative and senator to express your wish to maintain these two credits and vote against the current tax reform proposal.  We do support carefully crafted tax reform measures, but the current proposal fails to garnish our support.

Let’s use a simple fact pattern to illustrate the problem.  Assume an individual buys $100 of film credits in 2010 for $90 and files their Georgia income tax return in March of  2011 claiming the credits.  In a series of private letter rulings[1], the IRS holds that when a taxpayer acquires a transferrable tax credit such as the Georgia film credit, the taxpayer has acquired intangible personal property and at that point has not paid state taxes.  At the point the taxpayer files the Georgia return and actually uses the credit, the IRS asserts the taxpayer has disposed of the property (i.e. sold for tax purposes) in exchange for a $100 reduction of their tax liability.  At that point the taxpayer is deemed to have recognized a $10 capital gain in our fact pattern and has made a deductible $100 payment to the state of Georgia for income taxes.  This capital gain and payment would be reflected on the taxpayer’s 2011 income tax return.  Note, the IRS treats Georgia low income housing credits differently than they do Georgia film credits.  So the previous discussion only applies to Georgia film credits.

While this is perfectly fine in many instances, such as with many corporate taxpayers and individual taxpayers with fairly steady incomes from year to year, it can be troublesome for some individual taxpayers.  If an individual has a significant one time income event in 2010 and expects to have a far more modest level of income in 2011, the deduction for the taxes paid through the use of the tax credit may be partially or totally eliminated due to the application of the Alternative Minimum Tax.  When this occurs, the Georgia film credit provides no benefit to the buyer of the credit and they would have been better served had they acquired Georgia low income housing credits instead.

Therefore, in situations where a taxpayer has a very large sale of an asset, business or other income event in 2010 and expects to have a significant drop in income the following year, the taxpayer will generally be better served to buy Georgia low income housing credits rather than Georgia film credits regardless of the impact of the Alternative Minimum Tax in 2010.

State Tax Credit Exchange can assist you and your clients in determining the best options to save money.  Georgia and many other states have tax credit programs to foster growth in particular industries which adds jobs and stimulates the economy. Certain types of tax credits are structured to be transferrable so they can be converted into money by the seller.  A tax payer can buy a credit at a discount thereby reducing their tax liability. Certain transferable state tax credits can be purchased after year-end i.e. credits can be bought to offset 2009 liabilities. Most credits can be carried forward to future years and therefore can be bought in advance of future years’ quarterly estimates.  State Tax Credit Exchange sells Low Income Housing, Film and Entertainment, Renewable Energy and Historic state tax credits.

Republished from an article written by Steve Rothschild