Fundamentals: In the Bailout, Which Taxpayers Win?

The law that allows the Treasury Department to buy up toxic mortgage assets from banks and other institutions provides some tax relief – and some tax hits.

Download: Exec-The Emergency Economic Stabilization Act of 2008

Download: The Emergency Economic Stabilization Act of 2008

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By Robert Willens

The Emergency Economic Stabilization Act of 2008, popularly known as the bailout legislation, contains tax provisions that will benefit some taxpayers and penalize others. Among the widely-reported authorities the new law grants, the $700-billion government bailout legislation allows the Treasury Department to buy troubled mortgage assets from banks and other financial institutions, and invest directly in sputtering banks to bolster their liquidity position. But the new law changes some of the tax rules, too.

Here’s a rundown of those provisions and the affected tax law.

Gain or loss from the sale of stock

The Stabilization Act focuses on gains and losses related to so-called applicable preferred stock (APS) issued by an applicable financial institution (AFI). Under the new law, such gains or loss are treated as ordinary income or loss (as opposed to capital gain or loss). For this purpose, APS includes any stock which is preferred stock in Fannie Mae or Freddie Mac which was held by the AFI on September 6, 2008; or was sold by the institution on or after January 1, 2008 and before September 7, 2008.

An AFI is any financial institution referred to in Section 582(c)(2) of the Internal Revenue Code1. That select group includes any bank2; financial institution referred to in Section 591 of the Tax Code (mutual savings banks and savings and loan associations); small business investment company; and small business development corporation. Although the loss from the sale or worthlessness of Fannie or Freddie’s preferred stock would ordinarily be classified as a capital loss, the Stabilization Act enables these financial institutions to characterize such loss as ordinary in nature.

This is beneficial because capital losses can only be deducted against capital gains, whereas ordinary losses can be deducted against any variety of income. As a result, the losses are “usable” by virtually any affected financial institution. That means that the bank – through the associated tax benefit – can “book” the loss on the enumerated preferred stock, and stanch the capital drain the loss would otherwise engender.

Pay packages

The bill adds Section 162(m)(5) to the Internal Revenue Code, which applies to pay packages for employees of companies that accept bailout funds. In short, the new provision stipulates that some corporate payroll deductions are being disallowed for companies that take-up the government’s offer to buy-up troubled assets from the companies as a way of removing them from corporate balance sheets.

More specifically, the provision says that no tax deduction is allowed for remuneration that exceeds $500,000 paid out for services performed by so-called covered executives during the applicable taxable year (that includes deferred deduction executive remuneration.) The $500,000 takes into consideration the sum of the remuneration for the taxable year, plus the portion of the deferred deductible remuneration from a prior taxable year.

For purposes of the Act, the term “applicable taxable year” is defined as the first taxable year which includes any portion of the period in which the Treasury Department has the authority to buy-up troubled assets. That authority is laid out in Section 101(a) of the law. All subsequent taxable years in which the buy-out is in effect will also be classified as applicable taxable years. The authorities to buy up the toxic assets are scheduled to end on December 31, 2009, although the powers may be extended for two additional years upon the request of the Secretary of the Treasury approval by Congress.

A covered employee is defined as any employee who, at any time during the taxable year that the buy-out programs is in effect, is the chief executive officer, chief financial officer, or one of the three highest compensated officers – other than the CEO or CFO.

Finally, executive remuneration includes all payout for services performed including remuneration that would otherwise be exempted because it is “performance based” within the meaning of Section 162(m)(4)(C). Further, the deferred deductible remuneration referred to in the Stabilization Act relates to pay received for services performed in an application taxable year, but for the fact that the deduction for such remuneration is allowable in a subsequent taxable year.

Debt Forgiveness
Generally debt that is forgiven or cancelled by a lender must be included as income on tax returns, and is taxable. But there are certain exclusions written into Section 108(a)(1)(E) of the tax code related to a homeowners principal residence and referred to as qualified principal residence indebtedness (QRPI). Basically, the new legislation extends the beneficial provisions of Section 108(a)(1) for an additional three years through the close of 2012.

The section provides that gross income does not include amounts that would otherwise be included on account of the discharge of (QRPI). Under the tax code, this type of indebtedness includes acquisition indebtedness incurred with respect to one’s principal residence. Acquisition indebtedness, in turn, includes indebtedness incurred in acquiring, constructing, or substantially improving a qualified residence, but only if the debt is secured by such residence.

For a discharge of QRPI to be eligible for the section’s exclusion benefits, the forgiveness of the debt must be “on account of” a decline in the fair market value of the relevant principal residence or a deterioration of the “financial condition” of the debtor. Further, the amount excluded from gross income under Section 108 shall be applied to reduce the basis, in the debtor’s hands, of the principal residence which serves as security for the QRPI.

Covered securities

The Stabilization Act also requires brokers to furnish information to their customers with respect to “covered securities.” Specifically, the information must include the adjusted basis of securities and whether any gain or loss realized by the customer in connection with the disposition of the securities is long-term or short-term in nature.

Further, the law states that the adjusted basis should be determined in accordance with “first in, first out” principles unless the customer notifies the broker by means of an “adequate identification of the stock sold or transferred. For purposes of the bailout, a covered security is any “specified” security acquired on or after the applicable date. In the case of stock the applicable date is January 1, 2011; for debt instruments the applicable date is January 1, 2013.

In addition, the law extends alternative minimum tax relief – in the form of increased exemptions – for an additional year and extends, among other credits, the research and development credit through the end of 2009.

Unfortunately, the Stabilization Act contains some “revenue raisers.” Most notably, the legislation provides that any compensation which is deferred under a “non-qualified” deferred compensation plan of a “non-qualified” entity shall be included in gross income when there is no “substantial risk of forfeiture” of the rights to the payment. A substantial risk of forfeiture exists when one of two criteria are met. Either, the person’s rights to such compensation are conditioned on the future performance of substantial services, or the compensation is determined solely by reference to the amount of gain recognized on the disposition of an investment asset.

For this purpose, a non-qualified entity is defined as, (1) any foreign corporation – unless substantially all its income is “effectively connected” with the conduct of a business in the United States or is subject to a “comprehensive foreign income tax ; or (2) any partnership – unless substantially all of its income is allocable to persons other than foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax. These rules are scheduled to apply to deferred compensation with respect to services rendered after December 31, 2008. Moreover, the Act contains other rules which would require the inclusion in gross income, beginning in 2018, of prior deferrals.

Robert Willens is founder and principal of Robert Willens LLC

Footnotes
(1)The tax code provides that in the case of a financial institution referred to in Section 582(c)(2), the sale or exchange of a bond, debenture, note, or certificate or “other evidence of indebtedness” shall not be considered the sale or exchange of a capital asset. Thus, in effect, the bailout legislation extends the ameliorative provisions of Section 582(c)(1) to Fannie Mae and Freddie Mac’s preferred stock.
(2) Also includes any corporation which would be a bank except for the fact that it is a foreign corporation with respect to gains and losses which are effectively connected with the conduct of a banking business within the United States.

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