With the current top C-corporation tax rate at 35% and the top individual rate at 39.6% for S-corporation shareholders, many financial institutions actively look for deductions to take some of the bite out of their tax bill. The use of tax credits can be an extremely effective way to reduce tax liability. While tax deductions reduce the amount of taxable income to which the tax rates are applied to figure the liability, tax credits are a dollar-for-dollar reduction of the tax liability itself. There are a plethora of credits available, but this article will focus on two types of credits that are increasingly being used by financial institutions: historic tax credits and the research credit.
Historic Tax Credits
Federal historic tax credits (HTCs) are granted by the National Park Service for the rehabilitation of a historic building and are based on a maximum of 20% of qualified rehabilitation expenditures. Often when a real estate developer is renovating a historic building, the developer needs some capital investment and can't use the HTCs in a timely and efficient manner itself. The developer then looks to "sell" the credits to another taxpayer who can use the credits, such as a financial institution.
HTCs can be used to offset both regular and AMT tax. As part of the general business credit, they are limited to the total tax liability less 25% of the net regular tax in excess of $25,000. Unused credits can be carried back one year and forward twenty years. In the case of an S-corporation, the credits are passed through to individual shareholders who report them on their own tax return. Note that passive activity limitations may apply at the individual level.
Federal HTCs can't be purchased outright. Instead, there are two alternative structures through which a financial institution can receive the benefit of these credits. The first is through a partnership investment. In this case, the financial institution will contribute cash and receive an equity interest in the partnership that owns the historic building being rehabilitated. As a partner, the financial institution will be allocated a share of the HTCs, along with an equal share of the partnership's income or loss generated by the property. However, special allocations in which the entire credit but none of the income or loss is allocated to the "buyer" of the credit are not allowed. A put option can be used to force the sale of the partnership interest back to the partnership that owns the building once the recapture period (discussed below) has expired if the financial institution does not want to remain invested in the project long term.
If the project is sold or disposed of, or if the financial institution reduces its interest in the partnership within 5 years of the building's placed-in-service date, some or all of the credits have to be recaptured.
The IRS has recently challenged the partnership structure and won in the Federal Appeals Court by arguing that the intent of the structure was for the purchase and sale of credits, that the "buyer" of the credits was not a real partner in substance, and therefore could not be allocated the HTCs. The IRS subsequently issued a safe harbor allowing the use of the partnership structure without IRS challenge, so long as certain conditions are met.
The second structure is through a master lease. In this case, the HTC "buyer" does not have to become a partner to receive the benefit of the credit. The financial institution would enter into a master lease with the historic building's owner and then sublease the property to the actual tenants. The owner of the building can make an election to assign the credit to the financial institution. This avoids some of the problems with the partnership method discussed above. However, unless the building owner and financial institution have a net lease in place, the master lease is required to be at least 80% of the building's tax class life (39 years for non-residential and 27.5 years for residential) in order to assign the entire credit. Shorter leases result in only a portion of the HTC being allocated.
Many states also offer historic rehabilitation tax credits. Unlike the federal credits, the IRS does allow the outright purchase of state tax credits, avoiding the need for a partnership investment or master lease agreement.
If your financial institution is interested in historic tax credits and related investments, there are many tax and non-tax considerations that need to be analyzed to determine the potential benefits and pitfalls. Please contact your Wipfli representative for additional information.
A federal credit for research and development activities is available for taxpayers developing new or improved business components, including computer software. Financial institutions are increasingly developing new technologies related to online and mobile banking, cybersecurity, and other banking functions. The R&D credit could be applicable to software that is developed to interact with customers, allows customers to review data on the institution's system, or allows customers to initiate banking or brokerage transactions. Activities related to the development, enhancement, customization, and testing of these software applications can provide financial institutions with an opportunity to benefit from the R&D credit.
If a financial institution is eligible, the R&D credit is equal to a maximum of 20% of qualified research expenditures (QREs) in excess of a base amount. QREs for software development include taxable wages paid to employees for conducting, supervising, or directly supporting qualified research activities and 65% of contract research expenses paid to any person that is not an employee, provided that it would qualify if it were paid to an employee. In addition, the work must be performed in the U.S. The base amount is calculated using a percentage of average annual gross receipts for the four years preceding the year in which the credit is calculated.
Instead of using the above method, a taxpayer can elect to use the alternative simplified R&D credit, which is somewhat easier to calculate. In this case, the credit is equal to 14% of QREs in excess of 50% of the average QREs for three preceding tax years. If a taxpayer did not have QREs in any of the three preceding years, the alternative simplified credit is 6% of the current year QREs.
Financial institutions can use the R&D credit to offset regular tax down to the amount of tentative minimum tax, meaning that the credit can't be used against AMT. Financial institutions with receipts of less than $50 million are able to use the R&D credit to reduce AMT. As part of the general business credit, it is also limited to 25% of the regular tax liability in excess of $25,000. Any unused credit can be carried back one year and carried forward 20 years. In addition, taxpayers can amend prior open tax years to claim the credit. In the case of an S corporation, the credit is passed through to individual shareholders who can use the credit on their income tax returns to the extent they have a tax liability that is related to the S-corporation activity. Passive activity limitations may also apply to individual shareholders.
Many states also have a research and development credit available.
Wipfli's R&D practice is made up of experienced individuals who specialize in this area. They can perform a feasibility study to determine whether your financial institution qualifies and the approximate value of the credit. If feasible, a full study can also be performed to document in detail the information needed to support the credit. If your financial institution has recently developed software that may qualify, please contact your Wipfli representative.