United States: Key Tax Provisions Of The Emergency Economic Stabilization Act Of 2008 - 11 November 2008

United States: Key Tax Provisions Of The Emergency Economic Stabilization Act Of 2008

Although the key feature of the Emergency Economic Stabilization
Act of 2008 (Act) is the establishment of the Troubled Assets
Relief Program (TARP) to restore liquidity and stability to the
financial system, the Act as signed into law also contains many
important tax provisions. In this alert, members of Foley's Tax
& Employee Benefits Practice summarize the key tax provisions
of the Act, as interpreted by United States Department of the
Treasury in Notice 2008-94.

Tax Treatment of Executive Compensation for Participating TARP
Entities

The Act includes rules that modify the tax treatment of
executive compensation paid by institutions that participate in
TARP. These tax provisions are in addition to direct restrictions
on executive compensation paid by such participants and apply only
if the taxpayer (hereinafter, "a participating
institution") is a member of a controlled group of
corporations or commonly controlled businesses that sells (in the
aggregate) more than $300 million of troubled assets to the
government. In determining whether a controlled group has reached
the $300 million threshold, the Act excludes direct sales to the
government; however, this exclusion only applies if direct sales
are the only means by which the group's troubled assets are
acquired by the government.

Limits on Deductibility of Compensation

The Act expanded Section 162(m) of the Internal Revenue Code
(Section 162(m)), which generally places a $1 million limitation on
the deductibility of compensation paid by publicly held
corporations to their chief executive officers and their four
highest paid officers. Under the amendment, a participating
institution is disallowed a deduction for annual compensation
(including deferred compensation) in excess of $500,000 that it
pays to a "covered executive" in respect of services
performed in any year during the term of the Act.

The Act applies the $500,000 limitation in a substantially
different manner than the general $1 million limitation under
Section 162(m). Ordinarily, the Section 162(m) limitation applies
only to publicly held corporations and does not apply to
commission- or performance-based compensation (or to certain
grandfathered compensation arrangements). By contrast, the $500,000
limitation added by the Act applies to both privately and publicly
held entities and permits no exception for commissions,
performance-based compensation, or grandfathered compensation.

Another difference relates to the manner in which the limitation
is calculated. The general $1 million limitation under Section
162(m) is calculated on the basis of total compensation paid during
the year (other than excepted compensation) regardless of when the
compensation was earned. By contrast, the $500,000 limitation is
calculated with respect to the year in which the compensation is
earned, not the year it is paid, and amounts attributable to the
growth in deferred compensation for the passage of time such as an
increase for interest or investment returns, fully count against
the limitation. Thus, deferred compensation allocable to services
performed in a year covered by the Act (including a growth factor)
may not be deducted when paid in a later year to the extent that it
causes the total compensation for the services performed in the
earlier year to exceed $500,000.

According to Notice 2008-94, deferred compensation paid during a
year is "allocable" to services performed in an earlier
year if the executive possessed a "legally binding right"
to such remuneration based upon a formula that relates to services
performed in the earlier year. For example, if an executive
acquires a legally binding right to receive remuneration that is
tied to the amount of compensation earned during a particular year,
the deferred compensation is allocable to the services performed in
such year. Notice 2008-94 indicates that an executive does not have
a legally binding right to future remuneration for this purpose if
the employer has discretion to reduce or eliminate the compensation
unilaterally after the services are performed, unless the
employer's right is exercisable only on a condition or the
employer's discretion "lacks substantive
significance." It also indicates that a "risk of
forfeiture," that is, a condition that makes payment of the
deferred compensation dependent on the performance of future
services, does not prevent the right to the compensation from being
"legally binding." Rather, in this situation, the
compensation generally must be allocated pro rata over the period
of time the employee is required to perform such services.

The $500,000 limitation does not apply to (1) compensation for
services performed in years prior to the first year the employer
becomes subject to the limitation as a result of its participation
in TARP, or (2) compensation earned in a year after the term of the
Act. The Act is due to expire on December 31, 2009, but can be
extended. Accordingly, a participating institution (or any
institution that may become one during the term of the Act) will
need to track the years to which deferred compensation relates.

For purposes of the tax provisions of the Act, a "covered
executive" includes the chief executive officer (CEO), chief
financial officer (CFO), and any employee (other than the CEO and
CFO) who is one of the three most highly paid executives
(determined under the proxy disclosure rules, whether or not such
rules apply) during any portion of a taxable year in which the Act
is in effect. Once an individual is determined to be a covered
executive, he or she will remain a covered executive for the
duration of the term of the Act and afterward with respect to
deferred compensation. Thus, an executive who is one of the three
most highly paid executives in a year covered by the Act remains a
covered executive in later years covered by the Act, even if he or
she ceases to be one of the three most highly paid executives in
such years.

The Treasury Secretary is authorized to prescribe guidance,
rules, or regulations necessary to carry out the purposes of these
provisions, including to cover the case of any acquisition, merger,
or reorganization of a participating employer.

Tax Treatment of Severance Payments

The Act also amends Section 280G of the Internal Revenue Code
(Section 280G) to treat severance payments by a participating
institution to covered executives (i.e., the CEO, CFO, and their
highest paid executives) as "parachute payments." Under
the revised Section 280G, if the present value of the severance
payments to a covered executive equals or exceeds three times the
executive's average annual compensation during the base period
(the "base amount"), then the excess of such payments
over the base amount will be nondeductible. Additionally, the
covered executive will be subject to a 20-percent excise tax under
Section 4999 of the Internal Revenue Code on the same amount.

The provision only applies if the severance occurs during the
term of the Act and as a result of the involuntary termination of
the executive or in connection with any bankruptcy, liquidation, or
receivership of the employer. Thus, unlike the rest of Section
280G, it applies in the absence of a change of control of the
employer. Whether a payment is made on the account of the
employee's "severance" is determined in the same
manner as under present law. Thus, a payment should not be
considered a severance payment if the payment would have been made
at that time without regard to the termination of employment, or if
the payment would have been made with respect to a voluntary
termination.

Several of the exceptions that enable taxpayers to avoid Section
280G do not apply to severance payments by a participating
institution to a covered executive. For example, under the
amendment, the small business corporation exception does not apply
to severance paid by a participating institution to a covered
executive and, consequently, the $500,000 limitation applies to
entities that are not normally subject to the golden parachute
payment rules such as S corporations and corporations eligible to
be S corporations. Similarly, a participating institution cannot
escape Section 280G by obtaining shareholder approval of the
severance payment. Additionally, the amendment does not provide an
exclusion for reasonable compensation for services provided prior
to or after the date of severance. Consequently, payments
attributable to a post-severance non-competition agreement will be
treated as severance benefits.

Noticeably absent from the Act are definitions of
"severance" and "involuntary termination." The
meaning of the latter term is critical, since both the
participating institution and the covered executive have an
incentive to characterize any termination as a voluntary
termination. In Notice 2008-98, the Internal Revenue Service (IRS)
provided some preliminary guidance on the meaning of involuntary
termination. Under Notice 2008-98, an executive will be deemed to
undergo an involuntary termination if his or her employment is
terminated unilaterally by the employer notwithstanding the
executive's willingness and ability to continue providing
services. Thus, an involuntary termination can include the
employer's failure to renew the executive's employment
contract if the executive was willing to remain employed under
substantially the same terms and conditions. Notice 2008-94
suggests, however, that an employer's termination of an
executive may not be involuntary if it is due to the
executive's "implicit or explicit request" to be
terminated. Notice 2008-94 also states an executive's
termination for "good reason," due to a material negative
change in the executive's relationship with the employer,
constitutes an involuntary termination. In addition, an apparently
voluntary termination of employment can be an involuntary
termination if the facts and circumstances indicate that the
employer would have terminated the executive and the executive had
"knowledge" that he or she would be terminated.

Both participating institutions and their executives should pay
careful attention to the precise language used in any contractual
provisions relating to limits on parachute payments or providing
for tax gross-up payments by the employer. Many such provisions are
active only upon a change of control of the business and,
therefore, may not apply to severance covered by this
amendment.

In the case where an actual change of control occurs, the normal
Section 280G rules apply without regard to the amendment. Through a
quirk in the drafting of the definitions, however, the severance
rules may still apply to an actual change of control if the
participating institution is an S corporation.

The Treasury Secretary is authorized to prescribe guidance,
rules, or regulations necessary to carry out the purposes of these
provisions, including to cover related corporations and personal
service corporations.

Nonqualified Deferred Compensation From Tax-Indifferent
Parties

The Act makes another change to the treatment of compensation
that is unrelated to TARP. This change concerns deferred
compensation arrangements maintained by non-U.S. taxpayers who are
indifferent to the availability and timing of a deduction for the
deferred compensation. Although existing Section 457(f) accelerates
recognition of deferred compensation income not subject to a
substantial risk of forfeiture if the service recipient is a
governmental body or a Section 501(c)(3) or other tax-exempt
entity, it does not apply if the service recipient is foreign. The
Act adds a new Section 457A to the Code to fill this gap. New
Section 457A supplements, but does not replace, Section 409A and
other provisions of the Code and regulations governing deferred
compensation.

Acceleration of Deferred Compensation

Under the new Section 457A, compensation deferred by a service
provider under a "nonqualified deferred compensation
plan" that is covered by Section 457A must be included in
income as soon as the compensation is no longer subject to a
substantial risk of forfeiture, unless such compensation is paid
within 12 months after the end of the taxable year of the service
recipient during which the right to such compensation is no longer
subject to a substantial risk of forfeiture. Where the amount of
the deferred compensation is not "determinable" at the
time it is first no longer subject to a substantial risk of
forfeiture, taxation continues to be deferred until it is
determinable. However, the service provider incurs a steep price
for this additional deferral in the form of an additional 20
percent tax on the deferred compensation, plus interest (at the
underpayment rate, plus one percent). The circumstances under which
deferred compensation is not determinable are yet to be defined in
regulations.

Section 457A does not apply to compensation paid by a foreign
entity that would have been deductible by such foreign entity
against income effectively connected with a U.S. trade or business
if the compensation had been paid in cash on the date that the
compensation ceased to be subject to a substantial risk of
forfeiture. It also does not apply to a deferred compensation plan
of a foreign entity if the compensation is payable to an employee
of a domestic subsidiary of such entity and is reasonably expected
to be deductible by the subsidiary under Section 404(a)(5) when
such compensation is includible in income by such employee.

Nonqualified Deferred Compensation Plan

Whether compensation is deferred under a nonqualified deferred
compensation plan for Section 457A purposes is generally determined
in accordance with the same standards that apply under Section
409A. Thus, Section 457A does not apply to incentive stock options
or options granted under an employee stock purchase plan, nor does
it apply to a nonqualified stock option with a strike price that is
not less than the fair market value of the underlying stock on the
date of grant, or to a transfer of property to which Section 83
applies (such as a transfer of restricted stock), provided the
arrangement does not include a deferral feature. However, any other
arrangement under which compensation is based upon the increase in
value of a specified number of equity units of the service
recipient (regardless of exercise price) is a nonqualified deferred
compensation plan covered by Section 457A. Thus, for example,
Section 457A applies to stock appreciation rights.

"Nonqualified Entity"

Section 457A applies only if the nonqualified deferred
compensation plan is maintained by a nonqualified entity, defined
to include any foreign corporation unless substantially all of its
income is effectively connected with a U.S. trade or business (and
therefore taxable in the United States) or subject to a
"comprehensive foreign income tax." Income of a foreign
corporation is deemed to be subject to a comprehensive foreign
income tax only if the foreign corporation (i) is eligible for the
benefits of a comprehensive income tax treaty between the foreign
country imposing the tax and the United States or (ii) demonstrates
to the satisfaction of the Treasury that the foreign country has a
comprehensive income tax. Significantly, Section 457A does not
impose any requirement with respect to the timing of any
compensation deduction under the foreign tax law.

The term nonqualified entity also includes any partnership
unless substantially all of its income is directly or indirectly
allocated to persons other than (i) foreign persons with respect to
whom such income is not subject to a comprehensive foreign income
tax and (ii) tax-exempt organizations. Literally, this means that
the admission to a partnership of foreign partners not subject to a
comprehensive foreign income tax will subject deferred compensation
from the partnership to Section 457A, even if the income allocated
to the foreign partners is effectively connected with a U.S. trade
or business (and therefore subject to U.S. tax). Section 457A
should not impact investment partnerships or funds with domestic
tax exempt entities as investors as long as the tax exempt entities
use one or more blocking C corporations to own their interests.

Under Section 457A, aggregation rules similar to those that
apply under Section 409A will apply for purposes of determining
whether a deferred compensation plan sponsor is a nonqualified
entity. The legislative history indicates, however, that the
aggregation rules should not cause Section 457A to apply to a
nonqualified deferred compensation plan of a foreign corporation
that is not a nonqualified entity on a standalone basis, but is a
member of a controlled group that includes nonqualified entities,
to the extent of deferred compensation expenses that are properly
allocable to such corporation.

"Substantial Risk of Forfeiture"

For purposes of new Code Section 457A, compensation is subject
to a substantial risk of forfeiture only if the rights to such
compensation are conditioned upon the future performance of
substantial services. However, the Treasury is authorized to expand
the definition of substantial risk of forfeiture to cause
compensation based solely upon gain recognized on the disposition
of an investment asset to be treated as subject to a substantial
risk of forfeiture until the date of disposition of that asset. For
this purpose, an investment asset is any single asset (other than
an investment fund or similar entity) (1) acquired directly by an
investment fund or similar entity, (2) with respect to which
neither such entity nor any person related to such entity
participates in the active management of such asset (or if such
asset is an interest in an entity, in the active management of the
assets of such entity), and (3) substantially all of the gain on
the disposition of which (other than the nonqualified deferred
compensation) is allocated to investors of such entity. The
legislative history indicates that for this purpose, active
management includes participation in the day-to-day activities of
the asset, but does not include the election of directors or other
voting rights exercised by shareholders.

The exception for deferred compensation based upon gain with
respect to an investment asset applies only if the compensation is
determined solely by reference to the gain upon the
disposition of the investment asset. Thus, for example, it does not
apply in the case of an arrangement under which the amount of the
gain upon which the deferred compensation is based is reduced for
losses on the disposition of any other asset.

Effective Date

Section 457A is effective for deferred amounts that are
attributable to services performed after December 31, 2008.
However, deferred amounts that are attributable to services
performed before January 1, 2009 are generally includible in an
individual's gross income in the later of (i) the last taxable
year of the individual beginning before 2018 or (ii) the taxable
year in which there is no substantial risk of forfeiture of the
rights to such compensation, if not included before then. Earnings
on deferred amounts that are attributable to pre-2009 services are
subject to Section 457A only to the extent that the amounts to
which such earnings relate are subject to Section 457A.

Energy Tax Provisions

A package of energy tax incentives was added to the Act at the
last moment to sweeten the Act for several members of Congress. The
incentives include key extensions of expiring credits for renewable
energy investments, provisions that have had broad bipartisan
support but have been in political limbo for many months as they
were attached and then removed from several bills over the past
year. The Renewable Electricity Production Tax Credit (PTC) and the
Energy Investment Tax Credit (ITC) have been key to the development
of green power in the United States in recent years. Their
expiration at the end of 2008 would have resulted in a loss or
postponement of billions of dollars of new investment in renewable
energy resources. The latest iteration of the extension of the
energy tax incentives was in the proposed Energy Improvement and
Extension Act of 2008. A variation of this bill became Title B of
the Act.

Renewable Energy Incentives

One-Year Extension and Modification of the
PTC. The key and most costly provision of the
bill was an extension of the last day for placing in service
property eligible for the PTC to December 31, 2009 for wind and
refined coal, and to December 31, 2010 for all other qualifying
sources (including open and closed-loop biomass, hydropower,
geothermal, small irrigation, solar, and municipal solid waste from
landfill gas facilities). The PTC also was expanded to include new
biomass facilities and marine renewables (waves and tides) placed
in service after October 3, 2008.

Long-Term Extension of the ITC. The
other key provision for the renewable energy industry was an
eight-year extension of the 30-percent ITC for solar energy
property and qualified fuel cell property and the 10-percent ITC
for microturbines and geothermal facilities, through December 31,
2016. The Act increases the ITC cap for qualified fuel cell
capacity from $500 per one-half kilowatt hour to $1,500. The Act
also expands the 10-percent ITC to include combined heat and power
systems, qualified small wind property (capped at $4,000 per
taxpayer) and geothermal heat pump systems. The energy ITC can now
be claimed by public utilities under the Act, and the energy ITC
will be allowed to offset the alternative minimum tax (AMT).

Long-Term Extension and Modification of the Residential
Energy-Efficient Property Credit. The Act
extended through 2016 the 30-percent income tax credit for
residential solar property and eliminated the current $2,000 cap on
the credit, effective for solar electric energy property placed in
service after December 31, 2008. It also expanded the credit to
cover small wind systems and qualified geothermal heat pump
property. The residential credit will be available for offset
against the AMT for tax years beginning after 2007.

Other Tax Provisions

In addition to extending and expanding renewable energy
incentives, the Act included a number of carbon mitigation and coal
provisions, transportation provisions, and energy conservation
provisions. Among these tax provisions are:

1. A credit for plug-in electric drive vehicles equal to $2,500
   plus $417 for each kilowatt hour of traction battery capacity in
   excess of four kilowatt hours. There are limits on the amount of
   the credit ranging from $7,500 for vehicles under 10,000 pounds to
   $15,000 for vehicles over 26,000 pounds.


2. Extension through 2009 of the biodiesel PTC for small biodiesel
   producers and the credit for diesel fuel created from biomass. The
   biodiesel credit also was modified to eliminate the disparity
   between biodiesel and agri-diesel, and to eliminate the requirement
   of a certain production process.


3. A new 50-percent bonus depreciation allowance for qualified
   reuse and recycling property placed in service after August 31,
   2008.


4. Extension of the lifetime income tax credit of up to $500 for
   qualifying energy-saving improvements to a personal residence
   through 2009 and addition of energy-efficient biomass fuel stoves
   to the list of qualifying property (subject to a $300 credit
   limit).


5. Extension of the energy-efficient buildings deduction through
   2013 and extension of the credit for energy-efficient improvements
   to new homes through 2009.


6. Extension through 2010 of the credit for energy-efficient
   appliances and modification of the amount of the credit.


7. Provision for accelerated depreciation as 10-year property of
   smart electric meters and qualified smart electric grid systems
   (previously 30-year class life property).


8. Treatment of qualified bicycle commuting reimbursements as
   qualified fringe benefits for tax years beginning after December
   31, 2008.

Revenue Provisions

To offset part of the cost of the energy incentives, the Act
includes several revenue offsets. Three of the offsets are
addressed primarily to oil companies — limiting the Code
Section 199 deduction for oil and gas producers to three percent
for tax years beginning after 2009; eliminating the different
treatment of foreign oil and gas extraction income and foreign
oil-related income; and increasing the per-barrel rate of
contributions to the Oil Spill Liability Trust Fund. Another offset
is a one-year extension of the 6.2 percent federal unemployment tax
rate on payroll through 2009, after which it will revert to six
percent.

Other Changes and Extenders

AMT Relief

The Act provides temporary AMT relief by increasing the
exemption amounts. The new AMT exemption amounts are $69,950 (from
$66,250 in 2007) for married couples filing joint returns and
$46,200 (from $44,350 in 2007) for individual filers.

The Act also loosens the limitations on unused minimum tax
credits to allow the credit to be claimed over a two-year period
(rather than five years), and eliminates the adjusted gross income
phase-out in connection with the credit.

The Act provides relief for individuals with AMT income
attributable to the exercise of incentive stock options (ISOs). Any
underpayment of tax, penalties, and interest attributable to the
pre-2008 exercise of ISOs is abated. Individuals who already paid
such amounts will receive a refund in the form of a credit spread
over the years 2008 and 2009.

The Act also extends the application of a variety of
nonrefundable personal tax credits to 2008.

Brokers Reporting of Basis on Form 1099

Brokers who file a Form 1099 will be required to include the
taxpayer's adjusted basis and whether the gain or loss is
short-term or long-term. Generally, the default method of
determining basis will be first-in first-out unless the taxpayer
indicates otherwise to the broker. The basis of such securities
generally will be determined on an account-by-account basis.
Exceptions for wash sales apply. This rule becomes effective
January 1, 2011 for most stock and January 1, 2013 for most other
financial instruments.

Issuers of any share of stock, note, or bond in a corporation as
well as issuers of a commodity contract or financial instrument
must report changes in basis to taxpayers after certain
transactions (i.e., stock splits, mergers, and acquisitions) that
impact the taxpayers' basis. This rule is phased-in similarly
to the broker rule above.

Bank Relief

For banks, small business investment companies, business
development corporations, depository institution holding companies,
and certain other financial institutions, the sale of Fannie Mae or
Freddie Mac stock is treated as ordinary income (loss) instead of
capital income (loss).

Tax Return Preparer Penalty

The general standard for imposing preparer penalties has been
changed from "more-likely-than-not" to "substantial
authority" so that the same standard that applies to tax
filers now also applies to tax return preparers.

Extensions

The New Market Tax Credit has been extended through 2009, and
the research credit was extended until January 1, 2010. The latter
extension applies retroactively to research costs incurred since
December 31, 2007.

The Act extends the tax-free treatment of qualified charitable
distributions from traditional or Roth Individual Retirement
Accounts (IRAs) for tax years 2008 and 2009. Thus, taxpayers age 70
½ or older may exclude up to $100,000 of IRA distributions
per year that are paid directly to a qualified charitable
organization.

The Act extends the mortgage forgiveness exclusion to January 1,
2013. This provision is an exception to recognition of income on
the cancellation of indebtedness. Any income from the discharge (in
whole or in part) of qualified principal residence indebtedness is
excluded from gross income (but applied to reduce the adjusted tax
basis of the residence).

Special rules that increase corporate charitable deductions for
donations of certain property (computer property and food inventory
that will be used for the care of ill, the needy, or infants) also
have been extended by the Act.

Section 512(b)(13) of the Internal Revenue Code subjects certain
payments from a subsidiary to a parent exempt organization to the
unrelated business income that would otherwise be excluded. The
special exception applies for certain contracts entered into before
August 17, 2006 is extended to December 31, 2009.

Disaster Relief

The Act implements a number of disaster area relief provisions,
including waiver of the 10-percent of adjusted gross income (AGI)
limit on personal casualty losses for federally declared disasters
for tax years 2008 and 2009, and permission for the expensing,
rather than capitalizing, of qualified disaster expenses
and increases the expensing for qualified disaster
assistance property under Section 179 of the Internal Revenue Code.
In addition, the Act includes a number of temporary tax relief
provisions specific to the Midwestern disaster area, which
generally includes areas declared by the president where a major
disaster occurred (e.g., Wisconsin, Illinois, Michigan, Minnesota,
and Indiana). These temporary provisions include items such as
rehabilitation credits and extended net operating loss carryback
periods.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

Specific Questions relating to this article should be addressed directly to the author.