May 18, 2009

by Charles Swenson, CPA/PhD and Adrian Stern, CPA

This article was originally published in the AICPA Tax Insider.

Under the newly-enacted American Recovery and Reinvestment Act of 2009, the U.S. government will now guarantee and provide tax subsidies for qualifying bonds issued by county and city governments before 2011. This article describes the tax and finance aspects of these bonds. Such knowledge will be very useful when clients are considering these investments.

Build America Bonds

Section 1531 of Title I of Division B of the American Recovery and Reinvestment Act of 2009, Pub. L. No. 111-5, 123 Stat. 115 (2009) (enacted February 17, 2009) (ARRA), added 54AA to the Code, authorizing state and local governments, at their option, to issue two general types of Build America Bonds (BABs) as taxable governmental bonds with Federal subsidies for a portion of their borrowing costs. The subsidies take the form of either tax credits provided to holders of the bonds or refundable tax credits paid to state and local governmental issuers of the bonds. Build America Bonds have different levels of Federal subsidies and program requirements depending on the particular type of bond.

The first type of Build America Bond provides a Federal subsidy through Federal tax credits to investors in the bonds in an amount equal to 35 percent of the total coupon interest payable by the issuer on taxable governmental bonds (net of the tax credit), which represents a Federal subsidy to the state or local governmental issuer equal to approximately 25 percent of the total return to the investor (including the coupon interest paid by the issuer and the tax credit). This type of Build America Bond will be referred to in this Notice as Build America Bonds (Tax Credit).

The second type of Build America Bond provides a Federal subsidy through are fundable tax credit paid to state or local governmental issuers by the Treasury Department and the Internal Revenue Service (IRS) in an amount equal to 35 percent of the total coupon interest payable to investors in these taxable bonds. This type of Build America Bond will be referred to in this Notice as Build America Bonds (Direct Payment). The level of the 35 percent Federal interest subsidy on Build America Bonds (Direct Payment) is deeper than the corresponding approximately 25 percent Federal interest subsidy on Build America Bonds (Tax Credit). In addition, 1401 of ARRA, which added 1400U-2 of the Code, provides for a third type of Build America Bond (Direct Payment) known as Recovery Zone Economic Development Bonds, which provides for a deeper Federal subsidy through a refundable tax credit paid to state or local governmental issuers in an amount equal to 45 percent of the total coupon interest payable to investors in these taxable bonds. This type of Build America Bond will be referred to in this Notice as Recovery Zone Economic Development Bonds (Direct Payment).

Are These Bonds Tax-Advantaged?

Yes and no. The bonds which pay a 35 percent tax credit to investors are only tax advantaged insofar as the investor is normally in a bracket lower than 35 percent. Here’s why. Normally, interest on such muni bonds is exempt under IRC Sec. 103. However, if such bonds are subsidized or guaranteed by the Federal government, they become taxable. Here, BABs are treated essentially as normal muni bonds by Sec. 54AA. So if an investor is normally in the 35 percent bracket, it is no different tax-wise from a regular muni bond. The main advantage of these BABs is risk mitigation: the Federal government guarantees them.

For BABs where the issuing city of county receives a tax credit from the government, there is no direct tax advantage to investors. However, because the cost of capital to the issuing government is effectively lower by 35 percent, the issuing government may chose to pass part of this savings on in the form of higher interest paid to investors. This could occur if the issuing government wants to have a more competitive issuance.

Two-Year Exemption From the AMT

Another part of the act was a two-year exemption form alternative minimum tax (AMT) for bonds that would be normally subject to it. Bonds that cover expenditures for projects such as pollution control equipment, airport improvements or other similar projects are subject to the AMT which increases the interest rate on the bonds. This partial exemption should drive down the cost of issuing the bonds. The Act also allows for the refinancing of these bonds.

Effect on Recovery Zone

This effect should be more pronounced for Recovery Zone Economic Development Bonds in which the tax credit paid by the issuer goes to 45 percent. These BABs are restricted to fund projects is economically depressed areas such as state Enterprise Zones and Federal Empowerment Zones and Renewal Communities. There is a software that locates all of these zones and also describes the lucrative tax benefits which they can offer to your business clients.

Are There Forms To File?

If your clients invest in BABs which pay them a tax credit, there are two forms. Form 8038-CP should be filed after purchase of the bonds. This form enables the IRS to send checks to the investor for the tax credits. On the client’s Federal return, form 8038-G should be attached. You can find more information in this IRS publication (PDF).