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.

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 losss 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.

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