Business Incentives and Property Taxes in Bankruptcy

Generally, state and local governments grant companies business incentives to locate or expand in a community. Incentives can take the form of cash grants or tax abatements, such as property tax abatements and sales/use tax abatements. While some incentives are statutory, i.e., available as a matter of right where the qualifications are met, the most valuable incentives are negotiated by incentives professionals. Many incentives agreements provide for the incentives, such as real property tax abatements, to be provided over time, for example, over 10 years. In the current economic climate, governments are even granting incentives for companies to retain employees, which keeps jobs in the community, thereby supporting the local economy overall. Even the federal government has gotten into the game by offering grants to promote research and development and loans to support the development of technologies, such as alternative technology vehicles.

Since, as we know, there's no such thing as a free lunch, companies must meet certain hurdles to qualify for or to retain the incentives. The three primary hurdles are employment/hiring levels, wage levels and capital investment. Some, though not all, incentives agreements provide for the claw back of incentives if the hurdles are not met. In other words, if the company does not hire sufficient number of people, fails to retain a certain number of employees or fails to make adequate capital investments, it must return the benefits to the government. In some limited instances, conditions regarding a company's solvency or continued viability are being included in incentives agreements.

When a company enters bankruptcy, it is possible that it also did not meet the hurdles required for its incentives. Consequently, in addition to its other financial problems, it may be required to return incentives, for example, by returning cash grants or by paying real property or sales/use taxes on capital investments for prior periods. This may present a cash cost to the company when it can least afford it.

In general, the incentives agreement between the company and the state or local government controls if and when a clawback of incentives is required. Where the agreement does not require a clawback, there should generally be no concern, absent a statutory requirement. If the agreement provides for a clawback, it should be determined whether the company has or has not met its hurdles and whether entering bankruptcy itself triggers a clawback. It should also be determined whether corporate officers have personal liability for unpaid taxes under state law.

Executory Contract

When the incentives agreement provides for benefits over time, the bankruptcy courts may view the agreement as an executory contract under Bankruptcy Code ' 365, though there is no clear definition of executory contracts and even bankruptcy attorneys are unclear what falls within its scope. While the Bankruptcy Code does not define “executory contract,” it is generally interpreted to mean an agreement where substantial future performance is required by both parties, though it may apply to an agreement where substantial future performance is required by only one of the parties. Section 365 generally provides that the bankruptcy trustee can assume or reject any executory contract, subject to several caveats.

In a recent bankruptcy proceeding, our client was faced with the decision to assume or reject its incentives agreement with a local government. If assumed, the client would be required to pay a substantial clawback because the client had not met the investment and headcount requirements in the agreement. Consequently, the client decided to reject the incentives agreement.

In another matter, the client had approximately 40 locations, each with its own incentives agreement. To assist the client, we reviewed each agreement to assist management in determining whether to reject or assume each agreement.

Emerging from Bankruptcy

Very generally, there are a number of scenarios that occur when a company emerges from bankruptcy. First, a company may emerge intact, albeit with different shareholders (often the former creditors). Alternatively, the company's assets may be sold to a strategic acquirer or an investor group in a Bankruptcy Code ' 363 sale. Moreover, in more complex situations, the emergence plan may include a ' 363 sale of noncore assets or businesses, as well as the retention of the core business by a group of secured creditors, or a split up of core businesses among various creditor groups.

Each of these scenarios may present an opportunity to bring value to the company through incentives. When a company emerges from bankruptcy in its historical form (though with different owners), the trustee may have the right to assume or reject prior agreements, and many of the agreements provide cash (or cash equivalents) and above the line reductions in taxes that are necessary for a fresh start. In addition, and especially in the current economic climate, the state or local governments may be inclined to continue existing incentives agreements without clawbacks or to renegotiate incentives agreements so that the company can continue in operation. While the government may be entitled to a clawback, enforcing the clawback may be a factor in a company liquidating rather than emerging. Accordingly, the government may be inclined to forgo the clawback and assist the company in emerging and remaining part of the community's economy. This is because the governments' goal is to keep the employment and tax base of the community intact. If, as part of the emergence plan, the company must reduce the size of its operations, this may also present an opportunity for incentives, for example, where one plant is closed and some of the employees and assets are merged into another plant.

Another silver lining for a company that emerges in its historical form is through property taxes. First, the estate may seek cash refunds of property taxes if it can show that the assessed values in prior years exceeded the value of the property. See Bankruptcy Code ' 505(a). In addition, property tax for post-emergence periods may be lowered significantly by the bankruptcy court, thereby reducing cash taxes for the emerging company.

When assets are sold in a ' 363 sale, the trustee may reject any prior incentives agreements or the agreement may terminate by its terms, and the buyer may have the opportunity to negotiate with state and local authorities regarding where the assets will be located (the location of a business is the ultimate leverage in negotiating incentives). This may also present an opportunity to lower property taxes by having the court establish the property taxes for the business to be acquired. If a bankrupt business will be folded into the acquirer's existing business, the buyer may be able to negotiate incentives based on increased headcount and increased capital investment for its existing business.

In the more complex situation where noncore assets or businesses are sold while the core business emerges intact or split up among various creditor groups, the various parties in interest will have to analyze the incentives opportunities available to each. There may be a double benefit if the incentives qualify for federal income tax deferral under IRC ' 118 (though this treatment may not be beneficial for incentives received during 2009 when the 50% bonus depreciation is available).

Two Case Studies

Two examples illustrate the incentive opportunities for companies in bankruptcy. In a small Midwest town, an old-line manufacturing firm was the largest employer. It was also the largest customer of the municipally owned utility. If the company pulled out of this community, the town, and likely its municipal utility, would also become insolvent. The company, through a joint venture, won new work and agreed to source that work from this plant if the state and local community agreed to assist the company with incentives. And they did. The state and local town agreed to exempt the company from current and future sales/use taxes, property taxes, and franchise taxes for a period of 12 years. Furthermore, the state government drew down on federal funds to purchase new transformers for the plant that allowed the company to achieve a better electric rate from the municipal utility. The utility waived its infrastructure and demand charges that also dropped the rate. And, on top of these “above-the-line” savings, the state and local government gave the company $800,000 in cash grants. The good news for the community is that even with the current economic downtown affecting the country, this plant is still operating at historic levels.

In another Midwestern state, a company was seeking to relocate three manufacturing operations off-shore. The company agreed to remain in the state in exchange for a refundable tax credit of approximately $5 million per year for 20 years or $100 million cumulatively, even though the company agreed to retain only 1,800 of its 2,300 employees.

It serves to note that timing is critical to favorable incentives negotiations. During the pendency of the bankruptcy, while the economic cloud is the darkest, the government feels the most urgency to help preserve or locate jobs in the community. In this regard, Bankruptcy Code ' 365 also provides time limits for assuming or rejecting executor contracts. States also have the most confidence that the deals they strike during a bankruptcy will last beyond the bankruptcy because of the enforceability of a court's orders and the confirmation of the plan of emergence. Despite the prevailing view to the contrary, the bankruptcy process gives states a sense of long-term certainty in times of economic upheaval.

We also note that potential investors model projected business results in valuing a business that may be acquired out of bankruptcy, perhaps in an auction process. If incentives are available, a potential investor may be able to increase its bid for the value of incentives, which is often overlooked by investors. Potential investors often also overlook projecting noncash taxes (such as property taxes) in their models, which may or may not be impacted by available incentives.

Conclusion

In summary, though bankruptcy may appear to be a dark cloud in a company's business history, a silver lining in the form of incentives and property tax may be found. Proper attention to statutory and negotiated incentives, as well as property tax, may bring value to a company at a critical point in its economic life.

Bankruptcy counsel and potential investors should determine whether there are existing incentives agreements, including determining whether the agreements require clawbacks. In addition, counsel and investors should identify opportunities to either maintain existing incentives agreements even though the hurdles in the agreement have not been met or to obtain a better incentives arrangement. Finally, counsel and investors should review the company's property tax posture to assess whether property tax refunds are available and whether future property tax liabilities can be reduced. Generally, these matters are best handled by incentives and property tax experts.

Jerome M. Schwartzman is a Managing Director in the New York office of Duff & Phelps, a financial advisory services company. He heads the Tax Due Diligence group. Gregory C. Burkart is a Managing Director in the firm's Business Incentives Advisory group, resident in Detroit. Schwartzman can be reached at 212-871-5955 and Burkart can be reached at 248-675-6959.

Bankruptcy is a dark cloud on a company's business. Indeed, bankruptcy seems to combine the two inevitabilities, death and taxes. However, business incentives and property taxes can be a silver lining by bringing precious value ' cash and above-the-line cost reductions, such as property tax abatements, sale/use tax exemptions and, in some instances, favorable financing and utility rate reductions ' to help the company on its road to economic recovery.

But let's not get ahead of ourselves. Since entering and emerging from bankruptcy is a process, let's briefly look at the impact of bankruptcy on existing incentives before turning to the silver lining.

Incentives

Generally, state and local governments grant companies business incentives to locate or expand in a community. Incentives can take the form of cash grants or tax abatements, such as property tax abatements and sales/use tax abatements. While some incentives are statutory, i.e., available as a matter of right where the qualifications are met, the most valuable incentives are negotiated by incentives professionals. Many incentives agreements provide for the incentives, such as real property tax abatements, to be provided over time, for example, over 10 years. In the current economic climate, governments are even granting incentives for companies to retain employees, which keeps jobs in the community, thereby supporting the local economy overall. Even the federal government has gotten into the game by offering grants to promote research and development and loans to support the development of technologies, such as alternative technology vehicles.

Since, as we know, there's no such thing as a free lunch, companies must meet certain hurdles to qualify for or to retain the incentives. The three primary hurdles are employment/hiring levels, wage levels and capital investment. Some, though not all, incentives agreements provide for the claw back of incentives if the hurdles are not met. In other words, if the company does not hire sufficient number of people, fails to retain a certain number of employees or fails to make adequate capital investments, it must return the benefits to the government. In some limited instances, conditions regarding a company's solvency or continued viability are being included in incentives agreements.

When a company enters bankruptcy, it is possible that it also did not meet the hurdles required for its incentives. Consequently, in addition to its other financial problems, it may be required to return incentives, for example, by returning cash grants or by paying real property or sales/use taxes on capital investments for prior periods. This may present a cash cost to the company when it can least afford it.

In general, the incentives agreement between the company and the state or local government controls if and when a clawback of incentives is required. Where the agreement does not require a clawback, there should generally be no concern, absent a statutory requirement. If the agreement provides for a clawback, it should be determined whether the company has or has not met its hurdles and whether entering bankruptcy itself triggers a clawback. It should also be determined whether corporate officers have personal liability for unpaid taxes under state law.

Executory Contract

When the incentives agreement provides for benefits over time, the bankruptcy courts may view the agreement as an executory contract under Bankruptcy Code ' 365, though there is no clear definition of executory contracts and even bankruptcy attorneys are unclear what falls within its scope. While the Bankruptcy Code does not define “executory contract,” it is generally interpreted to mean an agreement where substantial future performance is required by both parties, though it may apply to an agreement where substantial future performance is required by only one of the parties. Section 365 generally provides that the bankruptcy trustee can assume or reject any executory contract, subject to several caveats.

In a recent bankruptcy proceeding, our client was faced with the decision to assume or reject its incentives agreement with a local government. If assumed, the client would be required to pay a substantial clawback because the client had not met the investment and headcount requirements in the agreement. Consequently, the client decided to reject the incentives agreement.

In another matter, the client had approximately 40 locations, each with its own incentives agreement. To assist the client, we reviewed each agreement to assist management in determining whether to reject or assume each agreement.

Emerging from Bankruptcy

Very generally, there are a number of scenarios that occur when a company emerges from bankruptcy. First, a company may emerge intact, albeit with different shareholders (often the former creditors). Alternatively, the company's assets may be sold to a strategic acquirer or an investor group in a Bankruptcy Code ' 363 sale. Moreover, in more complex situations, the emergence plan may include a ' 363 sale of noncore assets or businesses, as well as the retention of the core business by a group of secured creditors, or a split up of core businesses among various creditor groups.

Each of these scenarios may present an opportunity to bring value to the company through incentives. When a company emerges from bankruptcy in its historical form (though with different owners), the trustee may have the right to assume or reject prior agreements, and many of the agreements provide cash (or cash equivalents) and above the line reductions in taxes that are necessary for a fresh start. In addition, and especially in the current economic climate, the state or local governments may be inclined to continue existing incentives agreements without clawbacks or to renegotiate incentives agreements so that the company can continue in operation. While the government may be entitled to a clawback, enforcing the clawback may be a factor in a company liquidating rather than emerging. Accordingly, the government may be inclined to forgo the clawback and assist the company in emerging and remaining part of the community's economy. This is because the governments' goal is to keep the employment and tax base of the community intact. If, as part of the emergence plan, the company must reduce the size of its operations, this may also present an opportunity for incentives, for example, where one plant is closed and some of the employees and assets are merged into another plant.

Another silver lining for a company that emerges in its historical form is through property taxes. First, the estate may seek cash refunds of property taxes if it can show that the assessed values in prior years exceeded the value of the property. See Bankruptcy Code ' 505(a). In addition, property tax for post-emergence periods may be lowered significantly by the bankruptcy court, thereby reducing cash taxes for the emerging company.

When assets are sold in a ' 363 sale, the trustee may reject any prior incentives agreements or the agreement may terminate by its terms, and the buyer may have the opportunity to negotiate with state and local authorities regarding where the assets will be located (the location of a business is the ultimate leverage in negotiating incentives). This may also present an opportunity to lower property taxes by having the court establish the property taxes for the business to be acquired. If a bankrupt business will be folded into the acquirer's existing business, the buyer may be able to negotiate incentives based on increased headcount and increased capital investment for its existing business.

In the more complex situation where noncore assets or businesses are sold while the core business emerges intact or split up among various creditor groups, the various parties in interest will have to analyze the incentives opportunities available to each. There may be a double benefit if the incentives qualify for federal income tax deferral under IRC ' 118 (though this treatment may not be beneficial for incentives received during 2009 when the 50% bonus depreciation is available).

Two Case Studies

Two examples illustrate the incentive opportunities for companies in bankruptcy. In a small Midwest town, an old-line manufacturing firm was the largest employer. It was also the largest customer of the municipally owned utility. If the company pulled out of this community, the town, and likely its municipal utility, would also become insolvent. The company, through a joint venture, won new work and agreed to source that work from this plant if the state and local community agreed to assist the company with incentives. And they did. The state and local town agreed to exempt the company from current and future sales/use taxes, property taxes, and franchise taxes for a period of 12 years. Furthermore, the state government drew down on federal funds to purchase new transformers for the plant that allowed the company to achieve a better electric rate from the municipal utility. The utility waived its infrastructure and demand charges that also dropped the rate. And, on top of these “above-the-line” savings, the state and local government gave the company $800,000 in cash grants. The good news for the community is that even with the current economic downtown affecting the country, this plant is still operating at historic levels.

In another Midwestern state, a company was seeking to relocate three manufacturing operations off-shore. The company agreed to remain in the state in exchange for a refundable tax credit of approximately $5 million per year for 20 years or $100 million cumulatively, even though the company agreed to retain only 1,800 of its 2,300 employees.

It serves to note that timing is critical to favorable incentives negotiations. During the pendency of the bankruptcy, while the economic cloud is the darkest, the government feels the most urgency to help preserve or locate jobs in the community. In this regard, Bankruptcy Code ' 365 also provides time limits for assuming or rejecting executor contracts. States also have the most confidence that the deals they strike during a bankruptcy will last beyond the bankruptcy because of the enforceability of a court's orders and the confirmation of the plan of emergence. Despite the prevailing view to the contrary, the bankruptcy process gives states a sense of long-term certainty in times of economic upheaval.

We also note that potential investors model projected business results in valuing a business that may be acquired out of bankruptcy, perhaps in an auction process. If incentives are available, a potential investor may be able to increase its bid for the value of incentives, which is often overlooked by investors. Potential investors often also overlook projecting noncash taxes (such as property taxes) in their models, which may or may not be impacted by available incentives.

Conclusion

In summary, though bankruptcy may appear to be a dark cloud in a company's business history, a silver lining in the form of incentives and property tax may be found. Proper attention to statutory and negotiated incentives, as well as property tax, may bring value to a company at a critical point in its economic life.

Bankruptcy counsel and potential investors should determine whether there are existing incentives agreements, including determining whether the agreements require clawbacks. In addition, counsel and investors should identify opportunities to either maintain existing incentives agreements even though the hurdles in the agreement have not been met or to obtain a better incentives arrangement. Finally, counsel and investors should review the company's property tax posture to assess whether property tax refunds are available and whether future property tax liabilities can be reduced. Generally, these matters are best handled by incentives and property tax experts.

Jerome M. Schwartzman is a Managing Director in the New York office of Duff & Phelps, a financial advisory services company. He heads the Tax Due Diligence group. Gregory C. Burkart is a Managing Director in the firm's Business Incentives Advisory group, resident in Detroit. Schwartzman can be reached at 212-871-5955 and Burkart can be reached at 248-675-6959.