The Section 44 small business disabled individuals tax credit provides a tax incentive to comply with the Americans With Disability Act of 1990 (“ADA”). There is very little guidance for the tax credit, which makes it hard for taxpayers to plan for this tax incentive. The recent Arevalo v. Commissioner, No.05-61129 (5th Cir. 2006), case provides an opportunity to consider this tax credit.
Facts & Procedural History
In 2001, Arevalo participated in a telephone investment program promoted by Alpha Telecom, Inc. Alpha Telecom solicited numerous individuals to invest in payphones that could be used by persons with disabilities.
Alpha Telecom represented that the modifications rendered the phones compliant with the Americans with Disabilities Act (“ADA”). Alpha Telecom also represented that the investor could reap two tax benefits: (1) the phones, as depreciable property, would entitle investors to depreciation deductions under Section 167, and (2) the costs incurred towards compliance with the ADA would qualify the investor for a disabled access tax credit under Section 44.
Arevalo entered into a purchase agreement with Alpha Telecom whereby it agreed to sell two payphones to Arevalo for $5,000 each. The contract did not provide for locations of the payphones or any other identifying information regarding the phones. The agreement did state that the phones were approved for installation in accordance with the ADA but did not list what the modifications were or how much the modifications cost. The agreement also contained a buy-back election, valid for seven years, which Arevalo signed.
Arevalo simultaneously entered into a service agreement with Alpha Telecom for the operation and maintenance of the phones. Arevalo opted for “Level Four” service, the highest level, enabling him to leave the operation and maintenance of the phones solely to Alpha Telecom. In exchange for the operation and maintenance of the phones, Alpha Telecom was to receive seventy percent of the revenue generated by the phones. Arevalo was to receive the balance. If the phones did not generate a certain threshold of revenue, then Alpha Telecom would nonetheless pay Arevalo $58.34 per month. If the phones did not generate at least that sum, then Arevalo would receive the entirety of the revenue that was generated.
Alpha Telecom operated at a loss and eventually filed for bankruptcy. Arevalo filed a proof of claim. The Securities and Exchange Commission (“SEC”) brought an enforcement action against Alpha Telecom alleging that the payphone scheme was a security and that the company had failed to register with the SEC. The district court determined that the payphone scheme was a security, and, in 2003, the Ninth Circuit affirmed.
On his 2001 federal income tax form, Arevalo claimed both a depreciation deduction and a disabled access credit. Arevalo was audited by the IRS, and the IRS determined that he was not entitled to claim either the deduction or the credit. Arevalo challenged the deficiency in the U.S. Tax Court, but he did not appear for trial. Relying on stipulated facts and joint exhibits submitted by the parties, the U.S. Tax Court found in the IRS’s favor. Arevalo appealed.
The Section 44 Tax Credit
Section 44 provides a tax credit of up to $10,250 for small businesses to spend funds:
- for the purpose of removing architectural, communication, physical, or transportation barriers which prevent a business from being accessible to, or usable by, individuals with disabilities,
- to provide qualified interpreters or other effective methods of making aurally delivered materials available to individuals with hearing impairments,
- to provide qualified readers, taped texts, and other effective methods of making visually delivered materials available to individuals with visual impairments,
- to acquire or modify equipment or devices for individuals with disabilities, or
- to provide other similar services, modifications, materials, or equipment
Thus, most costs to purchase equipment or devices and to create or modify personal or real property are eligible for this credit if (1) they are reasonably necessary to comply with the ADA and (2) the primary purpose of complying with the ADA.
In addition to the dollar caps noted above, the tax credit is limited to 50 percent of the amount spent.
Businesses that with gross revenues under $1 million or less than 30 full-time employees can qualify for this tax credit.
Entitlement to the Tax Credit
The U.S. Tax Court and the Fifth Circuit (just like the Sixth Circuit did with a different taxpayer) held that Arevalo was not entitled to the Section 44 tax credit. There were several reasons for this decision, including:
- The prior precedent whereby the courts held that Alpha Telecom purchases are “investments” and not “businesses.”
- Arevalo could not show how funds were expended to make the payphones ADA compliant because Alpha Telecom did not disclose to Arevalo how the payphones were ADA compliant
- The Section 44 tax credit is only available to the party that is subject to the ADA, which in this case was Alpha Telecom and not Arevalo.
This decision is not surprising given the facts. The Section 44 disabled access tax credit can provide a great benefit for the right facts. The Arevalo case helps clarify what those facts are.
The case highlights the importance of having proper documentation and evidence when claiming tax credits, especially when it comes to eligibility for disabled access credits. Taxpayers should ensure that they have a clear understanding of the modifications made to the equipment, the costs incurred, and the location of the equipment before claiming eligible access expenditure. It is crucial to have the necessary information to support the claim, or it may be denied, resulting in a tax deficiency.