A taxpayer’s tax accounting methods determine when income is recognized and
costs are deducted for income tax purposes. Strategically adopting or
changing tax accounting methods can provide opportunities to drive tax
savings and increase cash flow. However, the rules covering the ability to
use or change certain accounting methods are often complex, and the
procedures for changing methods depend on the mechanism for receiving IRS
consent — that is, whether the change is automatic or non-automatic. Many
method changes require an application be filed with the IRS prior to the end
of the year for which the change is requested.
Among others, taxpayers should consider the following tax accounting
method implications and potential changes for 2023 and 2024, which are
further discussed below.
Although the IRS has continued to increase the types of accounting method
changes that can be made under the automatic change procedures, some common
method changes must still be filed under the non-automatic change
procedures. Importantly, a calendar year-end taxpayer that has identified a
non-automatic accounting method change that it needs or desires to make
effective for the 2023 tax year must file the application on Form 3115
during 2023 (i.e., the year of change). (Technically, a taxpayer with a
12/31/23 year end has until Tuesday, January 2, 2024, to file because
December 31 is a Sunday and Monday is the holiday observance of New Year’s
Day, therefore, Tuesday is the next business day after the due date).
Among the method changes that must be filed under the non-automatic change
procedures are many changes to correct an impermissible method of
recognizing liabilities under an accrual method (for example, using a
reserve-type accrual), and long-term contract changes. Additionally,
taxpayers that do not qualify to use the automatic change procedures because
they have made a change with respect to the same item within the past five
tax years will need to file under the non-automatic change procedures to
request their method change.
Generally, more information needs to be provided on Form 3115 for a
non-automatic accounting method change, and the complexity of the issue and
the taxpayer’s facts may increase the time needed to gather data and prepare
the application. Taxpayers that wish to file non-automatic accounting method
changes effective for 2023 should begin gathering the necessary information
and prepare the application as soon as possible to avoid a last-minute
rush.
A taxpayer that currently qualifies as a small business taxpayer for
accounting method purposes is able to use small business taxpayer accounting
methods – which include the overall cash method of accounting and other
simplifying provisions, such as exemptions from:
Generally, a small business taxpayer is a taxpayer, other than a tax shelter
under Section 448(d)(3), that meets the Section 448(c) gross receipts test
for a given tax year. For a tax year beginning in 2023, a taxpayer meets the
gross receipts test if it has average annual gross receipts for the three
prior tax years (2022, 2021, 2020) of $29,000,000 or less. In
calculating the gross receipts test, a taxpayer must follow the guidelines
for items to be included or excluded from gross receipts, and include the
gross receipts of all applicable entities and predecessors under the
aggregation rules.
Taxpayers must evaluate each year whether they qualify as a small business
taxpayer by continuing to meet the gross receipts test. In addition,
taxpayers should determine whether any M&A activities they have engaged
in or anticipate undertaking will affect their small business taxpayer
status. If so, the taxpayer should determine for what year accounting method
changes may be required, as well as whether it may be advantageous to make
the method changes earlier than required.
Taxpayers should verify as early as possible whether they remain eligible to
continue to use their current accounting methods. If method changes
are needed, a taxpayer needs to determine whether:
Additionally, if accounting method changes need to be made, taxpayers should
consider the impact of the Section 481(a) adjustments on their current year
tax returns as well as ensure that the methods being adopted are
consistently applied.
Heading into year-end tax planning season, companies may be able to take
some relatively easy steps to accelerate certain deductions into 2023 or, if
more advantageous, defer certain deductions to one or more later years. The
key reminder for all of the following year-end “clean-up” items is that the
taxpayer must make the necessary revisions or take the necessary actions
before the end of the 2023 taxable year. (Unless otherwise indicated, the
following items discuss planning relevant to an accrual basis taxpayer.)
In most circumstances, a taxpayer will want to
deduct bonuses in the year they are earned (the service year), rather than
the year the amounts are paid to the recipient employees. To accomplish
this, taxpayers may wish to:
Taxpayers with commission
liabilities should consider taking the following actions prior to the
end of the 2023 taxable year:
For federal income tax purposes, companies
may have an opportunity to take a current deduction for some of the expenses
they prepay, rather than capitalizing and amortizing the amounts over the
term of the underlying agreement or taking a deduction at the time services
are rendered.
A cash basis taxpayer can generally deduct prepaid expenses in the year of
actual payment as long as the prepaid expense meets an exception referred to
as the “12-month rule.” Under the 12-month rule, taxpayers can deduct
prepaid expenses in the year the amounts are paid (rather than having to
capitalize and amortize the amounts over a future period) if the
right/benefit associated with the prepayment does not extend beyond the
earlier of i) 12 months after the first date on which the taxpayer realizes
the right/benefit, or ii) the end of the taxable year following the year of
payment. As taxpayers are required to meet the Section 461 all events test
prior to applying the 12-month rule, accrual basis taxpayers must carefully
examine the nature of their prepaids to determine whether there is a fixed
and determinable liability and whether economic performance has occurred by
year end.
The rules provide some valuable options for accelerated deduction of
prepaids for accrual basis companies – for example, insurance, taxes,
government licensing fees, software maintenance contracts, and warranty-type
service contracts. Identifying prepaids eligible for accelerated deduction
under the tax rules can prove a worthwhile exercise by helping companies
strategize whether to make prepayments before year end, which may require a
change in accounting method for the eligible prepaids.
Often companies carry inventory that is obsolete,
unsalable, damaged, defective, or no longer needed. While for
financial reporting inventory is generally reduced by reserves, for tax
purposes a business normally must dispose of inventories to recognize a
loss, unless an exception applies. Thus, a best practice for tax purposes to
accelerate losses related to inventory is to dispose of or scrap the
inventory by year end.
An important exception to this rule is the treatment of “subnormal goods,”
which are defined as goods that are unsaleable at normal prices or unusable
in the normal way due to damage, imperfections, shop wear, changes of style,
odd or broken lots, or other similar reasons. For these types of items,
companies may be able to write down the cost of inventory to the actual
offering price within 30 days after year end, less any selling costs, even
if the inventory is not sold or disposed of by year end.
Subject to limitations, the so-called tangible property regulations (TPR)
permit a taxpayer to elect to deduct the costs of items that likewise are
expensed under a written financial accounting policy in place as of the
beginning of the tax year. The election must be made annually and, because
it is not a method of accounting, can be made for a given year without
regard to whether the taxpayer has made the election for a prior year. The
taxpayer can adjust the tax benefit of the safe harbor election by modifying
the associated financial accounting policy prior to the beginning of the tax
year for which the election will be made, changing the ceiling amount for
items eligible to be deducted.
Under the safe harbor election, taxpayers with an applicable financial
statement (AFS) may deduct amounts paid for tangible property up to $5,000
per invoice or item ($2,500 per invoice or item for taxpayers without an
AFS). Deductions must be substantiated by invoice.
Taxpayers contemplating an acquisition, disposition, or other M&A
transaction should consider the opportunities for accounting methods
planning as well as any procedural requirements. Both buy-side and sell-side
companies can benefit from proactively considering a transaction’s effects
on existing accounting methods and related potential risk mitigation or
planning strategies. Below are some examples of the opportunities to
consider.
In general, automatic accounting method changes are
not permitted in a taxpayer’s final year of a trade or business (e.g., when
a taxpayer is acquired in a taxable asset acquisition). During the
transaction process, taxpayers may contemplate certain changes in accounting
methods, such as the correction of an impermissible method or a change in
overall method. It is important to carefully consider the structure of a
transaction to determine if any accounting method changes are permitted or
required.
If a transaction does not result in the cessation of a trade or business,
taxpayers may want to plan for the timing of an accounting method change
(i.e., whether the change is made pre- vs. post-transaction). For example,
certain method changes may be qualified for accelerated taxable income
adjustments in a pre-transaction period. By beginning the planning process
early, taxpayers may be able to include beneficial terms in the agreement,
such as limiting the pre-transaction realization of potential tax benefits
to the sellers or requiring the sellers to correct potential exposure items.
A taxpayer looking to sell part or all of a
company may be able to use accounting methods planning to strengthen its
profile in attracting potential buyers. A comprehensive accounting method
review can uncover opportunities to mitigate potential risk and identify
ways to achieve desired tax attributes well in advance of the formal due
diligence process.
Acquisitive taxpayers should consider the impact
of a transaction’s structure on the tax attributes — including the tax
accounting methods — of acquired companies. In situations where the acquired
company’s accounting methods carry over, accounting method changes can align
the methods being used across the group to streamline the compliance
process. Alternatively, transaction structures resulting in the adoption of
new methods can provide opportunities to select methods that best align with
the taxpayer’s tax objectives. Taxpayers able to adopt new methods may also
benefit from the ability to establish methods that cannot be changed through
the automatic procedures at a later date, such as certain
percentage-of-completion methods under Section 460 or the 3-1/2 month rule
for deducting certain prepaid services.
The Tax Cuts and Jobs Act (TCJA) made significant changes to Internal
Revenue Code Section 174, which deals with the deduction of research and
experimental (R&E) expenses. Prior to the TCJA, businesses could deduct
these expenses in the year they were incurred. However, the TCJA introduced
new rules that require businesses to capitalize and amortize R&E
expenses over a five-year period or 15-year period for foreign costs,
starting from the midpoint of the taxable year in which the expenses were
incurred. This change applies to R&E expenses incurred in tax years
beginning after December 31, 2021. The changes to Section 174 also included
language defining any software developed internally or by third parties as
Section 174 expenses. Prior to the change, taxpayers rarely treated its
R&E expenses as Section 174 expenses and elected to deduct these costs
under Section 162.
In September 2023, the IRS released Notice 2023-63, which contains
substantive pre-regulatory guidance on the new Section 174 capitalization
requirements and announced that the Treasury and the IRS intend to issue
proposed regulations consistent with the Notice. The guidance provides
taxpayers with an advance look into upcoming proposed regulations, which the
IRS anticipates will apply for taxable years ending after September 8, 2023.
The Notice provides valuable guidance to taxpayers in several key areas.
Specifically, it provides clarity on which indirect costs should be treated
as Section 174 expenses, such as overhead, depreciation, and personnel costs
and which expenses should not be treated as 174 expenses, such as G&A
expenses. Additionally, the Notice provides guidance and examples on
software development costs that should and should not be treated as 174
expenses, which was a key area of confusion among taxpayers. R&E
performed under contract is another key area covered by the Notice The
Notice informs taxpayers that they must have no financial risk and no rights
to the research in order to treat the expenses performed under contract 162
costs instead of 174 expenses.
The Notice also provides guidance to taxpayers in the following areas:
Taxpayers that intend to rely on this guidance for the 2023 taxable year
should begin to consider how it may differ from positions taken for the 2022
taxable year or in calculating their 2023 estimated tax payments. In doing
so, taxpayers should take special note of certain key
areas of
uncertainty.
For taxpayers with divergent prior positions, the IRS intends to issue new
procedural guidance to assist taxpayers in making accounting method changes
that are needed to conform to the new guidance.
In the absence of specific guidance, the conservative approach has been to
factor the SRE expenditures into the calculation of both NUBIG/NUBIL and
RBIG/RBIL. To the extent the calculated limit under this approach does not
have a detrimental impact on the tax provision or tax filing positions, a
company may have the opportunity to wait to see if further guidance on this
issue is released. However, for other companies, the Notice’s guidance may
support beneficial positions with respect to calculating NUBIG/NUBIL and
RBIG/RBIL as neither the 338 or 1374 methods provide for a deemed
liquidation or cessation of the loss corporation. As needed, companies
should weigh the strength of these potential positions.
To date there is no guidance on the interaction of SRE expenditures
capitalized under Section 174 and the ULR. However, unamortized SRE
expenditures (to which Section 174(d) has not been applied) appear
distinguishable from deferred deductions or any other category of asset that
could be electively reattributed under the ULR. As such, to the extent a
group is selling a subsidiary with valuable unamortized SRE expenditures,
the group should consider whether to value the SRE amortization as part of
the deal consideration or seek a sale structure other than a stock sale.
Under the cost sharing regulations of Reg. §1.482-7, two or more
participants in a qualified CSA agree to bear intangible development costs
(IDCs) in proportion to each party’s expected benefit from exploiting the
developed intangible property. If during the course of a year, the actual
IDC expenditures of each CSA participant are not in proportion to the
expected benefit, cost sharing payments are made among CSA participants to
achieve the proper expense/benefit allocations. Payments received by a CSA
participant payee (from another CSA participant payor) are treated as
contra-costs or contra-expenses, and thus serve to reduce the payee’s IDCs.
Notice 2023-63 clarifies that payments made to a CSA participant payee that
incurs both immediately deductible IDCs and those that are required to be
charged to a capital account should be allocated among these cost categories
proportionately. If a CSA payment exceeds the total amount of IDCs in these
two categories, the excess is to be treated as income by the payee.
Furthermore, to comply with the different amortization periods, taxpayers
will have to segregate all IDCs that must be capitalized into U.S.-incurred
expenses and non-U.S.-incurred expenses.
Although this guidance regarding Section 174 and cost sharing is welcome,
open questions remain. For example, the guidance does not address the
treatment of outsourced research and development (R&D) activities within
a CSA, and it does not address intercompany R&D CSAs outside of
qualified CSAs under Reg. §1.482-7.
It is important for taxpayers who have filed or have previously filed
research and development (R&D) tax credits, have software development
expenses, or are in a trade or business that incurs research expenses, to
perform a Section 174 analysis. For others that may not have tracked or
identified these costs or have not historically claimed the R&D tax
credit, it is still necessary to identify Section 174 costs specifically, as
they are now subject to capitalization. Taxpayers are encouraged to
establish a methodology for calculating and documenting a consistent
approach to comply with these new rules. Further, with limited guidance from
the Treasury and IRS, taxpayers should consider other potential tax impacts.
Although Congress is considering legislation that would delay the ongoing
phase-out of bonus depreciation (which reduces from 80% in 2023 to 60% in
2024), considerable uncertainty remains as to the prospects for its passage.
As such, year-end tax planning for fixed assets emphasizes cash tax savings
through scrubbing fixed asset accounts for costs that can be deducted
currently under Section 162 rather than being capitalized and recovered
through depreciation, and reducing the depreciation recovery periods of
capital costs where possible.
Scrubbing fixed asset registers can also identify “ghost assets” that the
company has physically disposed of in prior years but for various reasons
have not been removed from the company’s accounting records. Identifying and
deducting the remaining tax basis through an automatic change in accounting
method can yield cash tax benefits as well.
Materials and Supplies. Scrubbing a company’s accounts for items that may be
treated as materials and supplies can also yield cash tax benefits.
Materials and supplies include spare parts, consumables (fuel, lubes, water,
etc.) that will be used within the next 12 months; items costing no more
than $200 each; and items that have an economic useful life of no more than
12 months. This definition can apply to a surprising array of items,
permitting nearly immediate cost recovery in many cases. Reviewing and
adjusting the process by which the company identifies items as materials and
supplies and are key to maximizing this opportunity. This potential cash tax
benefit is achieved through an automatic change in accounting method.
Additional potential benefits from reviewing the company’s application of
the TPR can be found in a Tax Notes article authored by BDO’s James
Atkinson. See J. Atkinson, “Preparing for a Post-Bonus Depreciation
World,” 179 Tax Notes 209 (April 10, 2023).
Under Section 263A, taxpayers must capitalize direct and indirect costs
allocable to real or tangible personal property produced or acquired for
resale. The types and amounts of costs required to be capitalized under
Section 263A typically go beyond those required to be capitalized for
financial accounting purposes. Accordingly, many taxpayers must
undertake a computation each year to capitalize “additional section 263A”
costs to property acquired or produced. For taxpayers seeking to streamline
this often time-consuming process, the historic absorption ratio (HAR)
election may be worth considering.
While the Section 263A regulations list numerous methods and sub-methods
taxpayers can use to identify and allocate additional Section 263A costs to
ending inventory, many taxpayers select one of the three simplified methods
(simplified production method, simplified resale method, and modified
simplified production method) outlined in the regulations to streamline
compliance efforts and reduce potential controversy with the IRS. Although
these methods are generally less administratively burdensome in comparison
to other alternatives, taxpayers must still dedicate significant efforts in
maintaining the annual calculations. Taxpayers currently using one of the
simplified methods may be able to further streamline their compliance
process by electing to use the HAR method.
A taxpayer qualifies to make the HAR election once it has consistently used
one of the three simplified methods for at least three consecutive tax
years. In the year the election is made, the taxpayer calculates the HAR by
averaging the absorption ratios from the prior three tax years. The HAR is
then applied to ending inventory for the next five tax years, beginning with
the election year. On the sixth year, the taxpayer must recompute the
absorption ratio(s) using actual data for the year under the applicable
simplified method:
Thus, while the HAR election still requires taxpayers to prepare Section
263A calculations for testing period years, the ability to bypass this
exercise for at least five years in a row can save taxpayers a considerable
amount of time in their compliance efforts.
A taxpayer makes the HAR election by attaching an election statement to the
tax return; no method change (Form 3115) or Section 481(a) catch-up
adjustment is required. However, terminating the HAR election requires a
non-automatic accounting method change, which the IRS generally will grant
only in unusual circumstances. Therefore, given the inflexibility of the
approach once the HAR election is made, taxpayers should carefully weigh the
benefits of the administrative relief associated with making the HAR
election against the trade-off of using a locked-in ratio in a year where
the actual absorption ratio may be lower. With this in mind, taxpayers
should consider making the election for a specific tax year when the
absorption ratios used for the testing period are lower than usual, as this
strategy might allow them to benefit both from minimizing compliance costs
and capitalizing less amounts to ending inventory.
The treatment of lease arrangements is a complex area due to many factors,
including the diversity of lease structures, changing U.S. GAAP practices,
and nuanced tax rules. In recent years, many companies have adopted ASC 842,
the new GAAP standard governing lease accounting. The tax classification of
an arrangement as a lease is independent of GAAP reporting, so the adoption
of ASC 842 does not necessitate a tax accounting method change. However,
given the changes in financial accounting practices, taxpayers adopting ASC
842 should perform a comprehensive tax review of their leases to ensure
proper tax methods are maintained and to identify any tax accounting method
changes that are needed.
A lease analysis for tax purposes generally focuses on the following three
key areas:
The classification of an arrangement as a “true” tax lease
is a highly facts-based analysis that should be performed on each lease a
taxpayer enters. While an arrangement may be presented as a lease for legal
and/or financial reporting purposes, the tax classification depends more on
the substance of the arrangement than the form. Tax treatment as a lease
versus the financing of a purchase, provision of services, or other
arrangement is based broadly on the (1) benefits and burdens of ownership
and (2) economic substance of the transaction.
Taxpayers with leases may fall into special
methods of accounting under Section 467. In general, a taxpayer is subject
to Section 467 if the lease meets all of the following criteria:
In most cases, taxpayers subject to Section 467 should recognize rental
income (lessor) or rent expense (lessee) in line with the payment schedule.
However, Section 467 may require the use of a different method, such as the
proportional rental accrual method. Taxpayers with leases that are not
subject to Section 467 should look to their overall method of accounting to
determine the timing of income and deductions.
By undertaking a tax analysis prior to entering into a new lease, taxpayers
may be able to negotiate more favorable lease terms that help align the
timing of income/deductions with their overall tax objectives.
As mentioned above, adoption of ASC 842 for
GAAP reporting purposes will likely change the way taxpayers compute
existing book-to-tax adjustments. To ensure existing tax accounting methods
are properly maintained, and to prevent errors or unauthorized method
changes, taxpayers should ensure they understand any new lease-related
balance sheet accounts and the appropriate tax treatment for such accounts.
Controlled foreign corporations (CFCs) are generally subject to the same
requirements as U.S. taxpayers to use proper methods of accounting for tax
purposes (for example, to calculate earnings and profits and to calculate
tested income for GILTI). A CFC that has adopted an improper method of
accounting or otherwise wishes to change an accounting method is required to
file Form 3115.
A potential benefit of filing Form 3115 to correct an improper method is the
ability to receive audit protection. If audit protection is granted, the IRS
is precluded from challenging a taxpayer’s improper treatment for open tax
years prior to the year of change. For CFCs or 10/50 corporations (foreign
corporations with U.S. shareholders owning at least 10% but no more than
50%), however, audit protection may be denied for a tax year before the year
the method change was requested under a “150% rule.” The 150% rule is met if
one or more of the CFC’s or the 10/50 corporation’s U.S. corporate
shareholders report deemed paid foreign taxes for that year that exceed 150%
of the average deemed paid foreign taxes reported during the three prior tax
years.
For the many CFCs that were subject to the transition tax imposed under
Section 965, the 150% rule denying audit protection may have disincentivized
them from filing method changes to correct improper accounting methods.
Affected taxpayers may now find themselves clear of the rule for the 2023 or
2024 tax year and should consider filing method changes to clean up their
impermissible methods prospectively. Some of the more common, automatic
method changes that CFCs may encounter include the following:
2023 Year-End Guide – Income Tax
What Lessons Can Corporate Tax Departments Take Into 2024?
In 2022, corporate tax departments that were already facing a persistent
lack of resources had to adapt tax provision work and control frameworks to
account for policy-related changes enacted over the last few years. With
2023 drawing to a close, now is a good time to revisit planning
considerations – no matter when your tax year ends.
That is especially true, given the various important changes that are
affecting, will affect, and will continue to affect tax functions. For
instance, many Inflation Reduction Act rules took effect this year, and
other changes, including some under OECD Pillar Two, are set to begin in
2024. Those policies, coupled with staffing and resource challenges, will
make it even more important for tax departments to maintain and follow
internal controls in the 2023 tax provision season.
Tax practices should therefore be prepared to continue handling complex
issues in the year ahead. Addressing topics such as internal controls and
tax technology can prepare you for the myriad changes 2024 could bring.
Managing Internal Controls
A tax office is only as strong as its accountability structure, and a strong
control environment allows the tax function to operate more thoroughly,
accurately, and efficiently. As companies adapt to policy changes and face
new requirements and tighter deadlines, building and maintaining reliable
control frameworks can help address issues like base erosion and profit
shifting. While strong
control
frameworks are required
for public companies
under the Sarbanes-Oxley Act, private companies can benefit from
implementing similar internal controls. Taking a more rigorous approach to
internal controls can enhance organizational accountability, reduce fraud
risk, and improve reporting. Private companies can also enlist third-party
service providers for support in establishing a control framework.
A business is ultimately responsible for managing whatever tax framework it
chooses to build. Even if an internal tax department outsources provision
and tax return preparation work to a third-party service provider, it should
ask its vendors the right questions and flag items that could result in
control issues, such as significant transactions like mergers and
acquisitions. Involving the tax department in transactional decision-making
will help leadership stay informed and avoid potential tax liabilities and
penalties. Further, quarterly controller meetings between internal tax
departments and external service providers to discuss recent and ongoing
transactions, lessons learned from past activities, and relevant tax issues,
as well as each party’s responsibility in addressing them, can help
companies develop and maintain effective control frameworks.
Maintaining Successful Tax Processes
As companies grow, management inevitably becomes more decentralized as local
teams are established to handle region-specific operations. Those smaller
teams might not have the tax expertise to manage local obligations, such as
timely filing returns and statutory audits and remaining compliant with
transfer pricing. That leads to financial statement risk and cash tax
exposure, complicating calculations of tax provision and taxes owed.
Decentralized teams also create concerns for the corporate tax department,
which must ensure that local offices are meeting their tax obligations.
Companies can combat those challenges by adding more oversight to local
finance teams. Although it would be ideal to employ regional tax
professionals to oversee and report into the overall tax function, ongoing
shortages of experienced employees makes staffing those positions difficult.
For departments unable to hire in-house regional tax professionals,
outsourcing specific tax functions like global tax compliance and requirements to third-party tax service teams allows the internal workforce
to focus on regional oversight.
Addressing Challenges Faced by Technical Functions
As technical tax functions have become more complex, strong control
frameworks have become more important for tax departments. Because of
continual changes in national and international tax policy and shifting
financial responsibilities resulting from economic uncertainty, tax
departments faced their fair share of obstacles in 2023.
Changing Tax Legislation
Between the implications of federal legislation like the Tax Cuts and Jobs
Act (TCJA) and changes to corporate income taxation in numerous states, tax
functions have had to adapt to many new tax laws. The TCJA eliminated the
graduated corporate rate schedule and reduced the top U.S. corporate rate to
21% from 35%, and changes in state law have resulted in corporate rate
reductions. While some of those legislative changes ultimately reduce tax
liabilities, they impose on tax departments the added responsibility of
monitoring and maintaining compliance as evolving laws continue to affect
companies’ total tax liability and tax provision computations.
Looking ahead to 2023 and 2024 tax reporting, businesses must navigate how
new minimum taxes introduced in the Inflation Reduction Act and the OECD’s
Pillar Two framework might affect their tax positions. The U.S. corporate
alternative minimum tax applies to companies with U.S. presence that have
book income greater than $1 billion for three consecutive years. Once
subject to that tax, a company must make adjustments based on current-year
income to calculate if there is an additional tax. The global minimum tax
introduced in Pillar Two also has a revenue threshold, but it applies only
if individual countries have enacted laws to conform to the Pillar Two
framework.
Companies that are close to those thresholds should have plans in place for
what could happen if they grow beyond them and become subject to the tax
requirements.
Multinational corporations in scope for the Pillar Two global minimum tax
will need to pay at least 15% in taxes on profits made in all countries.
Although the tax is designed to avoid double taxation by applying a top-up
tax to bring the total amount of income tax paid to the minimum of 15%,
multinational corporations could be subject to double taxation if
jurisdictions do not implement the rules consistently.
All those legislative and regulatory changes add complexity to the
computation of the tax provision and taxes owed, straining corporate tax
functions that lack adequate resources and knowledge. Consulting with an
experienced tax service provider can help tax departments avoid costly
risks, penalties, and restatements stemming from material weaknesses and
financial statement errors.
Understanding Complexities Presented by Valuation Allowances
Tax consultants can be especially helpful to tax teams in analyzing
valuation allowance considerations. Because of economic volatility, many
companies had to revisit their profit and loss operating forecasts in 2023.
As a result, some changed their positions on whether the deferred tax assets
(DTAs) on their balance sheets can be recoverable in the future, making tax
provision and liability estimations more complex. Also, the TCJA allowed for
the indefinite carryover of net operating losses and interest limitations,
like those under Internal Revenue Code Section 163(j), that were generated
post-TCJA. That makes the proper documentation and prediction of DTA
realization more important because there is theoretically no expiration date
for some. In practice, ASC 740 requires companies to apply a valuation
allowance to any DTA that will likely not be realized in the near future to
reflect a more accurate valuation of the business.
The TCJA amended IRC Section 174 to require the capitalization of some
research and experimental expenditures, which can further complicate when
and if a valuation allowance is required. Determining how to apply a
valuation allowance is a complex process that requires careful judgment. For
small tax departments without robust technological resources, determining
when a valuation allowance is appropriate and how to apply it correctly can
be difficult.
Taking Advantage of Tax Technology
Today’s tax departments are charged with doing more with less and might
still be relying on spreadsheet models, which can be prone to errors and
difficult to maintain, for income tax accounting.
Many companies have turned to tax provision and automation software to
overcome those challenges. Tax software can help teams be more accurate and
complete in their traditional tax functions, enabling employees to dedicate
more time to strategic tax processes. It is also important to thoroughly
train tax professionals to ensure technology is used to its full capacity.
Tax departments often encounter budget obstacles in building the business
case to add technology. Although some business leaders are concerned about
the resources needed to integrate tax technology, the benefits of tax
software can reduce costs in the long term by boosting efficiencies.
Over the last year, tax departments learned a lot as they dealt with
increasing complexity. Recent policy changes have added to that, and we
expect more of the same in the year ahead. But 2022 taught tax professionals
that with proper control frameworks, improved processes, and tax technology,
teams can manage challenges and mitigate risk with improved accuracy and
efficiency. As obstacles persist in the near term, we expect tax functions
equipped with the right resources and support to thrive.
Expanded Use of the Proportional Amortization Method for Tax Equity
Investments Simplifies Accounting for Investors
More equity investors involved with projects to receive income tax credits
and other income tax benefits might be able to use the proportional
amortization method (PAM) to account for their investments.
On March 29, 2023, the Financial Accounting Standards Board issued
Accounting Standards Update (ASU) 2023-02, “Investments – Equity Methods and
Joint Ventures,” to expand the use of the PAM for some tax credit equity
investments. As the required adoption date for public business entities
nears, investors should revisit their tax equity investments to determine
whether they will elect the PAM.
Qualifying equity investments are investments with yields generated
primarily through income tax credits and other income tax benefits and that
meet other criteria. Previously, the PAM was available only to account for
low-income housing tax credit (LIHTC) investments as an alternative to
either the cost or equity method.
Before, noncontrolling equity investments in other tax credit programs, such
as the new markets tax credit (NMTC) and renewable energy tax credit (RETC)
programs, were generally accounted for under the equity method of
accounting. Under that method, the accounting for the investment and the
credits was presented on a gross basis in the income statement, which many
stakeholders believed did not accurately reflect the true economics.
After considering stakeholder input, the FASB expanded the use of the PAM to
a greater population of tax credit equity investments. That should provide
more consistent accounting and a greater understanding of those arrangements
by financial statement users. Accordingly, tax equity investments in NMTC
structures, RETC structures, or other tax credit programs can now be
accounted for using the PAM if all criteria are met and the tax equity
investor elects to use that method.
The update also affects tax equity investments in LIHTC structures through
limited liability entities that are not accounted for using the PAM method –
that is, entities accounted for using the cost or equity method.
New disclosure requirements apply to investments that generate income tax
credits and other income tax benefits from a tax credit program for which
the entity has elected to apply the PAM (including investments within that
elected program that do not meet the conditions to apply the PAM).
PAM Overview
The PAM recognizes the amortization of the equity investment, income tax
credits, and other income tax benefits (such as depreciation) on the income
tax line of the income statement. The amortization of the equity investment
is recognized each period in proportion to the tax equity investor’s share
of the income tax benefits for that period over the investor’s share of the
total anticipated income tax benefits for the life of the investment.
For a tax equity investor to elect the PAM for an equity investment, it must
meet five requirements:
-
It is probable that the income tax credits allocable to the tax equity
investor will be available.
-
The tax equity investor is unable to exercise significant influence
over the operating and financial policies of the underlying project.
-
Substantially all the projected benefits are from income tax credits
and other income tax benefits. Projected benefits include income tax
credits, other income tax benefits, and other non-income-tax-related
benefits. The projected benefits are determined on a discounted basis
using a discount rate that is consistent with the cash-flow assumptions
used by the tax equity investor in making its decision to invest in the
project.
-
The tax equity investor’s projected yield based solely on the cash
flows from the income tax credits and other income tax benefits is
positive.
-
The tax equity investor is a limited liability investor in the limited
liability entity for both legal and tax purposes and its liability is
limited to its capital investment.
Explanation of Provisions
The PAM applies only to arrangements in which a tax equity investor has an
equity investment that is within the scope of ASC 323, “Equity Method
Investments.” To determine whether an investor has an equity investment in a
qualifying entity, it may first need to evaluate intermediary entities for
consolidation under ASC 810, “Consolidation.” Whether an investor would
consolidate those entities will vary depending on facts and circumstances.
A tax equity investor makes an accounting policy election to apply the PAM
based on each tax credit program, rather than by electing to apply the PAM
method at the tax equity investor level or to individual investments.
Further, a tax equity investor that applies the PAM to qualifying tax equity
investments must account for the receipt of the investment tax credits using
the flow-through method under ASC 740, “Income Taxes,” even if the investor
applies the deferral method for other investment tax credits received.
A tax equity investor should evaluate its eligibility to use the PAM at the
time of the initial investment based on facts and conditions that exist at
that time. It should reevaluate if there is a change in either the nature of
the investment (for example, the investment is no longer a flow-through
entity for tax purposes) or the relationship with the limited liability
entity that could result in the tax equity investor no longer meeting the
conditions to apply the PAM.
Non-income-tax credits (for example, refundable credits) are accounted for
in pretax income under U.S. GAAP. Tax credits generated pursuant to the
Chips and Science Act of 2022 and some credits enacted in the Inflation
Reduction Act of 2022 meet the definition of refundable credits. In applying
the “substantially all” test in the third criterion listed above, those
credits are considered only as part of the denominator in the fraction,
which could make it more difficult -- but not impossible -- to meet that
criterion.
Other Changes
ASC 323-740, “Investments-Equity Method and Joint Ventures-Income Taxes,”
included specialized guidance for LIHTC investments not accounted for using
the PAM. ASU 2023-02 changed some of those rules, including removing the
ability to account for LIHTC investments under a specialized cost method.
Therefore, if the tax equity investment is not in the scope of the equity
method, it will be accounted for under ASC 321, “Investments-Equity
Securities.” The update also removed the specific equity method impairment
guidance for LIHTC. Now, if a tax equity investment is accounted for under
the equity method, impairment will be measured using the
other-than-temporary model in the general sections of ASC 323. The update
also requires all tax equity investments accounted for using the PAM to use
the delayed equity contribution guidance in ASC 323-740-25-3, which requires
a liability to be recognized for delayed equity contributions that are
unconditional and legally binding or for equity contributions that are
contingent on a future event when it becomes probable.
Disclosure Requirements
ASU 2023-02 prescribes disclosure requirements for all investments that
generate income tax credits and other income tax benefits from a tax credit
program for which the tax equity investor has elected to apply the PAM.
Those disclosures are required for interim and annual periods and should
include the nature of the investments, as well as the effect of the
recognition and measurement of its investments and the related income tax
credits and other income tax benefits on its financial position and results
of operations.
The required disclosures are:
the amount of income tax credits and other income tax benefits recognized
during the period, including the line item in the income statement and
cash flow statement in which it has been recognized; and
-
the amount of investments and the line item in which the investments
are recognized in the balance sheet.
For investments accounted for using the PAM, the required disclosures are:
the amount of investment amortization recognized as a component of income
tax expense (benefit);
-
the amount of non-income-tax-related activity and other returns
received that is recognized outside of income tax expense (benefit) and
the line item in the income statement and cash flow statement in which
it has been recognized; and
-
the significant modifications or events that resulted in a change in
the nature of the investment or a change in the relationship with the
underlying project.
Effective Date and Transition
Public business entities must adopt ASU 2023-02 in fiscal years beginning
after December 15, 2023, including interim periods within those fiscal
years. All other entities must adopt for fiscal years beginning after
December 15, 2024, including interim periods within those fiscal years.
Early adoption is allowed for all entities in any interim period. If an
entity adopts the provisions in an interim period, it must adopt them as of
the beginning of the fiscal year that includes that interim period.
Entities may choose between the retrospective or modified retrospective
transition options (see special rules below for LIHTC investments not
accounted for using the PAM).
Retrospective Method
The tax equity investor evaluates all investments in which it expects to
receive income tax credits or other income tax benefits as of the beginning
of the earliest period presented. Determining whether the investment
qualifies for the PAM is made as of the investment date. A cumulative-effect
adjustment reflecting the difference between the previous and new accounting
is recognized in the opening balance of retained earnings as of the
beginning of the earliest period presented.
Specific transition rules apply to LIHTC investments that are affected by
the changes with respect to:
the cost method guidance in ASC 323-740;
-
the impairment guidance for equity method investments in ASC 323-740;
and
- the delayed equity contribution guidance in ASC 323-740.
To recognize the effect of those changes, the tax equity investor must
either use its general transition method (for example, retrospective,
modified retrospective) or apply a prospective approach. That election may
be made separately for each of the three transition adjustment types
described above. However, a tax equity investor applies a consistent
transition method for each transition adjustment type.
Modified Retrospective Method
The tax equity investor evaluates all investments in which it expects to
receive income tax credits or other income tax benefits as of the beginning
of the year of adoption. Determining whether the investment qualifies for
the PAM is made as of the investment date. A cumulative-effect adjustment
reflecting the difference between the previous and new accounting is
recognized in the opening balance of retained earnings as of the beginning
of the adoption period.
Planning Tips
As the required adoption date for public business entities nears, investors
should review their tax equity investments to determine whether to elect the
PAM, as well as whether to early adopt.
2023 Year End Guide – Business Incentives & Tax Credits
Employee Retention Credit
The employee retention credit (ERC) is a refundable payroll tax credit for
wages and health plan expenses paid or incurred by an employer (1) whose
operations were either fully or partially suspended due to a
COVID-19-related governmental order; or (2) that experienced a significant
decline in gross receipts during the COVID-19 pandemic. The ERC has arguably
been one of the most valuable provisions originating under the Coronavirus
Aid, Relief, and Economic Security Act — the CARES Act — offering
significant payroll tax relief for employers who kept employees on their
payroll and continued providing health benefits during the COVID-19
pandemic.
Eligible employers can file a claim retroactively until the statute of
limitations closes on April 15, 2024, for the 2020 ERC and April 15, 2025,
for the 2021 ERC. Note that the U.S. government has repeatedly revised the
requirements for U.S. taxpayers to claim the ERC since its initial
codification into law. As a result, many eligible taxpayers have been
uncertain as to whether they may properly claim this often-valuable tax
credit.
Employers should be certain that one of the two paths for eligibility
is satisfied:
Gross receipts in a calendar quarter were less than 80% of the gross
receipts for the corresponding quarter in 2019; or
-
Business operations were fully or partially suspended during the
calendar quarter because of orders from a governmental authority due to
COVID-19.
Most eligibility disputes involve the partial suspension test. While most
businesses were adversely impacted by COVID-19 related to government
actions, not all are eligible for ERC under this provision. To be eligible
under the partial suspension test, the suspension must have been material.
Identifying the relevant government orders is another common issue.
Qualifying orders must have been mandatory, in effect, and must have caused
a suspension of operations for the entire period during which the employer
paid the wages supporting the ERC claim.
Also, because the ERC was intended to benefit small businesses, requirements
exist that all businesses under common owners be aggregated into a single
employer. This rule prevents large businesses from splitting into many
entities to qualify. The same aggregation rule used to determine the size of
an employer is applied to determine whether the employer experienced a
partial suspension that was more than nominal.
In response to mounting concerns over a surge in improper claims for the
ERC, on September 14, 2023, the IRS announced an immediate moratorium on
processing new claims for the pandemic-era relief program. The moratorium,
effective until at least the end of the year, aims to protect businesses
from scams and predatory tactics. While the IRS continues to process
previously filed ERC claims received before the moratorium, the agency warns
that increased fraud concerns will result in longer processing times.
However, the pause on processing new claims does not modify the statute of
limitations that expires on April 15, 2024, for wages paid in 2020.
Therefore, an employer considering a new request for a legitimate ERC claim
should proceed after carefully reviewing Information Releases 2023-169 and
2023 -170, which the IRS released on September 14, 2023. For employers who
would like to make a change to a pending claim that has not been processed
or paid, the IRS is expected to issue guidance in the near future.
The IRS has also intensified its focus on reviewing ERC claims for
compliance concerns, including conducting audits and criminal investigations
on promoters and businesses submitting dubious claims. Hundreds of criminal
cases are currently under investigation, and thousands of ERC claims have
been referred for audit. Those with pending claims should expect extended
processing times, while those yet to file should review the guidelines and
consult trusted tax professionals.
As the IRS continues to refine its efforts to assist businesses facing
questionable ERC claims, it advises businesses to carefully consider their
situation and explore the options available to them. The IRS reminds anyone
who improperly claims the ERC that they must pay it back, possibly with
penalties and interest.
The IRS has stated that it will develop an ERC settlement program in late
2023 for employers that already received an ERC payment based on a claim now
believed by the employer to be overstated. Under the settlement program,
employers will be able repay the excess ERC amounts while avoiding penalties
and other future compliance actions.
Additionally, to assist businesses affected by aggressive promoters, the IRS
is developing a special withdrawal option for businesses that have filed an
ERC claim but have not yet had it processed. Details of this program are
expected to be announced in the coming months.
Given the increased IRS scrutiny of ERC claims, employers should reevaluate
their ERC positions regarding eligibility and the amount of the claim. The
IRS recommends that taxpayers seek advice from a trusted tax advisor.
Employers that have already filed a claim not prepared by a trusted tax
advisor should verify whether any of the red flags or other concerns listed
in the two IRS Information Releases apply to their situation. If they do,
they should have any already submitted claim reviewed by a trusted tax
professional. If the review does not support the claim as it was filed,
corrective action should be pursued.
Credit for Increasing Research Activities: Proposed Changes to Form 6765 and
Exam Environment
The IRS on September 15, 2023, released a preview of proposed changes to
Form 6765, Credit for Increasing Research Activities, which taxpayers use to
claim the research credit. The proposed changes, likely to become effective
at the beginning of the 2024 tax year, include a new Section E with five
questions seeking miscellaneous information and a new Section F for
reporting quantitative and qualitative information for each business
component, required under Section 41 of the Internal Revenue Code.
The IRS has also requested feedback on whether Section F should be optional
for some taxpayers, including those with qualified research expenditures
that are less than a specific dollar amount at a controlled group level;
with a research credit that is less than a specific dollar amount at a
controlled group level; or that are Qualified Small Businesses for payroll
tax credit purposes.
It is important to note that if Section F were made optional for certain
taxpayers, it would not exempt them from the requirement to maintain books
and records or provide Section F information in a similar format, if
requested; and it would not apply to amended returns for the research
credit.
Examination Environment
Currently, the IRS receives a significant number of returns claiming the
research credit, which requires substantial examination resources from both
taxpayers and the IRS. To ensure effective tax administration for this
issue, the IRS aims to clarify the requirements for claiming the research
credit by considering all feedback received from stakeholders before
finalizing any changes to Form 6765.
In response to ongoing concerns of improper claims of the research credit,
the IRS has intensified its focus on reviewing these claims for
nonconformities, including conducting a greater number of audits. Navigating
the complexities of the research credit can be challenging, especially with
the increased scrutiny, advancement of recent case law, and the newly
implemented IRS compliance measures in place.
It is important for taxpayers to accurately determine eligibility, validate
and properly record contemporaneous documentation to support research credit
claims, and defend against examinations. Taxpayers should work with a
trusted tax advisor to support compliance with IRS regulations and proper
eligibility for the research credit.
Tax Credit Monetization
The signing of the Inflation Reduction Act on August 16, 2022, marked the
largest-ever U.S. investment to combat climate change, allocating $369
billion to energy security and clean energy programs over the next 10 years,
including provisions incentivizing the manufacturing of clean energy
equipment and the development of renewable energy generation.
Overall, the act modifies many of the current energy-related tax credits and
introduces significant new credits and structures intended to facilitate
long-term investment in the renewables industry. Capital investments in
renewable energy or energy storage, manufacturing of solar, wind, and
battery components, and the production and sale or use of renewable energy
are activities that could trigger one of the over 20 new or expanded IRA tax
credits. The IRA also introduced new ways to monetize tax credits and
additional bonus credit amounts for projects meeting prevailing wage and
apprenticeship, energy community, and domestic content requirements.
45X – Advanced Manufacturing Production Tax Credit
The 45X Advanced Manufacturing Production Credit is a new production tax
credit meant to encourage the production and sale of energy components
within the U.S., specifically related to solar, wind, batteries, and
critical mineral components. To be eligible for the credit, components must
be produced in the U.S. or a U.S. possession and sold by the manufacturer to
unrelated parties.
The Department of Energy has released a full list of eligible components as
defined by the IRA, with specific credit amounts that vary according to the
component. Manufacturers can also monetize 45X credits through a direct
payment from the IRS for the first five years under Internal Revenue Code
Section 6417. They may also transfer a portion or all of the credit to
another taxpayer through the direct transfer system Section 6418 election.
The 45X credit is a statutory credit with no limit on the amount of funding
available; however, the credit will begin to phase out in 2030 and will be
completely phased out after 2033. Manufacturers cannot claim 45X credits for
any facility that has claimed a 48C credit.
48C – Qualifying Advanced Energy Project Tax Credit
In 2009, Congress enacted the America Recovery and Reinvestment Act, which
included the 48C tax credit for qualifying advanced energy project
investments. This credit initially applied to investment in facilities that
produced various renewable energy assets and other property that reduced
greenhouse gas emissions.
The Inflation Reduction Act provided new funding for the 48C credit and
expanded the definition of qualified advanced energy projects to include
facilities that produce components used in carbon capture, utilization and
storage, energy grid modernization, renewable fuel generation and
refinement, components of electric vehicles, and recycling facilities for
eligible components. Manufacturers investing to construct, re-equip, or
expand a facility that meets the definition of a qualified advanced energy
project can apply for an allocation of the 48C credit.
The IRS and Department of Energy will award $10 billion in 48C credits via a
two- step application process, with $4 billion reserved for projects located
in energy communities. The base amount of the 48C credit is 6%, but the
total credit can be as high as 30% if applicants meet prevailing wage and
apprenticeship requirements. Recipients can claim 48C credits on federal
corporate income taxes for a percentage of eligible investment costs placed
into service during the current tax year. Corporations or flow-through
entity shareholders who lack the ability to utilize the credits may sell
them for cash under the new IRA credit transfer provisions.
Taxpayers applying for 48C allocation must submit an initial concept paper
as well as a full application to be reviewed by the IRS and DOE. The first
round of 48C allocation will award $4 billion by March 31, 2024. While the
current round’s concept paper deadline has already passed, there will be
additional rounds for the remaining $6 billion of funding in 2024 and
beyond.
6418 – Transferability
Under IRC Section 6418, certain renewable energy tax credits can now be
transferred by companies generating eligible credits to any qualified buyer
seeking to purchase tax credits. Through credit transfers, taxpayers have
the option to sell all or a portion of their credits in exchange for cash as
part of their overall renewable energy goals if they are not able to fully
utilize the benefit. Companies are able to purchase these credits at a
discount, with the sale proceeds improving the economics of clean energy
development.
The market rate for the sale of credits will be highly dependent on the type
of credit being transferred, as well as the substantiation and documentation
related to the seller’s eligibility for the credit taken and any bonus
credit amounts claimed. The current rates seen in the market for
transferring credits is around $.90 to $.94 per $1 of credit, but these
amounts are subject to change based on specific fact patterns for each
individual transaction and the overall market trend.
Taxpayers considering buying or selling tax credits that are transferable
under the IRA should be looking ahead and forecasting their potential tax
liability and resulting appetite for buying and selling credits. These
credits can be transferred and utilized against estimated quarterly payments
as soon as transfer agreements are finalized. This expedited reduction in
cash outlay for the buyer and monetization of credits for the seller is a
consideration that should be taken into account by taxpayers interested in
entering the market of transferring credits. Note that taxpayers must be
able to effectively utilize general business credits for this opportunity to
be worthwhile.
Bonus Credits
The Inflation Reduction Act not only introduced new and expanded credits for
investment in and production of renewable energy and its related components,
it also included provisions for bonus credit amounts subject to meeting
specific requirements. The prevailing wage and apprenticeship requirement is
a 5x multiplier for certain credits that can bring the credit rate from 6%
to 30% by paying prevailing wages to all labor related to the construction,
installation, alteration, and repair of eligible property. Additionally,
taxpayers must ensure that a certain percentage of these labor hours are
performed by a qualified apprentice. Other common credit adders available
for taxpayers that meet energy community and domestic content requirements
provide a 10% adder to the base rate of the credit. Taxpayer documentation
will be required to substantiate the claim of these bonus credit amounts and
will need to be presented to a buyer in the event that these credits are
transferred under 6418.
Taxpayers that have current or planned investments or activities for which
they plan to utilize the prevailing wage and apprenticeship multiplier
should be planning a documentation strategy and procedure. In the event of
an IRS audit or transfer of these credits, taxpayers will be required to
substantiate the wages paid to laborers as well as the number of hours
performed by registered apprentices. Depending on the size and amount of
labor involved in qualified investments or production, documentation for PWA
as well as the domestic content requirements will likely be a highly
burdensome task if not planned accordingly at the outset of a project.
New Markets Tax Credits
The U.S. Treasury’s CDFI Fund recently released its annual allocation of New
Markets Tax Credits (NMTCs). The federal New Markets Tax Credit (NMTC)
program was established in 2000 to subsidize capital investments in eligible
low-income census tracts. The subsidy provides upfront cash in the form of
NMTC-subsidized loans fixed at below-market interest (2.5-3.5%). The loan
principal is generally forgiven after a seven-year term resulting in a
permanent cash benefit. Funding for these subsidized loans is highly
competitive and expected to be depleted quickly.
Taxpayers across many industries can be good candidates to participate in
the NMTC program.
Recipients are evaluated based on the community impact derived from the
investments (e.g., job creation, community services provided, etc.). Ideal
projects have at least $7 million in capital expenditure. These initial
questions will help interested parties assess if a project is viable for
NMTC.
Address of proposed project
- High-level project description
-
Status of construction/timeline of CAPEX (midstream projects are
permitted)
-
Estimate of direct jobs to be created by project (within 3 years of
PIS)
Taxpayers with ongoing or planned capital investments for late 2023 or early
2024 that are eligible to receive NMTC financing should begin reaching out
to community development entities. The latest round of allocation was
announced on September 22, and early outreach provides qualified active
low-income community businesses a strong advantage in securing this
financing due to the program’s competitive nature and limited funds.
2023 Year-End Guide – State and Local Tax
With thousands of taxing jurisdictions, from school boards to counties and
states, and many different types of taxes, state and local taxation is
complex. Each tax type comes with its own set of rules — by jurisdiction —
all of which require a different level of attention.
This article provides a high-level overview to help companies with 2023
year-end SALT planning considerations, and it provides guidance on how to
hit the ground running in 2024.
This article provides a high-level overview to help companies with 2023
Liquidity Events
Liquidity events take the form of IPOs; financings; sales of stock, assets,
or businesses; and third-party investments. Those events involve different
forms of transactions, often driven by business or federal tax
considerations; unfortunately, and far too often, the SALT impact is ignored
until the 11th hour or later.
A liquidity event is not an occasion for surprises. When a taxpayer is
contemplating any form of transaction, state and local taxes should not be
overlooked. Knowledgeable SALT professionals can help identify planning
opportunities and point out potential pitfalls, and it is never too early to
involve them. If you wait until after the transaction occurs or until the
state tax returns are being prepared, it may be too late to leverage their
insight.
From state tax due diligence to understanding the total state tax treatment
of a transaction to properly reporting and documenting state tax impacts,
addressing SALT at the outset of a deal is critical. If involved before the
year-end liquidity event, SALT professionals can suggest helpful adjustments
to the transaction that may be federal tax-neutral but could result in
identifying significant state tax savings or costs now, rather than later.
After the liquidity event, because the state tax savings or costs already
have been identified, they can be properly documented and reported
post-transaction. Further, because SALT expertise was involved at the front
end, state tax post-transaction integration, planning, and remediation can
be more seamlessly pursued.
Income/Franchise Taxes
If anything has been learned from the last six years of federal tax
legislation, it’s that state income tax conformity cannot be taken for
granted. While states often conform to myriad federal tax provisions, it's
important to verify S corporations are treated as such by each state they
operate in. Further, S corporations must confirm that their status applies
to state income taxes. Not asking those questions early can lead to a
misunderstanding and potential issues later.
Several states don’t conform to federal entity tax classification
regulations. Some, including New York, require a separate state-only S
corporation election. New Jersey now allows an election out of S corporation
treatment. Making those elections — or not — can lead to different state
income tax answers, so it’s important to understand the available options
before the transaction occurs.
Asking important questions early can help provide clarity in the
decision-making process:
If the liquidity event will result in gain, how is the gain going to be
treated for state income tax purposes?
- Is it apportionable business gain or allocable nonbusiness gain?
- Is a partnership interest, stock, or asset being sold?
- How will the gain be apportioned?
-
Was the seller unitary with the partnership or subsidiary, or did the
assets serve an operational or investment function for the seller?
-
Will the gross receipts or net gain from the sale be included in the
sales factor, and, if so, how will they be apportioned?
Those are just some of the questions that are never asked on the federal
level because they don’t have to be. But they are material on the state
level and, again, are unwelcome surprises.
Sales/Use Taxes
Most U.S. states require a business to collect and remit sales and use taxes
even if it has only economic, and no physical, presence. Remote sellers,
software licensors, and other businesses that provide services or deliver
their products to customers from a remote location must comply with state
and local taxes.
Left unchecked, those state and local tax obligations — and the
corresponding potential liability for tax, interest, and penalties — will
grow. Moreover, neglecting your sales and use tax obligations could result
in a lost opportunity to pass the sales and use tax burden to customers as
intended by state tax laws.
A company could very well experience material sales and use tax obligations
resulting from a sale, even though the transaction or reorganization is tax
free for federal income tax purposes. To avoid any material issues, several
steps should be taken:
Determine nexus and filing obligations;
- Evaluate product and service taxability;
- Quantify potential tax exposure;
- Mitigate and disclose historical tax liabilities;
- Consider implementing a sales tax system; and
- Maintain sales tax compliance.
Real Estate Transfer Taxes
Most states impose real estate transfer taxes (RETTs) or conveyance taxes on
the sale or transfer of real property, or controlling interest transfer
taxes when an interest in an entity holding real property is sold. Few
taxpayers are familiar with RETTs, and the complex rules and compliance
burdens associated with those state taxes could prove costly if they are not
considered up front.
State PTE Tax Elections
Roughly 35 states now allow pass-through entities (PTEs) to elect to be
taxed at the entity level to help their residents avoid the $10,000 limit on
federal itemized deductions for state and local taxes known as the “SALT
cap.” Those PTE tax elections are much more complex than simply checking a
box to make an election on a tax return. Although state PTE tax elections
are meant to benefit the individual members, not all elections are alike,
and they are not always advisable.
Before making an election, a PTE should model the net federal and state tax
benefits and consequences to the PTE — for every state in which the PTE
operates, as well as for each resident and nonresident member — to avoid
potential unintended tax results. A thorough evaluation of whether to make a
state PTE tax election (or elections) should be completed before the end of
the year, modeling the net tax benefits or costs, as should a determination
of timing elections, procedures, and other election requirements (e.g.,
owner consents, owner votes to authorize the election, and partnership or
LLC operating agreement amendments). If those steps are completed ahead of
time, then the table has been set to make the election in the days ahead.
When considering a state PTE tax election, one of the most important issues
to evaluate is whether members who are nonresidents of the state for which
the election is made can claim a tax credit for their share of the taxes
paid by the PTE on their resident state income tax returns. If a state does
not offer a tax credit for elective taxes paid by the PTE, then a PTE tax
election could result in additional state tax burden that exceeds some
members’ federal itemized deduction benefit ($0.37 is less than $1.00).
Therefore, as part of the pre-year-end evaluation and modeling exercise,
PTEs should consider whether the election would result in members being
precluded from claiming other state tax credits — which ordinarily would
reduce their state income tax liability dollar for dollar — in order to
receive federal tax deductions that are less valuable.
Does P.L. 86-272 Still Exist?
P.L. 86-272 is a federal law that prevents a state from imposing a net
income tax on any person’s net income derived within the state from
interstate commerce if the only business activity performed in the state is
the solicitation of orders of tangible personal property that are sent
outside the state for approval or rejection and, if approved, are filled by
shipment or delivery from a point outside the state.
The Multistate Tax Commission (MTC) adopted a
revised
statement
of its
interpretation of P.L. 86-272 which, for practical purposes, largely
nullifies the law’s protections for businesses that engage in activities
over the internet. To date, California and New Jersey have formally adopted
the MTC’s revised interpretation of internet-based activities, while
Minnesota and New York have proposed the interpretation as new rules. Other
states are applying the MTC’s interpretation on audit without any notice of
formal rulemaking.
Online sellers of tangible personal property that have previously claimed
protection from state net income taxes under P.L. 86-272 should review their
positions. Online sellers that use static websites that don't allow them to
communicate or interact with their customers — a rare practice — seem to be
the only type of seller that the MTC, California, New Jersey, and other
states still consider protected by P.L 86-272.
The effect of the MTC’s new interpretation on a taxpayer’s state net income
tax exposure should be evaluated before the end of the year. Structural
changes, ruling requests, or plans to challenge states’ evolving limitation
of P.L. 86-272 protections applicable to online sales can be put into place.
However, nexus or loss of P.L. 86-272 protection can be a double-edged
sword. For example, in California, if a company is subject to tax in another
state using California’s new standard, then it is not required to throw
those sales back into its California numerator for apportionment purposes.
Property Tax
For many businesses, property tax is the largest state and local tax
obligation and a significant recurring operating expense that accounts for a
substantial portion of local government tax revenue. Unlike other taxes,
property tax assessments are ad valorem, meaning they are based on the
estimated value of the property. Thus, they could be confusing for taxpayers
and subject to differing opinions by appraisers, making them vulnerable to
appeal. Assessed property values also tend to lag true market value in a
recession.
Property tax reductions can provide valuable above-the-line cash savings,
especially during economic downturns when assessed values may be more likely
to decrease. The current economic environment amplifies the need for
taxpayers to avoid excessive property tax liabilities by making sure their
properties are not overvalued.
Annual compliance and real estate appeal deadlines can provide opportunities
to challenge property values. Challenging real property assessments issued
by jurisdictions within the appeal window may reduce real property tax
liabilities. Taking appropriate positions on personal property tax returns
related to any detriments to value could reduce personal property tax
liabilities. Planning for and attending to property taxes can help a
business minimize its total tax liability.
Conclusion
There are 50 states and thousands of local taxing jurisdictions that impose
multiple different tax types. Ensuring that your company is in compliance
with those state and local taxes — and only paying the amount of tax legally
owed — can help reduce your total tax liability. As a taxpayer, it is
more efficient to be proactive, rather than reactive, when it comes to state
and local taxes. Being proactive will help identify issues and
solutions that can be applied to other taxing jurisdictions, as well as
helping limit audits, notices, penalties, and interest.
2023 Year-End Guide – Partnerships
The IRS in the past year has been actively challenging partnerships’ tax
positions in court – from the valuation of granted profits interests to
limited partner self-employment exemption claims and the structuring of
leveraged partnership transactions. At the same time, the agency is
dedicating to new funding and resources to examining partnerships.
These developments, along with some reporting and regulatory changes, mean
there are a number of tax areas partnerships should be looking into as they
plan for year end and the coming year:
Review Valuation of Granted Profits Interests, Partners’ Capital Accounts
-
Consider Active Limited Partners’ Potential Liability for
Self-Employment Tax
- Prepare for Expanded IRS Audit Focus on Partnerships
-
Review Structure of Leveraged Partnership Transactions, Application
of Anti-Abuse Rules
- Prepare for New Reporting on 2023 Form 1065 Schedule K-1
-
Evaluate Before Year End Expiration of Partnership Bottom-Dollar
Guarantee Transition Rules
Review Valuation of Granted Profits Interests, Partners’ Capital Accounts
In a recent Tax Court case, the IRS attempted — unsuccessfully — to supplant
the fair market value agreed to by unrelated parties in a partnership
transaction with its expert’s higher estimate, asserting that the taxpayer
received a taxable capital interest in exchange for services provided to a
partnership, not a nontaxable profits interest. If structured and
substantiated properly, profits interests can be valuable tools for
compensating providers of services to partnerships at no immediate tax cost.
Although the court upheld the taxpayers’ valuation, the IRS challenge
highlights the importance for partnerships to:
Properly determine, support and document value when granting and
establishing rights to profits interests, and
-
Strongly consider revaluing partners’ capital accounts according to
Treasury regulations to reflect fair market value when profits interests
are granted.
The case, ES NPA Holding LLC v. Commissioner, T.C. Memo 2023-55 (May 3,
2023), involved a partnership (ES NPA) that provided services to another
partnership in exchange for a partnership interest. The taxpayers contended
that interest was a profits interest, which was not immediately taxable. The
IRS argued that, under its higher estimation of the value of the underlying
business, ES NPA took a capital interest in the partnership that ostensibly
should be immediately taxable.
Relying on the fair market value negotiated among the parties to the
transaction, the Tax Court agreed with the taxpayer that there was not a
taxable capital shift between partners. Unsurprisingly, the Tax Court also
concluded — premised on the IRS’s guidance in Revenue Procedure 93-27 — that
receipt of a profits interest will not result in the immediate recognition
of taxable income. What is somewhat surprising is that the IRS challenged
whether the interest was, in fact, a profits interest. Facts in ES NPA Holding
Under the basic facts, a partnership (NPA, LLC) had three classes of units,
including Class A, Class B and Class C units. Upon liquidation of NPA, LLC,
the Class A and Class B units were to receive 100% of the original capital
assigned to these units before any amounts would be distributable to the
Class C units – which were the units that ES NPA received in exchange for
its services.
After an unrelated third party purchased 70% of the company for $21 million,
the parties to the transaction agreed that the original capital assigned to
the Class A and Class B units was $21 million and $9 million, respectively.
Thus, the total agreed to value of NPA, LLC was $30 million. Under this
valuation, the Class C units held by ES NPA would have $0 value in the event
of a hypothetical liquidation of NPA, LLC, at the time of the transaction –
suggesting ES NPA received only a profits interest in NPA, LLC.
IRS Challenge
Despite the parties’ agreement as to the $30 million equity valuation, the
IRS argued that the value of NPA, LLC was $52.5 million. Using this value,
the IRS determined that the liquidation value of the Class C units held by
ES NPA was in excess of $12 million (rather than $0). Assuming this
valuation is accurate, the Class C units would be considered capital
interests and would not be eligible for the safe harbor under Revenue
Procedure 93-27, which generally exempts from immediate taxation profit
interests – but not capital interests – received in exchange for the
provision of services to a partnership.
Based on its arguments, the IRS appears to believe that such a capital shift
would be immediately taxable to the recipient. Although not specifically
addressed in the Tax Court’s decision, receipt of a capital interest in
exchange for the performance of services is generally a taxable event under
established case law. However, there is some question around whether a
capital interest received for purposes other than the performance of
services would be immediately taxable.
Tax Court’s Holding
Ultimately, the Tax Court concluded that the best estimate of fair market
value in this case was the purchase price agreed to by unrelated parties.
While acknowledging that formal valuation reports may be helpful in
establishing fair market value, the Tax Court noted that such appraisals are
not required. Rather, as in this case, deference was provided to the
transaction price agreed to by unrelated taxpayers. Importantly, the Tax
Court noted that the testimony of the selling taxpayer was credible and
unbiased. The Tax Court further noted, “we find nothing in the record to
dispute a finding that the transaction was arm’s length and bona fide.”
What If the Court Accepted the IRS’s Narrow Reading of Its Own Revenue
Procedure?
Although this case is a “win” for the taxpayer, the IRS presumably didn’t go
to court without reason. The IRS believed the recipient of the Class C units
should immediately recognize taxable income. However, the IRS’s primary
argument sought to prevent application of Revenue Procedure 93-27 via a
narrow reading of the guidance. The IRS’s primary argument was not whether
the Class C units represented a capital interest. What if the Tax Court
agreed that Revenue Procedure 93-27 didn’t apply to these facts?
Revenue Procedure 93-27 is a safe harbor provision that states the IRS will
not treat receipt of a profits interest as immediately taxable. If the Tax
Court agreed that the safe harbor didn’t apply, as argued by the IRS, the
IRS would still need to address judicial precedent holding that receipt of a
profits interest is not taxable because the value of the interest received
is speculative. Thus, the IRS would then have had to successfully argue that
the Class C units had value beyond speculation. Given the result in the
IRS’s secondary, capital shift argument, it seems unlikely that it would
have prevailed.
Key Considerations and Takeaway
Acknowledging the taxpayer’s success in this case, it is important to note
that the IRS sought to challenge the taxpayer in court. This is presumably
not a decision taken lightly by the IRS. Is this a warning sign to taxpayers
when structuring transactions where the buyer anticipates future upside that
may or may not be speculative?
There are a few important factors that, if the facts had been different,
potentially could have altered the outcome of the case:
The Tax Court found the selling taxpayer’s testimony to be credible and
unbiased, with nothing in the record indicating something other than an
arm’s-length transaction.
-
The facts did not indicate that the taxpayer needed the cash to
support further business operations, was simply looking to monetize his
investment as quickly as possible or otherwise facing circumstances
prompting the seller to sell at a discount.
-
The lack of taxpayer relatedness was important in supporting the use
of the agreed fair market value.
-
The discussion within the Tax Court’s opinion doesn’t address whether
the property owner ever sought other bids for his business or if that
would have changed the court’s analysis and conclusion regarding the
credibility and unbiased nature of the witness.
Ultimately, while a positive outcome for the taxpayer in this case, the
IRS’s decision to take this case to trial should serve as a cautionary tale.
Taxpayers are well advised to closely scrutinize the factors in their own
transactions to ensure the fair market value positions are fully documented
and supported.
When issuing a profits interest, it's critical to document the valuation of
the partnership and to strongly consider a book up of capital accounts to
reflect the valuation. Analyzing and documenting whether the bargaining
positions of the parties are truly adversarial would presumably help
substantiate the parties’ agreement of value.
Consider Active Limited Partners’ Potential Liability for Self-Employment
Tax
A judicial resolution may be near for the unanswered question of whether
limited partners in state law limited partnerships may claim exemption from
self-employment (SECA) taxes — despite being more than passive investors.
Depending on the outcome in the pending Soroban Capital Partners litigation,
limited partners in state law limited partnerships who actively participate
in the partnership’s business may lose the opportunity to claim this
exemption. If this happens, these limited partners would likely become
subject to SECA tax on their partnership income.
SECA taxes can be substantial for active partners in profitable
partnerships. The SECA tax rate consists of two parts: 12.4% for social
security (old-age, survivors, and disability insurance) and 2.9% for
Medicare (hospital insurance). While the 12.4% social security tax is
currently limited to the first $160,200 of self-employment earnings,
partners who are subject to SECA tax must pay the 2.9% Medicare part of the
tax on their entire net earnings from the partnership. There is also an
additional 0.9% Medicare tax on all earnings from the partnership over a
certain base amount (currently $125,000; $200,000; or $250,000 depending on
the partner’s tax filing status)
Why are some limited partners in jeopardy of losing their SECA tax
exemption?
Under Internal Revenue Code Section 1402(a)(13), the distributive share of
partnership income allocable to a “limited partner” is generally not subject
to SECA tax, other than for guaranteed payments for services rendered.
However, the statute does not define “limited partner,” and proposed
regulations issued in 1997 that attempted to clarify the rules around the
limited partner exclusion have never been finalized.
More recently, courts have held — in favor of the IRS — that members in
limited liability companies (LLCs) and partners in limited liability
partnerships (LLPs) that are active in the entity’s trade or business are
ineligible for the SECA tax exemption. Despite these IRS successes, some
continue to claim that state law controls in defining “limited partner” in
the case of a state law limited partnership and, therefore, limited partners
in state law limited partnerships — even active limited partners — may be
eligible for the SECA tax exemption. This issue has yet to be specifically
addressed by the courts, but Soroban Capital Partners may be the first case
to squarely resolve it.
What is the issue in the Soroban Capital Partners litigation?
The Soroban Capital Partners litigation filed with the Tax Court involves a
New York hedge fund management company formed as a Delaware limited
partnership. The taxpayers challenge the IRS’s characterization of
partnership net income as net earnings from self-employment subject to SECA
tax. According to the facts presented, each of the three individual limited
partners spent between 2,300 and 2,500 hours working for Soroban, its
general partner and various affiliates – suggesting that the limited
partners were “active participants” in the partnership’s business.
In its March 2 objection to the taxpayers’ motion for summary judgment, the
government contends that the term “limited partner” is a federal tax concept
that is determined based on the actions of the partners – not the type of
state law entity. Citing previous cases, the government asserts that the
determination of limited partner status is a “facts and circumstances
inquiry” that requires a “functional analysis.” The taxpayers in Soroban, on
the other hand, argue that such a functional analysis does not apply in the
case of a state law limited partnership and that, in the case of these
partnerships, limited partner status is determined by state law.
Under the functional analysis adopted by the Tax Court in previous cases, to
determine who is a limited partner, the court looks at the relationship of
the owner to the entity’s business and the factual nature of services the
owner provides to the entity’s operations. For the SECA tax exemption to
apply, the government states (citing case law), “an owner must not
participate actively in the entity's business operations and must have
protection from the entity's obligations.”
What should limited partners do pending the outcome of the Soroban case?
Limited partners who actively participate in the partnership’s business
should review their facts and circumstances and potential exposure to SECA
tax. Although there is currently no clear authority precluding active
limited partners of a state law limited partnership from claiming exemption
from SECA tax, such a position should be taken with caution and a clear
understanding of the risks—including being subject to IRS challenge if
audited. The IRS continues to focus on scrutinizing such claims through its
SECA Tax compliance campaign. Moreover, the opportunity to claim the
exemption could be significantly narrowed depending on the outcome of
Soroban Capital Partners.
Prepare for Expanded IRS Audit Focus on Partnerships
The IRS on September 8, 2023, announced that it will leverage funding from
the Inflation Reduction Act to take new compliance actions, including
actions focused on partnerships and other high income/high-wealth taxpayers.
It intends to use artificial intelligence (AI) and improved technology to
identify potential compliance risk areas.
Subsequently, on September 20, the IRS further announced plans to establish
a new work unit to focus on large or complex pass-through entities. The new
pass-through area workgroup will be housed in the IRS Large Business and
International (LB&I) division and will include the people joining the
IRS under a new IRS hiring initiative. The creation of this new unit is
another part of the IRS’s new compliance effort.
With respect to partnerships, the IRS announcement on new enforcement
efforts indicates that the IRS will focus on two key areas:
Expanding its Large Partnership Compliance program by using AI to identify
compliance risks, and
-
Increasing use of compliance letters focused on partnerships with
balance sheet discrepancies.
Large Partnership Compliance and AI
The IRS began focusing on examinations of the largest and most complex
partnership returns through its Large Partnership Compliance pilot program
launched in 2021. It now plans to expand the program to additional large
partnerships, using AI to select returns for examination. The AI, which has
been developed jointly by experts in data science and tax enforcement, uses
machine learning technology to identify potential compliance risks in
partnership tax and other areas.
The IRS stated that it plans, by the end of this month, to have opened
examinations of 75 of the largest partnership in the U.S. in a cross section
of industries – including hedge funds, real estate investment partnerships,
publicly traded partnerships, and large law firms.
Compliance Letters and Balance Sheet Discrepancies
The IRS has identified ongoing discrepancies in balance sheets of
partnerships with over $10 million in assets. The IRS announcement explains
that there have been an increasing number of partnership returns in recent
years showing discrepancies in balances between the end of one year and the
beginning of the next year – many in the millions of dollars, without any
required attached statement explaining the discrepancy.
The IRS states that it did not previously have the resources to follow up
and engage with large partnerships on these discrepancies. Using its new
resources, the IRS plans to approach the issue by mailing out compliance
letters to around 500 partnerships starting in early October. Depending on
the partnerships’ responses, the IRS might take additional action, including
potential examination.
Planning Considerations
With the passage of the Bipartisan Budget Act of 2015 (BBA), promulgating
new centralized partnership audit rules, there has been an increased focus
on partnership compliance. In conjunction, recent reporting updates for
Schedule K-1, Schedule K-2, and Schedule K-3 require partnerships to now
disclose additional information. This new announcement from the IRS reflects
the agency’s continued focus on partnership compliance using a variety of
tools, including AI, and further highlights the necessity for consistent and
accurate partnership reporting.
With the IRS signaling its areas of focus, taxpayers can proactively enhance
their “exam readiness.” Prior to initiation of an exam, taxpayers may wish
to consider taking steps such as confirming application of the BBA
partnership audit rules across entities within a complex structure,
identifying open tax years for entities subject to these rules, assessing
completeness of existing tax return workpapers and relevant documentation,
and establishing a framework of the exam response process.
Once an audit notice or compliance letter arrives, prepared taxpayers will
be ready to implement their exam process. Key to a taxpayer’s exam process
will be considering designation of the partnership representative,
availability of documentation that the IRS will likely request, familiarity
with operating agreements and other transaction documents, and accessibility
of qualified advisors to assist in the exam process.
Review Structure of Leveraged Partnership Transactions, Application of
Anti-Abuse Rules
On May 12, the Department of Justice (DOJ) filed its opening brief in its
appeal to the Seventh Circuit of the Tax Court’s decision in Tribune Media
Co. v. Commissioner (T.C. Memo 2021-122). The government views the Tax
Court’s ruling as paving the way for inappropriate income tax planning,
potentially enabling taxpayers to follow the roadmap created by the taxpayer
in Tribune Media to implement leveraged partnership transactions without
triggering taxable gain while avoiding incurring meaningful economic risk.
The appeal is primarily focused on perceived errors by the Tax Court in
applying a liability allocation anti-abuse rule under Treas. Reg.
§1.752-2(j) and the general partnership anti-abuse rule under Treas. Reg.
§1.701-2. If successful on appeal, the case would likely be remanded to the
Tax Court for a determination regarding applicability of the liability
allocation and general anti-abuse rules. It is unclear whether the Tax Court
would reach a different conclusion upon remand.
The initial brief submitted by DOJ contains a discussion of factors
determined to be relevant in concluding the taxpayer’s guarantee was without
substance. Consideration should be given to these factors – summarized in
the conclusion below – when structuring or evaluating transactions.
Summary of Relevant Facts
In 2009, Tribune Media Company completed a transaction in which it
contributed the Chicago Cubs baseball team to a partnership in exchange for
an interest in the partnership plus a $714 million cash distribution. Under
the disguised sale of property rules in section 707(a)(2)(B), the $714
million would be viewed as a consideration received in connection with a
partial sale of the Chicago Cubs baseball team. However, through use of
liability guarantees, a significant portion of the debt used to fund the
cash distribution was allocated to Tribune Media. Under an exception to the
disguised sale rules, distributions funded by debt allocated to the
distributee are not treated as disguised sale consideration.
Based on rules described in Treas. Reg. §1.752-2, to the extent a partner
bears economic risk of loss (EROL) with respect to a liability, the
liability will be allocated to the partner. For purposes of determining
whether a taxpayer has EROL with respect to a particular liability, the
regulations provide for an analysis relying on hypothetical facts. Under
Treas. Reg. §1.752-2(b), a partner bears EROL with respect to a liability to
the extent that, if the partnership constructively liquidated, the partner
or a related person would be obligated to make a payment with respect to the
liability. For purposes of this analysis, regulations require the
constructive liquidation to be determined under all the following
hypothetical facts:
All the partnership’s liabilities become payable in full.
-
With the exception of property contributed to secure a partnership
liability (see Treas. Reg. §1.752-2(h)(2)), all the partnership’s
assets, including cash, have a value of zero.
-
The partnership disposes of all its property in a fully taxable
transaction for no consideration (except relief from liabilities for
which the creditors’ right to repayment is limited solely to one or more
assets of the partnership).
-
All items of income, gain, loss or deduction are allocated among the
partners.
- The partnership liquidates.
To benefit from the debt financed distribution exception to the disguised
sale rules, Tribune Media agreed to guarantee a portion of the debt used to
fund the distribution. The objective of this guarantee was to create EROL
resulting in an allocation of the liability to Tribune Media. Based on the
terms of the executed agreements and the general rules described in Treas.
Reg. §1.752-2, Tribune Media properly bore EROL. As shown on applicable
income tax returns, partnership liabilities were allocated to Tribune Media
and reflected its EROL.
Liability Allocation Anti-Abuse Rule
Upon examination, the IRS concluded that the parties’ attempt to create EROL
violated the anti-abuse rule under Treas. Reg. §1.752-2(j), which generally
provides that an obligation of a partner to make a payment may be
disregarded if facts and circumstances indicate that a principal purpose of
the arrangement is to eliminate the partner’s EROL with respect to that
obligation.
As discussed in both the Tax Court’s opinion and DOJ’s opening appeals
brief, the parties structured an arrangement that met the literal
requirements to create EROL under Treas. Reg. §1.752-2. However, under the
government’s view of the facts, Tribune Media did not bear meaningful risk
of loss. The government noted that that “[t]he Tax Court and Tribune itself
concluded that Tribune had no more than a ‘remote’ risk under the Senior
Guarantee” with “myriad protections in place that all but assured Tribune
would never be called upon to repay any portion of the Senior Debt.”
It appears that, in evaluating applicability of the section 752 anti-abuse
rule, the Tax Court focused on the fiction that is deemed to occur for
purposes of determining EROL under Treas. Reg. §1.752-2. Consequently, the
Tax Court assumed the debt became due and all relevant assets became
worthless. Under this interpretation, Tribune Media would be called upon to
satisfy the outstanding liability. Consequently, the Tax Court concluded
that the actual and remote risk to Tribune Media wasn’t relevant to the
anti-abuse rule under Treas. Reg. §1.752-2(j). With this ruling the Tax
Court would significantly limit the potential effectiveness of the
anti-abuse rule.
The government views the reference in Treas. Reg. §1.752-2(j) to “facts and
circumstances” to mean a required analysis of the actual economic
arrangement of the parties. This contrasts with the view apparently taken by
the Tax Court. In the Tax Court’s analysis, the anti-abuse analysis was
conducted under the lens of the hypothetical factual assumptions required
under the general rule of Treas. Reg. §1.752-2(b). The different views, of
course, could have dramatic results in terms of whether and when the
anti-abuse rule may apply.
General Partnership Anti-Abuse Rule
In addition to the liability allocation anti-abuse rule under Treas. Reg.
§1.752-2(j), the government has also taken issue with the Tax Court’s
application of the general partnership anti-abuse rule under Treas. Reg.
§1.701-2. In its decision, the Tax Court noted that the Treas. Reg. §1.701-2
anti-abuse rules apply only “to the function of the partnership as a whole.”
The government, on the other hand, points out that Treas. Reg.
§1.701-2(a)(2) requires that “[t]he form of each partnership transaction
must be respected under substance over form principles.”
Ultimately, DOJ believes the Tax Court has misapplied the general anti-abuse
rule. Acknowledging that the totality of the transaction may have had a
business purpose, analyzing specific aspects under the general anti-abuse
rule is appropriate. Similar to the discussion around the liability
allocation anti-abuse rule, a recharacterization of the loan guarantee could
have a significant impact on the tax consequences to the parties involved.
Conclusion
Based on the status of the Tribune Media case and the government’s appeal,
there are a few important factors for consideration and reasonably drawn
conclusions.
The government disagrees with the manner in which the Tax Court applied both
the liability allocation anti-abuse rule and the general anti-abuse rule. It
is reasonable to conclude that, if faced with a similar fact pattern, the
IRS will challenge application of the debt-financed distribution exception
to the disguised sale rules. In its brief, DOJ described the following
factors as critical in its determination that the loan guarantee was without
economic substance:
The Cubs’ baseball club had strong revenue flow and structural protections
built into the transaction ensuring the ability of the Cubs to meet its
financial obligations. In particular, the Cubs had stable and growing cash
flow streams from long-term media rights agreements along with strong
ticket sale revenue. Debt service arrangements were structured to pull
from these cash flow streams.
-
As part of obtaining approval from Major League Baseball to complete
the transaction, several parties to the transaction executed an
operating support agreement intended to provide a “financial safety net”
to the Cubs in times of economic uncertainty.
-
To prevent potential creditor seizure of the Cubs baseball team, the
Commissioner of Major League Baseball had the authority to take
significant actions, including requiring funding additional equity
contributions, the sale of the team and the provision of a super-senior
loan to fund operating expenses.
-
There is unique value to the collateral associated with a major
league baseball team. Based on S&P valuations, upon a distressed
asset sale, a 40% reduction in the value of the collateral would still
yield significant value.
-
Tribune Media documented its belief that the possibility of its
guarantees would be called upon was remote. On its financial statements,
Tribune Media disclosed the guarantees in the notes but did not record a
liability, create a reserve, or report any value associated with the
guarantees.
The Tax Court evaluated application of both the liability allocation
anti-abuse rule and the general anti-abuse rule. The Tax Court concluded
that the liability allocation anti-abuse rule was inapplicable. This
conclusion was premised on application of the hypothetical transactions
described in Treas. Reg. §1.752-2(b), i.e., the loan becomes due and
payable, and the obligor has no assets with which to satisfy the obligation.
Under this assumption, the Tax Court concluded that the remoteness of the
guarantor’s obligation is not relevant. If this approach is accurate,
application of the liability allocation anti-abuse rule would certainly seem
to be significantly limited. If appropriate to analyze this anti-abuse rule
under actual facts, it’s unclear whether the Tax Court would have reached a
different end result.
Until resolved on appeal, taxpayers should be able to rely on the Tax
Court’s ruling in Tribune Media to structure transactions involving
debt-financed distributions. However, taxpayers should likewise be prepared
for IRS challenge if audited.
Prepare for New Reporting on 2023 Form 1065 Schedule K-1
The IRS included new and modified reporting requirements in its
draft 2023 Form
1065 Schedule K-1
, released on June 14, 2023, including:
A modified reporting requirement concerning decreases in a partner’s
percentage share of the partnership’s profit, loss and capital, and
-
A new reporting requirement relating to partnership debt subject to
guarantees or other payment obligations of a partner.
Decreases in a Partner’s Share of Partnership Profit, Loss and Capital
The modification to the Schedule K-1 reporting reflected on the draft 2023
Schedule K-1 concerns certain decreases in a partner’s percentage share of
the partnership’s profit, loss and capital from the beginning of the
partnership’s tax year to the end of the tax year.
Reporting a partner’s percentage share of the partnership’s profit, loss and
capital at the beginning and the end of the tax year is not a new
requirement. Prior versions of the Schedule K-1 require the partnership to
check a box indicating if a decrease in a partner’s percentage share of
profit, loss and capital from the beginning of the tax year to the end of
the tax year is due to a sale or exchange of partnership interests. The
draft 2023 Schedule K-1 refines this reporting by distinguishing, in Part
II, Item J, between decreases due to sales of partnership interests and
decreases due to exchanges. Partnerships must check one box if a decrease in
a partner’s percentage share of profit, loss and capital from the beginning
to the end of the partnership tax year is due to a sale of partnership
interests and a separate box if the decrease is due to an exchange of
partnership interests.
While it is unclear why the IRS distinguishes a sale from an exchange in
this context, in the absence of clarifying instructions to the 2023 Form
1065, an exchange of partnership interests should be interpreted broadly to
encompass any non-sale transfers of partnership interests, whether taxable
or not, including by gift, a redemption or otherwise.
Partnership Debt Subject to Guarantees or Other Payment Obligations of a
Partner
The new reporting requirement reflected on the draft 2023 Schedule K-1
underscores the importance of properly classifying partnership liabilities
as recourse or nonrecourse under the Section 752 rules. The draft 2023
Schedule K-1, in Part II, Item K3, requires the partnership to check a box
if a partner’s share of any partnership indebtedness (also reported on the
Schedule K-1) is subject to guarantees or other payment obligations by the
partner.
The existence of a guarantee or other partner payment obligation is relevant
in determining whether a partnership liability is considered recourse or
nonrecourse under the rules of Section 752. Regulations state that a
partnership liability is a recourse liability to the extent that any partner
or related person bears an economic risk of loss with respect to the
obligation. A partner that has an obligation to make a net payment to a
creditor or other person with respect to a partnership liability upon a
constructive liquidation of the partnership, including pursuant to a deficit
restoration obligation (DRO) in the partnership agreement, is considered to
bear the economic risk of loss of that partnership liability. A partner’s
payment obligation with respect to partnership debt may arise pursuant to
any contractual guarantees, indemnifications, reimbursement agreements or
other obligations running directly to creditors, to other partners or to the
partnership.
The existence of a debt guarantee or other payment obligation by the partner
with respect to a partnership liability may indicate that the partner bears
some or all of the economic risk of loss for such liability, which is a key
factor in classifying a partnership liability as recourse or nonrecourse
under the rules of Section 752.
Evaluate Before Year End Expiration of Partnership Bottom-Dollar Guarantee
Transition Rules
The transition period for “bottom-dollar” guarantees ended on October 4,
2023, and in some cases partners that were relying on bottom-dollar
guarantees for partnership tax basis would have needed to have new
arrangements in place by that time if they intended to preserve tax basis
associated with a bottom-dollar guarantee. However, partners in some
partnerships may have until the end of the partnership tax year to set up
new arrangements.
Bottom-Dollar Guarantees and Transition Period
A bottom-dollar guarantee is a guarantee by a partner of an amount of
partnership debt, where the partner pays only if the creditor collects less
than the full amount of the debt from the partnership. Further, in a
bottom-dollar guarantee, even if the creditor does not collect the full
amount of the debt, the bottom-dollar guarantor pays nothing provided the
creditor collects at least the amount of the bottom-dollar payment
obligation. For example, a lender loans ABC partnership $100 secured by land
and partner A guarantees the bottom $10 of the loan. If the lender can only
recover $11 of the $100 loan, then Partner A has no obligation on the
guarantee. However, if the lender can only recover $6 of the $100 loan, then
Partner A would be liable for $4 under the guarantee ($10 bottom guarantee
less $6 recovered).
Regulations under Section 752 issued in 2019 curtailed the use of
bottom-dollar payment obligations to establish economic risk of loss for a
guarantor to be allocated recourse liabilities on partnership debt incurred
after October 5, 2016, unless special transition rules applied. The
transition rules in the 2019 regulations allowed taxpayers to continue using
bottom-dollar guarantees for debt existing on October 5, 2016, to the extent
the basis associated with the allocation of liabilities in connection with
the bottom-dollar guarantee under the old rules protected a negative capital
account prior to that date.
The transition rules were effective for only a seven-year period that ends
on October 4, 2023.
Tax Implications of Transition Period Ending
Upon expiration of the seven-year transition period on October 4, 2023, any
debt supported by a bottom-dollar guarantee during the transition period
will no longer be adequate to support the allocation of the debt to the
guarantor and the liability must be reallocated among the partners based on
the rules of Section 752. If debt allocations change due to the expiration
of the transition period, a partner with a negative tax capital amount no
longer supported by debt may recognize gain under Section 731.
Despite the final demise of bottom-dollar guarantees, other options may be
available for partners to achieve desired tax results, such as using
“vertical slice guarantees,” under which a partner guarantees a percentage
of each dollar of debt, and intelligently managing non-recourse liability
allocations.
Planning Considerations
Partnerships should review liability allocations to ensure that tax
deferrals continue as planned. The transition period under the 2019
regulations ended October 4, 2023, but there may still be time to make
arrangements to preserve tax basis before the end of the partnership tax
year.
Partners are required to determine the adjusted basis of their interest in a
partnership only when necessary for the determination of their tax liability
or that of any other person. Otherwise, the determination of the adjusted
basis of a partnership interest is ordinarily made as of the end of a
partnership tax year. Therefore, if a partner is not otherwise required to
determine the adjusted basis of his or her partnership interest in order to
determine the partner’s own tax liability or that of any other person for
the period between October 4, 2023, and the end of the partnership’s tax
year, the partner may have until the end of the partnership’s tax year to
set in place alternative arrangements.
Partnerships must disclose bottom-dollar guarantees on Form 8275 for tax
years ending on or after October 5, 2016, in which the guarantee is
undertaken or modified.
