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2023 Year-End Tax Planning for Businesses

Posted by BOOSCPA Strategic Tax Services Group Posted on Dec 11 2023
2023 Corporate Year End Tax Planning
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2023 Year-End Guide – Tax Accounting Methods

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.

Items taxpayers should review by year end:
    Be mindful of the December 31st deadline for non-automatic method changes
  • Verify eligibility to use small business taxpayer exceptions and evaluate method implications
  • Year-end clean-up Items: accelerate common deductions/losses, if appropriate
  • Revisit the de minimis book safe harbor for write-offs of tangible property
  • Consider methods implications of potential M&A transactions
Items to review in early months of 2024:
    Review latest specified research and experimental expenditures guidance (Section 174) and evaluate implications on 2023 tax year
  • Review opportunities for immediate deduction of fixed assets
  • Consider the UNICAP historic absorption ratio election
  • Review leasing transactions for compliance with tax rules
  • Evaluate accounting method changes for controlled foreign corporations

Items Taxpayers Should Review by Year End:
Be mindful of the December 31st Deadline for Non-automatic Method Changes
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. 

Verify Eligibility to Use Small Business Taxpayer Exceptions and Evaluate Method Implications
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:
    Section 471 inventory methods;
  • Section 263A uniform capitalization (UNICAP) rules;
  • The Section 460 requirements to use the percentage-of-completion method for certain long-term construction contracts; and
  • The Section 163(j) limit on the deductibility of business interest expense. 

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:
    The change(s) qualify to use the automatic change procedures (in which case Form 3115 can be filed in 2024); or
  • A non-automatic accounting method change needs to be filed before the end of 2023 for the change to apply in the first year the taxpayer does not qualify as a small business taxpayer. 
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.

Year-end Clean-up Items: Accelerate Common Deductions/Losses
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.)
Deduction of accrued bonuses. 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:
    Review bonus plans before year end and consider changing the terms to eliminate any contingencies that can cause the bonus liability not to meet the Section 461 “all events test” as of the last day of the taxable year. Taxpayers may be able to implement strategies that allow for an accelerated deduction for tax purposes while retaining the employment requirement on the bonus payment date. These may include using (i) a “bonus pool” with a mechanism for reallocating forfeited bonuses back into the pool; or (ii) a “minimum bonus” strategy that allows some flexibility for the employer to retain a specified amount of forfeited bonuses.
  • It is important that the bonus pool amount is fixed through a binding corporate action (e.g., board resolution) taken prior to year end that specifies the pool amount, or through a formula that is fixed before the end of the tax year, taking into account financial data as of the end of the tax year. A change in the bonus plan would be considered a change in underlying facts, which would allow the taxpayer to prospectively adopt a new method of accounting without filing a Form 3115.
  • Schedule bonus payments to recipients to be made no later than 2-1/2 months after the tax year end to meet the requirements of Section 404 for deduction in the service year.
Deduction of commission liabilities. Taxpayers with commission liabilities should consider taking the following actions prior to the end of the 2023 taxable year:
    Review commission agreements for needed revisions. By analyzing the terms of the arrangements, taxpayers can determine what event(s) must occur to fix the commission liability and meet the all events test under Section 461. Companies may consider revising commission agreements to remove contingences or otherwise better align their business goals with deduction timing for tax purposes.
  • One example of a contingency associated with commission liability is a requirement that a customer remain a customer for a specified time before the employee/agent is entitled to a commission. In this case, the liability would not be considered fixed until the conclusion of the specified time period, thereby precluding the taxpayer’s deduction of the commission liabilities prior to that date.
  • Consider the tax treatment of prepaid commissions and associated elections. For financial reporting purposes, many companies capitalize commissions paid to both employees and independent contractors, typically amortizing amounts over the same period as the related revenue stream under ASC 606. Tax requirements for capitalization of commissions and the timing of their deduction will differ based on the recipient of the commission and whether the recipient’s efforts to earn the commission facilitate the acquisition or creation of an intangible.
  • The Section 263(a) requirement to capitalize commissions as facilitative costs applies to commissions paid to third parties, including independent contractors, but employee compensation is exempt from this requirement. Thus, commissions paid to employees generally can be deducted in the year the commissions are incurred.
  • If the taxpayer prefers to capitalize commissions paid to employees, it may opt to do so by making an annual election. The flexibility to switch between deducting and capitalizing employee commissions each year provides a helpful planning opportunity for companies.
  • Schedule accrued commission payments to employee recipients to be made no later than 2-1/2 months after the tax year end. This timing is necessary to meet the requirements of Section 404 for a deduction in the service year. Accrued commissions to third parties (e.g., independent contractors) would generally be deductible in the year incurred.

Deductions of prepaid expenses. 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.

Inventory write offs. 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.

Revisit the De Minimis Book Safe Harbor for Write-offs of Tangible Property

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.

Critical year-end action items are:

    Review and make desired changes to the associated financial accounting policy prior to the beginning of the upcoming tax year; and
  • Plan to attach the required election statement to the timely-filed, original return for the year in which the election is to be effective.
Consider Methods Implications of Potential M&A Transactions
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.
Final year restrictions. 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.
Due diligence preparation. 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.
Post-transaction alignment. 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.

Items to review in early months of 2024:

Review Latest Section 174 Guidance and Evaluate Implications on 2023 Tax Year

The Tax Cuts and Jobs Act (TCJA)

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.

IRS Notice 2023-63
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:
    Methodology for allocating overhead and depreciation;
  • Short tax year treatment;
  • Project Completion method expense and revenue treatment;
  • Cost sharing agreements; and
  • Recovery of the costs for business sold or cease to exist.

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.

Planning Considerations for M&A Transactions

Section 7 of the Notice addresses some basic consequences of asset dispositions, entity terminations, and carryover transactions for corporations. However, the Notice leaves unaddressed a number of interactions between Section 174 and other M&A tax rules, including those addressed below.

Section 338(h)(10). While the Notice does not specifically address Section 338(h)(10), the Notice appears to make clear that specified research and experimental (SRE) expenditures capitalized under Section 174 by a target should remain with the selling parent following a Section 338(h)(10) election. As such, the SRE expenditures will provide no current year reduction in gain from the deemed asset sale but may provide the seller utilizable amortization in future tax years. To the extent the buyer and seller are negotiating a gross up payment in conjunction with the election, treatment of the SRE expenditures in the calculation of the gross up should be addressed.

Section 382. To date there has been no guidance on the interaction of Section 174 and the safe harbors outlined in Notice 2003-65. Notice 2003-65 provides two safe harbor methodologies for calculating the NUBIG/NUBIL and RBIG/RBIL from a loss corporation’s Section 382 ownership change, the 338 approach and the 1374 approach. Under both approaches, the NUBIG/NUBIL is the net amount of gain or loss that would be recognized in a hypothetical asset sale, whereby the loss corporation sells all of its assets, and the buyer assumes all of the loss corporation’s liabilities. 

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.

Unified Loss Rule. In certain situations when selling a subsidiary member at a loss, a consolidated federal income tax group can reattribute tax attributes (e.g., NOLs and deferred deductions) from the departing subsidiary to the group under an election within the unified loss rule (ULR). This election allows the group to retain valuable tax attributes.

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.

Cost Sharing Arrangements (CSAs) under Reg. §1.482-7.

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.

Review Opportunities for Immediate Deduction of Fixed Assets
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.

Fixed Asset Scrubs. Reviewing fixed asset registers for amounts that potentially may be recovered over a shorter depreciable life can yield cash tax benefits. For example, taxpayers may be able to reclassify certain interior improvements to a nonresidential building as “qualified improvement property” eligible for a shorter 15-year recovery period and bonus depreciation. The cash tax benefit from properly reducing the recovery period of depreciable property is achieved using the automatic accounting method change procedures.

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).

Consider the UNICAP Historic Absorption Ratio Election
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.

The historic absorption ratio method

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:

    If the recomputed ratio(s) are within 0.5% of the HAR used for the preceding five years, the taxpayer can continue using the HAR for another five years.
  • If the recomputed ratio(s) are not within the 0.5% range, then the taxpayer is required to begin another three year testing period of calculating the actual absorption ratios.
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.

Making and terminating the HAR election – weigh the benefits carefully

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.

Review Leasing Transactions for Compliance with Tax Rules

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:
Categorization. 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.
Timing of income/deductions. 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:
    The lease is for the use of tangible property;
  • Total consideration paid under the lease exceeds $250,000; and
  • The rent schedule provides for increasing/decreasing payments throughout the term of the lease and/or there is a rent allocation schedule that differs from the payment schedule.
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.
Maintaining the proper method. 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.

Evaluate Accounting Method Changes for CFCs

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:

    Changing from computing depreciation under the General Depreciation System (GDS) to the Alternative Depreciation System (ADS);
  • Switching to either the full inclusion method or the one-year deferral method for advance payments;
  • Changing to a proper Section 461 method to deduct liabilities such as bonuses and commissions in the year the liability is fixed and amounts are paid within 2-1/2 months of year end; and
  • Complying with Section 263A and adopting the U.S. ratio method to capitalize costs to ending inventory.

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:

  1. It is probable that the income tax credits allocable to the tax equity investor will be available.
  2. The tax equity investor is unable to exercise significant influence over the operating and financial policies of the underlying project.
  3. 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.
  4. 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.
  5. 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.


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.


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.