Employee Retention Credit

The recently signed stimulus package included considerable enhancements to the Employee Retention Credit (ERC). The new law, known as the Consolidated Appropriations Act (CAA) expands the ERC under the CARES Act that went into effect January 1, 2021, with the covered wage period extended until June 20, 2021. The new legislation is also retroactive to wages paid after March 12, 2020; so, employers who took Paycheck Protection Program (PPP) loans in 2020 are now eligible to take the ERC, provided these wages are not used for both the credit and PPP loan forgiveness.

 Tax Changes Under CAA 2021

The good news for employers who continued to pay their employees, despite being forced to close their business either fully or partially by a COVID-19 lockdown, is they are now eligible for an ERC refund.

Period of availability: For qualified wages paid after March 12, 2020, and before July 1, 2021, extending availability of the credit to the first two quarters of 2021. These periods may be outside the covered period for many PPP loan borrowers, and the employee retention tax credit is likely available.

Credit amount: The credit amount increased from 50% to 70% of qualified wages, for 2021, which is amended to include the cost to continue providing health benefits.

Maximum credit amount: The credit cap is increased to $7,000 for each of the first two quarters of 2021 ($10,000 in qualified wages X 70% tax credit rate), so that the maximum credit for 2021 will be $14,000. This aggregate $14,000 per employee maximum credit for the first two quarters of 2021 is available even if the employer received the $5,000 maximum credit for wages paid to such employee in 2020.

Credit eligibility requirements: The applicable number of employees increased from 100 to 500. This allows employers who had 500 or fewer full-time in 2019 to be eligible for the credit, even if employees are working, provided they meet other requirements. Note that in calculating this 500-employee threshold, the employees of all affiliated companies sharing more the 50% common ownership are aggregated.

Effective January 1, 2021, business operations that are either fully or partially suspended by a COVID-19 lockdown order, or for a quarter in 2021, if gross receipts are less than 80% of gross receipts for the same quarter in 2019. This differs from the original law in 2020 that stipulated gross receipts of less than 50% qualified.

Because the ERC credit can apply to wages already paid after March 12, 2020, many struggling employers can access this credit by reducing upcoming deposits or requesting an advance credit on Form 7200, Advance of Employer Credits Due To COVID-19 (per IRS website).

Advance payment clause: Advance payment of the credit is allowed for businesses with 500 or fewer employees, based on 70% of average quarterly payroll for the same quarter in 2019. Companies may be allowed to collect the payment prior to the payment of wages. However, if the advance payment is larger than the actual credit calculated, the company will need to repay the excess.

Please contact the Spiegel team for advice and any updates on this new legislation.

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

IRS Changes to Schedule K-1

The Internal Revenue Service (IRS) made significant changes to the Schedule K-1 for the 2020 tax year to improve the quality of information reported by partnerships. This consists of modified instructions for partnerships required to report capital accounts to partners. All partnerships, including limited liability companies taxed as partnerships, are required to report partners’ capital in Box L on the Schedule K-1.

Prior to 2020, a partnership could report partners’ capital using one of the following methods: tax basis, GAAP basis, Section 704(b) basis, or other method. With Notice 2020-43, all partnerships, including limited liability companies taxed as partnerships, are required to report partners’ capital on a tax basis starting with the 2020 tax return. Notice 2020-43 outlines two methods of reporting tax basis capital: Modified Outside Basis Method and Modified Previously Taxed Capital Method. The preliminary instructions for the 2020 Form 1065 provide a third option under consideration: Transactional Approach.

Modified outside basis method. The amount to report as a partner’s beginning capital account under the modified outside basis method is equal to the partner’s adjusted tax basis in its partnership interest as determined under the principles and provisions of subchapter K including, for 1) the partner’s share of partnership liabilities under section 752 and (2) the sum of partner’s section 743(b) adjustments. For purposes of establishing a partner’s beginning capital account, you may rely on the adjusted tax basis information provided by your partners. .

Modified previously taxed capital method. The amount to report as a partner’s beginning capital account under the modified previously taxed capital method is equal to the following: The amount of cash the partner would receive if you liquidated after selling all of the assets in a fully taxable transaction for cash equal to the fair market value of the assets; increased by the amount of tax loss determined without taking into account any section 743(b) basis adjustments that would be allocated to the partner following such a liquidation; and decreased by the amount of tax gain determined without taking into account any section 743(b) basis that would be allocated to the partner following such a liquidation. Instead of using the assets’ fair market value, you may determine the partnership’s net liquidity value, and gain or loss, by using such assets’ bases as determined under section 704(b), as determined for financial accounting purposes, or on the basis set forth in the partnership agreement for purposes of determining what each partner would receive if the partnership were to liquidate, as determined by partnership management.

Transactional approach. The amount to report as a partner’s beginning capital account under the transactional approach is (1) increased by the amount of cash and the tax basis of property contributed by the partner to the partnership (less liabilities assumed by the partnership or to which property is subject) as well as allocations of income or gain made by the partnership to the partner, and (2) decreased by the amount of cash and the tax basis of property distributed by the partnership to the partner (less any liabilities assumed by the partner or to which the property is subject) as well as allocations of loss or deduction made by the partnership to the partner.

The partnership is required to use one of the methods, and the method selected must be used by all partners for the year. While the capital on the K-1 may look different for 2020, the change to tax basis reporting does not cause an economic consequence to the partner. This is strictly a reporting requirement. However, partnerships that do not comply with the new reporting requirements will be subject to late filing penalties for failure to show all required information. For 2020, the late filing penalty is $210 for each month or part of a month, for a maximum of 12 months, multiplied by the total number of persons who were partners in the partnership during any part of the partnership’s tax year.

Check your 2019 K-1 statement to determine the prior method for basis reporting. Many partnerships will opt for the modified previously taxed capital method due to the availability of information. Please contact your Spiegel team with any questions or to discuss your options.

 

Author, Peter Lloyd

Senior Tax Manager, Spiegel Accountancy Corp

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

The 12-Month Rule – Determining the Deductibility of Prepaid Expenses

Taxpayers seeking additional business deductions before the end of the year might consider adopting the 12-month rule by prepaying some business expenditures before year-end. Certain expenses such as insurance, rebates, and licenses can be prepaid before year-end without needing to be capitalized for tax purposes, thus allowing a tax deduction for the current tax year. The 12-month rule must satisfy the requirements of economic performance in order to be utilized. The recurring item exception may provide some relief if the economic performance standard isn’t met.

Basics of the 12-Month Rule

Under normal circumstances, IRS regulations require taxpayers to capitalize (i.e., not deduct) amounts paid for certain prepaid assets. In other words, let’s say you spend $1,000 of your hard-earned money in October on a license that lasts one year. This doesn’t necessarily mean the entire amount is deductible in the tax year the payment is made. Cash-out = tax deduction. Those more familiar with accounting principles will argue that the matching principle needs to be applied, meaning that the deduction should be applied to the period in which it provides a benefit. Meaning, you would deduct 3/12 of the expense in the year the payment is made and 9/12 in the following year. This would be the IRS’ approach (See Reg. Sec. 1.162-3(d)). Taxpayers may be allowed to deduct the full $1,000 amount in the year in which it was paid by applying the 12-month rule. To apply this rule, we must look to Reg. Sec. 1.263(a)-4(f) which states that:

Except as otherwise provided in this paragraph, a taxpayer is not required to capitalize amounts paid to create any right or benefit for the taxpayer that does not extend beyond the earlier of:

  • 12 months after the first date on which the taxpayer realizes the right or benefit; or
  • The end of the taxable year following the taxable year in which the payment is made.

Let’s apply this to our license example. A license that lasts one year was purchased in October of the current year and it is set to expire in September of the following year. The payment creates a right that does not extend 12 months after it is initially created, thus satisfying the first condition. Also, it does not extend past the following taxable year since it ends in September, which satisfies the second condition. If the right had extended beyond September of the following year, the 12-month rule would no longer be satisfied, and the license would need to be deducted ratably over the life of the license.

Exception to the Exception: Understanding Economic Performance

The 12-month rule cannot be universally applied in all situations. If another regulation or code section specifically states that a certain type of prepaid asset is disallowed, the 12-month rule will not apply. Cash basis taxpayers will have slightly different results from accrual basis taxpayers. The rules for cash-basis taxpayers are relatively straight-forward: make the payment, and as long as the conditions above for the 12-month rule are satisfied, the taxpayer is eligible for the deduction. However, in order for this to always be true, economic performance must be satisfied. This is also true for accrual-basis taxpayers, but unlike cash basis taxpayers, accrual basis taxpayers will accrue certain expenses at year-end that a cash basis taxpayer will not.

In basic terms, economic performance is the timing of when a liability owed by a taxpayer is truly treated as being incurred. All of the necessary events need to have happened to determine that a) a liability is fixed, b) the amount can be determined with reasonable accuracy, and c) a specific action or event has taken place. For example, economic performance occurs for the following liabilities:

  • Rent Expense – generally, ratably over the period the taxpayer is entitled to use the property
  • Services – occurs as services are provided
  • Insurance – occurs when payment is made

This means that for prepaid services and prepaid rent, economic performance isn’t satisfied until the property is used or until the service is provided to the taxpayer, respectively. As such, merely paying the liability doesn’t mean the payment can be deducted. However, payment for an insurance premium in the event that needs to take place for economic performance. Assuming the 12-month rule is satisfied, prepaid insurance will be deductible upon payment. A more comprehensive list of prepaid assets and their respective economic performance traits can be found at the end of the article.

Exception to the Exception to the Exception: The Recurring Item Exception

What happens if economic performance hasn’t occurred, but you really want that tax deduction? It’s at the top of your wish list and you’ve been good all year. Surely Santa will step in on your behalf. Well, congratulations! The recurring item exception exists! Reg. Sec. 1.461-5 states that economic performance will be treated as having occurred with respect to liability if:

  1.  The liability is recurring in nature and is either not material, or provides for better matching of income and expense,
  2.  And economic performance will occur before the earlier of 8 1/2 months after year-end, or the filing of the tax return.

For example, a taxpayer accrues an expense for an insurance premium year-end. The premium covers October of the current year to September of the following year. The taxpayer makes the payment on January 15th of the following year. Even though this satisfies the 12-month rule, economic performance has not occurred before year-end since payment has not been made. However, under the recurring item exception, the deduction may be taken since insurance premiums are recurring in nature. It is not material, and payment was made within 8 ½ months of year-end.

Note: The recurring item exception cannot be applied to interest, rents, worker’s compensation, tort, breach of contract, and violation of law.

Bringing It All Together

To see how all of these concepts work together, let’s go through two examples:

Example 1:  Prepaid Advertising

On December 15th, a taxpayer pays a marketing firm $10,000 for advertising services that the taxpayer believes will be performed over the next 3 months. The marketing firm completes the advertising service by February 28th of the following year.

  • 12-Month Rule – The conditions for the 12-month rule are satisfied because the benefit to the taxpayer is realized within 12 months of the payment.
  • Economic Performance – For services, economic performance is satisfied as services are provided. The amount of the liability is fixed and determinable at year-end. However, the services were not provided by the end of the year so economic performance is not satisfied. Economic performance rules trump the 12-month rule, so it’s not looking good for the taxpayer thus far.
  • Recurring Item Exception – The taxpayer argues that they regularly engage marketing firms and the amount paid is not material to their financial statements. Also, the payment was made before filing the tax return.
  • Conclusion – The recurring item exception allows the taxpayer to apply the 12-month rule and the taxpayer is able to take the deduction. Note that for prepaid services, services must be provided within 3 ½ months of the payment being made. Other prepaids, such as prepaid interest, can be paid within 8 ½ months of year-end and still be deductible.

Example 2:  Prepaid Interest

On December 15th, a taxpayer pays an interest obligation of $10,000 related to business debt covering the second half of December and the first half of January of the following year.

  • 12-month Rule – The conditions for the 12-month rule are satisfied because the benefit to the taxpayer is realized within 12 months of the payment.
  • Economic Performance – For interest, economic performance is satisfied as the borrower has use of the money. The amount of the liability is fixed and determinable at year-end. However, the taxpayer cannot “use” the money for January in December, so economic performance is not satisfied. Again, economic performance rules trump the 12-month rule; so, it is still nondeductible.
  • Recurring Item Exception – The taxpayer argues that they regularly pay interest and the amount paid is not material to their financial statements. Also, the payment was made before filing the tax return. However, prepaid interest is one of the exclusively carved out items that cannot be applied by the recurring item exception.
  • Conclusion – Even though the 12-month rule is satisfied, economic performance and the inability to apply the recurring item exception prevent the taxpayer from deducting the prepaid January interest.

As you can see, these concepts work together to provide some relief to taxpayers while still trying to prevent abuse by others who would seek to make large prepayments before year-end for the sole purpose of lowering their tax liability. When determining the deductibility of prepayments for tax purposes, every situation is unique and requires a fair bit of analysis and understanding to make sure the taxpayer takes a defensible position. One should always consult with their tax advisor on their own circumstances to determine best practices.

Prepaid Expenses and Economic Performance

Prepaid Expense Economic Performance
Prepaid Insurance Payment

 

Prepaid Warranty and Service Contracts Payment

 

Prepaid License or Permit Fees Payment

 

Prepaid Taxes Payment

 

Prepaid Dues and Fees Payment

 

Prepaid Rebates Payment

 

Prepaid Rent Ratably over the period of time the taxpayer is entitled to use the property

 

Prepaid Services As services are performed

 

Prepaid Interest Ratably as the taxpayer has use of the money being borrowed

 

Prepaid Goods As the goods are provided to the taxpayer

 

Author, Jonathan Smith, Senior Tax Manager, Spiegel Accountancy Corp

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

Paycheck Protection Program Tax Treatment

More than 500 like-minded stakeholders are calling on Congress to overturn an Internal Revenue Service rule and allow Paycheck Protection Program (PPP) loan forgiveness to be fully tax-free.

In a December 3, 2020 letter to leaders of the House and Senate, the groups, led by the Associated General Contractors of America, urged lawmakers to enact legislation before the end of the year to correct the tax treatment of loan forgiveness under PPP.

IRS Notice 2020-32 states that “normally deductible business expenses will not be deductible if the business pays the expense with a Paycheck Protection Program loan that is subsequently forgiven,” which the coalition believes is a misinterpretation of the Coronavirus Aid, Relief and Economic Security Act. Section 1106(i) of the CARES Act states business expenses are “includible in gross income of the eligible recipient by reason of forgiveness” and “shall be excluded from gross income,” for purposes of the Internal Revenue Code of 1986. The coalition wants Congress to clarify this contradiction.

“At the onset of the COVID-19 pandemic, Congress responded with speed, cooperation, and an eye to preventing the worst potential economic outcomes. We ask that you bring that same spirit of urgency and cooperation before the end of this session to prevent an avoidable catastrophe for millions of small businesses that, without Congressional action, will face a surprising, and, in many cases, insurmountable tax bill next year,” the groups wrote. Spiegel Accountancy Corp Founding Principal, Jeff Spiegel, says, “Congress needs to act to get this resolved to allow expenses to be deducted.”

“The terms of the PPP are simple: if qualifying small businesses use a federally-guaranteed loan to pay their employees and cover certain non-payroll expenses, the loan will be forgiven,” the letter continued. “From April 3rd, when the program launched, through August 8th, when its authorization expired, the Small Business Administration guaranteed $525 billion in PPP loans to 5.2 million qualifying small businesses nationwide, preserving tens of millions of paychecks for their employees as the pandemic spread throughout the country.”

The coalition noted that if unchanged, the IRS ruling could increase small businesses’ taxes up to 37%.

“Since the IRS issued Notice 2020-32, Congress has signaled that it intends to reverse the ruling,” the letter said. “The Democratic and Republican Chairs of the House Ways and Means and Senate Finance Committees issued public statements saying that the IRS Notice, and, more recently, the IRS Revenue Ruling, is flawed and contrary to Congressional intent.”

The coalition added that the “most recent IRS revenue ruling” has created a renewed sense of urgency for Congress to address the issue before the end of the year.

“Allowing the IRS position to remain unchallenged will result in a significant tax increase on small business owners already suffering from the effects of COVID-19 shutdowns,” the groups wrote. “This tax will hit small business owners after their PPP loan has already been spent, and just as many states are re-imposing mandatory closures of thousands of businesses in the face of spiking numbers of COVID-19 cases. Many PPP loan recipients retained employees on their payrolls, even when there was little to no work to perform, in compliance with the intent of the program to keep people employed and off the unemployment rolls. The IRS changed the rules after businesses took out PPP loans, and business owners are now being asked to pay what amounts to a surtax on their workforce.

“Without Congressional action, businesses will face an unexpected tax bill when they file their taxes for 2020, as they continue to struggle with government-mandated shutdowns or slowdowns. Many of those businesses will close and never re-open. This senseless tax policy stands both the letter and spirit of the PPP on its head,” the letter concluded.

 

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

Rev. Rul. 2020-27 on PPP Loans and Taxes

On November 18, 2020, the U.S. Treasury Department and the Small Business Association (SBA) released Rev. Rul. 2020-27 that offers additional guidance on the tax treatment of expenses paid using Paycheck Protection Program (PPP) funds in the event the loan is not forgiven by the end of 2020. The IRS ruling concerning deductions for eligible PPP loan expenses is as follows:

(1) deny a deduction if the taxpayer has not yet applied for PPP loan forgiveness, but expects the loan to be forgiven; and

(2) provide a safe harbor for deducting expenses if PPP loan forgiveness is denied or the taxpayer does not apply for forgiveness.

The Treasury press release stated, “Since businesses are not taxed on the proceeds of a forgiven PPP loan, the expenses are not deductible. This results in neither a tax benefit nor tax harm since the taxpayer has not paid anything out of pocket.” Secretary Steve Mnuchin said, “These provisions ensure that all small businesses receiving PPP loans are treated fairly, and we continue to encourage borrowers to file for loan forgiveness as quickly as possible.”

While debt cancellation is ordinarily considered to be income, the PPP loan amount is nontaxable income. Borrowers may not deduct expenses paid with PPP funds (i.e. rent, mortgage interest, utilities) as that would be double-dipping. One of the most common questions is what if a borrower does not deduct expenses that ultimately end up not approved through loan forgiveness. Answer: It is possible to file an extension on 2020 taxes or file an amended income tax return once loan approval (or partial) has been authorized.

Additionally, the Treasury and IRS released Rev. Proc. 2020-51 this same day. This ruling provides a safe harbor for certain PPP loan participants, whose loan forgiveness has been partially or fully denied, or who decide to relinquish loan forgiveness, to claim a deduction for certain otherwise deductible eligible payments during the 2020 tax year.

Safe Harbor rules allow borrowers who decline loan forgiveness to claim a deduction for the otherwise deductible eligible payments on an original income tax return or information return, as applicable, for the taxable year in which the taxpayer decides to forego requesting forgiveness.

Mnuchin added, “Today’s guidance provides taxpayers with greater clarity and flexibility.”

 

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

Tax Relief for Victims of California and Iowa Disasters

The California wildfires and the Iowa derecho that occurred this summer have wreaked havoc on area residents. While federal disaster relief is available, the IRS recently released information on assistance it may offer. According to the IRS, victims of the latest California wildfires and the August 10th Iowa derecho now have until December 15, 2020 to file individual and business tax returns and make payments. It is not necessary for taxpayers to indicate on the return they are in a disaster zone. The IRS will automatically provide filing and penalty relief to any taxpayer within these disaster areas.

FEMA designated the following areas for disaster relief: Linn County in Iowa and Lake, Monterey, Napa, San Mateo, Santa Cruz, Solano, Sonoma, and Yolo counties in California. Any additional areas added to disaster relief status will automatically be provided the same relief. An updated list of affected localities can be found on the disaster relief page at IRS.gov. In the event an affected taxpayer does receive a penalty notice, the IRS recommends calling the number on the notice to have the penalty abated.

Taxpayers with a valid extension to file their return by October 15, 2020 will now have until December 15, 2020 to file their tax returns and make payments due during this time period. The IRS noted that tax payments related to 2019 returns that were due on July 15, 2020 are not eligible for this relief.

The December 15, 2020 deadline also applies to quarterly estimated income tax payments due on September 15, 2020, and the quarterly payroll and excise tax returns normally due on October 31, 2020. It also applies to tax-exempt organizations, operating on a calendar-year basis, that had a valid extension due to run out on November 15, 2020. Businesses with extensions also have the additional time including, among others, calendar-year corporations whose 2019 extensions run out on October 15, 2020.

Individuals and businesses in a federally declared disaster area who suffered uninsured or unreimbursed disaster-related losses can choose to claim them in the year the loss occurred (2020) or in the prior year tax return (2019). These returns must have the FEMA declaration number on any return claiming the loss: 4558 for California or 4557 for Iowa. See Publication 547 for details.

For information on disaster recovery, visit disasterassistance.gov.

 

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

CARES Act Rules for IRAs, RMDs & the August 31 Deadline

Retirees over the age of 70 ½ might be struggling to make sense of the new regulations with the passage of the SECURE Act at the end of 2019 and the current CARES Act. These new regulations may be confusing for retirees in regard to required minimum distribution (RMD) rules.

The SECURE Act passed last December is permanent and essentially raises the age for RMDs to 72; however, it went into effect January 2020. Therefore, if an individual turned 70 ½ in 2019, RMDs must still be taken in 2019 and 2020, since the age of 72 would not be reached until 2021.

So, how does the CARES Act come into play? Some say it’s like an RMD holiday. The CARES Act legislation essentially suspended RMDs from IRAs, inherited IRAs, 401(k)s, and inherited 401(k)s during 2020 and gave everyone the chance to put it back into their account within 60 days without taxation.

If an individual has already taken some or all RMDs and has gone past the 60-day mark, these funds may still be rolled over. The recently issued Notice 2020-51 allows an account holder to rollover all RMDs funds, distributed January 2020 to now, provided the rollover is made by August 31, 2020. Additionally, this move will not count as the one-per-year rollover allowed, so you may still enact a rollover for another purpose.

Another new benefit for retirement accounts is the ability to make a withdrawal from a qualified retirement plan or IRA due to a COVID-19 related issue. An individual can “self-certify” they have been financially impacted due to coronavirus-related circumstances. Plus, individuals under 59 ½ will be exempt from the 10% penalty tax for early withdrawal. Congress realized the need for hardship withdrawals, which meant individuals could access funds in their accounts without penalty. The maximum withdrawal amount is capped at $100,000.00. Participants may be permitted to recontribute the amount over a 3-year period, following the date of distribution, without affecting normal contribution limits. Repayment may be spread over the years 2020, 2021, and 2022 equally, as opposed to the entire amount being taxable the year the distribution was taken.

IRS waives requirements.

 

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

IRS Rules on Deductions & Expenses Regarding Your PPP Loan

Have you considered taking a deduction on your expenses paid with PPP funds?

While it might be tempting, the IRS considers this double-dipping. Standard business deductions are not allowed by the IRS if payment of those expenses also results in PPP loan forgiveness.

Under the CARES Act, PPP loans for small businesses can be totally forgiven provided the funds are primarily used to retain employees, among meeting other requirements. However, CARES Act guidelines also state loan forgiveness is not tax-deductible. The forgiveness of your loan will result in a “class of exempt income” under 1.265(b)(1) of the Regulations.

According to Treasury Secretary Steven Mnuchin, “The money coming in the PPP is not taxable. So, if the money that is coming is not taxable, you cannot double-dip. You cannot say that you’re going to get deductions for workers that you did not pay for.”

Mnuchin stated that he had personally reviewed the IRS guidance and if the loan forgiveness had been deemed taxable, business deductions would be allowed. “This is basically tax 101,” said Mnuchin.

Many lawmakers have expressed a desire to re-address these guidelines in future legislation since the intent of the PPP loan program was to help small businesses maximize their ability to maintain fluidity, retain employees, and recover from this crisis as best possible. It is quite likely that IRS guidelines on tax exemption may be specifically addressed in any new coronavirus-related legislation to clarify the original intent of the PPP loan program under the CARES Act.

Link to IRS document.

 

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

IRS Expands Eligibility on COVID-19 Distributions from IRAs

The IRS expanded its guidelines on June 20th with Notice 2020-50 that allows additional qualified individuals to take a coronavirus-related distribution (CRD) while avoiding the usual restrictions on early IRA distributions. Under the CARES Act, qualified individuals may receive favorable treatment for IRA distributions up to $100,000 from eligible retirement plans (i.e. 401k/403b and 457s) until December 31, 2020. Additionally, the 10% tax on early distributions is waived for any CRD if the distribution is taken before the account holder reaches 59 ½.

The Notice expands eligibility of “qualified individual” under the CARES Act

The original Act indicates a qualified individual is someone diagnosed with COVID-19, whose spouse or dependent is diagnosed with COVID-19 by a CDC approved test or a person who experienced adverse financial consequences resulting from being quarantined, furloughed or laid off or having hours reduced, unable to work due to lack of child care or closing or reduced hours for a business owned by the individual, any as a result of COVID-19.

The definition of “qualified” was expanded to include the individual and/or spouse, or a member of the individual’s household who had a job offer rescinded or start date delayed due to COVID-19. Additionally, a qualified individual includes someone whose income is affected by COVID-19 because a spouse or other household member (sharing the principal residence) experienced an income reduction due to COVID-19.

Also qualifying are household members unable to work due to lack of childcare because of COVID-19, as well as business owners/operators who lose income due to closing or reducing hours of business due to COVID-19.

Notice 2020-50 clarifies that while it is optional for employers and plans to designate distributions as COVID-related, qualified individuals whose distributions meet the above requirements will still receive this favorable federal tax treatment, even if a distribution is not classified as a CRD by the employer.

The CARES Act also provides somewhat of a tax holiday to a Qualified Individual

While a distribution from a qualified retirement plan is generally included in taxable income in the year of distribution, the CARES Act permits a qualified individual to include a CRD in taxable income ratably over a three-year period.  Notice 2020-50 clarifies this is an election on the part of the qualified individual who may choose instead to include the entire CRD in taxable income in the year of receipt; however, this election may not be changed. All CRDs must be treated in the same manner as reflected on the qualified individual’s 2020 tax return.

Additionally, the CARES Act permits a qualified individual to re-contribute a CRD to a qualified retirement plan. Unlike the tax treatment of a CRD, whether a CRD will be re-contributed to a qualified retirement plan or the manner in which it will be re-contributed, does not have to be determined before the filing of the qualified individual’s 2020 tax return.  Notice 2020-50 says that the decision can be made at any time during the three-year period and provides for the filing of amended returns to reflect the re-contribution of all or a portion of the CRD.

Link to IRS Notice 2020-50

 

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

What You Need to Know About the Centralized Partnership Audit Regime

What You Need to Know About the Centralized Partnership Audit Regime was originally published in AAPL’s Winter 2019 Edition of Private Lender Magazine.

Fund managers may not be aware of their new role during an IRS audit of companies with partnered members. The new centralized partnership audit regime (CPAR) introduced by the Bipartisan Budget Act (BBA) started with the 2018 tax year.

Under the old rules, there was no mechanism for the IRS to collect tax at the partnership level when issuing an IRS audit adjustment. Instead, the IRS had to seek payment of underpaid tax directly from partnership members. The old rules left the IRS with the inability to effectively collect tax from partnerships that have dozens, or even hundreds, of minority members.

The CPAR resolves the issue by allowing the IRS to collect tax directly from a partnership and shifts the responsibility for the collection of tax to the partnership.

Under Sec. 6221(b), certain partnerships are eligible to elect out of the BBA annually. If electing out, the IRS would generally make any adjustment relating to the partnership’s return in an audit of a partner, not an examination of the partnership. The partnership would not owe any taxes, interest or penalties.

A partnership can elect out of the CPAR if the partnership meets specific eligibility requirements. A partnership  is eligible within a tax year if it has 100 or fewer eligible partners. Eligible partners are individuals, C corporations, S corporations, foreign entities that would be C corporations if they were domestic entities, and estates of deceased partners.

A partnership is not eligible if it is required to issue a Schedule K-1 to any of the following partners:

  • Other partnerships
  • Disregarded entities
  • Trusts
  • An estate of an individual other than a deceased partner
  • Any person who holds an interest in the partnership on behalf of another person
  • Foreign entities that would not be treated as a C corporation were it a domestic entity

With these restrictions, fund managers will often find that their fund does not meet the eligibility requirements to elect out of the CPAR based on the composition of the fund’s investors.

Role of the Partnership Representative

Section 6223 of the code provides that unless the partnership has made a valid election out of the CPAR, each partnership must designate a partner or other person with a substantial presence in the U.S. as the partnership representative who shall have the sole authority to act on behalf of the partnership.

If an entity is designated as a partnership representative, the partnership must also appoint an individual to act on the entity’s behalf (a designated individual). To be a designated individual, the appointed person must also have a substantial presence in the U.S.

The partnership representative (or designated individual) can be the fund manager or any other individual, such as a CFO or controller. With the CPAR allowing the IRS to make tax assessments and collections of tax, interest and penalties at the partnership level, there are a few issues for fund managers and partnership representatives to consider:

  • Should the private placement memorandum (PPM) or LLC operating agreement be updated?
  • Can the fund withhold the tax from current year distributions, and what effect would that have on the fund’s yield?
  • Will a prior-year tax liability be shouldered unevenly by the current investors whose composition has changed through the admittance of new investors, or can the tax be specially allocated?
  • How to plan for the collection of taxes from investors who have already redeemed their investment from the fund

LLC Operating Agreement Revisions

Fund managers should review their PPM and LLC operating agreements with their legal counsel and tax advisors. Suggested changes include, but are not limited to, the following:

  • Replacement of a “tax matters partner” with a “partnership representative”
  • A statement that under section 6223, the partnership and its members are bound by actions of the partnership representative in dealings with the IRS
  • The elections or opt-outs that the partnership representative may make
  • That the designation for a partnership tax year remains in effect until the designation terminates
  • The partnership being held responsible for remittance of additional tax rather than individual partners being taxed
  • Current partners may be held responsible for the tax liabilities of prior partners
  • A disclosure that the taxes, interest and penalties would be calculated based on the highest tax rates

Observations

The 2018 IRS Data Book published in May 2019 accounts for the number of IRS examinations in 2018 of the 2017 tax year. Out of the 195 million tax returns filed in 2018 for the 2017 tax year, only 8,945 partnerships were selected for audit. Compare that with the 892,187 of individual tax returns audited, and it is clear to see that the IRS saw little benefit in pursuing audits of nontaxable partnerships. The question arises of whether we will see the IRS increase the number of partnership examinations for 2018 and future tax years.

Conversely, IRS audit rates are dropping overall due to a shrinking IRS budget. Examinations decreased by one-third in the past five years, down to only 0.5% of all tax returns filed. This decrease is anticipated to continue to trend lower. With such a low likelihood of an IRS examination, fund managers will want to ensure that their LLC operating agreement language is up-to-date for their changing responsibility but will not need to be overly concerned about being selected for an audit.

About the Author:

Beeta Lecha is a principal at Spiegel Accountancy Corp. She leads the Taxation and Fund Accounting practices. Lecha has 13 years of private equity and alternative investments experience, primarily focusing on private lending and real estate funds. In addition to fund accounting and investor reporting, Lecha provides tax strategy, tax planning and tax compliance for fund managers and real estate investors. Lecha is a member of the American Institute of Certified Public Accountants (AICPA) and the California Society of CPAs (CALCPA). She serves on the Education Advisory Committee of the American Association of Private Lenders (AAPL).

 

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.