Financial Services Year-End Tax Planning Webcast Series: Part I

EisnerAmper’s webcast “Financial Services Year-End Tax Planning Webcast Series: Part I,” highlighted important items to consider for year-end planning that impact private equity funds, hedge funds, venture capital funds, family offices, and individuals.

Panelists included:

• Simcha David, Partner-in-Charge, Financial Services Tax Group, EisnerAmper
• Mitchell Novitsky, Director, EisnerAmper

Here were a few items discussed:

IRC Sec. 1061 Carry Incentive

For taxable years beginning after December 31, 2017, a taxable carried interest earned by the GP (an applicable partnership interest) is generally subject to a three-year holding period to qualify for long-term capital gain rates. IRC Sec. 1061 does not apply to qualified dividend income, IRC Sec. 1256 contracts, or IRC Sec. 1231 gains.

One important update: These rules do apply to S corporations, although many litigators think the courts would disagree. Other guidance specifies that distributions in kind are subject to IRC Sec. 1061 (GP needs to continue to hold such shares to satisfy three-year holding period).

On November 13, Tax Notes reported that final regulations are expected to be released by year-end, which should clear up any remaining issues such as the transition rule and the capital account exception.

IRC Sec. 163(j) Interest Expense Limitations

Part of the TCJA, IRC Sec. 163(j) can limit the allowable business interest expense in a given year. The CARES Act increased adjusted tax income (ATI) limitation from 30% to 50% beginning tax years 2019 and 2020 for corporations, but for partnerships ATI limitation increased from 30% to 50% only for tax years beginning 2020. For partners in partnerships, if there is 2019 line 13k excess business interest expense (EBIE), 50% will be deductible in 2020 (without subjecting it to the 2020 IRC Sec. 163(j) calculation.) Elections out of this treatment can be made if not wanted.

An important update: Trader partnerships are not subject to IRC Sec. 163(j) with regard to partners who do not materially participate, as it will be subject to investment interest expense limitation instead. Note the IRC Sec. 163(j) calculation will still need to be done for the general partner. In regards to tiered partnerships, if a lower tier has EBIE, the upper tier will reduce its basis in lower tier by the amount of EBIE but will not report EBIE to its partners. The upper tier will track EBIE and deduct it when there’s excess taxable income (ETI) from the lower tier. For funds of funds, the amount on 13k doesn’t need to be reported to the partners but if it’s been reported in prior years, it should be tracked to free up such prior-year EBIE to be deducted in case there is ETI from the lower tier partnership.

Important updates to the small business exception: BIE (business interest expense) that’s allocated by an exempted small business entity to its partners is not subject to IRC Sec. 163(j) limitation at the partner level (even if the partner is otherwise subject to IRC Sec. 163(j)). Also a partner is allowed to treat carryover EBIE as BIE if in the succeeding year the partnership becomes an exempt entity. An important note: A corporate partner otherwise subject to IRC Sec. 163(j) will have to include investment interest expense allocated to it by an exempt small business as business interest expense, but will not have to retest the business interest expense allocated to it from an exempt small business.

Other guidance included the expansion of the ordering rules, partnership self-charged interest, debt proceeds, and expanded definitions of interest for guaranteed payments and swaps.

How to Calculate, Comply and Report Tax Capital Accounts on Schedule K-1

In 2019 and prior years, partnerships reported partner capital accounts on Schedule K-1 using tax basis, GAAP, IRC Sec. 704(b) book, or other methods. The reporting changes require partnerships to use the tax basis method prospectively. IRC Sec. 743(b) adjustments are not taken into account, but IRC Sec. 734(b) adjustments are included. The opening balances must be either the transactional (tax basis) method, MOB (modified outside basis) method, or MPTC (modified previously taxed capital) method. The ending capital account using tax basis method may not equal adjusted tax basis (outside basis).

Other guidance: Form 1065 Schedule L doesn’t need to be tax basis, non-tax basis relied upon by members, partners, creditors, or management must have Schedule L on tax basis, and Schedule M-2 must be reported on tax basis.

Private Equity and Hedge Fund Considerations Before Year-End

Effectively connected income (ECI) from lower-tier operating partnerships: Sale of partnership interest generating ECI may trigger additional withholding on foreign partners, so computations are needed for the gain as well as ECI associated with that gain. Regarding installment sales, an election can be made to opt out of the installment method in order to accelerate gain (this option is advantageous if gain in current year will be excluded under IRC Sec. 1202.) Other topics discussed were contingent payments and worthless securities. Hedge fund topics regarding year-end planning that were discussed included wash sales, straddles, constructive sales, short sales, and investor vs. trader annual testing.

Latest Updates to State and Local Tax Law

New York City (NYC) sources unincorporated business tax (UBT) service revenue to the location where the services are performed; thus, if services are performed outside of NYC, those services should not be subject to NYC UBT. C corporations (as opposed to S corporations) subject to NYC corporate tax source service revenue based on the location of the customer. In NYC there’s no official guidance relating to telecommuters and their impact on the sourcing of revenues for UBT, and there’s also no “one size fits all” approach. Thus, if an entity’s sole business location is in NYC, the conservative approach would be to source all of the revenue to NYC at this time for estimated tax purposes. At the time the return is due, however, assuming no guidance has been issued, a detailed analysis should be conducted to determine which revenues can be sourced outside of NYC. The burden of proof is on the taxpayer, so if individuals are telecommuting in other jurisdictions, each entity should maintain adequate records.

Another topic discussed was the “convenience of the employer” rule, which states that an employer must withhold NY state personal income tax from all nonresident individuals whose primary office is in NY state, even if they are telecommuting outside the state due to COVID-19.

Most states haven’t issued guidance regarding telecommuting and COVID 19, and there is no uniform approach amongst the states that have addressed the issue.

The entire webcast can be viewed here.