Year-End Tax Planning Webinars for Funds and GPs | Part II

Lisa is a partner in our private client services group. She serviced family offices and high net worth individuals for many years focusing on financial services, real estate, private equity, and small businesses. We're going to start with Lisa and then we'll go to Miri, who is a partner and leader in the national tax controversy and dispute resolution practice. Miri and her team spend 100% of their time addressing IRS matters for taxpayers including IRS exams, appeals matters, penalty abatements, and private letter ruling requests with strong success. We're going to start with Lisa and then shift over to Miri.

Lisa Cappiello:Thank you, Jeff. Hello everyone. Thank you for joining us today. As Jeff mentioned, I'm Lisa Cappiello. I know many of you are here today for CPE credits, but we are going to cover a lot of topics and give some really good examples, so I hope you have some great takeaways. As we come to the close of the year, tax planning is always at the forefront of our minds. It's really important that you don't look at tax planning in a vacuum. You want to look at not only the current year, but you want to also look at the upcoming years. It's critical to understand your own fact pattern as well.

Effective tax planning if done properly, can not only save you taxes in the current year and future years, it can also maximize funds available for your retirement, it can reduce estate taxes and it can help you manage cashflow. So what do you think of when you think of tax planning? Everyone thinks let's defer income, but I want to point out that may not always be the best answer. You want to take into consideration the possibility of higher tax rates. Maybe there's a life change that's happening. Are you getting married or is there a divorce pending? Maybe you're going to sell your principal residence or a second home and possibly some of your investments are anticipating realization events in the upcoming years. And lastly, are you planning on relocating to a lower taxing or no taxing state? These are reasons why you do not want to defer income.

So what can we do for tax planning? Passive activity losses, that's a great planning tool. What is a passive activity loss? It's a trade or business activity in which you do not materially participate. There are seven tests, but generally if you spend greater than 500 hours than you materially participate. Also, material participation is where you're involved in the activity on a regular, continuous and substantial basis. And the IRS considers rental activities to be passive unless of course you qualify as a real estate professional and for that you have to spend more than 750 hours.

So what are the passive activity loss rules? Basically, if your passive activity losses exceed your passive activity income, they're disallowed in the current year and these losses can be carried forward indefinitely until future years when you either have passive income or you fully dispose of the property. So many investors have these passive activities and they may have been generating losses which now have substantial passive activity loss carry forwards and you can use this in tax planning.

Jeff Parker:That's great. So Lisa, can you give us some examples of ways that we can use passive losses to do year-end planning?

Lisa Cappiello:Yes. If you're in a high income tax year this year and you dispose of your passive activity, what'll happen is not only will you be able to deduct the current year loss, you'll also be able to deduct any suspended passive activity losses and the loss on the disposition. They'll all be deductible in the current year. Also, you'll get the benefit of the reduction in your net investment income tax. What I want to point out is though you must dispose of the entire interest, it must be in a fully taxable transaction and it has to be with an unrelated party. So that's one way.

Another way is to transfer this passive activity by gift to a family member or trust. The disallowed passive losses are not deductible, but instead they increase the donee's basis in the property. And so when the donee sells the property, the gain on the sale of that property is then reduced. One important thing to mention here is that the basis is limited to the fair market value at the time of gift.

Jeff Parker:Lisa's going to give a series of examples, and what she's going to do is she's going to say what you shouldn't do and then what you should do instead.

Lisa Cappiello:Here we have Ill-advised taxpayer, he gifts the stock, it has a basis of $14,000. It has a suspended passive activity loss of $25,000. It's worth $39,000, but the stock at the time of the gift has a fair market value of $15,000. So the transfer gets the stock, sells the stock for $15,000. You would expect now with a basis of $39,000 that they would have a loss of $24,000. But unfortunately since the basis to the transferee is limited to the fair market value, the basis is only $15,000. And in this scenario, no loss is recognized by the transferee and neither the transferee nor the transferor get to benefit in this suspended passive activity loss.

Jeff Parker:What would've been a better way to do this?

Lisa Cappiello:So with this fact pattern, what should have happened was the taxpayer should have sold the stock, taken the benefit of the $25,000 suspended loss carry forward and then gifted the money.

Jeff Parker:Nice. When would gifting of passive activity loss investment work?

Lisa Cappiello:Again, using the same fact pattern, the stock has a basis of $14,000. It has a suspended passive activity loss of $25,000, but now the fair market value is $40,000. So at this point the donee is going to sell the property for 40,000 and they get the benefit of the increased basis of $39,000 and they only have a gain of $1,000. So that's when the fact pattern works.

Jeff Parker:Well done. So one thing we're going to apologize in advance is we tax people love to talk in code sections. So we're going to try not to do that and try to explain what they are, but it's a little unavoidable, but we'll do our best.

Lisa Cappiello:Another tax planning technique is looking at 461(l) limitations. This is a limitation on excess business losses for non-corporate taxpayers. The implementation of the 461(l) limitation finally took effect in 2021 and will remain in effect until 2028. It applies to non-corporate taxpayers, meaning individuals, estates and trusts. And what happens is it limits the amount of trade or business deductions that can offset your non-business income such as your investment income, your wage income. So it's really important for you to understand these 461 limitations and how they impact the current and future years.

How is this excess business loss calculated? Basically, it's the excess of your aggregate trade or business deductions over the sum of your aggregate trade or business income or gain plus the index limitation or the threshold amount. And for 2022 that was $540,000 for married filing joint. And in 2023 that has now risen to $578,000 for married filing joint and $289,000 for other taxpayers.

Jeff Parker:So we're starting to get a ... oh, sorry.

Lisa Cappiello:Sorry. So even if you satisfy your basis limitations and your at-risk limitations and your passive activity loss limitations, this 461(l) may now significantly limit your business losses too. And if your excess business loss is above that threshold amount, that loss is then carried forward as an NOL, which can be used to offset taxable income in a subsequent year. But of course NOLs have their own set of rules and basically an NOL can offset taxable income in the current year of up to 80%. Any unused NOLs of course can be carried forward indefinitely.

Jeff Parker:Great. So note that since these are excess trade or business losses, different rules are going to apply to investment partnerships and other entities. So tell us how this would apply.

Lisa Cappiello:Right, so as Jeff mentioned, these are trade or business losses. So what entities does it apply to? It would apply to management companies, it would apply to trader funds and 475 funds and it would also apply to their GP entities, but it does not apply to investor funds or their GP entities.

Jeff Parker:Now one thing to remember is material participation doesn't matter. So you're subject to 461 even if you invest in a trader fund that you don't run and remember that most if not all of the income and loss on a trade or business K-1 is subject to these rules. So not just particular lines, almost every line item. How do the 461 loss limitation rules and the net operating loss rules work together?

Lisa Cappiello:Great. We have a very simple example. In 2022 we have unhappy Sam and Sally, they have business A that generated $5 million of trade or business income and business B that generated $15 million of trade or business losses. So net they have a $10 million trade or business loss in 2022. 461(l) now limits that loss to $540,000, the threshold amount. So you now have $9,460,000 excess business loss that's carried forward to 2023 as an NOL.

As with Sam and Sally, many investors were not aware of this rule and did not plan appropriately. And so taking it now one step further in 2023, Sam and Sally are very happy. They're projecting $9 million combined trade or business income. So they think, "Okay, we have $9,000,460 NOL carry forward as a result of our 461 limit in 2022. So we should end up with no taxable income in 2023." But unfortunately, as I mentioned, NOLs are allowed to offset only 80% of current year taxable income, which is $7,200,000. So that leaves them with 2023 taxable income of $1.8 million. It's basically 20% of your current year taxable income. Of course any remaining NOLs are carried forward, but you cannot utilize them in the current year.

So it's critical for you to understand the application not only of the 461(l) limitation but then of the subsequent NOL limitations, and poor planning can cause taxpayers to significantly underpay their estimates and their extensions and that could lead to penalties and interests. And as interest rates rise, so do the penalties and interest.

Jeff Parker:I know these are all federal concepts. What do we need to worry about with regard to specific states?

Lisa Cappiello:These excess business loss limitation rules under 461 were originally set to be implemented in 2018, but the Cares Act suspended it until 2021. So it's really important for you to understand what states conform and the dates that they conform in order to plan appropriately.

Jeff Parker:And that's really the thing. Whenever there's a rule, our first thought is how can we use that rule for planning? So specifically, Lisa, what can we do for planning around section 461 limitations?

Lisa Cappiello:If you had a 461(l) limitation in 2022 and now coming into 2023, you have an NOL, the first thing you want to try and do is utilize the entire NOL and not get bit by that 80% rule. So what can you do? You can harvest gains in 2023. Maybe if you're self-employed, you can take additional income or postpone payments of expenses. An employee possibly you can move a January '24 bonus into December of '23 to ensure additional wages, or maybe if you were planning on making large charitable donations you could postpone them to the next year. These are ways to increase your income for a NOL in 2023.

But in 2023, if you think you may end up with a 461(l) limitation, what can you do to plan around that? The first thing you want to say is I need to postpone any trade or business deductions or losses. I would try to harvest trade or business gains within my fund, preferably short term. But if you still can't get around these 461(l) limitations, you want to make sure that you sufficiently pay in your estimates and your extensions so you don't have any underpayment penalties.

Jeff Parker:And of course if you're going to have more tax and you're in a state where you're able to be part of the pass through entity tax rules, you're going to want to take that into consideration and you're going to want to look at how your PTET estimates work in the interplay with what 461 is going to limit you and what taxes are going to have.

Lisa Cappiello:Yeah, that's a great point because if you have a 461(l) limitation in 2023 and you're moving into '24 with an NOL, do you want to make a PTET tax election in 2024? So those are things you want to consider and we're due for a polling question.

Bella:Poll #2

Jeff Parker:Thanks, Bella. Just as in advance once we're done, the next slide is going to be qualified small business stock, which is known as QSBS and also known as yet another code section, section 1202. So if you ever hear the buzzword section 1202, that is qualified small business stock and that will be coming up later today.

Lisa Cappiello:Thank you. And as Jeff mentioned, QSBS. So when the tax rates for C corporations were reduced from 35% to 21%, the choice of entity for C corp rose, a lot of people chose C corporations. This enabled your savvy investors to focus on this section 1202 qualified small business stock gain exclusion. And I want to point out that none of the recent tax laws have reduced these benefits. So it looks like it's going to be sticking around at least for a little bit, and also potential increases to the capital gains rates makes this benefit even more significant.

So what is the benefit of section 1202? Well, it allows taxpayers to avoid paying taxes of up to 100% of the taxable gain that's recognized on the sale of this QSBS stock and the current exclusion is the greater of $10 million or 10 times the aggregate adjusted basis of the stock at the time of issuance.

Jeff Parker:Great. So it's important to know whether the stock itself qualifies. So while on the one hand you want to do your own due diligence and you're going to be responsible for that, the way that you can save a lot of time is to go back to the corporation because if you're trying to figure out whether the stock qualifies, most likely there are other shareholders, maybe even larger shareholders that have already done this research. So you always want to go to the company and try to get as much information as you can.

Lisa Cappiello:Exactly, because there are certain things that the C corp must do in order to qualify. So here they are briefly, it must be a domestic US C corporation and the stock must be sold while the issuer is still a C corporation. It must be acquired on original issuance after August 10th, '93 directly from the corporation. Also, it must be stock for federal income tax purposes, which means it could be voting or non-voting, common or preferred, but non-vested stock that's subject to substantial risk of forfeiture under section 83(b) is not considered stock until it either vests or a timely 83(b) election is filed.

What are the eligible shareholders? Individuals, trust and pass through entities can all qualify for this exclusion but not C corporations. Another requirement is the aggregate gross asset value of the issuing C corp must be below $50 million at all times before and immediately after the issuance of this QSBS stock, and the QSBS stock must be held for more than five years to get this exclusion. One other criteria is the issuing C corp must use at least 80% of the fair market value of its assets in the active conduct of one or more qualified trade or businesses.

So what's a qualified trade or business? Well, it's any business other than those specifically excluded. And I listed on the slide here some different types of excluded industries. One thing I do want to mention is redemptions. You should always be aware of redemptions because they may disqualify a 1202 treatment even if those redemptions were before the issuance of the stock.

What are planning techniques, QS that may be for people to consider? So do you want to exercise a stock option and take advantage of this QSBS exclusion? How successful do you think the corporation will be? You want to think about that before you exercise your stock option. And also what is the cost to exercise? You have to pay now and you can't sell the stock for five years. So that's a consideration. Also, what happens if you sell the stock before the required five-year holding period? Well, section 1045 rollover planning allows you to reinvest the sales proceeds in other QSBS investments and continue your holding period.

So how can you use tax planning to increase this QSBS gain exclusion? Well gifts. Gifts is a perfect way because the person receiving the stock will receive the same treatment as a donor. They get the same basis, the same holding period. So here's a perfect example. A mother buys QSBS stock, she gives some to each of her children and all three of them hold this for greater than five years. They'll each benefit from this $10 million exclusion. So this has now multiplied the benefit. Keep in mind there may be gift tax consequences with respect to gifting of qualified small business stock.

There is one thing that I think we skipped a slide that's really important to go over. Yeah, it got out of order, is the different exclusions under qualified small business stock. So earlier when you acquired stock during the earlier periods, the exclusion was only 50% and 75%. And there was also an AMT adjustment required, so 7% of that excluded gain in the 50% and 75% exclusions were required to be added back for AMT. But after from September 28th, 2010 to present the exclusion is now 100% of the gain and there are no AMT adjustments.

I want to again state that this exclusion is limited to the greater of $10 million or 10 times the adjusted basis of the stock at the time of issuance. So here's a little example that demonstrates how beneficial this exclusion can be. So you have your savvy investor who buys USA Inc stock on January 1st, 2012 for $2 million in cash. On December 5th, 2018 he sells the stock for $22 million, so he realizes a gain of $20 million.

At the current rates, the federal tax alone would be $4,760,000. And if this qualified for a 1202 stock, 100% of that $20 million would be excluded. It's basically the greater of $10 million or 10 times the initial basis, which is $2 million. So it's really a great exclusion factor.

I do also want to briefly mention states again. It's always important to think about states, because some states conform, others do not. Some conform but modify the benefit, and others conform as of a specified date. So I'll give you an example. California does not allow section 1202 exclusion. New York does, and Massachusetts non-corporate taxpayers in Massachusetts can take the exclusion for sales now on or after January, 2022. So these are things to consider with respect to qualified small business stock.

Jeff Parker:Lisa, don't forget, New Jersey also does not allow 1202.

Lisa Cappiello:Exactly. Thank you for mentioning that. Now we're going to move into another planning tool which is qualified opportunity zones. So what's a actually qualified opportunity zone funds? it's organized to invest in this qualified opportunity zone property. It's either a partnership or corporation for federal income tax purposes. And what's great is currently there are designated QOZ zones in 50 states, the District of Columbia and five US territories.

Jeff Parker:What types of gains are eligible for deferral?

Lisa Cappiello:So eligible gains can either be both capital and qualified 1231 gains. They have to be recognized for federal income taxes before January 1st, 2027 and it can't be in a transaction with a related party. But what's great is these gains can be derived from the sale of stocks, bonds, real estate or partnership investments. They have to be timely invested in a QOZ qualifying investment within 180 days of realizing the gain.

So what are the benefits of a QOZ fund? You get a temporary deferral of realized capital gains until 12/31, 2026. Also, you have the potential basis adjustment of 10% if you were in the fund for five years or 15% if you were in the fund for seven years. I do want to point out this is currently not available for QOZ investments after 12/31, 2021 because we run out of the time because we end at 12/31, 2026. But you still have the deferral of the realized gain until '26 and there is a permanent exclusion from taxation for the appreciation of the interest in the fund if you hold it for at least 10 years.

Jeff Parker:Like pretty much everything else we've talked about today, the state rules depending on the state can be very different than the federal rules. So can you help us a little bit on some of the state conformity here?

Lisa Cappiello:Yeah, you want to understand the state conformity because the federal may defer this realized gain, but the state may not. So you want to take that into consideration when you're paying your estimates, your extensions for the states. For example, California does not conform. New York previously conformed, but New York has decoupled from qualified opportunities zone program for tax years beginning on or after January 1st, 2021. I do want to point out though that they still allow the permanent exclusion of the appreciation if you hold it for at least 10 years.

Jeff Parker:One thing also we just want to clarify is for QOZ, when we're talking about the state rules, we're talking about the state where the taxpayer lives. We're not talking about the location of the property. So you don't have to worry when you make the investment that investing in a different state is going to have a different set of rules. It's the state where you are.

Lisa Cappiello:Exactly. And so it's really important as we have been stressing that you understand the state taxes, especially with this type of tax planning because here you can be subject to double taxation. So I'm going to go over a brief example. I put it on the screen over here. Basically in 2022, the taxpayer is a New York resident, he decides to invest in a qualified opportunity zone. For federal tax purposes, that gain is deferred. But now since New York has decoupled from it, it's taxable to New York, so it's an add back.

A few years later in 2024, the taxpayer now moved and is a Georgia resident. They decide to dispose of the investment in this qualified opportunity zone fund. So what happens is the original gain, the original deferred gain is now taxable to the federal. And since Georgia conforms with the federal rules, it's also taxable to Georgia, but you don't get an offsetting credit from New York. So what has happened here is you pay tax to New York in the initial investment year and now you're paying tax to Georgia in the year that you sell it. So this is not a really great planning technique. So you want to really understand your fact pattern.

What other planning ideas are there? We still have bonus depreciation, although it's no longer 100%. In 2023, it's now 80%. And keep in mind, the remaining 20% is still depreciable. They have now included used property which has been significant and favorable from our previous rules. You can consider 179, but you need to understand the net income and the annual limitations when using that. And again, we want you to understand the importance of seeing which states have decoupled from bonus depreciation.

Jeff Parker:Right. One other thing we just want to mention is beyond the concepts, some of the states calculate things differently. So as an example, New York has a series of add-backs and subtractions that work separately. So when there's a bonus add back, you have to look at how it works with the passive loss rules. You have to look at how it works with 461. So the best thing to do is to model it all out, to have your accountant help you with using tax software or another technology tool to make sure that it's acting the way you think it's going to act.

Lisa Cappiello:Exactly. And so that brings us to our polling question number three.

Bella:Poll #3

Jeff Parker:Thanks, Bella. Also, just want to acknowledge we've gotten some great questions so far and I think what we're going to do just to keep things flowing is we're going to finish up with Lisa's topics. Then we'll get to some questions before we move on to Miri. And our next area we're going to talk about is going to be other tax planning considerations.

Lisa Cappiello:Thank you. So as Jeff mentioned, what else is there that we can consider? So if this year is a higher income year, of course you now want to defer your income. How can you do that? Well, maximizing your retirement savings is always an easy thing to do. The 401k limits now for 2023 are up to $30,000 if you're 50 or over and they're moving to 30,500 in 2024.

Also, the Secure Act 2.0 was enacted December 29th, 2022, and this expanded your retirement savings and they are a lot of different rules that now provide for greater savings. Another consideration, which is a great one, is you could satisfy your I-R-A-R-M-D through a qualified charitable distribution. In 2023, the amount of that was $100,000 per year and beginning in 2024, this amount is now indexed for inflation.

What's so good about that? Well, number one, the RMD is eliminated from income which reduces your AGI floors. It's not an itemized deduction and there's no charitable deduction limitations. What else? Roth IRA conversions. When do you want to do that? So you want to ask yourself, will your tax rate be higher when you retire? Is your taxable income in the current year lower? Maybe your IRA accounts have lost money. Or another thing to consider is do you plan on leaving this money to beneficiaries? Because if so, if you do a Roth conversion now and pay the tax, that money will be left to the beneficiaries and they will not have to pay tax on that.

Jeff Parker:Great. An additional tax saving strategy is what's called the backdoor Roth conversion. And this is we take advantage of a little wrinkle in the law. So effectively there are income limitations. You can't contribute to a Roth if you make more than a certain amount, but there is no income limitation in converting to a Roth. So what people can do is make a regular IRA contribution and then immediately convert it to a Roth. They do that before the IRA has any profit and therefore when they convert it to the Roth there's no taxable income.

But the important thing to remember is you can't pick and choose. While you can pick and choose which of your IRAs to convert, for tax purposes it looks at all of your IRAs. So this really only works in a circumstance where someone does not have any regular IRAs. So if they have none whatsoever and then they make a non-deductible IRA contribution, they can immediately convert it to a Roth. And you also have to be careful because a lot of people along the path of their careers may have a 401k that they left their job and they contributed, they moved their 401k over into a regular IRA. So maybe prior to doing that they were able to do a backdoor Roth conversion. Now that they've got a regular IRA that their old 401k money, if they do future back door Roth conversions, it would actually trigger tax. So you really want to be careful before you do this.

Lisa Cappiello:Exactly. That's why I can't do it. Anyway, moving forward, what else is there? So there are health savings accounts. This is an easy one because money grows tax-free and it can be carried forward. So for 2023 for a family you could put away $7,750. Plus if you're 55 or over an extra $1,000, so that's a freebie.

1031 exchanges, these are still great. Of course they only apply to real property, but you can defer paying taxes on the gain, which allows more capital to remain invested. You do want to be cautious. There's time requirements here for identifying the replacement property, 45 days from the closing of the first property, and ultimately completing the purchase, 180 days. And you must use a qualified intermediary.

What can you do with these 1031 exchanges? There's two different things, you could do wealth building, you could defer your capital gains tax liability and use this strategy over and over to defer it indefinitely building your portfolio and growing your wealth. Or another really great strategy is wealth transfer, because the beneficiaries inherit the property in the 1031 exchange and no taxes due until the property is sold. So if you do this correctly, the property is stepped up to fair market value at the time of death. And then you could eliminate the tax liability on the deferred gain altogether if done properly.

You can also harvest capital gains. As we talked about in 461, if you now have an NOL, you would want to harvest your capital gains. Or if you have current year 461(l) concerns, you want to harvest, trade or business gains. It's important to note that it's trade or business. Or if you have a very high income year, you want to harvest losses. So it all depends on your own fact pattern.

A few more things are installment sales. This could help you defer tax on gains currently. And you have tax-free capital. One other thing that people do, which is really great is donating appreciated long-term property to a qualified charity. So you avoid paying tax on the capital gains, you get a fair market value deduction for your charitable donation and the gift is increased by 23.8% if you don't sell it first and then gift the money. So it's really a great planning tool.

One other thing to mention is bunching charitable donations. Some people want to take all their charity in one year and then look at the standard deductions in other years. That's really a good planning tool, but you want to be aware of AGI limitations for different types of contributions and different types of charitable organizations.

Jeff Parker:Fantastic. Lisa's got one more slide to go and she's just going to talk about some final thoughts to consider and then we'll be able to get to a few questions.

Lisa Cappiello:Exactly. One thing I want to point out which is really important is you want to take advantage of the increased federal exemption for estate tax planning purposes because it's sunsets at the end of 2025. We're already almost in 2024. It's up to $12,920,000 for '23, estimated to go up to $13,610,000 and $14,160,000 by 2025. So you want to revisit your estate plan to ensure you're taking advantage of this.

Also, are your documents up to date? Are your wills and forms current, signed and notarized? And one other thing, are the beneficiaries that are listed still alive or are they the ones that you want to get the money? And two other things I want to just quickly mention are your annual exclusion gifts. Those are really great. You have $17,000 you can give away without any implications in 2023, it goes up to $18,000 in '24.

Lastly, you can always make direct payments on behalf of another person for medical expenses or tuition without even that counting towards your annual gifts, your GST or estate tax exemptions. So these are really great planning tools and as you can see, we've covered a lot of planning ideas here, but we do want to stress that the best tax planning is when you consider not only the current year but your future years, you take into consideration your own personal fact patterns and you look at the state implications. So thank you all so much for joining us today. Jeff, back to you.

Jeff Parker:That was fantastic. We've got a few minutes to answer a few questions. We've gotten a lot of great questions and anything we don't get to now, we'll get back to people later. But let me give you a few, Lisa, just going back chronologically from the beginning. So one of the questions we received is, "Can a taxpayer transfer a passive activity owned by both spouses into an LLC also owned by both spouses and keep their passive activity loss carry forwards?"

Lisa Cappiello:Read that again? So the passive activity loss is owned by both spouses?

Jeff Parker:That's right. And they want to transfer it into an LLC that's also owned by both spouses. And what would happen with the passive activity loss carry forwards?

Lisa Cappiello:It's interesting. When you transfer a passive activity loss, if it's transferred by gift, remember what happens is the passive activity suspended losses now increase the basis. So it all depends on whether it's transferred by gift or if you're making a contribution. So I would want to look at the fact pattern to ensure that it works.

Jeff Parker:Right. Most likely it will work though if it's spouses because there's unlimited gifts between spouses not only while they're married, but also in preparation for a divorce.

Lisa Cappiello:Exactly.

Jeff Parker:We also have a 1202 question, "I have a 1202 stock held in a partnership. What are the basis consequences?" So does the unrecognized gain increase their basis so that you don't have tax when you distribute it?

Lisa Cappiello:The 1202 stock in the partnership, what happens is that stock, the basis limitations, it's not done in the partnership, it's looked at by the owners of the partnership. So it moves down to the individual and then you calculate everything and the limitations at the individual level. If any of these questions are not answered to your satisfaction, please feel free to reach out to any one of us and we'd be happy to elaborate more on the questions.

Jeff Parker:Another question we received is, "What are examples of things that would qualify under bonus depreciation such as an automobile? Does that qualify?" So if the company purchases a car.

Lisa Cappiello:I don't know offhand, but I believe Jeff, if it's used for business-

Jeff Parker:I think that's right. You also have to look to see whether it's listed property. So there's some rules that say because cars lend themselves to personal use, there are better rules for things that are not called listed property, including there's some weight variations. And it's funny, some of the big luxury SUVs that weigh more, the rules are actually more beneficial. And I think that some of the car manufacturers were actually making some of the vehicles intentionally heavier so that they would be able to get an advantage.

Lisa Cappiello:Exactly. You do have listed property issues to consider as well.

Jeff Parker:Okay, so now we're going to move and finally somebody asked if there's a recording will be available. I would actually ask that question to Bella.

Bella:Yes, the recording will be available following the webinar. You'll receive a link a few minutes after the conclusion. So yes, it'll be recorded.

Jeff Parker:Great. Thanks a lot. Now we're going to turn things over to Miri Forster. Miri, if you want to jump in and go to the next slide. Just want to reintroduce Miri, she's the head of our tax controversy group and a really valuable asset to our firm and our clients. And what I would say as far as tax examinations is it's not a do it yourself project. You should not represent yourself for an audit any more than you should give yourself a haircut. So it's really important to work with a professional like Miri, who knows the rules, has years of experience and can represent you in front of an agent in a calm and productive manner. So Miri, why don't we talk about the initiatives a little bit that are being released by the IRS?

Miri Forster:Sure. And thanks, Jeff, for the very warm introduction. I'm really glad to be here today. So the IRS's new fiscal year, which just started October 1st, marks year two of increased funding provided by the Inflation Reduction Act. The funding is being used to ramp up the IRS's workforce so that it could increase enforcement. And the agency intends to hire 3,700 people nationwide to help expand its review of large partnerships, large corporations, high net worth individuals, and also to focus on abusive transactions.

Another thing that the funding's being used for is to improve technology so that the IRS can better identify taxpayers with the highest compliance risk. Now, when you look at their fiscal year 2024, the IRS is already committed to continued emphasis on partnerships. It's opening examinations of 75 of the largest partnerships. So think your hedge funds, your private equity funds, your REITs, your publicly traded partnerships, law firms and others.

And back in '21, the IRS through this large partnership compliance program, they opened exams of about 50 complex partnerships. They were trying to better understand the structures and the tax strategies that the partnerships were using. Now they're continuing those efforts with the new selections, but what they've also tacked on is the help of data analytics and AI, and the IRS hopes that their investments in advanced technology tools is going to help them select the best cases with the highest returns.

The other thing that's happening is the agency is sending notices to about 500 partnerships where they see balance sheet discrepancies. And these notices, they asked the partnerships to explain why an end of year 2020 number on the balance sheet may not match a beginning of year 2021 number. Or they may ask that why the balance sheet in total assets doesn't equal total liabilities and capital. I mentioned this notice because it requires a response, either a detailed statement explaining the discrepancy or a corrected partnership return with an explanation. If you fail to respond, you should expect further inquiry from the IRS.

Another development at the service is the formation of a new work unit within the large business and international division, and that's the division that deals with taxpayers with assets greater than $10 million. So this new work unit is going to be focused on pass-throughs. It's expected to stand up later this year. So S corporation should get ready for more attention from the IRS also.

Now of course, the IRS is also looking at individuals in response to criticism that it's been focused on low income taxpayers for too long. It's now increasing its audit coverage of high income taxpayers. And one of the ways it's doing this is to triple the size of its existing global high wealth program. That program, some of you may have heard of it called the Wealth Squad before, has been around for many years. They typically examine a high net worth taxpayer and they tack on three or more related pass through entities at the same time.

Now revenue officers are also out in full force. They're pursuing high income taxpayers with over $1 million in income and with more than $250,000 in outstanding tax debt. The IRS collections divisions, they're in the process of contacting at least 1,600 high wealth taxpayers to what they say collect hundreds of millions of dollars of outstanding taxes. And already just in the small amount of the fiscal year that started, they've closed about 100 cases and they've collected about $122 million. So they're quickly seeing their collection efforts pay off. So if you owe taxes, expect a knock on the door soon.

And then the last initiative that I want to focus on is the IRS continues to be focused on abusive transactions. Many are emerging. They've recently started initiatives to crack down on the fraudulent employee retention credit claims. Taxpayers are encouraged to have their claims reviewed by a trusted professional advisor. If anyone's discovered that they claimed it in error, there's actually two programs that have been announced. One is a voluntary withdrawal program and it allows taxpayers to withdraw the amended returns with the erroneous ERC claims so long as they haven't been processed or paid.

And separately, if you've already received the payment on an ERC claim that you think was incorrect, there's an ERC settlement program, the terms of which should be announced shortly, where you can return the funds to the IRS and hopefully minimize penalties and future compliance. So in summary, a lot of new initiatives at the IRS for the upcoming year across various taxpayer types.

Jeff Parker:Great. Now one thing we've noticed is that the agents themselves are getting much more sophisticated. And what we think is happening is similar to the SEC, the IRS is bringing in people out of industry who have years of practical industry experience. And these people know the partnership rules, the taxpayers industries, the financial services industry as an example. So the old days of a fund or a management company or a fund manager's 1040 getting audited by an agent who comes from what I like to call the restaurant and shoe store area is no more. So we're actually getting the really sophisticated agents who really understand the industries. So can you tell us a little bit, Miri, about some of the areas where the IRS is spending its time when they're doing the examinations?

Miri Forster:Sure, and you're absolutely right. The examiners are getting more sophisticated, especially with the lateral hires that are specialists from industry and they're asking very specific questions in a number of areas. One current focus area is the tax treatment of digital assets. They've been looking at this since 2018 when they announced a virtual currency compliance campaign. At that time, they sent notices to taxpayers to try to educate them on the tax treatment of cryptocurrency transactions.

They wanted to encourage non-compliant taxpayers to amend their returns. And they started examinations to make sure that transactions any gains were being properly reported. Those examinations are continuing to ramp up. And in addition to the proper tax treatment, the IRS now has its eye in foreign cryptocurrency accounts and taxpayer compliance with AFR and FCA filing requirements as well.

To show that they're serious, last year the IRS started a new digital assets office within the IRS. It has a dedicated project director and somewhere between half a dozen and a dozen people dedicated to identifying strategy and priorities related to the tax treatment of digital assets. Since that office was formed, the IRS has issued several FAQs to help with the tax treatment in this area. They've issued guidance on non-fungible tokens, on the tax treatment of staking rewards and most recently very detailed proposed regulations on broker reporting that's going to give the government and taxpayers more transparency on crypto transactions.

The other thing left on digital assets that I want to cover is just, it's been a few years, the individual income tax returns have been asking about whether taxpayers have participated or engaged in digital asset transactions. New for 2023, a similar question has been incorporated into the draft returns for C corporations, S corporations, and partnerships. So there's a lot going on in that area and I expect more to come.

The other area where we're seeing an uptick in exams is in real estate professionalism. Lisa briefly mentioned early on in the presentation about qualifying for real estate professional status, you have to satisfy a 750 hours test. There's a 50% test, there's a material participation test, and only if you materially participate or you're going to have non-passive activities, not subject to passive activity loss limitation rules or the net investment income tax. But if you don't, obviously you're going to lose all those benefits.

The determination of whether someone's a real estate professional, it's a determination based on the facts and circumstances. It's not an election. And the IRS is asking very specific questions for documentation to demonstrate that those tests have been met. They want to see calendars, they want to see journals, they want to see other written documentation. And taxpayers without the documentation to support their real estate activities are being denied these real estate professional status.

So that's another area. And then a third area where the IRS is paying a lot of attention is to taxpayers claiming large non-cash charitable contribution deductions. The IRS is challenging the valuations of the assets donated. They're looking very closely at the appraisals, whether they've been attached to the tax return for certain contributions, whether they've been signed off by a qualified appraiser also.

The IRS also wants to see contemporaneous written acknowledgements from the donees stating that no goods or services were provided in exchange for the donation. And taxpayers who are even unable to satisfy even one of the elements are at risk of having their non-cash contributions disallowed. And then there are also some abusive transactions on the horizon. One new focus is on art donations where high income taxpayers are being persuaded by promoters to buy art at a very large discount, wait a year, then they donate the art, they take a deduction for the art at a much higher value. And tacking onto those as they've done in many years, the IRS continues to pursue taxpayers that have invested in abusive syndicated conservation easements and micro captive transactions. So lots of good stuff going on already.

Jeff Parker:Okay, we have another polling question.

Bella:Poll #4

Jeff Parker:Thanks, Bella. This is our final polling question, but don't leave yet because there's definitely some more interesting things to talk about

Miri Forster:Including SECA tax campaigns, so don't leave yet.

Jeff Parker:That's right.

Thanks, Bella. So as we go to our next slide and we talk about SECA, just want to explain what that is because sometimes people know that by other terminology. That's the self-employment tax and really there's planning that is sometimes looked at regarding, as an example, a management company that is formed as a limited partnership or an S-corp that's not subject to self-employment tax. And there's a lot that's being looked at there. So that's what SECA is. And we know, Miri, the campaign's been going on for a really long time. So I really just want to ask you about the status of these cases and we expect resolution anytime soon.

Miri Forster:Thanks so much. Yeah, the campaign has been going on for a long time. I feel like I've been tracking it for a long time. The IRS is specifically focused on asset managers set up as state law limited partnerships. And within those state law limited partnerships, the limited partners, they typically receive a guaranteed payment for services and they pay self-employment tax on that. But they also claim an exemption from self-employment tax under section 1402(a)(13) of the code on their distributive share of income.

And the IRS takes the position that if a limited partner is active, all of his income is subject to self-employment tax and that a bifurcation of that income is not appropriate. The IRS continues to rely primarily on a tax court decision Renkemeyer v commissioner, where the tax court held that an attorney who was a partner in a law firm established as an LLP, not a limited partnership in a state law limited partner but an LLP, was a limited partner because he was active in his law firm.

And there've been some cases also in the LLC context, but currently no court has ruled on whether the SECA exemption extends to a limited partner who both contributes capital and performs services in a traditional state law limited partnership. It's really interesting that this bifurcation being challenged. Like 30 years ago, the IRS proposed some regulations that would allow the exemption where a limited partner spent less than 500 hours performing services. So presumably acknowledging that a limited partner could have both types of income, then Congress put a moratorium on the proposed regs back then and still so many years later, there's no clarity on the issue. The IRS says that taxpayers can rely on those proposed regs, so presumably a 500 hour or less test on a limited partner would be okay, but it seems to be that anything more than that, the IRS is going to challenge.

Now on the campaign, the IRS recently paused new exams in the area, but there's still hundreds of pending cases at exam, at appeals, and even some are in litigation at the tax court. The entire inventory of cases, in my opinion, has been proceeding very, very slowly. But for those cases that are in litigation in tax court now, there are two arguments being raised. The first has to do with the plain language in the statute in 1402(a)(13), and that it's unambiguous. It allows a limited partner in a limited partnership an exemption from SECA tax on its distributive share. And it talks also about guaranteed payments and that being subject to SECA tax.

But the second argument is also interesting in that it's IRS procedural argument. It looks specifically at the partner's role in the partnership, whether the partner is active or passive and says, "That's a partner item, it's not a partnership item. So that determination should be made at the partner level, not at the partnership level." And if the courts agree that it's a partner level item and the partner's assessment statutes have expired, then the government's case is over and the resolution of the substantive matter needs to wait for another case. As I said, I've been closely monitoring these cases, the firm has as well. We're closely monitoring the ones in tax court two, we look forward to sharing more updates and hopefully some clarity on them probably in 2024.

Jeff Parker:One thing we do just want to mention though is with where we are right now, we're still seeing a lot of management companies as an example, forming as limited partnerships. We talked to a lot of emerging managers. We work with several law firms. They still talk about this as well, and still oftentimes form as limited partnerships.

Now, one question we get a lot is what about changing midstream? Formed originally as an LLC, would it be appropriate to a limited partnership? And some people say yes, and some people say no. But one thing that we think is that if you were going to go that route, it's better to do so if you're able to demonstrate a non-tax reason such as an ownership structure change, and also both for ease and for variety of reasons. Doing so at sort of a clear defined time period close, such as beginning of a quarter, even better beginning of the year as opposed to September 12th at 3:00 PM. And then finally, Miri, what other enforcement trends are you seeing?

Miri Forster:Yes, I just want to mention three others. So the IRS is continuing to look at returns where there's a sale of a partnership interest. They want to make sure the gain or loss is reported correctly, as is the character long-term or short-term, depending on how long the interest was held. And they're also looking at basis, and negative tax basis capital accounts is another trigger that we've seen. I mean, partnerships have had to report tax basis capital on their returns since 2020. So now the IRS is taking that information to make sure basis is calculated correctly, that recourse and non-recourse liabilities have been accounted for in those computations appropriately.

It's really an easy way for the IRS to scrutinize loss deductions and make sure that partners are not claiming losses in excess of basis. And then finally, the IRS is looking at large taxpayers with mark to market elections and gains or losses from 1256 futures contracts, foreign currency contracts, and the like. Those types of contracts, they get preferential tracks treatment. So the IRS is sampling the transactions. They want to make sure the contracts are categorized properly and that the taxpayers are actually entitled to the better treatment from them.

Jeff Parker:Great. So as a one slide to go, just wondering what best practices you recommend.

Miri Forster:Yeah, it's a great question and everybody's so busy with so many other things in their businesses. But given the increased focus in so many areas by the IRS, it's really important to be proactive so that you're prepared when the IRS comes knocking. And you can also manage any potential risk upfront. Carefully review your partnership agreements, operating agreements, K one footnotes, anticipate the issues that the IRS might approach you about, especially the ones that we've already mentioned, if they're applicable to you. Make sure you prepare contemporaneous documentation, and if the law is not entirely clear and there's only FAQs, but not regulations or other things to help make sure you document what you've been relying on to get to your positions and maintain documents in a place where they can be easily retained.

I can't tell you how many times an exam starts and the relevant document is in one of a multitude of places or computer systems or the people that worked on the transaction are no longer at the firm and everybody's digging to try to get the documentation and become more fresh. And then when something is selected for examination, make sure you establish appropriate procedures with the exam team. You want the exam to move smoothly. You want due dates for information to be clear and reasonable and you just want a good working relationship with the parties. If you do all those things, if you're proactive, maybe you won't get examined in the first place. Or if you do, at least you'll be better prepared to manage the dispute when it comes up. Jeff, back to you.

Jeff Parker:Great. Just wanted to say thank you to Lisa and Miri for a great presentation. Thank you to our marketing department for all their work and to all of you for tuning in. On behalf of Lisa, Miri and me, just want to say thanks once again and we hope that you'll join us next Friday for our third and final webinar as our SALT team will be talking about pass-through entity taxes in even more detail, state tax updates and residency issues. Have a great weekend.

Transcribed by Rev.com