On-Demand Webcast: Financial Services Year-End Tax Planning--Part II

December 08, 2020

Part II of our webcast series focused on tax controversy updates and year-end tax planning for individuals.


Transcript

Thanks everybody for joining today. My name is Stephanie Hines and I am a partner in the personal wealth advisory group here at EisnerAmper. My focus is high net wealth and ultra-high net wealth individuals and their family offices, income and succession planning for both. Now under that definition of individuals and family offices, the majority of the clients that I provide services for are comprised of private equity and hedge fund managers. So this topic as far as planning for GPs is very close to my heart and deal with it on a daily basis.                                          

Stephanie Hines:So what we'd like to do is we have a number of topics to cover. So let's just jump right in and get started on the first one. Proposed regulations on carried interest. Ever since July when the proposed regulations came down, this has definitely been more in the discussion front than not. We'll start off with just going over a couple of the important dates. As we know in or as of 2018 Section 1061, which is your carried interest regulations, or section code, 1061 imposed a three year holding period requirement for certain carried interest agreements, including carried interest and private equity and hedge funds in order to qualify for those long-term cap gain treatment. Otherwise, anything that was held or anything that is held less than three years would be required to be classified into short-term capital gains and taxed at those ordinary rates.

So ever since the statute became effective, that is what we have had to address. And unfortunately, the statute not only outlined the reclassification requirements, but it also left a number of questions unanswered such as what if you have a distribution in kind? What if you sell an outright interest in the partnership and the GP entity? And then what happens if you transfer an interest to a family member? So these are all items that we're going to address in just a moment, just after we get through some of the basics.

So another date, which I'm not going to spend too much time on is as of August 15th of 2020, if you have a PFIC that has been or that makes the election to be treated as a qualifying electing fund, be careful because you may be subject to the same carried interest regime, providing that there is a partner's interest that meets the definition of an a political partnership interest in API, which is essentially your carry interest. And then absolutely the information being discussed here is based on proposed regulations and is subject to change once the final regulations are published. Again, when anytime that there's a final regulation published, we never know what the changes are going to be since there have been some significant changes between the statute and the proposed regulations.

So who are we talking about? So who is subject to Section 1061? So any taxpayer who holds an interest in an API, which is this applicable partnership interest. And I'll be using carried interest and API interchangeably. So again, essentially, the proper definition of an API is defined as your partnership interest in which directly or indirectly is transferred to the taxpayer in connection with the performance of substantial services in a trade or business. So essentially, that is your carry interest. That's your compensatory, your incentive.

For means of this webinar and discussion today, this is the structure that we're really going to be sticking with, this is the structure that we most often see. Where you have a triggering event. You have the GP receives an interest in the profits of the fund, which is in connection with the management company service to the fund. Owners, in this case, A, B and C, they receive their interest in the GP as their compensation. Which is therefore would be qualified as 1061. And that's their carried interest. Now over to the left, you can see that there are LPs also in the fund, they're clearly not going to be affected by Section 1061 and have to consider any of the 1061 reclassification.

So the first question comes down to is if there is or is there a carried interest that is subject to 1061? And that determination is really made at the entity level. Going back and thinking about the structure that we just stated or that I had just shown on the last slide, there are also five exemptions. I'm not going to spend too much time on these, I really just want to address number four, number five, the family office exemption, and then the bonafide, unrelated purchaser exemption, which is third party.

So the family office exemption states that Section 1061 may not include income or gain attributable to any asset not held for portfolio investment on behalf of a third party investor. That's very similar to the capital interest exemption. And it's actually not specifically mentioned in the proposed regulations, it was originally mentioned in the statute. So it's not clear if the capital interest exemption is going to exempt all of the family office structures. We're waiting to hear through the publication of final regulations whether or not that is going to be addressed. So that's definitely an open item.

Now, the bonafide, unrelated purchasers exemption, this is new to the proposed regulations, and it was added in essentially saying that any sale to a third party unrelated person would not be subject to the 1061 recharacterization. Which again, is basically saying that if you pay for your capital interest, then it's not going to be considered incentive. So therefore your long-term capital gains would not have to be recharacterized if held for less than three years.

So now the important part, what is going to be recharacterized? So five exclusions, your 1231 gain or loss, which is your property used in a trade or business. Section 1256, your contracts for marked market, qualified dividends and then your capital gains and losses that are characterized into the mixed straddle rules. Those do not fall under the carried interest regime and are not going to be required to be recharacterized from long-term to short-term. And the regulations are very, very specific about this. So as of now there's no reclassification that's required on those types of capital gains.

So I had mentioned earlier that there were some questions that had been unanswered when the statute had been enacted back a couple of years ago. These are your questions, and the proposed regulations do address them and with clarity, and some examples. So let's walk through these. So the first one, distributed API property. So this is essentially where you've received distributed property from the GP entity. And the question had been whether or not the holding period was going to tack on. Well, the proposed regulations have stated that the asset in the hands of the partner is going to include the partnerships holding period, and is going to have to essentially follow the bouncing ball. You're always going to have a look through for 1061.

So for example, if GP entity distributes Amazon stock to me, and the entity has held the securities for two years, that is going to tack on and it is going to be two years held for me as well. And again, always assuming that this is subject to 1061, I would have to hold that security for another year in order to receive beneficial treatment. So I'd have to hold it for, to get over that three year hurdle in order to reach the long-term. Whereas if I had held it, or pardon me if I had sold it immediately, even though it was two years, which would typically qualify for long-term treatment, because of the entity level it was subject to reclassification, I would then have to reclassify it and treat it as short-term.

Now, just something else to think about on the timing of distributions in kind, is if you receive securities from a GP entity, again, let's use Amazon again, and the same holding period of two years. If I were to turn around and contribute Amazon in order to receive a charitable contribution, you'd still have to look at the timing period of it. So in other words two years, because it's going to be considered short-term, that's ordinary when it comes down to receiving short-term, pardon me, sorry, receiving short-term distributions or short-term holding period. And it would be required that the deduction would actually limit it to cost and not long-term fair market value. So you still have to look down at the holding period.

Disposition of an API, we'll get to that in a minute, we've got a slide that outlines because there's a special rule called the look through rule. So we'll get to that in a moment. Gifting to family. So when you think of gifts, you don't necessarily think of a realization event. However, under the related, sorry. Under the proposed regulations, related persons are defined as family members, whether it's parents, siblings, children or grandchildren, the proposed regulations are now generally treating gifts of API property to family members as a realized event. So that's something to really take into consideration, especially when you're doing your estate planning. Because you don't want to transfer, let's call a portion of the carry interest into, I mean, you typically don't transfer, but into a trust for the benefit of because then you absolutely may be blowing up your estate plan. So it's something to really take into consideration. I don't know if this will change, again, with the final regs, but it's something to think about.

API treatment. Essentially, once an API that's subject to the carried interest rules, always an API subject to the carry interest rules, until one of the exceptions that I had mentioned in a prior slide are met. And that includes after a partner retires, or stop services, or upon going back to a transfer to a family member, you still have to look through to see if it actually qualifies and meets for one of these exemptions. One of the questions had been was if carried interest held by a grantor trust or a single member LLC, was going to be if you look through to the owner, and yes, it does. If the API is held by or transferred to a disregarded entity, again, a grantor trust or a single member LLC, it is going to be deemed as owned by the disregarded entity's owner.

So not going to spend any time on here, this is really just for references only. Definition of a related person because again, you have to look at the relationship between family members. But also you're going to have to look into just as far as definition of an API, the relationship between this college GP and management company, for example.

So when there's going to be a disposition of the partnership interest, there's something called the look through rule that you have to take into consideration. It's not just I've held my interest for five years, so therefore it's out of the three year, it's long-term, I get long-term beneficial treatment. That's not the case. So the look through rule basically states that if a shareholder disposes of their interest in a GP entity, and it's been held for greater than three years, you're still required to look through to the underlying assets. And if 80% or more of the fund's assets have a holding period of three years or less, then that substantially all tests are what's known as the substantially all tests has been met. And as a result, a portion of that gain is subject to recharacterization.

So I'm saying a portion because it's not all, well, always 100%. You then have to further look into the definition of the substantially all and what assets have been included. So if you do have any assets that are not included in the substantially all test, then you would be able to bifurcate some of that long-term gain and not have to recharacterize everything.

So before I move on, I mean, again, it's just worth mentioning that again, these are proposed regulations, anything subject to change. And when those final regulations are published, you can rest assure that we will be back outlining those as well. So let's move on.

So modification of excess business losses and net operating losses. So beginning in 2018, the tax cuts in JOBS Act provided that business losses that were incurred by individual taxpayers and not all losses, we're specifically speaking to business losses, that were incurred, were limited. And limitation was, for married filing joint taxpayers, it was 500,000, single taxpayers it was 250,000. Any loss in excess of that was then carry forward as a net operating loss. So in other words, if I incur a million dollar’s worth of trade or business losses, I would only be able to duck seeing as I'm married, $500,000 on my individual income tax return, and then the other 500,000 would be carried forward as a net operating loss, which we'll speak about in a minute.

Now the CARES Act came in and modified that limitation. And they essentially stated that for years beginning after 2020, after December 31st 2020. So in other words, from 2021, through the end of 2025, that's when the excess business loss limitation is going to come into play. Now the reason for the modification is based on what the CARES Act was, and if you really think what it was, the CARES Act was enacted back in March in order to provide immediate relief to individuals and families and businesses that were affected by COVID. So hence through the end of 2020. Now what does this mean? This means that this modification is retroactive to 2018 and has provided the ability to amend 2018 returns in the event there was an excess business loss limitation on your 2018 return. What this would do is it would offset other income and then if you still have an NOL, you can either carry it back or carry it forward.

So net operating loss. So we obviously can't mention excess business losses without discussing net operating losses. So just prior to TCJA, NOLs were subject to a two year carry back 20 year carry forward and there was absolutely no limitation on the income that it could offset. Now TCJA changed that. Primarily by NOLs could no longer be carried back but would be carried forward indefinitely. So that 20 year carry forward, there was no longer a limit. The allowable NOL deduction was no longer against 100% of your income. Now I'm speaking just to regular taxation, I'm not speaking to AMT taxation at this point in time. But the NOL would not exceed 80% of your taxable income, so you're always going to have some tax liability.

Now what the CARES Act did is, that again modified your NOLs. Not only did it modify when the business losses were but it also modified your NOLs. So it states that for any net operating losses that arise in 2018, '19 and '20 can be carried back for five years. So in other words, you can carry back your NOL to '13, '14 and '15. Now you don't have to you still have the opportunity and the ability to make the election to forego the carry back. But economically and tax efficiently if it made sense and you looked back on those years, you had the ability to amend. Now what it also did is it suspends the 80% taxable income limitation. So once again, it goes back to pre-TCJA where you can offset 100% of that income in the event your NOL is greater than what your adjusted gross income is.

Now, why is this important? Well, for discussion purposes, let's just use a management company. Let's not consider trader funds or anything for this because that can get a little complicated. But let's just speak to management companies. So if you have a management company that's essentially breakeven for 2020, it doesn't make sense to run it at a loss. And for 2020 that loss would go dollar for dollar against adjusted gross income versus next year in 2021, where the excess business losses and the change in net operating losses are reenacted and they take effect again. Now again, it all may be just timing, but you're thinking about cash flow, thinking about growth, thinking about any particular changes in the law under Biden's proposal, which we'll speak to next. It's something to take into consideration. You really, at this point in time, you have a planning opportunity to have your funds work for you.

So now I just mentioned, potential changes in taxation. So Biden's proposal, I'm just going to speak to individual taxation, there are some corporate items in his proposal, but again, we don't know. We're clearly still waiting for Georgia. We don't know if that's going to fall Democrat, Republican. If their votes land Senate Republican, then there's a little bit more of a checks and balances. If not, we can be up against some of this, not all of it. But it's at least good to have it on the forefront and know what may or may not be coming down the pike, and when. When originally the proposal first came out, the question was, is it going to be retroactive or were these proposals potentially going to be retroactive to the beginning of 2021 versus when he entered office? Now, it seems more likely it would potentially be 2022, or a midterm event. But at any rate.

So some of the items on his potential agenda are increasing ordinary income rates on taxpayers who have income exceeding $400,000. So that would go from 37 to 39.6%. Now this doesn't include your 3.8% of net investment income tax, which would bring it up to 43.4%. Now one of the two larger plays is the qualified dividends and long-term capital gains being taxed as ordinary income for taxpayers who have over a million dollars. Now this is a significant or could potentially be a significant change. Because at that point in time, you're looking at a 19.6% rate increase including, this 43.4% includes the net investment interest.

Now not only would this change federal, but the impact that it would have on your overall tax liability is if you're in a state where you're paying 13%, New York if you're a New York City resident, California's highest rate and now New Jersey, you could be essentially up to almost 60% tax rates if you're in a high state income tax. Earned income would be or earned income above 400,000 would now be subject to Social Security, right now it's capped at 137. The burden would still be split between employee and employees. But it's still an additional tax that you should consider.

Itemized deductions. Limiting the value of your itemized deductions to 28% for taxpayers with income in excess of 400,000. So if you have 39.6% income you're being taxed on and your itemized deductions are at 28%, that delta right there, even if nothing changes, you could still potentially have an increase in liability without doing anything different. Now one of the hot topics, and we'll speak to a couple of these in just a moment is the reduction of the estate and gift tax exemption as well as increasing the gift tax rate. So this essentially could reduce your estate exemption down to either three and a half million and your gift tax at one million, or even going back to, what it's supposed to sunset at in 2025 is $5 million. But then the gift tax rate would increase to 45% which essentially is making it more expensive to gift away your assets.

So it's almost worth it, if you are thinking about your estate plan and gifting items, to potentially do it now. And by now I mean just prior to this proposal being enacted, but also taking into consideration the fact that in 2026 this will sunset anyway. So even if you're not thinking about it now because of Biden's proposals, just it's something to definitely address prior to sunset in 2025.

Now the only item that I am going to mention on this slide is charity. And for 2020, there is an increased cash deduction. Cash deduction only, allowed up to 100% of your adjusted gross income. Now the ordering rules that you typically have, and I'm not going to get into them, have been suspended. What would happen is you would take your non qualified contributions, which is anything outside of this cash, figure them as you typically would, and then you can top off and you can actually wipe out your entire adjusted gross income by an additional cash deduction.

This one, again, I'm only going to mention accelerating the capital gains into 2020. Again, this is only if you think of potential changes coming in 2021. Now are we saying that this is definitely what you should do? Absolutely not. Because there are so many other items to think about. As I was saying, the itemized deductions could go down, tax rates could go up. However, if the state and local tax deduction is reinstated, there are a lot of moving parts in order to play but it's something to think about as far as accelerating income and potentially deferring some of the deductions.

Yeah. This is actually pretty much how I thought that this would fall as far as timing of income and deductions. We'll touch base on state tax planning in a little bit. But this is interesting. It's good to know where everybody's head is for this topic. So estate and gift tax considerations. Just a couple of housekeeping, annual gift tax exclusion is remaining the same for 2021 at 15,000. 30,000 for a married couple. Meaning that you and your spouse can give to as many donees as you would like, $30,000, split them and not incur a gift tax. The estate exemption is for 2020 at 11.58 million, increasing to 11.7 in 2021 as it stands now. Meaning that you and your spouse have just north of 23 million to gift away and that's coupled with the generation skipping tax. That exemption is the same with the generation skipping. The GST exemption is, sorry for the shortening. GST is you can actually shelter skip generation gifts to grandchildren using that same amount.

And again, just worth mentioning quickly, I had mentioned it earlier is that all of this regardless of what happens with Biden's proposal, all of this sunsets at the end of 2025. So in 2026, as of now we're going back to a $5 million estates and gift exemption.

Now, what are we going to do? Use it or lose it? And again, 2026 or perhaps earlier. But two of the things to really think about are transferring assets before they substantially appreciate. You want to remove assets that are going to appreciate, not necessarily the ones that already have. The whole thing is, is that if you transfer something that's valued at $1 now and in three years it's worth $100, you've now removed $99 worth of that appreciation from your estate tax free.

Now something also to keep in mind is that partnership interests or certain assets, specifically, certain partnership interests may be eligible for discounts if they're gifted, but they're not eligible for discounts upon death, and within estate tax. And those discounts are a lack of marketability and lack of control or minority interest. And essentially, what this permits you and allows you to do is you can give more for the same amount. Okay.

So just a couple of really quick planning ideas, if you're going to use that double exemption, either the 23 million as well as your GST, forgive your family loans. Sale to a defective grantor trust. We're in an environment of very, very low interest rates. And the structure of a defective grantor trust is always going to include a promissory note. Forgive that loan, chop off your existing trusts, pre funding life insurance trusts, instead of paying the premiums annually. Reconsider your insurance needs. Now is a really, really good time to do that. And then considering late allocation of GST exemption to these trusts.

So again, 23 million is a lot to give away. There are ways to work around this, if you don't want to give it away, all of it. So if you do want to use some of it, some of your exemption and take advantage of it, then have one spouse contribute. And we'll just use the total amount for sake of this conversation to a trust known as a SLAT, which I'll mention in a second. The other spouse shouldn't utilize any of it. And at least when the state exemption reverts back to five million, the taxpayer that made that contribution to the spousal lifetime access trust, won't have anything left. But the other spouse well, and you would have at least removed an additional six million from your estate. It's just to give me with the sunset coming down.

Now a SLAT. I've seen more SLATs this year than I have in prior years. And it's absolutely because of the election year. So what this is, is this is a trust that is set up for the benefit of the other trust. Sorry. This is a trust that's set up for the benefit of the other spouse as well as their children and grandchildren. And what this is, is this permits the initial, the donor spouse to give away property but to retain that indirect access. And the indirect access is because their spouse is a beneficiary and can still receive distributions from the trust.

It's a great estate plan or estate planning tool, because like I said you can still receive that indirect benefit or indirect access. Historically, we have low interest rates or we have historical lower interest rates right now. They're incredibly low, .15%, .48 and 1.31% for short, mid and long-term respectively. The 75-20 rate which is used in determining your annuity payments when you're setting up a GRAT, a grantor-retained annuity trust. Now this is a great estate freeze. This is a great way to freeze your estate. Now what it does is it freezes your estate, and I'll give an example in just a moment, it freezes your estate. However, again, it removes that appreciation.

The way that GRAT would work is if I were to take $10 million of stock, and I were to contribute it into this two-year GRAT, I would be required to take a two year annual, well annuity back. I would get my 10 million back but because these interest rates are so low, the amount in addition of, or in addition to that 10 million is going to be so much lower than if the interest rates were high. Now what that does is I get it back, I essentially freeze my estate, I'm back to square one. But the appreciation, as well as any of that immediate growth goes out to my kids or in trust. But goes out to my kids. So if there's this example, an eight to 10 or a 12% return, I've got 1.2 to $1.8 million that I've just received or sorry, removed from my estate. And then that's just after two years, and then it'll continue to appreciate and all of that's out of my estate.

Yep, the correct answer is for 2021, the exemption goes up to 11.7 million. The 11.58 million is what it is for 2020. So we've already touched based on the charitable considerations, just as far as the top offer for what's allowed for 2020. So we will move on to just a really quick comment regarding the state income and estate tax considerations. The state estate tax considerations, these are just something to refer back to, but statutory resident considerations, especially in light of COVID. Be aware if you have left your domicile state and gone to another one, and if you're there, essentially, the general rule is greater than 183 days, that state may try and tax you as a statutory resident. I've been having this conversation as probably as much as I have as far as the 1061 conversation. But just be aware, if you're in a state that's not your domicile state, and you've been there for greater than 183 days, it's worth having a conversation with your provider.

The other thing to just think about is if you're leaving your domicile state intentionally, just make sure it's done correctly. New York, for example, they're not forgiving. So you just really have to, and they're going to try and pull you back in and keep you as a resident as long as possible. Just make sure that it's done in a manner where you're checking all the boxes, and you are cutting the ties. And again, if there's any questions, this is something that we can absolutely help you with. And with that being said, thank you very much for joining this portion and I will turn it over to my partner, Miri Forster.

Miri Forster:Thanks so much, Stephanie. Again, this is Miri Forster. I'm a principal and co-leader of EisnerAmper's tax controversy practice. And it's great to be here today. For our remaining time together, I'm going to cover what's happening at the IRS from an operations perspective, and how the agency has been handling the pandemic. And also I'm going to highlight some areas of recent IRS focus so you can think proactively and be ready for an inquiry if the IRS comes knocking on your door.

All the service centers are currently open. Some employees are physically reporting to the service centers but at limited capacity because of COVID-19 restrictions and others have now been successfully set up to tele-work. But even with that, there are still delays and operations are a bit slower than usual. In terms of mail, and I believe the recent figure is about three million pieces of mail outstanding. So there's still some paper returns waiting to be processed and checks waiting to be cashed.

For a while the IRS stopped sending out tax due notices because of this backlog but in November, I guess they felt that they were caught up enough. So they started resuming sending out these balance due notices. And a few weeks ago they sent out a very significant number of Notice of Intent to levy notices, the CP14s. If you've recently received one, you will see for the first time that it included a QR barcode so that taxpayers could reach out to the IRS securely via the code and try to resolve their issues online instead of having to wait on hold with the IRS service centers. The IRS is thinking about adding these QR barcodes to other notices as well. So stay tuned.

Now thankfully, even with the delays, the IRS was also quick to implement ways to work more efficiently in the remote environment. They added a laundry list of tax returns that could be signed electronically instead of with a wet signature for this past filing season. And for the first time, they're allowing amended individual returns for 2019 to be e-filed. And they've even set up some temporary fax procedures for some other refund claims. And those electronic options have been a huge help for taxpayers. And to touch on when of Stephanie's discussion points where she talked about net operating loss carry back opportunities under the CARES Act, the IRS is allowing these form 1045 tentative refund claims to be faxed to the IRS until December 31st, 2020. That's also the final day to file an NOL carry back claim for 2019 and faxing is clearly faster than mailing.

Now the time for processing these refund claims is a bit inconsistent, but refunds usually take about 90 days. So it's really helpful if you're looking for quick cash. A reminder though, that these refunds are tentative, so the IRS can examine them after the return's been issued. And for refunds over $2 million for individuals review by the Joint Committee of Taxation will also be required as part of the examination process. And there are technology advances coming for 2021. The one I'm most excited about is coming in January, the IRS is launching a new secure platform for electronically uploading powers of attorneys to the IRS' CAF Unit. That's the unit that verifies the signatures on these forms and associates the POAs with a taxpayer's tax module. And then by the summer, we should be able to electronically initiate and sign these third party authorizations, and those authorizations should be electronically transferred to the client's IRS online account. You could probably hear how excited I am because these procedures will replace the current ones where you require wet signatures on POAs which obviously has been hard during COVID and mailing of these forms to the IRS.

The IRS has also been busy extending significant resources to combating civil fraud. And in March it created a dedicated fraud enforcement office. And really the timing couldn't be better. Because there are fraudsters emerging in the full force due to COVID-19. They're trying to get PPP loans, they're trying to claim employer retention credits for businesses that don't exist. There's a lot of identity theft and refund claims and fraudulent claims for state unemployment. So the fraud enforcement office is playing a critical role in responding to these challenges. Then the fraud enforcement office is also aggressively targeting high-income non-filers and there's talking about individuals with income greater than 100,000 that haven't filed a return prior to 2019. The Treasury Inspector General recently issued a report and it heavily criticized the IRS in this area or lack thereof, saying the IRS hasn't done enough to bring these non-filers into compliance and help address the tax gap. Okay, so our first polling question, Melody.

Miri Forster:Great. Thanks so much Melody. And it's good to see the results that most of you are not in the position I was in. I did timely mail my extension in early July with a payment but I still got a CP14 notice with that cool QR code saying that I hadn't timely filed even though I did. I have since resolved that though. Okay. So let's move to the next slide. Let's switch gears and talk about expectations for the IRS' fiscal 2021 year that began in October. The IRS operating divisions recently issued focus guides reflecting their strategic priorities for the current year. And I've summarized three of the main priorities on this slide.

First is to strengthen their compliance activities. Second is to leverage technology and data and analytics in selecting the best cases and identifying emerging noncompliance. And the third is to build and maintain a high performing diverse and inclusive workforce that is offered opportunities for focus training.

So I really want to talk about the first, one about strengthening compliance activities. This is a main goal of the large business and international division that deals with assets over 10 million, the small business self-employed division that deals with assets under 10 million, employment taxes and excise taxes, and also the tax exempt and government entities division. They've all made it clear they intend to strengthen compliance activities and that means expanding coverage of individuals. And that includes high wealth and high income taxpayers. And I'll talk about the distinction shortly, pass-thru entities partnerships and S corporations.

Also, looking at private foundations and retirement plans of closely held businesses and continuing to aggressively pursue abusive conservation easements, micro captive insurance companies, and charitable remainder annuity trusts. And also the last thing is penalties. The IRS has said it intends to expand the use of all civil penalties, even those that it has not used frequently in the past.

So I want to focus on the two first of all. That's the individuals and the pass-thru entities to let you know what we're seeing and what's going on at the IRS in these areas. Partnerships has been a big focus area, and that's been the case since 2015 when Congress enacted the centralized partnership audit regime as part of the Bipartisan Budget Act or the BBA. So it was enacted and it provides new rules for the examination assessment and collection of tax for partnerships beginning with 2018 and forward. Under the BBA, the default rule is a partnership level tax. So an entity level tax on IRS exam adjustments rather than a partner level tax and that entity level tax is calculated at the highest tax rate, unless the partnership submits modifications request to the IRS to play a lower rate.

The new rules apply to all partnerships that have to file a 1065, unless the partnership elects out. Which is an annual election. It's very limited in scope. So any partnership with even one pass-thru partner is ineligible to elect out. And under the BBA, the tax matters partner has been replaced with a partnership representative who now has sole responsibility over the partnership and as partners. So the partnership representative's actions with the IRS will bind the partnership and the partners, even if those actions are contrary to what's in the partnership agreement. And then the regime has also caused new questions to be added to due diligence checklist. And this is because a new partner in a BBA partnership may now be responsible for outstanding taxes from years prior to his or her investment.

So the rules are pretty complex. The IRS has tried to help navigate them and has recently launched a BBA webpage. And it includes right now information on designating a partnership representative on the option to elect out of the new regime that I just mentioned. And the third is on filing an Administrative Adjustment Request, an AAR to change a previously filed partnership return. The website link is attached and I believe it's also in the widgets in the program.

This third bullet, filing a BBA AAR is a hot topic right now. Because under the BBA amended K-1s are no longer permitted. So any BBA partnership that wants to correct a previously filed return has to use these new BBA AAR procedures. And high level, the BBA AAR is filed by the partnership representative. The specific forms really depend on whether the partnership files electronically or not. If you file electronically, you file an 8082 with a 1065 with the amended box check. If you file via paper, then you use a form 1065X to file your BBA AAR.

And AAR is accompanied by some new tax forms. One is this form 8985, and the 8985 is what the partnership uses to summarize all adjustments that the partnership is making. If the adjustment results in an Imputed Underpayment, which is essentially a positive adjustment, then the partnership has the option to pay the tax associated with the Imputed Underpayment at the highest tax rate when it files the AAR, or it can push those adjustments out to the partners, and that happens on another form. New form 8986. If the adjustment is a negative adjustment, so it does not result in an Imputed Underpayment, the partnership is required to push the adjustment out to each partner.

And now let's say you're a partner in a partnership and you get this 8986 push out statement, and you're a pass-thru partner also, you as the pass-thru partner must also decide whether to pay or push when you receive the 8986. And this process continues through the tiers until you reach the ultimate taxpaying individual or entity. Once the pass-thru partner pushes an adjustment out though, it's no longer responsible for taxes on that adjustment.

So a simple example, let's say you're a direct investor in partnership A. What happens if partnership A files a BBA AAR for 2019 and issues a push out statement to you in 2021? You as the direct individual investor, and the ultimate taxpaying individual, has to report that adjustment on your return for the adjustment year. In this example, that adjustment year is 2021. And that return is not filed till 2022. The benefit is that you as an investor wouldn't have to file an amended return for 2019 to take care of that adjustment. But perhaps your PACs position in 2021, where you now have to report the adjustment, is not as favorable as if the adjustment had been accounted for in 2019 in the first place. So there are a lot of intricacies and things to think about when you're making corrections using a BBA AAR.

Last thing to mention on the BBA is that when you file an AAR, it actually extends the statute limitations on assessment. This is new, typically amended returns in the past did not restart the statute. So if you are a partnership representative, and you recognize that there's a need to file a BBA AAR, I wouldn't wait too long to do so.

So I already went through this example. So what I want to do is move on to some exam issues. The BBA was enacted to streamline IRS efforts to conduct a partnership examination. And so we've noticed that partnership exam activity is on the rise, and we expect that to only continue. The IRS is currently focused on a number of partnership compliance campaigns. And for 2021, it plans to roll out a large partnership compliance program, similar to the one that it's been using for many years to audit large corps.

One very active campaign in the fund space is the self-employment tax or the SECA's tax campaign. Under this campaign, the IRS is focused on asset managers set up as limited partnerships with limited partners, who claim they're exempt from self-employment tax under Section 1402(a)(13) of the Internal Revenue Code. And the campaign started a couple of years ago and many of the cases are actually now proceeding to IRS Appeals since many weren't resolved at the exam level. Based on some case law, including a case called Renkemeyer v. Commissioner, the IRS really is steadfast that limited partners and limited partnerships that perform services are subject to SECA tax. In the Renkemeyer case, the Tax Court held that an attorney who was a partner in an LLP and was not a limited partner for purposes of 1402(a)(13), because he was active in his law firm. Therefore, he was determined to be subject to SECA tax on his distributive share.

And it's really interesting that the IRS is so aggressively pursuing this issue given that the language and the Internal Revenue Code clearly exempts limited partners from self-employment tax. And that Congress had the chance to change this law as part of the Tax Cuts and Jobs Act, and it chose not to. But they are and at this point, I expect one of these cases will head into litigation in the not so distant future. So it's definitely an area to watch.

The IRS is also very concerned with how tax payers are reporting sales of partnership interests. These exams are focusing on partnerships that either do not report the sale or fail to report the gain or loss from the sale correctly. Generally, the sale of a partnership interest results in capital gain or loss. Sometimes that is at 15%, but if you have appreciated collectibles at the time of the sale, or ones that depreciate real property, you could be subject to higher capital gains rates. And if you have a partnership with inventory items or unrealized receivables at the time of the sale you may have ordinary a gain or loss. So hot assets and the concept of valuation under Section 741 is a major focus area of the IRS.

So I want to move on to some individual exam trends as well. I said before that the IRS is focused on high wealth taxpayers and high income taxpayers. So I want to make sure everybody is clear on the distinction. The global high wealth exam typically is focused on the taxpayer's income and its assets. A global high wealth exam usually includes an individual exam and up to four related entities as part of the same exam. A high income focus is based on the individual's income, typically 100,000 or more. And those exams will usually include one related entity as well. These exams can take anywhere from 18 months to 24 months to finish. I've been helping lots of tax payers on these exams. From an individual perspective, I've seen questions on whether gift tax returns were required to be filed. Questions on loan documentation from years and years ago to prove whether it's recourse, non-recourse, qualified non-recourse so you can support basis in a partnership and any significant losses and even valuation issues related to non-cash charitable contributions.

Also, the IRS is spending a lot of time on virtual currency transactions. That's an emerging trend, they believe there's a lot of non-compliance by individual taxpayers, they've been trying to educate taxpayers as best as they could, sending out soft notices, urging them to update returns if necessary. And they've even added a question on the 1040 asking if taxpayers participated in a virtual currency transaction.

Also, on this slide, they're focused on the Section 965 Transition Tax making sure US shareholders, including individuals are including their 965 inclusion properly. They have international examiners, looking at these to make sure the calculations are correct. And they're also looking to make sure that you've properly claimed foreign tax credits. Melody, let's go to the last polling question.

Miri Forster:Great. Thanks, everyone, for sharing those. Those will be very helpful for us. So to close, now that you know exam activity is on the rise, the IRS is pursuing a broad range of issues, being prepared is the best and the easiest way to manage risk. So be proactive if you have a new investment, or you have a non cash charitable contribution, make sure your documentation is contemporaneous and it's in a good storage place. Revisit your tax positions, it was a tough 19 tax-year with a lot of new tax laws under TCJA and the CARES Act and the interplays between the two. If your documentation isn't in great order, look at them again. And it's a good time to plan ahead and just make sure that you have what you need to support those positions before an exam notice comes. And then remember about the opportunity to claim a refund at beneficial tax rates under the CARES Act. There's only a limited period of time to claim some of those refunds so we don't want you to miss out.

That brings us to the end of our webinar. We hope you'll join us for part three of our Financial Services Year-End Planning Series on December 15th, which will focus on international issues. And on behalf of all of us at EisnerAmper, thank you for joining and best wishes to you and your families for a happy and healthy holiday season.

About Stephanie Hines

Stephanie Hines, Partner in EisnerAmper Personal Wealth Advisors Group, provides expertise in planning and compliance for ultra-high and high net worth individuals in the areas of personal and fiduciary income taxation, succession and estate taxes.

About Miri Forster

Miri Forster, Principal and Co-Leader of the Tax Controversy practice, has over 20 years of experience providing tax dispute resolution services to public and private corporations, partnerships and high net worth individuals on a wide range of technical and procedural issues.

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