On-Demand: Financial Services Year-End Tax Planning--Part I

November 24, 2020

Part I of our webcast series focused on IRC Section 1061 carried interest regulations, IRC Section 163(j) interest expense limitations, SALT, tax capital reporting, and year-end tax planning for funds.


Transcript

First of all, I'd also like to welcome everybody to our Year-End Tax Planning Webcast Series. As you notice, this year, we've made it into a series. This is part one of that series. The series will continue part two on December 8th. We will be covering individual taxes and the partnership audit procedures. And then, on December 15th, we will be covering the international and then outbound kind of tax issues for year-end. So welcome and I really appreciate the fact that many of you have taken the time so close to the Thanksgiving holiday to come join us for a bit of a discussion on tax, and I hope that you enjoy yourself and learn something from the presentation today.

Simcha David:I'm going to start with a discussion on carried interest rules. So we did get proposed regulations on carried interest. Okay, we did get proposed regulations on carried interest. I'm going to spend a little bit of time, not that much of time, on it and I'll explain that in a minute, because the proposed regulations as they came out and it raised more questions than it answered. And if you look on the bottom of this slide, you'll see there on November 13th, Tax Notes reported from an IRS official that we would be expecting final carried interest regulations before year-end, and they are going to be significant changes to the proposed regulations.

Not going to sit and go through all the proposed regulations now, but we will go through some high-level points. So everybody knows the 1061, the carried interest rules, subject an applicable partnership interest, what we also review as the GP's interest to a three-year holding period. So carried interest now, in order for you to get the favorable long-term capital gains tax treatment of 20%, you would need to have a three-year holding period on the property versus a one-year holding property as it is for those who hold it, in general.

So the proposed regulations did clarify, which was taxpayer-favorable, that it does not apply to qualified dividend income. So if the GP gets a reallocation of qualified dividend income, that's still subject to the 20% tax rate. It does not apply to 1256 contracts. We do have the 60/40 rule. This was a little bit of a shocker. It doesn't apply to 1231 gains from depreciable or real property used in a trade or business. In that sense, it's anything that is not connected to Section 1222, which is the normal long term versus short term, because that's where they made the change.

And for applicable partnership interest, you would now be subject to a three-year holding period. The proposed regulations doubled down the IRS' point, the IRS' position, that an S corp is subject to the rules. Even after that and after they came out with a notice, said they were going to do this and they came in with proposed regs, there are still people out there who think that the IRS got it wrong, that based on the current law as it's written, these carried interest rules should not be able to apply to S corps, but they did clarify that it does, S corps, QEFs, REITs, RICs, all that.

Even though because of the pass-through nature of the income and that you get the character of the pass-through nature of the income, even though they're not officially pass-through, is that the three-year holding period would apply, as well. They clarified the distributions in-kind are subject again to 1061. So even did an in-kind distribution of a stock, when you did, you would hold onto it for a minimum of three years. You do tack on the holding period. So that would be a minimum of three years until 1061 has been met.

This was a little bit interesting on the sale of an API. So what happens if a general partner sells his general partnership interest, and he's held that interest for years, graded it for years? So usually, the way that works is you would calculate a capital gain, and your holding period in the partnership is your holding period. Under these proposed regulations, you would actually look through to the assets, the underlying assets of the fund to determine if those are more short term versus long term and, therefore, the gain on the sale of the applicable partnership interest, even though you held it and graded it three years could still be short term for the general partner.

They did go ahead and try to clarify the capital account exception. That is that if a general partner does put capital into a fund. Even if it's the same entity that's holding the carried interest, there should be an allowance for that piece to not be subject to the 1061. They took the time to really make this as complicated as they possibly can. They actually wrote that they must make allocations on the same terms to unrelated service partners.

So everybody's like, "Does that mean I now have to calculate a management fee and a carried interest to my general partner, reduce the capital account and that would be the capital account exception?" So it seems like it would be a nightmare to rely on. I think they got a lot of feedback from practitioners on the capital account exception and how difficult they made that out to be. And so, I guess we'll see. Hopefully, the final carried interest regulations will be a more simplified version of the craziness that they came out with, with the proposed regs.

There was also some transition rule that they had come out with. The preamble actually states that prior to 2018, most people weren't really keeping track of holding period on their unrealized. And so, we're going to come up with a transition rule that allows you to exclude all your regular three-year holding period. Well, if I wasn't keeping track of the holding period, that was my transition rule that says I can back out my three-year property, doesn't work. If I wasn't keeping track, I don't know what's three years.

So it didn't really make that much sense, the transition rule. So it's anybody's guess ultimately how that will pan out at the end. Of course, what was also left unsaid or really it doesn't seem like it was clarified that much is just, in general, the full unrealized carried prior to 1118, based on this transitional, it seems like it might be included, but again it wasn't spoken about specifically. And the second question that remains unanswered is with regard to the unrealized piece of the capital account of a general partner in a hedge fund.

So I'm not going to get too detailed on this, but the preamble basically said, "Listen, if you guys have applicable partnership interest, you're getting a carried interest and you've been taxed within the partnership on the gain," right? So let's say it's partially realized and partially unrealized. So on the realized piece, they said, "Listen, we're not going to make you take that money out of the fund and then put it back into the fund so that the capital account exception could apply to you. We don't want you to do that."

And so, that's why they put in the capital account exception there for that piece at the very least. In the preamble, it sounded like for that piece, you would not have any issues, and you could keep it in without having to keep the money out first and then put it back. And you could still rely on the capital account exception for that. What they weren't fully clear on was on the unrealized piece, right? So in a hedge fund, a general partner earns carry, part of which is realized by the end of the year and part of it which is unrealized.

So when the unrealized carry unwinds in a future year, that amount is definitely subject to 1061 and a longer holding period. The question is what about the earnings on my capital account that is at the end of the year, the current year, part of which is unrealized? So when the unrealized unwinds, that is subject, but the earnings on that are realized, the earnings on that capital account. It was not fully clear whether or not those amounts would be subject to 1061 or not. I think most firms are taking the view based on the way the regulations have been written, even though the preamble seems to say something else, that the earnings on that unrealized piece should actually not be subject to the rules of 1061.

So that is my high-level overview of 1061. We will be having another webcast once the final regulations come out. So hopefully, we will have a simpler version of these rules and something that we feel can be applied when the final carried interest regulations come.

Okay, yeah. That's what I thought. About 21.5% said funds borrowed from management company/internal entity, yeah. And that is something that the service is aware of, and that's why they put that assumption into the rules. Okay. So that's 1061 and I'm looking forward to the following webcast when the final regulations do come out. What we did get on Section 163(j), which are business interest expense limitation. We got final regs and new proposed regs when it comes to 163(j).

Believe it or not, the final regs had a number of changes and many of them were really taxpayer favorable. So we'll go through some of those changes. Those are changes from the 2018 proposed regs that we've been going through in the last two years. I'll give you some background to 163(j) and then some of the highlights as are applicable to financial services industry. So very quickly, Section 163(j) was put into the Internal Revenue Code as part of the Tax Cuts and Jobs Act of 2017.

It made a business interest expense limitation that is basically across all types of entities. It doesn't make a difference if it's related-party interest, if it's third party interest, then to equity ratios. All these things that were in the prior 163(j) have gone away, and basically it is a business interest expense limitation amongst all types of entities and all types of debt. The basic calculation's as follows. It's the sum of the taxpayers. You get to deduct the sum of the taxpayer's business interest income plus 30% of the taxpayer's adjusted taxable income, which obviously will take out business interest income.

We'll talk about the CARES Act and the change that that made and the taxpayer's floor plan financing interest, which you've never heard about. I always say this. Don't worry about the floor plan financing interest. Then, you compare that to the sum of the business interest expense. It will determine if there's a disallowed interest expense for a particular year. The rule does not apply to an electing real property trade or business, an electing farming business and certain activities of regulated utilities.

Now, those exceptions are unique in the fact that not only is the business interest expense not subject to 163(j). The income earned from those types of entities don't go into the calculation with regard if you're in a partnership, and you earn income from those types of entities. That income is also taken out of the calculation, if you have a business expense limitation up the chain and you needed some ATI. So that is how that works. The small business exception is an exception. We're going to change some of the wording.

Small business is going to be referred to as an exemption, and real property is going to be referred to as an exception. The small business exemption is actually similar to real property in that the business interest expense limitation does not apply. However, the items of income and expense from a small business, if it's in partnership form, when that flows up to the partners will be deemed to be business income.

So it would be part of the ATI that they can use further up, adjusted taxable income that they can use further up, the chain if they need to, to deduct their own interest expense if the section applies to them. So the final regulations made significant modifications, and many of those were taxpayer-friendly.

Okay, we got at least 54.6% who encountered Section 163(j). I think with some of the new rules fewer people will, but let's go ahead. So first, I'd like to take a quick review of the CARES Act changes to Section 163(j). So we have this limitation that business interest expense is deductible up to 30% of your adjusted taxable income. So the CARES Act came in and changed that. So for corporations in 2019 and 2020, the 30% of adjusted taxable income limitation was increased to 50%. So for all tax years in beginning in 2019-2020, the amount of deductible interest is now 50% of the ATI.

For partnerships, the rule is different. They left the 30% of ATI limitation in 2019. Presumably, this was done initially because it was after the filing deadline that this came out for partnerships. They assumed many people already filed partnership returns under the new partnership audit rule of, nope, you did not have the ability to go back and amend partnership returns. It was only prospective. And so, they said, "Leave 2019 as is. We'll compensate you for that." We'll see in a minute. They'll leave it as is, and only 2020 will be 50%.

Post this coming out, they came out with reg prop 2020-23, which actually gave certain partnerships the ability to go back and amend tax returns, actually amend them, for 2018 and 2019. So that being said, this rule stayed in place. And so, for partnerships, 2019, it was not changed. It was at 30% and it was only changed in 2020 to 50%. To compensate partners and partnerships with this discrepancy, and this is important, if you got Line 13k, which is excess business interest expense on a K-1 in 2019, your partner and you got that, that means you got nondeductible business interest expense.

That means you're going to be tracking. And then, in a future year, if you get what's called excess taxable income from that partnership, you will now have a possible deduction. So if you have that on your K-1 for 2019, 50% of that amount will be deductible in 2020 without regard to any of the other rules of 163(j). So you would not need excess taxable income to free up 50% of that 2019 Line 13k. So not only do you get 50% of ATI in 2020 itself, but you also get this additional deduction if on Line 13k, Schedule K-1, Line 13k 2019, you had a number there.

You're going to get 50% of that number as a deduction in 2020. You can elect out of that if you so choose, but that election would be done by the partner and not by the partnership. With regard to the 50% versus the 30% of ATI limitation, that is automatic again, unless the partnership elects out of it. They came out with another rule from the CARES Act, and that is that both corporations and partnerships can elect into using 2019 adjusted taxable income as opposed to 2020. So in 2020, instead of basing your business interest deduction on 50% of your 2020 ATI, you can do 2019 ATI if you left.

And presumably, the idea is that your 2019 ATI is going to be higher than the 2020 ATI because of the issues that business faced in 2020. So those were the CARES Act changes to IRC Section 163(j). Now, let's talk about the final regulations. Here we go, the definitional interest. So the definition of interest on the proposed regs was very, very broad. They brought it back a little bit and took out some of the things. So one of the few things they took out was guaranteed payments for capital. That was included in interest expense.

That is no longer included in the definition of interest. However, there's an expanded anti-avoidance rule, and there is an example of a guaranteed payment for capital in the anti-avoidance rule. So in essence, if instead of taking out debt, you go ahead and borrow from a partner, there is still a possibility that will be deemed to be interest expense, even though you're booking it as a guaranteed payment for capital. They came out again with the embedded loan rule, but they put into place that this rule for the notional principle contracts with significant non-periodic payments.

So there is proposed regs out there on the code section where there's an embedded loan rule concept and whether the interest on that embedded loan will be included interest expense. They say it would, but only for non-cleared swaps. So if you have swaps that clear through an exchange or they have emerged in collateral requirements that are of a federal regulator or similar to a federal regulator, this rule does not apply. So it only applies to the non-clear, and they gave an effective date that is 365 days after the publication of these final regs as opposed to 60 days like everything else, because they knew it would take time to implement these rules.

That being said, if you enter into one of these before the 365 days and there is avoidance here, you can get tripped up again by the anti-avoidance rule, which is applicable 60 days after, so keep that in mind. Commitment fees and other fees paid in connection with a lending transaction are also not deemed to be interest, which is interesting. In many debt funds, we try to make as much interest as we can, especially when you're dealing with UBTI issues. You'd rather something be deemed to be interest for your tax-exempt investors versus not.

So we'll see how that will be deployed. They came through with the ordering rules, and that is the deferred interest provisions and disallowing interest provisions come before 163(j) in terms of how much interest. You actually have interest expense. However, the passive loss limitation rules, the at-risk limitation rules, at Section, that should say, 461(l) come after the 163(j) computation. So even if an interest expense is allowed under 163(j), if it can surmise to a loss and you can take that loss, obviously the loss is still limited.

When that loss does reverse, you don't look at the fact that part of that loss is an interest expense component, and you don't have to worry about 163(j) for that part of the loss in that year. Again, the anti-avoidance rule, just very high level. It basically says that if a, if a, not the, a principle purpose of structuring a transaction is to reduce an amount incurred by the taxpayer, always been described as interest expense, then you've tripped up the anti-avoidance rule. Again, it's going to depend on all the facts and circumstances.

And then, it specifically says, "A purpose may be a principle purpose, even though it's outweighed by other purposes." So figure that one out. And not only that, but they're very clear to say that a business purpose, a business use for obtaining the fund, other than the fact that you're trying to minimize the interest expense, a business use for obtaining the funds is not enough. If one of your principle purposes of structuring the transaction in a particular way is to reduce the amount incurred that would otherwise be described as interest expense.

So what is deemed to be economically equivalent to interest? It's deducted by the taxpayer. It's incurred by the taxpayer in a transaction or series of integrated or related transaction in which the taxpayer secures the use of funds for a period of time. We all know what the general interest is. It's substantially occurred again in consideration for the time value of money, and it's not described in these other paragraphs, which has mainly described what interest is under the code, under 163(j). So this is the expanded anti-avoidance rule, and it seems to include or could include many things or many kind of transactions. So just got to be careful with them.

Okay, let's talk about the final regulations when it comes to partnerships. So the 11-step process, unfortunately if anybody's dealt with that, that's here to stay. It's not going anywhere. I believe some had asked for a reasonable amount. They didn't like that. They stuck with their 11-step process. However, if you allocate everything in your partnership based on a pro rata basis, then you're kind of exempt, because you're going to get to the same spot, regardless. Small business exception, this is really important.

The small business exception changed from the proposed regs. Under the proposed regs, if I have a small business that's, let's say, a partnership, okay, and there's business interest expense at that partnership, and then that business interest expense is exempt and it gets reported up to the partner, and let's say the partner's not a small business. So under the proposed regs, we thought the better understanding was that partner now has to retest the business interest expense of a small business that was underneath them, because it's a small business exception as opposed to real estate.

Under the real estate exception would not have to retest under the small business. We could avoid. While under the final regs, if a small business is the bottom entity, it's an operating partnership and because of the small business exception, the interest expense at that level is not subject to 163(j), it is no longer a business interest expense that needs to be retested up the chain. So this is a huge difference. It's a sea change from the way we dealt with business interest expense coming from a small operating business, important for private equity funds and some of the funds that may have made these kinds of investments.

So it's no longer required to retest up the chain. In addition, they clarified under the regs that if a partner is allocated excess business interest expense from a partnership, right? So in year one and two, you get excess business interest expense. In year three, that operating partnership becomes a small business, okay? Then, the partner's allowed to treat the carryover excess business interest expense for the prior years as business interest expense in that particular year. So you're allowed to treat it that way in that particular year.

However, the partner at their level, if they're subject to 163(j), may still be limited to those for that amount of business interest expense that was freed up because of the prior two years when the excess business interest expense was limited. You were not a small business in those years. So it would still be subject possibly to the business interest expense limitation, but the current year, the small business amount, that would no longer be. Now, this rule, they would clarify, doesn't apply with a real estate election.

So be very, very careful of this. If I have a partnership that in years one and two, I did not make a real estate election on, okay, so I have business interest expense coming from those partnerships, and I did not make a real estate election on them. In year three, the same entity, I go ahead and I say, "I'm going to make my real estate election now. Because I'm eligible, I'm going to exempt it." If you go ahead and make that, well, you become eligible at that point. If you make that partnership a real estate entity, all the excess business interest expense you earn prior from that partnership needs excess taxable income from that partnership to free up, up the chain.

But because you are now a real estate entity or you now elected to have the real estate election apply, none of your income will be excess income anymore, and it will freeze that excess business interest expense to where they can no longer get freed up. So when it comes to small business, it does allow it to free up. It does free up in the future year. It frees up in the year when you become a small business, but if you're going to make a real estate election, it might not free up at that point. So keep that in mind, but this is example 11 of the regs.

I highly recommend that everybody reads through it. I'm not going to go through it now. I will make one mention of something which is interesting. If you have a partnership that's a business, and that has business interest expense and investment interest expense, and your partnership has a corporate partner and the rule by a corporation is that everything is deemed to be business. Even investment interest expense is deemed to be business. What happens if that operating partnership is a small business?

That small business says the business interest expense is no longer subject to 163(j). We're a small business. My corporate partner doesn't have to worry about that business interest expense from my small business. However, the investment interest expense of a small business, because it's not caught under 163(j), when it goes up to the corporate partner and becomes business interest, if the corporate partner's otherwise subject to Section 163(j), that would be business interest expense to be included.

Okay, the regs also came out with allocation rules. They've got a mix of accepted and not accepted trades or businesses. It's the de minimis rule that says if 90% or more of your taxpayer's assets are either an accepted or not-accepted trade or business, then you don't have to start bifurcating up how much of the interest expense goes to which asset. They didn't want you specifically tracking. So if an entity has debt and there's interest expense, they didn't want you tracking, "Oh, I'm using all that money for my business versus my non-business," or vice versa.

They didn't want you doing that, because money's fungible. And so, they put this more fixed asset test, but they did put the limit in this rule in. If you have an asset that's used for both accepted and non-accepted businesses, it comes out with three permissible methodologies for allocating the interest expense among the assets. Okay, this was a big one. This is huge. Trader funds, finally. They came out and said that trader funds for their limited partners are no longer subject to 163(j), okay? Pat myself on the back, yoo-hoo.

We're all happy about this. As far as I can talk about it, the code did not read this way when they came out with it initially, and they finally corrected it. And so, basically for your limited partners and trader funds, the interest expense will remain invested interest expense as it always has, subject to that limitation and will not first be limited at the partnership or at the fund level as we had been doing for the last two years based on the preamble of the 2018 proposed regulations. And so, they basically say that for your limited partners or for your non-materially participating partners.

So any GP who's materially participating who also has money through a limited partnership interest, unfortunately that does get included, because you are materially participating. So it doesn't matter if you're actually the GP or the LP interest. As long as you're materially participating, 163(j) will apply to you at the trader fund level, but it will not apply to the limited partners. Instead, that will get reported up the chain. If you had reported amounts under 13k to your limited partners, we'll probably put a footnote of sorts in the K-1 of the code here saying that those amounts should free up. Please consult your tax advisor.

So keep that in mind. This is a huge change and this is in the new proposed regs that came out in 2020. Also under the new proposed regs, they came out with how to deal with tiered partnerships. Under the tiered partnership rule, unlike the way we've been doing it or many have been doing it in a fund-of-funds scenario that you keep reporting all the information up to your partners. It's the partnership and one layer up that gets included here. So if you have a portfolio company that's a partnership and you're a private equity fund, and you get Line 13k coming flowing up to you from that entity, you will stop at your level.

You will not report that up to the other partner. Not only that, you will reduce your tax basis in the underlying portfolio company, but your partners will not reduce their tax basis in your entity by that amount. You will track it at the fund level, and then you will go ahead and free it up in the years when you get excess taxable income in that particular partnership. So that's going to be a big change in how we do reporting. So again, the fund of funds will no longer be reporting of Line 13k to the partners.

And in private equity funds, as I said, you'll be tracking it, as well. So we'll see if these proposed regulations go final on the same quorum. You can early adopt if you want. That is allowed under these new proposed regs. I think it makes it a little easier in terms of perhaps a little bit easier on your investors, not necessarily easier on the partnership but easier on the investors with regard to keeping track of all the information necessary for Section 163(j).

The proposed regs also have a partnership self-charged interest rule. So if a partnership gets a loan from a partner, some people would just disregard the interest expense and interest income, because whatever interest expense is here flows up to that partner and that partner picks up the interest income for the same loan. So just disregard it all. It's all canceling out. It does not all cancel out the business interest expense. The interest expense at the partnership level, if it is an operating business, again subject to 163(j) will be business interest expense.

The income that the partner's earning, that that interest expense is now giving rise to income at the partner level, so the income that that partner's earning will be deemed to be excess business interest income in that particular year to the extent of the excess business interest expense that they get from the underlying entity. And if otherwise, it would be investment interest to that partner, the rest of it would be investment interest to that partner. So that was another big thing in the proposed regs.

The proposed regs and if you notice, this is not a 163(j) proposed reg. This is a 163-14. 163 is broader than 163(j). However, this proposed reg fixes the rule with regard to the interest tracing rules. So if you have a debt-financed distribution, there are interest tracing rules, and this proposed reg brings those into line so that 163(j) would apply to those, as well. And it basically says you look to the use of funds, if the amounts are required to be traced. There is a rule that came out, Notice 89-35 with regard to partnership expenditures, that somehow you can allocate the debt first on your expenditures before saying, "Hey, we've got a debt-financed distribution."

Once you have a debt-financed distribution under this proposed reg, you would have to trace it to determine whether it's business interest expense, investment interest expense, et cetera, at the entity realm. Okay. So that is it for me. Hopefully, you took some few points out of the presentation. Again, I think the small business exception is really important, how that's changed. I think what's really important again is the trader funds, how that's changed, as well. And I'm now going to hand it over to my colleague, David Chadwick, for the next portion.

David Chadwick:Thank you, Simcha. Quite interesting. This was definitely better than some of the previous ones on 163(j), lots of good news included. So thanks for sharing. So today, I'm going to be covering a few topics. I'm going to be going over the new tax basis capital reporting and a few considerations for both hedge and private equity funds to keep in mind when you're doing year-end planning. So first topic we're going to talk about is the change to the tax capital reporting, so a little background.

So 2019 and prior, the partnerships, we would report our partner's capital accounts on Item L, the K-1, and we're able to do so using a couple different options. We could report on tax basis. We could use GAAP. We could use 704(b) or another method, and most of the funds with audited financials, this was their gap balance. So if we give our investors K-1s, the investor was easily able to tie out their market value statement that they received from you and the K-1, and they knew that we at least got something right.

So in '18, the new reporting requirement to report a partner's negative tax basis came out. So we didn't go full throttle on tax basis reporting yet, but the IRS came out in '18 and said, "Okay, if any of your partners have negative tax basis, either at the beginning or end of the year, we want to know about it and we need to see it on the K-1." Why is the IRS shifting their focus and adding the additional requirements?

Just like a lot of the different items on the K-1s, they're trying to get a clearer picture as to what's going on with the taxpayer. They could better focus their efforts to look deeper, maybe potential audit risk and whatnot. So with negative tax basis, there's two things that I could think of off the top of my head that might be advantageous to know from the IRS perspective. One, has this partner taken cash in excess of their tax basis?

Could that have resulted in taxable gain that they're going to need to pick up? Or two, if this partner is showing a negative tax basis and they're being allocated losses, do they indeed have enough basis to take those losses? Are they at risk? So '18, we need to start reporting negative tax basis. '19, we see the initial draft 1065 instructions telling us that now we're going to need to see tax basis for every partner, and that's when all the commenters, all the practitioners and taxpayers start going a little crazy and saying, "This is going to be a huge administrative burden. I haven't been tracking tax basis over the years. How are we going to do this in such a short period of time?"

The IRS hears us and they delay reporting until 2020, so we get another year. That brings us to where we are now. Notice comes out in 2020 and says there's two proposed methods that we could use to report tax basis for all our partners, neither of which is a transactional method. The transactional method is how we all probably are thinking in our head how we calculate tax basis. I have cash moving. I'm allocated taxable income or loss. I have some nondeductible items, and that's where I land for my tax basis.

Now, we're talking about inside basis. So the transactional method is not the method that is proposed by the IRS. Again, commenters come out and say, "The transactional method just makes the most sense. This is how we've been tracking, if we've been tracking, and this is probably going to be the easiest way for us to get to a good starting point," because we're all thinking right now, "If my fund is 10, 15, 20 years old, how am I going to get to a good starting point, if I've been tracking at all?", because it's never been the partnership's responsibility to track basis for each partner.

Let me go to the next slide. So the IRS, they've acknowledged this, and so the draft 1065 instructions have did a little bit of a 180 as opposed to the notice that came out in June and said, "All right, the transactional method is now the only allowable option, and this is the only method that you should be using prospectively." That still leaves us with the question of, "How am I going to get to my starting point, if I haven't been tracking?" We'll get to the options. The IRS has acknowledged that this is going to be a difficult task, and we have four different options that they've given us and the instructions on how to get to good opening balances.

A couple of the notes is that the tax basis capital reporting, it's going to fall under the BBA, which is the centralized audit regime that came out of TCJA, but they've also told us that we could expect some penalty relief as long as we take ordinary and prudent care to come to our opening balances. So per the instructions, the latest draft instructions of the 1065 that came out in October, the IRS is giving us four options to come up to our opening balances. The transactional method, which if we've been tracking tax basis for all our partners as we've been going through, we're in a pretty good spot.

Probably the best case scenario, we are from an opening standpoint. So I'm going to just continue doing what I was doing. Maybe there's some 743 adjustments, which are not going to be included in the tax basis amount that's going to be included in our opening balances. We might need to make some slight adjustments, but for the most part, if I've been tracking and I'm reporting on a tax basis method, I'm in the best case scenario. I could use the modified outside basis method.

The modified outside basis method is essentially taking the partner's outside basis, making some modifications, taking out some liabilities, taking out any kind of 743 adjustments, and then getting back to more or less our inside basis as our starting point. And the IRS has mentioned that a partnership may rely on basis information provided by the partners. So practically speaking, I don't know how much sense this makes in a funds perspective. Maybe for a management company or some closely helped partnerships, I could rely on my partners.

I only have five, 10 partners. Maybe they're family members. We could just easily get that information. Once I start getting into the fund space, I have 1,500 partners. Am I going to really start sending notices out to my investors and ask them to tell me what their tax basis is? Probably not. We all know we send those kind of notices out, especially when it comes to tax. We're not going to get much of a response, if anything. So that leaves us with a few other options, the next one being the modified previously taxed capital method.

So this is taking the previously taxed capital method, which is based on a hypothetical liquidation of all the assets in the partnership. We treat all the assets as sold. We take cash received on a hypothetical liquidation, increased by a tax loss that would be allocated to the partner and decreased by a tax gain that was allocated to the partner.

Simcha David:And it's not necessarily fair market value, just hypothetical liquidation, right? So-

David Chadwick:That's right. So you could use the net liquidity value, which is the last point on here. You could use fair market value. You could use GAAP. There's a few different options that you're going to use, and you have to include that on the K-1s to the investors. I mean, I feel like it's obvious, but they do mention it needs to be applied consistently across partners.

Simcha David:Right. David, I just want to make a point to the people that are listening. And then, you have the 704(b) method you can go through in a second. So this is the service telling us, "We want you using transactional method going forward." How are you going to come up with your beginning balance? Possibly if you don't have a transactional amount, you can use these other methods. So you're starting with another method. You're switching to a second method, which in my head says that the number at the end of 1231, your ending tax capital, basis tax capital, is really not anything because you're combining two methodologies to get there.

And it wouldn't necessarily be anything. And so, the question is, is the service going to come out and say, "That's great. That's what we allowed you to do for 2020. We gave you penalty relief on that, but in 2021, your beginning tax capital balance needs to be good based on the transactional method." That, we're just not sure of. We think they might come out and do that, just to give us more time. And the reason they allowed this for beginning tax capital in 2020 is because we're now in November of 2020, and people are going to start filing soon. So we think that's what's going on, but we need to hear more from the service, but go ahead with the 704(b).

David Chadwick:No, that's a good point, and I think there's still going to be more work to do, even after we get past '20. So the last method is 704(b) method which is essentially your 704(b) capital count, plus or minus any 704(c), built-in gain or loss. And just as a reminder, your 704(c) property is that contributed property, and that built-in gain or loss is the variance between the original cost basis and the fair market value at the time of the contribution. And this also includes reverse 704(c) in the hedge world, which would be your reval accounts.

Okay, a few other notes. So each partner continues to be responsible for maintaining their outside basis, and the partners in the capital account, as reported on the K-1, might not necessarily tie to what that partner is de-calculating outside, and there could be reasons for that. So the number that is going to be on the K-1 is going to reflect your inside basis. What the partner's calculating outside, maybe they purchased that interest from another partner. Maybe they inherited that interest. So there could be different reasons as to why the two may vary and that's okay.

And then, last note on this is that on 1065, the Schedule L on page five of the return, it's your balance sheet. It does not need to be reported on a tax basis necessarily. So for all the funds that have audited financials, the Schedule L, and the return is going to continue to mirror the financial statement. It's just now your Schedule L is going to vary. There's going to be a difference between your Schedule L at the top of page five and the M-2 at the bottom of page five, which is just the summation of all your K-1s.

The IRS knows they're going to be different, and they said that the only reason you would need to state why there's a variance is if you've been on reporting on a tax basis, and then you go ahead into this year and you report, and your tax basis balance sheet on Schedule L doesn't actually tie to your M-2. Then, they'd want to know why there'd be any variance.

Simcha David:David, just another point for those that are listening today. So you may have had investors that may have looked at Item L to see, "Hey, this is my capital account." They're used to seeing that on a Schedule K-1. Just be wary. Because of the way we're changing, you're going to get either calls or whatever. This is not my tax basis, or what is this number that I'm looking at? And so, that's going to be a major change to the reporting of the capital accounts on the Schedule K-1, so just be aware of that with regard to investors.

David Chadwick:Yeah, that's a fair point. I think it's just going to trigger more questions. Okay, just a couple of other notes on other Schedule K-1 reporting. So last year, there were a couple of items I just wanted to reiterate and bring to everyone's attention. So Item N reporting on the front of the K-1, it's in the bottom left corner, right near the Item L that we've been discussing, but this reported any unrealized 704(c) or reverse 704(c). So this would include any unrealized built-in gain or loss, so the contributed property we just mentioned, or this would be your reval account.

And also, disregarded entity reporting was new last year. The IRS now wants to see the owner of the partnership. The partner's name is going to be the owner of that disregarded entity, and there's a separate section to include the name and identification number of the disregarded entity.

So moving on, we're going to go through a few considerations for hedge funds. So we wouldn't do any year-end planning session justice if we didn't mention wash sales, straddles and constructive sales, the most common adjustments we see in the hedge world. So I figured it would be worth mentioning these and give everyone a little bit of a refresher. So wash sales, it's a loss on a sale of security. If it's not allowed, if a substantially identical security is purchased, either 30 days before or after the sale.

So I buy stock A. I hold stock A for six months. I sell stock A for a realized loss, and I decide I want to get back into stock A 10 days later. The wash sales are going to tell me it's as if that sale never occurred, and I cannot take that loss. It's going to be deferred, and the way the mechanics is going to work is that loss deferral is going to get added to the basis of the newly acquired stock. Also, the holding period of the original lot is going to get tacked onto the newly acquired shares.

So you could have a situation possibly where I had a short-term loss that was disallowed that rolled into a newly acquired stock. I hold that stock long term, and now I have a long-term loss by the time I got out of the newly acquired stock. So a couple ways that we could deal with mitigating the effects of a wash sale is we could double down on the position. So if it makes sense 30 days out, if I want to stay in the position, but I know I'm sitting on some unrealized losses that I would like to recognize this year, I could double up my position and then go ahead 30 days later, sell that stock. I could recognize that loss and be able to take that in the current year.

I'm not going to create a wash sale, and then I'm still in the position. Another one that you could use is a correlated security. I don't know how useful this one is, but since it's substantially identical, for example, if you sell stock in Wal-Mart at a loss, and you go ahead and buy Target stock, it's not going to be substantially identical, even though they're in the same sector. It's not going to create a wash sale. So there's other ways that they get increasingly more complicated. The fact of the circumstance is you need to go through each kind of situation.

So if there's a situation where you're looking at huge wash sales, we could discuss it further. We could look through it further to see what the details are. Straddles and constructive sales are both going to be triggered by offsetting positions. Straddles, if I'm holding offsetting positions and actively traded personal property, such as long and short in the same stock, and I'm substantially reducing my risk, I'm going to create a straddle. So a common one that we see is if I hold stock A long and I go out and I buy a put option.

When I buy that put option, I'm hedging my risk and I'm going to create a straddle at that point in time. So if I were to sell the put option at a loss and I'm still holding my long security, and I have an unrealized gain, the straddle rules are going to tell me that I need to defer that loss to the extent I have unrealized gain in my long position. And also, at the time I entered that straddle, I've terminated the holding period of my long position.

So if I'm planning on doing this, I might want to take a look at the holding period of my long, because if I'm holding my long stock 364 days, and I go out and buy a put option, I enter a straddle. I'm going to cut my holding period at that point in time. It's going to be terminated. It's not a suspension of holding period. So while the straddle is on, my holding period is not going to be accruing until I get rid of that put option. I release the straddle. The clock's going to start again once I get out of the straddle.

So one way to try to help manage this is to specifically identify the straddles. So the code allows, at the time you enter the straddle, to specifically identify which lot you want to put up against your long lot. At the time I bought that put option, I hold one lot of stock A. At that point in time I entered the straddle, I could specifically identify that put option against my lot of long. And then, let's just say I had two other long lots. So now, I have three lots of long stock, and I have my put option, but I specifically identified to put my put against my first lot.

If I sell the put at a loss and I have unrealized gain, I know that I have to defer my loss, but if I specifically identify to put my put option against that specific lot and I sell that specific lot, I know both of them are realized lots and it's off the table. I'm not going to have a straddle. Absent the specific identification, in that same scenario, I've sold my first lot of long and I got rid of my put, but I have two other lots long with unrealized gain.

I could still have a straddle, because I have a realized loss on my put option, and I still have unrealized gain. Specific ID could help you out in that scenario. The thing is you need to do it at the time you're going to enter the straddle. Hindsight's 20/20. So this is one of those things that would need to be done at the time of the transaction. Constructive sales, unlike straddles and wash sales that are deferring loss to constructive sales, can accelerate gain. So the constructive sale rules tell me if I'm in a box position at the end of the year, and overall I have an unrealized gain, I'm going to have to treat that as a sale and I'm going to pick up that gain in the current year.

There is one exception that it's not as well-known as you would think, but there's a short-term hedging exception with the constructive sales. So if I'm boxed at the end of the year, the short-term hedging exception allows me to exit the offsetting position by the 30th day after year-end. So by January 30, if I cover the short and now I'm only holding long, and I hold that long position un-hedged for 60 days, I wouldn't have to treat it as a constructive sale.

So something to think about, something to plan around, but the exception does exist. Short sales, if you're covering shorts at the end of the year, we just got to remember they must settle in December for the loss to be allowed in the current year. If they're not going to settle until January, the loss is not going to be allowed. It's going to be deferred until the following year. And I'll talk a little bit about trader versus investor. So the trader-versus-investor analysis, it's an annual test. That's a key takeaway.

It's on a year-by-year basis, and the key differentiator between trader and investor is that is the treatment of expenses. So if the fund is a trader fund, the expenses are going to be above the line in "good expense" versus an investor expense, which would be below the line. And post-TCJA, for non-corporate taxpayers, these are completely nondeductible. So is it better to be a trader? Yes, but the facts and circumstances need to be reviewed on an annual basis to get you to that position. Another consideration which Simcha just went through is 163(j).

So if you are considered a trader fund, there is additional possible limitations on interest expense to the GP or those who materially participate. 461(l) was a limitation on businesses losses that came about with the TCJA. It placed a $500,000 loss limitation on joint filers, $250,000 for others. And the CARES Act, it suspended this loss limitation. It suspended them until after December 31st, 2020.

Simcha David:If you have a big loss on your management company and you've got a lot of income from your carried interest, unless it's limitation, 461(l), we've discussed in the past. So that is no longer applicable for the 2020 taxes.

David Chadwick:Right. And then, another note on the NOLs. So TCJA limited the utilization of the NOLs at 80% of taxable income, and you were unable to carry it back. The CARES Act came out and said that NOLs generated in '18, '19 or '20 can be carried back for five years with no cap. All right, a few private equity considerations. I'll try to get through these quick, Mitch. I know we're running a little bit low on time. So effectively connected income, nothing really that new here, but worth mentioning is historically our ECI considerations were from our lower tiered operating partnerships.

If we received ECI on our K-1s, we know we're allocating that to any of our former partners. We're going to need to possibly withhold on them. So that's been around forever. Something that's somewhat more definitive lately is the sale of that partnership interest. So if I decided to sell my interest in that partnership that was generating ECI, pre-TCJA, it was a little bit unclear as to if this, the capital gain generated from that disposition, would be subject to withholding. Is this ECI or not?

Some took the position it was ECI. Some took the position it wasn't ECI. There was a case, a Grecian Magnesite case, where this was essentially argued. The courts sided with Grecian Magnesite and said it's not ECI, and it's not subject to withholding and everyone said, "Okay, great. Now, we have more of a leg to stand on by taking a position on not to withhold. And then, TCJA came out and said, "Wait a minute, no, let's make a small tweak here." Basically, the TCJA came out and said that the sale of a partnership interest that was generating ECI is indeed subject to withholding. It is ECI. So when we're disposing of these interests, we need to consider how much of the gain is going to be considered ECI and what withholding do I need to do. And if-

Simcha David:And the 1446(f) withholding, that's the gross withholding, similar to FIRPTA withholding, not just simple withholding of the ECI. And how that interplays with partnerships is there's - you know and if you have a secondary transaction, you may get a request from the partner that's selling for information down from the fund. This isn't the place to have that very robust discussion. We've approached that subject on another webinar, and I'm sure we'll have more in the future, but that's something to keep in mind partly, because that can impact the funds.

David Chadwick:Right. And Jay Bakst, our international partner, is having a session on December 18, I believe. That's going to go into more foreign specifics, so we can move on. I want to touch on installment sales. Many of you are familiar with the installment sale rules. One thing worth noting is that you can elect out of installment sale treatment, and why would you want to do that? Why would any taxpayer want to accelerate gain when I'm clearly given the option to defer gain? Maybe if the sale included some 1202 qualified small business stock, which 1202 allows for gain exclusion.

So if the stock that I just sold is going to be eligible for a significant gain exclusion, maybe I want to recognize that gain in the current year rather than default of the installment method and recognize it over a number of periods where my gain exclusion is going to get prorated over that same period, just something to think about. Another one with installment sales is installment sales with contingent payments. So you could have the sales contract, accounts for contingent payments based on certain milestones, maybe an inclusion of a percentage of future profits.

We're given three options on how to recognize these or report the sale. It would be the installment sale. You could do a closed transaction, which is basically opting out, like we just talked about, or you have this open method. Now, the three methods to calculate the gain, just run through these real quick is if you have a max selling price stated in the contract. Basically, you don't know what you're going to get paid, but you know the max that you're going to get paid. The rules say you use that max amount to calculate your gross profit percentage and to calculate what gain you need to include as you go through over the installment periods.

The second scenario would be where you have a set number of periods, but maybe you don't have a max selling price. So what the rules are going to tell you to do is the cost basis needs to be allocated among the periods. And if I don't receive any proceeds in a specific tax year, I'm not able to take a loss that year, but I'm going to have to rather carry my basis that was allocated to that period to the following period, unless it's the final year of the installment sale or it's deemed worthless. The third scenario would be I don't have a max selling price, nor do I have a set period of when I'm going to get paid.

So these types of transactions are more scrutinized by the service, and they're going to make you allocate your cost basis over a 15-year period. And again, just like scenario two, if I don't receive any proceeds, I'm not going to be able to take a loss. I'm going to carry my basis over to the following period. And at the end of the 15 years, whatever my remaining cost basis, it's just going to get carried forward until I've either fully recovered my basis, or the security's been deemed completely worthless.

I think one of the key takeaways is that if I'm in this position and I'm not going to receive proceeds in a year, I'm not able to take the loss. I just need to carry my basis forward. Excuse me, closed transaction method under a contingent payment scenario, it's similar to a regular installment sale opt-out. So the election's made in the year of the sale. Your proceeds are going to include your cash, any fair market value of property received and also the fair market value of contingent payments.

You're going to be able to recover all the basis in year one, also the taxes paid in year one. So the risk lies with if I'm including fair market value for any contingent payments that I haven't received yet. What happens if I don't receive those payments? I'm paying tax in year one where I might not ever see that money. And then, the open method, which I said is highly scrutinized. The service really wants to know did an actual sale occur here, or is it more of a royalty type of setup? You'd be taxed on sale proceeds as they're received, and the basis would be immediately recovered.

I want to give Mitch time. I know we're running low on time. So the worthless securities, I encourage you to read through. If you're in a scenario where you have worthless securities, I think just really quick, getting to the worthless securities determination is difficult. It's not as cut and dry as you may think. There's options to get around it and get a better result. So I encourage you to look through this and call us if this is a scenario, but Mitch, I'm going to turn it over to you.

Simcha David:Just one point on that before we turn it over to Mitch. It has to be truly worthless in that particular year. Sometimes, that's a little more difficult, depending on what you're doing. Thank you, David. Go ahead, Mitch.

Mitchell Novitsky:Okay. My presentation is the state and local tax issues arising from COVID. I'm going to focus primarily on telecommuting issues. I know the presentations this morning dealt with 163(j), 461. We discussed NOLs. That's a subject for another day. I'm going to focus primarily on the issues that arise as a result of people telecommuting due to COVID. Now, I'm going to begin my presentation, and I understand these are the requirements.

And that is correct. 79% of the people said false. About a third of the states haven't addressed it at all. Some states have addressed certain parts, certain issues, not addressed other issues, but in short, I wanted to give my presentation. Obviously now, as you know, people are working from home. They're telecommuting. Often, that situation which presents itself is they may work for a particular employer in New York City, yet they live in New Jersey and Connecticut.

And there are various state and local issues that come up. I mean, I'm going to focus primarily on New York, but this would apply to all throughout the country. And particularly, I want to focus on two aspects of things for New York purposes, and we are with a financial group. And you've read a lot of articles in the papers over the last few months where people talk about hedge funds with management services. There may be an opportunity to not pay a lot of New York City taxes, because people are telecommuting, and they're working in other states.

So I want to begin with the unincorporated business tax. The unincorporated business tax in New York City, it's a big revenue-raiser. It's imposed on unincorporated businesses. 60% of the revenues come from law firms and financial companies, because many of them are unincorporated businesses, partnerships, and they're subject to this tax. So when you calculate the tax, how do you source your receipts to determine how much tax it's doing? Incidentally, the tax is on 4% of net income, and the reason it's such a big revenue-raiser too is there's a lot of add-backs for New York City purposes.

They make you add back payments to partners. So in short, you calculate your revenue subject to tax based on the location where the services are performed. So if the services are performed outside of New York City, they shouldn't be subject to New York City UBT. So that's why you've seen a lot of articles lately, and they specifically talk about hedge funds in particular and would apply to law firms and other things. Very few people live in the city percentage-wise. Most of them live outside of the city.

So would that enable these particular entities when they calculate their unincorporated business tax to not pay tax on all the services performed by telecommuters that are not in New York City, and it's not Jersey, Connecticut. It's also upstate, because this is a New York City tax. And I want to stress that this deals particularly focusing on the unincorporated business tax. C corporations have a separate rule. There, you look at where a customer is located.

So the articles and everything wouldn't apply as much to C corporations, because the customer determines where the income gets sourced. S corporations are a difficult rule, even though New York changed to market source. New York State went that way too, but New York City for S corps has stayed in terms of looking at where the services are performed, but in New York City, obviously as I mentioned before, there are many, many more unincorporated businesses and UBT is the key tax.

So what happens? Now, people are working from home. So if individuals are telecommuting and performing services, let's say you live in New Jersey or whatever, should you be able to source those revenues outside of New York City? Now, my poll question said, "What jurisdictions have issued guidance?" There has not been any official guidance from New York City yet on this particular point. And personally, I think that may be a good point.

Why has New York City not issued any guidance yet? It could be they didn't get around to it. It could be potentially they're doing this intentionally. They want to see how long COVID lasts. Of course, nobody knew how long COVID was going to last. It's interesting. A lot of states came out with releases as to how they're going to treat telecommuters in COVID, and they didn't expect it to last this far. And as far as we know, it could last six months, a year or who knows how much longer. So the city may be waiting intentionally and seeing.

Maybe this'll mean they'll audit taxpayers. Maybe they'll settle with them, but I think it's a positive. And incidentally, I began my career with the New York City Finance Department. I was in the legal affairs division, and they're losing revenue significantly. There's only so much they can get from these other taxes, the sin taxes or whatever on tobacco, alcohol, other things. This is a big revenue basis being lost. So what are they going to do?

I think they may be waiting it out, because then they may take an aggressive position. And unfortunately, as I saw with the city, maybe they'll settle with particular taxpayers, especially taxpayers where the dollar amount isn't significant enough. The burden of proof is on the taxpayer. And by waiting, they may feel that they'll be able to settle on some issues, but I personally feel that the city hasn't issued guidance yet. If the city issues guidance, then of course that guidance technically is something that we need to follow.

I mean, we can challenge the guidance. Say, maybe the guidance isn't a proper interpretation of the statute, constitutional issues, whatever the scenario is, but if they don't issue official guidance as many people have indicated and as you've read in a lot of the articles, then based on a clear reading of the statute, if services are performed outside of New York City, there's no guidance. The position should be that those revenues should be sourced to New York City.

However, I want to stress that, and we get a lot of questions from clients, there's no one-size-fits-all situation. Some clients are just in New York City. Some clients have an office elsewhere. Some clients have a formal arrangement with their employees where they're telecommuting, and they have a formal reimbursement or other business location at the telecommuting employee's location. So the facts and circumstances may be different. Some clients have better situations than others, and that's why it's very important when you read a newspaper article here and there.

And you hear, "Oh, we should be able to source revenues outside of the city." We've got to look at all the facts, as I mentioned, see if there's guidance. And see, your situation may be better than the next person. If you're only in New York City, then this revenue is sourced to New York City. If you're not only in New York City and you have other places, you may be able, even now, to take the position that certain revenues shouldn't be sourced, because somebody may be potentially based out of another location.

So that's a factor to be considered. Another thing is COVID-19, there was a point where the state and city mandated that people work from home. Now, it's not necessarily mandated, but a lot of companies aren't open and it may be optional. Some people are afraid to go in. Does that take into account how you should be sourcing the revenues? The key thing is, and as I mentioned, if there's no guidance, then the city statute is as is, and then there shouldn't be, in my opinion, a position that those revenues from telecommuters should be sourced out of New York City.

It's very important if that's the case. I mentioned I worked for the city. The burden of proof is on the taxpayer, and some of them are really tough on you. You have to come up with adequate records. So what would I suggest? I would suggest to get records from the employees as to where they are in a given day. Use your IT department. Whatever you need to do, it is very important to document, at this particular point in time, where people are in a daily basis.

So should ultimately the city acquiesce and agree that the statute reads one way, and they don't try to be aggressive and take some outrageous position as I've seen them do, having been an attorney there? Then, you're not going to win regardless, unless you maintain adequate records. We've been talking to some clients. And as I mentioned, it's no one size fits all. Some clients have already a presence outside of the city. Some don't, but a conservative approach, because there's potential penalties for underpaying an estimated tax is for estimated tax purposes to assume that the city will take the most aggressive position as possible.

If guidance is issued, then you can scale back. And then, at that particular point, if the guidance is favorable, then feel comfortable to obviously just pay in what's required according to the statute. And as I mentioned, if no guidance is issued by the time the returns need to be filed, then based on an application of the statute, one should be able to source certain revenues, but I want to stress again, no one size fits all. Everyone has a different situation with their employees and everything, but regardless it's very important, I stress again, to keep adequate records.

So for the meanwhile, keep adequate records. Wait and see what guidance is issued. And if there's one more estimate, you might want to be more conservative to that estimate, and we will keep you informed, and let's see if there's formal guidance. If there's no guidance, which if I had a bet, I think may be the case, then I think we clearly have a position, but everyone's set of facts is different to source those revenues out of New York City. Now, what are other jurisdictions doing, like Philadelphia?

They have a tax similar to New York, business and receipts tax, net profits tax. They also look at where the services are performed in terms of determining where revenue should be sourced. They're saying that if people are working from home solely as a result of COVID, they normally work in the city, those are city revenues. Now, they're giving you the reverse, and I'm sure the city will be happy to give you the reverse. If you have a business that's outside of New York City and some people live in the city, and they're working in the city just due to COVID, they'll say, "Okay, we won't source those revenues," but more people are going into the city obviously and less people live in the city.

So if the city gives, I think that might be the most they give, but as I mentioned, the statute is the statute, and the city's going to have to come up with a particular reason. Some people say that the city may say, "Well, your service is still in the city. The IT people are in the city. You're still directed by the city." Maybe that gives them the authority. As I said, I've seen them take very, very aggressive positions, having worked there, but let's wait for the guidance. And in the meanwhile, document, document, document, I can't stress that enough, all of the services performed by employees outside of the city.

Incidentally, there's another plane not related to COVID, but where do you determine where the services are performed, if people are performing services in different places? The city looks at any reasonable method, whether in terms of value, in terms of time spent. So when it comes to doing your tax return, we can work with you or work with your tax practitioners in terms of the exact sourcing of where the services are and also what to do in terms of COVID.

New York State, this is not as much of an issue. I'm going to finish this in just a couple of minutes. Please bear with me. New York State, it's not as much of an issue. They use three factor. Excuse me, I jumped ahead of the gun. The New York State uses three-factor versus one-factor partnerships that flow through entities. So it's not really as much of an issue for New York State purposes as it is for city purposes, because it's flow-through, and they use three factor.

Now, the other thing I want to mention too is as far as individuals are concerned, the other big issue, I mentioned UBT for employers and also withholding. We get questions, even entirely of our firm, people saying, "Well, I'm working in New Jersey. Why is the firm still withholding state tax, but it's a working tax?" And the reason is there's no personal working tax for the New York City nonresidents, but New York State nonresidents, they have the convenience of the employer rule.

If you are based out of a New York office and you are working outside for your own convenience, they call it, and the state recently issued guidance saying that it includes COVID situation as well, then you still have to withhold New York tax. So it's interesting that even though you think you haven't been in New York State since March or whenever you've been telecommuting, if you're based out of New York State unless you have a formal office in your home that your employer sanctions, then you still have to withhold New York tax.

So be careful of that. And as an employer, and I dealt with that situation when I worked with the city, you can be held personally liable on these trust fund taxes, income tax, sales tax, withholding tax, sales tax if you don't withhold. And the employees need to understand what the rule is as far as the state is concerned. Now, just the only other issue is when you have telecommute, there could be issues in other states, but I can tell you that most states have said that if somebody's working in the state, just due to COVID performing services, generally that won't create nexus or a filing obligation, because they understand that it's strictly due to the pandemic.

And then, how do you source the revenues if you work in the other state? You stayed as a particular position, but of course if there's no filing obligation, then you don't have to worry about that. Key thing, as I mentioned too, is withholding. You could still be working in New Jersey or wherever, but New York is still going to want tax paid on your behalf and also personal income tax. A lot of states, it's interesting. Jersey I mentioned earlier, they are issued to release in March saying, "Well, continue to withhold as is," but then once New York took this aggressive position and New Jersey now, it's months later, and all these people are paying tax to New York.

You get a credit in your resident state of Jersey for taxes paid to New York, but Jersey's losing out on all this money. So I understand how Jersey's reconsidering this issue, and all these states talk about how they love each other and work together, maybe with regard to solving COVID issues, but when it comes to taxes, everybody wants their own. So it's interesting to see what'll happen. New Hampshire's got an issue with Massachusetts. Jersey's losing all this money now because of this New York convenience of the employer rule, and so you get a credit.

So you're only paying tax either none to Jersey or only on a spread, if you're a high-income taxpayer, which may be next to nothing. I just want to leave also with residency issues. This has come up a lot. People think, "Well, I'm not in New York City." Let's say I'm by Florida, by my parents or whatever. So I don't have to pay New York City tax anymore or New York State tax, even though they're normally a New York City resident.

I mentioned before that convenience to the employer rule, but also residency, there's two tests. Either you're domiciled and that's your permanent location, or if you maintain a place and you spend 183 days. And getting into more details, another time, feel free to contact any of us, but in short, even if you're in Florida temporarily, it doesn't mean that you're no longer a New York City resident. So you could still be subject to New York City tax on all your income, if that's your domicile, if that's your home base.

And I've seen the reverse happen. Some people, let's say they're in New York, they have a place in Connecticut and they're just entering COVID. Guess what? They have a place in Connecticut more than 183 days. Once you're there more than 183 days, even if you're not domiciled in the state, you could be a resident for statutory residency purposes. So just be careful of your personal income tax issues that present themselves on the residency level and the personal income level. And on that note, I just want to note. Happy Thanksgiving. We're under tough times, but please take the time. Enjoy it with your family and all the best. Good luck to all of you.

Simcha David:Thank you so much, Mitch. I appreciate the statement for the state and local jurisdiction, because when they're starving for revenue, everybody goes at the taxpayer to pay as much as possible. And unfortunately, we've seen that in the past. So hopefully, they'll understand. They'll be more understanding about the situations as we face them. I just wanted to thank you so much, David. Thank you so much, Mitch. Thank you to those that helped put this together. Thank you, Brian. Thank you, Melody.

I just want to remind everybody that part two on December 8th from 12:00 to 1:00, part two of this series, with the topics of identified recent IRS enforcement trends and best practices, and identify tax planning opportunities for individuals with states and gift taxes. That's on December 8th. And on December 15th, it's understanding CFC downward attribution, discuss when a fund needs to withhold on a sale or partnership interest, FATCA, CRS, 1042 reporting. That's on December 15th. Thank you all for joining us. And as Mitch said, everybody have a very happy and healthy Thanksgiving.              

I'm going to start with a discussion on carried interest rules. So we did get proposed regulations on carried interest. Okay, we did get proposed regulations on carried interest. I'm going to spend a little bit of time, not that much of time, on it and I'll explain that in a minute, because the proposed regulations as they came out and it raised more questions than it answered. And if you look on the bottom of this slide, you'll see there on November 13th, Tax Notes reported from an IRS official that we would be expecting final carried interest regulations before year-end, and they are going to be significant changes to the proposed regulations.

Not going to sit and go through all the proposed regulations now, but we will go through some high-level points. So everybody knows the 1061, the carried interest rules, subject an applicable partnership interest, what we also review as the GP's interest to a three-year holding period. So carried interest now, in order for you to get the favorable long-term capital gains tax treatment of 20%, you would need to have a three-year holding period on the property versus a one-year holding property as it is for those who hold it, in general.

So the proposed regulations did clarify, which was taxpayer-favorable, that it does not apply to qualified dividend income. So if the GP gets a reallocation of qualified dividend income, that's still subject to the 20% tax rate. It does not apply to 1256 contracts. We do have the 60/40 rule. This was a little bit of a shocker. It doesn't apply to 1231 gains from depreciable or real property used in a trade or business. In that sense, it's anything that is not connected to Section 1222, which is the normal long term versus short term, because that's where they made the change.

And for applicable partnership interest, you would now be subject to a three-year holding period. The proposed regulations doubled down the IRS' point, the IRS' position, that an S corp is subject to the rules. Even after that and after they came out with a notice, said they were going to do this and they came in with proposed regs, there are still people out there who think that the IRS got it wrong, that based on the current law as it's written, these carried interest rules should not be able to apply to S corps, but they did clarify that it does, S corps, QEFs, REITs, RICs, all that.

Even though because of the pass-through nature of the income and that you get the character of the pass-through nature of the income, even though they're not officially pass-through, is that the three-year holding period would apply, as well. They clarified the distributions in-kind are subject again to 1061. So even did an in-kind distribution of a stock, when you did, you would hold onto it for a minimum of three years. You do tack on the holding period. So that would be a minimum of three years until 1061 has been met.

This was a little bit interesting on the sale of an API. So what happens if a general partner sells his general partnership interest, and he's held that interest for years, graded it for years? So usually, the way that works is you would calculate a capital gain, and your holding period in the partnership is your holding period. Under these proposed regulations, you would actually look through to the assets, the underlying assets of the fund to determine if those are more short term versus long term and, therefore, the gain on the sale of the applicable partnership interest, even though you held it and graded it three years could still be short term for the general partner.

They did go ahead and try to clarify the capital account exception. That is that if a general partner does put capital into a fund. Even if it's the same entity that's holding the carried interest, there should be an allowance for that piece to not be subject to the 1061. They took the time to really make this as complicated as they possibly can. They actually wrote that they must make allocations on the same terms to unrelated service partners.

So everybody's like, "Does that mean I now have to calculate a management fee and a carried interest to my general partner, reduce the capital account and that would be the capital account exception?" So it seems like it would be a nightmare to rely on. I think they got a lot of feedback from practitioners on the capital account exception and how difficult they made that out to be. And so, I guess we'll see. Hopefully, the final carried interest regulations will be a more simplified version of the craziness that they came out with, with the proposed regs.

There was also some transition rule that they had come out with. The preamble actually states that prior to 2018, most people weren't really keeping track of holding period on their unrealized. And so, we're going to come up with a transition rule that allows you to exclude all your regular three-year holding period. Well, if I wasn't keeping track of the holding period, that was my transition rule that says I can back out my three-year property, doesn't work. If I wasn't keeping track, I don't know what's three years.

So it didn't really make that much sense, the transition rule. So it's anybody's guess ultimately how that will pan out at the end. Of course, what was also left unsaid or really it doesn't seem like it was clarified that much is just, in general, the full unrealized carried prior to 1118, based on this transitional, it seems like it might be included, but again it wasn't spoken about specifically. And the second question that remains unanswered is with regard to the unrealized piece of the capital account of a general partner in a hedge fund.

So I'm not going to get too detailed on this, but the preamble basically said, "Listen, if you guys have applicable partnership interest, you're getting a carried interest and you've been taxed within the partnership on the gain," right? So let's say it's partially realized and partially unrealized. So on the realized piece, they said, "Listen, we're not going to make you take that money out of the fund and then put it back into the fund so that the capital account exception could apply to you. We don't want you to do that."

And so, that's why they put in the capital account exception there for that piece at the very least. In the preamble, it sounded like for that piece, you would not have any issues, and you could keep it in without having to keep the money out first and then put it back. And you could still rely on the capital account exception for that. What they weren't fully clear on was on the unrealized piece, right? So in a hedge fund, a general partner earns carry, part of which is realized by the end of the year and part of it which is unrealized.

So when the unrealized carry unwinds in a future year, that amount is definitely subject to 1061 and a longer holding period. The question is what about the earnings on my capital account that is at the end of the year, the current year, part of which is unrealized? So when the unrealized unwinds, that is subject, but the earnings on that are realized, the earnings on that capital account. It was not fully clear whether or not those amounts would be subject to 1061 or not. I think most firms are taking the view based on the way the regulations have been written, even though the preamble seems to say something else, that the earnings on that unrealized piece should actually not be subject to the rules of 1061.

So that is my high-level overview of 1061. We will be having another webcast once the final regulations come out. So hopefully, we will have a simpler version of these rules and something that we feel can be applied when the final carried interest regulations come.

Simcha David:Okay, yeah. That's what I thought. About 21.5% said funds borrowed from management company/internal entity, yeah. And that is something that the service is aware of, and that's why they put that assumption into the rules. Okay. So that's 1061 and I'm looking forward to the following webcast when the final regulations do come out. What we did get on Section 163(j), which are business interest expense limitation. We got final regs and new proposed regs when it comes to 163(j).

Believe it or not, the final regs had a number of changes and many of them were really taxpayer favorable. So we'll go through some of those changes. Those are changes from the 2018 proposed regs that we've been going through in the last two years. I'll give you some background to 163(j) and then some of the highlights as are applicable to financial services industry. So very quickly, Section 163(j) was put into the Internal Revenue Code as part of the Tax Cuts and Jobs Act of 2017.

It made a business interest expense limitation that is basically across all types of entities. It doesn't make a difference if it's related-party interest, if it's third party interest, then to equity ratios. All these things that were in the prior 163(j) have gone away, and basically it is a business interest expense limitation amongst all types of entities and all types of debt. The basic calculation's as follows. It's the sum of the taxpayers. You get to deduct the sum of the taxpayer's business interest income plus 30% of the taxpayer's adjusted taxable income, which obviously will take out business interest income.

We'll talk about the CARES Act and the change that that made and the taxpayer's floor plan financing interest, which you've never heard about. I always say this. Don't worry about the floor plan financing interest. Then, you compare that to the sum of the business interest expense. It will determine if there's a disallowed interest expense for a particular year. The rule does not apply to an electing real property trade or business, an electing farming business and certain activities of regulated utilities.

Now, those exceptions are unique in the fact that not only is the business interest expense not subject to 163(j). The income earned from those types of entities don't go into the calculation with regard if you're in a partnership, and you earn income from those types of entities. That income is also taken out of the calculation, if you have a business expense limitation up the chain and you needed some ATI. So that is how that works. The small business exception is an exception. We're going to change some of the wording.

Small business is going to be referred to as an exemption, and real property is going to be referred to as an exception. The small business exemption is actually similar to real property in that the business interest expense limitation does not apply. However, the items of income and expense from a small business, if it's in partnership form, when that flows up to the partners will be deemed to be business income.

So it would be part of the ATI that they can use further up, adjusted taxable income that they can use further up, the chain if they need to, to deduct their own interest expense if the section applies to them. So the final regulations made significant modifications, and many of those were taxpayer-friendly.

Simcha David:Okay, we got at least 54.6% who encountered Section 163(j). I think with some of the new rules fewer people will, but let's go ahead. So first, I'd like to take a quick review of the CARES Act changes to Section 163(j). So we have this limitation that business interest expense is deductible up to 30% of your adjusted taxable income. So the CARES Act came in and changed that. So for corporations in 2019 and 2020, the 30% of adjusted taxable income limitation was increased to 50%. So for all tax years in beginning in 2019-2020, the amount of deductible interest is now 50% of the ATI.

For partnerships, the rule is different. They left the 30% of ATI limitation in 2019. Presumably, this was done initially because it was after the filing deadline that this came out for partnerships. They assumed many people already filed partnership returns under the new partnership audit rule of, nope, you did not have the ability to go back and amend partnership returns. It was only prospective. And so, they said, "Leave 2019 as is. We'll compensate you for that." We'll see in a minute. They'll leave it as is, and only 2020 will be 50%.

Post this coming out, they came out with reg prop 2020-23, which actually gave certain partnerships the ability to go back and amend tax returns, actually amend them, for 2018 and 2019. So that being said, this rule stayed in place. And so, for partnerships, 2019, it was not changed. It was at 30% and it was only changed in 2020 to 50%. To compensate partners and partnerships with this discrepancy, and this is important, if you got Line 13k, which is excess business interest expense on a K-1 in 2019, your partner and you got that, that means you got nondeductible business interest expense.

That means you're going to be tracking. And then, in a future year, if you get what's called excess taxable income from that partnership, you will now have a possible deduction. So if you have that on your K-1 for 2019, 50% of that amount will be deductible in 2020 without regard to any of the other rules of 163(j). So you would not need excess taxable income to free up 50% of that 2019 Line 13k. So not only do you get 50% of ATI in 2020 itself, but you also get this additional deduction if on Line 13k, Schedule K-1, Line 13k 2019, you had a number there.

You're going to get 50% of that number as a deduction in 2020. You can elect out of that if you so choose, but that election would be done by the partner and not by the partnership. With regard to the 50% versus the 30% of ATI limitation, that is automatic again, unless the partnership elects out of it. They came out with another rule from the CARES Act, and that is that both corporations and partnerships can elect into using 2019 adjusted taxable income as opposed to 2020. So in 2020, instead of basing your business interest deduction on 50% of your 2020 ATI, you can do 2019 ATI if you left.

And presumably, the idea is that your 2019 ATI is going to be higher than the 2020 ATI because of the issues that business faced in 2020. So those were the CARES Act changes to IRC Section 163(j). Now, let's talk about the final regulations. Here we go, the definitional interest. So the definition of interest on the proposed regs was very, very broad. They brought it back a little bit and took out some of the things. So one of the few things they took out was guaranteed payments for capital. That was included in interest expense.

That is no longer included in the definition of interest. However, there's an expanded anti-avoidance rule, and there is an example of a guaranteed payment for capital in the anti-avoidance rule. So in essence, if instead of taking out debt, you go ahead and borrow from a partner, there is still a possibility that will be deemed to be interest expense, even though you're booking it as a guaranteed payment for capital. They came out again with the embedded loan rule, but they put into place that this rule for the notional principle contracts with significant non-periodic payments.

So there is proposed regs out there on the code section where there's an embedded loan rule concept and whether the interest on that embedded loan will be included interest expense. They say it would, but only for non-cleared swaps. So if you have swaps that clear through an exchange or they have emerged in collateral requirements that are of a federal regulator or similar to a federal regulator, this rule does not apply. So it only applies to the non-clear, and they gave an effective date that is 365 days after the publication of these final regs as opposed to 60 days like everything else, because they knew it would take time to implement these rules.

That being said, if you enter into one of these before the 365 days and there is avoidance here, you can get tripped up again by the anti-avoidance rule, which is applicable 60 days after, so keep that in mind. Commitment fees and other fees paid in connection with a lending transaction are also not deemed to be interest, which is interesting. In many debt funds, we try to make as much interest as we can, especially when you're dealing with UBTI issues. You'd rather something be deemed to be interest for your tax-exempt investors versus not.

So we'll see how that will be deployed. They came through with the ordering rules, and that is the deferred interest provisions and disallowing interest provisions come before 163(j) in terms of how much interest. You actually have interest expense. However, the passive loss limitation rules, the at-risk limitation rules, at Section, that should say, 461(l) come after the 163(j) computation. So even if an interest expense is allowed under 163(j), if it can surmise to a loss and you can take that loss, obviously the loss is still limited.

When that loss does reverse, you don't look at the fact that part of that loss is an interest expense component, and you don't have to worry about 163(j) for that part of the loss in that year. Again, the anti-avoidance rule, just very high level. It basically says that if a, if a, not the, a principle purpose of structuring a transaction is to reduce an amount incurred by the taxpayer, always been described as interest expense, then you've tripped up the anti-avoidance rule. Again, it's going to depend on all the facts and circumstances.

And then, it specifically says, "A purpose may be a principle purpose, even though it's outweighed by other purposes." So figure that one out. And not only that, but they're very clear to say that a business purpose, a business use for obtaining the fund, other than the fact that you're trying to minimize the interest expense, a business use for obtaining the funds is not enough. If one of your principle purposes of structuring the transaction in a particular way is to reduce the amount incurred that would otherwise be described as interest expense.

So what is deemed to be economically equivalent to interest? It's deducted by the taxpayer. It's incurred by the taxpayer in a transaction or series of integrated or related transaction in which the taxpayer secures the use of funds for a period of time. We all know what the general interest is. It's substantially occurred again in consideration for the time value of money, and it's not described in these other paragraphs, which has mainly described what interest is under the code, under 163(j). So this is the expanded anti-avoidance rule, and it seems to include or could include many things or many kind of transactions. So just got to be careful with them.

Okay, let's talk about the final regulations when it comes to partnerships. So the 11-step process, unfortunately if anybody's dealt with that, that's here to stay. It's not going anywhere. I believe some had asked for a reasonable amount. They didn't like that. They stuck with their 11-step process. However, if you allocate everything in your partnership based on a pro rata basis, then you're kind of exempt, because you're going to get to the same spot, regardless. Small business exception, this is really important.

The small business exception changed from the proposed regs. Under the proposed regs, if I have a small business that's, let's say, a partnership, okay, and there's business interest expense at that partnership, and then that business interest expense is exempt and it gets reported up to the partner, and let's say the partner's not a small business. So under the proposed regs, we thought the better understanding was that partner now has to retest the business interest expense of a small business that was underneath them, because it's a small business exception as opposed to real estate.

Under the real estate exception would not have to retest under the small business. We could avoid. While under the final regs, if a small business is the bottom entity, it's an operating partnership and because of the small business exception, the interest expense at that level is not subject to 163(j), it is no longer a business interest expense that needs to be retested up the chain. So this is a huge difference. It's a sea change from the way we dealt with business interest expense coming from a small operating business, important for private equity funds and some of the funds that may have made these kinds of investments.

So it's no longer required to retest up the chain. In addition, they clarified under the regs that if a partner is allocated excess business interest expense from a partnership, right? So in year one and two, you get excess business interest expense. In year three, that operating partnership becomes a small business, okay? Then, the partner's allowed to treat the carryover excess business interest expense for the prior years as business interest expense in that particular year. So you're allowed to treat it that way in that particular year.

However, the partner at their level, if they're subject to 163(j), may still be limited to those for that amount of business interest expense that was freed up because of the prior two years when the excess business interest expense was limited. You were not a small business in those years. So it would still be subject possibly to the business interest expense limitation, but the current year, the small business amount, that would no longer be. Now, this rule, they would clarify, doesn't apply with a real estate election.

So be very, very careful of this. If I have a partnership that in years one and two, I did not make a real estate election on, okay, so I have business interest expense coming from those partnerships, and I did not make a real estate election on them. In year three, the same entity, I go ahead and I say, "I'm going to make my real estate election now. Because I'm eligible, I'm going to exempt it." If you go ahead and make that, well, you become eligible at that point. If you make that partnership a real estate entity, all the excess business interest expense you earn prior from that partnership needs excess taxable income from that partnership to free up, up the chain.

But because you are now a real estate entity or you now elected to have the real estate election apply, none of your income will be excess income anymore, and it will freeze that excess business interest expense to where they can no longer get freed up. So when it comes to small business, it does allow it to free up. It does free up in the future year. It frees up in the year when you become a small business, but if you're going to make a real estate election, it might not free up at that point. So keep that in mind, but this is example 11 of the regs.

I highly recommend that everybody reads through it. I'm not going to go through it now. I will make one mention of something which is interesting. If you have a partnership that's a business, and that has business interest expense and investment interest expense, and your partnership has a corporate partner and the rule by a corporation is that everything is deemed to be business. Even investment interest expense is deemed to be business. What happens if that operating partnership is a small business?

That small business says the business interest expense is no longer subject to 163(j). We're a small business. My corporate partner doesn't have to worry about that business interest expense from my small business. However, the investment interest expense of a small business, because it's not caught under 163(j), when it goes up to the corporate partner and becomes business interest, if the corporate partner's otherwise subject to Section 163(j), that would be business interest expense to be included.

Okay, the regs also came out with allocation rules. They've got a mix of accepted and not accepted trades or businesses. It's the de minimis rule that says if 90% or more of your taxpayer's assets are either an accepted or not-accepted trade or business, then you don't have to start bifurcating up how much of the interest expense goes to which asset. They didn't want you specifically tracking. So if an entity has debt and there's interest expense, they didn't want you tracking, "Oh, I'm using all that money for my business versus my non-business," or vice versa.

They didn't want you doing that, because money's fungible. And so, they put this more fixed asset test, but they did put the limit in this rule in. If you have an asset that's used for both accepted and non-accepted businesses, it comes out with three permissible methodologies for allocating the interest expense among the assets. Okay, this was a big one. This is huge. Trader funds, finally. They came out and said that trader funds for their limited partners are no longer subject to 163(j), okay? Pat myself on the back, yoo-hoo.

We're all happy about this. As far as I can talk about it, the code did not read this way when they came out with it initially, and they finally corrected it. And so, basically for your limited partners and trader funds, the interest expense will remain invested interest expense as it always has, subject to that limitation and will not first be limited at the partnership or at the fund level as we had been doing for the last two years based on the preamble of the 2018 proposed regulations. And so, they basically say that for your limited partners or for your non-materially participating partners.

So any GP who's materially participating who also has money through a limited partnership interest, unfortunately that does get included, because you are materially participating. So it doesn't matter if you're actually the GP or the LP interest. As long as you're materially participating, 163(j) will apply to you at the trader fund level, but it will not apply to the limited partners. Instead, that will get reported up the chain. If you had reported amounts under 13k to your limited partners, we'll probably put a footnote of sorts in the K-1 of the code here saying that those amounts should free up. Please consult your tax advisor.

So keep that in mind. This is a huge change and this is in the new proposed regs that came out in 2020. Also under the new proposed regs, they came out with how to deal with tiered partnerships. Under the tiered partnership rule, unlike the way we've been doing it or many have been doing it in a fund-of-funds scenario that you keep reporting all the information up to your partners. It's the partnership and one layer up that gets included here. So if you have a portfolio company that's a partnership and you're a private equity fund, and you get Line 13k coming flowing up to you from that entity, you will stop at your level.

You will not report that up to the other partner. Not only that, you will reduce your tax basis in the underlying portfolio company, but your partners will not reduce their tax basis in your entity by that amount. You will track it at the fund level, and then you will go ahead and free it up in the years when you get excess taxable income in that particular partnership. So that's going to be a big change in how we do reporting. So again, the fund of funds will no longer be reporting of Line 13k to the partners.

And in private equity funds, as I said, you'll be tracking it, as well. So we'll see if these proposed regulations go final on the same quorum. You can early adopt if you want. That is allowed under these new proposed regs. I think it makes it a little easier in terms of perhaps a little bit easier on your investors, not necessarily easier on the partnership but easier on the investors with regard to keeping track of all the information necessary for Section 163(j).

The proposed regs also have a partnership self-charged interest rule. So if a partnership gets a loan from a partner, some people would just disregard the interest expense and interest income, because whatever interest expense is here flows up to that partner and that partner picks up the interest income for the same loan. So just disregard it all. It's all canceling out. It does not all cancel out the business interest expense. The interest expense at the partnership level, if it is an operating business, again subject to 163(j) will be business interest expense.

The income that the partner's earning, that that interest expense is now giving rise to income at the partner level, so the income that that partner's earning will be deemed to be excess business interest income in that particular year to the extent of the excess business interest expense that they get from the underlying entity. And if otherwise, it would be investment interest to that partner, the rest of it would be investment interest to that partner. So that was another big thing in the proposed regs.

The proposed regs and if you notice, this is not a 163(j) proposed reg. This is a 163-14. 163 is broader than 163(j). However, this proposed reg fixes the rule with regard to the interest tracing rules. So if you have a debt-financed distribution, there are interest tracing rules, and this proposed reg brings those into line so that 163(j) would apply to those, as well. And it basically says you look to the use of funds, if the amounts are required to be traced. There is a rule that came out, Notice 89-35 with regard to partnership expenditures, that somehow you can allocate the debt first on your expenditures before saying, "Hey, we've got a debt-financed distribution."

Once you have a debt-financed distribution under this proposed reg, you would have to trace it to determine whether it's business interest expense, investment interest expense, et cetera, at the entity realm. Okay. So that is it for me. Hopefully, you took some few points out of the presentation. Again, I think the small business exception is really important, how that's changed. I think what's really important again is the trader funds, how that's changed, as well. And I'm now going to hand it over to my colleague, David Chadwick, for the next portion.

David Chadwick:Thank you, Simcha. Quite interesting. This was definitely better than some of the previous ones on 163(j), lots of good news included. So thanks for sharing. So today, I'm going to be covering a few topics. I'm going to be going over the new tax basis capital reporting and a few considerations for both hedge and private equity funds to keep in mind when you're doing year-end planning. So first topic we're going to talk about is the change to the tax capital reporting, so a little background.

So 2019 and prior, the partnerships, we would report our partner's capital accounts on Item L, the K-1, and we're able to do so using a couple different options. We could report on tax basis. We could use GAAP. We could use 704(b) or another method, and most of the funds with audited financials, this was their gap balance. So if we give our investors K-1s, the investor was easily able to tie out their market value statement that they received from you and the K-1, and they knew that we at least got something right.

So in '18, the new reporting requirement to report a partner's negative tax basis came out. So we didn't go full throttle on tax basis reporting yet, but the IRS came out in '18 and said, "Okay, if any of your partners have negative tax basis, either at the beginning or end of the year, we want to know about it and we need to see it on the K-1." Why is the IRS shifting their focus and adding the additional requirements?

Just like a lot of the different items on the K-1s, they're trying to get a clearer picture as to what's going on with the taxpayer. They could better focus their efforts to look deeper, maybe potential audit risk and whatnot. So with negative tax basis, there's two things that I could think of off the top of my head that might be advantageous to know from the IRS perspective. One, has this partner taken cash in excess of their tax basis?

Could that have resulted in taxable gain that they're going to need to pick up? Or two, if this partner is showing a negative tax basis and they're being allocated losses, do they indeed have enough basis to take those losses? Are they at risk? So '18, we need to start reporting negative tax basis. '19, we see the initial draft 1065 instructions telling us that now we're going to need to see tax basis for every partner, and that's when all the commenters, all the practitioners and taxpayers start going a little crazy and saying, "This is going to be a huge administrative burden. I haven't been tracking tax basis over the years. How are we going to do this in such a short period of time?"

The IRS hears us and they delay reporting until 2020, so we get another year. That brings us to where we are now. Notice comes out in 2020 and says there's two proposed methods that we could use to report tax basis for all our partners, neither of which is a transactional method. The transactional method is how we all probably are thinking in our head how we calculate tax basis. I have cash moving. I'm allocated taxable income or loss. I have some nondeductible items, and that's where I land for my tax basis.

Now, we're talking about inside basis. So the transactional method is not the method that is proposed by the IRS. Again, commenters come out and say, "The transactional method just makes the most sense. This is how we've been tracking, if we've been tracking, and this is probably going to be the easiest way for us to get to a good starting point," because we're all thinking right now, "If my fund is 10, 15, 20 years old, how am I going to get to a good starting point, if I've been tracking at all?", because it's never been the partnership's responsibility to track basis for each partner.

Let me go to the next slide. So the IRS, they've acknowledged this, and so the draft 1065 instructions have did a little bit of a 180 as opposed to the notice that came out in June and said, "All right, the transactional method is now the only allowable option, and this is the only method that you should be using prospectively." That still leaves us with the question of, "How am I going to get to my starting point, if I haven't been tracking?" We'll get to the options. The IRS has acknowledged that this is going to be a difficult task, and we have four different options that they've given us and the instructions on how to get to good opening balances.

A couple of the notes is that the tax basis capital reporting, it's going to fall under the BBA, which is the centralized audit regime that came out of TCJA, but they've also told us that we could expect some penalty relief as long as we take ordinary and prudent care to come to our opening balances. So per the instructions, the latest draft instructions of the 1065 that came out in October, the IRS is giving us four options to come up to our opening balances. The transactional method, which if we've been tracking tax basis for all our partners as we've been going through, we're in a pretty good spot.

Probably the best case scenario, we are from an opening standpoint. So I'm going to just continue doing what I was doing. Maybe there's some 743 adjustments, which are not going to be included in the tax basis amount that's going to be included in our opening balances. We might need to make some slight adjustments, but for the most part, if I've been tracking and I'm reporting on a tax basis method, I'm in the best case scenario. I could use the modified outside basis method.

The modified outside basis method is essentially taking the partner's outside basis, making some modifications, taking out some liabilities, taking out any kind of 743 adjustments, and then getting back to more or less our inside basis as our starting point. And the IRS has mentioned that a partnership may rely on basis information provided by the partners. So practically speaking, I don't know how much sense this makes in a funds perspective. Maybe for a management company or some closely helped partnerships, I could rely on my partners.

I only have five, 10 partners. Maybe they're family members. We could just easily get that information. Once I start getting into the fund space, I have 1,500 partners. Am I going to really start sending notices out to my investors and ask them to tell me what their tax basis is? Probably not. We all know we send those kind of notices out, especially when it comes to tax. We're not going to get much of a response, if anything. So that leaves us with a few other options, the next one being the modified previously taxed capital method.

So this is taking the previously taxed capital method, which is based on a hypothetical liquidation of all the assets in the partnership. We treat all the assets as sold. We take cash received on a hypothetical liquidation, increased by a tax loss that would be allocated to the partner and decreased by a tax gain that was allocated to the partner.

Simcha David:And it's not necessarily fair market value, just hypothetical liquidation, right? So-

David Chadwick:That's right. So you could use the net liquidity value, which is the last point on here. You could use fair market value. You could use GAAP. There's a few different options that you're going to use, and you have to include that on the K-1s to the investors. I mean, I feel like it's obvious, but they do mention it needs to be applied consistently across partners.

Simcha David: Right. David, I just want to make a point to the people that are listening. And then, you have the 704(b) method you can go through in a second. So this is the service telling us, "We want you using transactional method going forward." How are you going to come up with your beginning balance? Possibly if you don't have a transactional amount, you can use these other methods. So you're starting with another method. You're switching to a second method, which in my head says that the number at the end of 1231, your ending tax capital, basis tax capital, is really not anything because you're combining two methodologies to get there.

And it wouldn't necessarily be anything. And so, the question is, is the service going to come out and say, "That's great. That's what we allowed you to do for 2020. We gave you penalty relief on that, but in 2021, your beginning tax capital balance needs to be good based on the transactional method." That, we're just not sure of. We think they might come out and do that, just to give us more time. And the reason they allowed this for beginning tax capital in 2020 is because we're now in November of 2020, and people are going to start filing soon. So we think that's what's going on, but we need to hear more from the service, but go ahead with the 704(b).

David Chadwick:No, that's a good point, and I think there's still going to be more work to do, even after we get past '20. So the last method is 704(b) method which is essentially your 704(b) capital count, plus or minus any 704(c), built-in gain or loss. And just as a reminder, your 704(c) property is that contributed property, and that built-in gain or loss is the variance between the original cost basis and the fair market value at the time of the contribution. And this also includes reverse 704(c) in the hedge world, which would be your reval accounts.

Okay, a few other notes. So each partner continues to be responsible for maintaining their outside basis, and the partners in the capital account, as reported on the K-1, might not necessarily tie to what that partner is de-calculating outside, and there could be reasons for that. So the number that is going to be on the K-1 is going to reflect your inside basis. What the partner's calculating outside, maybe they purchased that interest from another partner. Maybe they inherited that interest. So there could be different reasons as to why the two may vary and that's okay.

And then, last note on this is that on 1065, the Schedule L on page five of the return, it's your balance sheet. It does not need to be reported on a tax basis necessarily. So for all the funds that have audited financials, the Schedule L, and the return is going to continue to mirror the financial statement. It's just now your Schedule L is going to vary. There's going to be a difference between your Schedule L at the top of page five and the M-2 at the bottom of page five, which is just the summation of all your K-1s.

The IRS knows they're going to be different, and they said that the only reason you would need to state why there's a variance is if you've been on reporting on a tax basis, and then you go ahead into this year and you report, and your tax basis balance sheet on Schedule L doesn't actually tie to your M-2. Then, they'd want to know why there'd be any variance.

Simcha David:David, just another point for those that are listening today. So you may have had investors that may have looked at Item L to see, "Hey, this is my capital account." They're used to seeing that on a Schedule K-1. Just be wary. Because of the way we're changing, you're going to get either calls or whatever. This is not my tax basis, or what is this number that I'm looking at? And so, that's going to be a major change to the reporting of the capital accounts on the Schedule K-1, so just be aware of that with regard to investors.

David Chadwick:Yeah, that's a fair point. I think it's just going to trigger more questions. Okay, just a couple of other notes on other Schedule K-1 reporting. So last year, there were a couple of items I just wanted to reiterate and bring to everyone's attention. So Item N reporting on the front of the K-1, it's in the bottom left corner, right near the Item L that we've been discussing, but this reported any unrealized 704(c) or reverse 704(c). So this would include any unrealized built-in gain or loss, so the contributed property we just mentioned, or this would be your reval account.

And also, disregarded entity reporting was new last year. The IRS now wants to see the owner of the partnership. The partner's name is going to be the owner of that disregarded entity, and there's a separate section to include the name and identification number of the disregarded entity.

So moving on, we're going to go through a few considerations for hedge funds. So we wouldn't do any year-end planning session justice if we didn't mention wash sales, straddles and constructive sales, the most common adjustments we see in the hedge world. So I figured it would be worth mentioning these and give everyone a little bit of a refresher. So wash sales, it's a loss on a sale of security. If it's not allowed, if a substantially identical security is purchased, either 30 days before or after the sale.

So I buy stock A. I hold stock A for six months. I sell stock A for a realized loss, and I decide I want to get back into stock A 10 days later. The wash sales are going to tell me it's as if that sale never occurred, and I cannot take that loss. It's going to be deferred, and the way the mechanics is going to work is that loss deferral is going to get added to the basis of the newly acquired stock. Also, the holding period of the original lot is going to get tacked onto the newly acquired shares.

So you could have a situation possibly where I had a short-term loss that was disallowed that rolled into a newly acquired stock. I hold that stock long term, and now I have a long-term loss by the time I got out of the newly acquired stock. So a couple ways that we could deal with mitigating the effects of a wash sale is we could double down on the position. So if it makes sense 30 days out, if I want to stay in the position, but I know I'm sitting on some unrealized losses that I would like to recognize this year, I could double up my position and then go ahead 30 days later, sell that stock. I could recognize that loss and be able to take that in the current year.

I'm not going to create a wash sale, and then I'm still in the position. Another one that you could use is a correlated security. I don't know how useful this one is, but since it's substantially identical, for example, if you sell stock in Wal-Mart at a loss, and you go ahead and buy Target stock, it's not going to be substantially identical, even though they're in the same sector. It's not going to create a wash sale. So there's other ways that they get increasingly more complicated. The fact of the circumstance is you need to go through each kind of situation.

So if there's a situation where you're looking at huge wash sales, we could discuss it further. We could look through it further to see what the details are. Straddles and constructive sales are both going to be triggered by offsetting positions. Straddles, if I'm holding offsetting positions and actively traded personal property, such as long and short in the same stock, and I'm substantially reducing my risk, I'm going to create a straddle. So a common one that we see is if I hold stock A long and I go out and I buy a put option.

When I buy that put option, I'm hedging my risk and I'm going to create a straddle at that point in time. So if I were to sell the put option at a loss and I'm still holding my long security, and I have an unrealized gain, the straddle rules are going to tell me that I need to defer that loss to the extent I have unrealized gain in my long position. And also, at the time I entered that straddle, I've terminated the holding period of my long position.

So if I'm planning on doing this, I might want to take a look at the holding period of my long, because if I'm holding my long stock 364 days, and I go out and buy a put option, I enter a straddle. I'm going to cut my holding period at that point in time. It's going to be terminated. It's not a suspension of holding period. So while the straddle is on, my holding period is not going to be accruing until I get rid of that put option. I release the straddle. The clock's going to start again once I get out of the straddle.

So one way to try to help manage this is to specifically identify the straddles. So the code allows, at the time you enter the straddle, to specifically identify which lot you want to put up against your long lot. At the time I bought that put option, I hold one lot of stock A. At that point in time I entered the straddle, I could specifically identify that put option against my lot of long. And then, let's just say I had two other long lots. So now, I have three lots of long stock, and I have my put option, but I specifically identified to put my put against my first lot.

If I sell the put at a loss and I have unrealized gain, I know that I have to defer my loss, but if I specifically identify to put my put option against that specific lot and I sell that specific lot, I know both of them are realized lots and it's off the table. I'm not going to have a straddle. Absent the specific identification, in that same scenario, I've sold my first lot of long and I got rid of my put, but I have two other lots long with unrealized gain.

I could still have a straddle, because I have a realized loss on my put option, and I still have unrealized gain. Specific ID could help you out in that scenario. The thing is you need to do it at the time you're going to enter the straddle. Hindsight's 20/20. So this is one of those things that would need to be done at the time of the transaction. Constructive sales, unlike straddles and wash sales that are deferring loss to constructive sales, can accelerate gain. So the constructive sale rules tell me if I'm in a box position at the end of the year, and overall I have an unrealized gain, I'm going to have to treat that as a sale and I'm going to pick up that gain in the current year.

There is one exception that it's not as well-known as you would think, but there's a short-term hedging exception with the constructive sales. So if I'm boxed at the end of the year, the short-term hedging exception allows me to exit the offsetting position by the 30th day after year-end. So by January 30, if I cover the short and now I'm only holding long, and I hold that long position un-hedged for 60 days, I wouldn't have to treat it as a constructive sale.

So something to think about, something to plan around, but the exception does exist. Short sales, if you're covering shorts at the end of the year, we just got to remember they must settle in December for the loss to be allowed in the current year. If they're not going to settle until January, the loss is not going to be allowed. It's going to be deferred until the following year. And I'll talk a little bit about trader versus investor. So the trader-versus-investor analysis, it's an annual test. That's a key takeaway.

It's on a year-by-year basis, and the key differentiator between trader and investor is that is the treatment of expenses. So if the fund is a trader fund, the expenses are going to be above the line in "good expense" versus an investor expense, which would be below the line. And post-TCJA, for non-corporate taxpayers, these are completely nondeductible. So is it better to be a trader? Yes, but the facts and circumstances need to be reviewed on an annual basis to get you to that position. Another consideration which Simcha just went through is 163(j).

So if you are considered a trader fund, there is additional possible limitations on interest expense to the GP or those who materially participate. 461(l) was a limitation on businesses losses that came about with the TCJA. It placed a $500,000 loss limitation on joint filers, $250,000 for others. And the CARES Act, it suspended this loss limitation. It suspended them until after December 31st, 2020.

Simcha David:If you have a big loss on your management company and you've got a lot of income from your carried interest, unless it's limitation, 461(l), we've discussed in the past. So that is no longer applicable for the 2020 taxes.

David Chadwick:Right. And then, another note on the NOLs. So TCJA limited the utilization of the NOLs at 80% of taxable income, and you were unable to carry it back. The CARES Act came out and said that NOLs generated in '18, '19 or '20 can be carried back for five years with no cap. All right, a few private equity considerations. I'll try to get through these quick, Mitch. I know we're running a little bit low on time. So effectively connected income, nothing really that new here, but worth mentioning is historically our ECI considerations were from our lower tiered operating partnerships.

If we received ECI on our K-1s, we know we're allocating that to any of our former partners. We're going to need to possibly withhold on them. So that's been around forever. Something that's somewhat more definitive lately is the sale of that partnership interest. So if I decided to sell my interest in that partnership that was generating ECI, pre-TCJA, it was a little bit unclear as to if this, the capital gain generated from that disposition, would be subject to withholding. Is this ECI or not?

Some took the position it was ECI. Some took the position it wasn't ECI. There was a case, a Grecian Magnesite case, where this was essentially argued. The courts sided with Grecian Magnesite and said it's not ECI, and it's not subject to withholding and everyone said, "Okay, great. Now, we have more of a leg to stand on by taking a position on not to withhold. And then, TCJA came out and said, "Wait a minute, no, let's make a small tweak here." Basically, the TCJA came out and said that the sale of a partnership interest that was generating ECI is indeed subject to withholding. It is ECI. So when we're disposing of these interests, we need to consider how much of the gain is going to be considered ECI and what withholding do I need to do. And if-

Simcha David:And the 1446(f) withholding, that's the gross withholding, similar to FIRPTA withholding, not just simple withholding of the ECI. And how that interplays with partnerships is there's - you know and if you have a secondary transaction, you may get a request from the partner that's selling for information down from the fund. This isn't the place to have that very robust discussion. We've approached that subject on another webinar, and I'm sure we'll have more in the future, but that's something to keep in mind partly, because that can impact the funds.

David Chadwick:Right. And Jay Bakst, our international partner, is having a session on December 18, I believe. That's going to go into more foreign specifics, so we can move on. I want to touch on installment sales. Many of you are familiar with the installment sale rules. One thing worth noting is that you can elect out of installment sale treatment, and why would you want to do that? Why would any taxpayer want to accelerate gain when I'm clearly given the option to defer gain? Maybe if the sale included some 1202 qualified small business stock, which 1202 allows for gain exclusion.

So if the stock that I just sold is going to be eligible for a significant gain exclusion, maybe I want to recognize that gain in the current year rather than default of the installment method and recognize it over a number of periods where my gain exclusion is going to get prorated over that same period, just something to think about. Another one with installment sales is installment sales with contingent payments. So you could have the sales contract, accounts for contingent payments based on certain milestones, maybe an inclusion of a percentage of future profits.

We're given three options on how to recognize these or report the sale. It would be the installment sale. You could do a closed transaction, which is basically opting out, like we just talked about, or you have this open method. Now, the three methods to calculate the gain, just run through these real quick is if you have a max selling price stated in the contract. Basically, you don't know what you're going to get paid, but you know the max that you're going to get paid. The rules say you use that max amount to calculate your gross profit percentage and to calculate what gain you need to include as you go through over the installment periods.

The second scenario would be where you have a set number of periods, but maybe you don't have a max selling price. So what the rules are going to tell you to do is the cost basis needs to be allocated among the periods. And if I don't receive any proceeds in a specific tax year, I'm not able to take a loss that year, but I'm going to have to rather carry my basis that was allocated to that period to the following period, unless it's the final year of the installment sale or it's deemed worthless. The third scenario would be I don't have a max selling price, nor do I have a set period of when I'm going to get paid.

So these types of transactions are more scrutinized by the service, and they're going to make you allocate your cost basis over a 15-year period. And again, just like scenario two, if I don't receive any proceeds, I'm not going to be able to take a loss. I'm going to carry my basis over to the following period. And at the end of the 15 years, whatever my remaining cost basis, it's just going to get carried forward until I've either fully recovered my basis, or the security's been deemed completely worthless.

I think one of the key takeaways is that if I'm in this position and I'm not going to receive proceeds in a year, I'm not able to take the loss. I just need to carry my basis forward. Excuse me, closed transaction method under a contingent payment scenario, it's similar to a regular installment sale opt-out. So the election's made in the year of the sale. Your proceeds are going to include your cash, any fair market value of property received and also the fair market value of contingent payments.

You're going to be able to recover all the basis in year one, also the taxes paid in year one. So the risk lies with if I'm including fair market value for any contingent payments that I haven't received yet. What happens if I don't receive those payments? I'm paying tax in year one where I might not ever see that money. And then, the open method, which I said is highly scrutinized. The service really wants to know did an actual sale occur here, or is it more of a royalty type of setup? You'd be taxed on sale proceeds as they're received, and the basis would be immediately recovered.

I want to give Mitch time. I know we're running low on time. So the worthless securities, I encourage you to read through. If you're in a scenario where you have worthless securities, I think just really quick, getting to the worthless securities determination is difficult. It's not as cut and dry as you may think. There's options to get around it and get a better result. So I encourage you to look through this and call us if this is a scenario, but Mitch, I'm going to turn it over to you.

Simcha David:Just one point on that before we turn it over to Mitch. It has to be truly worthless in that particular year. Sometimes, that's a little more difficult, depending on what you're doing. Thank you, David. Go ahead, Mitch.

Mitchell Novitsky:Okay. My presentation is the state and local tax issues arising from COVID. I'm going to focus primarily on telecommuting issues. I know the presentations this morning dealt with 163(j), 461. We discussed NOLs. That's a subject for another day. I'm going to focus primarily on the issues that arise as a result of people telecommuting due to COVID. Now, I'm going to begin my presentation, and I understand these are the requirements.

And that is correct. 79% of the people said false. About a third of the states haven't addressed it at all. Some states have addressed certain parts, certain issues, not addressed other issues, but in short, I wanted to give my presentation. Obviously now, as you know, people are working from home. They're telecommuting. Often, that situation which presents itself is they may work for a particular employer in New York City, yet they live in New Jersey and Connecticut.

And there are various state and local issues that come up. I mean, I'm going to focus primarily on New York, but this would apply to all throughout the country. And particularly, I want to focus on two aspects of things for New York purposes, and we are with a financial group. And you've read a lot of articles in the papers over the last few months where people talk about hedge funds with management services. There may be an opportunity to not pay a lot of New York City taxes, because people are telecommuting, and they're working in other states.

So I want to begin with the unincorporated business tax. The unincorporated business tax in New York City, it's a big revenue-raiser. It's imposed on unincorporated businesses. 60% of the revenues come from law firms and financial companies, because many of them are unincorporated businesses, partnerships, and they're subject to this tax. So when you calculate the tax, how do you source your receipts to determine how much tax it's doing? Incidentally, the tax is on 4% of net income, and the reason it's such a big revenue-raiser too is there's a lot of add-backs for New York City purposes.

They make you add back payments to partners. So in short, you calculate your revenue subject to tax based on the location where the services are performed. So if the services are performed outside of New York City, they shouldn't be subject to New York City UBT. So that's why you've seen a lot of articles lately, and they specifically talk about hedge funds in particular and would apply to law firms and other things. Very few people live in the city percentage-wise. Most of them live outside of the city.

So would that enable these particular entities when they calculate their unincorporated business tax to not pay tax on all the services performed by telecommuters that are not in New York City, and it's not Jersey, Connecticut. It's also upstate, because this is a New York City tax. And I want to stress that this deals particularly focusing on the unincorporated business tax. C corporations have a separate rule. There, you look at where a customer is located.

So the articles and everything wouldn't apply as much to C corporations, because the customer determines where the income gets sourced. S corporations are a difficult rule, even though New York changed to market source. New York State went that way too, but New York City for S corps has stayed in terms of looking at where the services are performed, but in New York City, obviously as I mentioned before, there are many, many more unincorporated businesses and UBT is the key tax.

So what happens? Now, people are working from home. So if individuals are telecommuting and performing services, let's say you live in New Jersey or whatever, should you be able to source those revenues outside of New York City? Now, my poll question said, "What jurisdictions have issued guidance?" There has not been any official guidance from New York City yet on this particular point. And personally, I think that may be a good point.

Why has New York City not issued any guidance yet? It could be they didn't get around to it. It could be potentially they're doing this intentionally. They want to see how long COVID lasts. Of course, nobody knew how long COVID was going to last. It's interesting. A lot of states came out with releases as to how they're going to treat telecommuters in COVID, and they didn't expect it to last this far. And as far as we know, it could last six months, a year or who knows how much longer. So the city may be waiting intentionally and seeing.

Maybe this'll mean they'll audit taxpayers. Maybe they'll settle with them, but I think it's a positive. And incidentally, I began my career with the New York City Finance Department. I was in the legal affairs division, and they're losing revenue significantly. There's only so much they can get from these other taxes, the sin taxes or whatever on tobacco, alcohol, other things. This is a big revenue basis being lost. So what are they going to do?

I think they may be waiting it out, because then they may take an aggressive position. And unfortunately, as I saw with the city, maybe they'll settle with particular taxpayers, especially taxpayers where the dollar amount isn't significant enough. The burden of proof is on the taxpayer. And by waiting, they may feel that they'll be able to settle on some issues, but I personally feel that the city hasn't issued guidance yet. If the city issues guidance, then of course that guidance technically is something that we need to follow.

 I mean, we can challenge the guidance. Say, maybe the guidance isn't a proper interpretation of the statute, constitutional issues, whatever the scenario is, but if they don't issue official guidance as many people have indicated and as you've read in a lot of the articles, then based on a clear reading of the statute, if services are performed outside of New York City, there's no guidance. The position should be that those revenues should be sourced to New York City.

However, I want to stress that, and we get a lot of questions from clients, there's no one-size-fits-all situation. Some clients are just in New York City. Some clients have an office elsewhere. Some clients have a formal arrangement with their employees where they're telecommuting, and they have a formal reimbursement or other business location at the telecommuting employee's location. So the facts and circumstances may be different. Some clients have better situations than others, and that's why it's very important when you read a newspaper article here and there.

And you hear, "Oh, we should be able to source revenues outside of the city." We've got to look at all the facts, as I mentioned, see if there's guidance. And see, your situation may be better than the next person. If you're only in New York City, then this revenue is sourced to New York City. If you're not only in New York City and you have other places, you may be able, even now, to take the position that certain revenues shouldn't be sourced, because somebody may be potentially based out of another location.

So that's a factor to be considered. Another thing is COVID-19, there was a point where the state and city mandated that people work from home. Now, it's not necessarily mandated, but a lot of companies aren't open and it may be optional. Some people are afraid to go in. Does that take into account how you should be sourcing the revenues? The key thing is, and as I mentioned, if there's no guidance, then the city statute is as is, and then there shouldn't be, in my opinion, a position that those revenues from telecommuters should be sourced out of New York City.

It's very important if that's the case. I mentioned I worked for the city. The burden of proof is on the taxpayer, and some of them are really tough on you. You have to come up with adequate records. So what would I suggest? I would suggest to get records from the employees as to where they are in a given day. Use your IT department. Whatever you need to do, it is very important to document, at this particular point in time, where people are in a daily basis.

So should ultimately the city acquiesce and agree that the statute reads one way, and they don't try to be aggressive and take some outrageous position as I've seen them do, having been an attorney there? Then, you're not going to win regardless, unless you maintain adequate records. We've been talking to some clients. And as I mentioned, it's no one size fits all. Some clients have already a presence outside of the city. Some don't, but a conservative approach, because there's potential penalties for underpaying an estimated tax is for estimated tax purposes to assume that the city will take the most aggressive position as possible.

If guidance is issued, then you can scale back. And then, at that particular point, if the guidance is favorable, then feel comfortable to obviously just pay in what's required according to the statute. And as I mentioned, if no guidance is issued by the time the returns need to be filed, then based on an application of the statute, one should be able to source certain revenues, but I want to stress again, no one size fits all. Everyone has a different situation with their employees and everything, but regardless it's very important, I stress again, to keep adequate records.

So for the meanwhile, keep adequate records. Wait and see what guidance is issued. And if there's one more estimate, you might want to be more conservative to that estimate, and we will keep you informed, and let's see if there's formal guidance. If there's no guidance, which if I had a bet, I think may be the case, then I think we clearly have a position, but everyone's set of facts is different to source those revenues out of New York City. Now, what are other jurisdictions doing, like Philadelphia?

They have a tax similar to New York, business and receipts tax, net profits tax. They also look at where the services are performed in terms of determining where revenue should be sourced. They're saying that if people are working from home solely as a result of COVID, they normally work in the city, those are city revenues. Now, they're giving you the reverse, and I'm sure the city will be happy to give you the reverse. If you have a business that's outside of New York City and some people live in the city, and they're working in the city just due to COVID, they'll say, "Okay, we won't source those revenues," but more people are going into the city obviously and less people live in the city.

So if the city gives, I think that might be the most they give, but as I mentioned, the statute is the statute, and the city's going to have to come up with a particular reason. Some people say that the city may say, "Well, your service is still in the city. The IT people are in the city. You're still directed by the city." Maybe that gives them the authority. As I said, I've seen them take very, very aggressive positions, having worked there, but let's wait for the guidance. And in the meanwhile, document, document, document, I can't stress that enough, all of the services performed by employees outside of the city.

Incidentally, there's another plane not related to COVID, but where do you determine where the services are performed, if people are performing services in different places? The city looks at any reasonable method, whether in terms of value, in terms of time spent. So when it comes to doing your tax return, we can work with you or work with your tax practitioners in terms of the exact sourcing of where the services are and also what to do in terms of COVID.

New York State, this is not as much of an issue. I'm going to finish this in just a couple of minutes. Please bear with me. New York State, it's not as much of an issue. They use three factor. Excuse me, I jumped ahead of the gun. The New York State uses three-factor versus one-factor partnerships that flow through entities. So it's not really as much of an issue for New York State purposes as it is for city purposes, because it's flow-through, and they use three factor.

Now, the other thing I want to mention too is as far as individuals are concerned, the other big issue, I mentioned UBT for employers and also withholding. We get questions, even entirely of our firm, people saying, "Well, I'm working in New Jersey. Why is the firm still withholding state tax, but it's a working tax?" And the reason is there's no personal working tax for the New York City nonresidents, but New York State nonresidents, they have the convenience of the employer rule.

If you are based out of a New York office and you are working outside for your own convenience, they call it, and the state recently issued guidance saying that it includes COVID situation as well, then you still have to withhold New York tax. So it's interesting that even though you think you haven't been in New York State since March or whenever you've been telecommuting, if you're based out of New York State unless you have a formal office in your home that your employer sanctions, then you still have to withhold New York tax.

So be careful of that. And as an employer, and I dealt with that situation when I worked with the city, you can be held personally liable on these trust fund taxes, income tax, sales tax, withholding tax, sales tax if you don't withhold. And the employees need to understand what the rule is as far as the state is concerned. Now, just the only other issue is when you have telecommute, there could be issues in other states, but I can tell you that most states have said that if somebody's working in the state, just due to COVID performing services, generally that won't create nexus or a filing obligation, because they understand that it's strictly due to the pandemic.

And then, how do you source the revenues if you work in the other state? You stayed as a particular position, but of course if there's no filing obligation, then you don't have to worry about that. Key thing, as I mentioned too, is withholding. You could still be working in New Jersey or wherever, but New York is still going to want tax paid on your behalf and also personal income tax. A lot of states, it's interesting. Jersey I mentioned earlier, they are issued to release in March saying, "Well, continue to withhold as is," but then once New York took this aggressive position and New Jersey now, it's months later, and all these people are paying tax to New York.

You get a credit in your resident state of Jersey for taxes paid to New York, but Jersey's losing out on all this money. So I understand how Jersey's reconsidering this issue, and all these states talk about how they love each other and work together, maybe with regard to solving COVID issues, but when it comes to taxes, everybody wants their own. So it's interesting to see what'll happen. New Hampshire's got an issue with Massachusetts. Jersey's losing all this money now because of this New York convenience of the employer rule, and so you get a credit.

So you're only paying tax either none to Jersey or only on a spread, if you're a high-income taxpayer, which may be next to nothing. I just want to leave also with residency issues. This has come up a lot. People think, "Well, I'm not in New York City." Let's say I'm by Florida, by my parents or whatever. So I don't have to pay New York City tax anymore or New York State tax, even though they're normally a New York City resident.

I mentioned before that convenience to the employer rule, but also residency, there's two tests. Either you're domiciled and that's your permanent location, or if you maintain a place and you spend 183 days. And getting into more details, another time, feel free to contact any of us, but in short, even if you're in Florida temporarily, it doesn't mean that you're no longer a New York City resident. So you could still be subject to New York City tax on all your income, if that's your domicile, if that's your home base.

And I've seen the reverse happen. Some people, let's say they're in New York, they have a place in Connecticut and they're just entering COVID. Guess what? They have a place in Connecticut more than 183 days. Once you're there more than 183 days, even if you're not domiciled in the state, you could be a resident for statutory residency purposes. So just be careful of your personal income tax issues that present themselves on the residency level and the personal income level. And on that note, I just want to note. Happy Thanksgiving. We're under tough times, but please take the time. Enjoy it with your family and all the best. Good luck to all of you.

Simcha David:Thank you so much, Mitch. I appreciate the statement for the state and local jurisdiction, because when they're starving for revenue, everybody goes at the taxpayer to pay as much as possible. And unfortunately, we've seen that in the past. So hopefully, they'll understand. They'll be more understanding about the situations as we face them. I just wanted to thank you so much, David. Thank you so much, Mitch. Thank you to those that helped put this together. Thank you, Brian. Thank you, Melody.

I just want to remind everybody that part two on December 8th from 12:00 to 1:00, part two of this series, with the topics of identified recent IRS enforcement trends and best practices, and identify tax planning opportunities for individuals with states and gift taxes. That's on December 8th. And on December 15th, it's understanding CFC downward attribution, discuss when a fund needs to withhold on a sale or partnership interest, FATCA, CRS, 1042 reporting. That's on December 15th. Thank you all for joining us. And as Mitch said, everybody have a very happy and healthy Thanksgiving.

About Simcha B. David

Simcha B. David, Partner-in-Charge, Financial Services Tax Group, has more than 20 years of tax accounting and tax law experience, focusing on financial services and investment management entities.