On-Demand: Financial Services Year-End Tax Planning Webinar Series – Part 1

November 29, 2022

By: Lindsey Layman, Paul Kangail and Daniel Krauss

Join EisnerAmper as we review the key year-end tax planning strategies and takeaways. In this webinar, we provide an update and discuss the latest legislative tax developments and year-end tax planning for funds.


Transcript

Simcha David:Thank you. First of all, I'd just like to welcome everyone to our financial services year-end tax planning webinar. We are actually very excited to have three members of our San Francisco office who will be presenting to you today.Again, I want to thank all of you, many of you, I've gone through the list so I know that many people on this call I know personally and I want to thank you all for joining, you're valued friends or clients of the firm or members of the firm. So thank you all for joining. And again, I want to reiterate what was said earlier if you do have questions, because we're going to be getting through a lot of material and if you do have questions, please make sure to submit them so we might be able to get too live. But those that we can't get too live, we will definitely get back to you via email.

And obviously that's the point of this. It's not just one CPE credit, it's also the point of if you have questions based on the topics that we're going to go through, definitely submit them so we can get back to them and get back to you. This is part one of two, hopefully you signed up for both. This is going to the more traditional tax planning for private equity hedge, venture capital fund of funds management companies and general partners. And next week we have a great presentation with regard to state and local tax, which I know is high on everybody's mind with the new PTET stuff that's been coming out state by state. So, welcome. I'm going to hand off to Lindsey to begin the presentation and thank you all for attending and spending your lunch with us.

Lindsey Layman:Thank you Simcha and thank you everyone for joining us today. Like Simcha said, we are going to walk you through some year-end tax planning considerations for funds, as well as general partner and management company entities. Before we dive in, we are going to hit you up with our first polling question.

Astrid Garcia:Polling question number 1.

Lindsey Layman:All right. So I am going to kick us off today by first discussing several tax matters for hedge fund managers to consider. First, this is a great time of year to just review your year-to-date taxable income compared to your economic or book income. With the market conditions of 2022, it could be problematic to report taxable income that exceeds your book income. The last thing investors want to receive on their K one is realized gains when the fund is down for the year and has unrealized losses. So keeping that in mind, there are a few rules that we just want to remind you of as you work to harvest losses before the end of the year and really just to ensure that there're no surprises with that taxable income number.

So, first up, let's discuss wash sales. The wash sale rules were enacted to prevent investors from selling depreciated stock toward the end of the year to realize a loss and then repurchasing the same position immediately after to remain in that same economic position. So under these rules, if you sell a security at a loss, and purchase a substantially identical security within 30 days before or after the sale, then that original loss on the security is going to be deferred until the replacement security is sold. The easiest way to avoid a wash sell is simply to not repurchase the security within that 61 day window around the sale. And that would also include not repurchasing during January of the following year if January falls within that 61 day window. But what if you want to harvest the lost and still maintain your desired exposure? There's a few ways to achieve this.

So, first, if the exact security name is not critical for your portfolio, you could replace the lost security with something similar or with an ETF that represents the entire sector. Another strategy would be to utilize a basket swap. So say you identify a sub-portfolio of positions where each position is trading at a loss and you're also interested in adding economic exposure to some other positions, then you could sell that sub-portfolio and enter into a total return swap on a basket that includes both the liquidated sub-portfolio and the desired additional positions. As long as the basket is properly constructed, it should not trigger a wash sale, but this is something you would definitely want to run by your tax advisor to make sure that the structuring is correct.

Doubling down is another strategy. Let's say you have 100 shares of x, y, z stock that has an unrealized loss. You could purchase another 100 shares of x, y, z and then after that 31 day period, sell the first block to realize a loss. Of course, here there is some economic risk because you would have twice the exposure to x, y, z for those 31 days. And then depending on your fund's objectives and risk profile, there are some strategies utilizing derivatives that could also be considered. However, I really just wanted to remind everyone that the wash sale rules apply not just to stocks but also to options. So for two options to be considered substantially identical, they must be for the same underlying security with the same expiration date. So strike price is not going to be a factor. And then depending on the transaction, an option could also be considered substantially identical with the stock of the underlying security. So something to keep in mind as you're doing wash sale analysis.

And then finally, you might have some wash sales from previous years or earlier in 2022 and you might want to sell those replacement securities now to free up the previously deferred losses. So again, another reason that fund tax estimates could be helpful this time of year to evaluate what wash sells have happened in the year and that way you have time to unwind them before year end if it's something that you want to do. And then kind of an important note from the compliance side, at the fund level, we usually will not rely on wash sale numbers that are reported on 1099-S from the brokers. Instead, we are going to run our own analysis on all of the funds trading activity by utilizing the realized losses from all brokerage accounts for the funds. Dan, are you typically relying more on the 1099-S for individual traders?

Daniel Krauss:Definitely. The problem with 1099-S that we see from different issuers is that is they don't have an identical uniform method in terms of how they're showing the wash sale loss adjustments that have to be made. So for example, you can run into a situation where when you look at the 1099 and you look at the gain that's being reported, if you were to foot the 1099 by just deducting your cost basis from your proceeds and then adding back the loss sale adjustment, that number will not agree to the game in some instances. And so people will question whether or not the basis is already been adjusted by the report by the issuer. And in those instances what we've seen is that the game that they're reporting on the 1099 is not your taxable game. And when you look through the instructions, the issuer will let you know that you need to actually incorporate your wash sale adjustment that is reported on that 10 99 to then come up with your actual taxable meaning.

Lindsey Layman:Right. Thank you.

Daniel Krauss:So very important to just read the 1099 and just understand what the instructions state about whether or not basis has already been adjusted and the wash sale adjustment that's being reported is just informational or alternatively the example that I just provided, which is that basis hasn't been adjusted and you need to do it yourself in order to calculate your taxable view.

Lindsey Layman:Got it. Thank you, Dan. All right. Another way that a loss could potentially be deferred is if there's a straddle. So a straddle is when a fund holds offsetting positions in actively traded personal property, one with a gain and one with a loss. The offsetting positions can be any combination that reduces the risk of loss such as a long security in a short security or a call in a put. The IRS enacted these straddle rules to prevent traders from recognizing a loss in one year and deferring a gain to a subsequent year. So under the straddle rules, it really matches the timing of the loss and the gain up into the same tax period. So if you entered into a straddle and then you close one leg of a straddle at a realized loss, that loss would be deferred to the extent that there's unrealized gain on the remaining leg.

Also, the holding period is going to be terminated when the straddles entered into, so the loss would either be long term or short term depending on how long the position was held before entering the straddle. The use of the identified straddle rule can help prevent some of these issues. So the straddle has to be identified on the taxpayers books and records by the close of the day in which it's established. Under the identified straddle, the loss of roll rules don't apply to the losses recognized on closing part of the straddle. Instead, those losses are capitalized into the remaining piece of the straddle that has the unrealized gain. And then also the identification has the effect of controlling the size of the straddle.

So let's say you have an unbalanced straddle, by identifying the straddle, you can match the shares and the straddle to the offsetting shares. For example. If you owned a hundred thousand shares of x, y, z stock, and you buy puts covering 70,000 of those shares, you could identify the straddle as consisting of the puts and the 70,000 shares that it matches up with, those other 30,000 shares would therefore not be treated as part of the straddle. All right, so the washes and straddles that we just discussed really work to defer losses, constructive sales work in the opposite way in that they will actually accelerate gains. So constructive sales occur when a taxpayer enters into a transaction that effectively takes an offsetting position to a position that's already owned and it locks in the gain on that position.

So even though that gain is still unrealized because the position is still held, under the constructive sale rules, that gain is now going to be taxable. There is an exception to the rule if you meet the following criteria. So the first is the transaction has to be closed before the 30th day after the close of the tax year. So January of the subsequent year. The appreciated financial position has to then be held for another 60 days beginning on the date that the transaction was closed.

And at no time during that 60-day period is the taxpayer's risk of loss with respect to that position reduced. If all of those criteria are met, then the box position will not be considered a constructive sale and wouldn't be taxable in 2022. And then with short sales, this is just another reminder that most gains and losses are going to be effective on the trade date. However, if you're covering a short at a loss, then it actually has to settle before the end of the year in order for the loss to be allowed in 2022. And then again, I'm repeating myself, but it's important to note running tax estimates this time of year can really help fund managers plan around their current tax situation. So depending on the fund's needs, we can run estimates just at the fund level to help determine what the current taxable income is.

We can also do the analysis now for wash sales straddles constructive sales so that there could be time to plan around those and potentially unwind them before the end of the year. We can also take it a step further and provide estimated allocations to LPs if that's something they need for their own tax planning. Another item to consider for hedge funds is whether your fund is going to be a trader or investor for 2022. This is an annual test, so there is the potential to change from year to year. So if the fund strategy or trading frequency has changed significantly, now's a really good time to discuss with your tax provider if it could trigger a change in classification for your fund. The biggest difference in tax treatment of the two is where expenses are taken.

So expenses for trader funds are going to be considered trader business expenses and those are taken above the line as Dan's going to discuss later. Trader fund expenses are also going to be subject to a 461L limitation. Investor expenses on the other hand are considered portfolio, so those are taken below the line. For most investors, portfolio deductions are now going to be essentially non-deductible for federal purposes, so those are definitely not as beneficial as those trader expenses.

Astrid Garcia:Polling question number 2.

Lindsey Layman:Thank you. Now is also a great time to review your portfolio for worthless securities. You may already be looking for impairment as you get ready to prepare your financial statements, but it's important to note that the rules for deductible losses under gap are different from the tax statutes. So gap impairment losses are often not going to be currently deductible for tax purposes. So on the tax side, the general rule for deducting losses on worthless securities is found in section 165G, which permits a loss deduction for security that becomes worthless during the tax year as long as the security is a capital asset in the taxpayer's hands. The loss amount is determined by treating it as if there was a hypothetical sale on the security on the last day of the tax year in which the security becomes worthless. This is notable because using that hypothetical close date of December 31st could impact the holding period and effect whether the loss is going to be long-term or short-term.

A loss deduction's only going to be allowed when the security becomes completely worthless, meaning there is no current or future value, no deduction is going to be permitted for partial impairment even if that partial impairment is permanent. It's ultimately the taxpayer who's responsible for determining when that security is worthless. It could be a result from an identifiable event such as bankruptcy, liquidation, termination of business activities, complete insolvency, or some combination of those. And this determination is often subjective, but in general, the courts have upheld it when there is no reasonable possibility that the investors will receive anything of value in the future. Tax payers can also solidify their loss claims by formally abandoning the securities, but with that it moves the transaction date from that December 31st close date to the date of abandonment.

And then also these rules apply to short securities as well. Of course, in that direction you would be recognizing again, and because the IRS wants you to recognize gains as soon as possible, the criteria's a little less stringent. Rather than being completely worthless, the security just has to be deemed substantially. And with that I will hand it over to Paul.

Paul Kangail:Okay, great, thank you. The first topic we wanted to talk about was a recent update to the schedule K-2 and K-3s. So a quick background, 2021 was the first year that we had to file those forms. They required a partnership to include the schedule K-2 and K-3 in their 1065 filing requirement. And then to also include the K-3 along with the K-1s to the partners. These forms really replaced the box 16 reporting that was on the K-1 and greatly expanded the disclosure regarding what they called international tax relevant matters, trying to provide more information to the IRS, but also to the partners to help them fill out their forms with respect to foreign activities, especially foreign tax credits. So the first year was 2021, it was a pain, we survived it, but it definitely delayed the process, especially in the case of fund to funds getting those K-3s in and reported in information out to the partners.

So the update was last month the IRS released draft instructions to the 2022 schedule K and K-3 with respect to partnerships. And in there they created reception, and that sounds like it's a good thing, but in reality it's created some complexities that's going to make it a little bit more difficult to deal with this exception. The domestic filing exception has four prongs to it. The first one is that the partnership must have no or very limited foreign activity. And here when we're talking about foreign activity is really foreign passive activity, interest dividends, capital gain type income. And when they say limited, it's defined to be a foreign activity that results in $300 or less foreign taxes that are paid or accrued. So especially in the fund complex, that's a context, that's a very small number. So that's the first prong, generally no foreign activity.

And then the second prong is all direct partners must be US. That includes citizens, the states and trust, but it doesn't seem to include partnerships. So if you meet those first two tests, generally no foreign activity and all partners being direct US partners, it created a third prong, and that is that in order to fall within this exception, by January 15th, the partnership needs to notify all of its partners that they will not be receiving a K-3. So that January 15th date becomes very important and may be difficult to comply with. The last part of the test is that it's possible for a partner once they receive this notification to request that K through information be provided to that partner. So if that notification is received by the partnership by February 15th, a month later, then the partnership would be still required to comply with the K-2 and K-3 file requirements.

So, at a high level, it created an exception. The exception is very narrow in that you have to have all direct US partners, you can have no foreign activity, and you need to meet this January 15th notification date. So if we think about it like from a venture capital perspective, you've got a VC fund, let's say it has all US investments, it has all US limited partners, but it does have a GP, and the GP is another partnership. Well, the fact that the GP is a partnership, appears to make the partnership not eligible for this exception, even though that doesn't really seem to be too fair, that seems to be the right interpretation. So I guess one thing that we're thinking about is maybe for almost all of our funds and maybe for the GP, they'll just have to start providing the K-2 and the K-3 to try to deal with this notification requirement by January 15th to be able to meet this restrictive definition of a qualified partnership for this purpose.

It may not work. So I think that's one thing we wanted to think about is just maybe her K-2s and K-3s will now be necessary for purposes almost all of our filings. And Dan, I wanted to turn it over to you and get your thoughts. How did the K-3 process work from a 1040 perspective for 2021. First year that you were receiving these forms on behalf of your clients? Walk us through how that process went.

Daniel Krauss:The reason why I laugh a little bit about this whole new is that you go from getting your K-1, you look at one box that shows you your foreign taxes paid, then maybe you look at some footnote disclosures in the back of the K-1. Now you fast forward to 2021 and you get a K-3 that could be 30 pages long. And so for a lot of the clients that I work with that have a lot of head and private equity investments, you could be combing through 30 pages of POP for 50 to a hundred K-3s per client and that really drives up the cost of their tax compliance. Number two, we really needed to look through all those 30 pages because the big thing to keep in mind is by switching over to this new type of reporting, you have to consider all of the different types of foreign disclosures that an investor may be subject to at the individual level that they need to consider reporting when they file their 1040.

And the prime examples of that would be if you're transferring cash to a foreign corporation indirectly, and that cash limit is $100,000 more per corporation, there could be a 926 filing obligation that you're going to have. If there are footnote disclosures that speak to the partnership investment, either itself being a foreign partnership or indirectly investing into another foreign partnership depending on how much money you have in your investment, that can lead to in 8938 reporting requirement, which is essentially just informational and it reports investments that you have in foreign entities. Another big ticket item that goes on the new K-3 would be any investments in which we're not going to delve into too much in our conversation right now.

But the bottom line is, you really need to look through all these pages because if you don't and you kind of just pass it by and you don't check on the filing requirements, the fines that the IRS assesses if they catch you are very archaic. I mean, we could be talking about fines that are even tens to hundreds of thousands of dollars for not checking a couple of boxes on the form.

Paul Kangail:Okay, great. Yeah, so I think K-2s, K-3s are here to stay. I think that that information that's provided on them is valuable, especially if there is no box 16 on the K-1. So I do think we're leaning towards the thinking that more and more K-2s and K-3s will be necessary. And I'm hoping that the process is going to go smoother so that in some situations where some partnerships were delaying their K-3s until later in the year after the K-1s were delivered, hopefully more and more K-1s and K-3s would be going out to the investors at the same time. Okay, enough on that. So the next topic is SALT related considerations, and the first one is the state pass to entity tax provisions. Again, as Simcha mentioned, there's session two next week that's really going to focus on SALT related matters, state and local.

And they're going to spend quite a bit of time going through the pass to entity tax provisions. From a multiple state perspective, it's a very important and complex topic and we're going to spend a lot of time on that next week. But we thought we couldn't go through year-end planning without touching upon some of the considerations regarding the past due entity tax. So just a quick overview, the 2017 Tax Act created a $10,000 cap on the federal deduction for state income and property taxes for individuals. They could no longer fully deduct their state taxes as part of their itemized deductions, they were capped at $10,000 dollars. So, as a result, many states started to think about how could they create a workaround to these rules, and especially for high income tax rate states, California, New York, and others, it was pretty important to try to come up with a workaround if possible.

And after many attempts, the one that became the most common was a pass-through entity tax. So a tax that would be assessed at the partnership level with respect to participating partners, the partnership would pay that tax and that tax would then become a deductible item within the partnerships taxable income. So as states started to think through this process, the IRS then came about with some guidance back in 2020 and that guidance was noticed 2020 dash 75. And that guidance was attempting to clarify what future regulations would provide with respect to the deductibility of this type of pass through entity tax regime. And in general, the guidance was very favorable. It said that state income taxes that are assessed against a partnership and paid by a partnership or an S-corporation could be deductible by the partnership in the year in which they are paid.

So payments to a partnership by a partnership would be treated again as a deductible item against the partnership's income. And it clarified that these would not be jeopardy stated items on the schedule K or K-1 to the partners. So if you think about an investment management partnership, this expense paid by the partnership would be a page one expense. It would reduce box one, ordinary income allocated to its partners. So that's create a deductible item at the partnership level, rather individual level. And then generally that net ordinary income and that payment of the taxes would be specially allocated to those partners that participated in the election that would give them the benefit of the deduction. And then they would also be reported in general a credit that they would take against their state taxes. The notice also clarified that this passive entity tax would not be applied against the salt tax deduction limitation, which is exactly what we want from a federal perspective.

So this guidance was very favorable and once the guidance was issued, the state started to work on their own pastor entity tax provisions and further modify those. The one issue that was created from federal rules though was it did say it's a deduction for the partnership in the year which the taxes pay. So it seemed to imply that this was a cash basis deduction, but people have looked at that and we're not sure that they really meant that an accrual basis taxpayer couldn't still accrue the expense in the year in which it was accruable. Unclear, but if we think about it, it's probably going to be dependent upon the Section 461 and whether that liability is a fixed and determinable liability in the current year. And when we think about that, what are the factors that make this a fixed liability as a 1231 and what example was California?

And when we think about that from a 2021 perspective, California, when they first implemented its pass-through entity tax provisions, the only thing that was really required for a 2021 election was that when you filed your original return by the original due date, you actually had to pay in the tax. So let's call that March 15th, 2022, you had to pay in the tax and then when you filed the returns you had to include the proper forms. So for many California partnerships, what had to happen as of 12/31/2021? Nothing. So how could you say that that liability was really fixed in 2021 when you had done nothing to really perfect your election or make any payments? So, California was an example where a lot of people felt that that was not accruable and would actually become a deduction in the year in which was paid, which is 2022. But really it's a state by state analysis because as we talked about later, every state has different rules and so you really need to analyze it I think from a 461 fixed terminal perspective with respect to that state's provisions.

So when we then jumped further into it, the states again began to further develop their pass-through entity tax provisions. Currently there's 31 states that have these provisions. So that's a lot of states, and each of the states have their own methodology. So from a partnership perspective where you have individual partners and you have partners in multiple states is created a pretty huge tax compliance planning consideration. A lot of states, a lot of different rules and there's a lot of procedures associated with those rules. So when we think about it, some of the complexities are, what are the individual state election procedures and what's the timing of those elections? Very important that you understand that and you're not missing an election because each state has their own timing and process. And then where's the election? Is it at the partnership level, but is it also partnership and at the partner level? It varies by state.

For those that are entity level elections, can the partners elect in and elect out or do all partners have to participate in the election? Again, state by state. Income is actually subject to the pass entity tax calculation. States are different, some are apportioned income, some are apportioned income, some have different rules regarding whether they are resident partner or a non-resident partner. So again, a lot of fluctuation there. I could probably go on and on, but I think there's a lot of complexities about the various applications of these rules that really have to be considered. And when we thought about this from a California perspective, we wanted to point out just a few things that make this complex. First of all, for California the tax rate is 9.3%, but individuals could be subject to a 13.3% maximum rate.

Why can't they use a different rate other than the set 9.3%? But currently it's only at 9.3%. Additionally, there's a lot of issues that come up around the election process. So for California, the first step is by June 15th of the current year, you need to make a payment to the FTB and the payment is the greater of a $1,000 or 50% of the prior year tax liability. So what if you have a partnership that starts their business first year, July 1st? That partnership seems to be excluded from participating in the election in the current year just because it started later in the year. Why does that really make sense? What if you have a partnership that doesn't expect that income in the current year but all of a sudden has a large transaction of some sort large income recognition later in the year and didn't make the payment by 615 'cause they didn't expect that income?

They seem to be excluded from the process at all. So when we think about it, there's definitely complexities and more and more, I think this has to be part of our planning process to think about where do we make these payments? Especially if it's a first year, it's only a thousand dollars payment, that's pretty small, but where do you make these maybe on a safe harbor basis just in case something happens later in the year and you want to elect in? Again, this is just a California discussion, but I think that it's one where we want to start to think about it because missing out on these opportunities can be a difficult discussion with the investors, with the partners, because it does provide significant benefit where we can get the federal tax deduction, and also then the credit on the individual side. Lindsey, I went through a lot there. Is there anything else that you wanted to jump in that you've experienced?

Lindsey Layman:No, I was just going to add that it is very complex, especially as you're dealing with multiple states. So there's a reason we have another full hour next week to go a little bit deeper of a dive into all these things to consider.

Paul Kangail:Yeah, exactly. And they're definitely going to go through a lot of other states in the discussion as well, but it's one that can be overwhelming. Thank goodness we have the SALT team to help us with this.

Lindsey Layman:Yes.

Paul Kangail:One other just quick point on SALT consideration is with people working remotely with offices being reduced, home offices being reduced or closed, the state nexus issues continue to pop up, especially for that management company entity. Where are employees working in multiple states? Does that create a physical nexus in those states, therefore creating state income tax, state payroll, tax filings, maybe some local filings? So more and more for our clients, we really want to consider now what activities have changed from a state perspective and where these filings might be necessary on a go for basis. Definitely important to do it sooner because it could play into your apportionment calculations and that could also play into the pass to entity tax calculation for apportionment purposes. And it also alerts us to state income tax return extensions that need to be filed. We don't want to miss those because there're significant penalties sometimes we're failing to properly extend a tax return. So think about Nexus, think about changes in your business from a state perspective. That's a pretty important reminder.

All right, one second. Qualified small business stock. I don't want to talk too much. We have Dan coming up, but just a quick reminder that with QSBS, it's really important that when you have gains recognized from GSBS, you have distributions of stock that's QSBS, that you're making all your service providers aware of this it's really important that it gets property disclosed on the K-1s to the investors if it's a possibility of doing a 1045 roll-over. Timely disclosure is important, but it's one of those reminders I always like is just any chance, especially in the venture PE world that you have QSBS, if you do make us aware as soon as possible we'll help track that, but then especially if there's an event associated with it, making sure it's property disclosed currently for QSBS acquired after 2010 gains are a 100% excludable for federal tax purposes.

So definitely an important thing just to remember to properly discuss any QSBS in your portfolio. And then the last topic I was going to cover is 1061 carried interest. Not a lot of new developments here. The final regs that were issued back in 2021 were really effective for the '22 tax year, so that's this year. There's been various proposals out there potentially changing some of the rules. One was changing the holding period requirement from three years to five years. None of those were finalized, so we're still under the final regs. And I think one thing just to think about is the final regs did provide a capital interest exception, it wasn't perfect from a hedge fund perspective because some of the gains that are realized by hedge fund are not just long term capital gains, they're short-term another, but we have the final regs currently as they exist.

But I think just really do proper planning around the capital interest exception, if you're transferring part of your carry interest from the GP to an LP account, maybe setting up separate accounts within that LP to property track it. We definitely want to maximize that capital interest exception to avoid 10 61 for that portion. That was it, and I'll turn it over to Dan.

Astrid Garcia:Polling question number 3.

Daniel Krauss:I always forget to unmute. Thank you. Let's dive in, it looks like we have maybe 15 minutes to go over a decent amount of material. First thing that I wanted to talk about with everybody today is with respect to qualified small business stock and the potential to leverage that benefit. So to take a step back and just high level talk about what QSBS is. Qualified small business stock, first off, the issuer has to be a domestic S-corporation with less than 50 million dollars in assets at the time of issuance. The stock needs to be issued to a non-corporate taxpayer by the company and the issuance could be in exchange for money or other property could also be in exchange for compensation for services rendered for the issuer. LLCs and S-corporations do qualify. As far as non taxpayers are concerned, there're certain types of businesses that are not eligible for this type of tax treatment as far as the stock issuer and that normally relates to different types of businesses that provide services like accounting, legal, financial.

As far as some of the other criteria that we want to look at, in order to get the QSBS benefit, which we'll explain shortly what that is, you need to hold your investment for five years or more and the period begins on the date that the stock is issued to you. There are some exceptions to this rule, the biggest exceptions really have to do with restricted stock to founders, as well as stock options. Very quickly, with stock options you have to exercise your options or make election in order for the holding to begin and that's when you make a determination of whether or not the stock that was granted to qualifies under QSBS with respect to all the tests that we just went over. As far as the big benefit that we're talking about today, when you have a stock that qualifies under this regime and you have a liquidity event, from a federal tax perspective, the game that you can from that benefit will be the greater of 10 million dollars or 10 times what was originally paid for the stock in question.

As far as this benefit is concerned, it's per issuer. So meaning if you have multiple companies that you receive stock from, they qualify for this benefit, it would be 10 million or 10X what was originally paid for each stock. The other thing to keep in mind, while this has been a hotly contested topic amongst tax practitioners and as well as taxpayers, whether you're married or single, it doesn't matter, it's 10 million dollars per usurer per couple. Once again, this is a hotly contested topic so some people have a different opinion on this, but the general rule of thumb is, it doesn't matter if you marry a single, you're looking at the same exclusion. Now let's dive into how we could leverage this benefit. So we were talking before about the fact that this is a 10 million dollar exclusion, typically speaking, because most of the time there's not much cash exchange, so you're not getting a 10 times basis. And therefore, one of the ways that we see our clients work through maximizing the benefit is by setting up trusts, irrevocable trusts for the benefit of their errors.

By doing this, if you are in a situation where you have heavily appreciated QSBS stock that you know is going to exceed 10 million dollars with respect to the gain, you can take a portion of the stock and gift it into a revocable trust for the benefit of your errors, and by doing so, that will ensure that when the time comes to sell this stock, not only will you get a 10 million dollar exclusion for the stock that you're holding in your name, the trust as well will also be able to get their own 10 million dollar exclusions as well at the time of the sale. And just to quantify what we're talking about, if at the federal level you have a 10 million dollar exclusion, you're talking about tax savings of almost 2.4 million dollars per 10 million dollar benefit.

So it is very enticing if you could take advantage of this regime. Moving on, because I know we're short on time here. As far as from a state perspective, every state has it's own rules with respect to conformity. I can tell you living in the Bay Area, California, unfortunately, does not for QSBS. Okay, so the next topic that we're going to talk about is qualified opportunity zone funds. The intent of this tax regime is to really drive businesses and real estate investments towards low-income and economically distressed areas across the country. And investors are incentivized to do this because when you have a liquidity event, typically, you have capital gains. By investing into one of these opportunity zone funds, you have the opportunity to defer these gains for federal tax purposes as long as certain criteria is met. Once again, with respect to state conformity, every state is different. I can tell you California unfortunately doesn't conform to the qualified opportunities owned fund regime, but it's always good to talk to your tax advisor depending on the state you live in to see if maybe they have graciously formed to this regime.

As far as some considerations when you're going to invest into a qualified opportunity owned fund, yeah you have a 180-day deadline to make this investment and this 180-day deadline is going to depend on where a liquidity event occurred. If for instance, you just had a stock sale of the 180-day window could start upon when the stock sale actually occurred. If for instance, you have a gain that is coming through a pass through entity such as a partnership or an S-corporation, that 180-day window can start as late as March 15th, which would be the due date of the tax return for the entity in question in which this gain was derived. Now it's great that we have this game deferral, but like we said, it's a game deferral.

This is not a permanent exclusion. So the thing to keep in mind is when you make an investment into an opportunity zone fund, the gain will be included in your taxable income in the 2026 tax year or when the investment is sold. So it's the earlier of. Another thing to keep in mind, which I think was really lost in when this regime was passed, is that there are additional tax benefits to be had from an investment like this. Basically the way it would work is that as long as you hold an investment in one of these funds for at least 10 years, 100% of the appreciation from this fund is tax free. So it works very comparably to, for instance, Roth IRA where the contribution that you put in is with after tax dollars, but anything that comes out afterwards including appreciation, is not be taxable to the taxpayer. So similar to, but you got to hold the investment for 10 years.

Okay, so the next topic that we're going to cover is with respect to the excess business loss limitation that Lindsey had briefly touched during her side of the presentation. So, in December 2017, the Tax Cuts and Jobs Act amended section 461 to limit the amount of trade or business losses that non-corporate taxpayers can utilize to offset non-business income for tax years. Starting with 2018. However, as a result of the pandemic, the CARES Act was passed in December 2020 and the CARES Act retroactively deferred the excess business loss for three years so that it would become effective from tax years from 2021 through 2028. So this past busy season was the first year from a federal tax perspective that anybody needed to deal with this regime. Unfortunately, while many taxpayers welcomed this outcome as far as the three year deferral, it created a bit of a burden for anybody that already filed the 2018 and 2019 tax returns because if their losses were limited, the IRS mandated that even though they retroactively passed this law, you needed to go back in amend tax returns for those years.

So let's dig into exactly what the limits are and how this applies from a fund perspective. First off, the business loss limit that we're talking about is $270,000 for somebody that files a single or married separate, it's $540,000 for joint returns. This loss limit does not come into play until you first consider other regimes that would limit your loss. Some examples of that would be basis restrictions, at risk basis, as well as passive activity lost limits. So assuming that you don't have any limits with respect to outside basis, our risk basis, passive activity loss limits, then that's when these excess business loss rules come into play. And where you really see business magnified is when you're looking at whether or not your fund is considered a trader fund or an investor fund. If you're in a situation where you have an investor fund, the problem with these rules is that when it comes to income flowing through your investor fund, none of that income will most likely be considered trade or business income.

And therefore, if you have significant deductions that you can take advantage of at an investor fund level, mainly the biggest one that we can think of is passive entity tax deduction, there could be considerations to be made there with respect to the fact that if you have a very large entity level tax that you're paying, you'll be limited to either the $270,000 or the $540,000 if you're filing jointly with your spouse. On the flip side, if we're talking about a trader fund, the upside with a trader fund is that a lot of the income that you're going to see passing through a trader fund will be categorized as trader business income. And the biggest items that we're talking about would be capital gains, as well as any items of income that would float through Schedule-E.

And as long as we have a trader fund that reports trader business income as far as capital gains or income that flows through Schedule-E, unlike with an investor fund, you could go ahead and utilize the income items flow through Schedule-E as well as capital gains to offset the pass through entity tax deduction as well as any trader expenses that may be limited. If for instance, we were talking about an investor fund. As far as state conformity is concerned with regard to this regime, there are many states including California that conform, but once again, it's always good to speak to a tax advisor to ensure that you know the rules with respect to the state that you reside in.

And with that being said, we have one other just quick topic to cover, which is bonus depreciation. The thing to keep in mind here is that you have newer used property with a useful life of 20 years or less that will qualify for bonus depreciation. The big thing to consider with bonus depreciation is that for 2022, depending on the type of property we're talking about, there's potential that you could write off a 100% of the expenditure in question. An example of something where you wouldn't have a 100% right off yours and there's a separate set of rules that we don't have to go into, but just to know would be there's a separate deduction with respect to bonus depreciation.

However, after 2022, if we look at this graph fair, we can see that the right off becomes less and less appealing until you get to 2027, where unless they do something, bonus depreciation will no longer apply. As far as state conforming is concerned, most states do not conform to bonus depreciation. So it's very important for planning purposes, especially with the tax election that a lot of folks may make to consider the difference in depreciation expense that you're going to claim on the level versus the state level bonus depreciation is used. And with that said, I think have polling question here.

Astrid Garcia:Polling question number 4.

Daniel Krauss:So I think we're at time, and we can't take any questions, but maybe we could do one for the road before we wrap things up.

Lindsey Layman:Okay. Dan, one that we got was in relationship to the qualified small business stock that you were discussing, are there any other wealth transfer strategies that you're seeing in the marketplace lately?

Daniel Krauss: Yeah, so I mean the simplest strategy I would say for people to consider would be if you're charitably inclined, if you know that you're going to have a big liquidity event, which a lot of people were surprised with the amount of short-term capital gains they realized in 2021 or 2022, trying to bunch your charitable contributions together into one year to maximize your tax benefit for that, especially with short-term capital gains would be advisable. What a lot of people will do, because they want to have a little bit more of a leverage opportunity when it comes to charitable donations, is that they'll set up something called the donor advised fund, which is a type of tax exempt charitable investment account that you're using to support your charitable organizations. The annual administrative fees are very low since your DAB account isn't considered a separate legal entity for tax purposes, and therefore, there are no annual filing requirements that you'd have to make.

Like if you, for instance, set up a private foundation, the donation is irrevocable once it's made, which would enable you to take a charitable deduction on your tax return in the same year that you contribute the money to your donor fund. The upside here is that typically with the appropriate management, the money doesn't leave your DAF the same year and therefore the principal can appreciate and you can get a little bit more bang for your buck with how you're going to support your charitable endeavors.

Transcribed by Rev.com

About Paul Kangail

Paul Kangail is a Managing Director in our Financial Services Group He specializes in tax services for investment partnerships, including private equity, venture capital, hedge funds, fund of funds entities, and regulated investment companies.