2024 Year-End Tax Planning Guide for Businesses

Tax Accounting Methods

Corporations and pass-through entities may have opportunities to effectively improve their federal income tax positions and, in turn, enhance their cash tax savings by strategically adopting or changing tax accounting methods. Companies that want to reduce their current year tax liability (or create or increase a current year net operating loss (NOL)) should consider accounting method changes that accelerate deductions and defer income recognition. On the other hand, for various reasons (for example, to utilize an NOL), companies may choose to undertake accounting methods planning to accelerate income recognition and defer deductions. Importantly, when undertaking any future tax planning, companies should also keep in mind current tax proposals as well as changes[SC1] that could result based on the outcomes of the 2024 presidential and congressional elections.

The rules covering the ability to use or change certain accounting methods are often complex, and the procedure for changing a particular method depends on the mechanism for receiving IRS consent — i.e., whether the change is automatic or non-automatic. Many method changes require an application be filed with the IRS prior to the end of the tax year for which the change is requested.

The following are some of the many important issues and developments for companies to consider when reviewing their tax accounting methods in 2024:

• December 31st deadline for non-automatic method changes

• Modified procedural guidance for Section 174 R&E costs

• Claiming abandonment and casualty losses

• Tax rules for calculating percentage of completion revenue

• Tax accounting for sales of IRA credits

• Year-end opportunities to accelerate common deductions and losses

• IRS insights into treatment of transferable incentives

  
  

December 31st Deadline for Non-automatic Method Changes

Although the IRS allows many types of accounting method changes to be made using the automatic change procedures, some common method changes must still be filed under the non-automatic change procedures. A calendar year-end taxpayer that has identified a non-automatic accounting method change that it needs or desires to make effective for the 2024 tax year must file the application on Form 3115 during 2024 (i.e., the year of change).

Notably, Rev. Proc. 2024-23, released on April 30, 2024, removed from the IRS list of permissible automatic method changes any change made to comply with the Section 451 all-events test applicable for accrual method taxpayers. Effective for Forms 3115 filed on or after April 30, 2024, for a year of change ending on or after September 30, 2023, this method change may only be made using the non-automatic change procedures.

Among the other method changes that must be filed under the non-automatic change procedures are many changes to correct an impermissible method of recognizing liabilities under an accrual method (for example, using a reserve-type accrual), deferred compensation accruals, and long-term contract changes under Section 460. Additionally, taxpayers that do not qualify to use the automatic change procedures because they have made a change with respect to the same item within the past five tax years will need to file under the non-automatic change procedures to request their method change.

Generally, more information needs to be provided on Form 3115 for a non-automatic accounting method change, and the complexity of the issue and the taxpayer’s facts may increase the time needed to gather data and prepare the application. Therefore, taxpayers that wish to file non-automatic accounting method changes effective for 2024 should begin gathering the necessary information and prepare the application as soon as possible. 

IRS Releases Modified Procedural Guidance for Section 174 R&E Costs

On August 29, 2024, the IRS issued Rev. Proc. 2024-34, which provides modified procedural guidance permitting taxpayers with short taxable years in 2022 or 2023 to file an automatic accounting method change for a 2023 year for specified research or experimental expenditures (SREs) under Internal Revenue Code Section 174. The revised procedures are effective for Forms 3115 filed on or after August 29, 2024.

Effective for tax years beginning in 2022, the Tax Cuts and Jobs Act requires taxpayers to capitalize SREs in the year the amounts are paid or incurred and amortize the amounts over five or 15 years. Due to this shift in treatment, taxpayers using a different method of accounting for Section 174 costs were required to file a method change to comply with the new rules for their first taxable year beginning after December 31, 2021.  

Rev. Proc. 2024-34 Provides Taxpayers Additional Flexibility

Taxpayers may want or need to file successive accounting method changes to comply with new technical guidance issued by the IRS or correct or otherwise deviate from the positions taken with the initial method change. Prior to the issuance of Rev. Proc. 2024-34, taxpayers seeking to file successive automatic changes to comply with the updated Section 174 rules could only do so for changes made for the first and second tax years (including short tax years) beginning after December 31, 2021. Thus, a taxpayer with two short taxable years in 2022 (for example, due to a transaction) that filed an automatic Section 174 method change for one or both of those years previously would not have been able to file another automatic Section 174 method change for its 2023 year. Rev. Proc. 2024-34 provides taxpayers with additional flexibility to file an automatic Section 174 method change for any taxable year beginning in 2022 or 2023, regardless of whether the taxpayer has already made a change for the same item for a taxable year beginning in 2022 or 2023. Therefore, taxpayers that have not yet filed a federal income tax return for 2023 or have timely filed their 2023 return and are within the extension period for such return (even if no extension was filed), may be able to file an automatic change for SREs even if an accounting method change has been filed for a year beginning after December 31, 2021.

Rev. Proc. 2024-34 also modifies the existing procedural rules to permit taxpayers that are in the final year of their trade or business to use the automatic procedures to change to the required accounting method for SREs for any tax year beginning in 2022 or 2023. Under the prior guidance, taxpayers could only file an SRE method change in the final year of their trade or business for their first or second taxable year beginning after December 31, 2021.

Audit Protection May Not Be Available

Importantly, the updated guidance clarifies that if a taxpayer did not change its method of accounting in an effort to comply with Section 174 for its first taxable year beginning after December 31, 2021, the taxpayer will not receive audit protection for a change made in any taxable year beginning in 2022 or 2023. With this revision, the IRS is effectively denying audit protection for all taxpayers (regardless of whether they had short periods or full 12-month years in 2022 and 2023) that did not originally file a change to comply with Section 174 with their first taxable year beginning after December 31, 2021, unless they defer filing a method change until a tax year beginning in 2024 or after.

Claiming Abandonment and Casualty Losses

A taxpayer may be able to claim a deduction for certain types of losses it sustains during a taxable year — including losses due to casualties or abandonment, among others — that are not compensated by insurance or otherwise. To be allowable as a deduction under Section 165, a loss must be:

·       Evidenced by a closed and completed transaction,

·       Fixed by an identifiable event, and

·       Actually sustained during the taxable year.

The loss is allowed as a deduction only for the taxable year in which it is sustained. Further, the loss can be claimed on an originally filed tax return or on an amended tax return. It is important for businesses to be aware of any potential loss that has occurred, or may occur, in a taxable year, and to ensure that appropriate documentation and actions are taken within the taxable year to support the loss deduction. 

Abandonment Losses

To substantiate an abandonment loss, some act is required to evidence a taxpayer’s intent to permanently discard or discontinue the use of an asset in its business. No deduction is allowed if a taxpayer holds and preserves an asset for possible future use or for its potential future value. Suspending operations or merely not using an asset is not sufficient to establish an act of abandonment, nor is a decline in value of an asset sufficient to claim an abandonment loss. To demonstrate abandonment of an asset, a taxpayer must show both written evidence of an intention to irrevocably abandon the asset and an affirmative act of abandonment. Although some guidance exists on when a tangible asset is considered abandoned, showing abandonment of intangibles can be more challenging, and little guidance exists related to current technologies such as software, internet, or website-related intangibles.

Casualty Losses

The IRS defines a casualty broadly to include, for example, earthquakes, fires, floods, government-ordered demolitions or relocations of property deemed unsafe by reason of disasters, mine cave-ins, shipwrecks, sonic booms, storms (including hurricanes and tornadoes), terrorist attacks, vandalism, and volcanic eruptions. Importantly, casualty losses arise only from identifiable events that are sudden, unexpected, or unusual in nature, such as a natural disaster. A casualty loss does not include slow, progressive deterioration.

For a business taxpayer that needs to determine whether its gains or losses during the taxable year are treated as capital or ordinary under Section 1231, there is a special rule for involuntary conversions, which include casualties. An involuntary conversion, in relevant part, is the loss by fire, storm, shipwreck, or other casualty, or by theft, of property used in the taxpayer’s business or any capital asset that is held for more than one year. If losses from involuntarily converted property exceed gains from such property, Section 1231 does not apply to determine the character of the gain or loss. A net loss will be treated as an ordinary loss. If the taxpayer does not have losses from the involuntarily converted property, the general rules under Section 1231 must be followed.

Federally declared disasters. Generally, casualty losses are deducted only in the year in which the casualty event occurs. However, if the casualty loss is attributable to a federally declared disaster, a taxpayer may elect to take the deduction in the prior tax year. Disaster declarations are published on the Federal Emergency Management Agency (FEMA) website. The IRS typically publishes notifications in the Internal Revenue Bulletin shortly after a declaration as well.

Note that for individuals that experience a casualty event between 2018 through 2025, casualty losses are deductible only to the extent they are attributable to a federally declared disaster.

For more information on deducting abandonment, casualty, and theft losses, read the article authored by BDO’s James Atkinson, Developing an Action Plan for Casualty Gains and Losses 183 Tax Notes Federal 2303 (June 24, 2024).

Tax Rules for Calculating Percentage of Completion Revenue

The percentage of completion method (PCM) for long-term contracts, governed by Section 460 of the Internal Revenue Code, is often misapplied by taxpayers as a method of tax accounting.  Taxpayers with qualifying construction or manufacturing contracts frequently follow their book methodologies with minimal, if any, adjustments for tax purposes; however, the rules governing PCM under Section 460 differ significantly from those governing over-time recognition under GAAP.  Further, PCM method changes are typically non-automatic; thus, calendar-year taxpayers seeking to change their method for long term contracts must file a Form 3115 by December 31, 2024 in order to implement the change for their 2024 tax year.

Defining Long-term Contracts – Eligibility for PCM

Qualification as a PCM-eligible long-term contract is determined on a contract-by-contract basis and has two broad requirements: (i) the contract must be for a qualifying activity (either construction or manufacturing), and (ii) the contract must qualify as long-term.

Construction is considered a qualifying activity if one of the following must occur to satisfy the taxpayer’s contractual obligations:

·       The building, construction, reconstruction, or rehabilitation of real property (i.e., land, buildings, and inherently permanent structures as defined in Treas. Reg. §1.263A-8(c)(3));

·       The installation of an integral component to real property (property not produced at the site of the real property but intended to be permanently affixed to the real property); or

·       The improvement of real property.

Manufacturing will satisfy the activity requirement if the item being produced (i) normally requires more than 12 calendar months to produce (regardless of the actual time from contract to delivery); or (ii) is “unique.”  In this context, unique means far more than mere customization. The Section 460 regulations provide several safe harbors to assist taxpayers with determining whether the item being manufactured is unique.

To be considered long-term under the PCM rules, a contract must begin and end in two different taxable years. Therefore, in theory, even a two-day contract from December 31 to January 1 could qualify as a long-term contract.

PCM Calculation

For tax purposes, the taxpayer’s inception-to-date contract revenue corresponds to the ratio of inception-to-date contract costs incurred to total estimated contract costs. With respect to expense recognition, Section 460 mandates the accrual method for contract costs, such that deduction generally occurs in the same year the costs are taken into account in the PCM ratio’s numerator.  As previously noted, the tax rules governing PCM likely deviate from the book treatment of income/expenses in several aspects. For instance, under Section 460, taxpayers must follow how to determine the types and amounts of costs that are considered in the project completion rule. Further, there are specific rules pertaining to the treatment of pre-contracting costs (e.g., bidding and proposal costs), as well as look-back rules, which require a taxpayer, after the completion of a long-term contract, to perform a hypothetical recalculation of its prior years’ income using the actual total contract price and actual total contract costs, rather than the estimated total contract price and estimated total contract costs used for its prior year returns.

Interplay with Section 174

Many taxpayers with long-term contracts may be impacted by the requirement to capitalize Section 174 R&E expenditures. Taxpayers with significant contract-specific R&E expenditures may see some opportunity to defer the recognition of income in line with the deferral of R&E expense based on the IRS’s requirements for including R&E costs within the numerator and denominator of the completion percentage formula. Notice 2023-63 has clarified that the numerator of the completion percentage formula contains only the amortization of the capitalized R&E costs, not the gross amount of the year’s R&E expenditures. More recent guidance (Rev. Proc. 2024-09, released on December 22, 2023) provides some limited flexibility concerning the inclusion of Section 174 costs in the denominator.

Tax Accounting Considerations for Sales of IRA Tax Credits

Taxpayers either purchasing or selling certain federal income tax credits under the Inflation Reduction Act of 2022 (IRA) should be aware of specific tax accounting rules governing the treatment of amounts paid or received for those credits.  These special rules are provided in Section 6418 of the Internal Revenue Code, as well as in final Treasury regulations published in the Federal Register on April 30, 2024.

Taxpayers unaware of the new rules might overlook them and mistakenly apply the more familiar general rules instead, potentially resulting in sellers overstating their taxable income and purchasers claiming impermissible deductions.

The special tax accounting rules apply in preparing federal income tax returns of taxpayers engaging in qualifying transfers of eligible credits in 2023 or later years.

Eligible Credits

The new tax accounting rules apply to qualifying sales of “eligible credits,” which Section 6418(f)(1) defines as the following tax credits:

• The portion of the credit for alternative fuel vehicle refueling property allowed under Section 30C that is treated as a credit listed in Section 38(b);

• The renewable electricity production credit determined under Section 45(a);

• The credit for carbon oxide sequestration determined under Section 45Q(a);

• The zero-emission nuclear power production credit determined under Section 45U(a);

• The clean hydrogen production credit determined under Section 45V(a);

• The advanced manufacturing production credit determined under Section 45X(a);

• The clean electricity production credit determined under Section 45Y(a);

• The clean fuel production credit determined under Section 45Z(a);

• The energy credit determined under Section 48;

• The qualifying advanced energy project credit determined under Section 48C; and

• The clean electricity investment credit determined under Section 48E.

  
  
  
  

Section 6418 allows taxpayers to elect to transfer eligible credits to an unrelated person (but an eligible credit can only be transferred one time). Specific requirements and procedures apply in making such an election. 

Special Tax Accounting Requirements

Qualifying transfers of eligible credits are subject to specific tax accounting rules that differ from tax accounting principles generally applicable to the sale or exchange of property. Section 6418(b) provides that with respect to consideration paid for the transfer of an eligible credit, that amount:

• Must be “paid in cash”;

• Is not includible in the seller’s gross income; and

• Is not deductible by the purchaser of the eligible credit.

  
  

In the case of eligible credits determined with respect to any facility or property held directly by a partnership or S corporation, if the partnership or S corporation makes a qualifying election to transfer an eligible credit:

• Any amount received as consideration for the transfer of the credit is treated as tax-exempt income for purposes of Section 705 (dealing with the basis of a partner’s interest in a partnership) and Section 1366 (dealing with pass-through of items to S corporation shareholders); and 

• A partner’s distributive share of the tax-exempt income must be based on the partner’s distributive share of the otherwise eligible credit for each taxable year.

  
  

Just as the seller would not have realized income had it used the eligible credit to reduce its own federal tax liability rather than selling the credit, the final regulations provide a step-in-the-shoes rule for the eligible credit’s purchaser. The purchaser will not realize income upon its use of the credit to reduce its federal tax liability, even if the tax savings exceed the consideration paid to acquire the eligible credit.  

For any eligible credit (or portion of an eligible credit) that the taxpayer elects to transfer in accordance with Section 6418, the purchaser takes the credit into account in its first taxable year ending with, or after, the seller’s taxable year with respect to which the credit was determined.    

Basis Adjustment Rules

Under Section 6418 and the final regulations, if a Section 48 energy credit, Section 48C qualifying advanced energy project credit, or a Section 48E clean electricity investment credit is transferred, the basis reduction rules of Section 50(c) apply to the applicable investment credit property as if the transferred eligible credit was allowed to the seller, rather than to the purchaser. Section 50(c) generally provides that if a credit is determined with respect to any property, the basis of the property is reduced by the amount of the credit (subject to certain recapture rules).

The basis adjustment will affect the computation of the seller’s available cost recovery deductions for the investment property with respect to which the transferred credits arose, and so must be considered in preparing the returns of taxpayers engaged in the sale of eligible credits.

Applicability Dates

Section 6418 applies to taxable years beginning after December 31, 2022. Sellers must elect to transfer all or a portion of an eligible credit on the seller’s original return for the taxable year for which the credit is determined by the due date of that return (including extensions), but not earlier than February 13, 2023.  

The final regulations are applicable for taxable years ending on or after April 30, 2024. Taxpayers may apply the final regulations to taxable years ending prior to that date but must apply them in their entirety if they choose to do so. 

Year-end Opportunities to Accelerate Common Deductions and Losses

Heading into year-end tax planning season, companies may be able to take some relatively easy steps to accelerate certain deductions into 2024 or, if more advantageous, defer certain deductions to one or more later years. The key reminder for all of the following year-end “clean-up” items is that the taxpayer must make the necessary revisions or take the necessary actions before the end of the 2024 taxable year. (Unless otherwise indicated, the following items discuss planning relevant to an accrual basis taxpayer.)

Deduction of accrued bonuses. In most circumstances, a taxpayer will want to deduct bonuses in the year they are earned (the service year), rather than the year the amounts are paid to the recipient employees. To accomplish this, taxpayers may wish to:

• Review bonus plans before year end and consider changing the terms to eliminate any contingencies that can cause the bonus liability not to meet the Section 461 “all events test” as of the last day of the taxable year. Taxpayers may be able to implement strategies that allow for an accelerated deduction for tax purposes while retaining the employment requirement on the bonus payment date. These may include using (i) a “bonus pool” with a mechanism for reallocating forfeited bonuses back into the pool; or (ii) a “minimum bonus” strategy that allows some flexibility for the employer to retain a specified amount of forfeited bonuses.

  
  

It is important that the bonus pool amount is fixed through a binding corporate action (e.g., board resolution) taken prior to year end that specifies the pool amount, or through a formula that is fixed before the end of the tax year, taking into account financial data as of the end of the tax year. A change in the bonus plan would be considered a change in underlying facts, which would allow the taxpayer to prospectively adopt a new method of accounting without filing a Form 3115.

• Schedule bonus payments to recipients to be made no later than 2.5 months after the tax year end to meet the requirements of Section 404 for deduction in the service year.

  
  

Deductions of prepaid expenses. For federal income tax purposes, companies may have an opportunity to take a current deduction for some of the expenses they prepay, rather than capitalizing and amortizing the amounts over the term of the underlying agreement or taking a deduction at the time services are rendered. Under the so-called “12-month rule,” taxpayers can deduct prepaid expenses in the year the amounts are paid (rather than having to capitalize and amortize the amounts over a future period) if the right/benefit associated with the prepayment does not extend beyond the earlier of i) 12 months after the first date on which the taxpayer realizes the right/benefit, or ii) the end of the taxable year following the year of payment. Note that accrual method taxpayers must first have an incurred liability under Section 461 in order to accelerate a prepayment under the 12-month rule.

The rule provides some valuable options for accelerated deduction of prepaids for accrual basis companies – for example, insurance, taxes, government licensing fees, software maintenance contracts, and warranty-type service contracts. Identifying prepaids eligible for accelerated deduction under the tax rules can prove a worthwhile exercise by helping companies strategize whether to make prepayments before year end, which may require a change in accounting method for the eligible prepaids.

Inventory write offs. Often companies carry inventory that is obsolete, unsalable, damaged, defective, or no longer needed.  While for financial reporting inventory is generally reduced by reserves, for tax purposes a business normally must dispose of inventories to recognize a loss, unless an exception applies. Thus, a best practice for tax purposes to accelerate losses related to inventory is to dispose of or scrap the inventory by year end.

An important exception to this rule is the treatment of “subnormal goods,” which are defined as goods that are unsaleable at normal prices or unusable in the normal way due to damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar reasons. For these types of items, companies may be able to write down the cost of inventory to the actual offering price within 30 days after year end, less any selling costs, even if the inventory is not sold or disposed of by year end.

Continued phase-out of bonus depreciation. For eligible property placed in service during 2024, the applicable bonus percentage is 60%. As such, year-end tax planning for fixed assets emphasizes cash tax savings through scrubbing fixed asset accounts for costs that can be deducted currently under Section 162 (e.g., as repairs and maintenance costs) rather than being capitalized and recovered through depreciation, assessing eligibility for immediate Section 179 expensing, and reducing the depreciation recovery periods of capital costs where possible.

CCA Provides Insight into Treatment of Transferable Incentives

CCA 202304009 addresses whether a pharmaceutical or biotechnology company must capitalize costs incurred to purchase from a third party a priority review voucher (PRV) issued by the U.S. Food & Drug Administration (FDA). A PRV is a voucher entitling its holder to prioritized FDA review of a new medical treatment the applicant seeks to offer to the public. PRVs are considered valuable assets because their use can significantly reduce the time it would otherwise take to bring a new drug to market. A PRV can be held for use with a future FDA drug application or sold without restriction to another company for their use. PRVs have no expiration date and can be transferred an unlimited number of times.

In CCA 2023040009, the IRS concluded that a taxpayer must capitalize the amount spent to purchase a PRV either as a cost incurred to facilitate obtaining a franchise right or as a cost incurred to acquire a new intangible asset, depending on the intended use of the voucher. The IRS also provided guidance on how the capitalized costs should be recovered.

While CCA 202304009 discusses costs to acquire PRVs, the guidance might help forecast the tax accounting treatment of various other non-tax government incentives as well. For further information and analysis, read the article authored by BDO’s Connie Cunningham and James Atkinson, IRS Provides Insight Into Treatment of Transferable Incentives 65 TMM, 5/16/2024.

Business Incentives & Tax Credits

I.               Credit for Increasing Research Activities: Proposed Changes to Form 6765

The IRS announced the release of a revised draft of Form 6765, Credit for Increasing Research Activities, on June 21, 2024, that reflects feedback from external stakeholders. This follows the IRS's efforts to tighten documentation requirements for claiming the research credit. In September 2023, the IRS previewed proposed changes to Form 6765, adding new sections for detailed business component information and reordering existing fields. These changes aimed to improve information consistency and quality for tax administration but were criticized as overly burdensome.

The updated draft retains Section E from the previous version but requires additional taxpayer information. The "Business Component Detail" section, now Section G, is optional for Qualified Small Business (QSB) taxpayers and those with total qualified research expenditures (QREs) of $1.5 million or less and gross receipts of $50 million or less. Additionally, the IRS reduced the number of business components to be reported in Section G, requiring 80% of total QREs in descending order by amount, capped at 50 business components. Special instructions will be provided for taxpayers using the ASC 730 directive. The revised Section G will be optional for all filers for tax year 2024 to allow taxpayers time to transition to the new format. As outlined by the IRS, Section G will be effective for tax year 2025.

Examination Environment

Currently, the IRS receives a significant number of returns claiming the research credit, which requires substantial examination resources from both taxpayers and the IRS. To ensure effective tax administration for this issue, the IRS aims to clarify the requirements for claiming the research credit by considering all feedback received from stakeholders before finalizing any changes to Form 6765.

In response to ongoing concerns of improper claims of the research credit, the IRS has intensified its focus on reviewing these claims for nonconformities, including conducting more audits. Navigating the complexities of the research credit can be challenging, especially with the increased scrutiny, recent case law, and the newly implemented IRS compliance measures in place.

Planning Considerations

It is important for taxpayers to accurately determine eligibility, validate and properly record contemporaneous documentation to support research credit claims, and defend against examinations. Taxpayers should partner with a trusted tax advisor to ensure compliance with IRS regulations and proper eligibility for the research credit.

II.              Tax Credit Monetization

General IRA Overview

The signing of the Inflation Reduction Act (IRA) on August 16, 2022, marked the largest-ever U.S. investment committed to combat climate change, allocating significant funds to energy security and clean energy programs over the next 10 years, including provisions incentivizing the manufacturing of clean energy equipment and the development of renewable energy generation.

Overall, the act modifies many of the current energy-related tax credits and introduces significant new credits and structures intended to facilitate long-term investment in the renewables industry. Capital investments in renewable energy or energy storage; manufacturing of solar, wind, and battery components; and the production and sale or use of renewable energy are activities that could benefit from the over 20 new or expanded IRA tax credits. The IRA also introduced new ways to monetize tax credits and additional bonus credit amounts for projects that meet prevailing wage and apprenticeship, energy community, and domestic content requirements.

45X – Advanced Manufacturing Production Tax Credit

The 45X advanced manufacturing production credit continues to be a valuable production tax credit meant to encourage the production and sale of energy components in the U.S., specifically related to solar, wind, batteries, and critical mineral components. To be eligible for the credit, components must be produced in the U.S. or U.S. possessions and be sold by the manufacturer to unrelated parties. The Department of Energy has released a full list of eligible components as defined in the IRA, with specific credit amounts that vary according to the component. Manufacturers can also monetize 45X credits through a direct payment from the IRS for the first five years under Internal Revenue Code Section 6417. They may also transfer a portion or all the credit to another taxpayer through the direct transfer system Section 6418 election. The 45X credit is a statutory credit with no limit on the amount of funding available; however, the credit will begin to phase out beginning in 2030 and will be completely phased out after 2033. Manufacturers cannot claim 45X credits for any facility that has claimed a 48C credit.

48E and 45Y Clean Electricity Investment and Production Credits

For energy property and qualified facilities placed in service after December 31, 2024, Sections 48E and 45Y will replace the longstanding investment tax credit and production tax credit under Sections 48 and 45. The new provisions adopt a technology-neutral approach, whereby qualification for the credits will generally not be based on specific technologies identified in the IRC, but rather on the ability to generate electricity without greenhouse gas emissions. This represents a significant departure from historical practices and is expected to expand the range of technologies eligible for tax credits. Other relevant provisions of the IRA, such as bonus credit additions and monetization options, will still apply to the new Sections 48E and 45Y.

45Z Clean Fuel Production Credit

The clean fuel production credit under Section 45Z will become effective for transportation fuel produced at a qualified facility after December 31, 2024. On May 31, 2024, the IRS issued Notice 2024-49, providing guidance on the necessary registration requirements to claim the credit. Fuel that meets additional criteria to qualify as sustainable aviation fuel (SAF) will be eligible for an increased credit amount. As in the case of other renewable credits, the emissions rate is crucial for purposes of the 45Z credit, because the emissions factor for the fuel will directly impact the credit amount. Additionally, prevailing wage and apprenticeship rules will apply to Section 45Z qualified facilities, with certain exceptions.

Planning Considerations

With the passage of Section 6418 as part of the IRA, certain renewable energy tax credits can now be transferred by companies that generate eligible credits to any qualified buyer seeking to purchase tax credits. Through credit transfers, taxpayers have the option to sell all or a portion of their credits in exchange for cash as part of their overall renewable energy goals if they are not able to fully utilize the benefit. Companies with a high amount of taxable income and therefore a larger appetite for tax credits are able to purchase these credits at a discount, with the sale proceeds improving the economics of clean energy development.

The market rate for the sale of credits will be highly dependent on the type of credit being transferred, as well as the substantiation and documentation related to the seller’s eligibility for the credit taken and any bonus credit amounts claimed. The current rate seen in the market for transferring credits is around $0.93 to $0.96 per $1 of credit, but these amounts are subject to change based on specific fact patterns for each individual transaction and the overall market trend.

Taxpayers considering buying or selling tax credits that are transferable under the IRA should be looking ahead and forecasting their potential tax liability and resulting appetite for buying and selling credits. These credits can be transferred and utilized against estimated quarterly payments as soon as transfer agreements are finalized. This expedited reduction in cash outlay for the buyer and monetization of credits for the seller is a consideration that should be taken into account for taxpayers interested in entering the market of transferring credits.

III. Bonus Credits

The Inflation Reduction Act not only introduced new and expanded credits for the investment in and production of renewable energy and its related components but also included provisions for bonus credit amounts subject to specific requirements.

The prevailing wage and apprenticeship (PWA) requirement is a 5x multiplier for certain credits that can bring the credit rate from 6% up to 30% by paying prevailing wages to all labor related to the construction, installation, alteration, and repair of eligible property. Additionally, taxpayers must ensure that a specific percentage of these labor hours is performed by qualified apprentices.

The IRS and the Treasury Department issued final regulations on the PWA requirements in June 2024, and projects starting in 2025 and after will be unable to utilize the beginning of construction exemption. Other common credit additions available for taxpayers meeting energy community and domestic content requirements provide a 10% addition to the base rate of the credit. Taxpayer documentation will be required to substantiate the claim of these bonus credit amounts and will need to be presented to a buyer in the event that these credits are transferred under Section 6418.  

Planning Considerations

Taxpayers that have current or proposed investments or activities for which they plan to utilize the PWA multiplier should be formulating a documentation strategy and procedure. In the event of an IRS audit or transfer of these credits, taxpayers will be required to substantiate the wages paid to laborers, as well as the number of hours performed by registered apprentices. Depending on the size and amount of labor involved in qualified investments or production, documentation for PWA purposes, as well as for the domestic content requirements, will likely be a highly burdensome task if not planned for at the outset of a project.

IV. NMTC

The federal New Markets Tax Credit (NMTC) program was established in 2000 to subsidize capital investments in eligible low-income census tracts. The subsidy provides upfront cash in the form of NMTC-subsidized loans at below-market interest rates (3%-3.5%). The loan principal is generally forgiven after a seven-year term, resulting in a permanent cash benefit. Funding for these subsidized loans is highly competitive and expected to be depleted quickly.

The U.S. Treasury’s Community Development Financial Institutions (CDFI) Fund recently announced that, for 2025 only, it will double its annual allocation of NMTC funds.

Planning Considerations

Taxpayers across multiple industries may be good candidates for the NMTC.

Applying for the NMTC program involves several steps that help ensure the funding is allocated to projects that will have a meaningful impact on low-income communities. Applicants for the credit are evaluated based on the community impact derived from the investments (such as job creation, community services provided, etc.). In a program as highly competitive as the NMTC, applying early can make the difference between securing a portion of the limited funds available or missing out on funding opportunities. Early applicants are often better positioned to take advantage of available opportunities, and additional benefits may be possible for those who act swiftly.

The following initial questions will help determine if a project is viable for NMTC:

·       Address of the proposed project

·       High-level project description (a few sentences)

o   Status of construction/timeline of capital expenditures (midstream projects are permitted)

o   Estimated number of direct jobs to be created by the project

Taxpayers with ongoing or planned capital investments for later in 2024 or 2025 that are eligible to receive NMTC financing should begin reaching out to CDEs. Early outreach provides QALICBs a strong advantage in securing this financing due to the competitive nature and limited funds of the program.

Partnership Tax

Introduction

The IRS in the past year has continued to ramp up its scrutiny partnerships’ tax positions, including several pieces of new guidance taking a multiprong approach to partnership “basis shifting” transactions that the agency views as having the potential for abuse. At the same time, IRS is dedicating new funding and resources to examining partnerships.

These developments, along with some new reporting and regulatory changes, mean there are a number of tax areas partnerships should be looking into as they plan for year end and the coming year:

• Evaluate Partnership ‘Basis Shifting’ Transactions That Are Subject of New IRS Scrutiny

• Plan for Partnership Form 8308 Expanded Reporting and January 31 Deadlin

• Review Limited Partner Eligibility for SECA Tax Exemption

• Consider Effect of Proposed Rules on Transactions Between Partnerships and Related Persons

• Double-Check Positions on Inventory Items and Unrealized Receivables Under Section 751(a)

• Keep an Eye on Challenges to IRS Rules, Including Partnership Anti-Abuse Rules, Under Loper Bright 

• Watch for New Form for Partners to Report Partnership Property Distributions

• Prepare for Partnership Obligations Under Corporate Alternative Minimum Tax Regulations

Evaluate Partnership ‘Basis Shifting’ Transactions That Are Subject of New IRS Scrutiny

The IRS and Treasury have made clear that they intend to take a harder stance on transactions involving basis shifting between partnerships and related parties. On June 17, 2024, the IRS launched a multiprong approach to curtail inappropriate use of partnership rules to inflate the basis of assets without causing meaningful changes to the economics of a taxpayer’s business.

The guidance focuses on complex transactions involving related-party partnerships through which taxpayers “strip” basis from certain assets and shift that basis to other assets where the increased basis is intended to generate tax benefits – through increased cost recovery deductions or reduced gain (or increased loss) on asset sales – in transactions that have little or no economic substance.

To address what it deems the inappropriate use of such transactions to generate tax benefits, the IRS has taken several steps:

1. Notice 2024-54 describes two sets of upcoming proposed regulations addressing the treatment of basis shifting transactions involving partnerships and related parties.

2. Additional proposed regulations (REG-124593-23), issued concurrently with Notice 2024-54, identify certain partnership basis shifting transactions as reportable Transactions of Interest.

3. Revenue Ruling 2024-14 notifies taxpayers that engage in three variations of these related-party partnership transactions that the IRS will apply the codified economic substance doctrine to challenge inappropriate basis adjustments and other aspects of these transactions.

   
   

The IRS stated that the types of related-party partnership basis shifting transactions described in the current guidance cut across a wide variety of industries and individuals. It stated that Treasury estimates the transactions could potentially cost taxpayers more than $50 billion over a 10-year period. The IRS added that it currently has “tens of billions of dollars of deductions claimed in these transactions under audit.”

Basis Shifting Transactions Under IRS Scrutiny

An IRS Fact Sheet released concurrently with the basis shifting guidance states that there are generally three categories of basis shifting transactions that are the focus of the new guidance. It describes these three categories of transactions as:

1. Transfer of partnership interest to related party: A partner with a low share of the partnership’s inside tax basis and a high outside tax basis transfers the interest in a tax- free transaction to a related person or to a person who is related to other partners in the partnership. This related-party transfer generates a tax-free basis increase to the transferee partner’s share of inside basis.

2. Distribution of property to a related party: A partnership with related partners distributes a high-basis asset to one of the related partners that has a low outside basis. The distributee partner then reduces the basis of the distributed asset, and the partnership increases the basis of its remaining assets. The related partners arrange this transaction so that the reduced tax basis of the distributed asset will not adversely impact the related partners, while the basis increase to the partnership’s retained assets can produce tax savings for the related parties.

3. Liquidation of related partnership or partner: A partnership with related partners liquidates and distributes (1) a low-basis asset that is subject to accelerated cost recovery or for which the parties intend to sell to a partner with a high outside basis and (2) a high- basis property that is subject to longer cost recovery (or no cost recovery at all) or for which the parties intend to hold to a partner with a low outside basis. Under the partnership liquidation rules, the first related partner increases the basis of the property with a shorter life or which is held for sale, while the second related partner decreases the basis of the long-lived or non-depreciable property. The result is that the related parties generate or accelerate tax benefits.

Notice 2024-54: Forthcoming Proposed Rules Governing Covered Transactions

Notice 2024-54 describes two sets of proposed regulations that the IRS plans to issue addressing certain partnership basis-shifting transactions (covered transactions):

• Proposed Related-Party Basis Adjustment Regulations. Proposed regulations under Sections 732, 734, 743, and 755 would provide special rules for the cost recovery of positive basis adjustments or the ability to take positive basis adjustments into account in computing gain or loss on the disposition of basis adjusted property following certain transactions.

• Proposed Consolidated Return Regulations. Proposed regulations under Section 1502 would provide rules to clearly reflect the taxable income and tax liability of a consolidated group whose members own interests in a partnership.

  
  

Generally, for purposes of the notice and planned proposed rules, covered transactions:

• Involve partners in a partnership and their related parties,

• Result in increases to the basis of property under Section 732, Section 734(b), or Section 743(b), and

• Generate increased cost recovery allowances or reduced gain (or increased loss) upon the sale or other disposition of the basis-adjusted property.

• The IRS intends to propose that the Proposed Related-Party Basis Adjustment Regulations, when adopted as final regulations, would apply to tax years ending on or after June 17, 2024.

The IRS states that the proposed applicability date for the Proposed Consolidated Return Regulations will be set forth in the proposed regulations once issued.

Proposed Rules Identifying Basis Shifting as Transaction of Interest

The proposed regulations issued concurrently with Notice 2024-54 identify related-partnership basis adjustment transactions and substantially similar transactions as reportable Transactions of Interest.

Under the proposed rules, disclosure requirements for these transactions would apply to taxpayers and material advisers with respect to partnerships participating in the identified transactions, including by receiving a distribution of partnership property, transferring a partnership interest, or receiving a partnership interest.

Generally, the identified Transactions of Interest would involve positive basis adjustments of $5 million or more under subchapter K of the Internal Revenue Code in excess of the gain recognized from such transactions, if any, on which tax imposed under subtitle A is required to be paid by any of the related partners (or tax-indifferent party) to such transactions – specifically, Section 732(b) or (d), Section 734(b), or Section 743(b) – for which no corresponding tax is paid.

Notification that IRS Will Challenge Basis Stripping

In Revenue Ruling 2024-14, the IRS notifies taxpayers and advisors that the IRS will apply the codified economic substance doctrine to challenge basis adjustments and other aspects of certain transactions between related-party partnerships. The IRS will raise the economic substance doctrine with respect to transactions in which related parties.

1. Create inside/outside basis disparities through various methods, including the use of partnership contributions and distributions and allocation of items under Section 704(b) and (c),

2. Capitalize on the disparity by either transferring a partnership interest in a nonrecognition transaction or making a current or liquidating distribution of partnership property to a partner, and

3. Claim a basis adjustment under Sections 732(b), 734(b), or 743(b) resulting from the nonrecognition transaction or distribution.

   
   

Planning Considerations

The IRS guidance package highlights a ramping up of IRS scrutiny of the described partnership basis shifting transactions, but there are still questions with respect to how specifically the final rules will aim to address these transactions. Additional detail should become available when the IRS issues the proposed regulations described in Notice 2024-54. In drafting those rules, the IRS will have the opportunity to take into account comments submitted on the Notice.

Moreover, particularly in light of the Supreme Court’s recent decision to overturn Chevron deference in Loper Bright Enterprises. v. Raimondo, taxpayers are likely to challenge the IRS’s authority to issue the planned regulations.

Nonetheless, taxpayers that have structured partnership basis shifting transactions or transactions that merely fall under the mechanical rules like those described in the guidance should evaluate the effects of the anticipated rules on their transactions and consider next steps for compliance.

Plan for Partnership Form 8308 Expanded Reporting and January 31 Deadline

The IRS in October 2023 released a revised Form 8308, “Report of a Sale or Exchange of Certain Partnership Interests” seeking additional information on partnership interest transfers. The revised form was initially required for transfers occurring on or after January 1, 2023, affecting 2024 filings. However, the IRS in January 2024 provided some penalty relief with respect to 2023 transfers, provided certain action was taken by January 31, 2024. It is unclear if the IRS will provide such relief again in 2025 with respect to 2024 transfers.

The IRS relief provided in the past year responded to concerns, which are still relevant, that partnerships will not have the information necessary to complete the new Part IV of Form 8308 in time to meet the January 31 deadline for furnishing information to the transferor and transferee.

Expanded Form 8308 Reporting

Partnerships file Form 8308 to report the sale or exchange by a partner of all or part of a partnership interest where any money or other property received in exchange for the interest is attributable to unrealized receivables or inventory items (that is, where there has been a Section 751(a) exchange).

The IRS significantly expanded the Form 8308 reporting requirements in the revised form released in October. For transfers occurring on or after January 1, 2023, the revised Form 8308 includes expanded Parts I and II and new Parts III and IV. New Part IV is used to report specific types of partner gain or loss when there is a Section 751(a) exchange, including the partnership’s and the transferor partner’s share of Section 751 gain and loss, collectibles gain under Section 1(h)(5), and unrecaptured Section 1250 gain under Section 1(h)(6).

Furnishing Information to Transferors and Transferees

Partnerships with unrealized receivables or inventory items described in Section 751(a) (Section 751 property or “hot assets”) are also required to provide information to each transferor and transferee that are parties to a Section 751(a) exchange.

Under the regulations, each partnership that is required to file a Form 8308 must furnish a statement to the transferor and transferee by the later of (1) January 31 of the year following the calendar year in which the Section 751(a) exchange occurred or (2) 30 days after the partnership has received notice of the exchange.

Generally, partnerships must use the completed Form 8308 as the required statement, unless the form covers more than one Section 751 exchange. If the partnership is not providing the Form 8308 as the required statement, then it must furnish a statement with the information required to be shown on the form with respect to the Section 751(a) exchange to which the person is a party.

A penalty applies under Section 6722 for failure to furnish statements to transferors and transferees on or before the required date, or for failing to include all the required information or including incorrect information.

Penalty Relief with Respect to 2023 Transfers

The IRS issued guidance (Notice 2024-19) providing penalty relief for partnerships with unrealized receivables or inventory items that would fail to furnish Form 8308 by January 31, 2024, to the transferor and transferee in certain partnership interest transfers that occurred in 2023. To qualify for the relief, among other requirements, partnerships generally still had to furnish to the transferor and transferee Parts I–III of Form 8308 by the January 31, 2024, deadline.

Notice 2024-19 stated that, with respect to Section 751(a) exchanges during calendar year 2023, the IRS would not impose penalties under Section 6722 for failure to furnish Form 8308 with a completed Part IV by the regulatory due date (i.e., generally, January 31, 2024).

To qualify for last year’s relief, the partnership was required to:

• Timely and correctly furnish to the transferor and transferee a copy of Parts I, II, and III of Form 8308, or a statement that includes the same information, by the later of January 31, 2024, or 30 days after the partnership is notified of the Section 751(a) exchange, and

• Furnish to the transferor and transferee a copy of the complete Form 8308, including Part IV, or a statement that includes the same information and any additional information required under the regulations, by the later of the due date of the partnership’s Form 1065 (including extensions) or 30 days after the partnership is notified of the Section 751(a) exchange.

Planning Considerations

While the requirement of furnishing Form 8308 statements is not new, the inclusion of actual “hot asset” (i.e., unrealized receivables or inventory items) information within Form 8308 for transfers in 2023 and later has created difficulties.

Prior to 2023, this requirement could be satisfied by providing a taxpayer with a Form 8308 that merely notifies the transferor that they will have some amount of hot asset recharacterization. With the new form, partnerships are now required to provide actual recharacterization amounts.

The penalty relief for furnishing information in 2024 on 2023 transfers was welcome. However, it is unclear if the IRS will extend the relief for an additional year or otherwise address concerns about the availability of the information necessary to timely meet the requirement.

Review Limited Partner Eligibility for SECA Tax Exemption

There is some additional clarity in the ongoing dispute between the IRS and some partnerships over whether an active “limited partner” is eligible for the statutory exemption from self-employment (SECA) tax.

The U.S. Tax Court on November 28, 2023, responding to a Motion for Summary Judgment, held that nominally being a “limited partner” in a state law limited partnership is insufficient to qualify for the statutory exemption from SECA tax for limited partners (Soroban Capital Partners v. Commissioner, 161 T.C. No. 12). The court agreed with the government that the statutory exemption requires a functional analysis of whether a partner was, in fact, active in the business of the partnership and a “limited partner” in name only.

SECA Tax Exemption for Limited Partners

Under Internal Revenue Code Section 1402(a)(13), the distributive share of partnership income allocable to a limited partner is generally not subject to SECA tax, other than for guaranteed payments for services rendered. However, the statute does not define “limited partner,” and proposed regulations issued in 1997 that attempted to clarify the rules around the limited partner exclusion have never been finalized.

In recent years, courts have held – in favor of the IRS – that members in limited liability companies (LLCs) and partners in limited liability partnerships (LLPs) that are active in the entity’s trade or business are ineligible for the SECA tax exemption.

Despite these IRS successes, some – including the taxpayer in the Soroban case – continued to claim that state law controls in defining “limited partner” in the case of a state law limited partnership. This specific issue – i.e., the application of the exemption in the case of a state law limited partnership – had not previously been addressed by the courts.

Soroban Capital Partners’ Position and IRS Challenge

The Soroban Capital Partners litigation filed with the Tax Court involved a New York hedge fund management company formed as a Delaware limited partnership. The taxpayers challenged the IRS’s characterization of partnership net income as net earnings from self-employment subject to SECA tax. According to the facts presented, each of the three individual limited partners spent between 2,300 and 2,500 hours working for Soroban, its general partner and various affiliates – suggesting that the limited partners were “active participants” in the partnership’s business. For the years at issue, Soroban was subject to the TEFRA audit and litigation procedures.

The government contended that the term “limited partner” is a federal tax concept that is determined based on the actions of the partners – not the type of state law entity. Citing previous cases, the government asserted that the determination of limited partner status is a “facts and circumstances inquiry” that requires a “functional analysis.” The taxpayers in Soroban, on the other hand, argued that such a functional analysis does not apply in the case of a state law limited partnership and that, in the case of these partnerships, limited partner status is determined by state law.

Under the functional analysis adopted by the Tax Court in previous cases (not involving state law limited partnerships), to determine who is a limited partner, the court looks at the relationship of the owner to the entity’s business and the factual nature of services the owner provides to the entity’s operations.

Tax Court’s Analysis

To answer the question of whether Soroban’s net earnings from self-employment should include its limited partners’ distributive shares of ordinary business income, the court turned first to two preliminary questions:

1. What is the scope of the Section 1402(a)(13) SECA tax exemption for “a limited partner, as such”?

2. If the exemption requires looking through to the limited partner’s role in the partnership, does that inquiry concern a partnership item to be resolved in a TEFRA partnership-level proceeding?

   
   

With respect to the scope of the exemption – noting that neither the statute nor regulations define “limited partner” – the court highlighted that the statute expressly applies the exemption to “a limited partner, as such”. In interpreting statutes, the court explained that it looks at the ordinary meaning of the terms and that it must avoid rendering any words or clauses to be meaningless. Thus, the court interpreted the addition of the words “as such” to signify that Congress intended the exemption to apply to something more specific than a “limited partner” in name only.

Having concluded that a functional analysis is necessary to determine limited partner status for purposes of the exemption, the court turned to whether this inquiry concerned a “partnership item” under the applicable TEFRA procedures. The court explained that partnership items are those that (1) are required to be taken into account for the partnership tax year under subtitle A of the Internal Revenue Code and (2) are more properly determined at the partnership level.

The court stated the first prong is easily resolved – subtitle A generally requires partnerships to state the amounts of income that would be net earnings from self-employment in the hands of the recipients. The court further determined the second prong was satisfied, stating that a functional analysis of the partners’ activities involves factual determinations that are necessary to determine Soroban’s aggregate amount of net earnings from self-employment.

Accordingly, the court held that a functional analysis applies to determine whether a partner in a state law limited partnership is a “limited partner” for SECA tax exemption purposes, and, for a TEFRA partnership, that inquiry concerns a partnership item subject to a TEFRA proceeding.

Planning Considerations

This Soroban case appeared to be a big win for the government. By denying Soroban’s Motion for Summary Judgment and granting the government’s Motion for Partial Summary Judgment, the Tax Court cleared the way for this case to continue. Once the court proceeds with a functional analysis based on the facts, it can rule on whether the government’s Final Partnership Administrative Adjustments for tax years 2016 and 2017 should be upheld.

Based on prior court cases, the functional analysis will likely center around the roles and activities of the individual partners. If they are merely passive investors, then the analysis likely results in them being classified as limited partners under the SECA statute. However, if they are active in the business and/or are able to contractually bind the business under state law, the court is likely to reach the opposite conclusion.

The Soroban case involves a partnership subject to TEFRA. Although self-employment tax is not covered under the centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015 (BBA), it’s unclear how the IRS will attempt to address this treatment in audits of partnerships subject to the BBA rules instead of TEFRA.

Consider Effect of Proposed Rules on Transactions Between Partnerships and Related Persons

The Department of the Treasury and IRS in November 2023 issued proposed regulations (REG-131756-11) relating to the tax treatment of transactions between partnerships and related persons. The proposed amendments to the regulations under Sections 267 and 707 relate to the disallowance or deferral of deductions for losses and expenses in certain transactions with partnerships and related persons.

Tax Treatment of Transactions with Related Parties Under Current Regulations

In general, Section 267(a)(1) provides that a taxpayer may not deduct a loss on the sale or exchange of property with a related person as defined in Section 267(b). Section 267(a)(2) sets forth a “matching rule” that provides that if because of a payee’s method of accounting, an amount is not (unless paid) includible in the payee’s gross income, the taxpayer (payor) may not deduct the otherwise deductible amount until the payee includes the amount in gross income if the taxpayer and payee are related persons within the meaning of Section 267(b) on the last day of the taxpayer’s taxable year in which the amount otherwise would have been deductible.

As part of enacting the Internal Revenue Code of 1954, Congress added Section 707(b)(1) to the Code to address the sale or exchange of property between a partnership and a partner owning, directly or indirectly, more than 50% of the capital or profit interest in the partnership. Given a lack of statutory and regulatory guidance addressing transactions between a partnership and a related person who was not a partner, the Treasury Department and the IRS issued Reg. §1.267(b)-1(b) in 1958.

Reg. §1.267(b)-1(b) applies an aggregate theory of partnerships to provide that any transaction described in Section 267(a) between a partnership and a person other than a partner is considered as occurring between the other person and the members of the partnership separately. Specifically, Reg. §1.267(b)-1(b) provides that if the other person and a partner are within any of the relationships specified in Section 267(b), no deductions with respect to the transaction between the other person and the partnership will be allowed: (i) to the related partner to the extent of the related partner’s distributive share of partnership deductions for losses or unpaid expenses or interest resulting from the transactions, and (ii) to the other person to the extent the related partner acquires an interest in any property sold to or exchanged with the partnership by the other person at a loss, or to the extent of the related partner’s distributive share of the unpaid expenses or interest payable to the partnership by the other person as a result of the transaction.

Conflict with Statute and Proposed Amendments

Although the U.S. Tax Court upheld the validity of Reg. §1.267(b)-1(b) and its use of the aggregate theory, subsequent statutory changes to Sections 267 and 707(b) have made Reg. §1.267(b)-1(b) inconsistent with the statute. The statutory changes to Sections 267 and 707(b) enacted since 1982 indicate that Congress intended for a partnership to be viewed as an entity, rather than as an aggregate of its partners, in applying the rules of Sections 267 and 707(b). Therefore, the loss disallowance rules of Sections 267(a)(1) and 707(b)(1), the gain recharacterization rules of Section 707(b)(2), and the matching rule of Section 267(a)(2) similarly should be applied at the partnership level and not the partner level.

Accordingly, the IRS proposed changes to the regulations under Section 267, including removing Reg. §1.267(b)-1(b), to conform the regulations with the current statute.

Application of Proposed Regulations

Once the proposed regulations are finalized, Reg. §1.267(b)-1(b) will be stricken. This means that transactions described in Section 267(a) between a partnership and a person other than a partner will no longer be considered as occurring between the other person and each partner separately.

Consider the following example from the current Reg. §1.267(b)-1(b):

Example (1). A, an equal partner in the ABC partnership, personally owns all the stock of M Corporation. B and C are not related to A. The partnership and all the partners use an accrual method of accounting, and are on a calendar year. M Corporation uses the cash receipts and disbursements method of accounting and is also on a calendar year. During 1956 the partnership borrowed money from M Corporation and also sold property to M Corporation, sustaining a loss on the sale. On December 31, 1956, the partnership accrued its interest liability to the M Corporation and on April 1, 1957 (more than 2½ months after the close of its taxable year), it paid the M Corporation the amount of such accrued interest. Applying the rules of this paragraph, the transactions are considered as occurring between M Corporation and the partners separately. The sale and interest transactions considered as occurring between A and the M Corporation fall within the scope of section 267(a) and (b), but the transactions considered as occurring between partners B and C and the M Corporation do not. The latter two partners may, therefore, deduct their distributive shares of partnership deductions for the loss and the accrued interest. However, no deduction shall be allowed to A for his distributive shares of these partnership deductions. Furthermore, A's adjusted basis for his partnership interest must be decreased by the amount of his distributive share of such deductions. See section 705(a)(2).

Once the proposed regulation is finalized, the transactions would be treated as occurring between the ABC Partnership (as an entity) and M Corporation. Under Section 267(b)(10), a corporation and a partnership are related if the same persons own (A) more than 50% in value of the outstanding stock of the corporation, and (B) more than 50% of the capital interest, or the profits interest, in the partnership. In this case, A owns 100% of M Corporation and only 33-1/3% of ABC Partnership. Accordingly, since the partnership and corporation are unrelated, the partners can deduct the accrued interest liability to M corporation, and the partners can also deduct the loss on sale of property to M Corporation.

Planning Considerations

Given the fact that Treasury and IRS have stated in the Notice of Proposed Rulemaking that statutory changes in the 1980s indicate that Congress intended for a partnership to be viewed as an entity, rather than as an aggregate of its partners, there may be reasonable basis to take such a position even before the proposed regulations are issued in final form, as long as a disclosure is made. Taxpayers should consult with their BDO tax advisers if considering relying on the proposed regulations.

Double-Check Positions on Inventory Items and Unrealized Receivables Under Section 751(a)  

On appeal from the Tax Court, the U.S. Court of Appeals for the D.C. Circuit has clarified the application of the recharacterization provision under Section 751(a).

Reversing the Tax Court, the circuit court  held that gain attributable to inventory (Section 751(a) property) in the sale of a partnership interest by a nonresident alien is still the sale of a partnership interest under Section 751(a) and not taxable as U.S. source income under the law applicable in the year at issue (Rawat v. Commissioner, July 23, 2024).

Taxation of Gain on Partnership Dispositions by Nonresident Aliens

Gain or loss on the sale of partnership interests is generally taxed as a capital gain or loss under Section 741. However, to the extent the gain or loss is attributable to inventory and unrealized receivables – “Section 751(a) property” – the gain or loss is recharacterized as ordinary.

Specifically, Section 751(a) states that an amount realized on the sale of a partnership interest that is attributable to inventory items of the partnership “shall be considered as an amount realized from the sale or exchange of property other than a capital asset.”

Section 864(c)(8), enacted by the Tax Cuts and Jobs of 2017 (TCJA), treats a nonresident alien’s gain or loss from the sale of an interest in a U.S. partnership as taxable U.S.-source income. However, before the enactment of the TCJA, personal property law controlled, and a nonresident alien’s gain or loss from the sale of personal property was generally treated as foreign-source but could be treated as U.S.-source under certain exceptions, including for inventory.  A U.S. partnership interest is personal property for purposes of this rule.

Is Gain from Section 751(a) Property Treated as Gain from Selling Inventory?

Rawat, a nonresident alien, sold her interest in a U.S. partnership in 2008 for $438 million, with $6.5 million of her gain attributable to the sale of the company’s inventory. The IRS asserted that the gain attributable to inventory was U.S.-source and taxable. Therefore, Rawat owed $2.3 million in taxes on it. Rawat argued that the inventory-attributed gain was foreign-source and nontaxable. The Tax Court agreed with the government.

The dispute centered on the interpretation of Section 751(a): whether it causes gain from a partnership interest sale that is attributable to inventory merely to be taxed as ordinary income or actually to be treated as the sale of inventory and therefore potentially U.S. source in the hands of a nonresident alien.

There was no dispute that the statute required gain attributable to Section 751(a) property to be taxed as ordinary income if it was taxable to Rawat as U.S.-source income.

D.C. Circuit Finds Narrow Interpretation of Section 751(a)

The D.C. Circuit Court found relevant that the definition of “ordinary income” in Section 64 parallels the language in Section 751(a), with both Code sections referring to gain from the sale or exchange of property that is not a capital asset. It follows, the court reasoned, that the language of Section 751(a) that states that gain (or an amount realized) attributable to inventory “shall be considered as an amount realized from the sale or exchange of property other than a capital asset” may be read more plainly to mean “shall be considered as ordinary income.”

The court stated that this interpretation is further supported by the fact that Section 751(a) operates as a carveout to the general rule in Section 741 that gain on the sale of a partnership interest is treated as capital gain. The court further pointed to legislative history indicating Section 751(a) was enacted to end efforts to evade taxation as ordinary income.

On the contrary, the government argued that, under the statute, gain on the sale of a partnership interest from inventory or Section 751(a) property is not just taxed as ordinary income but is taxed as a sale of inventory rather than as of a partnership interest. The result being that the gain could be U.S.-source income to a nonresident alien under the pre-TCJA law.

However, the D.C. Circuit rejected the argument put forth by the government and previously accepted by the Tax Court. The D.C. Circuit noted that Section 751(a) states that the applicable gain is to be treated as ordinary income, nothing more, and that Congress would have stated more if it meant more. The broader reading of Section 751(a) is not supported by other sections of the Code using similar language or the legislative history, the court concluded. 

Accordingly, the court held that the sale by Rawat of the partnership interest attributable to inventory was still the sale of a partnership interest, and accordingly, under the law applicable at the time, was foreign-source income and non-taxable.

Planning Considerations

This court case has limited direct applicability after the TCJA enacted Section 864(c)(8). However, the court case is instructive in that it supports the idea that, absent a specific statutory exception, the entity theory of partnerships (rather than the aggregate theory) controls with respect to the sale of a partnership interest. Section 751(a) is merely a recharacterization provision and it does not operate to dictate that a partnership interest sale be deemed to be an actual sale of inventory.  

Because the Tax Court’s judgment has now been reversed by the circuit court, taxpayers that have relied on a similar theory as that adopted by the Tax Court in Rawat should review their positions. Although the reversal of the Tax Court in Rawat was a win for the taxpayer in the current case, taxpayers have taken other taxpayer-friendly positions based on a similar interpretation of Section 751(a) as argued by the government and originally accepted by the Tax Court in Rawat.

Keep an Eye on Challenges to IRS Rules, Including Partnership Anti-Abuse Rules, Under Loper Bright

In its June 2024 decision in Loper Bright, the Supreme Court overturned the longstanding Chevron doctrine, which gave deference to agency interpretations of silent or ambiguous statutes if the interpretation was reasonable. In overturning this principle, the Supreme Court held that courts must exercise independent judgment.

In light of the Loper Bright decision, taxpayers are bringing new challenges to IRS regulations, including in the Tribune Media case involving the application of a liability allocation anti-abuse rule under Treas. Reg. §1.752-2(j) and the general partnership anti-abuse rule under Treas. Reg. §1.701-2. For a detailed discussion of the relevant facts and anti-abuse rules, see BDO’s Tax Alert, “Government Appeals Tax Court Decision on Leveraged Partnership Transactions, Anti-Abuse Rules.”

Generally, in the Tribune Media case, the government appeals a Tax Court decision that it views as paving the way for inappropriate income tax planning, potentially enabling taxpayers to follow the roadmap created by the taxpayer in Tribune Media to implement leveraged partnership transactions without triggering taxable gain while avoiding incurring meaningful economic risk.

Loper Bright Arguments in Tribune Media

Tribune Media and the government have supplemented their arguments in their pending appeal before the Seventh Circuit on leveraged partnership transactions and the application of partnership anti-abuse rules. Tribune Media has submitted a letter to the court arguing that the U.S. Supreme Court’s decision in Loper Bright reinforces its argument that the general anti-abuse rule in question is invalid.

In its letter to the Seventh Circuit regarding the effect of Loper Bright in its case, Tribune Media challenges the validity of the general anti-abuse rule. It notes that, although the government does not expressly claim Chevron deference for the rule, the Loper Bright decision instructs the court to carefully scrutinize whether the IRS had the authority to issue the rule, which Tribune Media argues is regulatory overreach as “the agency even contends that it can invalidate a transaction that follows ‘the literal words’ of a statute that Congress enacted.” 

In its response, the government contends that the anti-abuse rule does not rely on Chevron deference, is based on established case law, and was promulgated within the bounds of authority granted to the IRS by Congress.

Planning Considerations

The decision in Loper Bright has opened the door for taxpayers to make fresh challenges to the validity of Treasury regulations. The Tribune Media case is an example of the type of challenge that taxpayers are making to the government’s authority to promulgate its interpretation of statutes in existing regulations. The issue in this specific case is whether the government can write broad anti-abuse regulations that change the taxation of transactions that follow a strict reading of the statute, but that the IRS and Treasury contend are abusive or argue aren’t in line with the intent of the statute.

 Watch for New Form for Partners to Report Partnership Property Distributions

The IRS has released a draft of new Form 7217, “Partner’s Report of Property Distributed by a Partnership,” and related instructions.

The form is to be filed by any partner receiving a distribution of property from a partnership in a non-liquidating or liquidating distribution. However, partners do not have to file the form for

1. Distributions that consist only of money or marketable securities treated as money,

2. Payments to the partner for services other than in their capacity as a partner under Section 707(a)(1), or

3. Payments for transfers that are treated as disguised sales under Section 707(a)(2)(B).

   
   

The partner uses the form to report the basis of distributed property, including any basis adjustments to the property required by Section 732(a)(2) or (b). The two-page draft Form 7217 is broken into two parts, with Part I used for reporting the aggregate basis of the distributed property on the distribution date and Part II covering the allocation of basis of the distributed property.

Partners are to file a separate Form 7217 for each date during the tax year that they actually (not constructively) receive distributed property subject to Section 732 – even if property distributions received on different days were part of the same transaction.

The instructions state that Forms 7217 are to be due when the partner’s tax return is due, including extensions. They add that partners should file their Forms 7217 attached to their annual tax return for the tax years in which they actually received distributed property subject to Section 732.

Planning Considerations

The draft form is a continuation of the IRS’s recent efforts to expand required disclosures from partnerships. Based on an initial review of the draft version of the form, it appears likely they IRS will need to make some modifications to appropriately capture the information being requested by the form.

Prepare for Partnership Obligations Under Corporate Alternative Minimum Tax Regulations

The IRS on September 12, 2024, issued proposed regulations on the corporate alternative minimum tax (CAMT), enacted by the Inflation Reduction Act, that include significant new provisions for partnerships with corporate partners subject to the CAMT.

For tax years beginning after December 31, 2022, the CAMT imposes a 15% minimum tax on the adjusted financial statement income (AFSI) of large corporations (generally, those with average annual AFSI exceeding $1 billion).

The proposed regulations set out rules for determining and identifying AFSI, including applicable rules for partnerships with CAMT entity partners. For a general discussion of the CAMT proposed regulations, see the Corporate Tax section of this guide.

CAMT Statute, AFSI Adjustments & Partnerships

Generally, the CAMT is imposed on AFSI – as determined under Section 56A – of an applicable corporation. Under Section 56A, AFSI means, with respect to any corporation for any tax year, the net income or loss of the taxpayer set forth on the taxpayer's applicable financial statement for that tax year, adjusted as further provided within that Code section.

Adjustments to AFSI are set out in Section 56A(c). Regarding partnerships, Section 56A(c)(2)(D) states that, except as provided by the Secretary, if the taxpayer is a partner in a partnership, the taxpayer's AFSI with respect to such partnership is adjusted to take into account only the taxpayer’s distributive share of such partnership’s AFSI. It adds that the AFSI of a partnership is the partnership’s net income or loss set forth on that partnership’s applicable financial statement, as adjusted under rules similar to the rules set forth in Section 56A.

Proposed Rules on for Partner's Distributive Share of Partnership AFSI

The IRS sets out in Prop. Reg. §1.56A-5 rules under Section 56A(c)(2)(D) regarding a partner's distributive share of partnership AFSI. The IRS explains that it is proposing adopting a “bottom-up” method which it believes is consistent with the statute and is more conducive to taking into account Section 56A adjustments. Under the proposed “bottom-up” method, a partnership would calculate its AFSI and provide this information to its partners. Each partner would then need to determine its “distributive share” of the partnership's AFSI. 

The proposed rules generally provide that, if a CAMT entity is a partner in a partnership, its AFSI with respect to its partnership investment is adjusted as required under the applicable regulations to take into account the CAMT entity’s distributive share of the partnership's AFSI.

Under the proposed rules, a CAMT entity's distributive share amount is computed for each tax year based on four steps:

1. The CAMT entity determines its distributive share percentage,

2. The partnership determines its modified financial statement income,

3. The CAMT entity multiplies its distributive share percentage by the modified financial statement income of the partnership (as reported by the partnership), and

4. The CAMT entity adjusts the product of the amount determined in step (3) above for certain separately stated Section 56A adjustments.

   
   

There are also related reporting and filing requirements in the proposed rules. Because a CAMT entity may require information from the partnership to compute its distributive share of a partnership’s AFSI, the proposed regulations would require a partnership to provide the information to the CAMT entity if the CAMT entity cannot determine its distributive share of the partnership’s AFSI without the information and the CAMT entity makes a timely request for the information.

Proposed Rules on AFSI Adjustments to Apply Certain Subchapter K Principles

The proposed regulations also include rules to provide for adjustments to carry out the principles of subchapter K regarding partnership contributions, distributions, and interest transfers. The rules, as proposed, would apply to most contributions to or distributions from a partnership, but not with respect to stock of a foreign corporation except in limited circumstances.

For both contributions and distributions of property, the IRS proposes a deferred sale method. Thus, for contributions, the proposed rules generally provide that, if property (other than stock in a foreign corporation) is contributed by a CAMT entity to a partnership in a non-taxable transaction, any gain or loss reflected in the contributor’s financial statement income from the property transfer is included in the contributor’s AFSI in accordance with the deferred sale approach set forth in the proposed rules.

The proposed regulations also include rules relating to the maintenance of books and records and reporting requirements for a partnership and each CAMT entity that is a partner in the partnership.

 ASC 740

Correctly accounting for and disclosing income taxes under ASC 740 is complex. As the end of the year draws closer, now is a good time to evaluate your company’s income tax accounting policies.

That is especially so this year, given the impending effective date of Accounting Standards Update (ASU) No. 2023-09, “Income Taxes (Topic 740): Improvements to Income Tax Disclosures,” which the Financial Accounting Standards Board (FASB) issued in late 2023. Given the potential complexity of the ASU’s new requirements, firms should consider whether processes, systems, and internal controls should be modified to facilitate effective implementation.

Special attention should be given to your tax function’s internal controls, which are vital to reducing risk and capitalizing on available resources.

This year-end planning guide walks you through the most important aspects of the ASU, as well as what to consider in designing strong internal tax controls that can help reduce reporting errors.

FASB Issues Final ASU to Improve Income Tax Disclosures

In response to feedback from the investor community requesting the disclosure of additional information pertaining to income taxes, the FASB issued ASU 2023-09 in December 2023.  One of the ASU’s overarching themes is the disaggregation of information that may previously have been aggregated or commingled, a change that’s expected to provide greater transparency and consistency. In particular, the disclosure requirements seek to increase visibility into various income tax components that affect rate reconciliation, as well as the qualitative and quantitative aspects of those components.

Main Provisions

The ASU requires public business entities ((PBEs) replacing the term “public entities”) to disclose additional information in specified categories with respect to the reconciliation of the effective rate to the statutory rate for federal, state, and foreign income taxes. It also requires greater detail about individual reconciling items in the rate reconciliation if the impact of those items exceeds a threshold.

Under the ASU, PBE information pertaining to taxes paid (net of refunds received) must be disaggregated for federal, state, and foreign taxes and further disaggregated for specific jurisdictions if the related amounts exceed a quantitative 5% threshold. That threshold is determined by multiplying 5% by the product of pretax income (or loss) from continuing operations and the applicable federal statutory rate, and it essentially emulates the requirement in SEC Regulation S-X.

The ASU also describes items that need to be disaggregated based on their nature, which is determined by reference to the item’s fundamental or essential characteristics.

Updated Annual Disclosure Requirements

Rate Reconciliation

ASU 2023-09 specifies categories for which disclosures associated with the rate reconciliation are required, and each category has varying degrees of qualitative and/or quantitative disclosure.

PBEs

The following categories must be included in annual disclosures in the rate reconciliation in tabular form both in amounts in the applicable reporting currency and in percentages:

• State and local income taxes in the country of domicile net of related federal income tax effects

• Foreign tax effects, including state or local income taxes in foreign jurisdictions

  • Reflects income taxes imposed by foreign jurisdictions.

  • Disaggregation is required when individual reconciling items equal or exceed the 5% threshold. This would include the statutory rate differential between the foreign jurisdiction and that of the county of domicile.

  • If an individual foreign jurisdiction meets the 5% threshold, it must be separately disclosed as a reconciling item. Further disaggregation is required for that jurisdiction for cross-border tax laws, tax credits, and nontaxable or nondeductible items that meet the 5% threshold.

• Effects of changes in tax laws or rates enacted in the current period

  • Applies to federal taxes of the country of domicile.

  • Reflects the cumulative tax effects of a change in enacted tax laws or rates on current or deferred tax assets and liabilities at the date of enactment.

• Effect of cross-border tax laws

  • Applies to incremental income taxes imposed by the jurisdiction of domicile on income earned in foreign jurisdictions. When the country of domicile taxes cross-border income but also provides a tax credit on the same income during the same reporting period, the tax effect of both the cross-border tax and its related tax credit may be presented on a net basis. 

  • Disaggregation required when individual reconciling items equal or exceed the 5% threshold and by nature of the item.

• Tax credits

  • Applies to federal taxes of the country of domicile.

  • Disaggregation required when individual reconciling items equal or exceed the 5% threshold and by nature of the item.

  • This category does not include foreign tax credits.

• Changes in valuation allowances

  • Applies to federal taxes of the country of domicile. For example, any change in valuation allowance in a foreign jurisdiction would be included in the foreign tax effects category and separately disclosed as a reconciling item if greater than the 5% threshold.

• Nontaxable or nondeductible items

  • Applies to federal taxes of the country of domicile.

  • Disaggregation required when individual reconciling items equal or exceed the 5% threshold and by nature of the item.

• Changes in unrecognized tax benefits

  • Aggregate disclosure of changes in unrecognized tax benefits is allowed for all jurisdictions.

  • This category reflects reconciling items resulting from changes in judgment related to tax positions taken in prior annual reporting periods.

  • When an unrecognized tax benefit is recorded in the current annual reporting period for a tax position taken or expected to be taken in the same reporting period, the unrecognized tax benefit and its related tax position may be presented on a net basis in the category in which the tax position is presented.

    
    

The FASB has determined that all reconciling items should be presented on a gross basis. However, it will allow net presentation of the effects of specific cross-border tax laws and the associated effects of foreign tax credits, as well as the netting of current-year uncertain tax positions and current-year tax positions against the relevant category. If a foreign jurisdiction meets the 5% threshold, it must be disclosed as a reconciling item. Irrespective of whether any foreign jurisdiction satisfies the 5% threshold, any individual item meeting the 5% threshold must be disclosed by nature.

PBEs must disclose the state and local jurisdictions that contribute to the majority (greater than 50%) of the effect of the state and local tax category, beginning with the state or local jurisdiction having the largest effect and proceeding in descending order.

If the information is not otherwise evident, PBEs must explain any disclosed reconciling items in the categories above, including their nature, effect, and underlying causes, as well as the judgment used in categorizing them.

It is noteworthy that the FASB decided to align the disclosure requirements with those in SEC Regulation S-X Rule 4-08(h)(2). The federal rate for a foreign entity should normally be that of the entity’s jurisdiction of domicile. However, if that rate is other than the U.S. corporate rate, both the rate and the basis for its use must be disclosed.

Entities Other Than PBEs

For entities other than PBEs, a qualitative disclosure of the nature and effect of the categories of items discussed above is required along with the individual jurisdictions that result in a significant difference between the statutory and effective tax rates. A numerical reconciliation is not required.

Income Taxes Paid

The ASU requires that all entities annually disclose the amount of income taxes paid (net of refunds received) disaggregated by federal, state, and foreign jurisdictions. It requires further disaggregation for any jurisdiction where the amount of income taxes paid is at least 5% of the total income taxes paid. In quantifying the 5% threshold for income taxes paid, the numerator of the fraction should be the absolute value of any net income taxes paid or income taxes received for each jurisdiction and the denominator should be the absolute value of total income taxes paid or refunds received for all jurisdictions in the aggregate.

Income Statement

The ASU makes some minor changes to the required income statement disclosures relating to income taxes, stipulating that income (loss) from continuing operations before income tax expense (benefit) be disclosed and disaggregated between domestic and foreign sources. It mandates the disclosure of income tax expense (benefit) from continuing operations disaggregated by federal, state, and foreign jurisdictions. Income tax expense and taxes paid relating to foreign earnings that are imposed by the entity’s country of domicile would be included in tax expense and taxes paid for the country of domicile.

Eliminated Disclosures

ASU 2023-09 eliminates the historic requirement that entities disclose information concerning unrecognized tax benefits having a reasonable possibility of significantly increasing or decreasing in the 12 months following the reporting date. It also removes the requirement to disclose the cumulative amount of each type of temporary difference when a deferred tax liability is not recognized because of the exceptions to comprehensive recognition of deferred taxes related to subsidiaries and corporate joint ventures. Entities should continue to disclose the types of temporary differences for which deferred tax liabilities have not been recognized under ASC 740-30-50-2(a), (c), and (d).

Effective Dates and Transition

All entities should apply the ASU prospectively with an option for retroactive application to each period in the financial statements. For PBEs, the guidance will be effective for fiscal years beginning after December 15, 2024, and for interim periods for fiscal years beginning after December 15, 2025. For entities other than PBEs, the guidance will be effective for fiscal years beginning after December 15, 2025, and for interim periods beginning with fiscal years beginning after December 15, 2026. Early adoption is allowed.

Planning Consideration

• When developing a plan to implement the new disclosure requirements, consider whether amounts meeting the 5% threshold are material to help guide an assessment of the jurisdictions and items that will be disaggregated in the disclosures. Specifically, it may be prudent to quantify those amounts in order to effectively assess the materiality of the amounts disaggregated.  

• Given the potential complexity of, and the resources necessary to satisfy, the new requirements established by the ASU, consider whether adoption will be made prospectively or retrospectively. Also contemplate the modifications to processes, procedures, systems, and internal controls that will be necessary to facilitate an effective implementation process. Those considerations will be of particular importance for entities with foreign operations.

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Reducing Risk With Tax Internal Controls

Internal controls are complex. Two decades after the enactment of Section 404 of the Sarbanes-Oxley (SOX) Act, income-tax-related material weaknesses continue to plague companies, with a recent report showing that tax-related restatements account for approximately 12% of all restatements.[1] 

Without proper internal controls, companies may be susceptible to reporting errors, which can lead to reputational risk and financial burdens stemming from remediation. Companies with strained or limited in-house resources must prioritize income tax accounting and reporting before it is too late.

Correctly accounting for and disclosing income taxes under ASC 740 is increasingly important to mitigate a company’s risk of restatement, material weakness, and SEC comments. In-depth knowledge of tax and financial reporting, proper audit documentation, and clear and transparent disclosures can help reduce income reporting risk.

While all public companies must be SOX compliant, many have not refreshed income tax controls since initial implementation, and new guidance has changed the standards required for compliance.

Controls often fail because they are not adequately designed or operating as intended. For instance, it is unlikely that one overarching management review control can cover all the areas of an income tax provision or clearly identify the nature of the review procedures for each key provision component. Controls also might lack supporting evidence of performance and review.

Planning Consideration

• If that sounds familiar, it’s probably time to examine your control framework. Improper design and execution of internal controls can result in material weaknesses and costly remediation, even with management review procedures in place.

The inherent benefits of a strong control environment may be crucial to a private company, despite internal controls often being viewed as a “public company problem.” Private companies are not immune from intense stakeholder scrutiny into accountability and risk and may want to consider implementing internal controls similar to those required by SOX Section 404. Public-company-level controls could be useful in the event of rapid growth, an initial public offering, or a sale to a private equity buyer.

Planning Consideration

• Companies with a clear understanding of the inherent risks that come from inadequate accounting practices demonstrate the ability to think big picture and be better prepared for growth or change in ownership.

There are many reasons to strengthen income tax accounting internal controls, including to reduce reputational risk, minimize consulting fees, preserve investor confidence and market capitalization, and improve resource capacity.

Planning Considerations

• Reputational risk: SOX, which is intended to protect investors from accounting errors and fraudulent financial reporting, requires the establishment of internal controls and reporting methods to ensure those controls. Corporations often view SOX compliance as onerous and expensive; however, the cost and effort to remediate can be far greater than the cost to implement and execute strong controls.

• Consulting fees: The direct costs of remediating a material weakness — with or without a restatement — can be particularly burdensome. They can include audit, remediation, and legal fees, and they add up quickly.

• Investor confidence and market cap: A material weakness can spark worries from investors about reduced future performance. Regardless of their validity, investor concerns are often demonstrated by a drop in stock price. With restatements posing the risk of possible stock decline, the impact on market capitalization for any given company could be in the billions.

• Resource Capacity: Focusing on the remediation and/or restatement of a past event is not a value-added use of already-strained resources. Tax capacity could be used more effectively to generate cost-saving ideas, improve and streamline processes, and focus on managing risk and delivering value.

 State and Local Tax

With thousands of taxing jurisdictions from school boards to states and many different types of taxes, state and local taxation is complex. Each tax type comes with its own set of rules — by jurisdiction — all of which require a different level of attention. 

This SALT guide can help companies with 2024 year-end planning considerations, and it provides guidance on how to hit the ground running in 2025.

State PTET Elections

Roughly 36 states now allow pass-through entities (PTEs) to elect to be taxed at the entity level to help their residents avoid the $10,000 limit on federal itemized deductions for state and local taxes (the “SALT cap”). Those PTE tax (PTET) elections are much more complex than simply checking a box to make an election on a tax return. Although state PTET elections are meant to benefit the individual members, not all elections are alike, and they are not always advisable.

Before making an election, a PTE should model the net federal and state tax benefits and consequences for every state where it operates, as well as for each resident and nonresident member, to avoid unintended tax results. Before the end of the year, taxpayers should thoroughly consider whether to make a state PTET election, modeling the net tax benefits or costs, and evaluate timing elections, procedures, and other election requirements. If those steps are completed ahead of time, the table has been set to make the election in the days ahead.

When considering a state PTET election, a key question is whether members who are nonresidents of the state for which the election is made can claim a tax credit for their share of the taxes paid by the PTE on their resident state income tax returns. If a state does not offer a tax credit for elective taxes paid by the PTE, a PTET election could result in an additional state tax burden that exceeds some members’ federal itemized deduction benefit.

Therefore, as part of the pre-year-end evaluation and modeling exercise, PTEs should consider whether the election would result in members being precluded from claiming other state tax credits — which ordinarily would reduce their state income tax liability dollar for dollar — in order to receive federal tax deductions that are less valuable.

Liquidity Events

Liquidity events take the form of IPOs; financings; sales of stock, assets, or businesses; and third-party investments. Those events involve different forms of transactions, often driven by business or federal tax considerations; unfortunately, and far too often, the SALT impact is ignored until the 11th hour — or later.

A liquidity event is not an occasion for surprises. When contemplating any form of transaction, state and local taxes can’t be overlooked; doing so can result in a shock for the client and, at the least, embarrassment for the practitioner. SALT experts can identify planning opportunities and point out potential pitfalls, and it is never too early to involve them. If you don’t consult them until after the transaction occurs or the state tax returns are being prepared, you’ve left it too late.

From state tax due diligence to understanding the total state tax treatment of a transaction to properly reporting and documenting state tax impacts, addressing SALT at the outset of a deal is critical. If involved before the year-end liquidity event, SALT professionals can suggest tweaks to the transaction that may be federal tax neutral but could identify significant state tax savings or costs now rather than later. After the liquidity event, because the state tax savings or costs already have been identified, they can be properly documented and reported post-transaction. Further, because SALT expertise was involved at the front end, state tax post-transaction integration, planning, and remediation can be pursued more seamlessly.  

Income/Franchise Taxes

If anything has been learned from the last seven years of federal tax legislation, it’s that state income tax conformity cannot be taken for granted. While states often conform to many federal tax provisions, are you certain an S corporation is treated as such by all the states where it operates? Is that federal disregarded entity disregarded for state income tax purposes as well? Not asking the question can lead to the wrong result. 

Several states don’t conform to federal entity tax classification regulations. Some, including New York, require a separate state-only S corporation election. New Jersey now allows an election out of S corporation treatment. Making those elections — or not — can lead to different state income tax answers, but you should make that decision before the transaction, not when the tax return is being prepared.

If the liquidity event will result in gain, how is the gain going to be treated for state income tax purposes? Is it apportionable business gain or allocable nonbusiness gain? Is a partnership interest, stock, or asset being sold? How will the gain be apportioned? Was the seller unitary with the partnership or subsidiary, or did the assets serve an operational or investment function for the seller? Will the gross receipts or net gain from the sale be included in the sales factor, and, if so, how will they be apportioned?

Those are just some of the questions that are never asked on the federal level because they don’t have to be. But they are material on the state level and can lead to unwelcome surprises if not addressed.

Sales/Use Taxes

Most U.S. states require a business to collect and remit sales and use taxes even if it has only economic, not physical, presence. Remote sellers, software licensors, and other businesses that provide services or deliver their products to customers from remote locations must comply with state and local taxes.

Left unchecked, those state and local tax obligations — and the corresponding potential liability for tax, interest, and penalties — will grow. Moreover, neglecting your sales and use tax obligations could result in a lost opportunity to pass the tax burden to customers as intended by state tax laws.

A company could very well experience material sales and use tax obligations resulting from a sale even though the transaction or reorganization is tax free for federal income tax purposes. To avoid any material issues, the following steps should be taken:

• Determine nexus and filing obligations;

• Evaluate product and service taxability;

• Quantify potential tax exposure;

• Mitigate and disclose historical tax liabilities;

• Consider implementing a sales tax system; and

• Maintain sales tax compliance.

  
  

Real Estate Transfer Taxes

Most states impose real estate transfer taxes or conveyance taxes on the sale or transfer of real property, or controlling interest transfer taxes on the sale of an interest in an entity holding real property. Few taxpayers are familiar with real estate transfer taxes, and the complex rules and compliance burdens associated with those state taxes could prove costly if they are not considered up front.

Property Taxes

For many businesses, property tax is the largest state and local tax obligation and a significant recurring operating expense that accounts for a substantial portion of local government tax revenue. Unlike other taxes, property tax assessments are ad valorem, meaning they are based on the estimated value of the property. Thus, they could be confusing for taxpayers and subject to differing opinions by appraisers, making them vulnerable to appeal. Assessed property values also tend to lag true market value in a recession.

Property tax reductions can provide valuable above-the-line cash savings, especially during economic downturns when assessed values may be more likely to decrease. The current economic environment amplifies the need for taxpayers to avoid excessive property tax liabilities by making sure their properties are not overvalued.

Annual compliance and real estate appeal deadlines can provide opportunities to challenge property values. Challenging a jurisdiction’s real property assessment within the appeal window could reduce related tax liabilities. Taking appropriate positions related to any detriments to value on personal property tax returns could reduce those tax liabilities. Planning for and attending to property taxes can help a business minimize its total tax liability.

P.L. 86-272

P.L. 86-272 is a federal law that prevents a state from imposing a net income tax on any person’s net income derived within the state from interstate commerce if the only business activity performed in the state is the solicitation of orders of tangible personal property. Those orders are sent outside the state for approval or rejection and, if approved, are filled by shipment or delivery from a point outside the state.

The Multistate Tax Commission (MTC) adopted a revised statement of its interpretation of P.L. 86-272 which, for practical purposes, largely nullifies the law’s protections for businesses that engage in activities over the internet. To date, California and New Jersey have formally adopted the MTC’s revised interpretation of internet-based activities, while Minnesota and New York have proposed the interpretation as new rules. Other states are applying the MTC’s interpretation on audit without any notice of formal rulemaking.

Online sellers of tangible personal property that have previously claimed protection from state net income taxes under P.L. 86-272 should review their positions. Online sellers that use static websites that don't allow them to communicate or interact with their customers — a rare practice — seem to be the only type of seller that the MTC, California, New Jersey, and other states still consider protected by P.L 86-272.

The effect of the MTC’s new interpretation on a taxpayer’s state net income tax exposure should be evaluated before the end of the year. Structural changes, ruling requests, or plans to challenge states’ evolving limitation of P.L. 86-272 protections applicable to online sales can be put into place.

However, nexus or loss of P.L. 86-272 protection can be a double-edged sword. For example, in California, if a company is subject to tax in another state using California’s new standard, it is not required to throw those sales back into its California numerator for apportionment purposes.

Tax Automation & Innovation 

An effective tax function needs the breadth and depth of technical knowledge to assess the impact of tax changes on a business’s overall tax liability and adjust tax strategies accordingly. That requires adaptability to meet tighter reporting deadlines while dealing with shrinking headcounts, demands for more real-time information, and the expectation of cross-functional collaboration. In other words, business leaders are pushing tax departments to do more work more quickly and accurately than ever before.

That’s where tax automation and innovation comes in. The end of the year, which falls between compliance and reporting busy seasons, is the perfect time to prepare an organization for quick-win transformation and deploy data readiness best practices to ensure a streamlined close.

What Can the Tax Function Feasibly Accomplish Before Year End?

Companies can use the precious post-compliance season to lay the groundwork for tax process implementation and improvements to go off without a hitch during the tax provision reporting period, which is the most compressed deadline during the tax life cycle. This year, that may include additional complexity because of the OECD Pillar Two reporting requirements. So, what can feasibly be done in two to three months?

Identify and Execute Quick Wins

Regardless of whether a company is in the nascent or late stages of relying on technical tax solutions, several important steps — ideally revisited annually — can contribute to more consistent and lasting success.

• Perform a post-mortem on the prior year end. Which workstreams took the longest and how can that be avoided this year? Can those workstreams be automated with simple pre-work, or is an extract, transform, load (ETL) tool or software necessary?

• Ask what return-to-provision items popped up as material in the 2023 compliance finalization. Was that caused by a lack of detailed data or information? A lack of time or review?

• Poll tax team members individually. What are they most concerned with executing for the year-end close? What process or file is the most challenging, and how can they streamline ahead of time or replace with a better, more automated solution?

• Will a hard close save time or duplicate work for the team?

• Draft a tax team workplan with specific dates for completion, sign-off, and review. Plan for live, daily debriefs across the entire tax team to avoid miscommunication and reliance on email alone.

• Specify tax technology best practices, including importing tax rates enacted through November 30 into the tax provision software to review the impact of any rate changes on beginning deferred balances (refreshing only if any law/rule changes occur in December, as discussed below); ensuring all users can access the necessary and appropriate data; and updating blended state current/deferred tax rates based on recently filed tax returns, as applicable (unless recomputing live apportionment rates).

Streamline the Year-End Close and Plan for Possible Tax Law Changes 

If a business is behind with its year-end close or has concerns about accounting for potential last-minute federal tax changes, it should consider five year-over-year processes that can help it realize more consistent and lasting success.

Fine-tune technologies and processes. Roll over the last period’s dataset within the tax provision system and relevant workpapers and perform system entity maintenance. Create a detailed year-end-close workplan with clearly defined roles, responsibilities, and timelines and prepare and test tax analytics dashboards.  

Capture year-to-date discrete impacts. Prepare the necessary tax entries for purchase accounting events, complete return-to-provision analyses (both domestic and foreign), and assess the tax effects of audits and amended returns. Also calculate the income statement and balance sheet effects of tax law changes, keeping in mind that the impact of any changes in rules and rates are recorded in continuing operations in the interim and annual period that the changes are considered enacted for U.S. GAAP purposes. Update for known global tax rate changes and, if the accounting department is responsible for recording tax effects of equity-related items, inform it of any new tax rates.  

Be ready for possible late December tax law enactment. While the status of any tax legislation is unclear pending the November election, it’s still smart to monitor tax proposals and run preliminary calculations for management.

Quantify any national, state, and local/regional tax rate change effects to deferred tax assets and liabilities, ideally by using tax provision software. Consider the effects tax legislation may have on net operating losses and valuation allowances based on changes that could affect future taxable income (for example, international tax provisions). 

Ensure documentation regarding key judgments is thorough. Focus on documentation for purchase accounting issues and estimates, valuation allowance conclusions, and current- and prior-year uncertain tax positions, as well as any facts supporting an indefinite reinvestment assertion. 

Conduct planning meetings. Ask any external auditors whether interim work can be accelerated. Request the prepared-by-client request list and agree on timing well in advance. Have the tax team review its workplan and have users test systems access early. Ask the finance organization to outline any timing expectations for tax deliverables and when pretax book income will be finalized.

Looking to 2025 and Beyond

Even companies that have mastered the year-end-close process should consider ways to improve and integrate their tax technology systems and more directly access and transform source data. Annually assessing data management and quality and the strength of the overall tech framework can keep a business’s tax function running smoothly all year long.

Master Data Management

In an ideal world, all data would be uniformly structured and digitized. But that’s not reality, especially for companies with rapid growth that have scaled to meet both business or profitability (shareholder) demands and customers’ digital market demands. Those companies may have acquired entities with disparate IT infrastructures or purchased in-house finance or IT technologies (inclusive of tax) without pausing to integrate new systems. Or perhaps C-suite leaders attempted to automate the front-end customer experience by deploying more modern technology, such as generative AI.

Those changes would require back office and tax functions to understand the related effects on their companies’ tax profiles or filing needs, while keeping an eye on the regulatory landscape to ensure compliance. Further, tax leaders are requesting more real-time, on-demand insights into effective tax rate drivers, total tax liabilities, and cash taxes paid worldwide.

Planning Consideration

• Instead of striving for perfection in a short window, tax departments and their organizations should start with a methodology to handle data that can’t be consistently structured. By digitizing as much as possible and applying an agreed methodology, organizations can reduce disruptions caused by new or dissonant data.

In selecting a master data repository or platform, a company can take the first step toward creating a hub to draw from for reporting needs and any downstream tax process or deliverable — be it for tax provision, tax compliance, audit defense, OECD Pillar Two directives, indirect tax reporting needs, or otherwise. Companies that have already taken that step are on the right path; those that haven’t should consider this proven way to bring structure to disparate tax data. Once a data lake or hub has been selected, turn to the creation of high-quality data for storage and use.

Data Quality

High-quality data is the cornerstone for effective and efficient tax processes. It allows for light- or no-touch data transference from the data lake to other necessary tax or finance systems and eventually can be used to train an AI model to accurately predict, analyze, and process tax-related information.

Planning Consideration

• In determining data quality, there are many factors to assess:

  • Accuracy: Is the data factually correct? Does it reflect the business’s financial transactions and compliance obligations for all regions and jurisdictions?

  • Integrity: Is the data transparently justifiable? Does it remain unaltered from its source after being processed and analyzed? Has it been safeguarded against unauthorized access, human error, or process disruptions?

  • Relevance: Is it the right data at the right time (especially when combining multiple data sets)? Does the information collected and analyzed directly support tax needs? Is it confused or mixed with unrelated information?

  • Timeliness: Does the data consistently represent a desired period or moment in time? Is it available when needed?

  • Completeness: Is the data quantitatively and qualitatively comprehensive? Does it include all necessary information without gaps that could lead to under- or overreporting tax obligations?

  • Accessibility: If the data needs to be verified or refreshed from a source, is it available without compounding unnecessary risk? Can the right people (such as tax professionals, auditors, and regulatory bodies) easily retrieve and use the data when needed?

Taking small steps and gradually introducing high-quality, master data concepts into specific functions will best position tax departments to realize the efficacy of their technologies.

Implementing Technology: Select Now, Build or Buy in 2025

Even if a company has chosen to implement a master data hub, there’s no universal method for doing so. The best approach will depend on several factors that vary by organization, so tax leaders should start with gathering information and defining goals. Perform a gap analysis and understand where infrastructure is failing. Where are the bottlenecks? Can stronger solutions bridge any gaps left by current tech processes?

Planning Consideration

• In building short- and long-term roadmaps for tax innovation, a business should ask the following questions:

  • What is the budget?

  • What kind of tech staff does the organization already employ?

  • Does the tax team have any co-sourcing or outsourcing arrangements?

  • What suppliers and third-party firms does the company work with?

  • What data management policies does the company have in place?

  • What is the company’s financial reporting cadence?

  • What is the company’s expected growth over the next year? Three years? Five years?

Scaling Up

Even if a business already has a tax technology plan, it can be difficult to decide how, when, and why to scale up. Many business leaders are prioritizing cost optimization. While scaling up requires a significant upfront investment, it can prove cheaper than addressing shortfalls stemming from outdated processes.

Planning Consideration

• In considering whether to scale up, first ask how existing tech can be improved. Identify top challenges in the tax team’s ability to keep up with increasing compliance demands and determine how technology can help. Then tailor plans to complement existing capabilities and foster cross-functional collaboration.

Building vs. Buying

Deciding to implement or scale up tax tech isn’t the final step. Tax leaders must assess which technology investments will have the greatest returns and whether they should build or buy solutions. Buying often requires software tailored to meet a company’s specific needs. And while building generally doesn’t mean starting from scratch, it still requires significant resources and time.

Planning Consideration

• In choosing whether to buy or build, a company should weigh the following six factors:

  • Cost

  • Urgency

  • Expertise

  • Scalability and regulatory compliance

  • Integration compatibility

  • Data security

Now is the time for tax planning! If you have questions about tax issues, contact HFM today. Our tax professionals are well versed on the latest guidance to provide our clients with professional, personalized services.