ARTICLE | September 19, 2023

Authored by RSM US LLP

The employee retention credit (ERC or ERTC) was originally enacted in the CARES Act in March of 2020 at the onset of the COVID pandemic. Congress acted quickly by enacting this credit to get money in the hands of employers who were continuing to pay employees despite being affected by COVID mitigation measures. Specifically, those effects were a significant decline in gross receipts (which is objective) or a full or partial suspension from government orders (which is very subjective).

Over time, the credit has been changed, and many businesses have been filing. Though the ERC ended for most on Sept. 30, 2021, many businesses continue to file because the statute of limitations is still open. Specifically, the statute for 2020 claims ends April 15, 2024 (taxpayers have another year beyond that for 2021 claims).

Determining eligibility is complex and includes careful analysis and calculation of qualified wages.

The IRS announced an immediate halt to processing ERC claims. Now what?

On Sept. 14, the IRS will discontinue processing claims for the remainder of 2023 in an attempt to limit fraudulent activity in the employee retention credit market. The IRS hopes this measure will reduce the number of fraudulent claims encouraged by third-party providers.

We expect there will be significant delays in processing ERC claims in 2024 when the IRS resumes processing procedures.

The announcement is also significant for those taxpayers who have already filed ERC refund claims but should not have due to ineligibility. Additional procedural guidance from the IRS is expected to allow taxpayers the ability to withdraw claims that have not been processed.

Further, the IRS also intends to provide guidance for those who have received refunds in error, who want to pay them back to avoid penalties and future compliance action.

Understand what options are available for submitted ERC claims

First, and most importantly, employers should work with their trusted tax professional.

The IRS provides some red flags for recognizing some of the aggressive promoters which include:

• Unsolicited calls or advertisements
• Statements about it being easy or determinable in minutes
• Large upfront fees or fees based on the size of the credit

Companies that did engage parties like this should have tax professionals review their substantiation to determine whether it appears to be valid or outside the provided guidance. The IRS published some guidance in July 2023 on supply chain impacts, for example, and in cases where employers were claiming a partial suspension from supply chain impacts, the IRS is expecting to see support of specific government orders and substantiation that suppliers were impacted by those orders. This is only one area of possible impact, but it’s an example of what employers need to be prepared for if the IRS reviews their claim.

You’ve submitted your ERC claim but haven’t received payment. What’s next?

Many employers, even with valid claims, are still waiting for refunds. These entities should expect more delays in processing (even beyond what we were experiencing before) and possibly will receive additional questions from the IRS. In some cases, such entities may be pulled for exam before the IRS issues a refund. The IRS can also commence examination even after the refund is issued.

Also, taxpayers need to be aware that even if a refund is issued, if it is later deemed invalid, the IRS has two years from the date the refund was issued to commence erroneous refund claim action. Erroneous refunds are subject to a 20% penalty.

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This article was written by Anne Bushman, Alina Solodchikova and originally appeared on 2023-09-19.
2022 RSM US LLP. All rights reserved.
https://rsmus.com/insights/services/business-strategy-operations/what-to-do-if-you-filed-an-employee-retention-credit-claim-irs.html

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. The RSM(tm) brandmark is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.

ARTICLE | September 07, 2023

Authored by RSM US LLP

On July 18, the Small Business Administration (SBA) published a rulemaking update significantly revising the regulatory framework for Small Business Investment Companies (SBICs).

The update, titled Small Business Investment Company Investment Diversification and Growth, has a broad impact on the current SBIC program and represents the most significant change to the program in decades. Among other changes, it creates new types of SBICs, modifies existing regulations to improve operational aspects of managing an SBIC, and updates the licensing process to encourage more fund managers to apply to the program.

The SBA indicated it hopes that the regulatory updates will expand the universe of private investment fund managers interested in the SBIC program, increase the flow of capital to underserved small businesses, and promote investment in businesses that are capital-intensive and critical to national security. This summary highlights certain key changes.

Background

The SBIC program’s stated mission is to encourage private capital investment in American small businesses, allowing them to grow, expand and modernize. This is accomplished through the SBA’s licensing and monitoring of private investment companies, which are commonly investment funds organized as limited partnerships that raise capital from private limited partners. The private capital raised is typically leveraged using SBA guaranteed debentures, which can often increase the fund’s deployable capital and enhance private capital returns.

Created by the U.S. Congress in 1958, SBICs have cumulatively invested over $123 billion in American small businesses since the inception of the program. There were 308 active SBICs as of Sept. 30, 2022, and approximately 78% utilize debenture leverage. SBICs made $7.9 billion of investments in 1,217 small businesses during the federal government’s fiscal year ended Sept. 30, 2022, with SBICs that utilize debentures making approximately 20% of these financings as equity-only investments. Highlighting a focus area for the SBA, only 7% of all financings were to small businesses owned by women, minorities or veterans.

The regulatory framework for SBICs has evolved over the years, with different license and leverage types becoming available and then later being modified or withdrawn. The last effort focused on equity investment, the Participating Securities Program, was launched in the early 1990s and created a form of nondebt SBA financing. Under that program, the SBA’s investment took the form of a preferred limited partnership interest, where the SBA earned a preferred return and a profit share. The lack of debt service encouraged licensees to invest in equity instruments, particularly for venture capital and growth-stage investments. This program suffered losses in the early 2000s in connection with the dot-com bubble, and the SBA stopped licensing these funds shortly after.

Since the Participating Securities Program ended, the primary way the SBA has provided capital to SBICs is through issuing SBA-guaranteed debentures. Debentures generally have a 10-year term, are non-amortizing and can be prepaid without penalty. Interest rates for newly issued debentures are set semiannually and are based on market pricing, typically ranging from 0.4% to 0.7% above the current 10-year Treasury rate. Interest payments are due semiannually, encouraging SBICs to invest in securities that generate current cash returns. The most recent debentures, priced in March 2023, carry a 5.168% rate, the highest since September 2008. The SBA typically commits to provide leverage to an SBIC, which the SBIC can then draw upon as needed through its life. Leverage may be committed to an SBIC at a 1:1 ratio to private capital, up to a 3:1 ratio to private capital, though 2:1 is most common. A single SBIC may use up to $175 million in debentures, while a fund family may use up to a combined total of $350 million at any time.

SBICs have been limited to investing in companies that meet certain criteria, chiefly being small or “smaller” businesses, as defined by the SBA. Portfolio companies must also be based in the United States, and prior to the July revision could not be primarily re-lenders, reinvestors, real estate projects or companies that will use the proceeds outside of the United States. SBICs have to abide by certain regulatory restrictions when structuring an investment, including limitations on interest rates charged to borrowers.

SBICs are subject to periodic reporting requirements, including filing quarterly and annual financial statements, notifying the SBA upon the occurrence of certain events and reporting certain information related to the financing of a new investment. The SBA requires that SBICs follow an SBA basis of accounting, which differs from U.S. generally accepted accounting principles (GAAP) in several key areas, and has published specific SBA model valuation guidelines. Most SBICs will also prepare financial statements on a U.S. GAAP basis for non-SBA purposes, such as to meet private investor obligations under their limited partnership agreement or to satisfy requirements of the Securities and Exchange Commission if the SBIC is associated with a registered investment advisor.

The SBIC program has a long track record of operating with a zero taxpayer subsidy rate, and the SBA monitors its licensees to address potential credit concerns. SBICs are subject to annual examinations for regulatory compliance, must prepare calculations that provide insight into the their current financial position, and are subject to enhanced monitoring or other remedial actions for noncompliance.

Regulatory changes

Accrual debentures

One of the most significant changes to the SBIC program is the creation of a new form of debenture, the accrual debenture. In contrast with existing debentures, accrual debentures will not have a current interest pay component and will instead accrue interest over the debenture’s term. SBICs will need to indicate if they intend to use traditional debentures or accrual debentures at the time of licensing, and SBA approval is subject to the same licensing process. Accrual SBICs may borrow up to 1.25 times their regulatory capital, and maximum leverage will be determined by aggregating total expected principal and interest over the life of the debenture.

The final rule describes a schedule of distributions that an accrual SBIC must use when distributing the proceeds from the sale of an investment:

• First, proceeds are paid to the SBA to the extent the SBIC owes the agency accrued and unpaid annual charges and accrued debenture interest.
• Second, proceeds are allocated among the SBA and private investors. The SBA’s sharing percentage is calculated as follows. The amount paid to the SBA must be at least their sharing percentage multiplied by the total distribution amount.

  Total leverage commitment
  (Total leverage commitment + Total private commitment)

• Third, any remaining amounts are paid to private investors.

The introduction of accrual debentures is intended to provide a source of SBIC financing that aligns better to equity-focused investments due its lack of a current pay interest obligation. Venture capital, growth capital and buyout investment

Reinvestor SBICs

Another significant change to the SBIC program is the introduction of reinvestor SBICs. These SBICs are allowed to invest in other, non-SBA-leveraged investment funds, whether or not the investees are SBICs. Those investee funds do need to have an investment strategy that aligns with current SBIC requirements, including that they invest in companies that meet the SBIC’s portfolio company size standards, have at least half of their employees in the United States and are controlled by entities or individuals in the United States. Reinvestor SBICs may also make co-investments into portfolio companies alongside investee funds, subject to certain conditions.

Reinvestor SBICs further expand the investment strategies that fit into the SBIC model and may increase the amount of capital allocated to SBIC and non-SBIC funds, and in turn to the portfolio companies they invest in. 

Licensing

The current licensing process may take up to 18 months, and is similar for both first-time applicants and returning applicants. Under the final rule, SBIC fund managers seeking an SBIC license for a subsequent fund may have an easier path. Subject to certain requirements, subsequent SBIC license applicants may submit a short form Management Assessment Questionnaire (MAQ). The short form MAQ is intended to expedite the licensing process and reduce the burden on fund managers. To be eligible for a short form MAQ, an applicant must meet certain criteria, including the following:

• The applicant must have a generally consistent: (1) investment strategy, (2) limited partner base, (3) limited partnership agreement, and (4) fund size. The new fund being raised may not be more than 133% larger than the applicant’s most recent fund, and the two largest limited partners must have at least verbally committed to invest in the new fund.
• The most recent fund must meet certain performance metrics relative to appropriate industry benchmarks.
• The manager of the licensee must be stable, demonstrate internal advancement and have no significant regulatory violations.

Additionally, SBA will prioritize applications from under-licensed states and will lower the fees for new or unleveraged applicants. A state’s under-licensed designation will be based on an SBA calculation that compares the licenses per capita for a given state versus a median figure for all states. A listing of such under-licensed states will be provided by SBA periodically.

Capital call lines of credit

Current regulations require that licensees obtain the SBA’s permission prior to entering into a secured line of credit facility with a third-party financial institution. The final rule exempts SBICs from needing that approval if the credit facility meets certain conditions:

• The line of credit is limited to 20% of the total unfunded capital commitments of the SBIC’s institutional investors.
• The line of credit has a term of no more than 12 months, and borrowings are required to be repaid within 90 days. The line of credit must have no outstanding balance for at least 30 consecutive days during the year.
• The lender is a federally regulated financial institution.

Reporting and monitoring updates

The final rule provided a variety of modifications to an SBIC’s reporting obligations, including the following:

• SBICs are required to file Portfolio Financing Reports on Form 1031 following investment activity.
• Form 1031 filings previously had been due within 30 days of a financing, but SBICs will now have the option to file them quarterly.
• Leveraged SBICs now must report investment valuations quarterly using the SBA accounting basis. Unleveraged SBICs may use U.S. GAAP as their accounting basis for their valuations.
• SBICs report their quarterly and annual financial statements on SBA Form 468. The SBA is updating the form to accommodate the changes in the final rule, including the need for additional information from reinvestor SBICs and the inclusion of additional reporting metrics such as total value to paid in (TVPI), multiple of invested capital (MOIC) and internal rate of return (IRR).

Additionally, there are changes to how the SBA will conduct its ongoing monitoring of SBIC’s. Most notable are the creation of a watchlist for timely identification of potential credit issues and more oversight when issues are identified. An SBIC may end up on the watchlist if its performance is sufficiently poor relative to an industry benchmark or if it faces regulatory or other issues. While on the watchlist, an SBIC may be required to report to the SBA more frequently and conduct portfolio reviews. It may be removed from the watchlist when the performance factors or other conditions are alleviated.

What’s next

These changes to the SBIC program are significant, and additional guidance will be needed in certain areas as they are implemented. The final rule became effective Aug. 17 and the SBA issued an updated standard operating procedure (SOP) Aug. 23, which provided additional guidance relative to these final rule changes and replaced some preexisting policy notes. The SBA anticipates operating under the new regulations promptly, including beginning the licensing process for accrual and reinvestor SBICs.

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This article was written by Ryan Hurley and originally appeared on 2023-09-07.
2022 RSM US LLP. All rights reserved.
https://rsmus.com/insights/industries/private-equity/significant-changes-to-the-small-business-investment-company-pro.html

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. The RSM(tm) brandmark is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.

ARTICLE | September 07, 2023

Authored by RSM US LLP

Executive summary: New requirements for the home energy audits

On Aug. 4th, the IRS and The Department of the Treasury (Treasury) released Notice 2023-59 which provides administrative and procedural guidance on the requirements for home energy audits for purposes of calculating the energy efficient home improvement credit under Internal Revenue Code section 25C. Prior to the release of the notice, the IRS released Fact Sheet 2022-40 which provides background information and answers to frequently asked questions with respect to the energy efficient home improvement credit. Treasury and the IRS intend to issue proposed regulations on the energy efficient home improvement credit. Until the issuance of such guidance, taxpayers can rely on sections 3 through 6 of the new notice with respect to the definitions related to home energy audits, certifications and/or requirements for home energy auditors, substantiation requirements for home energy audits and the transition rule for home energy audits conducted after Dec. 31, 2022, and on and before Dec. 31, 2023.

IRS and Treasury release guidance on tax credit for home energy audits 

Energy efficient home improvement credit

The Inflation Reduction Act (IRA) amended the existing energy efficient home improvement credit to implement a 30% credit percentage and add new types of qualifying expenditures to be included within the scope of the credit. For property placed in service on or before Dec. 31, 2022, the allowable credit was 10% of amounts paid or incurred for certain qualified energy efficiency improvements plus the amount of certain residential energy property expenditures paid or incurred during the taxable year. As modified by the IRA, for property placed in service after Dec. 31, 2022, the credit is generally equal to 30% of the aggregate amounts paid for qualifying expenditures.

For property placed in service after Dec. 31, 2022, qualifying expenditures include:

• Amounts paid or incurred by the taxpayer for qualified energy efficient improvements installed during the tax year;
• Residential energy property expenditures paid or incurred during the tax year; and
• Home energy audit expenditures incurred during the tax year.

Qualifying residential energy improvement expenditures include certain exterior windows and skylights, exterior doors, roofs and insulation materials. Qualifying residential energy property expenditures generally include expenditures for central air conditioners, natural gas; propane; or oil water heaters; furnaces; or hot water boilers, improvements to, or replacements of, panelboards; subpanel boards; branch circuits; or feeders, electric or natural gas heat pumps or heat pump water heaters, as well as biomass stoves or boilers. Requirements, such as those related to the property’s energy efficiency, may apply to each energy efficient improvement or residential energy property expenditure.

Expenditures for home energy audits conducted after Dec. 31, 2022, may qualify for the energy efficient home improvement credit. Qualifying home energy audits must include an inspection and written report with respect to a dwelling unit located in the United States and owned or used by the taxpayer as a principal residence. The report must identify the most significant and cost-effective energy efficiency improvements with respect to such dwelling. An estimate of the energy and cost savings must be included. The audit must be conducted and prepared by a home energy auditor that meets certain requirements specified by Treasury. This notice and the forthcoming proposed regulations provide those requirements.

The credit imposes several limitations that vary based on the type of qualifying expenditure paid or incurred. There is an aggregate annual $2,000 dollar credit limitation for biomass stoves and boilers, electric or natural gas heat pump water heaters and electric or natural gas heat pumps. All other qualifying expenses are subject to an aggregated annual $1,200 limitation. The mix of expenditures subject to the maximum annual limitation of $1,200 are subject to additional annual limitations. For example, qualified home energy audit expenditures are limited to $150. If a taxpayer incurs $1,000 dollars of qualified home energy audit expenditures, the 30% credit is capped at $150 with respect to these expenditures. In total, a taxpayer paying or incurring certain mixes of qualifying expenditures can potentially qualify for up to $3,200 in energy efficient home improvement credits per year. For property placed in service on or before Dec. 31, 2022, separate limitations applied, and the energy efficient home improvement credit included a lifetime maximum credit of $500.

New requirements for home energy audits

The notice outlines definitional and procedural guidance with respect to home energy audit expenditures paid or incurred by the taxpayer. The notice provides definitions for the following terms that will be applicable to home energy audits:

• Home Energy Audit Credit
• Home Anergy Audit
• Qualified Home Energy Auditor
• Qualified Certification Program

The inspection must be conducted by either a Qualified Home Energy Auditor or under the supervision of a Qualified Home Energy Auditor. Qualified auditors are individuals who are certified by a Qualified Certification Program at the time of the audit. The Department of Energy (DOE) has created a website that lists Qualified Certification Programs. Qualified Certification Programs are subject to certain requirements contained in the notice. Written reports must include the Qualified Home Energy Auditor’s identifying information, the name of the Qualified Certification Program of which the auditor is certified, and an attestation statement and signature. Substantiation requirements for the credit will include the written report signed by the Qualified Home Energy Auditor pursuant to general recordkeeping and retention requirements under section 6001 & Treas. Reg. section 1.6001-1 and compliance with Form 5695.

Transition rule

The notice creates a safe harbor for energy audits conducted by auditors other than Qualified Home Energy Auditors for home energy audits conducted after Dec. 31, 2022, and on or before Dec. 31, 2023. Taxpayers who paid or incurred expenses during this timeframe for home energy audits that meet the requirements of the energy efficient home improvement credit may be eligible even if they do not meet the new requirements contained in this notice.

Washington National Tax takeaways

There are several Federal, state, and local tax credits, incentives, and other rebates available for energy efficient home improvements. A home energy audit may help taxpayers identify eligible home improvements that may qualify for credits and incentives.

This notice provides additional insight on the substantiation and procedural requirements for claiming the energy efficient home improvement credit for qualified home energy audit expenditures. Taxpayers making energy efficient improvements to their homes will now have a better understanding of the procedures and information that will need to be collected in order to claim a credit for qualified home energy audit expenditures. Until the IRS and Treasury release proposed regulations with respect to the energy efficient home improvement credit, taxpayers may rely on sections 3 through 6 of the notice to calculate, substantiate and document qualifying expenditures incurred in connection with a home energy audit. Taxpayers should consult with their tax advisors prior to claiming tax credits for expenses incurred in conjunction with efficient home energy improvements.

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This article was written by Christian Wood, Deborah Gordon, Brent Sabot, Leo Rich and originally appeared on 2023-09-07.
2022 RSM US LLP. All rights reserved.
https://rsmus.com/insights/tax-alerts/2023/irs-treasury-release-guidance-tax-credit-home-energy-audits.html

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. The RSM(tm) brandmark is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.

ARTICLE | September 05, 2023

Authored by RSM US LLP

Executive summary

For many privately owned companies, an investment by a private equity fund (PEF) or venture capital (VC) provides an opportunity for liquidity to founders and other employee-shareholders. In many cases, the PEF or VC invests via a new class of preferred stock, while the employee-shareholders hold common stock. Often the employee-shareholders sell their common shares to the PE, VC or the company at the same price per share as the price of the new preferred investment, which might be at a higher value than the value ascribed to the common shares in the company’s section 409A valuation. The sale of stock at a price in excess of a 409A valuation can create risk that the shareholder must treat a portion of the sale proceeds as compensation, subject to higher tax rates, and that the company is subject to payroll tax withholding on that portion.

Compensation-related tax risks when cashing out employee shareholders

For minority shareholders of privately held companies, opportunities to monetize a portion of their investment are infrequent. However, one situation where a monetization event sometimes occurs, is in conjunction with a new PEF or VC investment. The new investment might provide the company with sufficient reserves to finance a buyback. Alternatively, the PEF or VC might acquire shares directly from the existing shareholders. A shareholder’s sale of stock to a third-party investor or to the corporation via a stock buy-back or redemption typically generates capital gain treatment.¹

Due to the broad application of section 61, when a seller of stock is also an employee or service provider, a portion of the sale proceeds received by that seller may represent compensation if the sale proceeds exceeds the fair market value of the stock sold. Section 61(a) includes compensation for services, “from whatever source derived” as gross income. This can include payments an employee-shareholder receives in excess of the fair market value of the property (e.g., corporate stock) they sell.² 

The following example describes a relatively common transaction involving a PEF investment into an operating C corporation and a corresponding liquidity event for certain shareholders.

XYZ Corp is a privately held corporation with a mix of small investors, founders, and employee-shareholders. PEF and XYZ have negotiated for an investment by PEF of $100M into XYZ for 10 million shares of Series A preferred stock at $10/share. The Series A preferred includes a liquidation preference of the original $100 million invested plus a cumulative dividend of 10% per year if declared. If not declared, the cumulative dividend is added to the liquidation preference. The Series A is also convertible into common stock on a 1:1 basis.

Prior to the investment, XYZ’s only outstanding equity is common stock and options to acquire common stock. XYZ recently had a valuation performed to satisfy section 409A requirements, which provided a value of $5/share for its common stock. In connection with the investment, XYZ has offered to redeem up to $20 million of existing common stock at the same $10/share PEF is paying for the Series A preferred.

In this fact-pattern, because the employee-shareholders receives purchase consideration in excess of the  $5/share 409A appraised share value, the excess may perhaps constitute compensation. However, because isolated share sales in excess or below a section 409A valuation occur frequently, additional pertinent facts and circumstances must be examined when assessing the risk of compensation income. Although no single factor is controlling, factors requiring analysis include:³

1. Whether the share sale was open to shareholders that are not service providers, and if so, how many took part. (Non-service providers taking part on the same terms as the employee-shareholders is a factor supporting capital treatment and not compensation.) 
2. Whether any negotiations took place directly between the PEF and the selling employee-shareholders. (Direct negotiations between the PEF and selling employee-shareholders is a factor supporting capital treatment and not compensation.)
3. The amount of time that elapsed between the 409A appraisal date and the share sale. (The more time that elapses, the less weight to place on the appraised value.)
4. Whether the shares were acquired by the PEF or by the company. 
5. If acquired by the PEF, whether the impetus for the sale by the employee-shareholders is that PEF wanted to acquire more shares than the company was willing to issue. For example, suppose XYZ only offered $80 million to PEF, which required PEF to acquire the remaining $20 million of shares they wished to acquire from the employee-shareholders. Because the impetus for the $20 million sale was PEF’s desire to acquire the shares, the fact-pattern more closely resembles a transaction generating capital treatment and not compensation. 
6. If acquired by the PEF, whether the shares acquired by the PEF were subsequently recapitalized into the Series A preferred pursuant to a plan at the time of the acquisition. (A prearranged recapitalization of the common shares acquired by PEF from the employee-shareholders into Series A preferred is a factor indicating compensation and not capital treatment.) 

In addition to the above, a company should consider the financial statement reporting of the transaction. The rules surrounding the financial statement determination of compensation under this fact pattern is beyond the scope of this discussion, and financial statement reporting is not controlling for tax reporting, but if financial reporting treats the transaction as partially compensatory, it is a factor that the company should consider.  

The tax risk highlighted here can affect the company, not merely the employee-shareholder. It is tempting to suggest that the risk is only to the shareholder, as the company would forego a compensation deduction and overstate rather than understate taxable income. However, the risk highlighted here is not simply an income tax consideration, as the company is responsible for various payroll tax withholding requirements for employee compensation. The company’s failure to make required payroll tax withholding payments could result in the imposition of penalties and interest. Depending upon the facts, a company can incur harsh tax liabilities based on the compensatory amounts received by the shareholder.⁴

Summary

Transactions (including the acquisition and disposition of corporate stock) involving service providers who are parties to the transaction require scrutiny. The IRS and courts have applied the rules of section 61 broadly to treat payments to service providers as compensation. In such a case, the nature of the service provider/recipient relationship is key. As with many areas of the tax law, a taxpayer’s specific facts and circumstances will ultimately determine the issue. Notably as discussed above, factors such as the inclusion of non-employee shareholders taking part in the sale or redemption, and separately negotiated sales to third party investors often lessen the compensatory risk.  Consult a tax advisor when faced with issues such as those discussed in this article.

1 This assumes that the buyback is not essentially equivalent to a dividend, pursuant to section 302.

2 See, e.g., Brinkley v. Comm’r., 808 F.3d 657 (5th Cir. 2015) (difference between claimed capital gain and the actual value of the sold stock was taxable as compensation); Azar Nut Co. v. Comm’r, 94 T.C. 455, 460 (1990), aff’d, 931 F.2d 314 (5th Cir. 1991) (employer purchasing property from an employee had paid a “premium or additional amount in excess of the fair market value,” and the premium constituted compensation).

3 See, e.g., Coven v. Comm’r, 66 T.C. 295 (1976) (Tax Court performed substance over form analysis and determined that payments were sale consideration and not compensation); Treister v. Comm’r, 51 T.C.M. 418 (1986) (Tax Court performed a fact-based analysis, distinguished Coven, and concluded that the taxpayer’s receipt of payments in excess of the value of the stock he sold was compensation for his consulting services).

4 See section 6672 (civil penalties equal to the amount of tax not collected); section 7202 (criminal penalties for willful failure).

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This article was written by Nick Gruidl, Joseph Wiener, Nate Meyers and originally appeared on 2023-09-05.
2022 RSM US LLP. All rights reserved.
https://rsmus.com/insights/services/business-tax/compensation-related-tax-risks-cashing-out-employee-shareholders.html

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. The RSM(tm) brandmark is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.

ARTICLE | September 05, 2023

Authored by RSM US LLP

Executive summary

IRS releases guidance on Roth catch-up contributions under SECURE 2.0

The IRS has provided additional guidance in Notice 2023-62 (Notice) regarding catch-up contributions under SECURE 2.0 Act (Act) section 603. Section 603 of the Act eliminated catch-up contributions after Dec.31, 2023, and required employees with income exceeding $145,000 (as indexed annually) to make any catch-up contributions on a Roth (rather than pre-tax) basis for tax years beginning after Dec. 31, 2023. Guidance provided in the Notice provides a two-year extension of the effective date for catch-up contributions being on a Roth basis for high income individuals and confirms catch-up contributions are available for tax years after Dec. 31, 2023.

IRS releases guidance on Roth catch-up contributions under SECURE 2.0

Two-year extension of Roth catch-up contribution requirement

Individuals who are age 50 or older, and who are participants in a retirement plan that allows deferral contributions (e.g., 401(k) and 403(b) plans) can elect to defer additional amounts into their retirement accounts, if allowed by their plan. The Internal Revenue Code refers to the extra contributions as “catch-up” contributions. Employees can make catch-up contributions on a pre-tax basis or, again, if allowed by the plan, as after-tax Roth contributions.

Section 603 of the Act added a new requirement that high-income individuals must make their catch-up contributions on a Roth basis. High-income individuals for this purpose are employees with wages more than $145,000 paid in the prior calendar year by the employer that sponsors the plan. Wages considered for this threshold are those subject to the Federal Insurance Contributions Act (FICA). Mandatory Roth treatment of catch-up contributions for high income individuals was set to start in tax years beginning after Dec. 31, 2023. Employers, plan recordkeepers, payroll companies and various industry and professional groups all expressed concerns about the abbreviated time under the Act for developing the necessary changes to plan documents, employee communications, and administrative procedures necessary to implement the change in the law.

Clarification on catch-up contributions after 2023

As drafted, Act section 603 ended catch-up contributions entirely for tax years beginning in 2024 due to a drafting error which removed section 402(g)(1)(C). This clearly was not the intent of Congress as the purpose of adding the Roth catch-up contribution requirement was for tax revenue generation. Stakeholders have been awaiting legislative action or confirmation from the IRS that catch-up contributions would still be permissible after Dec. 31, 2023. The Notice confirms that the IRS interprets the conflicting provisions of the Act in favor of catch-up contributions continuing to be available.

The Notice also confirmed that the elimination of section 402(g)(1)(C) does not change the applicability of section 402(g)(1)(A) or 402(g)(1)(B). Therefore, an individual’s deferral subject to the annual deferral and catch-up limits continue to be based on contributions made to all retirement plans, regardless of whether the individual’s made their deferrals and catch-up contributions to plans sponsored by the same employer or unrelated employers.

Outstanding considerations: more guidance forthcoming

The Notice’s transition relief is very helpful, but plan sponsors will still need guidance from IRS on matters such as:

1. The applicability of mandatory Roth treatment for catch-up contributions to self-employed individuals and governmental employees.

Self-employed individuals and certain governmental employees do not receive wages subject to FICA. Therefore, a question is still open as to whether these individuals would be subject to mandatory Roth treatment of catch-up contributions.

2. How an employer should treat an individual’s election to make catch-up contributions on a pre-tax basis if the employee exceeds the threshold for mandatory Roth treatment of catch-up contributions.

The Act provided that the Treasury may release regulations addressing how a plan sponsor is to treat an employee’s election to have catch-up contributions made on a pre-tax basis if they exceed the income threshold requiring Roth catch-up contributions. The Act and Notice did not address whether 1) the plan sponsor may overturn the employee’s election and automatically convert the pre-tax catch-up contributions to Roth catch-up contributions or 2) whether the plan sponsor would need to treat a pre-tax catch-up contribution election as void once the individual exceeds the income threshold and have the employee make a new election to treat their catch-up contributions as Roth contributions. There is also currently no guidance surrounding any necessary communications by the plan sponsor to affected employees who exceed the income threshold.

Key takeaways

The Notice confirms that catch-up contributions are here to stay and were not eliminated. Also, the transition period for the mandatory treatment of Roth contributions for high-income individuals shows the IRS’s intent to issue further guidance on unresolved issues surrounding implementation of that provision. Employers and recordkeepers received more time to amend their plan documents to implement mandatory Roth treatment of catch-up contributions for certain high-income individuals. As more guidance is provided, employers should continue to work with their recordkeepers and legal counsel, as appropriate, regarding amending their plans and implementing the proper testing and checks to ensure the Roth catch-up contribution income threshold is followed.

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This article was written by Anne Bushman, Bill O’Malley, Christy Fillingame, Lauren Sanchez and originally appeared on 2023-09-05.
2022 RSM US LLP. All rights reserved.
https://rsmus.com/insights/tax-alerts/2023/irs-releases-guidance-Roth-catch-up-contributions-under-secure-2.html

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. The RSM(tm) brandmark is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.

ARTICLE | July 25, 2023

Authored by RSM US LLP

Executive summary:

As part of its ongoing enforcement efforts related to Employee Retention Tax Credit (ERTC) claims, the IRS has released additional guidance. First, the IRS clarified its position on the ability of employers to claim they experienced a full or partial suspension of operations related to supply chain disruptions. Separately, the IRS released final regulations clarifying how the IRS will treat the overpayment of ERC refunds to employers.

IRS clarifies employee retention credit guidance

New ERTC guidance on supply chain disruptions

The IRS clarified its position on the impact of supply chain disruptions on employers claiming the Employee Retention Tax Credit (ERTC) in Generic Legal Advice Memorandum (GLAM) 2023-005 released July 21, 2023. One of the eligibility tests for the ERTC hinges on employers identifying a full or partial suspension of operations related to a government orders implemented to mitigate the spread of COVID-19. In many cases, employers have based their ERTC claims on the inability of their suppliers to make deliveries of goods or materials due to the COVID-19 crisis. The new IRS guidance explores five examples of supplier issues and analyzes the arguments relative to the published guidance in the CARES Act and IRS Notice 2021-20.

IRS Notice 2021-20 Q&A 12 allows employers to “step into the shoes” of their suppliers for purposes of the suspension of operations test. However, the employer must substantiate its eligibility with a governmental order and documentation demonstrating that the order caused its supplier to suspend operations, drove the inability of the supplier to obtain goods or materials, and the employer was not able to obtain materials from an alternate supplier. The scenarios in GLAM 2023-005 explore the nuances of this substantiation and clarify several points, namely:

• A supplier’s claim that its inability to provide goods and services to an ERTC claimant was related to the COVID-19 crisis without proof of specific government orders is not sufficient to support an ERTC claim for full or partial suspension of operations for a company that buys from that supplier.
• Employers claiming the ERTC who experienced supply chain disruptions, even those connected to specific government orders, may not claim full or partial suspension of operations related to the supply chain disruption if they held sufficient supplies on hand to operate or were able to obtain sufficient supplies from an alternate supplier. In addition, higher costs for critical goods resulting in lower profit margins do not qualify as a full or partial suspension of operations.
• A supplier’s claim that its inability to provide goods and services was due to bottlenecks in ports or delays due to a truck driver shortage may not be used to support an employer’s ERTC claim as full or partial suspension of operations without identifying the specific government orders and substantiation of their impact on the employer.
• News articles and social media postings do not constitute sufficient substantiation of the relationship of a delay in goods and services to government orders for COVID-19.
• Residual supply disruptions due to government orders do not constitute support for a full or partial suspension of operations during a subsequent quarter for which the governmental orders have been lifted.
• Limited product shortages, e.g., for a retail business that sells a significant array of products, are not sufficient to support a claim for full or partial suspension of operations if the employer was still able to source a wide variety of products for customers and did not otherwise have a partial suspension of operations due to government orders.

Many of the above scenarios are positions employers have taken on ERTC claims. Ultimately, the taxpayer is responsible for the information reported on their tax return, and employers should be aware of the potential for penalties (including a possible 20% negligence penalty), interest and repayment of tax for improperly-claimed credits.

IRS examinations of employee retention credits

The IRS continues to warn employers to be wary of third parties with aggressive tactics promoting ERTC claims. On March 20, 2023, the IRS announced that the ERTC was the newest entry on the Dirty Dozen list of tax scams due to the “aggressive marketing of these credits.”

As part of its effort to combat such claims, the IRS has ramped up enforcement of ERTC refund claims and significantly increased examination activity. Listed below are some issues that IRS has been raising on ERTC examinations:

• Appropriate aggregation of related companies for use in determining a decline in gross receipts and in determining employer size
• Capping of ERTC wages at the $10,000 limit
• Proper reduction of qualified wages for PPP loan forgiveness amounts and FFCRA sick and family leave credits
• Use of separation pay and paid-time-off amounts in determining qualified ERTC wages
• Appropriate limitation of wages claimed and appropriate support for “idle time” wage determinations– wages for which an employee was paid but was not as busy because of the effects of governmental orders – by large employers
• Calculation of full-time employees using the 30-hour weekly/130-hour monthly rules
• Proper reduction of wage deduction on the corresponding income tax return for ERTC wages claimed

IRS final regulations on erroneous refunds

In addition to the new guidance provided in GLAM 2023-005, the IRS released final regulations on July 24, 2023, updating the July 29, 2020 temporary regulations and solidifying the IRS’ position on erroneous refunds of COVID-19 credits. The final regulations apply underpayment of tax rules to denied ERTC claims, subjecting them to penalty and interest assessment and collection.

We recommend taxpayers claiming the ERTC have their substantiation documentation prepared and ready to submit if asked to provide it to the IRS.

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This article was written by Anne Bushman, Karen Field , Marissa Lenius, Kate Walters and originally appeared on Jul 25, 2023.
2022 RSM US LLP. All rights reserved.
https://rsmus.com/insights/tax-alerts/2023/irs-clarifies-employee-retention-credit-guidance.html

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. The RSM(tm) brandmark is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.