2020 estate strategies in times of uncertainty for privately held business owners

Read this is you are a business owner or an advisor to business owners.

With continued uncertainty in the business environment stemming from the COVID-19 pandemic, now may be a good time to utilize trust, gift, and estate strategies in the transfer of privately held business interests. 

As discussed in our May 26, 2020 article 2020 estate strategies in times of uncertainty for privately held business owners, there may be opportunity to free up considerable portions of lifetime gift and estate tax exemption amounts. This is possible due to suppressed values of privately held businesses and the uncertainty surrounding the impact of the 2020 presidential election on tax rates and future exemption and exclusion thresholds.

An element to consider is the ability to transfer non-controlling interests in a business. These interests are potentially subject to discounts for lack of control and lack of marketability. The discounts may further reduce the overall value transferred through a given strategy, potentially offloading a larger percentage of ownership in a business while retaining large portions of the gift and estate lifetime exemption. Part I of this series focused on the discount for lack of control. In Part II, let’s focus on the discount for lack of marketability.

Discount for lack of marketability

In the context of a hypothetical willing buyer and willing seller, the buyer may place a greater value on an ownership interest of an investment that is “marketable.” Marketable investments can be bought and sold easily and offer the ability to extract liquidity compared to an interest where transferability and marketability are limited. 

Simply put, buyers would rather own investments they can sell easily, and will pay less for the investment if it lacks this ability. Non-controlling interests in private businesses lack marketability—few people are interested in investing in a business where control rests in someone else’s hands. Discounts for lack of control commonly reduce the value of the transferred interest by 5% to 15%, discounts for lack of marketability can drop value of the business by 25% to 35%.

Market-based evidence of proxies for discounts for lack of marketability can be found within the following resources, studies, and methods (including, but not limited to):

• Various restricted stock studies
• The Quantitative Marketability Discount Model (QMDM) developed by Z. Christopher Mercer
• Various pre-initial public offering studies
• Option pricing models
• Other discounted cash flow models

In addition to these resources, to fully assess the degree of discount applicable to a subject interest, consider company-specific factors when estimating the discount for lack of marketability. The degree of marketability is dependent upon a wide range of factors, such as the payment of dividends, the existence of a pool of prospective buyers, the size of the interest, any restrictions on transfer, and other factors. 

To establish a comprehensive view on the applicable degree of discount, here are more things go consider. In a ruling on the case Mandelbaum v. Commissioner¹, Judge David Laro outlined the primary company-specific factors affecting the discount for lack of marketability, including:

1. Restrictions on transferability and withdrawal
2. Financial statement analysis
3. Dividend policy
4. The size and nature of the interest
5. Management decisions
6. Amount of control in the transferred shares

Conclusion

Business owners are knowledgeable of the facts and circumstances surrounding a business interest. They take a close look at what they are buying before they make an offer. Like most people, they prefer investments they can readily convert into cash, and are therefore generally not willing to pay the pro-rata value for a minority interest in a business when the interest lacks marketability. To assess an appropriate discount for lack of marketability, consider resources such as those referred to above, then ensure selected discounts are appropriate based on the factors specific to the company and interest being valued. 

Our mission at BerryDunn remains constant in helping each client create, grow, and protect value. If you have questions about your unique situation, or would like more information, please contact the business valuation consulting team.

Part III of this series will focus on the application of DLOC and DLOM to a subject interest.

¹Mandelbaum v. Commissioner, T.C. Memo 1995-255 (June 13, 1995).

Read this is you are a business owner or an advisor to business owners.

With continued uncertainty in the business environment stemming from the COVID-19 pandemic, now may be a good time to utilize trust, gift, and estate strategies in the transfer of privately held business interests. 

As discussed in our May 26, 2020 blog post 2020 estate strategies in times of uncertainty for privately held business owners, there may be opportunity to free up considerable portions of lifetime gift and estate tax exemption amounts through transfers due to suppressed values of privately held businesses, and the uncertainty surrounding the impact of the 2020 presidential election on tax rates and future exemption and exclusion thresholds. 

An element to consider when building on this opportunity is the ability to transfer non-controlling interests in a business. These interests are potentially subject to discounts for lack of control and lack of marketability. This may further reduce the overall value transferred through a given strategy, potentially offloading a larger percentage of ownership in a business while retaining large portions of the gift and estate lifetime exemption. Let’s focus on the discount for lack of control (DLOC).

Discount for lack of control

In the context of a hypothetical willing buyer and willing seller, the buyer may place a greater value on an ownership interest with the ability to make changes at their discretion, compared to an alternative ownership interest lacking control. Simply put, buyers like to be in control, and they will pay less for the investment if the interest lacks these characteristics. 

When valuing non-controlling business interests there is an inherent discount to full value recognized to reflect the fact that the subject interest does not hold a controlling position. As a result of this discount, the value of a non-controlling interest in a company will differ from the pro-rata value per share of the entire company. DLOCs alone commonly reduce the value of the transferred interest by 5% to 15%.

All else being equal, a non-controlling ownership position is less desirable (valuable) than a controlling position. This is because of the majority owner’s right to control any or all of the following activities: managing the assets or selecting agents for this purpose, controlling major business decisions, asset allocation choices, setting salary levels, admitting new investors, acquiring assets, selling the company, and declaring/paying distributions.
 
Market-based evidence of proxies for DLOCs can be found within the following subscription-based databases (including, but not limited to): 

• Control premium studies published in the Mergerstat^® Review series by FactSet Mergerstat/Business Valuation Resources
• Closed-end fund data
• The Partnership Profiles, Inc. Minority Interest Database and Executive Summary Report on Re-Sale Discounts for applicable entity types

In addition to these resources, to fully assess the degree of discount applicable to a subject interest, consider company-specific factors when estimating the DLOC. The degree of control for a subject interest may be impacted by relevant state statutes and the governing documents of the subject company. These factors are analyzed in conjunction with the current operational and financial policies established and implemented in practice by management to establish a comprehensive view on the applicable degree of discount.

Conclusion

Hypothetical business owners are knowledgeable of the facts and circumstances surrounding a business interest. They take a close look at what they are buying before they make an offer. Like most people, they like to be in charge, and are therefore generally not willing to pay the pro-rata value for a minority interest in a business when the interest lacks control. To assess an appropriate discount for lack of control, consider resources such as those referred to above, then ensure the selected discounts are appropriate based on the factors specific to the company and interest being valued. 

Our mission at BerryDunn remains constant in helping each client create, grow, and protect value. If you have questions about your unique situation, or would like more information, please contact the business valuation consulting team.

Read this if you are a business owner.

While recent articles within the exit planning community have noted a slowing of business transitions and exits, during times of uncertainty it may be even more important to focus on the opportunity at hand. Rather than waiting it out, we recommend that business owners try to be active, involved, and focus their efforts on improving their business.

The situation is similar to the ebb and flow of the tide. The current economy is the tide at an extreme low point. We know that the economy will recover, so what can be done in the meantime to take advantage of opportunities, and be ready to succeed when the tide rises?

Changing of tides

Suddenly, there has been a rapid and seismic shift in the landscape. Weaknesses and threats, rocks and hazards, may have emerged. How you choose to approach these perils will make a difference in the long term. Will you take the opportunity to discover, identify, assess, shore up, and mitigate these elements?

It is important to view this current state in the context of the larger, long-term perspective. Once the tide comes back, will you be able to set full sail ahead having built resiliency, redundancy, and strength into those areas while you had the opportunity? While the water is low, it presents a great opportunity for business owners to discover and understand: 

• What broke first and why? 
• How can you shore it up for better operations in the days ahead?
• What weak spots you didn’t know about are now apparent?
• How can you address those weaknesses?
• How can you leverage existing resources differently to chart a path forward?

Models of priority

There are various stages or hierarchies of priority in thinking about the progress of a business. 

Each priority model features bases and pinnacles. The pinnacles of each model are realized in a long-term setting, after the remaining bases have been solidified. While continued development of a clear vision for your business is paramount, dynamic shifts in the landscape call for reassessment of the bases. In the long-term, self-fulfillment manifests from properly executed strategy, but in the near- and mid-term, these various frameworks force strategic planning back to assess and address the base components. 

The bases of each model should serve as safe havens for reversion. When facing uncertainty and failure, have you made your base strong enough to redirect your efforts in an actionable plan for the long-term?

Action Planning Pyramid and Value Maturity Index

The Value Maturity Index, broken into five stages is a stepwise assessment of active exit and business strategy. Inherent in the value acceleration framework are the concepts of resiliency, redundancy, disaster recover, and actionable planning.

While we may have been fully entrenched in the build phase, setbacks due to dynamic changes in the landscape force us back to protect mode—the assessment and methodical shoring up of weaker points of the operation to protect against future downside risks.

Though this stepwise progression is linear in nature, keep in mind that flexibility and adaptability are paramount in changing course to address needs of your current state.

When we look at action planning, parallels can be drawn to the various models. Certainly, we are focused on continuing sales, marketing, and customer relationships, but it becomes a question of reversion to meeting the basic needs and serving client’s pain points rather than  beginning ground-breaking efforts. 

The current climate forces us to the base, with a focus on solidifying the exposed areas that may have been made apparent, and likely compounded, by the current realities. Concerns on management, metrics, core values, and priorities serve as the bases in need of coverage.

Maslow’s Hierarchy of Needs
 

Maslow’s Hierarchy of Needs¹ is a well-known motivational theory in psychology that comprises a five-tiered model of human needs, whereby each successive tier must be fulfilled (beginning at the base) before rising to the next tier. It can be used to view similar information from a psychological perspective.

Value acceleration and creating successful outcomes are largely tied to a clear long-term vision. We typically reside in the Self-actualization level of the hierarchy of needs when undertaking the high-level view of the framework.

Based on the adaptability and call for sudden directional changes in today’s climate, we are not as concerned with these top levels. We have them in our back pocket for easy recall, but they are not the pressing issue staring us in the face.

If we think about shoring up bases (the Protect Stage), in considering this psychological model, our focus is on the “basic needs” level. That is, keeping people (self, family, and employees) safe and remaining connected for immediate continuity.

McKinsey & Company Event Horizons

Many others in related fields are viewing the current situation in similar terms. In the McKinsey & Company Events Horizon view²:

• Resolve addresses those immediate hurdles and challenges a business is currently facing.
• Resilience focuses on near-term items to be addressed once the initial base is covered. 
• Return views the mid-term horizon in understanding how to return to scale by focusing on understanding metrics and increasing the frequency of measurements for informed decision making. 
• Reimagination and Reform typically go hand in hand, but without covering bases of needs, crafting a dynamic shift in operations to incorporate new environments may be counterproductive. 

However, once these bases have been clearly assessed and addressed, the path forward may appear dramatically different, in which case creative solutions to enhance opportunity should begin to form. Examples of this may include newly emerged revenue streams and opportunity areas, fully integrated systems and dashboards to capture timely decision making data points, or pivots in your business model adaptable and reactive to new environments.

One example that has been in the news recently involves CEOs being pleasantly surprised that productivity of employees has not dropped even though people are working from home. How sustainable is this productivity? What implications might this have for corporate real estate and office settings? The answers will vary widely, depending on your business and competitive environment.

Exposure, discover, and control

Back to our tides analogy for a moment. As the water receded, what new rocks were exposed or what existing challenges became more apparent? What is your plan to address these areas? Is this the time to make large investments in your company or the right investments? Now that the tide is out, it is time to shore up, move the rocks, and address elements of your business to prepare for long-term successes. Through our assessments, risk profiling, and benchmarking analyses, we help business owners discover the largest gaps across the company, prioritize the most impactful problem areas to address, and implement changes to enhance business value through continuous improvement. 

Taking stock of your company’s future through the incorporation of lessons learned will bolster value in the long-term by de-risking and developing new opportunities, methods, work, shifts in productivity, and shifts in mentality. That approach also brings lots of questions: If there are no early warning signs, why not? What should your indicators be? What metrics are crucial in identifying the pulse of your current situation? What is your business reliant on? How can you build information and indicators for rapid shifts in decision making? How strong are your current controls and how integrated are your management and information systems?

To answer these questions, you need to quantify and develop metrics that will aid in the early identification of future challenges, thus increasing your responsiveness with data-driven decision mechanisms. Having your fingers on the pulse of your company and understanding the impact of each input to your strategy will focus your attention on the information that matters most. This allows you to understand, position, and adapt to changes in your business and community environment in a proactive and agile manner. Measurements, forecasts, and dashboards should provide you with regular, valid, and relevant information you can use to take informed action in decision making.

Historical look backs during various points of time will allow you to key in on pivotal data indicators and inflection points. When looking at this from an operational view, industry and economic factors impacting your company can serve as corroborating pieces of evidence to further support data metrics analyzed.

As you perform look backs, it is also best practice to regularly study and update development, pipeline, and reliance metrics for feedback and information discovery with data integrated throughout your operations. This helps avoid lag time in reporting on stale information towards real-time actionable data points.  

Each metric is specific to your business and can be directly mapped back to increases in shareholder value. Understanding these drivers of business value will focus your attention and intention on improving in the right areas, while avoiding distracting and less impactful pain points.

Don’t fret over precision, rather build in flexibility and adaptability with scenario- and sensitivity-based criterion to understand changes, implications, and reliance of each input. Understanding these relationships in a broader scheme aid you in quick, impactful decision making guiding you towards enhanced value.

Resilience until the tides rise

This approach allows opportunity to fully assess the known and unknown problem areas, weaknesses, perils, and hazards your business may be facing. From that base you can begin to address these issues to scale effectively with lower overall risk when activity picks up.

Management metrics, core values, and priorities drive resilience for long-term continuity by shoring up the foundation to build for the future. Assembling evidence in troubled times provides opportunity to capitalize on and fulfill core values. Documenting these decisions and improvements memorialize your decision making, impact on value enhancement, and should serve as a playbook for future events.

What you make of the time you have now through identification, assessment, and addressing newly emerged risk areas provides the opportunity to increase success once the economy rebounds. We are here to help. If you have questions about your particular situation, or would like more information, please contact the business valuation consulting team. 

¹Maslow’s Hierarchy of Needs, Saul McLeod, updated March 20, 2020. SimplyPsychology. www.simplypsychology.org/maslow.html.
²Beyond coronavirus: The path to the next normal, Kevin Sneader and Shubham Singhal, McKinsey & Company, March 23, 2020.  www.mckinsey.com/industries/healthcare-systems-and-services/our-insights/beyond-coronavirus-the-path-to-the-next-normal. COVID-19: Briefing note, March 30, 2020, Our latest perspectives on the coronavirus pandemic. Matt Craven, Mihir Mysore, Shubham Singhal, Sven Smit, and Matt Wilson. McKinsey & Company. www.mckinsey.com/business-functions/risk/our-insights/covid-19-implications-for-business.

Read this if you want more information about the Paycheck Protection Program (PPP).

Most likely you have heard of the PPP within the Coronavirus Aid Relief and Economic Security (CARES) Act that was passed into law March 27, 2020. Below, we’ve shared some of the questions we have heard from many of our clients. If you need more information or have questions regarding your specific question, please contact us. 

Question #1: What was the PPP designed for? 
Answer: The PPP was designed with the goal of keeping American workers paid and employed. It aims to accomplish this by issuing loans to qualified businesses so that they can continue paying employees and other qualified expenses.

Question #2: Do you or your business qualify for this? 
Answer: There are several considerations when determining whether or not a business qualifies. For more information, see this recent blog post from Seth Webber, which address a number of these considerations. 

Question #3: What should the PPP loan be used to cover in your business?
Answer: The intent of allowable uses includes: (i) payroll costs, including (a) employee salaries, commissions, or similar compensations, (b) group health care benefits, (c) paid vacation, parental, sick, medical, or family leave, (d) allowances for dismissal or separation, (e) retirement benefits, and (f) state or local tax assessed on the compensation on employee;  (ii) payments of interest on any mortgage obligation, but not prepayment or payment of principal amounts; (ii) rent (including rent under a lease agreement); (iv) utilities; and (v) interest on any other debt obligations incurred before February 15, 2020. However, certain payroll costs are excluded, including salaries and wages which annualized amounts would result in compensation over $100,000 and sick and family leave wages for which a credit is allowed under the Families First Coronavirus Response Act.  

Additionally, you should consider the time period your allowable expenses are designated for. The Small Business Administration (SBA), in consultation with the Department of the Treasury (Treasury) issued a list of frequently asked questions (FAQs) and responses to these FAQs as of April 10, 2020, Paycheck Protection Program Loans FAQs. Within these FAQs, Question 20 asked, “The amount of forgiveness of a PPP loan depends on the borrower’s payroll costs over an eight-week period; when does that eight-week period begin?” The SBA and Treasury noted, “The eight-week period begins on the date the lender makes the first disbursement of the PPP loan to the borrower. The lender must make the first disbursement of the loan no later than ten (10) calendar days from the date of loan approval.” 

Question #4: What portion of the loan, if any, can be forgiven?
Answer: The Treasury Department issued guidance on March 31, 2020 indicating that at least 75% of the forgiven amount should be used for qualified payroll costs. Although the covered period is specified as February 15, 2020 through June 30, 2020, forgiveness amounts of the loan are based on expenses (primarily payroll) during the eight-week period following the receipt of the loan. There are other aspects of the forgiveness provisions that impact the actual amount forgiven, including maintaining or quickly rehiring employees and maintaining salary levels, with the overall forgiveness amount being reduced if full-time headcount declines, or if salaries and wages decrease more than 25%.

Question #5: What about the portion of your loan that is not forgiven?
Answer: For the portion of loan not forgiven, the life and terms of the residual loan appear favorable. Current guidance indicates a repayment period of two year loan at 1% interest. Included within this is a six-month deferral period on principal repayment. The loan does not require collateral or a personal guarantee.

Question #6: How should you keep track of the funding and allowable costs?
Answer: Best practice would be to set up a separate banking account. This will allow you to bifurcate the funding source and offset that amount by costs tracked over the covered period directly. This allows you to use other cash reserves and funding sources to meet other expense needs during the covered period. The funds need to be brought over (into that separate banking account) within 10 days of the application being approved.

Question #7: What other resources are available if the PPP is not a good fit for you?
Answer: There are additional programs available through the Small Business Administration (SBA) including the Economic Injury Disaster Loan (EIDL) program, which features an advance amount (EIDL Emergency Grant) of up to $10,000. Guidance remains outstanding on exact implications of the EIDL Emergency Grant amount with some SBA offices pointing to $1,000 per employee up to a total max of $10,000. This EIDL Emergency Grant does not have to be repaid, but if you subsequently receive funding through the PPP, your forgiveness amount will be reduced by the EIDL Emergency Grant amount. The EIDL program also features a max life of 30 year loan with interest rates of 3.75% and 2.75% for entities that are for-profit and non-profit, respectively. More information on this is detailed in Dave Erb’s recent blog post.

If you do not need to make use of the PPP and EIDL programs, but still face significant downturns in your revenue base, tax relief in the form of the Employee Retention Credit (ERC) may also be an option. The provisions of the ERC within the CARES Act specify eligibility as, an employer that does not participate in the PPP and: (i) a complete or partial shutdown in operations; or (ii) at least a 50% decline in gross receipts, based on quarterly comparison from 2020 to 2019. The ERC allows for a tax credit of 50% of qualified wages (max wages of $10,000 per employee and max credit of $5,000 per employee). For more information on the ERC provisions, see Bill Enck’s blog post.

As developments continue to unfold and changes in guidance continue to emerge, the BerryDunn Recovery Advisory Team can help you stay informed through the BerryDunn COVID-19 Resource Center.

Read this if you are a renewable energy producer, investor, or installer.

As Election Day approaches, much if not all of the nation’s attention is focused on the global COVID-19 pandemic, the millions of people it has affected, and its effect on the global economy. What haven’t been prominent in presidential election news are the different policy approaches of the two candidates. In the renewable energy sector, the differences are stark. Here is a brief look at those differences and tax approaches of the candidates.

General tax information: Trump 

Traditionally at this time in an election year we’re presented with tax plans from both candidates. While these are campaign promises and may not fully come to fruition after the election, they can shed light on what each candidate plans to prioritize if elected. As the incumbent candidate in this election, Donald Trump has not provided much detail on his tax plans for the next four years, as noted by the Tax Foundation’s Erica York:

“While light on detail, the agenda includes a few tax policy items like expanding existing tax breaks, creating credits for specific industries and activities, and unspecified tax cuts for individuals. The president has also expressed support for other policy changes related to capital gains and middle-class tax cuts. Of note, none of the campaign documents so far have detailed a plan for the expiring provisions under the 2017 Tax Cuts and Jobs Act (TCJA).”

The president’s main priorities have been growing the economy and creating jobs, both of which have taken a massive hit in 2020 due to the pandemic. President Trump has had little else to say on his plans for a second term other than extending the sunset of the Tax Cuts and Jobs Act (TCJA) of 2017 to 2025, or the end of this coming term. One of the items that could be considered is an expansion of the Opportunity Zone program, providing a tax deferral for investment in specified economically distressed areas.

Another item is how Net Operating Losses (see our prior blog post on this topic) will be treated and whether or not the TCJA or the Coronavirus Aid, Relief, and Economic Security (CARES) Act rules will be the ones used in the future. With the recent New York Times article detailing the president’s tax filings and showing how he took advantage of the NOL rules, it’s still a guess as to how that could impact the tax policy around NOLs going forward.  

Trump energy plan: fossil fuels first

In the energy sector, Trump’s focus has been on bolstering the oil and gas industry, while also trying to revive the flagging coal industry, and it appears his focus will continue in that vein. His proposed budget continues to provide tax breaks for fossil fuel companies, while planning to repeal renewable energy tax credits. Prior to his election in 2016, the renewable energy sector was somewhat hopeful that the benefits of increased jobs provided by the industry would be appealing to the President. This hasn’t played out over the last four years and with current energy credits scheduled to phase out and unprecedented unemployment, the jobs being provided by this sector may be part of the formula to help sway the administration to extending or expanding these programs.

General tax information: Biden 

Biden, as the challenger, has a much more detailed tax plan laid out. As expected, it is very different from the direction the Trump presidency has taken regarding taxes. A brief summary of his plan:

Raise taxes on individuals with income above $400,000, including:

• Raising the top individual income tax bracket from 37% back to 39.6%
• Removing the preferential treatment of long-term capital gains for taxpayers with income over $1 million
• Creating additional phase outs of itemized and other deductions 
• Instituting additional payroll taxes related to funding social security
• Expanding the Child Tax Credit up to $8,000 for two or more children

Biden’s plan would also raise taxes on corporations:

• Raising the corporate income tax rate from 21% to 28% 
• Imposing a corporate minimum tax on corporations with book profits of $100 million or higher.

According to the Tax Foundation’s analysis of Biden’s tax plan:  

“[Expectations are that it] would raise tax revenue by $3.05 trillion over the next decade on a conventional basis. When accounting for macroeconomic feedback effects, the plan would collect about $2.65 trillion the next decade. This is lower than we originally estimated due to the revenue effects of the coronavirus pandemic and economic downturn.”…“On a conventional basis, the Biden tax plan by 2030 would lead to about 6.5 percent less after-tax income for the top 1 percent of taxpayers and about a 1.7 percent decline in after-tax income for all taxpayers on average.”

Taxpayers earning more than $400,000 a year, and investors who have enjoyed preferential treatment and lower tax rates on capital gains will certainly pause at this proposal. While Trump’s tax policy has been to lower taxes in these areas to spur investment in the economy, Biden’s plan shows the need to generate tax revenue in order to cover the massive amounts spent during the COVID-19 pandemic.  

Biden energy plan: renewables first

Joe Biden’s energy policy is focused on climate change and renewable energy. In addition to ending tax subsidies for fossil fuels, his platform proposes investing $2 trillion over four years for clean energy across sectors, recommit to the Paris agreement, and achieve 100% clean energy by 2035.

Other Biden initiatives include:

• Improving energy efficiency of four million existing buildings
• Building one and a half million energy-efficient homes and public housing
• Expanding several renewable-energy-related tax credits
• Installing 500 million solar panels within five years 
• Restoring the Energy Investment Tax Credit (ITC) and the Electric Vehicle Tax Credit

Indeed, over the past decade the Democratic Party has been a proponent of investment in and expansion of renewable energy technologies. While increased taxes will certainly cause many business owners and investors to pause, and any changes will need to be passed by Congress, it is encouraging to the renewable energy sector that Biden’s policy platform states goals related to increasing renewable energy in the United States.

As one might expect during this era of the two main political parties being so far apart from each other on policy, the proposed tax plans of both candidates also stand in fairly stark contrast, as does their approach to the United States’ energy sources in the coming decade. There are benefits and consequences to both plans, which will have an impact beyond the 2020 election.  
 

Read this if you administer a 401(k) plan.

On December 20, 2019, the Setting Every Community up for Retirement Enhancement (SECURE) Act was signed into law. The SECURE Act makes several changes to 401(k) plan requirements. Among those changes is a change to the permissible minimum service requirements.  
 
Many 401(k) retirement plan sponsors have elected to set up minimum service requirements for their plan. Such requirements help eliminate administrative burden of offering participation to part-time employees who may then participate in the plan for a short period of time and then keep their balance within the plan. Although plan sponsors do have the ability to process force-out distributions for smaller account balances, a minimum service requirement, such as one year of service, can help eliminate this situation altogether.  

Long-term part-time employees now eligible

The SECURE Act will now require that long-term part-time employees be offered participation in 401(k) plans if they are over the age of 21. The idea behind the requirement is that 401(k) plans are responsible for an increasingly larger amount of employees’ retirement income. Therefore, it is essential that part-time employees, some of which may not have a full-time job, have the ability to save for retirement.  
 
Long-term is defined as any employee who works three consecutive years with 500 or more hours worked each year. This new secondary service requirement becomes effective January 1, 2021. Previous employment will not count towards the three-year requirement. Therefore, the earliest a long-term part-time employee may become eligible to participate in a plan under the secondary service requirement is January 1, 2024.  

403(b) plans not affected 

Please note this provision is only applicable for 401(k) plans and does not impact 403(b) plans, which are subject to universal availability. Furthermore, although long-term part-time employees will be allowed to make elective deferrals into 401(k) plans, management may choose whether to provide non-elective or matching contributions to such participants. These participants also may be excluded from nondiscrimination and top-heavy requirements.  
 
This requirement will create unique tracking challenges as plans will need to track hours worked for recurring part-time employees over multiple years. For instance, seasonal employees who elect to work multiple seasons may inadvertently become eligible. We recommend plans work with their record keepers and/or third-party administrators to implement a tracking system to ensure participation is offered to those who meet this new secondary service requirement. If a feasible tracking solution does not exist, or plans do not want to deal with the burden of tracking such information, plans may also consider amending their minimum service requirements by reducing the hours of service requirement from 1,000 hours to 500 hours or less. However, this may allow more employees to participate than under the three-year, 500-hour requirement and may increase the employer contributions each year. 

If you have questions regarding your particular situation, please contact our Employee Benefit Audits team. We’re here to help.

Read this if you are a solar developer or investor.

One of the most frequent questions we get from solar project developers is: “Will my investors be able to use the tax credits and the depreciation losses?” The answer, as with many things related to taxes, is “it depends.” One of the biggest hurdles is navigating the passive activity loss rules. While this is a fairly complicated topic, and includes a lot more of “it depends,” we’ll hit some of the major highlights here.

Passive or active?

For tax purposes, activities are grouped as either passive or active activities. Income from these activities are generally treated the same, aggregated as part of the taxpayer’s total taxable income and taxed according to the applicable tax bracket. Losses from these activities are treated very differently, though. Losses from active activities can be used to offset all taxable income, whereas losses from passive activities can only offset passive income. If there is not enough passive income in a given year to fully offset passive losses, the losses become suspended and carried forward. The losses carry forward until either there is passive income to offset or the activity is disposed of (sold or otherwise no longer owned), in which case the suspended losses release in full in that year.

Similarly, the Investment Tax Credit (ITC) takes on the attributes of the activity in which it is being generated. So if the solar project is determined to be an active activity for the investor, the ITC would be active and available to offset tax on all sources of income. But if the activity is determined to be passive, the ITC would be limited to use against tax on passive income. For an investor that has not considered this prior to purchasing a stake in a solar project, a limitation on the credit the investor can use could mean a reduction of the expected return on investment, and an unwelcome surprise.

Portfolio income

It is also important to point out here that a third type of income, portfolio income, is a very common type of taxed income comprised of interest, dividends, and gains from investments. This falls into a separate category from the active/passive analysis, which is often misunderstood. A taxpayer with lots of dividend income who thinks it is passive income ends up with a rude awakening as that is actually portfolio income and does not allow for the offset of passive activity losses.

Material participation test

IRS Publication 925 details all of the rules surrounding passive activities and includes a set of seven tests to determine material participation. If the taxpayer satisfies at least one of the material participation tests, the taxpayer’s share of the activity is considered active and not passive. The tests are: 

1. You participated in the activity for more than 500 hours. 
2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
5. You materially participated in the activity (other than by meeting this fifth test) for any five (whether or not consecutive) of the 10 immediately preceding tax years.
6. The activity is a personal service activity in which you materially participated for any three (whether or not consecutive) preceding tax years.
7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

Tests one through six are pretty cut and dry, but the totality of the circumstances test presented in number seven is very open to interpretation. While this allows you to make an argument in your favor, it also gives the IRS more latitude to disagree with you, making it the riskiest test to rely on.

The IRS defines “participation” as “[i]n general, any work you do in connection with an activity in which you own an interest.” This does not include work that would be considered work only done by an investor – such as reviewing operations, preparing reports for your own use, or monitoring the finances or operations of the activity. The work in consideration must also not be work that is customarily done by the owner of that type of activity, nor your only reason for doing the work being to avoid treatment of the activity as passive.

While a contemporaneous log is not required to prove material participation, it is always a good idea to keep track of the work and hours you are performing on behalf of the activity in order to substantiate material participation. This is typically the first thing the IRS asks for in the event of an audit. 

As you can see from the seven tests, there is also room to switch between active and passive treatment in any applicable year. So it is important that you take the ITC in the year the project goes in service and the ITC is generated. If you are passive in year one and end up with suspended credits and or losses, a subsequent switch to active status would not change the attributes of those suspended items―they would remain passive.

Lastly, and important to note, this determination is made at the individual taxpayer level. Project investors need to work with their tax advisors and legal counsel to understand their personal tax situation before investing in a project. Depending on the individual situation, an active or a passive treatment may be more beneficial, as everyone’s tax situation is different. The most important thing is knowing ahead of time so that planning can be done and expectations can be set. No one likes a tax surprise!

If you have any questions about your specific situation or would like to know more, please contact the team. We’re here to help.