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The CARES Act: Implications for businesses

By: David Erb
03.30.20

On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief and Economic Security (CARES) Act, which provides relief to taxpayers affected by the novel coronavirus and COVID-19. The CARES Act is the third round of federal government aid related to COVID-19. We have summarized the top provisions in the new legislation below, with more detailed alerts on individual provisions to follow. Click here for a link to the full text of the bill.

Compensation, benefits, and payroll relief
The law temporarily increases the amount of and expands eligibility for unemployment benefits, and it provides relief for workers who are self-employed. Additionally, several provisions assist certain employers who keep employees on payroll even though the employees are not able or needed to work. 

The cornerstone of the payroll protection aid is a streamlined application process for SBA loans that can be forgiven if an eligible employer maintains its workforce at certain levels. 

Additionally, certain employers affected by the pandemic who retain their employees will receive a credit against payroll taxes for 50% of eligible employee wages paid or incurred from March 13 to December 31, 2020. This employee retention credit would be provided for as much as $10,000 of qualifying wages, including health benefits. Eligible employers may defer remitting employer payroll tax payments that remain due for 2020 (after the credits are deducted), with half being due by December 31, 2021, and the balance due by December 31, 2022. 

Employers with fewer than 500 employees are also allowed to give terminated employees access to the mandated paid federal sick and child care leave benefits for which the employer is 100% reimbursed by the government through payroll tax credits, if the employer rehires the qualifying employees.

Any benefit that is driven off the definition of “employee” raises the issue of partner versus employee. The profits interest member that is receiving a W-2 may not be eligible for inclusion in the various benefit computations.

Eligible individuals can withdraw vested amounts up to $100,000 during 2020 without a 10% early distribution penalty, and income inclusion can be spread over three years. Repayment of distributions during the next three years will be treated as tax-free rollovers of the distribution. The bill also makes it easier to borrow money from 401(k) accounts, raising the limit to $100,000 from $50,000 for the first 180 days after enactment, and the payment dates for any loans due the rest of 2020 would be extended for a year.

Individuals do not have to take their 2020 required minimum distributions from their retirement funds. This avoids lost earnings power on the taxes due on distributions and maximizes the potential gain as the market recovers.

Two long-awaited provisions allow employers to assist employees with college loan debt through tax free payments up to $5,250 and restores over-the-counter medical supplies as permissible expenses that can be reimbursed through health care flexible spending accounts and health care savings accounts.

Deferral of net business losses for three years
Section 461(l) limits non-corporate taxpayers in their use of net business losses to offset other sources of income. As enacted in 2017, this limitation was effective for taxable years beginning after 2017 and before 2026, and applied after the basis, at-risk, and passive activity loss limitations. The amount of deductible net business losses is limited to $500,000 for married taxpayers filing a joint return and $250,000 for all other taxpayers. These amounts are indexed for inflation after 2018 (to $518,000 and $259,000, respectively, in 2020). Excess business losses are carried forward to the next succeeding taxable year and treated as a net operating loss in that year.

The CARES Act defers the effective date of Section 461(l) for three years, but also makes important technical corrections that will become effective when the limitation on excess business losses once again becomes applicable. Accordingly, net business losses from 2018, 2019, or 2020 may offset other sources of income, provided they are not otherwise limited by other provisions that remain in the Code. Beginning in 2021, the application of this limitation is clarified with respect to the treatment of wages and related deductions from employment, coordination with deductions under Section 172 (for net operating losses) or Section 199A (relating to qualified business income), and the treatment of business capital gains and losses.

Section 163(j) amended for taxable years beginning in 2019 and 2020
The CARES Act amends Section 163(j) solely for taxable years beginning in 2019 and 2020. With the exception of partnerships, and solely for taxable years beginning in 2019 and 2020, taxpayers may deduct business interest expense up to 50% of their adjusted taxable income (ATI), an increase from 30% of ATI under the TCJA, unless an election is made to use the lower limitation for any taxable year. Additionally, for any taxable year beginning in 2020, the taxpayer may elect to use its 2019 ATI for purposes of computing its 2020 Section 163(j) limitation. 

This will benefit taxpayers who may be facing reduced 2020 earnings as a result of the business implications of COVID-19. As such, taxpayers should be mindful of elections on their 2019 return that could impact their 2019 and 2020 business interest expense deduction. With respect to partnerships, the increased Section 163(j) limit from 30% to 50% of ATI only applies to taxable years beginning in 2020. However, in the case of any excess business interest expense allocated from a partnership for any taxable year beginning in 2019, 50% of such excess business interest expense is treated as not subject to the Section 163(j) limitation and is fully deductible by the partner in 2020. The remaining 50% of such excess business interest expense shall be subject to the limitations in the same manner as any other excess business interest expense so allocated. Each partner has the ability, under regulations to be prescribed by Treasury, to elect to have this special rule not applied. No rules are provided for application of this rule in the context of tiered partnership structures.

Net operating losses carryback allowed for taxable years beginning in 2018 and before 2021
The CARES Act provides for an elective five-year carryback of net operating losses (NOLs) generated in taxable years beginning after December 31, 2017, and before January 1, 2021. Taxpayers may elect to relinquish the entire five-year carryback period with respect to a particular year’s NOL, with the election being irrevocable once made. In addition, the 80% limitation on NOL deductions arising in taxable years beginning after December 31, 2017, has temporarily been pushed to taxable years beginning after December 31, 2020. 

Several ambiguities in the application of Section 172 arising as a result of drafting errors in the Tax Cuts and Jobs Act have also been corrected. As certain benefits (i.e., charitable contributions, Section 250 “GILTI” deductions, etc.) may be impacted by an adjustment to taxable income, and therefore reduce the effective value of any NOL deduction, taxpayers will have to determine whether to elect to forego the carryback. Moreover, the bill provides for two special rules for NOL carrybacks to years in which the taxpayer included income from its foreign subsidiaries under Section 965. Please consider the impact of this interaction with your international tax advisors. 

However, given the potential offset to income taxed under a 35% federal rate, and the uncertainty regarding the long-term impact of the COVID-19 crisis on future earnings, it seems likely that most companies will take advantage of the revisions. This is a technical point, but while the highest average federal rate was 35% before 2018, the highest marginal tax rate was 38.333% for taxable amounts between $15 million and $18.33 million. This was put in place as part of our progressive tax system to eliminate earlier benefits of the 34% tax rate. Companies may wish to revisit their tax accounting methodologies to defer income and accelerate deductions in order to maximize their current year losses to increase their NOL carrybacks to earlier years.

Alternative minimum tax credit refunds
The CARES Act allows the refundable alternative minimum tax credit to be completely refunded for taxable years beginning after December 31, 2018, or by election, taxable years beginning after December 31, 2017. Under the Tax Cuts and Jobs Act, the credit was refundable over a series of years with the remainder recoverable in 2021.

Technical correction to qualified improvement property
The CARES Act contains a technical correction to a drafting error in the Tax Cuts and Jobs Act that required qualified improvement property (QIP) to be depreciated over 39 years, rendering such property ineligible for bonus depreciation. With the technical correction applying retroactively to 2018, QIP is now 15-year property and eligible for 100% bonus depreciation. This will provide immediate current cash flow benefits and relief to taxpayers, especially those in the retail, restaurant, and hospitality industries. Taxpayers that placed QIP into service in 2019 can claim 100% bonus depreciation prospectively on their 2019 return and should consider whether they can file Form 4464 to quickly recover overpayments of 2019 estimated taxes. Taxpayers that placed QIP in service in 2018 and that filed their 2018 federal income tax return treating the assets as bonus-ineligible 39-year property should consider amending that return to treat such assets as bonus-eligible. For C corporations, in particular, claiming the bonus depreciation on an amended return can potentially generate NOLs that can be carried back five years under the new NOL provisions of the CARES Act to taxable years before 2018 when the tax rates were 35%, even though the carryback losses were generated in years when the tax rate was 21%. With the taxable income limit under Section 172(a) being removed, an NOL can fully offset income to generate the maximum cash refund for taxpayers that need immediate cash. Alternatively, in lieu of amending the 2018 return, taxpayers may file an automatic Form 3115, Application for Change in Accounting Method, with the 2019 return to take advantage of the new favorable treatment and claim the missed depreciation as a favorable Section 481(a) adjustment.

Effects of the CARES Act at the state and local levels
As with the Tax Cuts and Jobs Act, the tax implications of the CARES Act at the state level first depends on whether a state is a “rolling” Internal Revenue Code (IRC) conformity state or follows “fixed-date” conformity. For example, with respect to the modifications to Section 163(j), rolling states will automatically conform, unless they specifically decouple (but separate state ATI calculations will still be necessary). However, fixed-date conformity states will have to update their conformity dates to conform to the Section 163(j) modifications. 

A number of states have already updated during their current legislative sessions (e.g., Idaho, Indiana, Maine, Virginia, and West Virginia). Nonetheless, even if a state has updated, the effective date of the update may not apply to changes to the IRC enacted after January 1, 2020 (e.g., Arizona). 

A number of other states have either expressly decoupled from Section 163(j) or conform to an earlier version and will not follow the CARES Act changes (e.g., California, Connecticut, Georgia, Missouri, South Carolina, Tennessee (starting in 2020), Wisconsin). Similar considerations will apply to the NOL modifications for states that adopted the 80% limitation, and most states do not allow carrybacks. Likewise, in fixed-dated conformity states that do not update, the Section 461(l) limitation will still apply resulting in a separate state NOL for those states. 

These conformity questions add another layer of complexity to applying the tax provisions of the CARES Act at the state level. Further, once the COVID-19 crisis is past, rolling IRC conformity states must be monitored, as these states could decouple from these CARES Act provisions for purposes of state revenue.

2020 recovery refund checks for individuals
The CARES Act provides eligible individuals with a refund check equal to $1,200 ($2,400 for joint filers) plus $500 per qualifying child. The refund begins to phase out if the individual’s adjusted gross income (AGI) exceeds $75,000 ($150,000 for joint filers and $112,500 for head of household filers). The credit is completely phased out for individuals with no qualifying children if their AGI exceeds $99,000 ($198,000 for joint filers and $136,500 for head of household filers).

Eligible individuals do not include nonresident aliens, individuals who may be claimed as a dependent on another person’s return, estates, or trusts. Eligible individuals and qualifying children must all have a valid social security number. For married taxpayers who filed jointly with their most recent tax filings (2018 or 2019) but will file separately in 2020, each spouse will be deemed to have received one half of the credit.

A qualifying child (i) is a child, stepchild, eligible foster child, brother, sister, stepbrother, or stepsister, or a descendent of any of them, (ii) under age 17, (iii) who has not provided more than half of their own support, (iv) who has lived with the taxpayer for more than half of the year, and (v) who has not filed a joint return (other than only for a claim for refund) with the individual’s spouse for the taxable year beginning in the calendar year in which the taxable year of the taxpayer begins.

The refund is determined based on the taxpayer’s 2020 income tax return but is advanced to taxpayers based on their 2018 or 2019 tax return, as appropriate. If an eligible individual’s 2020 income is higher than the 2018 or 2019 income used to determine the rebate payment, the eligible individual will not be required to pay back any excess rebate. However, if the eligible individual’s 2020 income is lower than the 2018 or 2019 income used to determine the rebate payment such that the individual should have received a larger rebate, the eligible individual will be able to claim an additional credit generally equal to the difference of what was refunded and any additional eligible amount when they file their 2020 income tax return.

Individuals who have not filed a tax return in 2018 or 2019 may still receive an automatic advance based on their social security benefit statements (Form SSA-1099) or social security equivalent benefit statement (Form RRB-1099). Other individuals may be required to file a return to receive any benefits.

The CARES Act provides that the IRS will make automatic payments to individuals who have previously filed their income tax returns electronically, using direct deposit banking information provided on a return any time after January 1, 2018.

Charitable contributions

  • Above-the-line deductions: Under the CARES Act, an eligible individual may take a qualified charitable contribution deduction of up to $300 against their AGI in 2020. An eligible individual is any individual taxpayer who does not elect to itemize his or her deductions. A qualified charitable contribution is a charitable contribution (i) made in cash, (ii) for which a charitable contribution deduction is otherwise allowed, and (iii) that is made to certain publicly supported charities.

    This above-the-line charitable deduction may not be used to make contributions to a non-operating private foundation or to a donor advised fund.
  • Modification of limitations on cash contributions: Currently, individuals who make cash contributions to publicly supported charities are permitted a charitable contribution deduction of up to 60% of their AGI. Any such contributions in excess of the 60% AGI limitation may be carried forward as a charitable contribution in each of the five succeeding years.

    The CARES Act temporarily suspends the AGI limitation for qualifying cash contributions, instead permitting individual taxpayers to take a charitable contribution deduction for qualifying cash contributions made in 2020 to the extent such contributions do not exceed the excess of the individual’s contribution base over the amount of all other charitable contributions allowed as a deduction for the contribution year. Any excess is carried forward as a charitable contribution in each of the succeeding five years. Taxpayers wishing to take advantage of this provision must make an affirmative election on their 2020 income tax return.

    This provision is useful to taxpayers who elect to itemize their deductions in 2020 and make cash contributions to certain public charities. As with the aforementioned above-the-line deduction, contributions to non-operating private foundations or donor advised funds are not eligible.

    For corporations, the CARES Act temporarily increases the limitation on the deductibility of cash charitable contributions during 2020 from 10% to 25% of the taxpayer’s taxable income. The CARES Act also increases the limitation on deductions for contributions of food inventory from 15% to 25%.

We are here to help
Please contact a BerryDunn professional if you have any questions, or would like to discuss your specific situation.

Related Professionals

Focus: Disaster Loan Program and Paycheck Protection Program (PPP)

Background

The Coronavirus Aid, Relief and Economic Security (CARES) Act will provide $562 million to cover administrative expenses and program subsidy for the US Small Business Administration (SBA) Economic Injury Disaster Loans and small business programs. 

Additionally, the CARES Act specifically provides the authorization for $349 billion for the SBA 7(a) program through December 31, 2020. 

SBA disaster loan program (updated for CARES Act) highlights


General
The US Small Business Administration is offering designated states and territories low-interest federal disaster loans for working capital to small businesses suffering substantial economic injury as a result of the coronavirus and COVID-19.

Eligibility 
Industry may be subject to different standards, but the general rule of thumb is that the SBA defines most small businesses as having less than 500 people, both calculated on a standalone basis and together with its affiliates (see PPP below for more information). A company’s average annual sales may also be used for the small business designation. 

Historically, businesses that are not eligible for this program included casinos, charitable organizations, religious organizations, agricultural enterprises and real estate developers that are primarily involved in subdividing real property into lots and developing it for resale for themselves (other real estate entities may apply, such as landlords). 

However, the CARES Act expanded eligibility to include (i) any individual operating as a sole proprietor or independent contractor; (ii) private non-profits and (iii) Tribal businesses, cooperatives and ESOPs with fewer than 500 employees during January 31, 2020 to December 31, 2020.

If the entity has bad credit or has defaulted on a prior SBA loan, the entity is not eligible. The CARES Act removed the credit elsewhere requirement (i.e., previously if the business had credit available through another source, such as a line of credit, it was ineligible). 

Basic terms

  • Loan amount
    The lesser of $2 million or an amount determined that that borrower can repay (i.e., underwriting requirement).
  • Maximum term
    Up to 30 years and all payments on these loans will be deferred for 12 months from disbursement date. Interest will accrue.
  • Interest rate
    3.75% for for-profit business and 2.75% for a non-profit entity.
  • Collateral
    Loans for under $25,000 do not require collateral.  Any person with an interest in the company worth 20% or more must be a guarantor; however the CARES Act eliminates the guaranty requirement on advances and loans under $200,000. 
  • Use of proceeds
    Loan proceeds may be used to pay fixed debts (including short-term notes and balloon payments that are due within the next 12 months), payroll, accounts payable, and other bills the borrower would have to pay that but for the disaster would have been paid, such as mortgage payments. Landlords and other passive entities are eligible. Agriculture-related entities are eligible, but farmers are not. Borrowers must maintain proof of how the loan proceeds were used for three years from the date of disbursement. Borrowers cannot use the proceeds to expand their business, buy assets, make repairs to real estate or refinance long-term debt. 
  • Forgiveness
    No forgiveness provision.

Applying
Loan applications are available here

Length of time for funding
Upon submittal of a completed application, it can take 18-21 days to be approved and another four to five business days for funding. However, the SBA has never dealt with this much volume so expect delays.  

If funding is needed immediately, contact any SBA partnering non-profit lender and request an SBA microloan up to $50,000 or contact a commercial lending partner to see if they offer SBA express loans up to $1,000,000 (CARES Act increases this from $350,000 to $1,000,000) and/or SBA 7(a) loans up to $5 million. The 7(a) loans are typically processed within 30 days, while microloans and express loans are processed even more quickly. 

The CARES Act has also established an emergency grant to allow eligible entities who have applied for a disaster loan because of COVID-19 to request an advance of up to $10,000 on that loan. The SBA is to distribute the advance within three days. 

This advance does not need to be repaid, even if the applicant is denied a Disaster Loan. ($10,000,000,000 is appropriated for this program and funds will be distributed on a first come, first served basis). An applicant must self-certify that it is an eligible entity prior to receiving such an advance. Advances may be used for providing sick leave to employees, maintaining payroll, meeting increased costs to obtain materials, rent or mortgage payments, and payment of business obligations that cannot be paid due to loss of revenues. Applicants must apply directly with the SBA for this program.

Other considerations
Each company should review any current loan obligations and confirm that it does not include a provision forbidding that applicant from acquiring additional debt. If the document does, the applicant will want to discuss a waiver of that provision with its current lender. The lender should be amenable to this waiver and the applicant will want the waiver verified in writing. The lender should be amenable because the SBA disaster loan can be used to satisfy monthly debt obligations and any collateral taken by the SBA would be subordinate, if the same collateral secures the lender’s loan.

Under the CARES Act, Congress has also directed the SBA to use funds to make principal and interest payments, along with associated fees that may be owed on an existing SBA 7(a), 504 or micro-loan program covered loan, for a period of six months from the next payment due date. Any loan that may currently be on deferment will receive the six months of covered payments once the deferral period has ended. This provision will also cover loans that are made up to six months after the enactment of the CARES Act. If the loan maturity date conflicts with benefiting from this amendment, the lender can extend the maturity date of the loan. 

Newly enacted Paycheck Protection Program (PPP)


General
This new program will be offered with a 100% SBA guaranty through December 31, 2020, to lenders, after which the guaranty percentage will return to 75% for loans above $150,000 and 85% for loans below that amount. 

Eligibility 
A business, including a qualifying nonprofit organization, that was in operation on February 15, 2020, and either had employees for whom it paid salaries and payroll taxes or paid independent contractors, is eligible for PPP loans if it (a) meets the applicable North American Industry Classification System (NAICS) Code-based size standard or other applicable 7(a) loan size standard, both alone and together with its affiliates; or (b) has an employee headcount that is lower than the greater of (i) 500 employees or (ii) the employee size standard, if any, under the applicable NAICS Code. 

Businesses that fall within NAICS Code 72, which applies to accommodations and food services, are also eligible if they employ no more than 500 people per physical location. Sole proprietorships, independent contractors, and self-employed individuals are also eligible. It is unclear as of what date the size test will be applied, but historically, SBA size tests have been applied on the date of application for financing. More information on the NAICS-Code-based size standards can be found here

Borrowers are required to provide a good faith certification that the loan is necessary due to economic conditions brought about because of COVID-19 and that the borrower will use the funds to retain workers, maintain payroll and pay utilities, lease and/or mortgage payments.

The credit elsewhere test is waived under this program. 

Lenders shall base their underwriting on whether a business was operational on February 15, 2020, and had employees for whom it was responsible for or paid for services from an independent contractor. The legislation has directed lenders not to base their determinations on repayment ability at the present time because of the effects of COVID-19.

Applicants for SBA loan programs, including PPP loans, typically must include their affiliates when applying size tests to determine eligibility. That means that employees of other businesses under common control would count toward the maximum number of permitted employees. A business that is controlled by a private equity sponsor would likely be deemed an affiliate of the other businesses controlled by that sponsor and could thus be ineligible for PPP loans. However, the CARES Act waives the affiliation requirement for the following applicants:  

  1. Businesses within NAICS Code 72 with no more than 500 employees
  2. Franchises with codes assigned by the SBA, as reflected on the SBA franchise registry
  3. Businesses that receive financial assistance from one or more small business investment companies (SBIC) 

Basic terms

  • Loan amount
    Lesser of $10 million or 2.5 times the applicant’s average monthly payroll costs of the business over the year prior to the making of the loan (practically, this may become the year prior to the loan application), excluding the prorated portion of any annual compensation above $100,000 for any person. Note that under the CARES Act, “payroll costs” include vacation, parental, family, medical, and sick leave; allowances for dismissal or separation; payments for group health care benefits, including insurance premiums; and retirement benefits. Calculations vary slightly for seasonal businesses and businesses that were not in operation between February 15 and June 30, 2019. To the extent that a SBA Disaster Loan was used for a purpose other than those permitted for PPP Loans, the Disaster Loans may be refinanced with proceeds of PPP loans, in which case the maximum available PPP loan amount is increased by the amount of the Disaster Loans being refinanced. 
  • Maximum term
    Payments will be deferred for a minimum of 6 months and a maximum of 12. SBA is directed to issue guidance on the terms of this deferral. Any portion of the PPP loan that is not forgiven (see below) on or before December 31, 2020, shall automatically be a term loan for a maximum of 10 years. For PPP loans, the SBA has waived prepayment penalties.
  • Fees
    SBA will waive the guaranty fee and annual fee applicable to other 7(a) loans. 
  • Interest rate
    Maximum rate of 4%.
  • Collateral
    The standard requirements of collateral and a personal guaranty are waived under this program. Accordingly, there will be no recourse to owners or borrowers for nonpayment, except to the extent proceeds are used for an unauthorized purpose.
  • Use of proceeds
    This loan can be used for: (i) payroll support, excluding the prorated portion of any compensation above $100,000 per year for any person; (ii) group healthcare benefits costs and insurance premiums; (iii) mortgage interest (but not prepayments or principal payments) and rent payments incurred in the ordinary course of business, and (iv) utility payments. 
  • Forgiveness
    A borrower will be eligible for loan forgiveness related to a PPP loan in an amount equal to 8 weeks of payroll costs, and the interest on mortgage payments (not principal) made in the ordinary course of business, rent payments, or utility payments so long as all payments were obligations of the borrower prior to February 15, 2020. Payroll costs are limited to compensation for a single employee to be no more than $100,000 in wages and the amount of forgiveness cannot exceed the principal loan amount. 

    The amount of loan forgiveness will be reduced proportionally by any reduction in the borrower’s workforce, based on the full-time equivalent employees versus the period from either February 15, 2019, through June 30, 2019, or January 1, 2020, through February 29, 2020, as selected by the borrower, or a reduction of more than 25% of any employee’s compensation, measured against the most recent full quarter. If a borrower has already had to lay off employees due to COVID-19, employers are encouraged to rehire them by not being penalized for having a reduced payroll at the beginning of the covered period, which means the initial 8 week period after the loan’s origination date. 

    Accordingly, reductions in the number of employees or compensation occurring between February 15, 2020, and 30 days after enactment of the CARES Act will generally be ignored to the extent reversed by June 30, 2020. Any additional wages that may be paid to tipped workers are also covered in the calculation of payroll forgiveness. Borrowers must keep accurate records and document their payments because lenders will need to verify the payments to allow for loan forgiveness. Borrowers will not have to include any forgiven indebtedness as taxable income. 

Applying
A company needs to apply on or before June 30, 2020, with a lender who is currently approved as a 7(a) lender or who is approved by the SBA and the Treasury Department to become a PPP lender. PPP lenders have delegated authority to make and approve PPP loan, with no additional SBA approval required. 

There are certain portions of the CARES Act that require SBA to provide further guidance so there may be some slight changes to the rules and procedures as best practices present themselves. 

We recommend contacting existing 7(a) lenders as soon as possible to learn what you will need to provide for underwriting and approving a PPP loan. 

We are here to help
Please contact a BerryDunn professional if you have any questions, or would like to discuss your specific situation.

Article
Impact of CARES Act on SBA loans

The recent Tax Cuts and Jobs Act includes many sweeping tax law changes, some of which left taxpayers scrambling at the end of 2017 to maximize tax saving opportunities. While the dust settles on tax reform at the federal level, the whirlwind at the state level is just beginning, with many unanswered questions. We’ve pulled together a look at key changes in place or under consideration in a number of states.

One change in particular, the limitation on the individual itemized deduction for state and local taxes, resulted in many making a mad dash to prepay local property taxes.

Prior to the act, itemizing taxpayers could deduct certain state and local taxes, including property taxes, income or sales taxes (but not both), and other personal property taxes. The new act limits the state and local property tax deduction to $10,000. The increase in the standard deduction makes this irrelevant for many taxpayers, who will no longer itemize deductions due to the higher standard deduction. However, this limitation means more to higher-income taxpayers, especially those living in high-tax states. Many of these states are considering strategies to preserve the deduction for high-income residents.

The California approach

One strategy under consideration by states (including California, Illinois, and New Jersey), is to convert state and local tax expense, limited to $10,000, into deductible charitable contributions. Some proposals involve creating a state fund for public purposes that would allow income tax credits for taxpayers’ fund contributions. In New Jersey, the state senate voted to advance a bill that would allow local municipalities to set up charitable funds to which residents could donate their property taxes. While this may seem like a great solution, it seems unlikely taxpayers achieve the intended result.

Established case law and guidance indicate the portion of a charitable contribution for which a benefit is received is not deductible. The very intent of this strategy is to create a federal benefit to the taxpayer. The taxpayer’s state cash outflow would be neutral, and a federal benefit received in excess of any cost. It appears likely the IRS would find there is no net deductible charitable contribution, and given the revenue neutrality for the state, would see it as a tax.

The New York approach

Other states, including New York, have considered creating a new employer-side payroll tax, or otherwise shifting from an employee paid tax system to an employer paid tax system. This may be more viable than the charitable contribution strategy, but isn’t without its own hurdles. There is a risk that this just shifts tax burden, with the employer paying the employee’s income taxes (which in itself constitutes taxable income).

States with graduated tax rates would face a challenging task of addressing how to administratively apply this concept to a payroll tax. If successful, businesses would have increased employment costs, unless they can reduce salaries to offset the increase. The practical challenges present additional obstacles for success, in terms of employee morale, minimum wage issues, or other legal considerations. Even clearing the hurdles only addresses the issue as it relates to wage income, with other sources of income left behind.

This is less concerning in states with lower or no individual income taxes. These states often rely more heavily on sales taxes or entity level business taxes for revenue. While it is a much larger change for states to implement, there may now be more incentive for states to consider their own tax reform strategies.

How states address the additional burden placed on its residents, especially those in high tax jurisdictions, is only one. Many states' tax codes piggyback off of the federal rules, and states will have to consider how, or if they will conform to the federal changes, and to what degree. Until they address these issues, taxpayer uncertainty remains. If you have questions about the new law and how it affects your business, please contact me


 

Article
Going stateside: Tax reform

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.  
 

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The presidential election: two different approaches to energy

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.

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New permissible minimum service requirements for 401(k) plans

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).

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Discounts for lack of control and marketability in business valuations (Part II)