• The Tax Court’s decision in Denham Capital Management LP v. Commissioner confirms that limited partner status under state law doesn’t automatically exempt partners from self-employment (SECA) tax if they’re actively involved in the partnership’s business.

• The ruling emphasizes a functional analysis based on the facts and circumstances of each partner’s involvement, reinforcing the precedent set in Soroban Capital Partners.

• Fund managers must reassess their partners’ roles and compensation structures to make sure they’re compliant with SECA tax rules, especially when partners are materially participating in the business.

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On December 23, 2024, the Tax Court held, in Denham Capital Management LP v. Commissioner, that active limited partners in an investment management company formed as a limited partnership were subject to self-employment (SECA) tax and not entitled to the statutory exemption for limited partners.  

The Tax Court previously decided in Soroban Capital Partners LP v. Commissioner, consistent with the IRS’s position, that the determination of limited partner status is a “facts and circumstances inquiry” that requires a “functional analysis.”  However, the Denham case is the first in which the Tax Court has applied the functional analysis of whether a state law limited partner was, in fact, active in the business of the partnership and a “limited partner” in name only. The key issue in the Denham Case, as in Soroban, was whether limited partners in state law limited partnerships may claim exemption from SECA taxes – despite being more than passive investors.  

Application of Functional Analysis in Denham 

Denham Capital Management was organized as a limited partnership under Delaware law and offered investment advisory and management services to private equity funds. As the court addressed the functional analysis, it reaffirmed that determinations of eligibility for the exemption under Section 1402(a)(13) require a factual inquiry into how the partnership generated the income in question and the partners’ roles and responsibilities in doing so. 

The court noted that, in the years at issue, Denham’s income consisted solely of fees received in exchange for services provided to investors, including advising and operating private investment funds. The court found the partners’ time, skills, and judgment to be essential to the provision of these services. It found unconvincing claims that Denham’s income – largely distributed to the partners as profits – were returns on investments, when only one of the partners had made a capital contribution to obtain their interest. 

Moreover, the court stated that all the partners, except for one that had made a capital contribution, were required to “devote substantially all of [their] business time and attention to the affairs of the partnership and its affiliates.” The court determined that the partners treated their roles in Denham as their full-time employment, with each participating in management and playing crucial roles in the business. 

Other relevant facts cited by the court included: 

• Fund marketing materials made clear that the partners had a significant role in Denham’s operation. 

• The partners’ expertise and judgment were a significant draw for fund investors, who could withdraw their investments if certain partners no longer participated. 

• Investment decisions for the funds were made by that fund’s investment and valuation committees, which included the partners. 

• The partners each exercised significant control over personnel decisions. 

• A sizable number of Denham employees received total compensation exceeding the partners’ guaranteed payments, suggesting such payments were not designed to adequately compensate the partners for their services. 

Concluding that “[i]ndividuals that serve roles as integral to their partnerships as those the [p]artners served for Denham cannot be said to be merely passive investors,” the court held that the partners were not “limited partners, as such” under Section 1402(a)(13) and the partners’ distributive shares were ineligible for the SECA tax exemption for limited partners. 

Takeaways for Fund Managers 

This is another big win for the government. Similar to the Tax Court’s ruling in Soroban Capital Partners LP v. Commissioner, the Tax Court in Denham required a functional analysis centered around the roles and activities of the individual partners. In Denham, the Tax Court detailed the various activities of the partners to show that they were active participants in the business of Denham and were not merely passive investors receiving a return on their capital. 

Primarily, it is important to note that, as in Soroban, the Tax Court denied the argument that the partners were eligible for the SECA tax exemption under Section 1402(a)(13) merely because they were limited partners in a state law limited partnership, making it clear that federal law and not state law prescribes the classification of individuals and organizations for federal tax purposes.  

In accordance with the Tax Court’s decisions in Soroban, Denham, and previous cases, fund managers and their tax advisers should be determining whether a partner, including a limited partner in a state law limited partnership, is subject to SECA tax by evaluating the activities of the partner using a functional analysis similar to the Tax Court’s analysis in Denham. Fund managers should also consider the guidance provided for in 1997 Proposed Reg. §1.1402(a)-2(h), which is instructive despite never being finalized. Pursuant to this guidance, an individual is considered a limited partner unless the individual: 

• Has personal liability for the debts of or claims against the partnership by reason of being a partner; 

• Has authority (under the law of the jurisdiction in which the partnership is formed) to contract on behalf of the partnership; or 

• Participates in the partnership’s trade or business for more than 500 hours during the partnership’s taxable year. 

It is still possible that the taxpayer in Denham will file an appeal. BDO will continue to monitor developments in this and similar cases. 

How MGO can help  

At MGO, our tax professionals work closely with fund managers, general partners, and their advisors to navigate the ever-evolving landscape of partnership taxation and self-employment tax exposure. We provide tailored analyses to evaluate the roles of individual partners, assess the applicability of SECA tax exemptions, and align partnership structures with federal tax requirements.

Leveraging our deep experience in private equity and fund advisory, we help our clients proactively address their compliance risks, prepare for potential IRS scrutiny, and implement tax strategies that align with both your business goals and your current legal interpretations. Contact us to learn how. 

Written by Joe Pacello and Julie Robins. Copyright © 2025 BDO USA, P.C. All rights reserved. www.bdo.com 

The post Tax Court Denies Fund Manager’s Claim of Exemption from Self-Employment Tax  appeared first on MGO CPA | Tax, Audit, and Consulting Services.

• The Treasury and IRS released proposed corporate alternative minimum tax (CAMT) regulations, finalized procedural rules for the 1% stock repurchase excise tax, and provided penalty waivers for certain CAMT underpayments.

• Recent rulings clarify how related-party advances, share surrenders, and S corporation transactions are treated, particularly affecting debt/equity characterization.

• An IRS private letter ruling confirms that contractual arrangements granting beneficial ownership of a professional corporation’s stock can trigger consolidation, underscoring economic substance over legal title.

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During 2024, the U.S. Department of the Treasury and the IRS issued important tax guidance for U.S. corporations — including long-awaited proposed regulations on the corporate alternative minimum tax and final procedural regulations on the stock repurchase excise tax.

Corporate Alternative Minimum Tax Guidance Includes Detailed Proposed Regulations

The Inflation Reduction Act of 2022 (IRA) created a new corporate alternative minimum tax (CAMT) for taxable years beginning after December 31, 2022. Since being signed into law, the U.S. Department of the Treasury and the Internal Revenue Service have released multiple pieces of guidance culminating in proposed regulations.

Taxpayers may generally rely on the notices above from their publication date to the publication of the proposed regulations discussed below.

In the above-mentioned guidance, the Service released Form 4626, Alternative Minimum Tax—Corporations and accompanying instructions for corporate taxpayers to report their applicable corporation calculations and CAMT liability. In addition, Schedule K to Form 1120, U.S. Corporation Income Tax Return, was modified to add Line 29 relating to CAMT.

Proposed Regulations

The proposed regulations conform to many aspects of the prior notices but expand on the interim guidance in noteworthy ways, some of which are described below. The length and detail of the proposed regulations highlight the technical complexity of administering and complying with the CAMT regime.

Effective Dates

The proposed regulations are prospective in nature. In general, the proposed regulations apply to tax years and transfers ending or occurring, respectively, after September 13, 2024 (i.e., the date the proposed regulations were published in the Federal Register). However, certain aspects of the proposed regulations have different effective dates tied to the date the final regulations are published in the Federal Register, or to the period between September 13, 2024, and the date the final regulations are published in the Federal Register.

Taxpayers may rely on the proposed regulations, subject to a consistency requirement.

Safe Harbor

Notice 2023-7 contained a safe harbor that allowed a taxpayer to use a simplified method with fewer adjustments to calculate its AFSI for purposes of determining its applicable corporation status, which dictates whether the corporation is subject to the CAMT regime. The safe harbor reduced the threshold AFSI needed to be an applicable corporation from $1 billion to $500 million (and from $100 million to $50 million for the U.S.-specific prong of the foreign-parented multinational group test). The original safe harbor was only available for the first taxable year beginning after December 31, 2022.

The proposed regulations contain a slightly modified version of the $500 million (or $50 million) safe harbor that is available for years not covered by the original safe harbor.

Other Noteworthy Areas

The following are key areas in which the proposed regulations provide new or more detailed guidance:

• Calculating a corporate partner’s distributive share of partnership AFSI

• Creating deemed foreign-parented multinational groups when there is a non-corporate parent

• Addressing purchase accounting and other AFSI impacts resulting from M&A transactions

• Adjusting AFSI for financial statement loss carryforwards

• Allowing corporations to cease being applicable corporations

• Providing relief for bankruptcy or insolvency transactions

Penalty Waiver: Notice 2024-66

In addition to the proposed regulations, the Service issued Notice 2024-66, which provides a waiver for additional taxes imposed on a corporation that fails to make estimated tax payments related to its CAMT liability for tax years beginning after December 31, 2023, and before January 1, 2025.

As with the previous waivers, this waiver only covers taxes imposed under Section 6655 and does not waive additional taxes for underpayments under other Code Sections, such as Section 6651, which imposes additional tax for payments not made by the due date of the corporation’s return (without extension).

The proposed CAMT regulations are substantial in detail, technical complexity, and length, and include guidance on many areas applicable to M&A transactions. For example, the proposed regulations address certain effects of M&A transactions on the calculation of AFSI. The proposed regulations also significantly increase the scope of the definition of a foreign-parented multinational group to include some common investment structures. Taxpayers should carefully review the potential impact of the proposed regulations when engaging in M&A transactions and restructurings.

IRS, Treasury Issue Final Procedural Regulations on Stock Repurchase Excise Tax

Under the new corporate excise tax, a 1% corporate-level tax is imposed on net stock repurchases occurring after December 31, 2022. The excise tax applies to “covered corporations,” which are generally publicly traded domestic corporations, with certain foreign-owned domestic structures being included as well.

The excise tax was enacted as part of the Inflation Reduction Act of 2022, and the Service provided interim guidance in the form of Notice 2023-2 in December 2022. In April 2024, Treasury released proposed regulations incorporating the operating rules set forth in the notice, proposing additional guidance on foreign stock acquisitions, and responding to feedback received with respect to the notice. Separately but on the same day, Treasury also released proposed procedural regulations that articulate how to report and pay the excise tax.

Specifically for the procedural regulations, the Department of the Treasury and the IRS released final regulations on June 28, 2024. The final regulations largely adopt the proposed regulations. For taxable years ending on or before June 28, 2024, stock repurchase excise tax returns were required to be filed by October 31, 2024 (the due date for Form 720 for the third quarter of calendar year 2024). If a covered corporation has more than one taxable year ending after December 31, 2022, and on or before June 28, 2024, it should file a single Form 720 with a separate Form 7208 attached for each year.

Consistent with the proposed regulations, future stock repurchase excise tax returns must be filed by the due date of Form 720 for the first full calendar quarter after the end of the taxable year of the covered corporation. For example, a covered corporation with a tax year ending on December 31, 2024, must file its return by April 30, 2025 (the due date for a first-quarter Form 720).

Taxpayers should be aware that in certain leveraged transactions — those involving third-party debt — there may be ambiguity in the application of the excise tax depending on the nature of the funding and the obligors on the facility. Any transactions involving exchanges of public company stock should consider these rules and their impact on structuring.

Tax Court Rules for Taxpayer on Related-Party Advances

In Estate of Thomas H. Fry v. Commissioner of Internal Revenue, TC Memo 2024-8 (2024), the Tax Court held Section 385(c), which generally binds a taxpayer to its initial characterization of an investment as either debt or equity, did not apply to cash advances where no formal instruments had been issued. This case may have implications for corporations with undocumented related party advances.

Determining Debt or Equity Treatment for Tax Purposes

Determining whether an interest in a corporation is debt or equity is a fact-intensive inquiry. Courts have traditionally applied multi-factor tests that look at the intent and relationship of the parties, the financial condition of the corporation, and each party’s legal and economic rights. As these factors are weighted in each case, and the form or name of the instrument is not necessarily determinative of its treatment, taxpayers face uncertainty as to whether the IRS will agree with their chosen characterization.

In addition, Section 385(c) binds taxpayers to their characterization of an interest in a corporation once a position is taken. The IRS, on the other hand, is not bound by the taxpayer’s characterization and has the ability to reclassify an instrument from debt to equity, and vice versa. As a result, taxpayers should perform a detailed assessment to determine the correct treatment before reporting a position on a return. In practice, however, this does not always occur, and later discovery that an instrument’s treatment may be questionable often results in taxpayers’ performing this assessment after the fact, thereby potentially triggering the application of the Section 385(c) rules.

Estate of Fry v. Commissioner

Mr. Fry was the sole shareholder of two S corporations, Crown and CR Maintenance. CR Maintenance encountered financial difficulties, and Crown provided financial assistance that allowed CR Maintenance to continue operations. In particular, Crown transferred money directly to CR Maintenance and paid bills on CR Maintenance’s behalf. The amounts were accounted for as loans on both parties’ general ledgers and tax returns but were not otherwise documented. CR Maintenance did not claim interest deductions and Crown did not report interest income related to the amounts.

In a dispute concerning Mr. Fry’s basis in his CR Maintenance stock, Mr. Fry argued that these transactions should not be considered debt but, instead, should be treated as constructive equity contributions and distributions. The Service disagreed with Mr. Fry, asserting that Section 385(c) precluded him from recharacterizing the transactions as equity contributions.

Tax Court Holdings

In its memorandum opinion, the Tax Court held that Section 385(c) did not apply in this case because there was “no formal issuance of any instrument evidencing the creation of an interest in stock or equity.” In addition, the Tax Court suggested that Section 385 might not apply to S corporations based on the exclusion of S corporations from the regulations promulgated under Section 385(a) in 2016.

The court further held that the transfers and payments more likely than not failed to constitute debt based on an analysis using traditional debt-equity factors. The court then determined that the transfers and payments primarily benefited Mr. Fry and, as a result, held they should be considered deemed distributions to Mr. Fry and subsequent contributions to CR Maintenance.

Estate of Fry appears to limit the application of Section 385(c) where no formal notes or stock instruments are issued. However, the broader implications of the ruling and its reasoning are unclear. In non-precedential guidance, the Service has inconsistently applied Section 385(c) in circumstances where the issuer reports an instrument on its tax return differently from the label given to the legal documents.

The Service has also indicated that Section 385(c)(1) precludes a taxpayer from arguing that undocumented cash transfers were equity transactions when the transfers were reported as loans on the taxpayer’s books, records, and tax return balance sheets. In Estate of Fry, however, the Tax Court appears to shed some light on what actions constitute a characterization for purposes of Section 385(c). In particular, where there has been no formal issuance of an instrument that purports to be either debt or equity, the application of Section 385(c) may be precluded.

Estate of Fry may support the proposition that related party advances are not characterized as either debt or equity for purposes of Section 385(c) unless there has been a formal issuance of an instrument that purports to be either debt or equity, even if the taxpayer has reported the transaction as debt or equity on its books, records, or tax return balance sheets. However, taxpayers are reminded that memorandum opinions are not binding on the Tax Court, although they can be used as persuasive authority.

Taxpayers should exercise caution in attempting to rely on Estate of Fry, particularly in cases that involve distinguishable fact patterns (for example, if one party to the cash transfer accrues or deducts interest on the advance), due to the lack of reasoning in support of the Tax Court’s holding regarding Section 385(c) and the limited precedential value inherent in a memorandum opinion.

IRS Rules Stock Contributions Will Not Result in Deemed Dividends or Application of Gift Tax

A shareholder may, for valid business reasons (e.g., to improve the marketability of an investment), voluntarily surrender shares to the capital of a corporation, which raises questions of how the surrender impacts the other shareholders in the corporation. In PLR 202406002, the IRS ruled that a proposed voluntary surrender of shares to the capital of a corporation will not create deemed dividend income for the noncontributing shareholders and will not result in a taxable gift to the noncontributing shareholders.

In the proposed transaction, an executive of the company and a series of trusts established by that executive will contribute a proportionate amount of their common shares to the company for no consideration. The contribution of the shares may occur in one or more installments. The company has in place a share repurchase program, but neither the executive nor the trusts have participated in the program. The share repurchase program and the proposed contribution each have separate independent business purposes.

Income Tax Rulings

Citing Commissioner v. Fink, 483 U.S. 89 (1987), the Service ruled in PLR 202406002 that the executive and the trusts will not recognize gain or loss as a result of the contribution and that the basis in the shares contributed will be preserved in the basis of the executive’s and the trusts’ respective retained shares. In addition, the Service ruled that the contribution will be a contribution to the capital of the company and, therefore, will not be taxable to the company under Internal Revenue Code (IRC) Section 118(a).

The Service also indicated that the noncontributing shareholders will not recognize income as a result of the contribution and specifically provided that the contribution will not be treated as a distribution of property to the noncontributing shareholders.

The ruling is subject to many key representations, including that:

1. There is no belief that any purchase pursuant to the share repurchase program will be taxed as a dividend to the participating shareholder or is a dividend within the meaning of IRC Sections 301 and 302.

2. The contribution is an isolated transaction.

3. The contribution is not part of a plan to periodically increase the proportionate share of any shareholder in the assets or earnings and profits of the company.

Nevertheless, the contribution will have the economic effect of increasing the noncontributing shareholders’ proportionate interest in the assets and earnings and profits of the company.

IRC Section 305(c) provides a broad rule that creates a deemed distribution of stock in certain transactions involving a corporation and its shareholder(s) (e.g., recapitalizations), which may be taxable under the general distribution rules of Section 301. By ruling that the contribution will not result in a deemed distribution to the noncontributing shareholders (likely because no deemed dividend results when a recapitalization is not undertaken pursuant to a plan to increase a shareholder’s proportionate interest in the assets or earnings and profits of the corporation), the IRS eliminated any potential taxation of the economic benefit conferred on the noncontributing shareholders under Section 305 or Section 301.

Gift Tax Rulings

The Service also ruled that gift tax will not apply to the increase in value bestowed on the noncontributing shareholders by the executive and the trusts as a result of the contribution, because the contribution is a transaction occurring in the ordinary course of business (i.e., it is undertaken for bona fide business reasons, it is an arm’s length transaction, and the executive and the trusts lack donative intent). The Service also recognized that the executive and the trusts are conferring an economic benefit on each other and between each of the trusts. However, the Service ruled that these are effectively value-for-value exchanges and, therefore, will not be subject to gift tax.

PLR 202406002 closes the loop started by Commissioner v. Fink and provides answers that avoid adding unintended tax consequences and complexity to a transaction that is usually undertaken for independent, nontax business reasons. In Fink, the Supreme Court denied a loss to a corporation’s dominant shareholder following the shareholder’s voluntary surrender of shares to the corporation, viewing the surrender as a contribution to capital. Instead, the Court held that the basis in the contributed shares must be added to the shares retained by the shareholder.

The Supreme Court case serves as authority for the shareholder’s gain or loss and basis consequences resulting from a stock surrender. The classification of the transaction as a contribution to the capital of a corporation supports the application of IRC Section 118(a) to prevent the transferee corporation from including any amount in its gross income.

With the issuance of PLR 202406002, taxpayers and practitioners now have an indication of the Service’s view of the other aspects of a stock surrender—namely, the treatment to the noncontributing shareholders. Taxpayers considering surrendering shares to the capital of a corporation should consult with their advisors regarding the application of PLR 202406002 to their facts.

Uncertainties Surround Treatment of S Corporation State Law Conversions

Comments submitted on behalf of the American Bar Association Section of Taxation (ABA tax section) in a letter dated July 2, 2024, suggest the IRS should supplement or expand its 2008 guidance on F reorganizations involving S corporations and qualified subchapter S subsidiaries (QSubs) to include consequences of an F reorganization accomplished by state law conversion to a limited liability company (LLC). The additional guidance is needed to address uncertainties in planning and other transactions commonly used by S corporations and their shareholders.

Summary of 2008 IRS Guidance

Rev. Rul. 2008-18 provides guidance on whether, in an F reorganization involving an S corporation, the historic Subchapter S election and employer identification number (EIN) continue for the reorganized (surviving) entity. The revenue ruling addresses two specific transactions, each of which meet the requirements of an F reorganization under Section 368(a)(1)(F):

The 2008 ruling concludes that under these two fact patterns, the historic S corporation election does not terminate but continues for the corporation that is the survivor of the reorganization (Newco). However, Newco must obtain a new EIN.

Uncertainties Surrounding S Corporation State Law Conversions

Rev. Rul. 2008-18 does not address the continuation of an S corporation election or EIN when the S corporation undergoes an F reorganization (with or without a QSub election made for the contributed corporation) through a state law “conversion” to an LLC. Whether a QSub election is necessary in a state law conversion is also unclear, since — assuming no entity classification election is made to treat the LLC as a regarded corporation — the surviving LLC would be disregarded under Treas. Reg. §301.7701-3. If a QSub election is required by the IRS, the election would not be valid if made after the corporation converts to an LLC.

In addition, any delay by the state in processing the conversion raises questions about whether the subsidiary loses its S corporation status in the reorganization transaction and, therefore, reverts to C corporation status for a period of time. If so, the corporation could be subject to built-in gains tax under Section 1374.

Comment Letter Recommendations

To address the uncertainties for S corporations surrounding F reorganizations accomplished by state law conversions, the ABA tax section in its comment letter recommends the IRS supplement or expand Rev. Rul. 2008-18 to address a third situation:

Situation 3: The shareholder of an S corporation contributes all of the S corporation stock to a newly formed corporation (Newco). The contributed corporation is converted under state law from a corporation to an LLC for which no entity classification election is made. In addition, no QSub election is made for the contributed corporation.

The comment letter concludes that this fact pattern should have the following consequences:

• The historic S corporation election would not terminate but would continue for the newly formed corporation as the survivor of the reorganization.

• The LLC (formerly the S corporation) would retain its historic EIN.

• The newly formed survivor corporation would need to obtain a new EIN.

• The LLC would be respected as a disregarded entity, eliminating the need to make a QSub election, and would not be treated as a C corporation for federal income tax purposes for any period of time during the reorganization transaction, including for purposes of taxing built-in gains under Section 1374.

Should the IRS not accept the comment letter’s suggestions to update or supplement their 2008 guidance, the ABA tax section alternatively recommends the IRS provide a streamlined procedure for curing a timely but invalid QSub election. This would be similar to Rev. Proc. 2013-30, where an election has been deemed invalid because the subsidiary did not meet the domestic corporation requirement at the time the election was made.

A QSub can provide tax planning opportunities where there is a business reason to maintain S corporation operations in a separate subsidiary. For example, since a QSub is a disregarded entity, the sale of an interest in a QSub is treated as a sale of its assets for federal income tax purposes, which provides the buyer with a step-up in the tax basis of the acquired assets. There may be other benefits as well, and F reorganizations may be used in pre-transaction planning structuring.

IRS Rules Professional Corporation Arrangement Requires Consolidation

Many states, through licensing and regulation of professions like medicine or law, restrict or prohibit business ownership by unlicensed individuals or entities. To invest in these types of businesses without violating state law, investors often must enter into contractual arrangements pursuant to which the investor acquires economic rights without changing the ownership of legal title. In PLR 202417008, the IRS ruled that a professional corporation must join an investor’s existing consolidated group as a result of legal agreements that granted the investor beneficial ownership of the professional corporation’s stock.

In the PLR, two professional corporations, PC1 and PC2 (together, the PCs), entered into agreements with a member of an existing consolidated group (Sub), either directly or indirectly through a disregarded entity of Sub, for administrative and management support services. In addition, the PCs and their respective shareholders entered into agreements with Sub (or its disregarded entity) restricting:

1. The transferability of the shares in the PCs.

2. The ability of the PCs to undertake certain corporate actions.

Citing IRC Section 1504(a) and Rev. Rul. 84-79, the IRS ruled that upon executing the above-mentioned agreements, PC1 and PC2 will join the consolidated group with respect to which Sub is a member. For a corporation (other than a common parent) to join a consolidated group, Section 1504(a) requires that members of a consolidated group directly own a certain amount of stock in the corporation.

Case law and IRS guidance (including Rev. Rul. 84-79) indicate that direct ownership for purposes of Section 1504(a) means beneficial ownership (which is generally determined based on the economic substance of the arrangement), not mere possession of legal title. The IRS found that the legal agreements between the PCs, the shareholders of the PCs, and Sub (or its disregarded entity) separated legal title (i.e., legal ownership) from the economic rights (i.e., beneficial ownership), the latter of which Sub (or its disregarded entity) obtained as result of the contractual arrangements.

The PLR is consistent with similar rulings previously issued by the IRS, all of which are predicated on state law not prohibiting beneficial ownership by non-professionals and underscore the beneficial ownership aspect of the Section 1504(a) test.

PLR 202417008 highlights the contractual arrangements involved in the transfer or acquisition of beneficial ownership, giving investors interested in participating in the economics of certain regulated businesses a view of the key legal documents and provisions the IRS evaluated in applying Section 1504(a).

How MGO Can Help Your Business Adapt to 2024 Tax Changes

With major 2024 guidance from the Treasury and IRS — including proposed CAMT regulations, finalized rules for the 1% stock repurchase excise tax, and rulings affecting S corporations, debt/equity characterization, and beneficial ownership — corporate taxpayers face new complexities. MGO’s tax professionals can help you develop CAMT strategies, navigate excise tax compliance, clarify S corporation structures, and address beneficial ownership arrangements. We provide solutions aligned with your business goals so you can stay ahead of fast-evolving tax requirements.

The post Corporate Tax Roundup: CAMT Regulations, Stock Repurchase Excise Tax, and Other Key Developments appeared first on MGO CPA | Tax, Audit, and Consulting Services.

The Corporate Transparency Act (CTA) is a significant shift in business reporting requirements, mandating certain companies to show beneficial ownership details to the Financial Crimes Enforcement Network (FinCEN). Designed to combat money laundering, the CTA applies to millions of small- and medium-sized businesses.

A recent nationwide injunction temporarily delayed enforcement of the CTA, but the law’s requirements remain. Your business should prepare now to avoid potential penalties when enforcement resumes. This article outlines the CTA’s requirements, the impact of the injunction, and practical steps for compliance.

Key CTA Requirements

The CTA requires “reporting companies” to show information about beneficial owners, including:

• Full legal name, address, and date of birth

• Unique identifying numbers (such as passport or driver’s license)

• Ownership percentage or decision-making control

The law primarily applies to privately held entities such as LLCs and corporations, though exemptions exist (e.g., publicly traded companies and nonprofits). Companies with complex ownership structures — such as startups, family businesses, or private equity-backed firms — may face challenges reporting beneficial owners.

For a full breakdown of CTA requirements, see Beneficial Ownership Reporting Deadline Approaches – Are You Prepared?.

Nationwide Injunction on Enforcement

A recent court decision temporarily halted FinCEN’s ability to enforce the CTA, delaying the original January 1, 2025, deadline. However, this injunction is unlikely to permanently derail the law. Once legal challenges are resolved, enforcement is expected to resume quickly. The Fifth Circuit has sent this issue to a merits panel. Briefings will start in February, with oral arguments scheduled for March 25, 2025. After these oral arguments, the court will review and issue an opinion. This could push off the information reporting deadline to sometime in the second quarter of 2025. Additionally, an application was filed with the Supreme Court by the Justice Department on December 31, 2024. As of this discussion, the Supreme Court has not yet said if or how it will respond.

Key takeaways from the injunction:

• The delay provides businesses with a brief opportunity to prepare, but compliance will likely remain mandatory.

• Businesses should act now to avoid being caught off guard when enforcement resumes.

Risks of Noncompliance 

When enforcement resumes, businesses not complying could face:

• Fines: Up to $500 per day, capped at $10,000.

• Criminal penalties: Including imprisonment for willful violations.

The CTA’s enforcement will likely include rigorous audits by FinCEN, particularly for companies with layered or opaque ownership structures. Delaying preparation increases the risk of last-minute errors or penalties.

Steps to Prepare for Compliance

Even with enforcement delayed, your business should take proactive steps to comply:

• Conduct an ownership review: Find all individuals with at least 25% ownership or significant control. Document roles, ownership percentages, and needed personal details.

• Gather documentation: Collect valid identification (such as driver’s licenses or passports) for all beneficial owners. Verify that all information is current.

• Assess your filing obligations: Decide whether your company qualifies as a “reporting company” or is exempt. Consult legal or tax advisors if needed.

• Build internal processes: Establish systems for ongoing compliance, including reporting ownership changes to FinCEN.

Industry-Specific Challenges

Some industries face unique compliance challenges:

• Cannabis: Ownership layers required by state licensing can complicate beneficial ownership reporting.

• Technology/startups: Venture capital-backed companies must track frequent changes in ownership.

• Manufacturing and life sciences: Family-owned entities often overlook reporting requirements due to assumptions of exemption.

Understanding how the CTA affects your industry can help reduce risks.

What to Expect Post-Injunction

Businesses should prepare for the following once the injunction is lifted:

• Renewed enforcement: FinCEN will likely resume enforcement with little or no grace period.

• Increased audits: The delay may allow FinCEN to strengthen oversight and audit mechanisms.

• Potential changes: Regulatory adjustments are possible but should not be relied on to end compliance obligations.

Acting now minimizes risks and avoids costly penalties when enforcement resumes.

Final Thoughts

The Corporate Transparency Act is a major regulatory shift that requires proactive planning. While the nationwide injunction delays enforcement, your business should use this time to review ownership structures, collect documentation, and set up compliance processes. Acting early reduces risk and supports readiness when enforcement resumes.

For more detailed guidance, explore our related articles:

• Nationwide Injunction on Corporate Transparency Act Enforcement

• Beneficial Ownership Reporting Deadline Approaches – Are You Prepared?

• Countdown to Corporate Transparency Act Reporting: Is Your Business Prepared?

The post Corporate Transparency Act Update: Deadlines, Enforcement, Risks, and Steps to Prepare for Compliance appeared first on MGO CPA | Tax, Audit, and Consulting Services.

• Starting in 2024, long-term, part-time (LTPT) employees must be allowed to make salary deferrals to 401(k) plans if they work at least 500 hours per year for two consecutive years (down from the previous three-year requirement).

• Many 401(k) plan service providers are not fully prepared for the implementation of these changes, posing the risk of operational failures, costly corrective contributions, and compliance issues for employers.

• Employers need to carefully plan for SECURE Act compliance to avoid increased plan administration expenses, potential audits, and corrective actions resulting from overlooking LTPT employees.

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The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act of 2019) and the SECURE 2.0 Act of 2022 (collectively, SECURE) enacted a new mandate that, starting in 2024, long-term, part-time (LTPT) employees must be allowed to make salary deferrals into their employer’s 401(k) plan.  

The systems used by many 401(k) plan service providers are not ready for the required implementation starting with the first plan year beginning on or after January 1, 2024 (i.e., January 1, 2024, for calendar year plans).  

Some executives may view this change as an issue that does not require their attention and that will be handled by their human resources (HR) staff and the 401(k) plan service providers. But not complying with the rules might be costly for the employer if corrective contributions for LTPT employees who were not allowed to participate are required, along with ancillary costs.

New Mandate

For decades, tax-qualified retirement plans could exclude employees who work fewer than 1,000 hours of service per year, even if the employee worked for the employer for many years. Employees who worked over 1,000 hours generally could not be excluded from the plan (with certain non-hours-based exceptions). To improve access to workplace retirement savings plans, the 2019 SECURE Act required 401(k) plans to allow employees who have worked at least 500 hours in three consecutive years (based on employment with the employer from January 1, 2021, onward) to make elective deferrals to the plan. Thus, if an employee had 500 hours of service in 2021, 2022, and 2023 (but never had 1,000 hours of service per year), that employee must be allowed to make salary deferrals into the employer’s 401(k) plans starting with the first plan year beginning on or after January 1, 2024. For plan years beginning in 2025 and later, SECURE 2.0 of 2022 reduces the three-year measurement period to two years.

On November 27, 2023, the IRS issued proposed regulations that employers can rely on to apply the LTPT employee rules until the final rules are issued.

An Example of How the Rules Work

Let’s assume a calendar year 401(k) plan has a requirement that employees must be age 21 and complete 1,000 of service before being eligible for plan participation that includes making elective deferrals and receiving company matching contributions.  Starting in 2024, some employees who do not meet the 1,000-hour service requirement might be eligible to make salary deferrals. The employer is not required to make matching contributions or any other employer contributions for LTPT employees who make salary deferrals.  

Counting the hours worked to determine plan eligibility is not new and the rules are essentially the same for counting 1,000 hours and 500 hours.  Hours for new employees should be counted for 12 months following their date of hire, but the measurement period can be switched to the plan year for administrative ease. However, while the 1,000-hour requirement is a standalone measure for each year, the 500-hour count is relevant for two or three years, depending on the plan year under evaluation.  Therefore, for a calendar year plan beginning January 1, 2024, the hours are counted for 2021, 2022, and 2023.  Any employee whose count is 500 or more but less than 1,000 in each of those three years should be allowed to make elective deferrals into the calendar year plan as of January 1, 2024.   

As a further example, assume Susan was hired on June 1, 2021, by an employer that sponsors a calendar year 401(k) plan. On December 31, 2021, the first plan year end after Susan’s hire date, the employer switches her hours worked to be measured based on the plan year.  Year One for Susan runs from June 1, 2021, through May 31, 2022.  Year Two for Susan runs from January 1, 2022, through December 31, 2022, and Year Three for Susan runs from January 1, 2023, through December 31, 2023.  Susan worked 500 hours in Year One, 680 hours in Year Two, and 520 hours in Year Three.  Therefore, effective January 1, 2024, she should be allowed to make elective deferrals under the plan.  Note that the switch from counting hours based on Susan’s date of hire anniversary to using the plan year as her eligibility computation period causes the hours she worked from January 1, 2022, through May 31, 2022, to be double counted in both her first and second year.  

Even though vesting schedules have no relevance to Susan’s elective deferrals (since she is always 100% vested in her own contributions), she will receive a year of vesting credit for each year after 2021 that she works at least 500 hours (i.e., Susan has three years vesting credit if she became eligible for employer contributions in 2024). This would be significant if she subsequently becomes eligible to participate in the plan for a reason that is not solely on account of being an LTPT employee. Once an individual is eligible for the plan, they remain eligible and do not have to requalify to participate. 

For the 2025 plan year, the period from June 1, 2022, through May 31, 2022, will drop out of the determination. Additionally, the period from January 1, 2022, through December 31, 2022, will drop out of the determination because of the change made by SECURE 2.0 to look back only two years instead of three. Accordingly, Susan’s 2025 plan eligibility as an LTPT employee will be based on her hours worked during the 2023 and 2024 plan years. 

The future years’ determination is complicated, especially if the employee’s hours worked fluctuate above and below 1,000 hours.  

Why Should I be Concerned?

While employers are not required to match the LTPT employee deferrals and LTPT employees are excluded from the annual tests that otherwise apply to all employees (e.g., coverage, nondiscrimination, and top-heavy requirements), there might be some increased cost to the plan sponsor for including LTPT employees in the 401(k) plan. Employers should consider the following potential increases in plan cost due to the new LTPT employee mandate.  

1. Increased Plan Audit Expense -The additional participants due to LTPT employee status must be counted when determining if the 401(k) plan must have an annual independent audit of the plan’s financials.  Starting with the 2023 plan year, 401(k) plans that have more than 100 participant accounts as of the first day of the 2023 plan year must have an annual independent audit. Before 2023, 401(k) plan participants who were eligible to make salary deferrals were counted as participants — even if they did not contribute anything — for purposes of counting the number of participants. The DOL changed the rules starting in 2023, among other things, to include only those with account balances as participants. Keep in mind that the number of participants can be decreased by taking advantage of rules that allow distributions of small account balances (accounts valued at less than $7,000 starting in 2024) to former participants.  

2. Increased Plan Administration Costs – The time spent internally and by plan service providers increases as the number of plan participants increases, particularly if recordkeeping for a new category of participants is necessary. The LTPT employee rules raise unique recordkeeping challenges necessitating new programing and new procedures to stay in compliance.  

3. Costly Corrective Actions – The employer must take steps to correct any instance of when an employee that is eligible to make elective deferrals was not notified of being eligible. Increasing the number of eligible employees increases the possibility of someone being missed. But the immediate concern is based on feedback that many administration systems are not ready for the implementation of the LTPT rules as early as January 1, 2024 (for calendar year plans). Any delay in communicating the eligibility to LTPT employees that causes a delay of payroll deductions of elective deferrals beyond their eligibility date would be an operational failure that would need correction under the IRS’s Employee Plans Compliance Resolution System (EPCRS).  While corrective contributions to make up the employee’s missed contribution are not always required, notices would need to be provided to any participant that had a missed deferral period to advise them that their future retirement savings might need adjustment due to the delay in making elective deferrals.  

4. Decreased Forfeitures – LTPT employees earn vesting credit for each year after 2021 during which they work at least 500 hours but less than 1,000 hours. While the vested percentage has no impact on the years the employer does not make contributions on the employee’s behalf, vesting as an LTPT employee carries over to any years that the employee becomes eligible for employer contributions.   

5. Operational Compliance Before Plan Amendment Deadline – For a 401(k) plan to be “qualified” (that is, eligible for favorable tax treatment), it must comply with the statutory requirements in both form and in operation. SECURE provides that the written plan document is not required to be amended until the end of the 2025 plan year. However, the plan must operate in compliance with the applicable changes in the law for all plan years, starting with the effective date of the change. Since the LTPT rules took effect for plan years beginning on or after January 1, 2024, the 401(k) plan would need to be operated with those rules starting in 2024, even though a formal, written plan amendment is not required until the end of the 2025 plan year. Therefore, any decisions regarding compliance with the LTPT employee provisions should be documented and the proper procedures and controls put in place.   

While plan sponsors might rely on their 401(k) plan service providers to identify eligible LTPT employees, liability for noncompliance remains on the employer. The risk associated with not allowing LTPT employees to make elective deferrals to a 401(k) plan can be avoided if the plan lowers the 1,000-hour requirement to not more than 500 hours or determines eligibility on the elapsed time method instead of the counting hours method of determining eligibility to make salary deferrals under the plan.   

SECURE provides numerous exceptions from coverage, nondiscrimination, and top heaviness tests for employees who participate in the plan solely on account of the LTPT employee provisions. Any employee that satisfies the more generous plan document provisions will not qualify for the confusing rules that otherwise apply to LTPT employees. Still, avoiding LTPT employee status altogether might be cost effective. 

How MGO Can Help

We are here to help support you in navigating the complexities of the new LTPT requirements under the SECURE Act. Our experienced team can help you assess your current 401(k) plan structures, identify potential gaps in compliance, and implement necessary updates to align with the new rules. We can assist with plan design modifications, administrative processes, and reducing risks associated with LTPT employee compliance. Reach out to our team today to take a proactive approach to SECURE Act compliance. 

Written by Joan Vines and Norma Sharara. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com 

The post New Requirement to Cover Long-Term, Part-Time Employees in 401(k) Plans Enters Into Effect appeared first on MGO CPA | Tax, Audit, and Consulting Services.

• The SECURE Act and SECURE 2.0 Act have expanded access to retirement plans for long-term, part-time employees (LTPTs), who must now be included if they meet certain criteria starting January 1, 2024.

• The method of counting participants for Form 5500 has changed and now focuses on account balances instead of eligibility to defer contributions, complicating participant headcounts.

• The updated rules may alter whether a retirement plan requires an annual audit based on participant count, especially affecting organizations with previously excluded LTPT employees.

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There are two significant regulatory changes to retirement plans that will require immediate attention from plan sponsors — both to ensure current operational compliance and comply with any upcoming deadlines. Many of your long-term, part-time (LTPT) employees may now be eligible for 401(k) retirement plans, and there is also a new method of counting defined contribution retirement plan participants on Form 5500 Annual Return/Report. You should note that your retirement plan’s audit status could be affected when these changes take effect.

In addition to understanding the far-reaching implications that could help you avoid any missteps with LTPT employee eligibility and revised participant headcounts, it’s also crucial to understand any missteps that may have already occurred.

Navigating New Eligibility Opportunities for Long-Term, Part-Time Employees

Prior to the SECURE Act of 2019 and SECURE 2.0 Act of 2022 (collectively SECURE), you as an employer could exclude employees from your tax-qualified defined contribution plans based on the number of hours they worked per year. Typically, this meant that part-time employees were ineligible to contribute to their employer’s retirement plan — no matter how many years they had worked for you. Note that an IRS Employee Plans Newsletter issued on January 26, 2024, defined LTPT employees as workers who have worked at least 500 hours per year in three consecutive years (although the consecutive year condition will be reduced to two years in 2025).

SECURE expanded LTPT employee access to their employer retirement plans by requiring 401(k) plans to allow employees that meet the LTPT requirements to make elective deferrals starting with the first plan year beginning on or after January 1, 2024. As an employer, you are not required to make employer contributions for LTPT employees.

However, the burden of identifying, notifying, and enrolling these newly eligible LTPT employees does now fall on you. Failing to inform LTPT employees of their eligibility as of January 1, 2024, may have resulted in non-compliance. To rectify any compliance issues, you can check out the IRS amnesty program known as the Employee Plans Compliance Resolution System (EPCRS).

It is essential to understand this new requirement because LTPT employee eligibility may affect two other administrative functions for plan sponsors: Form 5500 filing and the annual employee benefit plan audit requirement. 

A Key Change When You Count Participants for Form 5500

Prior to 2023, IRS Form 5500 — an essential part of ERISA’s reporting and disclosure framework — required defined contribution retirement plan sponsors to include employees who were eligible to make elective deferrals on the first day of the plan year. In most organizations, LTPT employees would be excluded from this headcount unless the employer’s plan allowed them to make contributions to the retirement plan.

Now, employers need only include participants with an account balance in the defined contribution retirement plan as of the first day of the plan year (but, for new plans, the participant account balance count is determined as of the last day of the first plan year). This may sound like a simple change, but the potential increase in participants who are LTPT employees complicates the matter.  

The Impact on Your Plan’s Audit Requirement

Your organization’s obligation to have an annual audit of its retirement plan is dependent on the number of plan participants as of the first day of the plan year.  

Beginning with the 2023 plan year, defined contribution plans that have more than 100 participant accounts as of the first day of the 2023 plan year generally must have an annual independent audit. Before 2023, all plan participants who were eligible to make salary deferrals were included in headcounts as participants even if they had not made any plan contributions. The DOL changed the rules starting in 2023 to include only those with account balances as participants. Keep in mind that the number of participants can be decreased by taking advantage of rules that allow distributions of small account balances (accounts valued at less than $7,000 starting in 2024) to former participants, if the defined contribution plan adopted these provisions. 

The audit requirement of plans with 100 or more employees may change since employees without account balances are no longer counted. An organization may find that the defined contribution plan no longer requires an audit if eligible employees have not contributed to the 401(k) plan, but the audit requirement may be triggered when previously excluded LTPT employees begin to make elective deferrals. 

Understanding the New Normal for Certain Retirement Plans 

The LTPT employee rules take effect for plan years beginning on or after January 1, 2024 (for calendar-year end plans). If your organization missed the deadline to allow LTPT employees to participate in your plan, the good news is that there is a path to compliance. However, implementing these complicated changes in the law requires in-depth knowledge of the complex issues surrounding tax-qualified retirement plans.  

Experienced consultants can provide guidance and support throughout the process in the following ways: 

• Analyze plan documents and employee data to identify any compliance gaps or issues that need to be addressed 

• Engage in detailed discussions with plan sponsors to explain the intricacies of the changes and helping them understand the necessary steps to ensure compliance 

• Facilitate communication with service providers to aid in a smooth transition and implementation of any required changes 

• Calculate corrective actions required to rectify any non-compliance issues and confirm future compliance 

• Guide the employer in enrolling in the IRS’s amnesty program (EPCRS), if necessary, to self-report non-compliance issues 

• Help plan sponsors track the path taken to incorporate the necessary changes into the plan documents, to ensure ongoing compliance and avoid future issues 

• Discuss Form 5500 preparation considerations, including participant head count

How MGO Can Help 

Our team is equipped to help you navigate the complex changes brought about by the SECURE Act and SECURE 2.0 Act. We can analyze plan documents and employee data to identify your compliance gaps and make sure your LTPT employee eligibility is properly addressed. From guidance on Form 5500 reporting requirements to understanding/implementing the necessary changes to participant headcounts, we can guide you through compliance issues and penalty pitfalls. Reach out to our team today to learn how we can help you.

The post Your Guide to SECURE Act and IRS Form 5500 Updates appeared first on MGO CPA | Tax, Audit, and Consulting Services.

• The IRS and Treasury Department have finalized regulations on prevailing wage and apprenticeship (PWA) requirements, aiming to streamline and clarify eligibility for increased clean energy incentives introduced under the Inflation Reduction Act of 2022.

• Projects may be exempt from PWA requirements if they meet certain requirements, like the Beginning of Construction (BOC) or One Megawatt exceptions, with transition rules to make sure the work performed before January 29, 2023, remains unaffected.

• You as the taxpayer bear the responsibility for making sure you’re compliant with PWA requirements, including record-keeping.

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The IRS and the Treasury Department on June 18 released final regulations concerning the prevailing wage and apprenticeship (PWA) requirements related to increased credit or deduction amounts for some clean energy incentives introduced by the Inflation Reduction Act of 2022 (IRA).

In general, taxpayers are eligible for increased credit amounts by satisfying the PWA requirements or one of the exceptions found under Internal Revenue Code Section 45(b)(6)-(8). By satisfying the PWA requirements, taxpayers can generally increase the base amount of the credit or deduction by five times. A dozen credits and the Section 179D deduction reference the PWA requirements, with the specific applicability varying depending on the particular IRA provision.

The IRS and Treasury received 342 written comments in response to the PWA proposed regulations.

Interaction with Davis-Bacon Act 

While the Davis-Bacon Act (DBA) provides a framework for prevailing wages in the context of federal contracts, the IRS and Treasury clarified in the final regulations that the DBA was not intended to be strictly mirrored for purposes of the IRA. According to the final regulations, if Congress had intended for the IRA to strictly adhere to DBA guidance, it would have explicitly stated so in the statute and included additional statutory language beyond the reference found under Section 45(b)(7). Many comments from stakeholders suggested conforming to DBA guidance and precedent. However, the IRS and Treasury reaffirmed the general approach taken in the proposed regulations, incorporating DBA guidance only to the extent it is relevant for prevailing wages and the administration of the relevant IRA tax provisions. 

For example, significant commentary from stakeholders suggested adopting various prefiling compliance requirements analogous to those under the DBA. The IRS and Treasury generally avoided this, citing the need for sound tax administration. While the government encourages practices that align with the policy goals of the PWA requirements and sound record-keeping activities, they opted not to impose any prefiling requirements. This decision is based on the fact that the increased credit amounts provided by the PWA requirements are an optional benefit that is not binding until the taxpayer files a tax return claiming the increased amount. However, the facts and circumstances surrounding the taxpayer’s prefiling activities may still support a conclusion as to whether the additional intentional disregard penalty would be applicable. 

Conversely, the IRS and Treasury did incorporate the DBA concept of “the site of the work” with respect to secondary sites to help define the applicability of PWA requirements at those locations, including unrelated third-party manufacturing activity occurring offsite. This reflects the government’s approach of adopting DBA guidance narrowly, to the extent such adoption supports the sound tax administration of IRA provisions. 

PWA Exceptions and Transition Rules

The two principal exceptions to the PWA requirements are the Beginning of Construction (BOC) and One Megawatt exceptions. Qualified facilities or energy projects that began construction before January 29, 2023, or have a maximum net output of less than one megawatt AC, are eligible for increased credit amounts without needing to meet the PWA requirements. 

To provide clarity, the government reiterated that the prevailing wage requirements apply to the construction, alteration, or repair of a facility, whereas the apprenticeship requirements apply only to the construction period of a facility. Following the principles under Section 45, the PWA requirements apply to the portion of the activity that generates a credit or deduction under the applicable Internal Revenue Code section. 

Commenters raised concerns about the confusion caused by the varying effective dates of the PWA requirements across different credit provisions. In the interest of sound tax administration, the government determined that a transition rule was appropriate. The final rules state that any work performed before January 29, 2023 (60 days after the publication of Notice 2022-61), is not subject to the PWA requirements, regardless of whether there is an applicable BOC exception. Therefore, for Sections 45L, 45Z, and 48C, taxpayers need only comply with the PWA requirements for construction, alteration, or repair activities occurring on or after January 29, 2023. 

The government also acknowledged the confusion over what constitutes the beginning of construction for purposes of the BOC exception. To provide uniformity, the final rules adopt the DBA definition of construction, consistent with the general approach in the proposed rules. Thus, the activities that trigger the PWA requirements are any activities that constitute construction under Treas. Reg. §1.45-7(d)(3). However, the final rules provide transition relief for taxpayers who relied on definitions in prior IRS notices to determine activities that triggered the initial stages of construction. Penalties are waived for those taxpayers, provided they make correction payments to impacted workers within 180 days of the publication of the final rules. 

For the One Megawatt exception, the final rules largely adopt the proposed rules while reaffirming that the definition of a qualified facility, energy project, or energy storage technology for purposes of the exception will follow the guidance under the respective Code sections. 

Taxpayer Responsibilities for PWA Requirements

Stakeholders requested guidance on the taxpayer’s responsibility for compliance with PWA requirements, given that the taxpayer may not have contracted directly with all contractors and subcontractors. Comments included proposed safe harbors if the taxpayer contracted with third parties to ensure compliance, suggestions to permit contractors to make corrective payments on behalf of the taxpayer, and concerns over the application of the PWA requirements in the context of credit transfers under Section 6418.  

The government reiterated that the burden of compliance, including any correction or penalty payments, must be the taxpayer’s responsibility. However, the final rules provide flexibility in how the payments are made, as long as there is adequate record-keeping, and generally did not adopt any changes from the proposed rules. 

Regarding the taxpayer’s obligation to appropriately apply the applicable prevailing wage rates, and to reduce uncertainty, the final rules clarify that the applicable prevailing rates are determined at the time the contract for the construction, alteration, or repair of the facility is executed by the taxpayer and a contractor (and apply to the contractor’s subcontractors). The final rules also incorporate the substantiality concept discussed in the preamble to the proposed rules, clarifying that there is no obligation to update the wage rate if a contractor is provided additional time to complete its original commitment or if additional work is merely incidental. If work is contracted over an indefinite period, there is an annual obligation to update the applicable wage rates. 

Apprenticeship Guidance

To assist with complying with the apprenticeship requirements, the final rules provide various examples on how to calculate labor hours. Generally, taxpayers must consider all labor hours, including those worked by contractors with fewer than four employees, from the beginning of construction through the facility’s placed-in-service date. Training hours of qualified apprentices count towards the labor hours requirement only if the hours relate to construction, alteration, or repair work. 

The final rules confirm that, consistent with registered apprenticeship program industry practice, the ratio requirement must be met daily to ensure that apprentices are properly overseen by journey-workers. 

For record-keeping purposes, taxpayers are ultimately responsible for compliance with the PWA requirements and may not rely solely on certifications from contractors and subcontractors. To assist with compliance, taxpayers must maintain records, which could include hiring a third party to manage them.  

The final rules provide scenarios to address privacy concerns and personally identifiable information (PII) by offering three alternatives: (1) taxpayers may collect and physically retain redacted records from every relevant contractor and subcontractor; (2) taxpayers may utilize third-party vendors to collect and physically retain records on behalf of the taxpayer with redacted PII; and (3) taxpayers, contractors, and subcontractors may physically retain unredacted records for their own employees. In all scenarios, unredacted records must be made available to the IRS upon request. 

The good faith effort exception was adjusted after reviewing comments and consulting with the Department of Labor. The exception is deemed satisfied if there is no registered apprenticeship program within the geographic area of operation. To qualify, the taxpayer must provide a written request that includes proposed dates, the occupation of apprentices, location, expected apprentice hours, contact information for the taxpayer or contractor, and who will employ the apprentices (the taxpayer or a contractor). This request must be sent to at least one Registered Apprenticeship Program (RAP) within the facility’s geographic area, although apprentices can be sourced from any location. The request must be sent 45 days before the apprentice is set to begin work, with any subsequent requests to the same RAP made 14 days before the apprentice starts. The period for the good faith effort exception has been extended from 120 days to 365 days (or 366 for leap years). 

The RAP must respond substantively to the specific request; automated or non-substantive replies do not count. The taxpayer is not required to follow up with the RAP or respond to a non-substantive reply. Compliance with “established standards and requirements” means that a taxpayer cannot claim to meet the good faith effort exception by refusing to pay user fees if required; they can reach out to a different RAP with different requirements if needed. The good faith effort exception cannot be used for a RAP sponsored by the taxpayer; if no apprentices are available, the taxpayer must contact a different RAP. 

The IRS and Treasury considered feedback that the apprenticeship requirements could pose challenges for taxpayers relying on foreign labor to install equipment, as foreign contractors and subcontractors may not be able to hire apprentices from registered programs. They suggested expanding the good faith effort exception to accommodate these taxpayers. However, the IRS and Treasury, informed by the DOL, clarified that foreign employers can hire qualified apprentices or register apprenticeship programs if they meet certain conditions, such as having a physical presence and legal authorization to operate in the U.S. Ultimately, the IRS and Treasury decided not to create special exceptions for taxpayers using foreign contractors. 

Miscellaneous Observations 

• In addition to issuing the final regulations, the IRS updated its PWA FAQs 

• The final rules address the PWA requirements as they relate to Indian Tribal governments.  

• Project labor agreements (PLAs) are addressed in the final rules, notably as a way to avoid penalty payments if certain wage and apprenticeship requirements are met as part of a PLA.  

• While the IRS and Treasury do not intend to enact prefiling compliance requirements, there may be commercial considerations related to lenders, investors, and transferee taxpayers, if applicable.  

• The IRS and Treasury also addressed the PWA requirements as they apply to specific code sections.

How MGO Can Help 

Our team has experience navigating complex tax regulations, including those surrounding PWA requirements. We can assist you in optimizing your clean energy incentives while making sure you’re fully compliant every step of the way. From providing guidance on identifying applicable exceptions to coordinating record-keeping and addressing any issues related to foreign labor and good faith effort exceptions, reach out to our team today to discuss how we can help you achieve your goals.  

Written by Gabe Rubio, Jesse Tsai and Leah Turner. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com 

The post IRS Treasury Release Prevailing Wage Apprenticeship Final Regulations appeared first on MGO CPA | Tax, Audit, and Consulting Services.

• The IRS’s proposed regulations eliminate the “associated property rule” for property improvements, aligning with the Federal Circuit’s Dominion Resources decision. This change simplifies accumulated production expenditures (APEs) by excluding costs of associated property temporarily withdrawn from service.  

• Under the proposed regulations, taxpayers are required to include only the direct and indirect costs of improvements in APEs, significantly reducing interest capitalization requirements in situations where the associated property rule applied prior.  

• Taxpayers will be able to adopt the changes starting in 2025, but doing so may require an accounting method change under Sections 446 and 481. The IRS is still determining if this will be an automatic or non-automatic method change which could affect filing procedures/fees. 

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The IRS on May 15 published proposed regulations (REG-133850-13) that would remove the “associated property rule” and related rules from the regulations on interest capitalization requirements for improvements to “designated property.” The proposed regulations follow the rationale of the Federal Circuit decision in Dominion Resources, which invalidated the existing regulations.  

The proposed regulations would also modify the definition of “improvement” for purposes of these regulations under Reg. §1.263A-8(d)(3) so that it is consistent with the definition provided in the tangible property regulations under Reg. §1.263(a)-3. 

While the proposed regulations are proposed to apply to tax years beginning after the date that final regulations are published, taxpayers may apply the proposed regulations for tax years beginning after May 15, 2024, and on or before the date that final regulations are published. 

Capitalization Requirements and Associated Property Rule 

Internal Revenue Code Section 263A generally requires the capitalization of direct and indirect costs of real or tangible personal property produced or improved by a taxpayer. Section 263A(f) provides rules for capitalizing interest for these purposes and for determining the amount of interest required to be capitalized. The requirement to capitalize interest is limited to interest that is paid or incurred during the production period and that is allocable to real property or certain tangible personal property produced by the taxpayer (designated property). 

The regulations under Section 263A specify that taxpayers must use the “avoided cost method” to determine the amount of interest required to be capitalized with respect to the production of designated property. Under the avoided cost method, the taxpayer must capitalize any interest that the taxpayer would have avoided if accumulated production expenditures (APEs) had been used to repay or reduce the taxpayer’s outstanding debt.  

In the case of an improvement to real property qualifying as the production of designated property, the regulations include an “associated property rule,” which states that APEs include: 

1. An allocable portion of the cost of land, and  

2. For any measurement period, the adjusted basis of any existing structure, common feature, or other property that is not placed in service, or must be temporarily withdrawn from service to complete the improvement (associated property), during any part of the measurement period if the associated property directly benefits the property being improved, the associated property directly benefits from the improvement, or the improvement is incurred by reason of the associated property. 

Federal Circuit Decision in Dominion Resources 

The Federal Circuit invalidated the associated property rule for property temporarily withdrawn from service in Dominion Resources, Inc. v. U.S., 681 F.3d 1313 (Fed. Cir. 2012). The court held that the regulation was not a reasonable interpretation of the avoided cost method and violated the requirement that the IRS provide a reasoned explanation for adopting a regulation.  

The case involved a utility company that had to temporarily withdraw from service two electric generating plants while replacing coal burners in the plants. During this time, the taxpayer incurred interest on debt unrelated to the improvements. The IRS challenged the taxpayer’s deduction of some of that interest, arguing that the taxpayer’s APEs should include the cost of the improvements and the adjusted basis of the property temporarily withdrawn from service to complete the improvement. 

The taxpayer challenged the validity of the associated property rule for property temporarily withdrawn from service. The Federal Circuit agreed with the taxpayer, concluding that the regulation unreasonably links the interest capitalized when a taxpayer makes an improvement to the adjusted basis of property temporarily withdrawn from service to complete the improvement. 

New Proposed Regulations 

In the preamble to the proposed regulations, the IRS agrees with the Federal Circuit’s rationale in Dominion Resources. It states that treating the adjusted basis of any associated property that is temporarily withdrawn from service to complete the improvement as a component of APEs contradicts the avoided cost method because the adjusted basis of the temporarily withdrawn property does not represent an “avoided” amount.  

Following this rationale, the proposed regulations would remove the associated property rule for property temporarily withdrawn from service. In addition, the IRS goes further in the proposed regulations than the Dominion Resources decision, concluding that the associated property rule should also be removed for improvements to property “not placed in service.” 

After the proposed changes to the rules – which would remove from APEs the adjusted basis of associated real property, the adjusted basis of associated tangible personal property, and an allocable portion of the cost of the land when the taxpayer makes an improvement – a taxpayer would be required to include in APEs only the direct and indirect costs of the improvement itself. 

The proposed regulations retain the substantive rules in Reg. §1.263A-11(f), which relates to the cost of property purchased for further production prior to being placed in service. The holding in Dominion Resources was limited to improvements to property “temporarily withdrawn from service” and did not address situations in which a taxpayer purchases property for further production prior to placing the property in service. The IRS notes in the preamble to the proposed regulations that unlike the cost of property that is temporarily withdrawn from service to be improved, the cost of property purchased for further production prior to being placed in service represents an “avoided” amount under avoided cost principles because the cost of such property is a component cost of the original production activity. However, the proposed regulations do modify Reg. §1.263A-11(f) to clarify that Section 1.263A-11(f) applies only to situations in which property is purchased and further produced before the property is placed in service. 

Insight 

Effective in 2025 for calendar-year taxpayers, taxpayers will no longer be required to include associated property in the taxpayer’s APEs for property temporarily withdrawn from service or include associated land costs when making improvements to property.  Only the direct and indirect costs of the improvements will be required to be included in APEs – significantly reducing APEs and, therefore, interest capitalization in situations where the “associated property rule” would have applied. 

Note that a change in a taxpayer’s treatment of interest to a method consistent with the proposed regulations is a change in method of accounting to which Sections 446 and 481 apply. 

In informal conversations with IRS officials regarding what taxpayers must to do to comply with the proposed regulations (assuming their current method is different), the IRS has indicated that it is still evaluating whether an accounting method change to comply with the proposed regulations would fit into an existing automatic method change, require the introduction of a new automatic method change, or be effectuated via filing a non-automatic method change. If the IRS ultimately decides that the change must be made through non-automatic filing procedures, taxpayers seeking to adopt the proposed regulations would have to file the method change by the last day of the year of change and pay a filing fee to the IRS. 

How MGO Can Help 

Complex tax regulations like the proposed adjustments to interest capitalization requirements can be challenging to navigate. MGO’s tax professionals can help you understand how these updates can impact your business — as well as implement strategies to optimize compliance and your financial outcomes. From assistance with evaluating the proposed regulations to adjusting your accounting methods to planning for potential IRS filing, reach out to our team today to find out how we can provide customized solutions to meet your needs. 

Written by Julie Robins and Connie Cunningham. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com  

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• The IRS and Treasury Department have introduced measures, including proposed regulations and revenue rulings, to curb the misuse of partnership rules that artificially inflate the tax basis of assets — and these transactions often lack economic substance and are targeted for generating inappropriate tax benefits.  

• Proposed regulations designate certain related-party partnership basis-shifting transactions are reportable “Transactions of Interest”, which involve adjustments of $5 million or more and must now be disclosed.  

• Leveraging enhanced funding from the Inflation Reduction Act, the IRS has established a new group within its Office of Chief Counsel to address partnership tax issues — underscoring its commitment to closing loopholes and making sure partnership rules reflect clear taxable income and liability.

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The IRS and Treasury on June 17 launched a multiprong approach to curtail inappropriate use of partnership rules to inflate the basis of assets without causing meaningful changes to the economics of a taxpayer’s business.  

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

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

• Notice 2024-54 describes two sets of upcoming proposed regulations: 

• The first set would require partnerships and partners to treat certain basis adjustments under Sections 732, 734, and 743 arising from covered transactions in a way that would restrict them from deriving inappropriate tax benefits from the basis adjustments.  

• The second set would provide rules to ensure clear reflection of the taxable income and tax liability of a consolidated group of corporations when members of the group own interests in partnerships. The Notice indicates that these proposed regulations would adopt a single-entity approach with respect to interests in a partnership held by members of a consolidated group. 

• Proposed regulations (REG-124593-23) identify certain partnership basis shifting transactions as reportable Transactions of Interest. 

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

In addition, the IRS announced it is launching a new group within the IRS Office of Chief Counsel focused on developing new partnership guidance, including guidance aimed at “closing loopholes.” The new group – another component of the IRS’s increased focus on partnership compliance leveraging funding from the Inflation Reduction Act – will work with the previously announced new passthrough work group that is being established in the IRS Large Business & International division.  

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

Basis Adjustments Under Subchapter K 

Under subchapter K of the Internal Revenue Code, a distribution by a partnership of the partnership’s property or a transfer of an interest in a partnership may result in an adjustment to the basis of the distributed property, partnership property, or both.  

A distribution of partnership property may result in an adjustment to the basis of the distributed property under Section 732(a), (b), or (d). In some cases, the distribution may also result in an adjustment to the basis of the partnership’s remaining property under Section 734(b). In addition, a transfer in certain cases may result in an adjustment to the basis of partnership property under Section 743(b) with respect to the transferee partner. 

Under Section 754, if a partnership makes an election in accordance applicable regulations, the basis of partnership property shall be adjusted: (1) in the case of a distribution of property, in the manner provided by Section 734; and (2) in the case of a transfer of a partnership interest, in the manner provided in Section 743. 

A partner’s adjusted basis in its partnership interest is commonly referred to as the partner’s “outside basis” in its partnership interest. A partnership’s adjusted basis in its property is commonly referred to as the “inside basis” of the partnership’s property, and each partner has a share of inside basis. 

Basis Shifting Transactions Under IRS Scrutiny 

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

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

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

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

Notice 2024-54: Forthcoming Proposed Rules Governing Covered Transactions 

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

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

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

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

1. Involve partners in a partnership and their related parties, 

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

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

The Proposed Related-Party Basis Adjustment Regulations would set forth a required method of recovering adjustments to the bases of property held by a partnership, property distributed by a partnership, or both, arising from the covered transactions described in the notice. These rules would also govern the determination of gain or loss on the disposition of such basis-adjusted property. The regulations would also address similar transactions involving tax-indifferent parties (e.g., certain foreign persons, a tax-exempt organization, or a party with tax attributes that make it tax-indifferent) rather than related parties.  

The IRS describes the Proposed Related-Party Basis Adjustment Regulations as “mechanical rules applicable to all covered transactions without regard to the taxpayer’s intent and without regard to whether the transactions could be abusive or lacking in economic substance.” The rules would apply only if, and to the extent that, property has been allocated a basis increase.  

The IRS intends to propose that the Proposed Related-Party Basis Adjustment Regulations, when adopted as final regulations, would apply to tax years ending on or after June 17, 2024. The IRS adds that, once final, the regulations would govern the availability and amount of cost recovery deductions and gain or loss calculations for tax years ending on or after June 17, 2024, even if the relevant covered transaction was completed in a prior tax year. 

The Proposed Consolidated Return Regulations would, the IRS plans, provide for single-entity treatment of members that are partners in a partnership, so that covered transactions cannot shift basis among group members and distort group income. The IRS intends these rules to prevent direct or indirect basis shifts among the members of a consolidated group resulting from covered transactions.  

The IRS states that the proposed applicability date for the Proposed Consolidated Return Regulations “will not relate to the issuance” of Notice 2024-54 but will be set forth in the proposed regulations once issued.  

The IRS requests comments by July 17, 2024, on both the Proposed Related-Party Basis Adjustment Regulations and Proposed Consolidated Return Regulations. 

Proposed Rules Identifying Basis Shifting as Transaction of Interest 

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

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

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

The transactions would include either:  

1. A distribution of partnership property to a partner that is related to one or more other partners in the partnership, or 

2. A transfer of a partnership interest where the transferor is related to the transferee or the transferee is related to one or more of the partners. 

The proposed regulations identify that a transaction would be substantially similar to the related-partnership basis adjustment transactions above if the transaction does not involve related partners and one or more partners of the partnership is a tax-indifferent party. 

The IRS proposes these rules to apply to identify certain partnership related-party basis adjustment transactions and substantially similar transactions as transactions of interest effective as of the date of publication of final regulations in the Federal Register. 

Notification that IRS Will Challenge Basis Stripping 

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

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

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

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

The revenue ruling describes three situations in which related parties coordinate to create disparities between inside and outside basis through various methods, such as the contribution or distribution of property with specific tax attributes or the allocation of tax items in accordance with Section 704(b) and (c). The parties then attempt to exploit these disparities by engaging in transfers resulting in basis adjustments under the rules of Section 732(b), 734(b), or 743(b) to reduce taxable income through increased deductions, reduced gain, or increased loss. 

In the revenue ruling, the IRS rules that the transactions in the three described situations lack economic substance under Section 7701(o) and that taxpayers involved are not entitled to the associated basis adjustments.  

New Partnership Group in Office of Chief Counsel 

Continuing the agency’s expansion of compliance efforts focused on partnerships and other high-income taxpayers following the enhanced funding provided by the Inflation Reduction Act, the IRS is creating a new group in its Office of Chief Counsel dedicated to developing guidance on partnerships and related compliance issues. The announcement follows an announcement of a similar effort by the IRS to dedicate a group within the IRS Large Business & International division to partnerships and other passthrough entities.  

The new Associate Office that will focus exclusively on partnerships, S-corporations, trusts, and estates. The office will be drawn from the current Passthroughs and Special Industries Office. In addition, the IRS plans to bring into the office outside experts with private-sector experience with passthroughs to work alongside the current IRS employees. 

Insight 

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

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

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

How MGO Can Help 

Navigating the complexities of the new IRS guidance on partnership basis-shifting transactions requires a proactive and informed approach — and our team of experienced tax professionals can help in partnership compliance and planning, as well as making sure your organization remains aligned with evolving regulations.  

Whether your company needs assistance with evaluating the impact of the proposed rules, developing tax strategies that keep you compliant, or addressing disclosure requirements for Transactions of Interest, we can provide tailored support to help you achieve financial clarity. Reach out to our tax team today for guidance on this topic.  

Written by Julie Robins and Neal Weber. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com 

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• SEC rules mandate fairness opinions for adviser-led secondary transactions.

• Tax considerations vary between taxable events and tax-deferred rollovers.

• Carry crystallization and holding periods are key tax planning concerns.

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The Securities and Exchange Commission (SEC) last year adopted regulations governing potential conflicts of interest inherent in “adviser-led secondary transactions” initiated by private fund investment advisers. In addition to these new SEC regulatory requirements, there are important tax considerations for investment advisers undertaking these transactions.

Given the increased frequency of adviser-led secondary transactions in the industry, this article provides an update on relevant tax considerations. For a more detailed discussion of the SEC rules, see the 2023 BDO Insight “How the SEC’s Proposed Rules on Fairness Opinions Affect Private Fund Advisers.” 

What Is an Adviser-Led Secondary Transaction? 

An “adviser-led secondary transaction” is a transaction initiated by the investment adviser that offers private fund investors the choice to: (1) sell all or a portion of their interests in the private fund; or (2) convert or exchange all or a portion of their interests in the private fund for interests in a new continuation fund formed by the adviser. 

This type of transaction can be a good option for a manager of a fund that is nearing the end of its term with some investors ready to cash out, some looking to continue holding their investment positions, and new investors wanting to acquire an interest in the retained assets. Funding for the purchase and contribution of the legacy fund’s remaining assets comes from investors in the continuation fund. 

The benefits of adviser-led secondary transactions include reducing the burden of fund administrative expenses spread over a relatively small number of remaining residual assets and increasing the time horizon for investors to realize a liquidity event in assets that are expected to have continued upside. Often these residual assets comprise illiquid, contingent value rights whose value is dependent on an underlying company’s future milestone events. 

While adviser-led secondary transactions can appear straightforward, an inherent conflict of interest exists between the adviser and the investors, particularly since the adviser is on both sides of the transaction, which involves the purchase of assets from existing investors and the contribution of those assets to new and existing investors in a continuation fund. Specific regulatory requirements outline what an adviser must do prior to undertaking an adviser-led secondary transaction. 

SEC Regulatory Requirements 

Under final SEC rules adopted in August 2023 (SEC Rule 211(h)(2)-2), before soliciting investors to participate in an advisor-led transaction, the adviser must perform two exercises: (1) obtain a fairness opinion or independence valuation from an independent valuation specialist and (2) disclose any material business relationships between the adviser or related persons and the independent opinion provider. 

Fairness Opinion or Independent Valuation from an Independent Valuation Specialist 

The adviser must hire an outside valuation specialist to either render a fairness opinion on a predetermined transaction value or to perform an independent third-party valuation. The differences between receiving a fairness opinion versus an independent valuation are worth highlighting. A fairness opinion specifically opines as to whether a specific price in a transaction is fair. Fairness opinions are narrowly focused in scope. If the opinion renders an unfavorable outcome, the provider is prohibited from advising the client on changing the terms of the transaction to arrive at a different outcome. An independent valuation establishes a valuation estimate, often in the form of a range. An independent valuation can provide involved parties with a range of valuation estimates upon which a reasonable transaction value can be arrived at. 

Disclosure of Material Relationships 

The adviser (and its related persons) must disclose any material business relationships it has had within the past two years with the independent valuation provider issuing the fairness opinion or independent valuation. This is intended to provide a level of transparency to the investor and attempts to uncover any inherent conflicts of interest before an adviser-led secondary is conducted. 

Tax Considerations 

In addition to the regulatory steps outlined above, there are several critical tax considerations that the adviser should address early in the process before embarking on the adviser-led secondary transaction. Planning well ahead of the transaction can help guide structuring of the deal and mitigate the risks of unintended results. Although there are many ways to effectuate an adviser-led secondary transaction, there are two key items an adviser should consider: 

Taxable vs. Tax Deferred 

Investors that elect to not participate in the continuation fund will typically have a taxable event upon their redemption. However, investors that elect to participate in the continuation fund may be able to do so in a tax-deferred manner. Commonly, rollovers of existing investors are structured in a tax-deferred manner, but the sponsor should give careful thought to the facts and circumstances of its fund, investors, and investments. Non-U.S. investors and U.S. tax-exempt investors may be indifferent as to whether the rollover is taxable or tax-deferred. U.S. taxable investors (for example, U.S. individuals, family offices, and general partner capital and carry interests) generally will be the most sensitive to tax considerations of the structure. Fund sponsors should understand these issues to identify which groups of investors would prefer a tax-deferred option and structure the transaction accordingly. When structuring to achieve tax deferral, the fund sponsor and its tax advisors will need to address issues such as tax basis and holding periods of the transferred assets and investors. Where the legacy fund holds portfolio companies eligible for the benefit of Qualified Small Business Stock (QSBS) treatment, the rollover may impact that tax status. Other tax considerations include whether the continuation fund inherits the legacy fund’s other tax attributes, such as tax elections, IRS audit liabilities, accounting methods, and tax Identification number. 

Carry Considerations 

A question that will arise during planning a continuation fund is whether the existing carry is “crystallized” (i.e., earned and payable). The portion of carry pertaining to investors that cash out will be crystallized. The portion pertaining to continuing investors may be crystallized depending on the economic arrangement of the continuation vehicle. If rollover investors are continuing the status quo of the old fund, then the pre-existing carry will likely not be crystallized. If instead carry is reset, then preexisting carry of the legacy fund would be crystallized and credited to the general partner’s capital account. There are significant holding period considerations with respect to the carry as well as the portfolio investments that are transferred, since a three-year rule holding period rule applies under Internal Revenue Code Section 1061. 

Conclusion 

Adviser-led secondary transactions offer advisers and investors an option to avoid the costly, ongoing administrative burden of continually extending a legacy fund while, at the same time, maximizing the opportunity window for investors and advisers to realize a liquidity event in those residual fund assets. The increased use of evergreen and continuation fund structures has provided additional avenues to maximize the value of residual fund assets while avoiding the relatively stringent time limitations of a traditional fund structure. 

In the context of compliance, it is important for registered investment advisers to understand and adhere to SEC Rule 211(h)(2)-2 to avoid conflicts of interest and protect the interests of their existing and new investors. Finally, careful consideration and planning around key tax issues generated by adviser-led secondary transactions are critical to maximize tax efficiencies and mitigate potential investor risks. 

Why MGO 

MGO supports private fund advisers in navigating the complexities of SEC regulations and tax planning for adviser-led secondary transactions. Our team helps maintain compliance while optimizing tax outcomes, offering strategic guidance tailored to your unique fund structure and investor needs. From managing fairness opinions to structuring tax-efficient rollovers, MGO partners with you to minimize risk and maximize investor value. 

Written by Steve Cuneo, Donna Lobete and Joe Pacello. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com 

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What This Means for Your Business

Current Filing Status:

While the CTA remains in effect, the Financial Crimes Enforcement Network (FinCEN) will comply with the court’s order for as long as it remains in effect. Reporting companies are not currently required to file their beneficial ownership information and will not be subject to liability for failing to do so while the preliminary injunction remains in place. However, the obligation to file has already accrued, and further developments may reinstate deadlines. 

Options to Consider: 

1. Businesses Near Completion: Filing now may help minimize future administrative challenges if the injunction is lifted without a grace period. 

2. Businesses Taking a Wait-and-See Approach: Entities may prefer to delay filing while awaiting further legal or regulatory clarity, depending on the complexity of their filings and available resources. 

Legal Landscape: 
This is a preliminary ruling. Appellate courts may overturn the injunction, and a final resolution could take months or longer. Reporting requirements, deadlines, and enforcement mechanisms remain subject to change. 

Next Steps: 

MGO recommends reviewing your reporting status with legal counsel to determine the best approach for your organization. For additional guidance, refer to FinCEN’s BOI reporting website. 

For deeper insights, visit our article: Beneficial Ownership Reporting Deadline Approaches — Are You Prepared? 

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