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The choice of entity is among the most important decisions facing taxpayers when starting a business or investment activity. The choice of tax entity generally includes a C corporation, S corporation or partnership, each having its own advantages and disadvantages that must be evaluated in terms of how the entity’s tax and legal characteristics align with the goals of the business and its investors.

Existing businesses should also evaluate their choice of entity—especially now, in light of President Biden’s proposals to increase the tax burden on corporations and high-wealth individuals. Depending on the circumstances, it may make sense to consider converting an existing entity to a different type of tax entity or structure in order for businesses and their owners to better manage their overall tax obligations. An analysis should be performed to determine the amount of any immediate tax cost that would be incurred upon changing entity classification compared to the future tax benefits of conversion.

Choice of entity decisions need to take into account many tax and legal considerations based on the taxpayer’s specific facts and circumstances, as well as business and investment goals. Taxpayers should keep in mind that current tax proposals would raise tax rates and make other changes to the federal income tax system for corporations and high-wealth individuals. These proposals should be monitored, and their potential effects should be considered when evaluating the short and long-term benefits of a particular entity choice.

Tax considerations when choosing an entity

There any many tax considerations that play into the choice of entity decision, some of which are discussed below. All of the considerations should be analyzed together with other important factors, such as whether investors intend to distribute or reinvest available cash, income projections including whether the business anticipates upfront losses, the expected rate of return on investment, the time horizon for exit and available exit strategies.

Effective tax rate on earnings

The rate at which businesses pay tax on their earnings impacts after-tax cash flow and return on investment. Further, whether the business distributes or reinvests its available cash affects enterprise value.

C corporations pay tax on their earnings at the corporate level at a 21% rate, and earnings distributed as dividends are subject to tax again at the shareholder level. This double taxation amounts to an overall effective tax rate on distributed earnings of around 40%, as opposed to a single 21% rate on earnings that are reinvested in the business. President Biden’s tax proposals would increase the corporate tax rate to 28%, which would increase the overall rate on distributed earnings to 45%—or even higher for individuals that would, under his tax plan, be subject to ordinary income tax rates on dividends.

Passthrough entities (S corporations and partnerships), on the other hand, do not pay entity level tax. Instead, their earnings are reported by and taxed at the rates of their owners, regardless of whether the earnings are distributed. For individual owners, this means a top marginal tax rate of 37% on passthrough earnings, or 29.6% if the qualified business income deduction applies. President Biden’s plan would increase an individual owner’s top rate to 39.6% and phase out the qualified business income deduction at income levels exceeding $400,000.

Although, based on the difference in tax rates, C corporations that reinvest their earnings may be able to generate greater after-tax cash flow than a passthrough entity, the analysis should not end there. A C corporation shareholder may pay more tax upon disposing of its investment than a passthrough owner, especially in cases where no viable tax planning strategy exists (see “Exit Strategies,” below). In addition, C corporations that do not pay dividends may be subject to the accumulated earnings tax and the personal holding company tax.

Exit strategies

The amount of tax owed on exit plays a very important role in the choice of entity decision. Due to the difference in the build-up of tax basis in investments in C corporations versus investments in passthrough entities, C corporation shareholders will generally have a larger gain on the disposition of their investment than passthrough entity owners. The tax on disposition will depend on the owners’ tax rates and the amount of ordinary income recapture, among other factors.

There are certain exit strategies that may be used to defer the tax on gains from dispositions of investments. These strategies include:

• Reinvesting the gains in qualified opportunity zones or qualified opportunity funds;
• Selling the shares of a C corporation to an employee stock ownership plan; and
• Transferring the investment through estate planning. Note that under President Biden’s tax proposals, the tax basis step-up of property at death would be limited.

In addition, non-corporate shareholders may be permitted to exclude part or all of the gain from the sale or exchange of “qualified small business stock” (QSBS) of C corporations that has been held for at least five years. The overall gain exclusion per issuer is limited to the greater of $10 million or 10 times the aggregate adjusted basis of the disposed shares. Each partner in a partnership and each shareholder in an S corporation is entitled to their own $10 million limitation on dispositions of QSBS by the partnership or the S corporation.

Changes to entity classification

Converting from one type of entity to another requires thoughtful consideration, analysis, and planning, and certain entity types may provide more flexibility than others for changing entity status. Converting to a different type of entity may trigger immediate tax consequences, which must be measured relative to any potential future tax benefits. Examples of possible tax consequences include taxable liquidations, tax on built-in gains, gain on liabilities in excess of tax basis, deferred revenue recognition, and changes in accounting methods.

Other tax considerations

The following are among the many other tax issues to consider when choosing an entity, the tax treatment for which can vary by entity type:

• International tax rules, such as taxation of controlled foreign corporations, foreign tax credit limitations, and consequences of repatriation tax deferral;
• Deductibility of upfront net operating losses;
• Self-employment taxes (note that the social security base would increase under President Biden’s tax proposals);
• State income taxes, which vary by state;
• Estate and inheritance tax consequences for individual owners and their families; and
• Tax reporting requirements, which in certain cases can be less onerous for C corporations as opposed to passthrough entities.

Non-tax considerations

While the choice of entity is often a tax driven decision, there are also many non-tax factors to consider, such as:

• Liability protection for owners and management;
• Flexibility for making day-to-day management decisions and for binding the organization;
• Access to capital;
• Transferability of ownership interests; and
• Available exit strategies and succession planning.

How We Can Help

We can help you better understand the requirements and operational differences between C corporations, S corporations and partnerships, as well as model the immediate and long-term costs and benefits of converting, or not converting, from your current entity status or form.

On August 4, 2021, the IRS issued Notice 2021-49, which provides long overdue guidance for employers that have taken or are considering taking the employee retention credit (ERC) as initially made available under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) and modified and extended under the American Rescue Plan Act of 2021 (ARPA). Generally, the maximum ERC for 2020 is $5,000 per employee, while the maximum for 2021 is $28,000 per employee.

The ARPA extended the ERC for wages paid after June 30, 2021 and before January 1, 2022. The IRS previously issued nearly 100 frequently asked questions (FAQs) and two notices (Notice 2021-20 and 2021-23) in an attempt to provide guidance on the ERC. However, these FAQs and notices fail to address some important questions, such as whether cash tips received by employees and wages paid to an owner with more than 50% ownership of a company are qualified wages for the ERC. Notice 2021-49 addresses this issue and clarifies other issues related to the mechanics of the credit. The notice also clarifies and provides additional guidance for several other important provisions of the ERC as modified by the ARPA.

In addition, on August 10, 2021, the IRS issued Revenue Procedure 2021-33, which provides a safe harbor for employers to exclude (1) the amount of the forgiveness of a Paycheck Protection Program (PPP) loan under the Small Business Act, (2) a shuttered venue operator grant under the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (Economic Aid Act), and (3) a restaurant revitalization grant under the ARPA from “gross receipts” for purposes of determining eligibility to claim the ERC.

Background

The CARES Act provides for a refundable tax credit for eligible employers that pay qualified wages, including certain health plan expenses, to some or all employees after March 12, 2020 and before January 1, 2021.

The Taxpayer Certainty and Disaster Tax Relief Act of 2020 (Relief Act) amended and made technical changes to the ERC for qualified wages paid after March 12, 2020 and before January 1, 2021, primarily expanding eligibility for certain employers to claim the credit. The Relief Act also extended the ERC to qualified wages paid after December 31, 2020 and before July 1, 2021 and modified the calculation of the credit amount for qualified wages paid during that time. The Relief Act permitted employers to qualify for the ERC if they experienced revenue declines of 20% (previously 50%), and it changed the definition of large employer from an employer that averaged 100 employees to one that averages 500 employees, enabling businesses with 500 or fewer employees to take the ERC for all wages paid, rather than only for wage payments for which no services were provided. The Relief Act also allowed employers that received PPP loans to also take the ERC, retroactive to March 2020.

The following summarizes Revenue Procedure 2021-33 and some of the most significant issues addressed in Notice 2021-49.

Safe Harbor for Gross Receipts – Revenue Procedure 2021-33

Under Internal Revenue Code Section 448(c) for for-profit entities and Section 6033 for tax-exempt organizations, PPP loan forgiveness, shuttered venue operator grants and restaurant revitalization grants are not included in employers’ gross income but are included in gross receipts. Revenue Procedure 2021-33 provides a safe harbor for employers to exclude those amounts from gross receipts solely for determining ERC eligibility. The IRS said that Congress intended for employers to be able to participate in these relief programs and also claim the ERC. Therefore, including amounts provided under those relief programs in gross receipts for determining eligibility for the ERC would be inconsistent with Congressional intent.

Under the revenue procedure, an employer is required to consistently apply the safe harbor by (1) excluding the amount of the forgiveness of any PPP loan and the amount of any shuttered venue operator grant and restaurant revitalization grant from its gross receipts for all relevant quarters in determining eligibility to claim the ERC, and (2) applying the safe harbor to all employers treated as a single employer under the ERC aggregation rules.

Employers elect to use the new safe harbor by excluding amounts under those relief programs when claiming the ERC on Form 941, Employer’s Quarterly Federal Payroll Tax Form (or 941-X if filing an amended return). In other words, a separate “election” form is not needed. If an employer revokes its safe harbor election, it must adjust all employment tax returns that are affected by the revocation. Employers must retain in their records support for claiming the ERC, including their use of this new safe harbor for determining gross receipts.

Clarifications to the ERC Under Notice 2021-49

Applicable Employment Taxes

Notice 2021-49 confirms that, for the third and fourth quarters of 2021, eligible employers can claim the ERC against the employer’s share of Medicare tax (or the portion of Tier 1 tax under the Railroad Retirement Tax Act) after these taxes are reduced by any credits allowed under the ARPA for qualified sick leave wages and qualified family leave wages, with any excess refunded.

Recovery Startup Business

An ERC of up to $50,000 per quarter is available to “recovery startup businesses.” A recovery startup business is an employer that began carrying on a trade or business after February 15, 2020. The notice clarifies that an employer is not considered to have begun carrying on a trade or business until such time as the business has begun to function as a going concern and performed those activities for which it was organized.

The notice also states that a not-for-profit organization can be treated as an eligible employer due to being a recovery startup business based on all of its operations and average annual gross receipts. For ERC purposes, a not-for-profit organization is deemed to be a “trade or business.”

Further, a recovery startup business that has 500 or fewer full-time employees may treat all wages paid with respect to an employee during the quarter as “qualified wages.”

Finally, the aggregation rules apply when determining whether an employer is a recovery startup business, as well as to the $50,000 limitation on the credit. Thus, a recovery startup business would need to apply IRC Sections 52(a) (for related corporations), 52(b) (for related non-corporate entities, such as partnerships, trusts, etc.) and 414(m) (affiliated service group rules).

Qualified Wages

Qualified wages generally are determined differently based on whether the employer is a small or large employer, in that qualified wages for large employers are limited to wages paid to an employee for time the employee is not providing services due to a full or partial suspension of business operations or a decline in the employer’s gross receipts.

The notice clarifies the rule for qualified wages for a “severely financially distressed employer” (SFDE). An SFDE is an employer that, in the third or fourth quarter of 2021, has gross receipts of less than 10% of its gross receipts for the same quarter in 2019. For SFDEs, qualified wages are any wages paid in the quarter, regardless of the size of the employer. This is different from the standard ERC rule, which limits qualified wages for large employers to wages paid while the employee is not performing services.

Full-Time Employees Versus Full-Time Equivalents

Confusion abounds about the definition of “full-time employee” and whether “full-time equivalents” are to be included when determining whether an employer eligible for the ERC is a large or small employer. Notice 2021-49 clarifies that eligible employers are not required to include full-time equivalents when determining the average number of full-time employees. The notice also confirms that wages paid to an employee who is not a full-time employee may be treated as qualified wages if all other requirements are met.

Treatment of Tips and FICA Tip Credit

Considerable confusion has arisen as to whether tips count as qualified wages for the ERC, since customers (not the employer) generally pay the employee the tips. Notice 2021-49 clarifies that cash tips are qualified wages if all other requirements to treat the amounts as qualified wages are met. The notice also confirms that eligible employers are not prevented from receiving both the ERC and the FICA tip tax credit on the same wages.

Timing of Qualified Wages Deduction Disallowance

The IRS has provided guidance on the timing of the disallowance for wage deductions on the employer’s federal tax return relating to qualified wages claimed for the ERC. The IRS previously confirmed that employers must reduce the deduction claimed for employee wages on their federal tax return by the amount of qualified wages claimed under the ERC. Notice 2021-49 confirms that this reduction in the deduction amount must occur in the same tax year the ERC is claimed. Accordingly, if an employer files a claim for the credit for a prior tax year, it must also file an amended federal tax return to reduce the amount of the wage deduction claimed in the corresponding period.

Related Individuals

The IRS previously stated that wages paid to related individuals, as defined by IRC Section 51(i)(1), are not taken into account for ERC purposes. Notice 2021-49 clarifies that, by applying the ownership attribution rules, the definition of a “related individual” includes a majority owner (i.e., a person with more than 50% ownership) of an entity if the majority owner has a brother or sister (whether by whole or half-blood), ancestor or lineal descendant. The spouse of a majority owner is also a related individual for purposes of the ERC if the majority owner has a family member who is a brother or sister (whether by whole or half-blood), ancestor or lineal descendant.

Insight

Wages paid to a sole owner or majority owner will rarely qualify for the ERC, according to the guidance provided in Notice 2021-49, because of the way the ownership attribution rules are applied. The owner must have no family other than a spouse in order to treat his or her wages as qualified wages. Members of Congress have voiced their disagreement with this guidance. It is possible the IRS will revise their position regarding related individuals in future guidance.

Alternative Quarter Election for Calendar Quarters in 2021

The Treasury Department and the IRS have been asked whether an eligible employer must consistently use the alternative quarter election once it has been made. The Notice 2021-49 confirms that employers are not required to use the alternative quarter election consistently. For example, an employer may be an eligible employer due to a decline in gross receipts for the second quarter of 2021 using the standard quarter comparison; the employer could then use the alternative quarter election to be an eligible employer for the third quarter of 2021.

Gross Receipts Safe Harbor in Notice 2021-20

Notice 2021-49 confirms that the safe harbor rule that allows an employer to include the gross receipts of an acquired business that it did not own during a calendar quarter in 2019 continues to apply to employers that acquire businesses in 2021 for purposes of measuring whether there was a decline in gross receipts. In addition, an employer that came into existence in 2020 (e.g., the third quarter of 2020) should use that quarter to determine whether it experienced a significant decline in gross receipts for the first three quarters in 2021 and should determine whether it experienced a significant decline in gross receipts by comparing the fourth quarter of 2020 to the fourth quarter of 2021.

Insights

Guidance provided in Notice 2021-49 has created several opportunities for certain employers to obtain additional ERCs. For example, some restaurant employers may not have included cash tips as qualified wages for their previous ERC claims. Under the notice, those employers can now file amended returns to claim additional ERCs or employers who did not count amounts paid to full-time equivalent employees as qualified wages for the ERC may now do so. Revenue Procedure 2021-33 has also created an opportunity for certain employers that received PPP loan forgiveness, shuttered venue operator grant or restaurant revitalization grant to obtain additional ERC. Employers should review the contents of the notice and the revenue procedure with their tax advisor to determine if additional ERCs may be available, and if so, employers may file Form 941-X to request the additional credit or refund.

Employers should also determine if they may have claimed more ERC than they were entitled to based on the guidance in Notice 2021-49. For example, some small business owners may not have applied the ownership attribution rules correctly. If necessary, Form 941-X may be filed to correct the error. According to the notice, the IRS will not assess penalties for failure to timely pay or deposit tax if the taxpayer can show reasonable cause and not willful neglect for the failure.

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H.R. 3684, the Infrastructure Investment and Jobs Act, proposes to end the ERC on September 30, 2021 rather than December 31 (but recovery startup businesses would remain eligible through year-end). That provision may or may not be included in the infrastructure bill that is eventually signed into law (which is expected in the next month or so).

On June 17, 2021, the IRS released an advance copy of Rev. Proc. 2021-28, providing guidance for taxpayers on how to change their method of computing depreciation to a 30-year recovery period under the alternative depreciation system (ADS) for certain residential rental property placed in service before 2018 and held by an electing real property trade or business (RPTOB). The IRS also released Rev. Proc. 2021-29, which permits an eligible partnership to file an amended Form 1065, U.S. Return of Partnership Income, as an alternative to filing an administrative adjustment request (AAR) or a Form 3115 to change to this depreciation method. Rev. Proc. 2021-28 modifies guidance for automatic accounting method changes previously issued under Rev. Proc. 2019-08 and Rev. Proc. 2019-43.

Rev. Proc. 2021-28 is effective June 17, 2021. Rev. Proc. 2021-29 applies to partnership taxable years that began in 2018, 2019, or 2020.

The revenue procedures expand the scope of the relevant automatic accounting method change procedures to apply to taxpayers that made a RPTOB election in 2019 as well as taxpayers that made the RPTOB election in 2018. The revenue procedures also permit taxpayers to make an accounting method change by filing Form 3115 or by filing an amended return, and permit eligible partnerships to file amended Forms 1065 in lieu of filing an AAR.

Background

The 2017 Tax Cuts and Jobs Act (TCJA) permits qualified taxpayers to make a RPTOB election in order to be exempt from the interest expense limitation under Section 163(j) of the Internal Revenue Code. As an offset, Section 168(g)(8) requires electing RPTOBs to depreciate nonresidential real property, residential rental property and qualified improvement property under the ADS. Prior to the TCJA, the recovery period under the ADS for residential rental property was 40 years. The TCJA modified this recovery period to 30 years for property placed in service after December 31, 2017. An electing RPTOB that owned residential rental property placed in service prior to December 31, 2017 was required to follow the change in use rules under Section 168(i)(5) and Reg. §1.168(i)-4(d) and depreciate such property over 40 years.

The Consolidated Appropriations Act, 2021 (CCA 2021), enacted on December 27, 2020, retroactively expanded the 30-year recovery period for RPTOB taxpayers to include certain residential rental property placed in service before January 1, 2018. This change makes the recovery period 30 years for residential rental property held by an electing RPTOB, regardless of when the property was placed in service.

Rev. Proc. 2019-08 provides guidance for an electing RPTOB on changing the depreciation method for its existing property (property placed in service before its RPTOB election year) to the ADS in the year it makes the RPTOB election. Rev. Proc. 2019-08 also provides that if an electing RPTOB fails to change its existing property to the required ADS for its election year or the subsequent taxable year, it will be considered to have adopted an impermissible method of accounting for that property and must then change the accounting method to a permissible method. If a taxpayer is eligible, it may make the method change by filing Form 3115 using designated automatic accounting method change number (DCN) 88, as provided under Section 6.05 of Rev. Proc. 2019-43. DCN 88 provides an automatic change in method of accounting for depreciation due to a change in the use of MACRS property.

New Guidance

Rev. Proc. 2021-28 applies to residential rental property meeting all the following criteria:

• The property was placed in service by the taxpayer before January 1, 2018, or was placed in service by the transferor of the residential rental property before January 1, 2018 if the acquisition of such property by the transferee-taxpayer is subject to Section 168(i)(7) (this section provides “step-in-the shoes” treatment for certain depreciable property in certain types of transactions—Section 3.04 of Rev. Proc. 2021-28 provides some examples of the application of this rule);
• The property is held by an electing RPTOB; and
• The property was not subject to the ADS depreciation method prior to January 1, 2018 in the hands of the taxpayer or the transferor if the acquisition of such property by the transferee-taxpayer is subject to Section 168(i)(7).

Rev. Proc. 2021-28 applies only to RPTOB elections made on or before December 27, 2020 (the date of enactment of the CCA 2021). It does not apply to a taxpayer making a late RPTOB election under Section 4 of Rev. Proc. 2020-22, or a taxpayer withdrawing a RPTOB election under Section 5 of Rev. Proc. 2020-22.

Rev. Proc. 2021-28 permits an electing RPTOB to file an amended federal income tax return or information return, an AAR under section 6227 or a Form 3115, Application for Change in Accounting Method, to change its method of computing depreciation for certain existing residential rental property to use a 30-year ADS recovery period. If such property is included in a general asset account (GAA), Rev. Proc. 2021-28 also provides procedures to change a taxpayer’s GAA treatment for such property.

Rev. Proc. 2021-28 expands the availability of the relevant automatic changes as follows:

• Generally, a taxpayer that improperly depreciates an item on only one federal tax return has not established a tax accounting method and, to correct the error, would be required to amend that return. However, once the impermissible treatment has been used on two consecutive federal tax returns, the taxpayer has established the method of accounting and would need to change to a permissible method by filing Form 3115. Rev. Proc. 2021-28 expands the application of the automatic method changes under DCN 88 (see above) and DCN 87 (which applies to a change in GAA treatment due to a change in the use of MACRS property), to permit a taxpayer that has only filed one federal tax return using an impermissible method to change to a permissible method by filing Form 3115 instead of an amended return.
• A taxpayer now may use the automatic changes even if the year of change is the final year of the taxpayer’s trade or business.
• A taxpayer now may use the automatic changes even if it has made or requested a change for the same residential rental property during any of the five taxable years ending with the year of change for taxable years of change beginning in 2019, 2020, 2021, or 2022.
• For property not included in a GAA, the taxpayer must own the property at the beginning of the year of change to use DCN 88.
• A taxpayer may include changes for both DCN 87 and DCN 88, from permissible to permissible methods of accounting for depreciation under a GAA election under Section 6.12(3)(b) of Rev. Proc. 2019-43, and for dispositions of depreciable assets in a GAA, on the same Form 3115.

If a taxpayer filed an accounting method change under Section 6.01 (impermissible to permissible method of accounting for depreciation or amortization) of Rev. Proc. 2019-43 before June 17, 2021, and the change was made either on a modified cut-off basis (if the property is in a GAA) or with a Section 481(a) adjustment (if the property is not in a GAA), the taxpayer does not have to file another accounting method change under Rev. Proc. 2021-28.

Partnership Options in Lieu of Filing Form 3115

Rev. Proc. 2021-29 allows certain BBA partnerships (a partnership subject to the centralized partnership audit regime enacted as part of the Bipartisan Budget Act of 2015) to file amended returns for tax years beginning in 2018, 2019 or 2020 instead of AARs. By granting this relief, taxpayers may generally receive an acceleration of refunds related to depreciation changes. To take advantage of the relief, a partnership must have filed initial partnership returns and schedules before June 17, 2021 and the amended returns and Schedules K-1 must be filed on or before October 15, 2021. Rev. Proc. 2021-29 applies only if the BBA partnership and the residential rental property are within the scope of Rev. Proc. 2021-28. Note however, if a partnership is eligible to file an amended return under Rev. Proc. 2021-29, the partnership may also make changes on its amended return in addition to the retroactive ADS change for residential rental property.

Limited Time to File Amended Return or AAR

Rev. Proc. 2021-28 provides that a taxpayer, including a non-BBA partnership, may file an amended federal income tax return or amended Form 1065 for its RPTOB election year on or before April 15, 2022, but in no event later than the applicable period of limitations on assessment for the taxable year for which the amended return is being filed. A BBA partnership that does not file an amended return may file an AAR for the election year on or before April 15, 2022, but in no event later than the applicable period of limitations on making adjustments under Section 6235 for the reviewed year. Collateral adjustments to taxable income or to tax liability must be made on the amended return or amended Form 1065, or AAR, and such adjustments also must be made on original or amended federal income tax returns or Forms 1065, or AARs, for any affected succeeding taxable years. For residential rental property in a GAA, the taxpayer must make the adjustments in Reg. §1.168(i)-1(h)(2)(ii) and (iii)(B).

Note that this guidance does not provide any relief in the form of being able to make an automatic accounting method change for taxpayers that are, or plan on, performing a cost segregation study after making a RPTOB election. These taxpayers may not be able to file an automatic accounting method change to reclassify any personal property that has been treated as longer-lived property to shorter depreciation recovery periods due to the order in which the RPTOB election and cost segregation study are implemented and the current accounting method change guidance.

In short, if a taxpayer has changed the depreciation of personal property to the ADS when making the RPTOB election (because the assets have not been properly reviewed and classified as personal property instead of residential rental property or nonresidential real property), the taxpayer likely has made an unauthorized accounting method change for the personal property. If a taxpayer subsequently performs a cost segregation study to properly classify the personal property, the current procedural guidance will prohibit filing an automatic accounting method change within five years of a prior accounting method change (including an unauthorized change). A taxpayer that inadvertently misclassified some assets in its fixed asset system and does not discover the misclassification until after the RPTOB election is made may also be prohibited from filing an automatic accounting method change. A taxpayer may file a non-automatic accounting method change—which may only be requested for the current tax year, requires Form 3115 to be filed with and reviewed by the IRS national office and requires the payment of an IRS user fee. Alternatively, a taxpayer could wait for the five-year period to pass before filing an automatic accounting method change.

The Biden Administration’s American Families Plan and other tax proposals may complicate the tax landscape for high-income earners. Many of the proposals target taxpayers earning more than $400,000 per year.

The American Families Plan proposals include:

• Increasing the top marginal income tax rate to 39.6% for households making over $400,000;
• Taxing long-term capital gains at 39.6% for households making over $1 million;
• Reducing the step-up in basis for gains in excess of $1 million at death and taxing the gains if the property is not donated to charity;
• Eliminating carried interest and taxing that income at ordinary income rates;
• Permanently extending excess business loss limitation rules; and
• Applying the 3.8% net investment income tax consistently for those making over $400,000.

To add significance to these proposals, President Biden also proposes earmarking $80 billion for IRS audit efforts that will target high-income individuals who have engaged in tax avoidance or other tactics to reduce their taxable income. The additional funding will be accompanied by increased IRS enforcement powers.

In addition, President Biden put forth the following proposals during his election campaign:

• Phasing out the 20% qualified business income tax deduction;
• Limiting the benefit of itemized deductions to 28% of their value and restoring the “Pease limitation” cap on itemized deductions;
• Reducing the lifetime estate tax exemption from $11.7 million to $3.5 million (i.e., back to 2009 levels) and increasing the estate and gift tax rate from 40% to 45%; and
• Imposing the 12.4% social security payroll tax on earned income above $400,000.

These proposals, although not specifically mentioned in the American Families Plan, continue to be part of the President’s tax agenda.

What can taxpayers do now?

Given the real possibility of targeted tax increases on the wealthy, as well as the uncertainty of when any increases might take effect, individuals, business owners and family offices should review their current situations to identify opportunities in which their overall federal and state tax liabilities could be minimized.

• Taxpayers should evaluate the extent to which they can time the recognition of income and deductions within a desired tax year. Planning should not only be driven by current and future tax rates but also by the taxpayer’s individual facts and circumstances, including income and cash goals.
• Due to the uncertainty of whether tax legislation will ultimately be passed, and to what extent, tax planning efforts should include multiple “what-if” scenarios to prepare for a range of possible legislative outcomes and effective dates.
• As the future tax landscape takes shape, taxpayers should consider strategies to minimize tax on their capital gains, such as:

• Accelerating capital gains to take advantage of lower rates;
• Managing levels of other taxable income to avoid higher rates on capital gains;
• Timing when tax is due by using or electing out of the installment method; and
• Using deferral strategies such as like-kind exchanges, investments in qualified opportunity zones, and ESOP rollover transactions.

• Individuals and families should revisit their estate plans in light of President Biden’s tax proposals. Individuals—especially those with large estates—should evaluate the benefits of multi-generational wealth transfers, the use of trusts and other estate planning opportunities, and be prepared to implement strategies in advance of proposals becoming law.

How we can help

We can provide comprehensive tax and financial planning assistance to wealthy individuals and their families, as well as for their business interests, whether in a domestic or cross-border context. We are experienced in all aspects of estate, income, gift, and trust tax consulting and compliance; charitable giving and philanthropic foundations; executive compensation; and cash flow, retirement, and life insurance planning.

Our professionals can keep you up to date on the status of tax proposals, provide insights on how new policies will affect your tax position, assist in assessing planning opportunities, and perform scenario planning and tax calculations. Our professionals also can assist with IRS audits and other inquiries.

On February 11, 2021, the Tax Court ruled in favor of the IRS in Little Sandy Coal Company v. Commissioner, finding that the taxpayer (petitioner) failed to meet the “substantially all” requirement with respect to the “process of experimentation” test under Internal Revenue Code (IRC) Section 41.
Details

The dispute involved research tax credits claimed by Corn Island Shipyard, Inc. (CIS), a subsidiary of Little Sandy Coal Company, for the construction of several vessels for the tax year ending June 30, 2014. CIS is a corporation that designs, constructs and launches seafaring craft such as tankers and dry docks. The IRS took the position that CIS did not meet the “substantially all” requirement, i.e., that substantially all of the activities involved in the research constitute elements of a process of experimentation, which according to the relevant regulations means that 80% or more of the taxpayer’s research activities constitute elements of a process of experimentation for the costs related to the business component to be qualified. The IRS also determined that there was no identifiable sub-business component for the “Shrink Back” provision of Treas. Reg. §1.41-4(b)(2) to apply (under which a taxpayer will be permitted to claim certain improvement costs where the improvements made to an existing product account for less than 80% of the total product costs) and that CIS failed to produce sufficient records to substantiate its research tax credit. The Tax Court analyzed two selected projects: the “Apex Tanker” project and the “Dry Dock” project as representative samples of the types of activities undertaken by the taxpayer in the year at issue.

Although the Tax Court had “no doubt” that the iterative and detailed processes in designing the Apex Tanker and the Dry Dock evidenced processes of experimentation, the Court remained unconvinced that the taxpayer proved that the development activities constituted at least 80% of a process of experimentation.

For the Apex Tanker, Petitioner argued that many elements of the vessel—compared to previous models CIS had designed—were “redesigned and re-engineered during the development process.” CIS claimed that the tanker’s hull—“which makes up 90% of the vessel and was part of an extensive process of experimentation—demonstrated that the vast majority of the vessel, including every major system on the vessel, was re-engineered and redesigned meeting the substantially all requirement.” The court rejected this argument, ruling that the substantially all test must “be applied in reference to activities—not physical elements of the business component being developed or improved.”

Furthermore, although the Dry Dock project was a completely new design, the Court stated that, “accepting that the dry dock consisted entirely of novel elements that CIS had not previously designed and built would establish only that the design of those elements was uncertain at the start of the development process. Resolving that design uncertainty may have required, but did not necessarily require, a process of experimentation.” For both projects, the Court is clear that, “the novelty of an element of a business component does not establish that the work involved in developing that element involves a process of experimentation.”

In both examples, CIS asserted that substantially all of the time spent by its employees went toward a process of experimentation. The Tax Court responded that, while employee time or wages is a reasonable basis for determining if the substantially all test is satisfied, there must be a line-by-line analysis.

Significantly, the Court held that only the activities of the employees conducting direct research may be used to ascertain the numerator of the fraction that determines if a business component meets the 80% threshold and would not include supply costs or employees directly supporting or supervising research. According to the Court, the latter employees should be removed as they would not be directly involved in activities that constituted a process of experimentation. The Court further held that because supplies are not activities, when the fraction described in Treas. Reg. §1.41-4(a)(6) is computed using costs as a measure of activities, the costs of supplies used in the development of the product should not be taken into account. Correspondingly, the denominator is broad. In the view of the Tax Court, the sum of all other qualified activities and direct research should be included in the denominator. Here, it was mathematically impossible for either the Apex Tanker or the Dry Dock—analyzed at the project level—to meet the 80% threshold because the activities of directly supporting and supervising employees were excluded.

Even if a project did not meet the 80% threshold, the Tax Court signaled its acceptance that sub-components of these vessels could have likely satisfied a process of experimentation test, but given that CIS chose an “all or nothing strategy” to identify only the project at large as the business component without looking to the subcomponent level, the Tax Court was prevented from applying the “Shrink Back Rule.” This resulted in all activities related to the projects to be disqualified from inclusion in IRC Section 41.

The Tax Court focused on the taxpayer’s lack of substantiation with respect to its non-time- tracked employees. Although the Court recognized that CIS was burdened because there was an absence of any nontax reason to track the work of some of its employees by project and activity, the Tax Court highlights that Treas. Reg. §1.41-4(d) requires taxpayers to retain sufficient records to demonstrate they are eligible for the credit. Although the record-keeping requirement is liberal, the Court found that CIS’ choice “not to maintain detailed records of how its (non-production employees) spent their time placed on (CIS) the burden of demonstrating . . . the portion of those individuals’ work that did and did not involve a process of experimentation.” Thus, because CIS lacked detailed documentation, the burden fell on it to produce evidence of time allocations that it did not know. Consequently, CIS failed to meet its burden and all of the qualified activities associated with the projects were excluded.
Insights

The Tax Court’s decision rejects the U.S. District Court for the Northern District of Texas’ holding in Trinity Industries v. United States for its lack of detailed analysis around how two of the ships at issue, in that case, satisfied the substantially all requirement. The Tax Court’s decision reinforces the importance of analyzing business components and having a methodology to support a reasonable basis to quantify whether the substantially all test is met. The Court is particularly direct in requiring a “line by line” analysis of the costs associated with the processes of experimentation that occur for each business component.

Although Petitioner argued that analysis should be conducted based on assessing the new or improved nature of the product, the Court found that the process of experimentation test must be based on the activities of the employees. Without sufficient substantiation to support that substantially all of the activities constituted a process of experimentation, the taxpayer was unable to meet its burden and, due to the taxpayer’s all or nothing approach, its entire research tax credit was rejected. Taxpayers should carefully consider documenting employees’ time by type and by project.