2021 Federal Tax Notes and Musings for Closely Held Business

BROOKS NELSON: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters. It's December, and we're talking about year-end tax planning.

BROOKS NELSON: Today's podcast will focus on selected developments affecting closely held businesses. Joining me are my colleagues from Cherry Bekaert: Barry Weins, Mike Elliott, and Sarah McGregor.

BARRY WEINS: This is Barry Weins. I'm a director in Tampa with the Professional Practices Group, and I work with corporations, C corporations, and private equity groups.

MIKE ELLIOTT: I'm Mike Elliott. I'm also a director in the Tampa office with the Professional Practices Group. I handle partnerships, primarily in the real estate industry and private equity.

SARAH MCGREGOR: I'm Sarah McGregor calling in from Greenville, South Carolina.

BROOKS NELSON: Alrighty. Sarah, how's life treating you?

SARAH MCGREGOR: Life is good. I'm still anticipating we might get a tax bill before the end of the year, which would be a great present and a way to start the new year. There are roughly 20 days left before year end, and there's a lot to get done for our clients.

BROOKS NELSON: Okay, let's narrow the topic a bit. We're not talking about major tax legislation today. Instead, we'll discuss court cases, IRS rulings, notices, and other developments from the year that affect closely held businesses. Barry, how much guidance has the IRS issued this year?

BARRY WEINS: It's been a prolific year for guidance. There have been at least 65 notices and over 50 revenue procedures, plus numerous revenue rulings and final regulations implementing provisions of the Tax Cuts and Jobs Act from 2017. The IRS has also been redesigning forms and instructions, and the tax court has been active again after COVID delays. Despite all that activity, the IRS still has limited phone availability.

BROOKS NELSON: Mike, can you go over recent revenue procedures that benefit companies with PPP loans and provide a little background?

MIKE ELLIOTT: There were three revenue procedures issued simultaneously addressing the taxability of PPP loan forgiveness. Companies received PPP loans to fund payroll and other eligible expenses, with the expectation of forgiveness. The IRS's previous position required deducting expenses when incurred, but treating loan forgiveness as income when the loan was forgiven.

MIKE ELLIOTT: That created basis timing issues for partners and S corporations when expenses were incurred in 2020 but forgiveness occurred in 2021. Taxpayers could be limited by basis in 2020 and then get a basis increase only when forgiveness occurred in 2021.

MIKE ELLIOTT: The IRS allowed an election to recognize tax-exempt income when the expenses are paid or accrued, when the forgiveness application is filed, or when forgiveness is granted. That could solve basis timing issues, but the revenue procedures were issued in November after returns were filed.

MIKE ELLIOTT: One revenue procedure addressed partnerships subject to the BBA audit rules, which generally limit amendment rights, and made an exception allowing amendment of 2020 returns to account for PPP loan forgiveness and related basis adjustments. Amended returns and amended Schedule K-1s must be provided before year end, so there is limited time to act.

MIKE ELLIOTT: In short, partners and partnerships can amend 2020 returns to match deductions and tax-exempt income in 2020 instead of waiting until 2021, but timing and compliance considerations determine whether to amend.

BROOKS NELSON: Mike, there were final regulations on carried interests. What changed and what will partnerships and partners need to report?

MIKE ELLIOTT: Proposed regulations issued last year drew many comments, and the IRS revised several provisions in the final regulations. One key improvement is clarification of the capital interest exception. The final regs simplified the test to focus on whether allocations are commensurate with capital contributed, eliminating a complex earlier rule.

MIKE ELLIOTT: The final regs also allow allocations attributable to a bona fide loan or advance from another partner to be treated as capital interest, provided the loan is evidenced and repayable. That means borrowing capital from another partner can be respected as contributed capital.

MIKE ELLIOTT: The look-through rule has been simplified. The final regs narrow some situations where applicable partnership interests transferred to related or unrelated parties would trigger recharacterization of long-term capital gains as short-term. The recalculation rule was modified so recharacterization occurs only upon recognized gain on a seller exchange.

BROOKS NELSON: What does API mean in this context?

MIKE ELLIOTT: API stands for applicable partnership interest. It generally refers to a service provider's interest that compensates them with future profits interests for raising capital or making investments, where certain gains could be recharacterized if assets were held less than three years.

SARAH MCGREGOR: I would add that these rules increase reporting requirements for 2021 tax returns. Partnerships with partners holding APIs must provide information about one-year and three-year disposition amounts, indicating long-term capital gains on assets held more than one year and less than three years. Partners will need to use that information to recharacterize gains appropriately.

BROOKS NELSON: Barry, Mike has covered partnerships. What's new for S corporations?

BARRY WEINS: The PPP loan relief provisions also apply to S corporations. If an S corporation had basis limitations because of PPP-funded expenses, shareholders can amend returns, although S corporations don't have the strict 12/31 deadline that some partnerships face.

BARRY WEINS: The IRS is placing more emphasis on tracking S corporation shareholder basis. Historically, basis calculations were often handled informally on worksheets. The IRS now requires Form 7203, S-Corporation Shareholder Stock and Debt Basis Limitations, to be filed with each shareholder's return when a current-year deduction exists, previously disallowed deductions are allowed in the current year, distributions not classified as dividends occur, loan repayments from the S corporation occur, or stock dispositions occur.

BARRY WEINS: Form 7203 requires detailed calculations for stock and debt basis. The IRS expects specific basis tracking for different forms of debt rather than aggregating them. This increases recordkeeping burdens and requires proper documentation of debt terms, interest rates, and repayment schedules.

BARRY WEINS: Taxpayers should review and document shareholder loans, ensure proper terms and interest rates, and confirm distributions and loan repayments are disclosed on Schedule K and Schedule K-1 to avoid surprises.

BROOKS NELSON: Barry, are you implying that owners sometimes move money between personal and company accounts without formal documentation?

BARRY WEINS: Yes, that happens. Formalities are sometimes lacking, and now more caution is required.

BROOKS NELSON: There's been buzz about new Schedules K-2 and K-3. Mike, explain those.

MIKE ELLIOTT: Schedules K-2 and K-3 provide much more detail for international items that used to be reported on Schedule K and Schedule K-1. Partnerships will file Schedule K-2 to report partnership-level foreign amounts and provide Schedule K-3 to each partner showing their share. These forms are detailed—about 20 pages each—and will make returns more burdensome when international activity exists. If you have no international items, these forms are not relevant.

SARAH MCGREGOR: K-2 and K-3 also apply to S corporation shareholders. The IRS recently announced leniency for this year, stating that a good-faith effort will be accepted and they won't be overly punitive for minor omissions.

BROOKS NELSON: Mike, what changes came in final regulations affecting small business taxpayer exceptions to accounting methods?

MIKE ELLIOTT: The small business taxpayer rules apply if average annual gross receipts for the prior three years are under $26 million. However, the tax shelter definition could exclude an entity even if gross receipts are under the threshold. One tax shelter definition involves syndicates: if more than 35% of losses are allocated to limited participants, a syndicate determination could disqualify the small business exception.

MIKE ELLIOTT: Proposed regs allowed electing to use prior-year allocations instead of current-year allocations to determine syndicate status. That helps when a current-year loss would otherwise create syndicate status. Final regs removed a prior five-year lock-in rule and now permit making the election annually. Taxpayers can choose each year whether to use prior-year allocations, giving flexibility and preventing automatic switching to accrual accounting that could be costly.

MIKE ELLIOTT: This change helps small businesses remain eligible for cash-method accounting and certain exceptions from business interest expense limitations if they meet the gross receipts test and aren't tax shelters.

BROOKS NELSON: Barry, many closely held businesses are managing overall income at year end. What pitfalls have we seen in tax news?

BARRY WEINS: Two cases illustrate issues for closely held C corporations. The first is ASPRO, decided in January. A paving company with three shareholders paid management fees to related parties without written agreements, invoices, or documentation, and the payments weren't proportional to ownership or work performed. The court concluded these payments were not bona fide management fees and were disguised distributions. The IRS disallowed the deductions, and the court agreed.

BARRY WEINS: The second case, Plentywood Drug, involved a pharmacy in Plentywood, Montana. The shareholders owned the real estate and leased it to the C corporation without a written lease. Rent increased significantly over the years, and the IRS challenged the reasonableness of the rent and treated excess rent as distributions. Because comparable data was scarce, the court pieced together valuation evidence and adjusted rent for certain years. Taxpayers prevailed on most issues, and penalties were not imposed due to the circumstances.

BARRY WEINS: The takeaway is that corporations must document and support payments deducted by the corporation and included as income by shareholders to avoid recharacterization as nondeductible dividends.

BROOKS NELSON: On the opposite end, TIGTA has raised flags about underpaying compensation to S corporation owners. Barry, what's the current state of play?

BARRY WEINS: The Treasury Inspector General for Tax Administration issued a report in August 2021 highlighting undercompensation of S corporation owners. The IRS has historically focused on other issues, but this report has increased attention on reasonable compensation for S corporation shareholder-employees. The standard is whether you would pay someone else an equivalent amount for the same services.

BARRY WEINS: The report has prompted the IRS to allocate more resources to this area. Legislative proposals have been discussed to subject S corporation income to additional payroll-like taxes to reduce incentives to underpay compensation, but that is separate from current audit focus.

BROOKS NELSON: Mike, we discussed a partner who made loans that went bad and later argued they were capital contributions. What happened there?

MIKE ELLIOTT: A partnership had a 10% partner who provided loans to the partnership that later became uncollectible. The partnership argued the loans were intended as capital contributions to avoid discharge of indebtedness income. The IRS and court looked at how the partnership treated the amounts historically—recording them as liabilities, not increasing the partner's capital account or allocations—and rejected the argument. The partner recognized discharge of indebtedness income and later claimed a bad debt deduction, which likely results in a capital loss, creating a mismatch.

MIKE ELLIOTT: The lesson is that the historical treatment and consistency with economic reality matter when classifying intercompany obligations as loans or capital contributions.

BROOKS NELSON: Barry, you had a similar case, Kelly, involving loans from an S corporation to related parties.

BARRY WEINS: In Kelly, an S corporation made loans to related entities repeatedly during a downturn. Initially the loans might have been reasonable, but continued funding with little prospect of repayment led the court to recharacterize the transfers as distributions. The distributions exceeded basis, resulting in significant taxable gain. The court emphasized whether a reasonable lender would have made the loans given the borrower's prospects and whether repayment terms were commercially reasonable.

BARRY WEINS: When making intercompany loans, document commercial terms, assess borrower wherewithal at origination, set reasonable interest rates, and maintain repayment schedules. These factors tie back to shareholder basis and Form 7203 reporting.

BROOKS NELSON: This is common among closely held businesses where cash moves among related entities and informal loans become tangled. Intentional documentation and planning are essential.

BROOKS NELSON: Sarah, one last item: the infrastructure bill eliminated the Employee Retention Credit for fourth-quarter 2021 wages. The IRS issued a notice—what relief did they provide?

SARAH MCGREGOR: The bill was signed in November, well into the fourth quarter. Employers who anticipated ERC availability reduced payroll tax deposits and faced potential penalties for underpayments. The IRS notice provides penalty relief for employers who underpaid payroll taxes for fourth-quarter wages because they reasonably anticipated the ERC, provided they catch up the deposits by year end.

SARAH MCGREGOR: Relief does not apply to underpayments for other reasons or to continued underpayment after December 20. Employers can still file amended Form 941 returns to claim qualified ERC for prior quarters, and many employers are still eligible to claim ERC for 2020 and 2021 within applicable statutes of limitations.

BROOKS NELSON: Final comments?

MIKE ELLIOTT: We're anxiously waiting to see if there's a bill before year end.

BARRY WEINS: I echo that. If a bill passes, some will view it as a gift and others as a lump of coal.

BROOKS NELSON: There's a lot of activity effective for 2021, and taxpayers should not overlook developments that apply to this year and the upcoming tax-filing season. Collecting necessary information now and reviewing basis, lending arrangements, and documentation is important.

BROOKS NELSON: Thank you for listening to our discussion of selected highlights for closely held businesses. A quick disclaimer: we are not providing tax advice on this podcast. Please consult your tax advisor, preferably at Cherry Bekaert, for specific tax issues or to discuss information from today's podcast.

BROOKS NELSON: Check the firm's website at cbh.com for the latest guidance and materials on this and other tax and business topics. This concludes today's podcast. Please like, share, and subscribe.

BROOKS NELSON: Thank you, Barry, Mike, and Sarah, and thank you to our listeners for spending time with us. Let's call it a day and go forth in peace.