The SEC unanimously approved the PCAOB’s new auditor’s reporting standard Monday, supporting the communication of “critical audit matters” as a way for auditors to provide more information to investors and the public.

The SEC unanimously approved the PCAOB’s new auditor’s reporting standard Monday, supporting the communication of “critical audit matters” as a way for auditors to provide more information to investors and the public.

As defined in the PCAOB standard and related amendments, critical audit matters are any matter arising from the current period’s audit of the financial statements that was communicated or required to be communicated to the audit committee, and that:

• Relates to accounts or disclosures that are material to the financial statements, and
• Involved especially challenging, subjective, or complex auditor judgment.

The standard marks the first major change to the standard form auditor’s report in 70 years, PCAOB Chairman James Doty has said.

SEC Commissioner Kara Stein said in a statement that she expects the new auditor’s report to provide investors with more meaningful information about the audit, including significant estimates and judgments, significant unusual transactions, and other areas of risk at a company.

“This new information from the auditor will add to the total mix of information available to investors when making voting and capital allocation decisions,” Stein said. “Hearing directly from the auditor on these topics should improve an investor’s experience.”

SEC Chairman Jay Clayton said in a statement that he supports the standard, but he cautioned that some commenters were concerned that divulging critical audit matters would result in an increase in litigation that does not benefit investors, or in boilerplate disclosures. He said he will be disappointed if the new standard results in frivolous litigation costs or defensive, lawyer-driven auditor communications.

Because of this, Clayton said he is pleased that the PCAOB intends to monitor the results of implementation of the standard through its post-implementation review (PIR) process.

“Ultimately, I support a timely and effective PIR for these revised auditing standards,” Clayton said. “And it will be critical that this PIR is completed as soon as practicable. To this end, I have directed the SEC staff to assist as needed in that process.”

The FASB proposed providing guidance to customers on the accounting for fees paid in a cloud computing arrangement by incorporating guidance already included in the software revenue recognition standard applied by cloud service providers to determine whether an arrangement is the sale or license of software.

If the arrangement includes a software license, the customer would account for the license the same way it accounts for other software licenses. If an arrangement does not include a software license, the customer would account for it as a service contract. The proposal is part of the Board’s simplification initiative to move quickly on narrow topics to improve US GAAP. The proposal would be effective 1 January 2016 for calendar year-end companies, and early adoption would be permitted. The proposed transition would be either prospective or retrospective at an entity’s election. Comments are due by 18 November 2014.

The FASB issued a new standard — Accounting Standards Update No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern — that will explicitly require management to assess an entity's ability to continue as a going concern, and to provide related footnote disclosures in certain circumstances.

According to the new standard, substantial doubt exists if it is probable that the entity will be unable to meet its obligations within one year after the issuance date. The likelihood threshold of "probable" is used similar to its current use in U.S. GAAP for loss contingencies. Disclosures will be required if conditions give rise to substantial doubt. Management will need to assess if its plans will alleviate substantial doubt to determine the specific disclosures. 

The new standard will be effective for all entities in the first annual period ending after December 15, 2016 (December 31, 2016 for calendar year-end entities). Earlier application is permitted.

On Monday, June 10th, the American Institute of CPAs (AICPA) today introduced the Financial Reporting Framework for Small-and Medium-Sized Entities to help the small business community with its financial reporting needs. The FRF for SMEsTM accounting framework is a new accounting option for preparing streamlined, relevant financial statements for privately held owner-managed businesses that are not required to use US Generally Accepted Accounting Principles (GAAP).

The FRF for SMEsTM framework offers small business owners an alternative to the non-GAAP options that are currently available. It provides efficient, meaningful results without needless complexity or cost. To be clear, the FRF for SMEs™ is not GAAP, but is complementary to efforts by the Financial Accounting Foundation (FAF)’s Private Company Council (PCC) to modify GAAP for private companies. The AICPA fully supports the work of the PCC, FAF and the Financial Accounting Standards Board to address the private company environment.

Relevant, Reliable, Simplified Reporting:

 Small businesses will use the FRF for SMEs^TM to prepare financial statements that clearly and concisely report what a business owns, what it owes and its cash flow. Lenders, insurers and other financial statement users will find this new accounting framework helps them clearly understand key measures of a business and its creditworthiness, including: 

• Business profitability
• Cash available
• Assets to cover expenses
• Concise disclosures

A New, Standardized Approach:

 The framework’s streamlined common-sense requirements are based on traditional and proven accounting methods to ensure consistent application.  Specifically, the FRF for SMEs^™:

• Uses  historical cost – steering away from complicated fair value measurements
• Offers a degree of optionality – businesses can tailor the presentation of statements to their users
• Includes targeted disclosure requirements
• Reduces book-to-tax differences
• Produces reliable financial statements that can be compiled, reviewed or audited

“I think this new accounting framework is exactly what business owners, CPAs and community bankers have been looking for as a viable and reliable alternative to the options already available,” said Richard J. Caturano, chairman of the AICPA Board of Directors.  “The FRF for SMEs^™ expands the accounting options for CPAs and private companies, while providing comprehensive, consistent and cost-beneficial financial statements.”  

The FRF for SMEs^™ issued by the AICPA was developed by a working group of experts from the CPA profession with a solid understanding of what users of private company financial statements need.  This new accounting framework has also undergone public comment and professional scrutiny, and incorporates significant feedback from CPAs, bankers and other relevant stakeholders.   

How is the FRF for SMEs less complicated and less costly?

The FRF for SMEs will be constructed of accounting principles that are especially suited and relevant to a typical SME. Examples include the following:

 The FRF for SMEs will use historical cost as its measurement basis and depart from the increased use of fair value.

 The FRF for SMEs will not require complicated accounting for derivatives, hedging activities, or stock compensation.

Moreover, the FRF for SMEs disclosure requirements will be greatly reduced, providing users of financial statements with the relevant information they need while recognizing that those users can obtain additional information from management if they desire.

A temporary, 100% depreciation deduction for capital investments; An extension of bonus depreciation under Section 168(k);

A retroactive extension of the 15-year recovery for qualified real property, the research credit, the active financing exception, and the controlled foreign corporation (CFC) look-through rule.

These provisions may affect a company's estimated tax payment liabilities immediately. In addition, they may have immediate financial statement implications for affected companies in the period of enactment.

This Alert summarizes these provisions and analyzes their income tax accounting implications.

Temporary 100% Depreciation Allowance for Capital Investments and Extension of Bonus Depreciation

From January 1, 2008 through December 31, 2009, Section 168(k) provided an additional depreciation deduction allowance equal to 50% of the adjusted basis of qualified property acquired and placed in service in those years.

The Small Business Jobs Act of 2010 extended the increase in the depreciation deduction allowance through December 31, 2010. The Act further extends this section for property acquired and placed in service before January 1, 2013. For property with longer production periods, the Act extends this section for property acquired before January 1, 2013 and placed in service before January 1, 2014.

In addition, the Act provides 100% bonus depreciation under Section 168(k) — effectively allowing immediate expensing — for the cost of qualified property acquired and placed in service after September 8, 2010 and before January 1, 2012, subject to the original use and acquisition rules currently in the section.

"Qualified property" includes property meeting the definition of bonus eligible property under Section 168(k) and, significantly, includes qualified leasehold improvement property due to the re-enactment of a 15-year recovery period for such property, as discussed below.

The Act also extends the Section 168(k)(4) election allowing corporations to accelerate pre-2006 AMT credits, but not research credits, in lieu of bonus depreciation for tax years 2011 and 2012. In doing so, the Act also permits taxpayers to reconsider whether prior Section 168(k)(4) elections apply to property subject to this latest extension of bonus depreciation (so-called "second round extension property").

Under prior law, Section 168(k)(4) elections were to be binding on all future years. In addition, the prior law provision allowing refunds of the research credit was not incorporated into the Act.

The increase in bonus depreciation to 100% could result in companies' tax positions for the year changing from taxable income to net operating losses or AMT. As such, it could affect their ability to claim other tax benefits, such as the Section 199 domestic production deduction.

Companies should consider their ability to realize any new tax losses as well as the effect on other tax benefits and carryforwards and evaluate whether bonus depreciation is their optimal tax position. If it is not, taxpayers can elect under Section 168(k)(2) to remove some, but not all property additions, from these new bonus depreciation rules.

Section 179 Expensing

A taxpayer may elect to deduct the cost of certain property placed in service for the year instead of depreciating those costs over time, subject to certain limitations. Under the Small Business Jobs Act, for tax years beginning in 2010 and 2011, the maximum amount a taxpayer can expense is $500,000 and the phase-out threshold is $2 million.

The definition of property qualifying for Section 179 includes qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. The maximum amount taxpayers may expense for real property is $250,000.

The Act indefinitely extends Section 179 expensing for tax years beginning after December 31, 2011, and sets the maximum amount and phase-out thresholds at $125,000 and $500,000, indexed for inflation. The Act did not extend the definition of qualifying property to include qualified leasehold improvement property, qualified restaurant property, or qualified retail improvement property.

15-Year, Straight-Line Cost Recovery for Qualified Leasehold Improvements, Qualified Restaurant Buildings and Improvements, and Qualified Retail Improvements

The Act retroactively reinstates the 15-year recovery period and straight-line depreciation method applicable to qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements for property placed in service from January 1, 2010 through December 31, 2011.

Research Credit

The Act retroactively reinstates the research credit for amounts paid or incurred from January 1, 2010 through December 31, 2011. Before the Act, the credit had expired for amounts paid or incurred after December 31, 2009.

The rates and structure of the credit remain unchanged. Thus, taxpayers must choose between the regular credit computation using a 20% rate and an alternative simplified credit computation using a 14% credit rate.

Fiscal-year taxpayers that have already filed their 2009 tax year returns will need to consider filing amended returns to claim research credits for research expenses incurred during the period in which the credit had expired. In doing so, they should consider that the IRS has for several years now applied increased scrutiny to research credits claimed on amended returns.

In particular, taxpayers may wish to consider the possibility of using the IRS's advanced issue resolution programs — like the pre-filing agreement program — to reduce uncertainty and accelerate both the examination and the resolution of amounts claimed.

Active Financing Exception

The Act retroactively reinstates through 2011 the active financing exception from Subpart F of the Code. The active financing exception provides a temporary exception to the definition of foreign personal holding company income under subpart F for certain income that is derived in the active conduct of a banking, financing, or similar business (see Section 954(h)) or insurance business (see Sections 953(e) and 954(i)).

Prior to the Act, the active financing exception applied to tax years of foreign corporations beginning after December 31, 1998, and before January 1, 2010, and to tax years of U.S. shareholders with or within which such tax years of the foreign corporations end.

CFC Look-Through Rule

The Act retroactively reinstates through 2011 the look-through treatment of payments between related CFCs. The temporary CFC look-through exception applies to dividends, interest, rents, and royalties received or accrued by one CFC from a related CFC, to the extent such amounts are attributable or properly allocable to income of the related CFC that is neither subpart F income nor income treated as effectively connected with the conduct of a trade or business in the United States. (See Section 954(c)(6)).

Prior to the Act, the temporary look-through exception applied to tax years of foreign corporations beginning after December 31, 2005 and before January 1, 2010, and to tax years of U.S. shareholders with or within which such tax years of the foreign corporations end.

Income Tax Accounting Implications

Under ASC 740-10-45-15, the effects of changes in tax rates and laws on deferred tax balances are recognized in the period the new legislation is enacted (i.e., the period that includes December 17, 2010, for the Act), which in this case would be the fourth quarter for entities with a calendar year-end.

The total effect of tax law changes on deferred tax balances is recorded as a component of tax expense related to continuing operations (not an extraordinary item) for the period in which the law is enacted, even if the assets and liabilities relate to discontinued operations, a prior business combination, or items of accumulated other comprehensive income.

As discussed above, the Act includes accelerated depreciation, for tax purposes, of qualifying capital investments. This acceleration will directly affect the tax basis of affected assets in subsequent periods and have a corresponding effect on deferred tax liabilities.

The incentives include income tax credits, sales tax exemptions, and property tax abatements are standard incentives offered by states and local jurisdictions to encourage private investment and ease corporate tax burdens for companies across any industry.

Income Tax Credits

Research and Development And Investment Tax Credits

Income tax credits are a frequently considered tax incentive for any company. They allow a company to reduce its income tax liability by a certain percentage of the amount spent reinvesting in the company.

Two of the most common income tax credits are research and development (R&D) and investment tax credits (ITC).

R&D credits are typically based on a percentage of a company's expenditures on R&D. Many states model their R&D credit on the R&D credit available for federal income tax purposes. Under this model, the company can claim a credit equal to a percentage of the company's "qualified" costs in excess of a base amount. Qualified costs include wages and supplies incurred in conducting R&D activities. The rate of credit can vary significantly from state to state.

ITCs are generally calculated as a percentage of the cost of qualified equipment purchased for use in the taxpayer's business. Often, state ITCs are applicable to businesses using manufacturing/R&D equipment in that state.

Favorable federal/state income tax laws also allow such companies to offset income with accelerated depreciation expense.

Increased research spending and accelerated depreciation translates into lower taxable income and less tax liability. Further, net operating loss carryforward deductions can reduce taxable income for years into the future. The bottom line is that income tax credits are only valuable if the company generates sufficient income tax liability to utilize the credits.

Sales Tax Exemptions

Many states attempt to provide an additional source of capital by exempting or limiting the amount of sales tax companies pay for R&D and manufacturing materials and/or equipment.

Because these are exemptions and not credits, companies realize an immediate benefit at the time of the purchase as opposed to waiting for the utilization of an income tax credit. Thus, savings are immediate which is especially beneficial for interested in generating additional funds to reinvest into their business.

Training Incentives

Training incentives, in the form of tax credits or grants, are increasingly appealing to biotech companies due to high employee training expenditures.

When applied to all related training costs, such as travel, facility, and trainer fees, these incentives can add up to significant savings. These programs, however, often impose specific accounting and reporting requirements. Property Tax Incentives

Another broad category of potential tax benefits is property tax incentives. Property tax incentives usually come in the form of rate reductions and/or abatements.

Different from other tax incentives (such as income tax credits or sales tax exemptions), property tax incentives are generally obtained through the local jurisdiction (e.g., county government) instead of being a state-level incentive.

Because property tax incentives are often obtained by negotiation with the local authorities, rather than pursuant to a state statute, the amount and availability of incentives can vary greatly from one jurisdiction to the next.

However, compared with relative state-level incentives, these local incentives can result in impressive savings and should be considered and pursued whenever possible.

Base Tax Strategy on Specific Company Needs

To get the most benefit from state programs, it will be critical for companies to carefully evaluate how each state's package applies to the company. While incentives may look good on paper, the results can vary significantly depending on the situation of the company. Applied properly, however, incentives can contribute to the long-term success of the company.

The market reform provisions specify minimum health requirements that employers must include in health plans. These requirements are included specifically in the Public Health Service Act (PHSA), and by cross-reference in the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (Code).

The agencies have issued interim final regulations and temporary regulations, with requests for comments, on many of the market reform requirements.

As these regulations have been reviewed and employers and plans try to implement the guidance, many questions have arisen. The FAQs — Part I and Part II — are the agencies' attempt to provide more guidance quickly. It is anticipated that many of the answers to the FAQs will be included in the final regulations.

Young adults The health care reform package requires group health plans that provide dependent coverage for children to continue to make the coverage available for an adult child until the child turns 26 years of age with some exceptions.

Plans are required to provide a 30-day period, no later than the first day of the plan's next plan year that begins on or after September 23, 2010, to allow participants to enroll an adult child. Plans must notify participants of this enrollment opportunity in writing. Some plans began covering young adults voluntarily before the September implementation date.

Before passage of the health care reform package, employer-provided health insurance coverage was generally excluded from income if the employee's child was under age 19 (or under age 24 if a student). The health care reform package extends the exclusion from gross income to any employee's child who has not attained age 27 as of the end of the tax year.

This tax benefit applies regardless of whether the plan is required by law to extend health care coverage to the adult child or the plan voluntarily extends the coverage. The income exclusion provision was effective March 30, 2010. The IRS, DOL and HHS issued regulations in July 2010.

Preventive services

The health care reform package prohibits cost-sharing (co-pays, co-insurance and deductibles) for preventative services for new plans beginning on or after September 23, 2010.

Preventive services include: •Blood pressure, diabetes and cholesterol tests •Cancer screenings •Counseling on smoking-cessation, weight loss, and other wellness endeavors •Routine immunizations •Preventive services for women •Well-baby and well-child visits

If plan or issuer has a network of providers, it may impose cost-sharing requirements for recommended preventive services delivered by an out-of-network provider. However, health plans and insurers will not be able to charge higher cost-sharing (copayments or coinsurance) for emergency services outside of a plan's network.

The IRS, DOL and HHS issued regulations on cost-sharing for preventive services in July 2010. Appeals

The health care reform package also expanded rights of individuals to appeal adverse determinations made by their health plans. New health plans beginning on or after September 23, 2010 must have an internal appeals process that allows individuals to appeal denials or reductions for covered services and rescissions of coverage.

If an internal review denies an individual's claim, the individual has the right to an external appeal.

Health plans must notify individuals of their right to appeal adverse determinations and the appeals procedures. Additionally, health plans are required to continue coverage pending the outcome of an individual's internal appeal.

The IRS, DOL and HHS issued regulations on the expanded appeal rights in July 2010. DOL recently issued a Technical Release that provides an enforcement grace period for compliance with certain new provisions with respect to internal claims and appeals.

Lifetime and annual limits

Lifetime limits on most benefits are generally prohibited in any health plan or insurance policy issued or renewed on or after September 23, 2010.

The new law also restricts and phases out the annual dollar limits that all job-related plans, and individual health insurance plans issued after March 23, 2010, can put on most covered health benefits. None of these plans can set an annual dollar limit lower than:

•$750,000 for a plan year starting on or after September 23, 2010 but before September 23, 2011

•$1.25 million for a plan year or policy year starting on or after September 23, 2011 but before September 23, 2012

•$2 million for a plan year or policy year starting on or after September 23, 2012 but before January 1, 2014

•No annual dollar limits are allowed on most covered benefits beginning on January 1, 2014.

Other provisions

The health care reform package also prohibits group health plans and health insurance issuers from imposing pre-existing condition exclusions on children under 19 for the first plan year beginning on or after September 23, 2010.

Additionally, insurers and plans will be prohibited from rescinding coverage except in cases involving fraud or an intentional misrepresentation of material facts for plan years beginning on or after September 23, 2010.

Group health plans must also meet certain nondiscrimination requirements effective for plan years beginning on or after September 23, 2010.

It should also be noted that all the September 23, 2010 deadlines apply to "plan years beginning on or after September 23, 2010" so that, for example, a plan that runs on a calendar year would not be required to put these additional benefits in place until January 1, 2011.

Grandfathered plans

A grandfathered health plan is a plan that existed on March 23, 2010, the date of enactment of the Patient Protection and Affordable Care Act. Grandfathered plans, like new plans after September 23, 2010, must extend coverage to young adults under age 26; not place lifetime limits on coverage; not exclude coverage for children with pre-existing conditions; and not rescind coverage except in cases of fraud or an intentional misrepresentation of material fact.

Question 1. In determining whether a plan is a grandfathered plan, a sponsor generally need look at only the six items specified in paragraph (g)(1) of the grandfathered plan regulations. These six items are briefly:

•Elimination of all or substantially all benefits to diagnose or treat a particular condition.

•Increase in a percentage cost-sharing requirement (e.g., raising an individual's coinsurance requirement from 20% to 25%).

•Increase in a deductible or out-of pocket maximum by an amount that exceeds medical inflation plus 15 percentage points.

•Increase in a copayment by an amount that exceeds medical inflation plus 15 percentage points (or, if greater, $5 plus medical inflation).

•Decrease in an employer's contribution rate towards the cost of coverage by more than 5 percentage points.

•Imposition of annual limits on the dollar value of all benefits below specified amounts.

The agencies are continuing to look at the question of under what circumstance a change in insurance issuers will eliminate grandfathered status. The interim regulations provided it would, but this guidance states — citing to FAQ 6 of Part I — that the agencies are reconsidering the issue.

Question 2. Grandfather status applies on a benefit-package-by-benefit package basis; not a plan basis. For example, a sponsor can treat a PPO, POS, and HMO as separate benefit packages. If one benefit package loses grandfathered status, it does not affect the status of the other packages.

Question 3. Some sponsors have been interested in restructuring their tiers of coverage from self-only and family to self-only, self-only plus one, self-only plus two, etc. in order to charge by the number of dependents covered. That plan would lose grandfathered status if the employer percentage cost for any coverage that was previously family coverage (i.e., self-only plus one, self-only plus two, etc.) was less than 5 percentage points below the employer percentage cost of family coverage on March 23, 2010. For example, if the employer percentage cost of family coverage on March 23, 2010 was 50%, the new employer percentage cost could not be less than 45%. However, if a coverage tier is completely new — e.g., the employer only provided self-only coverage before and now added family coverage, no limit applies.

Question 4. Each change in cost sharing is separately tested against the standards. Thus, if the sponsor raises the copayment level for one category of services (such as outpatient or primary care) over the permissible limit for grandfathered status but leaves all other services unchanged (and even if the aggregate change is not in excess of the permissible limit), the plan loses grandfathered status.

Question 5. Group health plans are not prevented from providing wellness incentives through premium discounts or additional benefits to reward healthy behavior, from rewarding high quality providers, and by incorporating evidence-based treatments. However, penalties (such as cost-sharing surcharges) could result in the plan losing grandfathered status. The interim final regulations asked for comments on encouraging wellness and the agencies will be issuing more guidance in the future. The question notes that plans should be careful to comply with HIPAA restrictions on discrimination based on health status related factors. Dental and Vision Plans

Question 6. If dental and/or vision benefits are structured so they are offered separately or are not an integral part of a plan (evidenced by a separate election and even a nominal fee), they are exempt from HIPAA and thus exempt from the market reforms.

Rescissions

Question 7. Rescission (defined as retroactively cancelling coverage) is only permitted if there is fraud or intentional misrepresentation. The fraud or intentional misrepresentation is not limited to medical histories but also covers, for example, marital status or a dependent's age — but it has to be fraud or intentional misrepresentation, which can be hard to prove. The agencies do not consider retroactive termination back to the date of an employee's termination from service due to a delay in administrative record-keeping to be a rescission. Similarly, a retroactive termination because an employee or former spouse did not notify the plan of a divorce is not considered a rescission. (However, this does not affect the former spouse's right to elect COBRA coverage timely.)

Preventive Health Services

Question 8. The guidance on what is a preventive health service refers to the recommendations and guidelines of the United States Preventive Services Task Force (USPTF), the Advisory Committee on Immunization Practices of the Centers for Disease Control and Prevention (Advisory Committee) and the Health Resources and Services Administration (HRSA). That guidance does not always specify the scope, setting, or frequency of the services. The interim final regulations provide that in such a case the plan is to use reasonable medical management techniques (which generally limit or exclude benefits based on medical necessity or medical appropriateness using prior authorization requirements, concurrent review, or similar practices). This question makes clear that to the extent the guidelines don't address the frequency, method, treatment, or setting, the plan may rely on the relevant evidence base and these established techniques.

Clarification Relating to Policy Year and Effective Date of the Affordable Care Act for Individual Health Insurance Policies

Question 9. Individual health policies are based on a policy year. Different states interpreted the Affordable Health Act effective date differently with respect to such policies. This FAQ provides that if a policy is effective on or after September 23, 2010, it is subject to the market reforms. An insurer may not delay the effective date by creating a policy year that starts later. For example, if an insurer provides that all policies have a policy year starting January 1 and sells a policy in October 2010, the new rules still apply for the short policy year October to December 2010. Because some states provided conflicting advice, if insurers relied in good faith on guidance or instructions from a state insurance regulator, then insurers have a reasonable time after the issuance of these FAQs to come into compliance. However, issuers may not rely on good faith with respect to any policies sold after the issuance of this guidance .

Implications

As sponsors attempt to implement the Affordable Care Act, many practical questions are arising. The agencies are using informal guidance such as these FAQs to address the most common and most important questions. We can expect to see additional FAQs in the future.

On 10 August 2010, technical corrections to the HIRE Act were enacted with retrospective application to the date of enactment of the HIRE Act.

The technical corrections clarify that the statute of limitations will expire for an entity’s entire tax return (but not for the item(s) that were not disclosed) if the reason for the entity failing to report all required international transactions is due to reasonable cause and not willful neglect.

Entities should consider the potential effects of the HIRE Act, as amended on 10 August 2010, on the statute of limitations when considering whether an uncertain tax position should be recognized solely because of the expiration of the statute of limitations.

Recognition of tax positions can occur at any point prior to or after the tax position is reported to the taxing authority in the tax return and that recognition would occur in the first interim period in which:

? the more-likely-than-not recognition threshold is met by the reporting date.

? the tax position is effectively settled through examination, negotiation, or litigation.

? the statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired.

? To the extent that the other criteria (i.e., meeting the more-likely-than-not threshold or effectively settling the position) have not been met at the balance sheet date, before an entity may rely on the statute of limitations expiring to recognize a previously unrecognized tax position, the entity should verify that the provisions of the HIRE Act do not prevent the statute of limitations from expiring.

For 2010, only corporations with $100 million or more of assets must file Schedule UTP. For corporations with assets below $100 million and greater than or equal to $10 million, the requirement to file Schedule UTP will be phased in over five years.

Final Schedule UTP drops the draft schedule's requirement to include a maximum tax adjustment (MTA) with each tax position disclosed. Instead, the final schedule requires filers to rank their tax positions on an annual basis by the amount of the U.S. federal income tax reserve recorded for each tax position.

The concise description requirement no longer requires filers to include a "rationale" and reasons for the uncertainty. Instead, the description must provide the Service with sufficient information to reasonably identify the tax position and the nature of the issue.

Final Schedule UTP eliminates the draft schedule's requirement to disclose tax positions for which filers did not record a reserve based on an IRS administrative practice of not examining the position.

With the final schedule and instructions, the IRS issued an internal directive for all Large Business and International Division personnel outlining the planned treatment of Schedule UTP information. Announcement 2010-76, which was also issued with the guidance package, outlines modifications to the IRS's policy of restraint.

Who Must File Schedule UTP

For 2010, corporations with total assets of $100 million or more must file Schedule UTP if:

they file Form 1120, U.S. Corporation Income Tax Return, Form 1120-L, U.S. Life Insurance Company Income Tax Return; Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return; or Form 1120-F, U.S. Income Tax Return of a Foreign Corporation; they or a related party issued audited financial statements reporting all or a portion of their operations for all or a portion of their tax year; and they have tax positions subject to disclosure on Schedule UTP

Form 1120 filers meet the $100 million threshold if the amount reported on page 1, item D, of Form 1120 equals $100 million or more. Form 1120-L and 1120-PC filers satisfy the threshold if the higher of their beginning or end-of-year total assets on accompanying Schedule L equals $100 million or more. Form 1120-F filers must use worldwide assets to determine whether they meet the threshold, even when filing a protective Form 1120-F.

For corporations with less than $100 million in assets, a five-year phase-in of the Schedule UTP applies. Under the phase-in rule, the total asset threshold will drop to $50 million or more in 2012 and $10 million or more in 2014.

The Service notes that CAP filers are subject to Schedule UTP filing requirements. In Announcement 2010-75, however, it also announced that it will expand CAP and make it permanent. It expects to issue details on the program changes shortly, as well as guidance on how CAP filers should comply with Schedule UTP's disclosure requirements.

As for pass-through entities and tax-exempt organizations, the Service will consider whether they should be subject to the filing requirement in 2011 or later.

What Must be Disclosed

The final instructions require filers to disclose each federal income tax position taken on their income tax return if: (1) the position is taken on a tax return for the current or prior tax year and (2) either the corporation or a related party recorded a reserve for U.S. federal income tax in an audited financial statement for the position or did not record a reserve for the tax position based on an expectation to litigate.

To be consistent with the determinations made by the corporation or a related party under applicable accounting standards, the final instructions do not require filers to disclose tax positions for which no reserve was required either because (1) the amount was immaterial for audited financial statement purposes, or (2) the amount was sufficiently certain so that no reserve was required.

As such, a tax position that a filer would litigate, if challenged, but that is clear and unambiguous or immaterial for audited financial statement purposes, is not required to be disclosed.

Finally, the Service notes that transfer pricing-related tax positions and valuation-related tax positions are subject to disclosure and are ranked along with all other tax positions disclosed.

Related Parties

The instructions define related party as an entity with a relationship to the corporation as described in Sections 267(b), 318(a), or 707(b). A related party also may be an entity that is included in consolidated audited financial statements in which the filer is included.

To address taxpayer concerns, the instructions provide that corporations must disclose only their own tax positions and not those of a related party.

Tax Position Taken in a Return

A tax position taken in a tax return means a tax position that would result in an adjustment to a line item on that tax return (or would be included in a Section 481(a) adjustment) if the position were not sustained. Each tax position should be reported separately on Schedule UTP if multiple tax positions affect a single line item on the tax return.

Audited Financial Statement

The final instructions define audited financial statement as a financial statement on which an independent third party expresses an opinion under GAAP, IFRS, or another country-specific accounting standard, including a modified version of any of these (for example, modified GAAP). The instructions indicate that compiled or reviewed financial statements are not audited financial statements.

Record a Reserve

For purposes of Schedule UTP disclosures, the instructions provide that corporations or related parties record a reserve for a tax position when a reserve for federal income tax, interest, or penalties is recorded in the corporation's or related party's audited financial statements.

While the initial recording of a reserve will trigger reporting of a tax position, subsequent increases or decreases in the tax position's reserve amount in years the tax position is not taken in the return will not require the tax position to be disclosed.

Three examples included in the instructions illustrate the rules for recording a reserve.

Reserve Not Recorded Based on Expectation to Litigate

The instructions outline the circumstances under which a corporation or related party must disclose a tax position for which no reserve is recorded based on an expectation to litigate. Those positions must be disclosed when: (1) the corporation or related party determines the probability of settling with the IRS is less than 50%, and (2) the corporation determined that it is more likely than not to prevail on the merits in litigation.

Transition Rule

The final instructions do not require disclosure of tax positions taken in tax years before 2010, regardless of whether or when a tax reserve was recorded for the position. To illustrate how the transition rule works, the instructions include an example.

Periods Covered

The final instructions direct calendar-year filers or filers whose fiscal year begins in 2010 and ends in 2011 to include the 2010 Schedule UTP with their 2010 federal income tax return. The instructions do not require filers to complete Schedule UTP for a short tax year that ends in 2010.

Ranking

To allow the Service to evaluate a position's materiality, the final instructions require filers to rank the tax positions disclosed on Schedule UTP based on the amount of recorded U.S. federal income tax reserve for that position. According to the instructions, the size of a tax position for ranking purposes is determined on an annual basis and is the amount of U.S. tax reserve recorded.

Announcement 2010-75, however, indicates that the ranking is based on the recorded U.S. federal income tax reserve (including interest and penalties). The inclusion of interest and penalties could make calculating the size of each tax position for ranking purposes more complicated. EY plans to seek clarification of this inconsistency from the Service.

The instructions also require filers to designate tax positions for which the reserve exceeds 10% of the aggregate amount of the reserves for all tax positions disclosed on the schedule, except for positions based on an expectation to litigate. Filers are not required to disclose the actual amounts of the tax reserves.

For reserves that cover multiple tax positions, filers must allocate the reserve among the various tax positions to determine their respective sizes. Filers do not need to determine a size for tax positions that they expect to litigate. Instead, the instructions permit them to assign these positions any rank.

The determination of the size of a tax position taken by an affiliated group filing a consolidated return is determined at the affiliated group level for all members of the affiliated group.

Concise Description

Filers must include a concise description of the tax positions disclosed on Schedule UTP. The instructions indicate that the description should include relevant facts about the position's tax treatment and information sufficient to reasonably identify the tax position and inform the Service of what the issue is. Filers are not required to provide an assessment of the hazards of the tax position or an analysis of the position's strengths and weaknesses. The instructions include three examples, each of which set out hypothetical facts and a sample description that the Service would consider to be sufficient disclosure.

Consistency Between Schedule UTP and Financial Reporting

Announcement 2010-75 notes that filers must identify a unit of account based on FIN 48 principles or consistently apply another level of detail that allows the Service to reasonably identify the tax position and its underlying issue. As such, IFRS or other non-US GAAP filers may not use their entire tax year as a unit of account.

The instructions require the unit of account used by a GAAP taxpayer for reporting a tax position on Schedule UTP to be the same unit of account used by the taxpayer for GAAP reporting. The instructions include an example of two taxpayers that each report under US GAAP and use different units of account for reporting tax positions in connection with the research credit.

Penalties

The final instructions do not address the possible imposition of penalties on filers that fail to disclose tax positions on Schedule UTP or disclose them inadequately. The Service notes in Announcement 2010-75 that it will "review compliance regarding how the schedule is completed by corporations and … take appropriate enforcement action, including … opening an examination or making another type of taxpayer contact."

Minimizing Duplicate Reporting

To minimize duplicate reporting, the final instructions treat the "complete and accurate" disclosure of a tax position on "the appropriate year's" Schedule UTP as satisfying the requirement to file Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement. Similarly, the instructions treat the "complete and accurate" disclosure of tax positions on Schedule UTP as satisfying the disclosure requirements of Section 6662(i), provided the disclosed position is not a reportable transaction.

The Service also plans to revise Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, to reduce duplicate reporting. As part of the revision process, it will form a working group and work with external stakeholders to develop "appropriate revisions," beginning in 2011.

Exchange of Information

Responding to taxpayer concerns, the Service also announced (Announcement 2010-75) that it would refrain from exchanging information disclosed on Schedule UTP with foreign governments unless the United States had a reciprocal arrangement with another country to share uncertain tax position information. Before disclosing the information under a reciprocal agreement, however, the Service would consider other factors, such as the relevance of the information to the foreign government.

Structure of Schedule UTP

Part I

Final Schedule UTP is divided into three parts. Part I requests information on current-year tax positions and is divided into six columns lettered A through F. These columns request the following information:

Column A requires corporations to number their tax positions. Column B requests the primary code sections related to the tax position and allows corporations to list up to three. Column C asks the corporation to indicate, by checking the appropriate box, whether the tax position creates temporary or permanent differences. If the tax position creates both, the corporation must check both boxes.

Column D is used if the tax position relates to a pass-through entity; if so, the corporation must provide the employer identification number of the pass-through entity to which its tax position relates, or enter "F" for a foreign entity without an EIN.

Column E asks the corporation to indicate if the tax position is major by checking a box if the tax position is greater than or equal to 10% of all tax positions listed on the form.

Column F requires the corporation to rank the tax positions from largest to smallest. To identify the type of position and rank, corporations must enter a "T" in column F for transfer-pricing-related tax positions, followed by a number representing that tax position's rank (e.g., T1). A "G" must be entered for all other tax positions. Expectation — to-litigate positions may be assigned any ranking number.

To address taxpayer concerns over the related-party provisions, Part I asks the corporation to indicate by checking a box if it was unable to determine whether it had tax positions to disclose because it could not obtain sufficient information from one or more related parties. Part II

Part II is used to report tax positions for prior tax years that have not previously been reported. Its format mirrors columns A-F of Part I and also includes the same related-party checkbox.

Column G in Part II asks corporations to list the prior tax year in which the tax position was taken and the last month of that tax year, using a six-digit number (e.g., 201012 for tax positions in tax years ending December 31, 2010, that were not disclosed on a 2010 Schedule UTP).

The instructions for Part II indicate the Service does not expect corporations to complete Part II for 2010 tax years.

Part III

Part III of the draft form provides space for corporations to provide a concise description of each of their numbered tax positions, as discussed previously in this Alert.

Internal Directive for LB&I Personnel on Schedule UTP Information

As part of its implementation of Schedule UTP, the IRS also issued an internal directive for all Large Business and International (LB&I) Division personnel outlining the planned treatment of Schedule UTP information. Under the directive, initial processing of Schedule UTP information will be centralized to identify trends, determine compliance with the schedule, and note areas where further guidance may be needed.

The directive reminds LB&I examiners of the need to approach tax positions on audit with impartiality and to be mindful of "their responsibility to apply the law as it currently exists, not how we would like it to be." It emphasizes that tax positions are uncertain for a number of reasons, including ambiguity in the law. As such, items disclosed on Schedule UTP may not require an examination or an audit adjustment. The directive also reminds examiners that Schedule UTP is not intended as a substitute for other examination tools or for independent judgment, nor should it be used to shortcut other parts of the audit process.

Policy of Restraint

To address taxpayer concerns over Schedule UTP's effect on attorney-client privilege, tax practitioner privilege, the work product doctrine, and its policy of restraint, the Service announced (Announcement 2010-76) changes to its policy of restraint as it affects information requested under the final Schedule UTP. The Service intends to modify IRM 4.10.20 to incorporate the announced changes.

The policy of restraint as outlined in the announcement states that the Service will not assert that privilege has been waived when an otherwise privileged document is provided to an independent auditor as part of an audit of the taxpayer's financial statements. That exception does not apply if the taxpayer has taken actions that would otherwise waive the privilege or if a request for tax accrual workpapers is made under IRM 4.10.20.3 because of unusual circumstances or because listed transactions are involved.

The policy of restraint also states that taxpayers may redact certain information from requested tax reconciliation workpapers related to the preparation of Schedule UTP, including information related to the development of the concise description of tax positions, the amount of any reserve related to a tax position, and computations to determine the ranking of tax positions reported on the schedule or the designation of a tax position as a major tax position.

LB&I examiners are instructed to engage with taxpayers early on to eliminate uncertainty as quickly as possible, and to discuss the issues disclosed on the Schedule UTP in advance of issuing the initial information document requests. The directive states that current quality review standards will be adjusted to ensure LB&I examiners follow the processes outlined in the directive.

The issuance of a final schedule and instructions makes it important for companies with assets of $100 million or more that issue audited financial statements to begin to prepare for filing of Schedule UTP with their 2010 tax returns.

In addition, companies can consider obtaining further clarity around their uncertain tax positions and consider other methods to mitigate risk. Tax return reporting will require planning for new procedures and controls that need to be implemented in order to report all of the information required.

Planning for the changes to compliance processes and procedures should begin as soon as possible so that necessary data is captured during the provision cycle.

In addition, the residual method of allocating arrangement consideration is no longer permitted under Issue 08-1. Issue 09-3 removes non-software components of tangible products and certain software components of tangible products from the scope of existing software revenue guidance, resulting in the recognition of revenue similar to that for other tangible products. The new guidance requires expanded qualitative and quantitative disclosures.

The new guidance is effective for fiscal years beginning on or after June 15, 2010. However, companies may be able to adopt as early as interim periods ended September 30, 2009. The guidance may be applied either prospectively from the beginning of the fiscal year for new or materially modified arrangements or retrospectively.

The guidance requires companies to apply a two-step approach, separately evaluating the instrument's contingent exercise provisions and then the instrument's settlement provisions. Certain common price protection provisions may result in some instruments (or embedded features) being reclassified to assets or liabilities (or bifurcated) and marked-to-market through earnings.

The guidance is applicable to existing instruments and is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years.

Under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), a financial instrument or other contract that meets the definition of a derivative is required to be recognized at fair value and marked-to-market through earnings.

However, paragraph 11(a) of FAS 133 provides a scope exception for contracts issued or held by a reporting entity that are both (1) indexed to its own stock, and (2) classified in stockholders' equity. EITF Issue No. 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity's own stock (EITF 07-5), addresses the determination of whether an instrument meeting the definition of a derivative is indexed to an entity's own stock for purposes of applying the paragraph 11(a) scope exception.

FAS 133 also requires that embedded derivative features in a hybrid instrument (e.g., conversion option in a convertible debt instrument) that meet certain criteria be separated from the host contract and accounted for separately as derivative instruments.

One of those criteria, paragraph 12(c), states that if a separate instrument with the same terms as the embedded derivative feature would be a derivative instrument subject to the requirements of FAS 133, then the embedded derivative feature should be separated from the host contract (assuming paragraphs 12(a) and 12(b) of FAS 133 have also been met).

However, if the embedded derivative feature meets the criteria for the paragraph 11(a) scope exception, it would not need to be separated from the host contract and accounted for as a derivative. Therefore, EITF 07-5 is also applicable to the assessment of whether embedded derivative features should be bifurcated.

• How management's internal cash flow and discount rate assumptions should be considered when measuring fair value when relevant observable data do not exist

• How observable market information in a market that is not active should be considered when measuring fair value

• How the use of market quotes (e.g., broker quotes or pricing services for the same or similar financial assets) should be considered when assessing the relevance of observable and unobservable data available to measure fair value

The guidance states that significant judgment is required in valuing financial assets. For example, prices in disorderly markets cannot be automatically rejected or accepted without sufficient evaluation. In addition, a distressed market does not result in distressed prices for all transactions—judgment is required at the individual transaction level.

From start to finish, the FASB issued this FSP in literally a matter of days to help financial-statement preparers deal with valuations involving financial assets in markets that are not active.

The FSP is effective upon issuance, including prior periods for which financial statements have not been issued (i.e., Q3 for calendar-year companies).

The Emergency Economic Stabilization Act of 2008, the Energy Improvement and Extension Act of 2008, and the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 (the Acts) were signed into law on 3 October 2008 (enactment date). The Acts contain a number of tax law changes, including, among others, extensions of expiring and previously expired tax credits (such as the research tax credit), energy production and conservation related tax incentives, and modifications to provide certain financial institutions ordinary loss treatment on the sale or exchange of preferred stock in the Federal National Mortgage Corporation (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation ("Freddie Mac”).

Pursuant to paragraph 27 of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (Statement 109) and paragraph 20 of Accounting Principles Board Opinion No. 28, Interim Financial Reporting, the effects of a change in tax law on deferred taxes should be recognized in the period the law is enacted and included in income from continuing operations. The effects of new tax legislation on taxes currently payable also must be recognized in the period of enactment with allocation to earlier or later periods prohibited. However, if the effect of the tax law changes is considered to be significant, appropriate subsequent event disclosures should be provided.

Entities will need to evaluate and recognize the effect of these tax law changes on their current and deferred taxes in the reporting period that includes 3 October 2008. Entities should not record the effects of these tax law changes in any earlier period, including those periods for which financial statements have not yet been issued. For example, a calendar year-end company should recognize the effects of the tax law changes (including the effects of retroactive tax adjustments) in its fourth quarter. Third quarter income tax expense and the estimated effective tax rate used for the third quarter should not reflect any changes related to the Acts. In assessing the realizability of deferred tax assets as of the end of the third quarter, a calendar year-end company should assess the need for a valuation allowance based upon the enacted tax laws as of 30 September 2008 and not consider the effects of the Acts.

One of the more significant provisions in the Acts relates to the treatment of losses on the sale or exchange of preferred stock in Fannie Mae and Freddie Mac as ordinary losses. Prior to the enactment date, deferred tax assets reported related to declines in the fair value of, or losses on the sales of, Fannie Mae and Freddie Mac preferred stock investments held, or previously held, by applicable financial institutions would generally be assessed for realizability as capital losses as that would generally be the type of loss generated on sale. That is, it is not appropriate to consider the modification of the tax treatment for these losses under the Acts (i.e., ordinary versus capital) in a period prior to the enactment date. This may result in a calendar year-end company recording a valuation allowance on deferred tax assets related to losses on these securities based on their realizability as capital losses in the third quarter (i.e., to the extent that it is not more likely than not that the company will be able to realize the benefits of the capital losses) and reversing the valuation allowance in the fourth quarter in conjunction with the changes in tax treatment for these losses due to the change in tax law under the Acts.

Require enhanced tabular disclosure of the compensation of the registrant's principal executive officer, principal financial officer, the three other highest paid executive officers (the five named executive officers or NEOs).

Require a new "Compensation Discussion and Analysis" (CD&A), which would discuss in "plain English" the objectives and implementation of the registrant's executive compensation programs - focusing on the most important factors underlying specific compensation policies and decisions. CD&A would replace the current Compensation Committee report and stock price Performance Graph.

Require a new "Director Compensation Table" that would disclose annual director compensation, together with a related narrative, similar to the Summary Compensation Table for NEOs and the related CD&A.

Amend Form 8-K to require disclosure of material new compensation arrangements affecting the NEOs, as well as material changes or events affecting their existing compensation arrangements.

Require disclosure of the registrant's policies and procedures for approving related party transactions.

Require disclosure of (a) whether each director and director nominee is independent; (b) any audit, nominating and compensation committee members who are not independent; and (c) any relationships that are not otherwise disclosed that were considered when determining whether each director and director nominee is independent.

The SEC has provided a 60-day comment period following publication in the Federal Register.

Accordingly, the comment period is expected to end in late March, 2006.

The SEC's proposing release discusses the proposed transition for any final rule. Compliance with the new disclosure requirements would be prospective. That is, an issuer would not be required to restate disclosures provided under the current rules prior to the effective date of the amended rules. The SEC also is considering requiring the following effective date transition:

Form 10-K and Form 10-KSB – fiscal years ending 60 days or more after publication of the final rule;

Form 8-K – for triggering events that occur 60 days or more after publication of the final rule;

For registration statements, including post-effective amendments, under the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Company Act of 1940 – 120 days or more after publication of the final rule; and Proxy statements – for filings 90 days or more after publication of the final rule.

The American Jobs Creation Act of 2004 was signed into law on October 22, 2004. The Act included a provision regarding the treatment of nonqualified deferred compensation which created Internal Revenue Code Section 409A.

All plans must be operationally compliant to Sec. 409A in 2005. All plan documents must be amended to reflect the new law by December 31, 2006.

The U.S. Department of Treasury (“Treasury”) is providing additional information to assist companies in the transition process. Initial guidance was issued on December 20, 2004 (amended January 5, 2005). The second round of guidance was released through Proposed Regulations on September 29, 2005.

In addition to traditional nonqualified deferred compensation, IRC Sec. 409A affects other plans, such as: Supplemental Executive Retirement Plans (SERPs), certain types of stock options, restricted stock, stock appreciation rights (SARs) and severance agreements.

The regulations generally provide that stock options and stock appreciation rights for employer stock issued at an exercise price at least equal to fair market value on the date of grant are excluded from coverage under Sec. 409A.

The guidance under the new Proposed Regulations provides detail regarding appropriate valuation considerations and methodologies that would allow a company to exclude its nonqualified deferred compensation from the consequences of Sec. 409A.

A valuation performed by a qualified independent appraiser using traditional appraisal methodologies is presumed reasonable to support the value on which nonqualified deferred compensation is based.

The report, based on The Conference Board/Mercer Oliver Wyman survey of 271 risk management executives, found that more than 90% of executives say they are building or want to build enterprise risk management processes into their organizations but only 11% report they have completed their implementation.

Enterprise risk management (ERM) is a framework, instituted by a firm's board of directors and management, applied strategically and across the enterprise, designed to identify potential events that may impact the firm, manage risks within defined parameters, and provide reasonable assurance regarding the achievement of the firm's business objectives.

Companies continue to face increasing pressures to implement ERM processes. Both industry and government regulatory bodies, as well as investors, are increasingly examining these policies and processes. Boards of directors in a rising number of industries are now required to review and report on the effectiveness of ERM frameworks in their companies.

"Most companies are in the process of adopting enterprise risk management to contribute to the value of the organization, to meet rising corporate governance challenges and regulatory actions particularly in the U.S, and to meet the challenges arising from external and internal risks," says Ellen Hexter, senior research fellow and program director for The Conference Board and coauthor of the report. "Enterprise risk management is clearly gaining ground."

The survey results indicate that more than two-thirds of both boards of directors and senior management staff consider risk management to be an increasingly important responsibility. At the financial/operational levels, especially among chief financial officers, there is an even higher awareness of the importance of ERM. Behind this trend: pressures to reduce the unexpected volatility of earnings and a need to implement internal mandates demanded by the Sarbanes-Oxley Act and other similar regulatory frameworks globally.

The study finds that companies fully embracing ERIVl are better able to improve management practices, such as strategic planning, and have a greater ability to understand and weigh risk/reward equations in their decisions.

For many years, cheap stock has been a significant issue in the SEC staff’s review of IPO registration statements. When equity securities were issued to employees within one year of the IPO filing, the SEC staff typically challenged any valuation of the underlying securities at a price below the anticipated IPO range.

The SEC generally presumed that the anticipated IPO price provided the best evidence of fair value, and the SEC staff was very skeptical of valuations that concluded the fair value of securities at the grant date was significantly less than the anticipated IPO price.

The incidence of restatements related to the valuation of cheap stock lead the AICPA to undertake a project to provide better guidance to preparers, auditors and valuation specialists.

Compliance with the Practice Aid will not insulate a company from SEC staff questions regarding the valuation of pre-IPO equity compensation.

The SEC staff still can be expected to challenge both the appropriateness of the valuation methodology in the circumstances and the underlying assumptions used to value pre-IPO equity compensation.

However, the Practice Aid provides a framework, which when appropriately interpreted and applied, should yield a credible valuation to which the SEC staff ultimately will not object.

The Practice Aid provides an overview of the valuation process for the equity securities of a privately-held-company, including the various factors to be considered and various approaches to determining fair value.

It further recommends that companies provide extensive disclosures in IPO registration statements regarding their determination of the fair value of equity securities issued as compensation.

These disclosures are specified in paragraphs 179-183 of the Practice Aid and pertain to both the financial statements and Management’s Discussion and Analysis (MD&A). The Practice Aid also provides illustrative disclosures.

In most cases, observable market prices for equity securities of privately-held-companies are not available.

As a result, the fair value of these equity securities must be determined by reference to the fair value of the underlying business determined using a market approach (e.g., a market multiple analysis) or an income approach (e.g., a discounted cash flow analysis).

The Practice Aid recommends that privately-held companies obtain contemporaneous valuations from independent valuations specialists in order to determine the fair value of securities issued as compensation.

The Practice Aid asserts that a contemporaneous valuation by an independent party is more objective and provides more persuasive evidence of fair value than a retrospective valuation and or one that is performed by a related party (e.g. a director, officer, investor, employee or the investment firm underwriting the IPO).

In the absence of an independent contemporaneous valuation, the Practice Aid recommends that the company provide more extensive disclosures in its IPO registration statement about the milestones that occurred between the date the securities were issued and the date on which their fair value was determined.

The Practice Aid also discusses the IPO process and its effects on enterprise value. Specifically, the Practice Aid discusses how the IPO often significantly reduces the company’s cost of capital.

A company’s cost of capital inversely affects enterprise value (i.e., a reduced cost of capital increases the fair value of the enterprise and the related fair value of its common equity securities).

Accordingly, the fair value of a new public company may be significantly higher than its value immediately before the IPO. Other examples of factors that impact the valuation include the stage of development, whether significant milestones have been obtained and the likelihood of the IPO occurring.

Essentially all relevant evidence should be considered in estimating the fair value of a private enterprise and its equity securities, and the basis for the valuation and the underlying judgments should be clearly documented.

Ultimately, the company, not the valuation specialist, is responsible for the reasonableness of the estimate of fair value used to record the cost of equity compensation in its financial statements.

The valuation should not be biased in favor of a particular amount or result; instead, all evidence, both positive and negative, should be considered. Clearly, a contemporaneous valuation is less likely than a retrospective valuation to be biased by hindsight knowledge about actual events and results that one otherwise would have had to predict in determining fair value as of the grant date.

The SEC staff discussed observations with respect to the Practice Aid at the 2004 AICPA SEC Conference .

Concerns raised by the SEC staff include

(1) the inappropriate application of the “asset-based” appraisal methodology in other than a start up company,

(2) the inappropriate use of the current value method for allocating value to various classes of equity securities when a company has more than one class of equity security outstanding and is in neither liquidation nor a very early stage of development, and

(3) the inappropriate averaging of the results of methods of allocating enterprise value to class of equity when those methods yield materially different results (e.g., averaging a forward-looking allocation method that considers the value inherent in a going concern with the current value method that is based on the value in liquidation).

The Practice Aid was developed by staff of the AICPA and a project task force comprising representatives from appraisal, preparer, public accounting, venture capital, and academic communities.

Observers to the project task force included representatives from both the SEC and the FASB. The Practice Aid is applicable to all privately-held companies, whether or not they contemplate a future IPO.

Also, the Practice Aid’s guidance is applicable whether a privately-held company applies APB Opinion 25, “Accounting for Stock Issued to Employees,” Statement 123, “Accounting for Stock-Based Compensation,” or Statement 123(R), “Share-Based Payment.”

Under APB Opinion 25, nonpublic companies are permitted to recognize the cost of employee stock options using the “intrinsic-value method.”

Under Statement 123, nonpublic companies are permitted to recognize the cost of employee stock options using the “minimum-value method,” under which the option essentially is valued using a volatility of zero. Under either the intrinsic-value method or the minimum-value method, a nonpublic company must determine the fair value of the stock underlying the option award, for which the Practice Aid provides relevant guidance.

Under FAS 123(R), a nonpublic company must value equity awards to employees at fair value unless it qualifies for an exception.

Under that exception, if a nonpublic company cannot reasonably estimate the expected volatility of its stock, it must use a “calculated value” that incorporates each of the inputs required by Statement 123(R), with the exception of the expected volatility of its stock.

Instead, to determine the calculated value, the historical volatility of an appropriate industry sector index would be used (see section S7.4.2 of the 2nd Edition of our Financial Reporting Developments Publication, Share-Based Payment, FASB Statement No, 123 (revised 2004) for additional information about the calculated value method).

We do not believe that the calculated value method can be used for options granted to nonemployees, which must be valued under a fair-value-based method using an estimate of expected volatility of the company’s stock.

Further, if an employer has measured options or similar award to nonemployee’s at fair value, it would be unable to assert that it could not estimate expected volatility for purposes of measuring the fair value of awards to employees.

Under either the fair-value-based method or the calculated-value value method, a nonpublic company must determine the fair value of the stock underlying the option award, for which the Practice Aid provides relevant guidance.

Under FAS 123(R), a nonpublic entity may change its measurement technique from calculated value to fair value either because it becomes a public entity (e.g., files an IPO registration statement) or because it determines that it can estimate expected volatility of its own shares.

A change from the calculated-value method to the fair-value-based method would be accounted for as a change in estimate under FASB Statement No. 154, Accounting Changes and Error Corrections, which only would be applied prospectively.

That is, compensation cost for unvested awards granted prior to the change must continue to be recognized based on the calculated value that was measured on the date of grant.

All share-based payments granted subsequent to the change must be measured using the fair-value-based method. Because the fair-value-based method is expected to produce a better estimate of fair value, an entity is not permitted to change its method of estimating the value of employee stock options from the fair-value-based method to the calculated-value method.

The most significant of the proposed changes would result in:

Expensing acquisition-related transaction costs and restructuring costs;

Recognizing contingent consideration obligations and contingent gains (assets) acquired and contingent losses (liabilities) assumed at their acquisition-date fair values, with subsequent changes in fair value generally reflected in income;

Capitalizing in-process research and development (IPR&D) assets acquired;

Recognizing the full fair values of assets acquired, liabilities assumed, and noncontrolling interests in acquisitions of less than a 100 percent controlling interest;

Recognizing holding gains and losses in step acquisition and partial disposition transactions;

Accounting for changes in the ownership of a subsidiary (that do not result in a loss of control) as capital transactions;

Classifying noncontrolling interests as a separate component of consolidated stockholder’s equity.

The FASB expects to issue final standards in mid-2006 that would be effective for fiscal years beginning after December 15, 2006.

Form 10–Q and Form 10–K require disclosure, as specified in Item 308(c) of Regulation S–K, regarding "any change in the registrant's internal control over financial reporting . . . that occurred during the registrant's last fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting." However, the SEC staff's FAQ No. 9 on Section 404 reporting states, "we would not object if a registrant did not disclose changes made in preparation for the registrant's first management report on internal control over financial reporting."

Notwithstanding the SEC staff's position in that FAQ, the form of the CEO and CFO certification in Exhibit 31 to Form 10–Q and Form 10–K, as specified in Item 601 of Regulation S–K, requires the CEO and CFO to certify, in paragraph 4(d), that they have disclosed in the periodic report any material change in internal control over financial reporting. Generally, the SEC will not accept any modifications to the form of the CEO and CFO Section 302 certifications specified in Item 601 of Regulation S–K. Accordingly, we recommend that issuers consult with their securities counsel, and clearly apprise the CEO and CFO, before omitting any disclosures about material changes in internal control over financial reporting in reliance on FAQ No. 9.

Effectiveness of Controls

With the impending inception of reporting on internal control over financial reporting under Section 404, management should carefully consider their conclusions, and the related disclosures in intervening quarterly reports, about the effectiveness of the issuer's disclosure controls and procedures. In some cases, management's documentation and testing of internal control over financial reporting performed to date may have identified material weaknesses. Even if management plans to remediate those weaknesses prior to year end, management should consider the associated implications to the effectiveness of the issuer's disclosure controls and procedures as of the end of each interim period.

If management is aware of any material weaknesses at the end of an interim period, management must evaluate whether it can conclude that its disclosure controls and procedures are effective at the "reasonable assurance" level. Issuers that previously disclosed the conclusion of the CEO and CFO that disclosure controls and procedures were effective may now determine that identified but unremediated material weaknesses will require a different conclusion for purposes of the current quarterly report. Because the evaluation date corresponds to the end of the interim period, management should disregard planned actions to correct known material weaknesses after that date.

In the unlikely event that an issuer concludes that a material weakness does not affect disclosure controls and procedures, the SEC staff's FAQ No. 9 on Section 404 reporting states, "if the registrant were to identify a material weakness, it should carefully consider whether that fact should be disclosed, as well as changes made in response to the material weakness."

Should management ultimately report under Section 404 that the issuer's internal control over financial reporting is not effective as of the end of the fiscal year, the SEC staff will likely question the basis for management's conclusions that disclosure controls and procedures were effective as of the end of interim periods within that year. Accordingly, management should carefully consider the status of its Section 404 reporting initiative in reaching its conclusions and developing its disclosures in response to Item 4 of Part I of Form 10–Q.

For certain issuers, the SEC staff has questioned the reasons underlying an "except for" qualification of management's conclusion regarding the effectiveness of the disclosure control and procedures (i.e., when management concluded that disclosure controls and procedures were effective at the "reasonable assurance" level except for certain items). In those cases, the SEC staff has challenged whether the issuer's disclosure controls and procedures were effective in light of the noted exceptions. In such circumstances, we recommend that issuers consult with their securities counsel and consider whether known weaknesses warrant a conclusion that disclosure controls and procedures are ineffective.

The Practice Aid provides an overview of the valuation process for the equity securities of a privately-held company, including factors to be considered and approaches to determining fair value.

In most cases, observable market prices for securities identical to those of the privately-held company are not available.

Accordingly, the fair value of such securities must be determined using other valuation approaches. Often, the fair value of the common equity securities must be determined by reference to the fair value of the business determined using a market approach or an income approach (e.g., a discounted cash flow analysis).

The Practice Aid suggests that a private company obtain a contemporaneous valuation from an independent valuation specialist in order to determine its accounting measurement for equity securities issued as compensation.

The AICPA Task Force concluded that an independent contemporaneous valuation is preferable to a retrospective valuation or one performed by a related party (e.g., director, officer, investor, employee).

In the absence of an independent contemporaneous valuation, the Practice Aid recommends that the company should provide more extensive disclosures in its IPO registration statement about the milestones that occurred between the date the securities were issued and the date on which their fair value was determined.

The Practice Aid discusses the IPO process and its effects on enterprise value. Specifically, the Practice Aid discusses how the IPO often significantly reduces the company's cost of capital.

A company's cost of capital inversely affects enterprise value (i.e., a reduced cost of capital increases the fair value of the enterprise and the related fair value of its common equity securities). Accordingly, the fair value of a new public company may be significantly higher than its value immediately before the IPO.

Because many privately-held companies raise capital by issuing preferred stock instead of common stock, the Practice Aid discusses the various rights of preferred stock and their effect on value.

In addition, the Practice Aid discusses approaches to correlating enterprise value with the underlying value of the various classes of preferred stock and common stock. The Practice Aid also includes an illustrative valuation report.

The Practice Aid does not provide auditing guidance; instead, auditors should continue to refer to Statement on Auditing Standards No. 101, Auditing Fair Value Measurements and Disclosures, for general guidance on auditing fair value measurements and disclosures.

The Practice Aid addresses the process and factors involved in estimating the fair value of common stock issued as compensation by a privately-held company. It does not address the compensation accounting method to be followed by privately-held companies. However, as discussed further below, determining the fair value of the share award or share underlying an option grant is necessary to apply any of the current or proposed compensation accounting methods.

Under APB Opinion 25, nonpublic companies are permitted to recognize the cost of employee stock options using the "intrinsic method." Under Statement 123, nonpublic companies are permitted to recognize the cost of employee stock options using the "minimum value method," under which the option essentially is valued using a volatility of zero. Under either the intrinsic method or the minimum value method, a nonpublic company must determine the fair value of the stock underlying the option award.

On March 31, 2004 the FASB issued an Exposure Draft, Share-Based Payment. The FASB has tentatively decided that nonpublic companies will be able to elect to account for all share-based awards using either the preferred fair value method or the intrinsic value method. This would be an accounting policy decision by the nonpublic company and should be applied consistently to all share-based awards.

Under the intrinsic value method, nonpublic companies would be required to remeasure the intrinsic value of employee stock options at each reporting date until the option is exercised, is forfeited, or expires unexercised (essentially the same as "variable accounting" under Opinion 25).

However, for awards of stock, the intrinsic value measurement (which is the same as fair value) would be made on the grant date and would not be subsequently adjusted. If a nonpublic company changes its accounting for share-based payments from the intrinsic value method to the fair value method, whether voluntarily or because it becomes a public company, awards outstanding on the date of the change must continue to be accounted for under the intrinsic value method until they are settled.

Further, the Exposure Draft does not permit a change from the preferred fair value method to the intrinsic value method. Under either the fair value method or the intrinsic value method, a nonpublic company must determine the fair value of the stock underlying the option award.

Schedule M-3 would replace the Schedule M-1 for taxpayers with total assets of $10 million or more. Other taxpayers would continue to complete Schedule M-1.

Treasury and the IRS state that the Schedule M-3 will allow the differences between the taxpayer's financial accounting net income and taxable income to become more apparent and will assist IRS examiners in identifying the returns that should be audited.

Treasury and the IRS further state that the new schedule should reduce the number of unnecessary audits but should also allow IRS examiners to concentrate on returns in which taxpayers have taken aggressive positions or have engaged in aggressive transactions.

Treasury and the IRS expect the proposed Schedule M-3 to be finalized for use with federal income tax returns for tax years ending on or after December 31, 2004.

Foreign Entities

Treasury and the IRS released proposed Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities, and requested comments regarding the new form. In addition to requesting comments about proposed Form 8858---including matters that should be addressed in the instructions to the form---the Service also asked for comments on current Forms 5471 and 8865, and whether any modifications are necessary in light of proposed Form 8858.

Significantly, proposed Form 8858 appears to be an audit guideline for IRS examiners.

These guidelines are generally contained in schedules that list specific questions regarding the activities of the FDE. For example, proposed Form 8858 requests information regarding whether the taxpayer claimed a worthless stock or bad debt deduction as the result of an entity classification election under Section 7701 ("check-the-box election") during the tax year.

U.S. persons that are tax owners of a foreign disregarded entity ("FDE") or that own certain interests in foreign tax owners of FDEs would be required to file a separate proposed Form 8858 for each FDE. For purposes of filing the form, the tax owner of the FDE is the person treated as owning the assets and liabilities of the FDE for U.S. tax purposes.

Notably, proposed instructions were not released in conjunction with the form. Reporting on proposed Form 8858 would be required for annual accounting periods of tax owners of FDE's beginning on or after January 1, 2004.

In other situations, the activities of the provider of outsourced goods or services are disregarded only if the provider qualifies as an independent agent.

In yet other situations, the activities of a provider of outsourced goods or services are disregarded unless the provider has (and habitually exercises) the authority to conclude contracts binding on its principal (or, under the Code, has a stock of merchandise belonging to the principal from which orders are regularly filled on the principal’s behalf).

Finally, at the other end of the spectrum, the activities of a provider of outsourced goods or services are wholly disregarded in all circumstances.

What this spectrum of rules lacks, however, is a truly unifying rationale or theme that explains why different rules are adopted in different situations.

The IRS itself has underscored the ad hoc nature of the development of these rules and their general lack of integration.

This internal complexity of the U.S. international tax rules relating to outsourcing is only compounded when the problem is viewed from a broader perspective that takes into account the fact that “cross-border” outsourcing necessarily crosses borders .

Other countries with a connection to the outsourcing arrangement also may claim the right to tax all or a portion of the income generated by the arrangement, which makes a review of their international tax rules an indispensable part of any systematic planning process.

These countries, as sovereign entities, are free to adopt international tax rules that are different from--and that conflict with--those of the United States, thereby creating an additional, external form of complexity that taxpayers must address in the planning process.

On the other hand, interest and trading income earned by Hong Kong financial institutions from some foreign activities is subject to a tax rate of 16 percent while in Singapore financial income earned by financial institutions from qualifying sources may be subject to a concessionary rate of 10 percent.

In addition, unlike Hong Kong, Singapore and some other countries in the region have extensive networks of bilateral tax treaties, which provide some assurance to investors that they will be subject to protection from onerous taxation and not subject to discrimination under domestic law. Thus, concerns arise as to the ability of Hong Kong to maintain its dominance as a regional financial centre.

Tax Competition

To understand Hong Kong's tax competitiveness for financial activities in relation to Singapore, Malaysia, and Taiwan, we sum up the major differences in the tax regimes in the table below. Hong Kong has the lowest corporate tax rate and the lowest withholding taxes, especially on interest income. However, the other three countries do have a number of exemptions, tax holidays, and reduced tax rates for selective activities. Unlike Singapore, Malaysia, and Taiwan, Hong Kong does not have a sales tax that affects financial activities.

Hong Kong does impose Stamp Duty, though in Hong Kong and the other jurisdictions Stamp Duty is generally not an issue with respect to debt based activity. Another advantage for Hong Kong is that it does not use exchange controls, unlike Malaysia and Taiwan. However, the lack of bilateral tax treaties is a disadvantage for Hong Kong, unlike Singapore and Malaysia which have extensive tax treaty systems.

We also provide the range of possible effective tax rates on the cost of financial intermediation 14 in the four countries.

In the absence of special preferences under the corporate and withholding tax regimes in the other three countries, Hong Kong provides the most tax competitive regime for financial activities.

With special low-tax corporate and withholding regimes in Singapore, Taiwan, and Malaysia (but sales tax still applied to financial transactions), Hong Kong international financial activities can be somewhat more highly taxed than similar financial activities in the other three countries.

Tax Competitiveness of Financial Intermediary

Hong Kong Singapore Malaysia Taiwan --------------------------------------------------------------------- Profit Tax Rate 16% 25.5% 28% 25%

Withholding Tax Rates on Interest 0% 7-15 10-15% 10-20%

Stamp Duties

Yes Yes Yes Yes

General Sales Tax

None VAT- 3% Turnover-3% VAT-5%/3%

Exchange Controls No No Yes Yes

Effective Tax Rate

High

6.0% 22.5% 26.9% 31.0%

Low 6.0% 3.0% 3.0% 9.0%

Background

Payments of royalties to foreign parties for the right to use intellectual property in the United States are subject to a 30% withholding tax, unless the tax is reduced or eliminated by an income tax treaty.

Taxpayers, however, can only claim income tax treaty benefits by submitting proper certifications on proper IRS forms. If a U.S. taxpayer (or, under new regulations, a foreign subsidiary) pays royalties to a foreign person without deducting tax and without obtaining the proper documentation, the U.S. taxpayer will be liable.

In addition, payments of any royalties to all individuals and partnerships are subject to a 28% backup withholding tax, unless the recipient either certifies its foreign status (in an approved manner) or provides its U.S. TIN (in an approved manner) in order for the payor to file Form 1099-MISC.

If, however, the payor (or, under new regulations, a foreign subsidiary) makes a royalty payment without receiving the proper certification and without deducting the tax, the payor will be liable.

Implications

Although there has not been much audit activity in this area for many years, there clearly will be in the near future. The Service has let it be known that it is very interested in the area of withholding for royalty payments. This issue likely affects the areas of software, publishing, and the entertainment industry as well.

E&Y is aware of at least one taxpayer that discovered that it was making very substantial royalty payments to foreign persons without obtaining the proper documentation and without withholding tax. It is important to note, however, that even if a taxpayer followed improper procedures in the past, there are steps to take now that can significantly reduce liabilities for previous failures to withhold.

Most Recent Development:

IRS Addresses Withholding Tax Matters---From the Enforcement Perspective

At the Executive Enterprises Institute's International Tax Withholding and Information Reporting Seminar in New York City on June 17 and 18, the Internal Revenue Service ("IRS") addressed several matters of interest to U.S. withholding agents and payors, including non-U.S. financial institutions acting as Qualified Intermediaries ("QI"). Given the breadth of issues covered, this is the first of two Alerts being issued to address Chief Counsel and Enforcement matters. The IRS indicated the following:

The Service will look at approximately 15 U.S. withholding agents. As a result, most U.S. banks, brokerage firms, insurance companies, and investment companies which filed Forms 1042---both large, medium, and small---are all potential candidates for these Form 1042 audits.

The selected entities will be contacted within the next 30-60 days. The Form 1042 audit will be a true income tax audit, the IRS emphasized, and not merely a compliance check. As noted in the FSI Tax Alert dated November 13, 2003, the IRS has set forth the items that will be reviewed during this audit. The audit will include an opening conference, the issuance of Information Document Requests ("IDRs"), follow-up IDRs, and a closing conference. Subsequent to these audits, the IRS may issue No Change letters, recommendations for Changes of Examination Results, and other available administrative measures, all of which may result in the audited entity being required to issue amended Forms 1042.

If a selected entity is already under examination by an audit team and has an international examiner, the IRS examination team will work with the entity to determine whether the entity wants that examiner to conduct the Form 1042 audit or whether, instead, it is wishes to have the a member of NYC-based "Form 1042 SWAT Team" undertake the review. If a selected entity is not under examination, then a member of the "NYC Form 1042 SWAT Team" will conduct the audit.

Each NYC Form 1042 SWAT team will include an Area Counsel, who is responsible for Financial Services, as well as an international examiner/revenue agent and computer audit specialist ("CAS").

The IRS is conducting a training workshop during the week of July 12. Approximately 15 international examiners or revenue agents, as well as CAS and IRS counsel, will participate in the training sessions.

It bears noting that even if an entity is not selected in the first wave, the IRS may still audit compliance by the entity. As long as the statute of limitations is open, the taxpayer is subject to examination.

Investors and public companies are embarking on a new relationship after passage of the huge corporate responsibility and accounting reform law in July. The new law, the Sarbanes-Oxley Act of 2002, aims to restore investor confidence and public trust in business at a time when both are at their lowest levels since the Great Depression.

Corporate certification

Both the new law and the SEC impose tough, new certification requirements.

Investors will be watching if companies’ certify their initial financial statements or restate past results and certify them.

Under the new law, corporate CEOs and chief financial officers (CFOs) must swear to the accuracy of their companies’ earnings, losses and accounting. The sworn statements will be attached to annual or quarterly reports filed with the Securities and Exchange Commission (SEC).

Each CEO or CFO must certify:

· He or she has reviewed the annual or quarterly report;

· The report does not contain untrue statements of material facts or omissions of material facts;

· Internal controls have been put in place to safeguard material information

· Corporate executives and auditors are aware of any deficiencies in internal controls.

The most perplexing issue is what the term internal controls means and how a company can meet the internal control requirement. The term internal controls will be better defined as new regulations are issued that the new law.

Based on a recent survey of CFOs, most public companies finance executives feel they have already have put into place internal controls sufficient to safeguard assets and assure that financial reporting is reasonable-the issue is how to communicate those controls effectively to the audit committee and defining the process that management can demonstrate to the audit committee that those controls are being adhered to by the Company leadership and line management.

The new certification requirement extends to all public companies, regardless of whether they are domiciled in the US or not. Congress added this provision so US companies could not get around this rule by moving their headquarters offshore.

August 14 was the first deadline for CEOs and CFOs to certify their financial results as accurate. On that day, the CEOs and CFOs of 745 public companies were required to submit their certifications to the SEC. In September, October and November, the CEOs and CFOs of 200 more companies will submit certifications.

Stock trading

During so-called blackout periods, when workers are prevented from buying or selling stock in their pensions or 401(k) plans, company executives also will be prohibited from making the same stock purchases or sales. This rule puts executives and workers on a level playing field.

Corporate CEOs and executives also have heightened reporting standards for insider trading. The new law requires a two-day insider disclosure window. Reports of insider trading will be posted by the SEC on the Internet.

Enhanced criminal penalties

The new law adds to the criminal penalties for corporate fraud and pension fund violations. Criminal pension fund violations increase from the current one-year maximum jail term to 10 years. Criminal securities fraud is punishable by 25 years in jail.

A corporate executive caught filing false financial statements can risk up to 20 years in jail and a $5 million fine. Penalties for obstructing justice and shredding documents are dramatically increased to a maximum jail term of 20 years.

Accounting reform

A new federal agency – the Public Company Accounting Oversight Board (PCAOB) – will police accounting practices. The PCAOB has broad powers to impose criminal penalties on accounting firms, corporate executives and others. It can also subpoena people and records to aid in its investigation of accounting abuse.

To avoid conflicts of interest between accounting firms and clients, firms are banned from some consulting services.

Itisn’t easy for anyone, but it’s especially difficult for small- and mid-cap sized public companies.

When Sarbanes-Oxley was passed, Congress rejected the recommendation of the SEC and eschewed an approach of expressly allowing the SEC to tailor the Act’s requirements to different types of companies.

It also declined to permit individual companies to tailor the Act’s provisions to each company’s specific circumstances, as it had done in the Foreign Corrupt Practices Act in 1977.

Instead, the Act applies a “one-size-fits-all” approach, and that’s created enormous difficulties, both domestically and globally.

The SEC has effectively been relegated to an “all-or-nothing” approach, given the poor craftsmanship that ultimately characterizes this important legislation. Particularly with internal controls, the SEC has deferred the applicability of its requirements, giving smaller companies (and foreign public companies) an opportunity to employ a longer lead time to prepare for the ultimate day of reckoning.

Unfortunately, many smaller companies haven’t really taken advantage of the SEC’s largesse, instead choosing to defer spending and implementation until they’re certain they’ll have to comply.

This is short-sighted at best, and potentially counterproductive, at worst. The provisions of SOX are becoming “best practices” for all companies, whether publicly-traded or not, whether for profit or not.

Smaller companies that defer considering and implementing SOX best practices also runs the significant and costly risk of losing the all-important “compliance premium” when and if their company is sold.

When companies seek to sell themselves, or are acquired, there are only two possible outcomes—they can sell themselves to a public company (or a company desirous of becoming a public company), or they can be sold to public investors.

In either case, if the company to be acquired is not SOX compliant, any thoughtful acquirer must deduct the anticipated costs associated with implementing SOX requirements and best practices.

This results in a loss of revenue upon an anticipated sale. Even worse, it could prolong and defeat a potential transaction, depending on the nature of the assessment made of the company to be acquired.

Even beyond Section 404’s difficultimplications, companies that have fewer resources than the Fortune 500 are legitimately worried about the costs of SOX compliance, given the statute’s one-size-fits-all bias.

But many smaller companies are missing an opportunity to seize control of their own situations by developing thoughtful approaches to the myriad regulatory requirements SOX imposes.

To try and sort through some of these issues, this month’s column offers some rules of thumb smaller and mid-cap companies may want to consider in an effort to get ahead of the regulatory curve.

1. Marketplace forces now require companies to pursue full transparency and state-of-the-art compliance policies.

Companies that don’t set, then meet, higher standards, will be abandoned or turned on by investment banks, big four accounting firms, insurance companies, commercial banks and rating agencies, and will find it hard to attract both capital and quality directors. This means that, one way or another, wittingly or not, corporations and financial institutions will be compelled to meet new governance standards in order to survive and prosper.

2. Develop a thoughtful SOX methodology.

The starting point in any analysis is to develop a customized summary of the Act, and its applicability to the operations of a specific company. This is not the place for one-size-fits-all checklists that many companies and their advisors use to create the illusion of diligence and security. Checklists, especially in the area of regulatory compliance, are usually not worth the paper on which they’re printed. The goal is to divide the requirements of SOX into major categories (e.g., internal controls, governance, ethics and transparency), and then articulate, from a businessperson’s perspective, what the statute and the SEC’s implementing regulations are attempting to achieve.

3. Establish an internal compliance team.

While outside assistance is ultimately likely to be necessary, every company should have its own internal compliance team. This offers the prospect of a team that really knows the company best, and also promises to save money by coming up with pragmatic approaches that fit a company’s particular profile. Members of the internal compliance team should include the company’s internal general counsel, the head of internal audit functions, the head of the company’s disclosure committee, staff personnel who work with the company’s audit committee, and others.

4. Develop a game plan.

Consideration of the requirements of SOX should not be haphazard or rely on serendipity. It is essential that every requirement of SOX be examined, along with the best means of implementing them. Where there are alternative approaches, all such possibilities should be considered. The key to avoiding later difficulties is ensuring that the company gives thoughtful consideration to a wide variety of issues and alternatives.

5. Identify all alternatives considered; explain all approaches modified or rejected.

If a review process is well-structured, companies can benefit by having detailed notes of their review, the reasons that certain alternatives were rejected or modified, and the rationale for approaches taken. Having this kind of contemporaneous record of the efforts undertaken, and the results reached (as well as the rationales employed) is invaluable if regulatory or class-action scrutiny should occur.

6. Companies should pay careful attention to the ramifications of proposed best practices, not merely their legality or necessity.

While adherence to statutory and regulatory fiats is necessary, they’re not sufficient. It’s in a corporation’s self-interest to look beyond specific legislative and regulatory mandates, and think about effecting real governance and transparency reforms that can position the company for greater success and distinguish the company from the pack.

7. It is critical to have a compliance/ethics board committee that plays a central role in establishing corporate best practices.

The assessment of what is required, and what is desirable, under SOX, cannot be left exclusively to senior management, although they play a critical and important role in the process. Rather, public companies should establish Qualified Legal Compliance and Ethics Committees, whose functions include assessing compliance with SOX, evaluating how a company compares with its core group of competitors, and overseeing decisions made to implement some best practices and/or forego others.

8. Companies would do well to create a senior compliance officer position and an ombudsman post.

Compliance and ethics have become the watchword since Enron and its progeny spawned SOX. While public companies (other than financial services firms) are not specifically required to have a Senior Compliance Officer, it is a false saving, and a huge mistake, not to create such a position. Equally significant is the need to permit employees and other corporate constituencies to report conduct they believe is troublesome. Although SOX requires this type of process for financial reporting issues, companies do well to extend it to all manner of potential misconduct. Creating the opportunity to learn of misconduct first can save a company millions and millions of dollars, and senior management their jobs.

9. Companies should consider developing compliance and ethical disclosures that truly inform investors.

Unfortunately, in today’s environment, disclosure is often seen as a means for avoiding liability down the road, not as a method of informing readers. Particularly for mid- and small-cap companies, the effort to analyze compliance with SOX, and the decisions reached about adopting (or rejecting) certain best practices, should form clear and concise disclosures. By doing this, companies can avoid liability for misleading investors who, in the absence of such disclosure, will believe every company is complying with best practices.

10. Mid- and small-cap companies should work together to develop approaches to the requirements, costs, burdens and benefits of SOX.

There is definitely truth to the old saw that if we don’t all hang together, we will surely hang separately! Mid- and small-cap companies should review their compliance and regulatory programs with comparably situated companies on a regular and periodic basis, to make sure that they have considered best practices as those practices evolve and develop.

11. Mid- and small-cap companies should track the costs associated with their compliance and regulatory regimes.

Government regulators have heard a great deal of complaining about the huge costs of compliance, but few companies are in a position to back up their “sense” of the actual costs with hard data. This could prove important. Regulators and prosecutors will definitely want to review a company’s decisions, costs, burdens and potential rewards before bringing an enforcement action complaining about a purported failure to comply with some provision of SOX or another.

12. Good ethics and compliance policies will always prove profitable.

Companies that have good governance and transparency have been empirically shown to outperform their core group of competitor companies, and outperform the market as a whole. Although there are a lot of expenses associated with SOX, there are benefits as well.

Mid- and small-cap companies have more flexibility than they realize in tailoring the requirements of SOX and the SEC’s rules thereunder to each company’s specific circumstances.

Sole proprietorships (individuals) – or no special entity –the profits or losses attributes to the individual and is subject to individual tax rates.

Standard corporations or ("C corp") – C corps are entites separate from the individuals that own the stock and the shareholders are limited to their investment in the company. The income from corporations does not automatically attribute back to its shareholders but is subject to tax. Corporations come in different varieties and include:

Personal holding companies.- a company that holds investment assets-the income from these entities in general attributes back to the shareholders. Personal service corporations-. Is a corporation controlled by employees that provide personal services. While quite popular, the income may be attributed back to the shareholders if not operated properly.

S corporations – While recognized as regular corporations for state law purposes, for federal tax law purposes-these companies are not or subject to a very low tax rate. This type of company exists primarily so that small businesses may operate without the tax burden of regular corporation while enjoying the benefits of a limited liability.

Partnerships – provide an well defined approach for several entities to work together without the corporate structure:

General partnerships – The partnership owners (or partners) operate and own the business. The downside is that their liability is not limited to their investments, like corporations

Limited partnerships – are partnerships that have general and limited partners. Limited are not allowed to participate in managing the business but their liability is limited by their investment in the partnership. Some of these partnerships can actually be traded on a public exchange. Limited liability partnerships (LLPs) – similar to limited partnerships but liability is limited to the general partners from acts of its other partners (like malpractice). Limited liability companies (LLCs) – A combination of both limited partnerships and corporations.-it has limited liability like a corporation and is not subject to tax but passes through its income to its shareholders.

Yet, a business owner planning to sell a business will want the highest valuation the business can sustain and must be able to defend that valuation to any potential buyer who questions the price. If weaknesses in the valuation are exposed, the seller will be forced on the defensive in negotiations.

Sellers Shouldn’t Overlook These Problems

Two common problems that occur in valuations are:

Whether to include goodwill depends on a complex set of assumptions, including the size of the business, the extent of the seller’s direct involvement, and whether consulting or noncompete agreements have been developed.

A discount or a premium is ignored or incorporated incorrectly in the valuation. What weak points would a buyer attack? How can the seller ensure that the valuation will withstand the buyer’s tests and scrutiny? Here is how each valuation method might be challenged and how the seller could defend it.

Discounted Cash Flow Method

With discounted cash flow, the valuator evaluates the business based on the value of its future earnings potential through cash flow. This method recognizes that a dollar today is worth more than one received in the future. Therefore, it discounts the business's projected earnings to adjust for real growth, inflation and risk. A number of variables used in this method can be disputed:

Starting point – Is the base period financial position (usually the current year) a representative year? Can the seller’s valuator prove it is not an unusually profitable year?

Projected forecast – Does the forecast follow the same pattern as the past? If the seller’s valuation is based on higher-percentage revenue growth than occurred in the past, can it be substantiated?

Years projected – A normal forecast period is either three, five or 10 years. If the seller’s forecast period is shorter or longer, the buyer may demand an explanation. For a cyclical business, the forecast must incorporate a full cycle.

Discount rate – This variable estimates the discounted cash flow over the life of the business. Because it can have an unusually large effect on the valuation, the discount rate may have to be renegotiated with the buyer.

Adjusted Book Value Method The adjusted book value method is usually the least controversial. This approach appraises all assets and liabilities as a method of valuing the entire business. The identification and valuation of intangible assets is the most troublesome aspect of this method. Intangible assets may include the customer list, licenses, patents, work force or the business’s goodwill. Buyers are likely to challenge intangible assets in various ways:

Basis Challenge – Does an intangible asset really add monetary value to the business? For example, the buyer may assert that the already-employed work force does not have a value because many skilled workers can easily be found in the region.

Life of the intangible asset – How long will favorable contracts with a supplier continue? When does a lease expire? Will a major customer remain after the business changes hands?

Debt Assumption Method The debt assumption method usually results in the highest price. It involves considering how much debt a business could have and still operate, using cash flow to pay the debt. Buyers may find the following issues debatable:

Net income – How does the seller’s valuator find the net income for the company? Are some estimates of expenses too low?

Adjustments – Are perks to the owner added back into income? Have adjustments to income been made from forecasts that are too optimistic?

Market Value Method The market value method analyzes large firms in relation to similar companies to find a value. The valuator usually chooses from eight to 12 businesses for comparison.

To arrive at fair market value for these businesses, the valuation professional adds and subtracts various premiums and discounts from the computation, making adjustments for comparability. The buyer may challenge this type of valuation in several ways:

Choice of companies – Two companies are rarely so similar that one can be directly compared with the other. Therefore, the buyer may reject one or several of the companies selected as not comparable to the seller’s company. The seller should be ready to defend the selections by showing how the company is similar and how its fair market value has been adjusted to reflect differences.

Adjusted value of companies – The buyer may bring up differences in location, size, structure, financing or other features to charge that a similar company is not fairly valued.

Defensibility Is Critical Valuation of a business is a complicated, ticklish task. While a business owner wants the highest value for the business, a high valuation will be of little use if it can’t stand up to a buyer’s scrutiny. Key steps in the valuation must be supportable. We would be pleased to advise you on the value of your business for transaction purposes.

For example, a shareholder who owns stock worth $3,000,000 in a closely held company (for which stock he or she originally paid $200,000) will pay almost $800,000 in federal and state income taxes on the sale (assuming a combined federal and state tax rate of approximately 26%), meaning that he or she will net $2,200,000, at best, from the sale.

In contrast, by selling his or her stock to an ESOP, he or she will pay no federal income taxes, and possibly no state income taxes, on the sale. The selling shareholder will net $3,000,000 on the sale, a tax deferral of $800,000!

However, this ESOP tax deferral is available only if the following requirements are satisfied:

• The selling shareholder must be either an individual, a trust, an estate, a partnership, or a subchapter S corporation, and must have owned the stock sold to the ESOP for at least three years.

• The selling shareholder must not have received the stock from a qualified retirement plan (e.g., an ESOP or stock bonus plan), by exercising a stock option or through an employee stock purchase program.

• The company establishing the ESOP is a C corporation (not an S corporation).

• The sale must otherwise qualify for capital gains treatment, but for the sale to the ESOP.

• The stock sold to the ESOP must (in general) be voting common stock or preferred stock that is convertible into voting common stock.

• For the 12 months preceding the sale to the ESOP, the company that establishes the ESOP must have had no class of stock that was readily tradable on an established securities market.

• After the sale, the ESOP must own at least 30% of the company that establishes the ESOP (on a fully diluted basis). Although not a requirement for the tax deferral, the company also must consent to the election of tax-deferred treatment, and a 10% excise tax is imposed on the company for certain dispositions of stock by the ESOP within three years after the sale.

•Within a 15-month period beginning 3 months before the sale to the ESOP and ending 12 months after the sale, the selling shareholder must reinvest the sale proceeds in replacement securities (common or preferred stock, bonds, and/or debt instruments) issued by publicly traded or closely held domestic corporations that use more than 50% of their assets in an active trade or business and whose passive investment income for the preceding year did not exceed 25% of their gross receipts.

Municipal bonds are not eligible reinvestment vehicles, nor are certificates of deposit issued by banks or savings and loans, mutual funds, or securities issued by the U.S. Treasury.

In addition to these requirements for the tax deferral, the stock purchased by the ESOP may not be allocated to the seller, certain members of his or her family, or any shareholder in the company that establishes the ESOP who owns more than 25% of any class of company stock. A prohibited allocation causes a 50% excise tax to be imposed on the company and adverse income tax consequences to the participant receiving the allocation.

Reinvesting the Proceeds in ESOP Notes and Other Securities

The ESOP tax deferral has one downside in that a subsequent sale of the replacement securities will trigger the tax that had been deferred by the sale to the ESOP. To address this problem, an investment alternative has been developed--an innovative security known as an "ESOP Note." ESOP Notes are publicly registered securities, issued by highly rated companies such as Ford Motor Credit, ITT Financial, Xerox Credit Corporation, and General Electric Capital Corporation. They have a 60-year maturity and bear a floating rate coupon indexed to 30-day commercial paper. These securities have call protection for 30 years. ESOP Notes can be margined up to 75% or more of their market value, allowing investors access to a substantial portion of their initial sale proceeds without triggering any tax liability on the part of the seller. The borrowing cost is normally the broker call loan rate plus a spread, which is greatly offset by the income earned on the ESOP Notes.

Careful planning of the reinvestment of the ESOP sale proceeds is extremely important. The business owner who sells his or her company to the employees through an ESOP can create liquidity today while deferring capital gains taxes indefinitely.

In the event of the selling owner's death after the ESOP sale, his or her heirs will receive a stepped-up basis on the replacement securities, meaning the taxation on the sale of his or her business is avoided forever.

With the help of a knowledgeable investment advisor, the selling shareholder can design a well-diversified portfolio than can be rebalanced according to the changing fundamental and technical conditions of the capital markets.

Steps to Setting up an ESOP Assuming this tax deferral/avoidance appeals to a closely held business owner, how does such an owner go about selling 30% or more of his or her company to an ESOP? The first step is a feasibility study, which tells the owner whether the characteristics of his or her company are such that he or she is a good candidate for a sale to an ESOP. This feasibility study may involve one or more conversations with a qualified ESOP attorney or a full-blown written feasibility analysis prepared by a financial consultant.

If the circumstances are such that the ESOP alternative is feasible, the next key step is to obtain a professional valuation of the entire company and of the portion of the company that is being sold to the ESOP.

A valuation by an independent appraiser is one of the requirements for a transaction between an ESOP and an owner of the company that establishes the ESOP. The ESOP cannot pay more than fair market value for the shares that it purchases from the owner.

The independent appraisal is used by the ESOP fiduciary (a board of trustees, an administrative committee, or an institutional trustee) to ensure that the ESOP does not pay more than fair market value for the shares, as determined as of the date of the sale. Based on recent case law, the ESOP fiduciary must conduct the proper due diligence to make this determination in good faith.

The ESOP plan document and the ESOP trust agreement also must be designed and implemented as the valuation process progresses. If the company does not have adequate cash resources to finance the purchase of stock by the ESOP, as is usually the case, the company must obtain a loan from a commercial lender, and loan terms must be negotiated.

In addition, a stock purchase agreement between the owner of the company and the ESOP must be negotiated and prepared.

The ESOP then borrows the money from the company that the company obtains from the commercial lender. The ESOP uses these loan proceeds to purchase company stock from the owner at no more than its fair market value, as determined by an independent appraiser as of the date of the purchase.

The company's debt to the commercial lender and the ESOP's debt to the company is normally repaid over a five- or seven-year term and with tax-deductible contributions by the company to the ESOP.

Contributions to the ESOP that are used to pay the interest on the ESOP's loan from the company are fully deductible. Contributions used to repay ESOP loan principal are deductible up to an amount equal to 25% of the total compensation paid or accrued to all participating employees. Dividends paid on stock acquired by an ESOP with an ESOP loan also are generally deductible to the extent they are used to repay that specific loan, provided that the company that establishes the ESOP and issues the dividends is not subject to the alternative minimum tax, in which event the dividends may not be fully deductible.

The ESOP as a Versatile Financial Tool

As demonstrated by the above discussion, an ESOP is a versatile financial tool that can be used by a selling shareholder to obtain significant tax benefits in selling a portion or all of his or her company.

An ESOP also can be used in connection with the spinoff of a division or corporate expansion; it can be given a special class of preferred stock to minimize equity dilution; and it can be combined with a 401(k) plan to attract employee equity into a company.

There are few "free lunches," tax-wise, today. Selling stock to an ESOP is one of the remaining ones, and it should be irresistible to shareholders of closely held companies.

The IRS has provided transition relief for third party settlement organizations (TPSOs) for reportable transactions under Code Sec. 6050W during calendar years 2024 and 2025. These calendar years will be the final transition period for IRS enforcement and administration of amendments made to the minimum threshold amount for TPSO reporting under Code Sec. 6050W(e).

The IRS has provided transition relief for third party settlement organizations (TPSOs) for reportable transactions under Code Sec. 6050W during calendar years 2024 and 2025. These calendar years will be the final transition period for IRS enforcement and administration of amendments made to the minimum threshold amount for TPSO reporting under Code Sec. 6050W(e).

Background

Code Sec. 6050W requires payment settlement entities to file Form 1099-K, Payment Card and Third Party Network Transactions, for each calendar year for payments made in settlement of certain reportable payment transactions. Among other information, the return must report the gross amount of the reportable payment transactions regarding a participating payee to whom payments were made in the calendar year. As originally enacted, Code Sec. 6050W(e) provided that TPSOs are not required to report third party network transactions with respect to a participating payee unless the gross amount that would otherwise be reported is more than $20,000 and the number of such transactions with that payee is more than 200.

The American Rescue Plan Act of 2021 (P.L. 117-2) amended Code Sec. 6050W(e) so that, for calendar years beginning after 2021, a TPSO must report third party network transaction settlement payments that exceed a minimum threshold of $600 in aggregate payments, regardless of the number of transactions. The IRS has delayed implementing the amended TPSO reporting threshold for calendar years beginning before January 1, 2023, and for calendar year 2023 (Notice 2023-10; Notice 2023-74).

For backup withholding purposes, a reportable payment includes payments made by a TPSO that must be reported on Form 1099-K, without regard to the thresholds in Code Sec. 6050W. The IRS has provided interim guidance on backup withholding for reportable payments made in settlement of third party network transactions (Notice 2011-42).

Reporting Relief

Under the new transition relief, a TPSO will not be required to report payments in settlement of third party network transactions with respect to a participating payee unless the amount of total payments for those transactions is more than:

• $5,000 for calendar year 2024;
• $2,500 for calendar year 2025.

This relief does not apply to payment card transactions.

For those transition years, the IRS will not assert information reporting penalties under Code Sec. 6721 or Code Sec. 6722 against a TPSO for failing to file or furnish Forms 1099-K unless the gross amount of aggregate payments to be reported exceeds the specific threshold amount for the year, regardless of the number of transactions.

In calendar year 2026 and after, TPSOs will be required to report transactions on Form 1099-K when the amount of total payments for those transactions is more than $600, regardless of the number of transactions.

Backup Withholding Relief

For calendar year 2024 only, the IRS will not assert civil penalties under Code Sec. 6651 or Code Sec. 6656 for a TPSO’s failure to withhold and pay backup withholding tax during the calendar year. However, TPSOs that have performed backup withholding for a payee during 2024 must file Form 945, Annual Return of Withheld Federal Income Tax, and Form 1099-K with the IRS, and must furnish a copy of Form 1099-K to the payee.

For calendar year 2025 and after, the IRS will assert those penalties for a TPSO’s failure to withhold and pay backup withholding tax.

Effect on Other Documents

Notice 2011-42 is obsoleted.

Notice 2024-85

IR-2024-299

The Treasury Department and IRS have issued final regulations amending regulations under Code Sec. 752 regarding a partner’s share of recourse partnership liabilities and the rules for related persons.

The Treasury Department and IRS have issued final regulations amending regulations under Code Sec. 752 regarding a partner’s share of recourse partnership liabilities and the rules for related persons.

Background

Code Sec. 752(a) treats an increase in a partner’s share of partnership liabilities, as well as an increase in the partner’s individual liabilities when the partner assumes partnership liabilities, as a contribution of money by the partner to the partnership. Code Sec. 752(b) treats a decrease in a partner’s share of partnership liabilities, or a decrease in the partner’s own liabilities on the partnership’s assumption of those liabilities, as a distribution of money by the partnership to the partner.

The regulations under Code Sec. 752(a), i.e., Reg. §§1.752-1 through 1.752-6, treat a partnership liability as recourse to the extent the partner or related person bears the economic risk of loss and nonrecourse to the extent that no partner or related person bears the economic risk of loss.

According to the existing regulations, a partner bears the economic risk of loss for a partnership liability if the partner or a related person has a payment obligation under Reg. §1.752-2(b), is a lender to the partnership under Reg. §1.752-2(c), guarantees payment of interest on a partnership nonrecourse liability as provided in Reg. §1.752-2(e), or pledges property as security for a partnership liability as described in Reg. §1.752-2(h).

Proposed regulations were published in December 2013 (REG-136984-12). These final regulations adopt the proposed regulations with modifications.

The Final Regulations

The amendments to the regulations under Reg. §1.752-2(a) provide a proportionality rule for determining how partners share a partnership liability when multiple partners bear the economic risk of loss for the same liability. Specifically, the economic risk of loss that a partner bears is the amount of the partnership liability or portion thereof multiplied by a fraction that is obtained by dividing the economic risk of loss borne by that partner by the sum of the economic risk of loss borne by all the partners with respect to that liability.

The final regulations also provide guidance on how a lower-tier partnership allocates a liability when a partner in an upper-tier partnership is also a partner in the lower-tier partnership and bears the economic risk of loss for the lower-tier partnership’s liability. The lower-tier partnership in this situation must allocate the liability directly to the partner that bears the economic risk of loss with respect to the lower-tier partnership’s liability. The final regulations clarify how this rule applies when there are overlapping economic risks of loss among unrelated partners, and the amendments add an example illustrating application of the proportionality rule to tiered partnerships. They also add a sentence to Reg. §1.704-2(k)(5) clarifying that an upper-tier partnership bears the economic risk of loss for a lower-tier partnership’s liability that is treated as the upper-tier partnership’s liability under Reg. §1.752-4(a), with the result that partner nonrecourse deduction attributable to the lower-tier partnership’s liability are allocated to the upper-tier partnership under Reg. §1.704-2(i).

In addition, the final regulations list in one section all the situations under Reg. §1.752-2 in which a person directly bears the economic risk of loss, including situations in which the de minimis exceptions in Reg. §1.752-2(d) are taken into account. The amendments state that a person directly bears the economic risk of loss if that person—and not a related person—meets all the requirements of the listed situations.

For purposes of rules on related parties under Reg. §1.752-4(b)(1), the final regulations disregard: (1) Code Sec. 267(c)(1) in determining if an upper-tier partnership’s interest in a lower-tier partnership is owned proportionately by or for the upper-tier partnership’s partners when a lower-tier partnership bears the economic risk of loss for a liability of the upper-tier partnership; and (2) Code Sec. 1563(e)(2) in determining if a corporate partner in a partnership and a corporation owned by the partnership are members of the same controlled group when the corporation directly bears the economic risk of loss for a liability of the owner partnership. The regulations state that in both these situations a partner should not be treated as bearing the economic risk of loss when the partner’s risk is limited to the partner’s equity investment in the partnership.

Under the final regulations, if a person owning an interest in a partnership is a lender or has a payment obligation with respect to a partnership liability, then other persons owning interests in that partnership are not treated as related to that person for purposes of determining the economic risk of loss that they bear for the partnership liability.

The final regulations also provide that if a person is a lender or has a payment obligation with respect to a partnership liability and is related to more than one partner, then the partners related to that person share the liability equally. The related partners are treated as bearing the economic risk of loss for a partnership liability in proportion to each related partner’s interest in partnership profits.

The final regulations contain an ordering rule in which the first step in Reg. §1.762-4(e) is to determine whether any partner directly bears the economic risk of loss for the partnership liability and apply the related-partner exception in Reg. §1.752-4(b)(2). The next step is to determine the amount of economic risk of loss each partner is considered to bear under Reg. §1.752-4(b)(3) when multiple partners are related to a person directly bearing the economic risk of loss for a partnership liability. The final step is to apply the proportionality rule to determine the economic risk of loss that each partner bears when the amount of the economic risk of loss that multiple partners bear exceeds the amount of partnership liability.

The IRS and Treasury indicate that they are continuing to study whether additional guidance is needed on the situation in which an upper-tier partnership bears the economic risk of loss for a lower-tier partnership’s liability and distributes, in a liquidating distribution, its interest in the lower-tier partnership to one of its partners when the transferee partner does not bear the economic risk of loss.

Applicability Dates

The final regulations under T.D. 10014 apply to any liability incurred or assumed by a partnership on or after December 2, 2024. Taxpayers may apply the final regulations to all liabilities incurred or assumed by a partnership, including those incurred or assumed before December 2, 2024, with respect to all returns (including amended returns) filed after that date; but in that case a partnership must apply the final regulations consistently to all its partnership liabilities.

T.D. 10014

Final regulations defining “energy property” for purposes of the energy investment credit generally apply with respect to property placed in service during a tax year beginning after they are published in the Federal Register, which is scheduled for December 12.

Final regulations defining “energy property” for purposes of the energy investment credit generally apply with respect to property placed in service during a tax year beginning after they are published in the Federal Register, which is scheduled for December 12.

The final regs generally adopt proposed regs issued on November 22, 2023 (NPRM REG-132569-17) with some minor modifications.

Hydrogen Energy Storage P property

he Proposed Regulations required that hydrogen energy storage property store hydrogen solely used for the production of energy and not for other purposes such as for the production of end products like fertilizer. However, the IRS recognize that the statute does not include that requirement. Accordingly, the final regulations do not adopt the requirement that hydrogen energy storage property store hydrogen that is solely used for the production of energy and not for other purposes.

The final regulations also provide that property that is an integral part of hydrogen energy storage property includes, but is not limited to, hydrogen liquefaction equipment and gathering and distribution lines within a hydrogen energy storage property. However, the IRS declined to adopt comments requesting that the final regulations provide that chemical storage, that is, equipment used to store hydrogen carriers (such as ammonia and methanol), is hydrogen energy storage property.

Thermal Energy Storage Property

To clarify the proposed definition of “thermal energy storage property,” the final regs provide that such property does not include property that transforms other forms of energy into heat in the first instance. The final regulations also clarify the requirements for property that removes heat from, or adds heat to, a storage medium for subsequent use. Under a safe harbor, thermal energy storage property satisfies this requirement if it can store energy that is sufficient to provide heating or cooling of the interior of a residential or commercial building for at least one hour. The final regs also include additional storage methods and clarify rules for property that includes a heat pump system.

Biogas P property

The final regulations modify several elements of the rules governing biogas property. Gas upgrading equipment is included in cleaning and conditioning property. The final regs clarify that property that is an integral part of qualified biogas property includes but is not limited to a waste feedstock collection system, landfill gas collection system, and mixing and pumping equipment. While a qualified biogas property generally may not capture biogas for disposal via combustion, combustion in the form of flaring will not disqualify a biogas property if the primary purpose of the property is sale or productive use of biogas and any flaring complies with all relevant laws and regulations. The methane content requirement is measured at the point at which the biogas exits the qualified biogas property.

Unit of Energy P property

To clarify how the definition of a unit of energy property is applied to solar energy property, the final regs update an example illustrate that the unit of energy property is all the solar panels that are connected to a common inverter, which would be considered an integral part of the energy property, or connected to a common electrical load, if a common inverter does not exist. Accordingly, a large, ground-mounted solar energy property may comprise one or more units of energy property depending upon the number of inverters. For rooftop solar energy property, all components of property that are installed on a single rooftop are considered a single unit of energy property.

Energy Projects

The final regs modify the definition of an energy project to provide more flexibility. However, the IRS declined to adopt a simple facts-and-circumstances analysis so an energy project must still satisfy particular and specific factors.

T.D. 10015

The IRS has provided relief from the failure to furnish a payee statement penalty under Code Sec. 6722 to certain partnerships with unrealized receivables or inventory items described in Code Sec. 751(a) (Section 751 property) that fail to furnish, by the due date specified in Reg. §1.6050K-1(c)(1), Part IV of Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, to the transferor and transferee in a Section 751(a) exchange that occurred in calendar year 2024.

The IRS has provided relief from the failure to furnish a payee statement penalty under Code Sec. 6722 to certain partnerships with unrealized receivables or inventory items described in Code Sec. 751(a) (Section 751 property) that fail to furnish, by the due date specified in Reg. §1.6050K-1(c)(1), Part IV of Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, to the transferor and transferee in a Section 751(a) exchange that occurred in calendar year 2024.

Background

A partnership with Section 751 property must provide information to each transferor and transferee that are parties to a sale or exchange of an interest in the partnership in which any money or other property received by a transferor in exchange for all or part of the transferor’s interest in the partnership is attributable to Section 751 property. The partnership must file Form 8308 as an attachment to its Form 1065 for the partnership's tax year that includes the last day of the calendar year in which the Section 751(a) exchange took place. The partnership must also furnish a statement to the transferor and transferee by the later of January 31 of the year following the calendar year in which the Section 751(a) exchange occurred, or 30 days after the partnership has received notice of the exchange as specified under Code Sec. 6050K and Reg. §1.6050K-1. The partnership must use a copy of the completed Form 8308 as the required statement, or provide or a statement that includes the same information.

In 2020, Reg. §1.6050K-1(c)(2) was amended to require a partnership to furnish to a transferor partner the information necessary for the transferor to make the transferor partner’s required statement in Reg. §1.751-1(a)(3). Among other items, a transferor partner in a Section 751(a) exchange is required to submit with the partner’s income tax return a statement providing the amount of gain or loss attributable to Section 751 property. In October 2023, the IRS added new Part IV to Form 8308, which requires a partnership to report, among other items, the partnership’s and the transferor partner’s share of Section 751 gain and loss, collectibles gain under Code Sec. 1(h)(5), and unrecaptured Section 1250 gain under Code Sec. 1(h)(6).

In January 2024, the IRS provided relief due to concerns that many partnerships would not be able to furnish the information required in Part IV of the 2023 Form 8308 to transferors and transferees by the January 31, 2024 due date, because, in many cases, partnerships would not have all of the required information by that date (Notice 2024-19, I.R.B. 2024-5, 627).

The relief below has been provided due to similar concerns for furnishing information for Section 751(a) exchanges occurring in calendar year 2024.

Penalty Relief

For Section 751(a) exchanges during calendar year 2024, the IRS will not impose the failure to furnish a correct payee statement penalty on a partnership solely for failure to furnish Form 8308 with a completed Part IV by the due date specified in Reg. §1.6050K-1(c)(1), only if the partnership:

• timely and correctly furnishes to the transferor and transferee a copy of Parts I, II, and III of Form 8308, or a statement that includes the same information, by the later of January 31, 2025, or 30 days after the partnership is notified of the Section 751(a) exchange, and
• furnishes to the transferor and transferee a copy of the complete Form 8308, including Part IV, or a statement that includes the same information and any additional information required under Reg. §1.6050K-1(c), by the later of the due date of the partnership’s Form 1065 (including extensions), or 30 days after the partnership is notified of the Section 751(a) exchange.

This notice does not provide relief with respect to a transferor partner’s failure to furnish the notification to the partnership required by Reg. §1.6050K-1(d). This notice also does not provide relief with respect to filing Form 8308 as an attachment to a partnership’s Form 1065, and so does not provide relief from failure to file correct information return penalties under Code Sec. 6721.

Notice 2025-2

The American Institute of CPAs is encouraging business owners to continue to collect required beneficial ownership information as required by the Corporate Transparency Act even though the regulations have been halted for the moment.

The American Institute of CPAs is encouraging business owners to continue to collect required beneficial ownership information as required by the Corporate Transparency Act even though the regulations have been halted for the moment.

AICPA noted that the while there a preliminary injunction has been put in place nationwide by a U.S. district court, the Financial Crimes Enforcement Network has already filed its appeal and the rules could be still be reinstated.

"While we do not know how the Fifth Circuit court will respond, the AIPCA continues to advise members that, at a minimum, those assisting clients with BOI report filings continue to gather the required information from their clients and [be] prepared to file the BOI report if the inunction is lifted," AICPA Vice President of Tax Policy & Advocacy Melanie Lauridsen said in a statement.

She continued: "The AICPA realizes that there is a lot of confusion and anxiety that business owners have struggled with regarding BOI reporting requirements and we, together with our partners at the State CPA societies, have continued to advocate for a delay in the implementation of this requirement."

The United States District Court for the Eastern District of Texas granted on December 3, 2024, a motion for preliminary injunction requested in a lawsuit filed by Texas Top Cop Shop Inc., et al, against the federal government to halt the implementation of BOI regulations.

In his order granting the motion for preliminary injunction, United States District Judge Amos Mazzant wrote that its "most rudimentary level, the CTA regulates companies that are registered to do business under a State’s laws and requires those companies to report their ownership, including detailed, personal information about their owners, to the Federal Government on pain of severe penalties."

He noted that this request represents a "drastic" departure from history:

First, it represents a Federal attempt to monitor companies created under state law – a matter our federalist system has left almost exclusively to the several States; and

Second, the CTA ends a feature of corporate formations as designed by various States – anonymity.

"For good reason, Plaintiffs fear this flanking, quasi-Orwellian statute and its implications on our dual system of government," he continued. "As a result, the Plantiffs contend that the CTA violates the promises our Constitution makes to the People and the States. Despite attempting to reconcile the CTA with the Constitution at every turn, the Government is unable to provide the Court with any tenable theory that the CTA falls within Congress’s power."

By Gregory Twachtman, Washington News Editor

The IRS has launched a new enforcement campaign targeting taxpayers engaged in deferred legal fee arrangements and improper use of Form 8275, Disclosure Statement. The IRS addressed tax deferral schemes used by attorneys or law firms to delay recognizing contingency fees as taxable income.

The IRS has launched a new enforcement campaign targeting taxpayers engaged in deferred legal fee arrangements and improper use of Form 8275, Disclosure Statement. The IRS addressed tax deferral schemes used by attorneys or law firms to delay recognizing contingency fees as taxable income.

The IRS highlighted that plaintiff’s attorneys or law firms representing clients in lawsuits on a contingency fee basis may receive as much as 40 percent of the settlement amount that they then defer by entering an arrangement with a third party unrelated to the litigation, who then may distribute to the taxpayer in the future. Generally, this happens 20 years or more from the date of the settlement. Subsequently, the taxpayer fails to report the deferred contingency fees as income at the time the case is settled or when the funds are transferred to the third party. Instead, the taxpayer defers recognition of the income until the third party distributes the fees under the arrangement. The goal of this newly launched campaign is to ensure taxpayer compliance and consistent treatment of similarly situated taxpayers which requires the contingency fees be included in taxable income in the year the funds are transferred to the third party.

Additionally, the IRS stated that the Service's efforts continue to uncover unreported financial accounts and structures through data analytics and whistleblower tips. In fiscal year 2024, whistleblowers contributed to the collection of $475 million, with $123 million awarded to informants. The IRS has now recovered $4.7 billion from new initiatives underway. This includes more than $1.3 billion from high-income, high-wealth individuals who have not paid overdue tax debt or filed tax returns, $2.9 billion related to IRS Criminal Investigation work into tax and financial crimes, including drug trafficking, cybercrime and terrorist financing, and $475 million in proceeds from criminal and civil cases attributable to whistleblower information.

Proper Use of Form 8275

The IRS stressed upon the proper use of Form 8275 by taxpayers in order to avoid portions of the accuracy-related penalty due to disregard of rules, or penalty for substantial understatement of income tax for non-tax shelter items. Taxpayers should be aware that Form 8275 disclosures that lack a reasonable basis do not provide penalty protection. Taxpayers in this posture should consult a tax professional or advisor to determine how to come into compliance. In its review of Form 8275 filings, the IRS identified multiple filings that do not qualify as adequate disclosures that would justify avoidance of penalties. Finally, the IRS reminded taxpayers that Form 8275 is not intended as a free pass on penalties for positions that are false.

FS-2024-32

IR-2024-310

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of August 2017.

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of August 2017.

August 2
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates July 26-28. 

August 4
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates July 29- Aug. 1. 

August 9
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates Aug. 2-4. 

August 10
Employees who work for tips. Employees who received $20 or more in tips during July must report them to their employer using Form 4070.

Social security, Medicare, and withheld income tax. File Form 941 for the second quarter of 2017. This due date applies only if you deposited the tax for the quarter timely, properly, and in full. 

August 11
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates August 5-8. 

August 15
Social security, Medicare, and withheld income tax. If the monthly deposit rule applies, deposit the tax for payments in July. Nonpayroll withholding: If the monthly deposit rule applies, deposit the tax for payments in July. 

August 16
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates August 9–11. 

August 18
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates August 12–15. 

August 23
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates August 16–18. 

August 25
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates August 19–22. 

August 30
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates August 23-25.

September 1
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates August 26-29.

Lawmakers from both parties spent much of June debating and discussing tax reform, but without giving many details of what a comprehensive tax reform package could look like before year-end. At the same time, several bipartisan tax bills have been introduced in Congress, which could see their way to passage.

Lawmakers from both parties spent much of June debating and discussing tax reform, but without giving many details of what a comprehensive tax reform package could look like before year-end. At the same time, several bipartisan tax bills have been introduced in Congress, which could see their way to passage.

Tax reform

House Speaker Paul Ryan, R-Wisc., predicted that tax reform would be accomplished in 2017. “Transformational tax reform can be done, and we are moving forward," Ryan said in June. We need to get this done in 2017. We cannot let this once-in-a-generation moment slip by.” Last year, House Republicans unveiled their “Better Way Blueprint,” which sets principles for tax reform, including lower individual tax rates, a reduced corporate tax rate, and a border adjustment tax, among other measures.

“Republicans have been afraid to expose their Blueprint to scrutiny,” Rep. Lloyd Doggett, D-Texas, a senior member of the House Ways and Means Committee, said. “The Republican Blueprint is both the wrong way for tax policy and the wrong way to legislate tax reform,” Doggett said.

In the Senate, the chair of the Senate Finance Committee (SFC), Orrin Hatch, R-Utah, asked stakeholders for input on tax reform. Hatch requested recommendations on individual, business and international tax reform. "After years of committee hearings, public statements, working groups, and conceptual exercises, Congress is poised to make significant steps toward comprehensive tax reform," Hatch said. “As we work to achieve those goals, it is essential that Congress has the best possible advice and insight from experts and stakeholders," he added.

Sen. Ron Wyden, D-Oregon, is ranking member of the SFC and urged lawmakers to take a bipartisan approach to tax reform. "The only way to pass lasting, job-creating tax reform that’s more than an economic sugar-high is for it to be bipartisan," Wyden said. "Tax reform takes a lot of careful consideration to write a bipartisan tax reform bill, and I know because I’ve written two of them."

Small business

The Senate Small Business Committee explored tax reform at a hearing in June. “Tax compliance costs are 67 percent higher for small businesses," Committee Chair James Risch, R-Idaho, said. Ranking member Jeanne Shaheen, D-N.H., said that “small businesses spend 2.5-billion hours complying with IRS rules.”

Mark Mazur, former Treasury assistant secretary for tax policy, was one of the experts who testified before the committee. Mazur said that small businesses generally have a larger per-unit cost of tax compliance than larger businesses. “One particular area that adds to the complexity of complying with the tax code is accrual accounting,” he said.

Other tax legislation

In June, the House passed HR 1551, a bipartisan bill. The legislation generally modifies the tax credit for advanced nuclear power facilities.

A number of bipartisan stand-alone tax bills have been introduced in Congress recently. They include:

• The Invent and Manufacture in America Bill, a bipartisan bill that would enhance the research tax credit. Generally, the bill would increase the value of the credit by up to 25 percent for qualified research activities.
• The Graduate Student Savings Bill, introduced by a group of Senate Democrats and Republicans. The bill would generally allow funds from a graduate student’s stipend or fellowship to be deposited into an individual retirement account (IRA).
• The Adoption Tax Credit Refundability Act is another bipartisan bill. The measure generally would enhance the adoption tax credit.
• Another bipartisan proposal would treat bicycle sharing systems as mass transit facilities for purposes of qualified transportation fringe benefits.

Additionally, a group of House Democrats and Republicans wrote to Treasury Secretary Steven Mnuchin in June. The bipartisan group of lawmakers asked Mnuchin to preserve the state and local sales tax deduction in any tax reform plan.

If you have any questions about tax reform, please contact our office.

The much-anticipated regulations (REG-136118-15) implementing the new centralized partnership audit regime under the Bipartisan Budget Act of 2015 (BBA) have finally been released. The BBA regime replaces the current TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) procedures beginning for 2018 tax year audits, with an earlier "opt-in" for electing partnerships. Originally issued on January 19, 2017 but delayed by a January 20, 2017 White House regulatory freeze, these re-proposed regulations carry with them much of the same criticism leveled against them back in January, as well as several modifications. Most importantly, their reach will impact virtually all partnerships.

The much-anticipated regulations (REG-136118-15) implementing the new centralized partnership audit regime under the Bipartisan Budget Act of 2015 (BBA) have finally been released. The BBA regime replaces the current TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) procedures beginning for 2018 tax year audits, with an earlier "opt-in" for electing partnerships. Originally issued on January 19, 2017 but delayed by a January 20, 2017 White House regulatory freeze, these re-proposed regulations carry with them much of the same criticism leveled against them back in January, as well as several modifications. Most importantly, their reach will impact virtually all partnerships.

Scope

Under the proposed regulations, to which Congress left many details to be filled in, the new audit regime covers any adjustment to items of income, gain, loss, deduction, or credit of a partnership and any partner’s distributive share of those adjusted items. Further, any income tax resulting from an adjustment to items under the centralized partnership audit regime is assessed and collected at the partnership level. The applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to any such item or share is also determined at the partnership level.

Immediate Impact

Although perhaps streamlined and eventually destined to simplify partnership audits for the IRS, the new centralized audit regime may prove more complicated in several respects for many partnerships. Of immediate concern for most partnerships, whether benefiting or not, is how to reflect this new centralized audit regime within partnership agreements, especially when some of the procedural issues within the new regime are yet to be ironed out.

Issues for many partnerships that have either been generated or heightened by the new regulations include:

• Selecting a method of satisfying an imputed underpayment;
• Designation of a partnership representative;
• Allocating economic responsibility for an imputed underpayment among partners including situations in which partners’ interests change between a reviewed year and the adjustment year; and
• Indemnifications between partnerships and partnership representatives, as well as among current partners and those who were partners during the tax year under audit.

Election out

Starting for tax year 2018, virtually all partnerships will be subject to the new partnership audit regime …unless an “election out” option is affirmatively elected. Only an eligible partnership may elect out of the centralized partnership audit regime. A partnership is an eligible partnership if it has 100 or fewer partners during the year and, if at all times during the tax year, all partners are eligible partners. A special rule applies to partnerships that have S corporation partners.

Consistent returns

A partner’s treatment of each item of income, gain, loss, deduction, or credit attributable to a partnership must be consistent with the treatment of those items on the partnership return, including treatment with respect to the amount, timing, and characterization of those items. Under the new rules, the IRS may assess and collect any underpayment of tax that results from adjusting a partner’s inconsistently reported item to conform that item with the treatment on the partnership return as if the resulting underpayment of tax were on account of a mathematical or clerical error appearing on the partner’s return. A partner may not request an abatement of that assessment.

Partnership representative

The new regulations require a partnership to designate a partnership representative, as well as provide rules describing the eligibility requirements for a partnership representative, the designation of the partnership representative, and the representative’s authority. Actions by the partnership representative bind all the partners as far as the IRS is concerned. Indemnification agreements among partners may ameliorate some, but not all, of the liability triggered by this rule.

Imputed underpayment, alternatives and "push-outs"

Generally, if a partnership adjustment results in an imputed underpayment, the partnership must pay the imputed underpayment in the adjustment year. The partnership may request modification with respect to an imputed underpayment only under the procedures described in the new rules.

In multi-tiered partnership arrangements, the new rules provide that a partnership may elect to "push out" adjustments to its reviewed year partners. If a partnership makes a valid election, the partnership is no longer liable for the imputed underpayment. Rather, the reviewed year partners of the partnership are liable for tax, penalties, additions to tax, and additional amounts plus interest, after taking into account their share of the partnership adjustments determined in the final partnership adjustment (FPA). The new regulations provide rules for making the election, the requirements for partners to file statements with the IRS and furnish statements to reviewed year partners, and the computation of tax resulting from taking adjustments into account.

Retiring, disappearing partners

Partnership agreements that reflect the new partnership audit regime must especially consider the problems that may be created by partners that have withdrawn, and partnerships that have since dissolved, between the tax year being audited and the year in which a deficiency involving that tax year is to be resolved. Collection of prior-year taxes due from a former partner, especially as time lapses, becomes more difficult as a practical matter unless specific remedies are set forth in the partnership agreement. The partnership agreement might specify that if any partner withdraws and disposes of their interest, they must keep the partnership advised of their contact information until released by the partnership in writing.

If you have any questions about how your partnership may be impacted by these new rules, please feel free to call our office.

If you converted your traditional IRA to a Roth IRA earlier this year, incurred a significant amount of tax liability on the conversion, and then watched as the value of your Roth account plummeted amid the market turmoil, you may want to consider undoing the conversion. You can void or significantly lower your tax bill by recharacterizing the conversion, then reconverting your IRA back to a Roth at a later date. Careful timing in using the strategy, however, is essential.

What is a recharacterization?

"Recharacterization" is simply the term given to the transaction in which you undo your original conversion from a traditional IRA to the Roth. Even if you converted your entire account to a Roth, you do not need to recharacterize the entire amount that you converted from your traditional IRA to the Roth and can choose to only recharacterize a portion of the amount. To roll the money back and then forward into new Roth IRA, you must undo the original Roth conversion, wait at least 30 days (discussed in further detail, below) and then reconvert the IRA back to the Roth. This move may save you significant tax dollars since your IRA account is worth less due to the decline in market values.

Note. Roth IRAs are currently - but temporarily - restricted to taxpayers with adjusted gross incomes (AGI) that do not exceed certain amounts. For example, for 2008 Roth IRAs can be established by individuals with a maximum AGI of $116,000 ($169,000 for joint filers and heads of household). This restriction is completely lifted in 2010, when the AGI and filing status restrictions are eliminated.

Example. In June 2008, you converted your entire traditional IRA account balance of $200,000 to a Roth. However, the market has taken a toll on your account and it has declined in value and now in December is worth $100,000. Say you are in the 25 percent tax bracket -- the conversion would have left you with a $50,000 tax bill (since conversion amounts, in this case $200,000, are taxed at ordinary income tax rates). However, if you recharacterize and convert the $100,000 account back into a Roth after meeting the timing requirements, you will owe only $25,000 in taxes on the conversion.

Reasons for recharacterization

Recharacterizing a Roth conversion may be appropriate for many reasons, especially if your Roth account has lost significant value but you have a large tax bill for the conversion, which perhaps may even be more than the amount currently in your account. You might also want to consider undoing the conversion if you cannot afford the tax bill due, the conversion will propel you into a higher tax bracket, or subject you to the alternative minimum tax (AMT).

What is required

The recharacterization of a Roth conversion must meet certain requirements. The conversion must be completed by your tax filing deadline (typically April 15). If you converted an IRA in 2008, you have until October 15, 2009 to recharacterize the Roth conversion. However, you will then have to wait at least until the year after you originally converted the IRA to reconvert the account back to a Roth, or at least 30 days after the recharacterization (whichever is later). Essentially, if you converted your traditional IRA into a Roth in 2008 you will have to wait until 2009 to convert the funds back into a Roth account.

Notice

For the recharacterization to work, you will also have to provide notice to the financial institution(s) which is the trustee of your IRA accounts and the IRS before the date of the trustee to trustee transfer (a recharacterization is generally done in a trustee-to-trustee transfer). The notice generally includes information pertaining to the date of applicable transfers, type and amount of contribution being recharacterized, and will need to be attached to your tax return Form 8606, Nondeductible IRAs, with a statement explaining the recharacterization.

Net Income Attributable (NIA) to the conversion

A recharacterization must also include the transfer of any net income attributable (NIA) to the contribution amount. NIA is generally any earnings or losses attributable to the converted amounts in the account. If the Roth IRA that you are recharacterizing consists only of the amounts originally converted from the traditional IRA, there is generally no need to compute NIA. Generally, NIA must be computed when less than the entire account balance is being recharacterized, your Roth includes amounts from other transaction such as a Roth IRA contribution (made after the conversion to the Roth), or the Roth includes funding from another Roth IRA conversion. The financial institution that has custody of your Roth may offer a service to help you compute your NIA, or talk with your tax advisor for help.

If you would like further information on Roth conversions or reconversions, please feel free to contact this office. As explained, there are time periods and deadlines that must be met, so procrastination may prove expensive in some situations.

You have carefully considered the multitude of complex tax and financial factors, run the numbers, meet the eligibility requirements, and are ready to convert your traditional IRA to a Roth IRA. The question now remains, however, how do you convert your IRA?

Conversion basics

A conversion is a penalty-free taxable transfer of amounts from a traditional IRA to a Roth IRA. You can convert part or all of the money in your regular IRA to a Roth. When you convert your traditional IRA to a Roth, you will have to pay income tax on the amount converted. However, a traditional IRA may be converted (or rolled over) penalty-free to a Roth IRA as long as you meet the requirements for conversion, including adjusted gross income (AGI) limits in effect until 2010. You should have funds outside the IRA to pay the income tax due on the conversion, rather than taking a withdrawal from your traditional IRA to pay for it - those withdrawals are subject to an early withdrawal penalty and they cannot be put back at a later time to continue to accumulate in the tax-free environment of an IRA.

Big news for 2010 and beyond

Beginning in 2010, you can convert from a traditional to a Roth IRA with no income level or filing status restrictions. For 2008, Roth IRAs are available for individuals with a maximum adjusted gross income of $116,000 ($169,000 for joint filers and heads of household). These income limits have prevented many individuals from establishing or converting to a Roth IRA. Not only is the income limitation eliminated after 2009, taxpayers who convert to a Roth IRA in 2010 can recognize the conversion amount in adjusted gross income (AGI) ratably over two years, in 2011 and 2012.

Example. You have $14,000 in a traditional IRA, which consists of deductible contributions and earnings. In 2010, you convert the entire amount to a Roth IRA. You do not take any distributions in 2010. As a result of the conversion, you have $14,000 in gross income. Unless you elect otherwise, $7,000 of the income is included in income in 2011 and $7,000 is included in income in 2012.

Conversion methods

There are three ways to convert your traditional IRA to a Roth. Generally, the conversion is treated as a rollover, regardless of the conversion method used. Any converted amount is treated as a distribution from the traditional IRA and a qualified rollover contribution to the Roth IRA, even if the conversion is accomplished by means of a trustee-to-trustee transfer or a transfer between IRAs of the same trustee.

1. Rollover conversion. Amounts distributed from a traditional IRA may be contributed (i.e. rolled over) to a Roth IRA within 60 days after the distribution.

2. Trustee-to-trustee transfer. Amounts in a traditional IRA may be transferred in a trustee-to-trustee transfer from the trustee of the traditional IRA to the trustee of the Roth IRA. The financial institution holding your traditional IRA assets will provide directions on how to transfer those assets to a Roth IRA that is maintained with another financial institution.

3. Internal conversions. Amounts in a traditional IRA may be transferred to a Roth IRA maintained by the same trustee. Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, in lieu of opening a new account or issuing a new contract. As with the trustee-to-trustee transfer, the financial institution holding the traditional IRA assets will provide instructions on how to transfer those assets to a Roth IRA. The transaction may be simpler in this instance because the transfer occurs within the same financial institution.

Failed conversions

A failed conversion has significant negative tax consequences, and generally occurs when you do not meet the Roth IRA eligibility or statutory requirements; for example, your AGI exceeds the limit in the year of conversion or you are married filing separately (note: as mentioned, the AGI limit for Roth IRAs will no longer be applicable beginning in 2010).

A failed conversion is treated as a distribution from your traditional IRA and an improper contribution to a Roth IRA. Not only will the amount of the distribution be subject to ordinary income tax in the year of the failed conversion, it will also be subject to the 10 percent early withdrawal penalty for individuals under age 59 1/2, (unless an exception applies). Moreover, the Tax Code imposes an additional 6 percent excise tax each year on the excess contribution amount made to a Roth IRA until the excess is withdrawn.

Caution - financial institutions make mistakes

The brokerage firm, bank, or other financial institution that will process your IRA to Roth IRA conversion can make mistakes, and their administrative errors will generally cost you. It is imperative that you understand the process, the paperwork, and what is required of you and your financial institution to ensure the conversion of your IRA properly and timely. Our office can apprise you of what to look out for and what to require of the financial institutions you will deal with during the process.

Determining whether to convert your traditional IRA to a Roth IRA can be a complicated decision to make, as it raises a host of tax and financial questions. Our office can help you determine not only whether conversion is right for you, but what method is best for you, too.

Limited liability companies (LLCs) remain one of the most popular choice of business forms in the U.S. today. This form of business entity is a hybrid that features the best characteristics of other forms of business entities, making it a good choice for both new and existing businesses and their owners.

Limited liability companies (LLCs) remain one of the most popular choice of business forms in the U.S. today. This form of business entity is a hybrid that features the best characteristics of other forms of business entities, making it a good choice for both new and existing businesses and their owners.

An LLC is a legal entity existing separately from its owners that has certain characteristics of both a corporation (limited liability) and a partnership (pass-through taxation). An LLC is created when articles of organization (or the equivalent under each state rules) are filed with the proper state authority, and all fees are paid. An operating agreement detailing the terms agreed to by the members usually accompanies the articles of organization.

Choosing the LLC as a Business Entity

Choosing the form of business entity for a new company is one of the first decisions that a new business owner will have to make. Here's how LLCs compare to other forms of entities:

C Corporation: Both C corporations and LLCs share the favorable limited liability feature and lack of restrictions on number of shareholders. Unlike LLCs, C corporations are subject to double taxation for federal tax purposes - once at the corporate level and the again at the shareholder level. C corporations do not have the ability to make special allocations amongst the shareholders like LLCs.

S Corporation: Both S corporations and LLCs permit pass-through taxation. However, unlike an S corporation, an LLC is not limited to the number or kind of members it can have, potentially giving it greater access to capital. LLCs are also not restricted to a single class of stock, resulting in greater flexibility in the allocation of gains, losses, deductions and credits. And for estate planning purposes, LLCs are a much more flexible tool than S corporations

Partnership: Partnerships, like LLCs, are "pass-through" entities that avoid double taxation. The greatest difference between a partnership and an LLC is that members of LLCs can participate in management without being subject to personal liability, unlike general partners in a partnership.

Sole Proprietorship: Companies that operate as sole proprietors report their income and expenses on Schedule C of Form 1040. Unlike LLCs, sole proprietors' personal liability is unlimited and ownership is limited to one owner. And while generally all of the earnings of a sole proprietorship are subject to self-employment taxes, some LLC members may avoid self-employment taxes under certain circumstances

Tax Consequences of Conversion to an LLC

In most cases, changing your company's form of business to an LLC will be a tax-free transaction. However, there are a few cases where careful consideration of the tax consequences should be analyzed prior to conversion. Here are some general guidelines regarding the tax effects of converting an existing entity to an LLC:

C Corporation to an LLC: Unfortunately, this transaction most likely will be considered a liquidation of the corporation and the formation of a new LLC for federal tax purposes. This type of conversion can result in major tax consequences for the corporation as well as the shareholders and should be considered very carefully.

S Corporation to an LLC: If the corporation was never a C corporation, or wasn't a C corporation within the last 10 years, in most cases, this conversion should be tax-free at the corporate level. However, the tax consequences of such a conversion may be different for the S corporation's shareholders. Since the S corporation is a flow-through entity, and has only one level of tax at the shareholder level, any gain incurred at the corporate level passes through to the shareholders. If, at the time of conversion, the fair market value of the S corporation's assets exceeds their tax basis, the corporation's shareholders may be liable for individual income taxes. Thus, any gain incurred at the corporate level from the appreciation of assets passes through to the S corporation's shareholders when the S corporation transfers assets to the LLC.

Partnership to LLC: This conversion should be tax-free and the new LLC would be treated as a continuation of the partnership.

Sole proprietorship to an LLC: This conversion is another example of a tax-free conversion to an LLC.

While considering the potential tax consequences of conversion is important, keep in mind how your change in entity will also affect the non-tax elements of your business operations. How will a conversion to an LLC effect existing agreements with suppliers, creditors, and financial institutions?

Taxation of LLCs and "Check-the-Box" Regulations

Before federal "check-the-box" regulations were enacted at the end of 1996, it wasn't easy for LLCs to be classified as a partnership for tax purposes. However, the "check-the-box" regulations eliminated many of the difficulties of obtaining partnership tax treatment for an LLC. Under the check-the-box rules, most LLCs with two or more members would receive partnership status, thus avoiding taxation at the entity level as an "association taxed as a corporation."

If an LLC has more than 2 members, it will automatically be classified as a partnership for federal tax purposes. If the LLC has only one member, it will automatically be classified as a sole proprietor and would report all income and expenses on Form 1040, Schedule C. LLCs wishing to change the automatic classification must file Form 8832, Entity Classification Election.

Keep in mind that state tax laws related to LLCs may differ from federal tax laws and should be addressed when considering the LLC as the form of business entity for your business.

Since the information provided is general in nature and may not apply to your specific circumstances, please contact the office for more information or further clarification.