The Advisor: Helping You Manage Your Life and Legacy in Today's Complex World
This quarterly newsletter provides articles of interest, insights, and recent developments involving interdisciplinary legal topics affecting high-net worth individuals as well as family offices, trust companies, financial advisors, and similar private client service providers. We hope you find this publication informative, and we welcome your feedback on topics you'd like to read about in future publications.
IRS Announces Much-Anticipated Updated Voluntary Disclosure Procedure
When the United States Internal Revenue Service announced in March 2018 that it would be terminating the Offshore Voluntary Disclosure Program (OVDP) on September 28, 2018, many taxpayers and practitioners were left wondering whether there would be a successor program that would provide potentially "willful" taxpayers who have failed to disclose foreign financial assets and accounts (Foreign Accounts) to the US government with an avenue to disclose such Foreign Accounts while potentially avoiding criminal prosecution.1 On November 29, 2018, the IRS released a much-anticipated Memorandum that explains its updated voluntary disclosure practice (VDP).
The Memorandum sets forth the procedures that taxpayers with undisclosed Foreign Accounts must follow to avoid potential criminal prosecution and mitigate exposure to monetary penalties. Notably, the VDP is available in connection with both domestic and offshore disclosures. Applications to the VDP require preclearance from the IRS Criminal Investigation Division, which requires taxpayers to submit specific information. Once the preclearance is granted, taxpayers must submit more detailed information to the IRS Criminal Investigation Division for preliminary acceptance. Once accepted, the case is routed for civil examination under the Civil Resolution Framework set forth in the Memorandum. Under the VDP, the taxpayer generally must provide information spanning the most recent six tax years. It should be noted that the IRS has discretion to apply the VDP to disclosures made prior to September 28, 2018.
Individual US taxpayers have an annual obligation to report and pay income tax on income from all sources and to disclose certain Foreign Accounts to the IRS and to the Treasury Department's Financial Crimes Enforcement Network (FinCEN). Taxpayers face significant monetary penalties and potential criminal charges if they fail to disclose their interests in Foreign Accounts.
To encourage compliance with these reporting obligations, the IRS launched the OVDP as an amnesty program in 2009, with subsequent iterations offered through September 28, 2018. The OVDP enabled US taxpayers to voluntarily resolve past tax and reporting noncompliance with respect to Foreign Accounts by correcting past reporting errors or failures and disclosing and paying all taxes due with respect to such assets. The OVDP was the only program available to a taxpayer whose noncompliance could be determined to be "willful," which generally means that the taxpayer knew or should have known that he or she had an obligation to report the Foreign Accounts to the US government. In exchange for completing the program, the taxpayers was provided with reduced civil monetary penalties and protection from criminal prosecution related to the tax noncompliance.
Overview of the Procedures Currently Available to Taxpayers
Separate from the OVDP, the IRS developed a series of additional programs and procedures for noncompliant taxpayers. For example: (i) the Streamlined Filing Compliance Procedures (Streamlined Procedures) for individual taxpayers whose failure to report Foreign Accounts was not due to willful or fraudulent conduct; (ii) the Delinquent International Information Return Submission Procedures (Delinquent Procedures) for taxpayers who do not need to use the OVDP or the Streamlined Procedures; and (iii) procedures contained in the Internal Revenue Manual for taxpayers to disclose and remedy past tax noncompliance.
For taxpayers wishing to disclose their Foreign Accounts, the best method of disclosure depends upon each taxpayer's particular facts and circumstances. However, the OVDP was the only IRS procedure that provided potential protection against criminal prosecution for noncompliance that could be viewed as intentional. As such, the VDP fills an important void that was created when the OVDP ended.
Similar to the OVDP and many of the existing procedures provided for noncompliant taxpayers, the VDP requires participating taxpayers to pay certain civil penalties. However, there are important differences in how the penalties under the VDP are applied. Specifically under the VDP, the field agent assigned to the taxpayer's case has discretion to determine the amount and type of penalties imposed against the taxpayer, and the "baseline" penalty guideline is generally higher than the penalty framework provided under the OVDP. For example, under the VDP, the default is the imposition of a 75 percent fraud penalty on the unpaid tax due in the tax year with the highest tax liability. This represents a significant increase when compared to penalties imposed under the existing procedures and the OVDP. Additionally, under the VDP, there is also a default 50 percent "willful" FBAR penalty imposed on the highest aggregate balance of all unreported Foreign Accounts.
We also note that unlike the OVDP, within the VDP framework, a taxpayer who disagrees with the field agent's determination of taxes and penalties due retain his or her right to appeal the field agent's determination. Overall, the VDP allows for a significantly broader set of potential outcomes than the OVDP.
Although the closure of the OVDP may have surprised many taxpayers, Acting IRS Commissioner David Kautter explained that "[t]axpayers have had several years to come into compliance with US tax laws under this program. . . . All along, we have been clear that we would close the program at the appropriate time, and we have reached that point."2 Although there are currently several options available to taxpayers seeking to remedy past tax noncompliance with respect to their Foreign Accounts, this is an important reminder that none of the above mentioned options is permanent.
If you have any questions about any of the topics discussed in this article or general US tax or reporting requirements for domestic or foreign financial assets and accounts, please contact your Arnold & Porter attorney or firm contacts in the Tax and White Collar Defense groups.
*Ashley Slisz contributed to this article. She is a Washington and Lee University School of Law graduate employed at Arnold & Porter and is not admitted to the New York Bar.
Update on Proposed IRS Regulations on Qualified Opportunity Zone Tax Incentives
The Tax Cuts and Jobs Act (Tax Act), enacted in December 2017, offers new tax incentives for taxpayers that invest through special investment vehicles known as "qualified opportunity funds" (QOFs) in certain economically distressed areas across the United States that have been designated as Qualified Opportunity Zones (QOZs). These tax benefits are further detailed in the September edition of The Advisor. Despite the significant tax benefits offered under the QOZ legislation, many investors were hesitant to make investments into QOZs until additional guidance was issued. On October 19, 2018, the US Internal Revenue Service (IRS) issued proposed regulations (Regulations) for QOZs that provide much-needed guidance, although a number of significant open questions remain.
Overview of QOZ Legislation
Investments in QOFs generally provide the following three tax incentives:
- Temporary deferral of taxable gain from the disposition of property to the extent invested in a QOF within 180 days. The deferred gain must be recognized on the earlier of (1) the date the QOF investment is disposed of and (2) December 31, 2026.
- Elimination of 10 to15 percent of the deferred gain if the taxpayer holds the QOF investment for at least five to seven years.
- Permanent elimination of gain on any post-acquisition appreciation with respect to a QOF investment held by the taxpayer for at least 10 years.
A QOF must be organized as a partnership or corporation (as determined for US federal income tax purposes) for the purpose of investing in QOZ Property (defined below). At least 90 percent of the QOF's assets must consist of QOZ Property (the 90% Test). A QOF that fails the 90% Test may be subject to penalties.
QOZ Property includes (1) certain tangible property located in a QOZ (QOZ Business Property) and (2) certain equity interests in a corporation or partnership (QOZ Subsidiary).
QOZ Business Property is tangible property that satisfies the following requirements:
- The QOF acquires the property by purchase from an "unrelated" person after December 31, 2017.
- The QOF uses the property in a trade or business.
- Either the "original use" of the property in the QOZ commences with the QOF or the QOF "substantially improves the property" by spending on improvements, during any 30-month period beginning after the property's acquisition, an amount exceeding the property's adjusted tax basis at the beginning of such period.
- During "substantially all" of the QOF's holding period for the property, "substantially all" of the property's use is in a QOZ.
A QOZ Subsidiary is a corporation or partnership that satisfies the following requirements:
- The QOF acquires its equity interest in the corporation or partnership after December 31, 2017.
- The corporation or partnership is a "QOZ Business," i.e., "substantially all" the tangible property owned or leased by it is QOZ Business Property, at least 50 percent of its gross income is derived from the active conduct of a trade or business and less than five percent of the average of its properties' aggregate bases is attributable to certain "financial assets."
The Tax Act left open a number of important issues, making it difficult for taxpayers to take advantage of the tax incentives under the QOZ regime. After much urging from taxpayers and tax professionals for additional guidance, the IRS issued the Regulations to provide further clarity on certain of these issues. Although the Regulations are not effective until finalized, investors and QOFs generally are permitted to rely on the Regulations immediately, provided they apply the Regulations consistently and in their entirety. Below is an overview of the most significant points addressed by the Regulations.
Requirements at the Investor Level
- Eligible Gain. The Regulations clarify that only recognized gain treated as capital gain, rather than ordinary income, for US federal income tax purposes is eligible for tax benefits under the QOZ regime.
- Use of Leverage to Invest in a QOF. There are no tracing rules requiring a taxpayer electing to defer capital gain to use the same cash from the capital-gain transaction to fund the investment in a QOF. A taxpayer simply is required to invest cash in the QOF equal in amount to the amount of capital gain intended to be deferred. Accordingly, a taxpayer should be able to leverage all or part of its investment in a QOF.
- Eligible Investors. Any taxpayer that recognizes capital gain for US federal income tax purposes is eligible for the tax benefits under the QOZ regime. As such, a broad range of entities can utilize this regime, including C corporations, regulated investment companies, real estate investment trusts, partnerships, S corporations, trusts, and estates.
- QOZ Investments by Partnerships. Where a partnership recognizes capital gain from the disposition of property, the partnership itself may elect to defer the tax thereon by investing such gain in a QOF within 180 days of the disposition. To the extent the partnership does not make such an election, the capital gain will be allocated to the partners therein, and the partners themselves may be permitted to make deferral elections on a partner-by-partner basis. In the case of a deferral election made by a partner, the 180-day period during which the partner will be required to invest in a QOF generally will begin on the last day of the partnership's taxable year. Alternatively, a partner may choose to begin the 180-day period on the date of the disposition by the partnership, which may be advantageous if the partner intends to invest in a QOF before the last day of the partnership's taxable year.
- Rollover of Gain to Another QOF. If an investor makes an election to defer gain under the QOZ regime and later sells its interest in the QOF, thereby subjecting the investor to tax on the deferred gain, the investor may make a second election to defer the gain generated from the sale of its QOF interest to the extent the investor makes a new QOF investment. However, this rule applies only if the investor disposes of its entire initial investment in the original QOF.
- Basis Step-Up. Under the Tax Act, a taxpayer that holds a QOF investment for at least 10 years may be entitled to a basis step-up equal to the fair market value of the investment when the taxpayer disposes of the investment, thereby eliminating gain on any post-acquisition appreciation with respect to the QOF investment. However, the QOZ designations are set to expire in December 2028. This expiration date has caused some concern over whether a QOF investment that hits its 10-year holding period after December 2028 could qualify for the basis step-up. The Regulations clarify that the expiration of the QOZ designations will not prevent taxpayers from qualifying for the basis step-up, provided the taxpayer disposes of its QOF investment by December 31, 2047. A taxpayer that does not dispose of its QOF investment by then will lose its ability to step up its basis to the fair market value. The Regulations also clarify that, although the proposed basis step-up rules are effective only with respect to dispositions of QOF investments occurring after the IRS adopts the proposed rules as final regulations, taxpayers generally can rely on and apply, these rules (even if the final regulations do not incorporate them), provided the taxpayer's 180-day period for making its QOF investment begins before the final regulations' date of applicability.
Requirements at the QOF Level
- Self-Certification. QOFs will be required to file an IRS Form 8996 with the IRS on an annual basis to certify that they satisfy the applicable requirements.
- Effective Date of QOF Status. QOFs are permitted to identify, on the first IRS Form 8996 that they file with the IRS, which month they want their QOF status first to be effective.
- Existing Entities. The Regulations clarify that entities in existence prior to 2018 can qualify as QOFs. However, as noted above, a QOF must be organized "for the purpose of investing in QOZ Property," and 90 percent of a QOF's assets must consist of QOZ Property, which, as defined, includes only certain property acquired by a QOF after 2017. As such, it may be difficult, from a practical perspective, for an existing entity to satisfy all the technical requirements necessary to be treated as a QOF.
- 90% Test. As noted above, the 90% Test requires a QOF to ensure that at least 90 percent of its assets consist of QOZ Property in order to avoid penalties. This determination is made on an annual basis, by measuring the percentage of the QOF's QOZ Property at the end of each six-month period of the QOF's taxable year, and averaging these two amounts. The Regulations clarify that the 90% Test is based on the value of the QOF's assets, as provided in the QOF's "financial statements" (as defined for this purpose) or, if the QOF does not have "financial statements," the cost of the QOF's assets. The Regulations also clarify that the 90% Test does not apply to any portion of an entity's taxable year before its QOF status first is effective. An entity's testing dates for the taxable year in which it effects its QOF status will be either (1) the end of the six-month period after effecting its QOF status and the end of its taxable year (if the entity chooses any of the first six months in its taxable year to begin its QOF status) or (2) the end of its taxable year (if the entity chooses any of the last six months in its taxable year to begin its QOF status). For example, an entity with a calendar taxable year that chooses to begin its QOF status in April will have its first two testing dates on September 30 and December 31 of that year.
- QOZ Business Property. As mentioned above, QOZ Property includes certain tangible property that qualifies as QOZ Business Property. To qualify as QOZ Business Property, the "original use" of the property must commence with the QOF or the QOF must "substantially improve" the property (i.e., within any 30-month period after acquiring the property, the QOF must spend on improvements an amount exceeding the property's adjusted tax basis at the beginning of such period). The Regulations clarify the application of these rules in the context of a QOF's acquisition of an existing building and surrounding land. Under the Regulations, because the building is an existing building, its "original use" is not deemed to commence with the Fund and, therefore, the building must be substantially improved. The substantial improvement test will be measured based on the purchase price of, and improvements made to, the building alone. The QOF is not separately required to improve the surrounding land.
- QOZ Subsidiary. As mentioned above, QOZ Property includes equity interests in a QOZ Subsidiary that is a QOZ Business. An entity must satisfy three requirements to be a QOZ Business.
- First, less than five percent of the average of the aggregate unadjusted bases of the entity's property may be attributable to certain "financial assets," including stock and partnership interests, but excluding "reasonable" amounts of working capital. The Regulations provide a working capital safe harbor, pursuant to which working capital will be treated as "reasonable" if (1) the amount of working capital is designated in writing for the acquisition, construction and/or substantial improvement of tangible property in a QOZ; (2) there is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of such amount, and the schedule requires such amount to be spent within 31 months of the receipt thereof; and (3) such amount actually is used in a manner that is substantially consistent with the prior two requirements.
- Second, at least 50 percent of the entity's gross income must be derived from an active trade or business. The Regulations provide a safe harbor for income derived from reasonable working capital.
- Third, "substantially all" of the tangible property owned or leased by the QOZ Subsidiary must be QOZ Business Property. The Regulations provide a safe harbor for tangible property constructed via the expenditure of reasonable working capital amounts.
Note that a similar working capital safe harbor does not apply to a QOF that intends to own QOZ Business Property directly, rather than through a QOZ Subsidiary. Accordingly, the foregoing working capital safe harbor likely will incentivize QOFs to operate through QOZ Subsidiaries.
- "Substantially All" Requirement. The QOF requirements reference the term "substantially all" in several contexts. For example, to qualify as a QOZ Business, "substantially all" of the tangible property owned or leased by a QOZ Subsidiary must constitute QOZ Business Property. The Regulations clarify that the term "substantially all" means 70 percent for this specific purpose. However, the Regulations reserved on the term's meaning in other QOF contexts.
A number of significant open questions remain. For example, there is uncertainty regarding (1) whether, and to what extent, any failures by a QOF to satisfy its applicable requirements will lead to a decertification of the QOF's status; (2) the interplay between the QOF rules and the partnership income tax rules, particularly whether future guidance will allow the tax benefits under the QOZ regime to be triggered by a QOF's sale of its underlying QOZ Properties, rather than solely by an investor's sale of its QOF interest; and (3) whether states will adopt the QOZ regime for state-income-tax purposes.
Notwithstanding these open questions, the Regulations provide helpful guidance for making QOFs an attractive investment vehicle for investors and sponsors alike. Further guidance, including final regulations, should be forthcoming. We will, of course, keep our clients apprised of relevant developments as they emerge.
*Ashley Slisz contributed to this article. She is a Washington and Lee University School of Law graduate employed at Arnold & Porter and is not admitted to the New York Bar.
Planning One Year After the Tax Cuts and Jobs Act
It has been one year since President Trump signed into law the most significant revision to the Internal Revenue Code since 1986, with the enactment of the Tax Cuts and Jobs Act (TCJA). This article highlights only a few of the many tax planning strategies available to taxpayers following the TCJA. The TCJA created significant wealth transfer planning opportunities by doubling the lifetime estate and gift tax exemption (the exemption) from $5,000,000 to $10,000,000 (indexed annually for inflation). For 2018 the exemption is $11,180,000 and for 2019 the exemption will be $11,400,000.
The increased exemption is not permanent and it is set to expire on December 31, 2025, returning to the pre-TCJA figure of $5,000,000. While the exemption is set to decrease, Treasury recently clarified that if a taxpayer utilizes his or her increased exemption now, and later dies when the exemption is reduced, that the gifts made during the increased exemption period will not be subject to estate tax. As a result, taxpayers are using the following strategies to ensure utilization of the increased exemption:
- Irrevocable Trusts: Taxpayers are creating and funding irrevocable trusts for the benefit of their descendants in order to utilize the increased exemption. For example, a taxpayer may settle an irrevocable trust for the benefit of their children and fund the trust with assets up to their remaining exemption amount. This will enable the taxpayer to remove up to a maximum of $11,180,000 from their estate. By making the gift during the increased exemption period, a taxpayer can protect against the potential decrease in the exemption amount starting in 2026. In addition, by making the gift now, a taxpayer removes all future appreciation on the assets from their estate, meaning the appreciation on those assets will pass transfer tax free to their descendants. In certain circumstances, in addition to being able to provide for descendants, taxpayers may also be able to structure the trust to provide for their spouse. Finally, taxpayers may consider utilizing assets that are eligible for valuation discounts, such as interests in a closely held corporation, to fund the irrevocable trust. The utilization of discounts enables taxpayers to further leverage the increased exemption by reducing the gift tax value of the transferred assets.
- Self-Settled Asset Protection Trusts (APT): Taxpayers are settling irrevocable self-settled asset protection trusts. More than a dozen states permit an APT to be created. The structure of the APT allows a taxpayer to make a completed gift, while retaining the ability to receive income from the trust, as well as protect the trust assets from future creditors. In light of the increase exemption, taxpayers are using this type of trust to remove assets (and appreciation) from their estate while retaining the ability to receive income from the assets if absolutely necessary. This type of trust is not appropriate for taxpayers with existing creditor issues.
- Forgiveness of Outstanding Loans: As part of a previous estate planning strategy, a taxpayer may have sold an asset to a trust created for the benefit of their descendants. In return for selling the asset to the trust, a taxpayer usually receives a promissory note. In light of the increased exemption, taxpayers may consider forgiving the balance due on any outstanding promissory notes as an easy way to utilize the increased exemption.
As a result of the increased exemption, many taxpayers who previously may have been subject to the estate tax may no longer be subject to the estate tax. This does not mean that planning is no longer relevant for these taxpayers; rather they should carefully consider the impact of income taxes.
- Incomplete Non-Grantor Trusts (INGs): As a result of a limitation imposed on itemized deductions under the TCJA, taxpayers are now limited to a maximum deduction of $10,000 per year for their state and local income and property taxes. This limitation particularly impacts taxpayers who reside in states with high income taxes. As a result, taxpayers are creating INGs in order to move income-producing assets to a state that (i) imposes no income taxes on a trust or (ii) does not impose income taxes on a nonresident beneficiary of a trust. The most common jurisdictions being Delaware, Nevada and Wyoming, where the fiduciary income tax laws are favorable. In order to be successful, the taxpayer needs to retain control over the trust assets so that the funding of the trust is not considered a completed gift for federal gift tax purposes, while avoiding any power that would result in the taxpayer being considered the grantor for federal income tax purposes. This is usually quite a tightrope to walk, but the creation and structure of INGs has been blessed by the IRS in recent Private Letter Rulings (please note that Private Letter Rulings are not binding precedent).
- Exercising Powers of Substitution: Often times when an individual creates an irrevocable trust during their lifetime, he or she retains the ability to substitute assets inside of the trust with assets held outside of the trust, so long as the assets are of equivalent value. This "substitution power" is commonly used to obtain grantor trust status which allows the settlor to pay the trust's income tax liability. Taxpayers who fall below the increased exemption amount should monitor and consider substituting low-basis assets inside of a trust (e.g., appreciated stock) for high-basis assets held outside of a trust (e.g., cash) to get a basis "step-up" at death. By engaging in this strategy, taxpayers can ensure that any appreciation on the low-basis assets permanently escapes income taxation at their death.
Following the recent mid-term election, the House of Representatives and the Senate are controlled by different parties, meaning legislative change related to tax reform is unlikely in the next two years. Now is the time to reevaluate your current estate plan and engage in planning prior to 2025.
© Arnold & Porter Kaye Scholer LLP 2018 All Rights Reserved. This newsletter is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
See our previous Advisory on the closure of the OVDP: "IRS Announces Last Chance for Taxpayers with Undisclosed Foreign Assets to Enter the Offshore Voluntary Disclosure Program."