Actionable federal tax insights for 2024

It’s been six years since the Tax Cuts and Jobs Act (TCJA) of 2017 was enacted and business entities may just now be feeling the effects of many revenue generating measures contained within the legislation. Several of those measures include limitations on popular business deductions such as net operating losses (NOLs), interest, research and development (R&D) expenses and the excess business loss limitation.

• NOLs: As of 2018, NOLs can no longer be carried back to prior tax years; however, they can be carried forward indefinitely. In addition, NOLs are now subject to a limitation equal to 80% of the taxable income of the year the NOL is used.
• Interest: Interest expense is limited for most business entities to 30% of adjusted taxable income plus business interest income. The calculation of adjusted taxable income changed in 2022 from earnings before interest, taxes, depreciation and amortization (EBITDA) to the narrower earnings before interest and taxes (EBIT), resulting in higher limitations and lower deductions.
• R&D: As of 2022, R&D activities must be capitalized and amortized, rather than expensed in the year incurred. The amortization period varies depending on whether the activity is foreign or domestic.
• Excess business loss: The TJCA placed a limitation on the amount of business deductions an individual can claim in excess of their business income. Taxpayers with significant business losses will see a vast difference in their economic and taxable income in the year of the limitation. Any amounts limited are carried forward to subsequent years as NOLs.

We discuss each of these limitations in greater detail in individual pieces, but it’s important to note many of them affect the others. Furthermore, all these above limitations result in tax attributes that an entity will carry forward into future years. Planning and projecting how these attributes may be realized in the future is key to understanding the potential tax liability and cash-flow impact going forward, and to avoid any unexpected surprises.

Enacted as part of the Tax Cuts and Jobs Act (TCJA) of 2017, the limitation on the deduction for business interest expense (BIE) restricts a taxpayer’s ability to claim a deduction at 30% of adjusted taxable income (ATI). This provision, often referred to as the section 163(j) limitation, was phased in — with ATI initially calculated based on earnings before interest, taxes, depreciation and amortization (EBITDA) — and beginning in 2022, with ATI calculated based on earnings before interest and taxes (EBIT).

The more restrictive EBIT threshold resulted in substantial increases to the number of taxpayers, and the dollar amounts, subject to the section 163(j) limitation in 2022. With the rapid rise of interest rates during 2023, and no apparent easing in sight, the issue will likely be exacerbated in 2023 and continue into future high interest rate years. While BIE that is suspended under section 163(j) carries forward indefinitely, this is of minimal solace to many taxpayers whose limitation may be perpetual in nature and not drive a tax benefit until an eventual exit, and even then, potentially based on less favorable characterization.

This issue has gained attention in recent months. While there seems to be bipartisan support for reverting the ATI calculation to the EBITDA threshold, when or even if relief will be granted is currently unknown.

If left unchecked, the perfect storm of the EBIT threshold and high interest rates will disproportionately impact industries and structures that tend to carry heavier debt loads including private equity, manufacturing and other capital-intensive enterprises. However, thoughtful and proactive planning opportunities can potentially mitigate or eliminate a taxpayer’s exposure to the 163(j) limitation, particularly if planning is performed in the structuring stage of a transaction.

With recent legal changes and funding increases, the IRS has begun to audit high-net worth taxpayers and partnership more aggressively. The IRS and Department of the Treasury (Treasury) leadership believe that these taxpayers are subject to less independent third-party reporting and are, correspondingly, more apt to understate taxable income.

While high-net worth individuals are now facing more frequent audits, the approach and most frequently examined items remain the same. Charitable contributions, business assets that might also have some personal use (e.g., aircraft), and debt considerations remain points of emphasis for the IRS when auditing individuals.

Partnership audits, however, are unrecognizable as compared to just several years ago. Previously, if a partnership audit resulted in an adjustment, that adjustment was allocated to the partners, who were individually liable for any tax due. This was a burdensome and sometimes ineffective process for the IRS, which resulted in hesitation to audit a partnership unless the IRS believed it was engaged in potentially abusive behavior.

Effective as of 2018, most partnerships are now under the centralized partnership audit regime (CPAR), an approach that shifts the procedural burdens of audits, as well as the payment of tax due on any adjustments to the partnership. With the shifting of this administrative burden, the IRS has been much more willing to audit and adjust partnership items. As a result, aggressive tax planning that at one point would likely have been ignored by the IRS, is now being targeted. The IRS has made significant investments in technological developments, including artificial intelligence (AI), and with its recently increased funding, has been able to hire additional personnel.

The net result of these changes is a change in the risk landscape, as audits of both partnerships and high-net worth individuals continue to increase. While many legitimate planning techniques that be implemented to minimize tax liabilities, proper planning and care should be taken to justify the position.

The Tax Cuts and Jobs Act (TCJA) of 2017 expanded additional first-year depreciation, often referred to as bonus depreciation, to provide for a 100% deduction for property placed in service by the end of 2022. Beginning in 2023, bonus depreciation phases out, reducing eligible bonus depreciation by 20% each year until it’s completely phased out in 2027. One hundred percent bonus depreciation could be extended for several more years if lawmakers are successfully able to pass a bipartisan compromise; however, the likelihood of passage is currently unknown.

While the bonus depreciation phase out is generally unfavorable for taxpayers, there are still many planning opportunities that can be implemented to accelerate depreciation expense, including:

• Review placed in service dates: Taxpayers should pay close attention to the dates assets are placed in service, particularly as they approach the end of a year. The timing difference of even a few days can cause the asset to be placed in service in a subsequent year, which will affect bonus depreciation availability.
• Review asset classes and depreciable lives: Fixed assets should always be assigned to their proper asset classes, which determine the depreciable life of such assets. Coming off several years with 100% bonus depreciation, many taxpayers may not have paid close attention to these classifications. With bonus depreciation phasing out, it is important taxpayers ensure that fixed assets are properly assigned to the correct asset class and depreciated over the proper term.
• Elect (and maximize) the de minimis safe harbor: Taxpayers can elect to expense tangible property, up to a certain dollar amount, to the extent such property is also deducted for book purposes. While this is a routine election, many taxpayers may not be maximizing the allowable deduction. Amounts eligible for this election vary based on whether the taxpayer has an audited financial statement.
• Review deductible repairs and maintenance expenses: Amounts paid for repairs and maintenance to tangible property that do not result in improvements can be immediately expensed. There are very specific rules and definitions related to claiming these expenses that often require a facts-and-circumstances analysis.
• Materials and supplies: Taxpayers may also have opportunities to currently expense certain types of materials and supplies, depending on the type and cost of the supply.

With bonus depreciation currently phasing out, taxpayers should refresh their accounting methods and elections relating to fixed assets, and materials and supplies to take advantage of accelerated deductions.

In recent years, inventory prices have increased drastically across most industries. In this type of inflationary environment, impacted businesses may find relief in adopting the last-in, first-out (LIFO) inventory method of accounting, which provides tax deductions related to rising inventory costs.

The LIFO method allows taxpayers to include the most recently purchased or manufactured inventory in cost of goods sold for the year, leaving lower costed inventory on the balance sheet. During periods of inflation, the newest inventory has a higher cost, which leads to a larger cost of goods sold deduction, and correspondingly, lower taxable income for the year.

The inflation we’ve experienced over the last few years is largely attributable to the COVID-19 pandemic and related supply chain disruptions. While overall prices have decreased or stabilized since peaking in June 2022, in certain industries inflation is still running in the double digits. Taxpayers who elect the LIFO method of accounting can utilize tax savings to help to mitigate other rising costs of conducting business.

The election to use LIFO is made on a taxpayer’s timely filed return; however, electing taxpayers are also required to use LIFO on their financial reports or statements issued to creditors or shareholders. Due to this conformity rule, taxpayers should consider the benefits of the LIFO method prior to issuing any financial reports or statements for the year.

A change or module update to an enterprise solution system, which is software that integrates systems and data for organizational needs, could have significant tax implications. Any modifications to how items are accounted for or tracked within internal financials should be analyzed for underlying tax accounting method changes. As businesses implement new systems, it’s common to reassess various book accounting policies and methodologies. Common examples include:

• Inventory costing
• Inventory reserves
• Revenue recognition including changes to deferred revenue recognition
• Contract expenses
• Changes to how expenses are accrued for (e.g., change from estimating to a more precise method)
• Changes to company compensation plans (e.g., bonus plans)
• Changes to lease accounting

Often, tax professionals are asked to assist with the tax requirements of the new enterprise systems; for example, tracking of data needed for allocation and apportionment or depreciation reports. However, businesses may be missing crucial indirect impacts of the systems change that require tax accounting methods to be assessed.

Performing a tax methods assessment concurrently with an enterprise solution update ensures that the tax impacts are identified and addressed before the various tax filings are due, and any changes in accounting methods are properly accounted for and reported to the IRS.

With recent legal changes and funding increases, the IRS has begun to audit high-net worth taxpayers and partnership more aggressively. The IRS and Department of the Treasury (Treasury) leadership believe that these taxpayers are subject to less independent third-party reporting and are, correspondingly, more apt to understate taxable income.

While high-net worth individuals are now facing more frequent audits, the approach and most frequently examined items remain the same. Charitable contributions, business assets that might also have some personal use (e.g., aircraft), and debt considerations remain points of emphasis for the IRS when auditing individuals.

Partnership audits, however, are unrecognizable as compared to just several years ago. Previously, if a partnership audit resulted in an adjustment, that adjustment was allocated to the partners, who were individually liable for any tax due. This was a burdensome and sometimes ineffective process for the IRS, which resulted in hesitation to audit a partnership unless the IRS believed it was engaged in potentially abusive behavior.

Effective as of 2018, most partnerships are now under the centralized partnership audit regime (CPAR), an approach that shifts the procedural burdens of audits, as well as the payment of tax due on any adjustments to the partnership. With the shifting of this administrative burden, the IRS has been much more willing to audit and adjust partnership items. As a result, aggressive tax planning that at one point would likely have been ignored by the IRS, is now being targeted. The IRS has made significant investments in technological developments, including artificial intelligence (AI), and with its recently increased funding, has been able to hire additional personnel.

The net result of these changes is a change in the risk landscape, as audits of both partnerships and high-net worth individuals continue to increase. While many legitimate planning techniques that be implemented to minimize tax liabilities, proper planning and care should be taken to justify the position.

The employee retention credit (ERC) is a point of significant emphasis for the IRS. The ERC is a tax credit for employers impacted by COVID-19 and was designed to encourage employers facing decreased earnings or suspension of operations due to government orders to continue to pay employees. The credit was included on the most recent IRS annual “Dirty Dozen” list of tax scams because of the lack of clarity in the law and the fact that ERC promotors have seized upon the uncertainty, resulting in the filing of tens of thousands of fraudulent claims.

The IRS is attempting to reduce the number of fraudulent claims filed by slowing the processing times for pending ERC claims, as well as auditing as many of the claims they deem suspicious. ERC audits are particularly painful, as the IRS has yet to compile meaningful data on the credit, and due to the perception that many of the claims do not legitimately meet the credit’s criteria. Audits begin with a very lengthy document request, requiring the taxpayer to provide all the information required to both determine eligibility and calculate the credit. There is an expectation that the taxpayer’s management meet with the IRS to discuss not only their credit claim but also how the client learned about ERC, as well as providing the details of the ERC firm’s agreement with the taxpayer.

ERC audits have become notoriously difficult, even if the taxpayer is clearly eligible and the calculations are beyond reproach, but even more so if the calculations are poorly documented and/or the taxpayer’s eligibility is in question. ERC audits require representation because of the nuance of the law, the sensitivity of the taxpayer interview and the volume of data. A single error in the eligibility portion of the exam could engager the entire credit.

Taxpayers found ineligible upon audit face having to repay the credit in full, will be assessed penalties and interest, are likely to incur defense counsel fees, and are unlikely to recover the amount paid to the firm who filed the ERC claim. In total, the taxpayer could be out an amount that is up to or more than double the initial credit amount. For taxpayers who are questioning their ERC eligibility and have filed or are considering filing a claim, please contact your tax advisor to determine if you’d like to take advantage of a recently issued IRS relief procedure.

Despite their increasing prominence in our economy, the taxation of digital assets is an area that remains rife with uncertainty. To date, the Department of the Treasury (Treasury) and the IRS have issued minimal guidance on the taxation of digital assets. The direction that has been provided is significantly limited in scope and many commonplace transactions have yet to be addressed.

Tax advisors are using the available IRS guidance, general tax principles and other law precedent to develop positions and report digital asset transactions. To the extent possible, taxpayers who interact with digital assets should consult their tax advisors prior to executing transactions. This proactive communication has the potential to both take advantage of planning opportunities, as the structure and timing of transactions can affect the ultimate tax liability and mitigate risk, as transactions involving digital assets may require additional substantiation.

The nature of digital assets, coupled with a lack of reporting requirements, has contributed to our ever-expanding tax gap. In an effort to reduce related underpayments, the federal government is implementing several strategies focused on digital asset compliance and enforcement, including:

• New regulations: In 2023 the IRS released a long-anticipated set of proposed regulations on the implementation of information reporting for digital assets. Once effective, it’s believed the application of these regulations will bring in significant tax revenue.
• Operation Hidden Treasure: This joint effort between the IRS Office of Fraud Enforcement (OFE) and the IRS Criminal Investigation (CI) focuses on pursuing taxpayers who omit cryptocurrency income from tax filings.
• Informational questions: For several years, the IRS has asked individual tax filers about their digital asset activity, reinforcing the need to report digital asset transactions. Beginning in 2023, business filers will also be required to answer the same question.
• Regulation by litigation: In the absence of legislation on the oversight of digital assets, agencies including the U.S. Securities and Exchange (SEC) commission are developing their own interpretation of U.S. law which may impact tax reporting and attempting to enforce it via litigation.

Taxpayers that hold or transact in digital assets should take these developments seriously and take steps to accurately track and report activity now. Baker Tilly can advise clients on the adequacy of record keeping, documentation best practices and the degree of tax risk in a particular transaction. It’s important for taxpayers address these items before an IRS inquiry, as the IRS has frequently taken the position that the burden to prove the legitimacy of a digital asset transaction and corresponding position claimed on a return lies with the taxpayer.

In addition, taxpayers should prepare for the upcoming regulation implementation to avoid overpayments of tax, IRS audits and other unintended consequences that could result from legal unknowns or gaps in information sharing with the IRS.

Every U.S. state and territory has active unclaimed property (UP) statutes, and the compliance requirements of the various jurisdictions are inconsistent, complex and constantly changing. Knowledgeable resources are scarce and getting into compliance is challenging, but as noted in our article “Unclaimed property and the risk of audit,” the risks of noncompliance are high.

Annual compliance

UP, which generally represents an aged obligation on a company’s books owed to a customer, vendor or employee, is challenging to administer. Companies looking to initially become compliant or those attempting to maintain compliance are often best served by an experienced UP team.

UP statutes in every U.S. jurisdiction require companies report and remit UP, as well as to notify the owners of any UP above specified dollar thresholds that their property will be reported as UP unless the owner comes forward to claim the property. Annual compliance with these statutes reduces risk and exposure.

Voluntary disclosure agreements

Voluntary disclosure agreements (VDAs) are often used to bring companies into compliance. VDAs allow companies to report significant past due UP, a process that provides more protection than simply filing past-due property on a current year report. While not every jurisdiction offers a VDA, terms typically include the abatement of interest and/or penalty and reporting for fewer years than if the company were to be subject to an audit.

Companies with material UP that are not in compliance with state statutes should strongly consider consulting a UP team for an analysis of their current exposure and the creation of a plan to mitigate the associated risks of noncompliance.

Unclaimed property (UP) generally represents an aged obligation on a company’s books owed to external third parties (vendors, customers or employees) such as any type of uncashed check, accounts receivable credits, payroll or various types of inactive banking and investment accounts.

Every U.S. state and territory has active UP statutes, which require companies to report and remit UP to the states. Receiving an UP audit notice is never good news for a company; these notices can carry substantial additional risks, including:

• Most UP audits are conducted by third-party auditors contracted by the states. While some are paid on a time and material basis, others receive a contingent fee based on their findings.
• Historically, only large companies were targeted for UP audits. Now mid-sized and smaller companies are receiving UP audit notices as well.

Audits can often take several years to complete, requiring significant internal resources to defend and complete. Under an audit, the company’s state of incorporation may have the right to perform an estimation of liabilities for periods where records are missing or are incomplete, which can exceed the total value of the actual UP identified during the audit. As audits typically cover a review period of 10 report years (13-15 calendar years), the inclusion of an estimated liability is not infrequent in audits.

For companies subject to UP audits, having an experienced team working with you is critical to achieving the best possible outcome. In addition to the risks noted above, assessments typically come with accompanying penalties and interest. As with many similar items, the best defense is a good offense; annual compliance, and as needed, voluntary disclosure agreements, can reduce the risk of adverse audit outcomes.

With the recent rise in real property values, some qualified opportunity funds (QOFs) are receiving attractive offers to sell. QOFs generally hold real property via a qualified opportunity zone business (QOZB). Because the qualified opportunity zone (QOZ) program started in 2018, owners of QOFs have not yet met their 10-year hold period required to receive permanent gain exclusion. It is important to understand both the investor implications of an “early exit” and the various tax planning strategies available to QOFs and QOZBs.

An “early” QOZB asset sale has at least three investor implications:

1. The sale is not an inclusion event, meaning a QOF’s investors are not automatically required to recognize deferred gains.
2. If a QOF decides to liquidate and trigger an inclusion event, the QOF’s investors need not file amended returns; rather, the investors will pay tax on the originally deferred gain in the year of the inclusion event.
3. Capital gains resulting from a QOZB’s sale of real property will be reported to the QOF’s investors via a Schedule K-1. These gains are considered “eligible gains,” which can be invested into the same or a new QOF.

QOZBs that sell real property before the 10-year holding period should examine potential tax strategies before executing a transaction. There are several options for how a QOF, its investors and its underlying QOZB investment can proceed in light of an early disposal, with varying tax consequences. The applicable rules for QOZs can be complex and difficult to navigate; taxpayers can encounter adverse tax consequences from simply holding too much cash at the QOZB level or holding onto to cash too long at the QOF level. Proactive tax planning can minimize or eliminate tax related to the sale of a QOF investment. A consultation with a knowledgeable tax advisor is recommended prior to entering into a sale.

Qualified opportunity zone (QOZ) investments allow taxpayers to defer certain capital gains by investing in projects and businesses located in economically distressed areas within 180 days of the date the capital gain is realized. The intent of this program is to rejuvenate struggling communities; accordingly, there are certain criteria the investment must meet in order to qualify for the deferral of investor gains. Any gain deferred by investing in a QOZ project must be recognized upon the earlier of Dec. 31, 2026 (the inclusion date), or broadly, when the QOZ investment is disposed of.

There are several complex rules governing QOZs. For purposes of demonstrating the impact of the inclusion date, consider the following example:

Taxpayer A sells stocks with a tax basis of $500,000 for $1.5 million, realizing a $1 million taxable capital gain. Instead of paying taxes on this gain, he invests $1 million into a QOZ fund within 180 days of the stock sale. Because he pays no tax on the gain of the initial sale, his basis in the QOZ investment is zero.

On Dec. 31, 2026, the deferral period ends by law, and all deferred gains up to that point will be recognized. Taxpayer A will recognize $1 million of gain in 2026, which will bring Taxpayer A’s basis in his QOZ investment up to $1 million. If Taxpayer A continues to hold the investment for at least 10 years, any additional gains will be tax-free.

As the inclusion date approaches, it’s important taxpayers and advisors begin planning. While this date may seem far off, proactively planning for this known upcoming capital gain will provide the most opportunity for managing tax liabilities, particularly for taxpayers with large inclusion amounts.

When considering the utilization of a business aircraft, the initial consideration is often whether to lease, buy or purchase a fractional share in an aircraft. Each option presents advantages and disadvantages, many of which go beyond tax considerations.

• Leasing an aircraft: For some businesses, particularly those with a less consistent need for air transportation, it may be more practical and cost effective to lease an aircraft as needed. Depending on the structure of the lease, the business may need to hire a management company to handle the day-to-day operations of the airplane. Lease payments may be deductible.
• Purchasing an aircraft: Purchasing an aircraft offers greater accessibility to travel; however, the costs are substantial. In addition to the purchase price of the plane there will be operating and maintenance costs such as fuel, insurance, hanger fees, pilot and crew. The aircraft can be depreciated over its useful life, some of which may be accelerated via bonus depreciation, and most operating costs are deductible.
• Fractional ownership in an aircraft: Purchasing an interest in an aircraft through a fractional provider is considered a hybrid option; this arrangement allows owners access to a plane or fleet of planes, while costs are shared among owners. This arrangement also alleviates the need for businesses to manage the operation of the aircraft in exchange for a management fee paid to the aircraft operator. There are several structures a fractional ownership can take.

Each of the three options have varying tax benefits inherent in their structure. In addition, the deductibility of all aircraft expenses varies further based on several factors, including whether the use of aircraft is an ordinary and necessary deduction for the business, and the amount of business vs. personal use in a year. These factors have a direct impact on deductibility, and thus, the financial burdens of aircraft use and ownership.

Finally, the IRS and Federal Aviation Administration (FAA) have detailed procedures that must be followed to substantiate the tax implications of aircraft use and ownership. The effort a business is willing to put forth to substantiate deductions can have determined their deductibility. Investments in an aircraft, whether via a lease, purchase or fractional ownership, is a significant investment with business, financial and tax implications. A knowledgeable tax advisor can help you determine the best strategy.