VOLUME 2, ISSUE 3
KROST QUARTERLY M A G A Z I N E
THE FINANCIAL SERVICES ISSUE The QUALIFIED SMALL BUSINESS STOCK Gain Exclusion
NEXUS: UNDERSTANDING BUSINESS TAXES BETWEEN STATE LINES
New Capital Gains Treatment for Carried Interests
TRADER TAX STATUS: DO YOU QUALIFY?
Matthew Weber, CPA, MAcc, leads the Financial Services Industry group at KROST
AND MORE... WWW.KROSTCPAS.COM
KROSTCPAs.com
Volume 2, Issue 3 / August 2019 Offices Pasadena Headquarters 790 E. Colorado Boulevard Suite 600 Pasadena, CA 91101 Woodland Hills Office 21800 Oxnard Boulevard Suite 1040 Woodland Hills, CA 91367 Valencia Office 26650 The Old Road Suite 216 Valencia, CA 91381 West LA Office 6100 Center Drive Suite 950 Los Angeles, CA 90045 Phone: (626) 449-4225 Fax: (626) 449-4471 Principals Gregory A. Kniss, CPA Managing Principal Lou Guerrero, CPA, MBT Principal - Tax Practice Leader Jason C. Melillo, CPA Principal - Assurance & Advisory Jean Hagan Principal - Business Management So Sum Lee, CPA Principal - Tax Production, Copy, and Design Bethany Wolfe, Editor-in-Chief Anna Chen, Editor Ellen Reynerson, Graphic Designer Diana Vu, Assistant Editor
CONTENTS
4 7 11 14 16 18
The Qualified Small Business Stock Gain Exclusion By Matthew Weber, CPA, MAcc
2019 FinTech M&A and Market Report By Paren Knadjian
Nexus: Understanding Business Taxes Between State Lines By Matthew Weber, CPA, MAcc
Trader Tax Status: Do you Qualify? By Randall Poe
Outsourced Accounting for Family Offices By Stacey R. Korman, CPA, MST
New Capital Gains Treatment for Carried Interests By Matthew Weber, CPA, MAcc
Mayra Silva, Assistant Editor Inquiries may be sent to: admin@KROSTCPAs.com Stock Photography Adobe Stock - Used with permission Copyright Š 2019 by KROSTCPAs.com All rights reserved. No part of this publication may be reproduced, distributed, or transmitted in any form or by any means, including photocopying, recording, or other electronic or mechanical methods, without the prior written permission of the publisher, except in the case of brief quotations embodied in critical reviews and certain other noncommercial uses permitted by copyright law.
THE FINANCIAL SERVICES ISSUE KROST Quarterly is a digital publication released by KROST CPAs & Consultants headquartered in Pasadena, California. Established in 1939, this full-service Certified Public Accounting and Consulting firm serves clients across a variety of industries. With a focus on recognizing opportunities and creating value, KROST equips clients with tools to make better business and financial decisions for the future.
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INTRODUCING KROST’S FINANCIAL SERVICES TEAM Matthew Weber is a Tax Manager at KROST. He has been with the firm’s tax practice since July 2015 and has over ten years of experience in public accounting. His areas of expertise include federal and multi-state tax compliance and consulting for individuals, corporations, and partnerships. Matthew is the leader of the Financial Services Industry Group at KROST, offering specialized services to management companies and their investment vehicles. MEET MATTHEW
Our team produces regular KROST Insights posted to our website. This issue will highlight some of the hot topics in the Financial Services industry including Sales Tax Nexus, QSBS, Carried Interests, Trader Tax Status,
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KROST QUARTERLY VOL. 2 ISSUE 3 - THE FINANCIAL SERVICES ISSUE
Greg Kniss, CPA Managing Principal
FINANCIAL SERVICES
Team at KROST 360° Service Model
Lou Guerrero, CPA, MBT Principal - Tax
• • • • • • • • • •
Matthew Weber, CPA, MAcc Manager - Tax
•
Carried interest Qualified Small Business Stock (QSBS) Special allocations of incentive fees Mark-to-market treatment and elections (Section 475) Regulated futures contracts (Section 1256) Wash sale rules Specialized profit and loss allocations for syndicators and investors Unrelated business income for tax-exempt investors Federal withholding issues for foreign investors Self-employment tax issues for traders and management fee income Cryptocurrency transactions
Experience You Can Trust Our Sector Expertise • • • • •
Hedge Funds Money Managers Private Equity Firms Venture Capitalists Family Offices
Paren Knadjian Practice Leader M&A and Capital Markets
Stacey R. Korman, CPA, MST Director - Accounting
“Our focus is on management companies and their investment vehicles. We have assisted the management companies of Hedge Funds, Money Managers, Private Equity Firms and their principals with a wide range of accounting and tax services for the last 15 years.” 3
THE QUALIFIED SMALL BUSINESS STOCK
GAIN EXCLUSION
By Matthew Weber, CPA, MAcc Manager - Tax
I
f you sell stock that has appreciated in value, then you must recognize a taxable capital gain. Sounds straightforward, right? While that may be true most of the time, it is in the best interest of investors in small corporations and startups to become familiar with the tax benefits of the Qualified Small Business Stock (QSBS) gain exclusion. If you are a non-corporate investor who acquired stock of a domestic C corporation directly from that corporation for money, property (other than stock), or certain services and have held that stock for more than five years, then you may be eligible for the QSBS gain exclusion under Internal Revenue Code Section 1202 when you sell that stock. NON-CORPORATE INVESTORS CAN EXCLUDE CAPITAL GAINS FROM SALES OF QSBS Depending on the acquisition date of the QSBS, non-corporate investors may exclude 50%, 75%, or 100% of the gain they realize on the disposition of QSBS issued after August 10, 1993, and held for more than five years. If the QSBS is from stock options, then the acquisition date is the exercise date, not the date of grant.
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PERCENTAGE GAIN EXCLUSION BY ACQUISITION DATE
Acquired between August 11, 1993 and February 17, 2009:
50% GAIN EXCLUSION
Acquired between February 18, 2009 and September 27, 2010:
75% GAIN EXCLUSION
Acquired after September 27, 2010:
100% GAIN EXCLUSION
There is a cumulative limit on the gain from a single issuer that a taxpayer may exclude. Eligible gain from any one corporate issuer in any given tax year is taken into account only to the extent that it does not exceed the greater of: 1. $10 million reduced by the aggregate amount of eligible gain taken into account by the taxpayer in prior years from the same issuer, or; 2. 10 times the adjusted basis of all qualified stock of the issuer that the taxpayer disposed of during the tax year. Additions to the basis are disregarded. This limitation can severely restrict the tax benefit of this provision in the event of a truly substantial windfall. The $10 million limitation is applied on a shareholder-by-shareholder basis and any property contributed to the issuing corporation is its fair market value as of the contribution date. Married taxpayers filing separately have $5 million of eligible gain for each spouse. It is important to note that both before and immediately after the date of issuance, a qualified small business corporation’s aggregate gross assets cannot exceed $50 million. Since the date of issuance, at least 80% (by value) of the corporation’s assets must have been used in the active conduct of one or more qualified trades or businesses. Stock issued to a taxpayer cannot qualify for the exclusion if the issuing corporation purchases (directly or indirectly) any of its own stock from the taxpayer or persons related to the taxpayer within the four-year period beginning two years before the date of issuance. A safe-harbor de minimis amount can be redeemed without rendering the stock ineligible for the exclusion. The aggregate amount paid for the stock by the issuing corporation in such redemptions cannot exceed $10,000 or more than 2% of the stock held by the taxpayer and all related persons. Stock will also not qualify for the exclusion if the issuing corporation engages in a “significant redemption.” A redemption is significant if the corporation, within a two-year period beginning one year before the issuance of the stock, redeems stock with an aggregate value exceeding 5% of the aggregate value of all the corporation stock. A de minimis exception applies if either the aggregate amount paid for all stock redeemed during the two-year period does not exceed $10,000 or no more than 2% of all outstanding stock. Another opportunity for QSBS holders is provided by Internal Revenue Code Section 1045. A rollover option is available to QSBS holders that have held the stock for at least six months. Section 1045 allows a QSBS holder to rollover gains into replacement QSBS. The taxpayer must invest in the replacement QSBS within 60 days of the sale of the QSBS. The
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taxpayer will only recognize gain to the extent that the amount realized on the sale exceeds the cost of any QSBS purchased during the replacement period (less any portion of that cost previously taken into account under Section 1045). The amount of the deferred gain reduces the basis in the replacement QSBS, so any gain not recognized currently is deferred, not excluded.
“THE PROTECTING AMERICANS FROM TAX HIKES ACT OF 2015 (“PATH ACT”) MADE SEVERAL TAX BREAKS PERMANENT, INCLUDING THE QSBS GAIN EXCLUSION.”
There is no specific language in either Section 1202 or Section 1045 that indicates the two sections are mutually exclusive. Therefore, it is reasonable to conclude that a taxpayer who exceeds the dollar limits of Section 1202 could use Section 1045 to defer the excess gain. Obviously, the QSBS gain would have to meet the longer five-year holding period for the Section 1202 exclusion. The Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”) made several tax breaks permanent, including the QSBS gain exclusion. The law made permanent the exclusion of 100% of the gain on the sale or exchange of QSBS acquired after September 27, 2010, and held for more than five years. The PATH Act also permanently extended the rule that eliminates the 100% excluded QSBS gain as a preference item for AMT purposes. In addition, QSBS gain excluded from income is not subject to the 3.8% Net Investment Income Tax (additional tax on capital gains, interest, dividends, and other investment income), which is imposed on high-income taxpayers. It is critical that founders, investors, and employees who wish to utilize QSBS engage the right professionals for advice. In addition, it is prudent for corporations to document the QSBS status of their newly issued stock at each round of financing.
CONTACT MATTHEW 6
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2019 FINTECH M&A AND MARKET REPORT By Paren Knadjian Practice Leader - M&A and Capital Markets
10% 6%
32%
52%
T
he Financial Technology market (FinTech) continues to grow and flourish in 2019 with Venture Capital (VC) aggressively funding start-ups, Private Equity (PE) firms active in buyouts and growth investments, and incumbent financial institutions stepping up their M&A activity. Transactions remain robust with 1,212 deals announced in 2019 so far (as of June 30, 2019) amounting to $100 billion in capital deployed. That’s only 31% of deals announced in 2018 by deal count, but 54% of the capital deployed.
52% of the activity was corporate deals including divestitures. 32% was PE growth and buyout activity including buyout/ leveraged buyouts (LBOs), management buy-ins, add-ons, growth/expansion, asset acquisitions, and dividend recapitalizations. 10% by volume was VC and angel activity (all stages) and 6% was public market activities including Initial Public Offerings (IPOs), Private Investment in Public Equity (PIPEs), and reverse mergers.
1
FINTECH M&A AND CAPITAL MARKETS ACTIVITY 2019 PE Growth & Buyout
Public Markets (Inc IPOs)
VC
Corporate M&A
1
PitchBook Data, Inc.
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announced in 2018 but 54% of the capital deployed. M&A and Capital Markets Activity 2010-2019 $200.00B
3,958
$180.00B $160.00B
4,000
3,435
3,135
$100.00B
1,641
$80.00B $60.00B $40.00B
650 $33.51B
1,140
856 $30.20B
$20.00B $0.00M
$115.20B
2,335
2010
2011
3,500
3,909
$140.00B $120.00B
4,500
$185.16B
$105.78B
$109.21B
3,000 $100.08B
2,000
$67.25B
1,500
$42.02B 1,212
$19.85B
2012
2013
2014
2,500
2015
Capital Deployed
2016
2017
2018
Deal Count
2019
1,000 500 0
Source: PitchBook Data, Inc.
Source: PitchBook Data, Inc
The main blockbuster deal in 2019 was the $22 billion acquisition of merchant services provider First Data (NYS: FDC) by 52% oftechnology the activity was corporate deals including and very Divestitures. 32%last was PE Growth and activity banking provider Fiserv (NAS: FISV). FiservM&A has been active in the 3 years booking 14Buyout transactions in total. including Buyout/LBOs, Management Buy-Ins, Add-ons, Growth/Expansion, Asset Acquisitions, and Dividend Recapitalizations. 10% saw by volume was VC andInAngel activity (allDunn stages) and 6% was Market activities The early months of 2019 the most activity. February 2019, & Bradstreet wasPublic acquired by CC Capital, Thomas H. including IPOs, Reverse Mergers. Lee Partners, and PIPEs, othersand through a $6.9 billion public-to-private LBO. In January 2019, payment services provider Concardis was acquired by Nets via its financial sponsors Advent International, Bain Capital, and others for $6 billion. FinTech M&A and Capital Markets Activity 2019
Transaction valuations have also risen in 2019, valuation/revenue multiples are at a median of 8.28x and valuation/EBITDA multiples are at a median of 12.95x compared to 4.73x and 10.94x for the same multiples in 2018. 6%
10%
YEAR 2018 2019
COMPANY COUNT
1,130 3,354
DEAL COUNT
1,212 52% 3,909
32% CAPITAL INVESTED
$100,078.36 $185,161.46
PE GrowthVALUATION/REVENUE & Buyout VALUATION/EBITDA MEDIAN MEDIAN Corportate M&A
12.95x 10.94x
8.28x 4.73x (Inc IPOs) Public Markets VC
Source: PitchBook Data, Inc.
In the public markets, Square (NYS: SQ) remains the darling of the FinTech industry retaining a market cap of $30 billion for most of 2019. Adyen NV, a technology company in the merchant’s payments space, which did an IPO in mid-2018 (raising Source: PitchBook Data, Incat an almost $20 billion market capitalization. A key new entry in the public markets was Nexi SpA, €849 million), is trading an Italian PayTech company. The company raised €2 billion in its initial public offering on the Borsa Italiana stock exchange The main blockbuster deal in 2019 was the $22 billion acquisition of merchant services provider First Data (NYS: on April 12, 2019. Its market cap currently stands at $5.7 billion. FDC) by banking technology provider Fiserv (NAS: FISV). Fiserv has been very active in the last 3 years booking 14 The Venture Capital market remained very active with 1,335 investors investing in 802 companies in the first half of 2019. The leading firm that attracted VC money was SoFi, a FinTech consumer finance company. The company raised an estimated $500 million of Series H venture funding in a deal led by Qatar Investment Authority in May, putting the company’s pre-money valuation at $4.3 billion. Next Ventures and other undisclosed investors also participated in the round. Affirm, a developer of an online lending platform designed to provide an alternative to traditional credit cards at the point of sale, raised $300 million of Series F venture funding in a deal led by Thrive Capital in April, putting the company’s pre-money valuation at $2.7 billion. Finally, Carta, the Palo Alto-based FinTech company that specializes in capitalization table 8
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management and valuation services, raised $300 million of Series E venture funding in a deal led by Andreessen Horowitz in May, putting the company’s pre-money valuation at $1.4 billion. Goldman Sachs Principal Strategic Investments and others also participated in the round. Based on several ongoing and emerging trends, we expect that M&A and Capital Markets activity will remain robust in 2019. 1. There are clear technical trends in FinTech with most new investments in big data, machine learning, artificial intelligence, and blockchain; 2. Traditional financial institutions worldwide will realize that they have to embrace the disruptive nature of FinTech which will result in more acquisitions by these financial institutions; 3. Consumers and businesses are demanding more rapid, less rigid, less bureaucratic and more transparent services from their financial services providers. This will help companies like SoFi and Affirm build their businesses; 4. Tech giants Apple, Google, Amazon, and Facebook are determined to be players in the financial services space through the use of their technology by their vast user base. They have and will continue to be investors in innovative FinTech; 5. Technology for the insurance market, InsurTech, continues to develop and is being rapidly deployed worldwide; 6. About 1.7 billion adults globally remain unbanked – China has the world’s largest unbanked population, followed by India, Pakistan, and Indonesia. These four economies, together with three others—Nigeria, Mexico, and Bangladesh—are home to nearly half the world’s unbanked population. The necessity and desire of governmental, charitable, and for-profit companies to deploy FinTech in developing countries, particularly in mobile banking and mobile payments, will ensure growing investment in innovative FinTech companies. The FinTech market continues to grow and innovate and that, in turn, attracts investment. But as companies mature, we also expect to enter a period of consolidation, as is so often the case with emerging industries. So, expect more VC investments but a growing amount of LBO and buyout activity.
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80
A N N I V E R S A R Y
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KROST QUARTERLY VOL. 2 ISSUE 3 - THE FINANCIAL SERVICES ISSUE
NEXUS:
UNDERSTANDING BUSINESS TAXES BETWEEN STATE LINES By Matthew Weber, CPA, MAcc Manager - Tax
O
ne of the methods asset management companies use to generate revenue is by charging management fees to their investors. Usually, management fees are collected based on a percentage of the assets under management. The fees are typically collected without regard to the performance of the assets being managed and are treated as ordinary income to the company. On a federal compliance level, the process is clear-cut. The company would recognize ordinary income on the management fees received and offset the income with ordinary expenses incurred during the year (i.e. salaries, office expense, professional fees, etc.). However, the process becomes less straightforward on the state and local tax levels. Many companies mistakenly assume to source the revenue from management fees to the commercial domicile of the company and not source to any other state. This may not be the correct answer if the company receives management fees from investors inside and outside its home state. If the company only receives management fees from investors in the same state it conducts business, then sourcing to the company’s commercial domicile state would be correct. However, many companies receive management fee income from investors both in and out of state. In such cases, depending on the state that the investor resides, the company may have Nexus even without a physical presence in the state. KROST QUARTERLY VOL. 2 ISSUE 3 - THE FINANCIAL SERVICES ISSUE
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WHAT IS NEXUS AND WHAT IS ITS BUSINESS IMPACT? State Nexus is a term used to determine if a state has the lawful ability to tax a business for activity within their border. The rules for determining Nexus differ both by state and by type of business. There are general terms for the different types of Nexus standards, the most common are physical presence standards, economic presence standards, and/or factorbased standards, as well as terms for methods of determining economic nexus, such as market-based sourcing vs. cost of performance.
PHYSICAL PRESENCE
Physical Presence is a standard in which the state deems a business has Nexus in their jurisdiction. State Nexus may apply to businesses that have offices, employees, or any other type of physical presence in the state.
ECONOMIC PRESENCE
Economic Presence refers to a standard without regard to physical presence in the state. A business can have economic presence solely by generating sales in the state. Any sales generated would trigger economic Nexus in the state, and the state would have the lawful ability to tax the business on any income generated within state lines. This leads to the issue of how sales are sourced. Each state has different laws on how sales are to be sourced, including different methods for different types of businesses. The two main methods are market-based sourcing and cost of performance. MARKET-BASED SOURCING Market-based sourcing is a method of sourcing sales based on the location of the market. Many states differ on the definition of what constitutes market-based sourcing. Sales can be sourced based on the verifiable location of where the service is being used, where the customers are located, or by the customers’ billing addresses. COST OF PERFORMANCE Cost of performance is a method of sourcing sales based on the location of incomeproducing activities (i.e. cost of producing the sales). States may differ on what constitutes an income-producing activity, but in general, an income-producing activity can include workstations in a state such as offices, home offices, sales teams, or any costs associated with creating revenue. Under the cost of performance standards, the states vary on the method of sourcing sales for corporations doing business in and out of the state.
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FACTOR-BASED
Factor-based refers to a dollar threshold provided by the state for either property, payroll, or sales in which a business would need to pass in order to have nexus. The factor-based presence can be used in conjunction with economic nexus standards. States that have a factor-based standard may differ on the dollar amount of the threshold. For example, in 2018 Michigan used an economic nexus standard for certain businesses and had a factor-based standard for any corporation that had over $350,000 of sales in the state.1 The economic nexus standard would trigger the first phase of nexus without regard to physical presence, and the factor-based standard would add a dollar threshold to determining nexus in Michigan.
The rules for nexus and sourcing management fees are complex. States differ on what methods they use in determining nexus and sourcing rules for management fees. The rules may change year to year, and it is important for every company to perform an annual state nexus analysis to determine their state filing obligations. States may assess penalties and interest on the failure to file or pay income tax should a business have nexus in the state. 1
Mich. Comp. Laws §206.621
CONTACT MATTHEW
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TRADER TAX STATUS: DO YOU QUALIFY? By Randall Poe Staff - Tax
WHAT IS TRADER TAX STATUS? Trader tax status is a special set of rules that allow traders to treat trading activity as an ordinary business. Trader status allows taxpayers to deduct the trading and broker fees directly from their adjusted gross income (AGI). This treatment is very advantageous because the 2017 Tax Cuts and Jobs Act (TCJA) now disallows individuals from deducting trading and broker fees through their 2% miscellaneous deductions on Schedule A. WHO QUALIFIES FOR TRADER TAX STATUS? According to the Internal Revenue Service, taxpayers are categorized as either investors or traders. Even taxpayers that extensively engage in trading securities can be categorized as an investor, but not a trader. While both investors and traders can qualify for Trader Tax Status, it is important to identify the difference between the two categories.
A TAXPAYER IS CONSIDERED AN INVESTOR IF THE INDIVIDUAL: 1. Trades primarily from their own brokerage account 2. Seeks profit primarily from price appreciation 3. Typically holds investments for longer periods of time 4. Invests infrequently and irregularly 5. Trades through a broker 6. Is not a licensed broker and does not advertise themselves as such1 A TAXPAYER IS CONSIDERED A TRADER IF THE INDIVIDUAL: 1. Is a licensed broker 2. Actively participates in trading and managing brokerage accounts 3. Locates buyers and sellers 4. Seeks profits primarily from daily trading transactions2 14
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WHERE DO TRADERS REPORT INCOME AND EXPENSES? Traders report their business expenses (e.g., investment interest, broker fees, etc.) on Form 1040, Schedule C. Gains and losses from the sale of securities are treated as capital gains and must be reported on Form 1040, Schedule D. However, taxpayers can elect to treat gains and losses as ordinary income through the mark-to-market election (Section 475(f)).
PROS AND CONS OF MARK-TO-MARKET ELECTION PROS:
CONS:
•
• •
• •
Capital gains and losses are treated as ordinary income Losses are not limited to the excess capital loss limitation of $3,000 Wash sale rules do not apply
Gains are not taxed at capital gains rates Investments must be recorded at fair market value at year-end
HOW DO YOU MAKE THE MARK-TO-MARKET ELECTION? The taxpayer must make the election by attaching a statement to their income tax return (not including extensions). The election must be made by the due date of the prior year tax return for the election to take effect in the current year. For example, for the mark-to-market election to take effect in 2019, the election must be filed by the due date of the 2019 tax return (April 15, 2020). Form 3115 (Application for Change in Accounting Method) must be filed with the election. The election statement must include the following information: 1. That you’re making an election under section 475(f) 2. The first tax year for which the election is effective 3. The trade or business for which you are making the election. Investors/traders should explore the idea of trader tax status going forward. Remember, to qualify as a trader you must be a licensed broker, actively participating in trading and managing brokerage accounts, and seeking profits primarily from daily trading transactions. If you do qualify as a trader, broker and trader fees will be deducted directly from your income on the Form 1040, Schedule C. Capital gains and losses will be reported as capital in nature on the Schedule D, unless the mark-to-market election is made which elects to treat gains and losses as ordinary income.3 As long as the 2% miscellaneous deductions are disallowed, the trader tax status has clear advantages for taxpayers. CCH Tax Research Consultant, SALES: 15,104.30, Dealers and Traders CCH Tax Research Consultant, SALES: 45,058, Traders 3 Topic No. 429 Traders in Securities (Information for Form 1040 Filers) - IRS 1
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OUTSOURCED ACCOUNTING FOR FAMILY OFFICES By Stacey R. Korman, CPA, MST Director - Accounting
BRIEF HISTORY OF FAMILY OFFICE The existence of the Family Office structure dates back millennia to the Roman Empire, where wealthy households utilized an administrator referred to as the major domus, or Head of House, to manage the family’s assets.1 Through the centuries, this structure has evolved to fit modern needs. In today’s global world, the complexity of investment, and operational and tax strategies has made the creation of a SingleFamily Office (SFO) increasingly popular for individuals and families considered ultra-high-net-worth, which is defined as having control of at least $30 million in assets. Per a 2017 survey performed by the Wharton Global Family Alliance, 21.7% of the Family Offices surveyed had Assets Under Management in excess of $100 million. Primary focuses of the Family Office include servicing needs related to intergenerational wealth management, consolidation of professional functions (i.e. investment management, estate and tax planning), philanthropy, and lifestyle tendencies. A typical structure involves the Family Office acting as a general partner and providing administrative services to the various trusts, foundations, and limited partnerships that make up the overall family dynamic, for which the office charges management fees. Driving factors for families to seek out a Family Office provider are to have a central organization which 16
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can exhibit control over the multifarious interests of a wealthy family, help ensure the confidentiality and security of information, and to help mitigate being affected by the actions of other investors. To manage an operation like this effectively, a wide array of expertise is needed in areas such as business operations, technology, general accounting, estate and tax, legal issues pertaining to contract and litigation oversight, investment, and philanthropic strategy. Due to the specialization of these types of expertise, the average Family Office in the United States services 4-6 households and is comprised of 8-11 employees including investment professionals, lawyers, accountants, and other support staff. As technology continues to improve, especially in the areas of cloud computing and data analytics, more and more businesses are looking at outsourcing operational functions as a viable alternative to maintaining a core of professionals in-house.
“IN TODAY’S GLOBAL WORLD, THE COMPLEXITY OF INVESTMENT AND OPERATIONAL AND TAX STRATEGIES HAS MADE THE CREATION OF A SINGLE-FAMILY OFFICE (SFO) INCREASINGLY POPULAR FOR INDIVIDUALS AND FAMILIES CONSIDERED ULTRA-HIGH-NET-WORTH”
Due to the nature of the Family Office and its primary goal of serving and safeguarding wealth, there can be an instinct to shy away from outsourcing traditionally internal functions because of a lack of trust or institutional control. While basic bookkeeping functions can be maintained in-house, technological advancement in the areas of cloudbased networks, data management systems, and accounting platforms can make it much more cost-effective and efficient to outsource the entire accounting process to a trusted advisor. Firms with the resources and expertise to handle advanced functions, such as financial reporting, cash flow analysis and budgeting/forecasting, development and implementation of internal controls, and tax and estate planning, remove the necessity to have multiple in-house experts. SFOs can be complex and require a large team to manage, especially if the organization manages other external households under the Family Office. In addition, consideration should be given to the control environment. Both traditional internal controls as well as cybersecurity controls should be scrutinized in the same way as in a more traditional business entity. Consideration also needs to be given to the proper utilization of technology to increase automation and efficiencies in the areas of accounts payable and receivable, cash management and maintenance of the accounting database as well as financial reporting and data analytics. The bigger an organization the SFO becomes, the more sophisticated the systems and procedures of the overall accounting environment must be, which can easily be handled through outsourced accounting for family offices. With the assistance of a trusted advisor, many concerns can be addressed to safeguard family wealth and plan for the future.
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Single Family Offices: Private Wealth Management in the Family Context - Wharton Global Family Alliance
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NEW CAPITAL GAINS TREATMENT FOR CARRIED INTERESTS By Matthew Weber, CPA, MAcc Manager - Tax
C
arried interests have allowed investment fund managers to be compensated for services with income that qualifies as long-term capital gains, which is taxed at a lower rate than ordinary income. Numerous efforts have been made during the last two decades to cut back or eliminate the favorable tax treatment of carried interests by taxing all income from carried interests as ordinary income. The 2017 Tax Cuts and Jobs Act (TCJA) enacted Internal Revenue Code Section 1061, which did not eliminate the benefit of carried interests, but rather kept the prior tax treatment with new limits. OVERVIEW OF SECTION 1061 Section 1061 increases the holding period required for longterm capital gains treatment from more than one year to more than three years for an “applicable partnership interest” (API). Section 1061(c)(1) defines an API as any interest in a partnership which, directly or indirectly, is transferred to, or is held by, the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business. Prior to the enactment of Section 1061, taxpayers could claim long-term capital gains treatment through a passthrough loophole, as long as the carried interest was held for over a year. Today, this same taxpayer would have short-term capital gains (taxed at ordinary income rates), notwithstanding Section 83 or any election made under Section 83(b). It should be noted that the three-year holding period rule applies to capital gains recognized after 2017, regardless of when the taxpayer acquired the API. Section 1061(c)(2) defines the term applicable trade or business as any activity that is conducted on a regular,
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KROST QUARTERLY VOL. 2 ISSUE 3 - THE FINANCIAL SERVICES ISSUE
“NUMEROUS EFFORTS HAVE BEEN MADE DURING THE LAST TWO DECADES TO CUT BACK OR ELIMINATE THE FAVORABLE TAX TREATMENT OF CARRIED INTERESTS. ”
continuous, and substantial basis, regardless if such activity is conducted in one or more entities, and consists, in whole or in part, of: 1. Raising or returning capital; and 2. Either (A) investing in, or disposing of, specified assets, or identifying specified assets for investing or disposition, or (B) developing specified assets. Specified assets include securities, commodities, rental or investment real estate, cash, cash equivalents, options, derivative contracts, and a partnership interest to the extent of the partnership’s proportionate interest in any of the aforementioned assets. The statute does not list a non-publicly traded, closelyheld partnership interest as a specified asset. However, a partnership interest, for purposes of determining the proportionate interest of a partnership in any specified asset, includes any partnership interest that is not otherwise treated as a security, like a partnership interest that is not widely held or publicly traded. For example, if a hedge fund acquires an interest in an operating business that is operated in a non-publicly traded, closely held partnership, then that partnership interest is a specified asset for purposes of Section 1061. The carried interest rules exclude certain partnerships from the definition of an API. Specifically, an API does not include any partnership interest that is held by a corporation. Neither the statute nor the legislative history elaborates on what is meant by a corporation. However, in March 2018, the IRS issued Notice 2018-18,1 which announced that future regulations will clarify that the term corporation does not include an S corporation. Another aspect of the definition of API refers to a case where a taxpayer owns capital interest in the partnership which permits the taxpayer to share in partnership capital commensurate with (a) the amount of capital contributed, or (b) the value of such interest that was subject to tax under Section 83 upon issuance or vesting. A partnership interest will not fail to be treated as transferred or held in connection with the performance of services merely because the taxpayer made contributions to the partnership. Lastly, Section 1061(d) provides a look-through or aggregate approach in the case of the sale of an API to a related person. Under Section 1061(d), if a taxpayer transfers an API to a 1
Notice 2018-18 - Internal Revenue Service
KROST QUARTERLY VOL. 2 ISSUE 3 - THE FINANCIAL SERVICES ISSUE
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related person (as defined below), then the taxpayer is partnership is holding capital assets that do not satisfy the required to include gross income as a short-term capital gain more than three-year holding period requirement, then the the excess (if any) of: gain on the sale of the interest after more than three years would qualify for long-term capital gains treatment in spite a. the taxpayer’s net long-term capital gain of the partnership’s shorter holding period for its capital attributable to the sale of an asset held not more assets. If an API is sold after the more than three-year holding than three years as is allocable to the interest; over period requirement is satisfied, then Section 751 would apply b. any amount treated as a short-term capital gain to treat any gain on “hot assets” as ordinary income and under the general rule with respect to the transfer the balance of the gain would be long-term capital gains. of the interest. However, if the partnership is holding capital assets that do not satisfy the more than three-year holding period The related party sale rule should not result in double requirement, then the gain on the sale of the interest after counting the short-term capital gain. more than three years would qualify for long-term capital gains treatment in spite of the partnership’s shorter holding The term related party means a person related to the period for its capital assets. Although Section 1061(d) does taxpayer if: (a) such person is a member of the taxpayer’s apply a look-through concept if the partnership interest is family within the meaning of Section 318(a)(1); or (b) such sold to a related party, there does not appear to be any lookperson performed a service within the current calendar year through rule to capture any partnership assets that have less or the preceding three calendar years in any applicable trade than a three-year holding period. or business in which or for which the taxpayer performed a service. Example 1: If a partnership sells a capital asset with a holding period of two years, then the partner would typically be entitled to long-term capital gains treatment on the gain APPLICATION OF SECTION 1061 passing through on his/her Schedule K-1. But if the partner If an interest falls within the scope of an API, then gain on the is holding an API, this gain passing through would be a sale of capital assets will be recharacterized as short-term short-term capital gain regardless of whether the partner’s capital gains unless the holder satisfies the more than three- interest has satisfied the more than three-year holding period year holding period requirement. The more than three-year requirement. holding period requirement potentially applies to both the sale of the capital assets by the partnership (i.e., with respect Example 2: If a partnership sells a capital asset with a holding to gain passing through on a Schedule K-1) and the sale of period of four years, then the partner of an API would be the interest. entitled to long-term capital gains treatment on the gain passing through on the Schedule K-1, even if his/her interest If an API is sold after being held for three years or less, then had a holding period of fewer than three years. Section 751 would apply to treat any gain on “hot assets” as ordinary income (e.g., depreciation recapture, inventory The more than three-year holding period requirement or depreciable real estate held for less than a year) and the appears to apply to APIs issued prior to the enactment of balance of the gain would be treated under Section 1061 as Section 1061. short-term capital gains. Section 1061 affects many hedge funds, private equity funds, If an API is sold after the more than three-year holding period and real estate funds. While Section 1061 does not change requirement is satisfied, then Section 751 would apply to treat the basic favorable treatment of carried interests, investment any gain on “hot assets” as ordinary income and the balance fund managers need to keep Section 1061 in mind when of the gain would be long-term capital gains. However, if the structuring compensation arrangements.
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KROST QUARTERLY VOL. 2 ISSUE 3 - THE FINANCIAL SERVICES ISSUE
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Robert A. Benson, former chef and restauranteur, leads the Hospitality Industry group at KROST, serving up operations solutions for area businesses.
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