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Authored by John Leow The significant income tax benefits afforded to opportunity zone (OZ) investors create numerous gift and estate tax planning considerations. The OZ incentive allows investors to gift their interest in a qualified opportunity fund (QOF) to a grantor trust enhancing the available tax benefits, particularly in light of doubling the lifetime gift exemption that was made available to taxpayers as a result of the Tax Cuts & Jobs Act (TCJA). If lifetime gifting is warranted, this strategy maximizes the tax-deferral benefit of a QOF investment for both investors and their heirs, potentially resulting in the best combined estate and income tax outcomes. Opportunity zone benefits  The OZ incentive, created by the TCJA, is designed to stimulate new investment in designated communities. Virtually anyone with capital gains can receive federal tax benefits by investing those gains in a QOF, which in turn invests in real estate projects or operating businesses located within the more than 8,000 qualified OZs across all 50 states and U.S. territories. A QOF investment offers three potential tax benefits: First, the tax on the original capital gain is deferred and reported on the 2026 tax return, or in the year the investment in the QOF is sold, if earlier.   Second, 10% of the deferred gain is forgiven for QOF investments held for five years, and 15% is forgiven if the investment is held for seven years by Dec. 31, 2026.   Third, the tax basis of an OZ investment held at least 10 years is deemed its fair market value on sale. The result is that all taxable gain on the OZ investment is permanently eliminated, which is the most valuable attribute of the OZ incentive. Estate planning benefits Individuals generally have two different types of assets: Income in respect of a decedent (IRD) assets are generally income tax favored during a person’s lifetime, like an IRA, 401(k) account, annuity, note receivable from the sale of an asset or, now, the deferred gain portion of a QOF investment related to an OZ. Non-IRD assets are stocks, bonds, or real estate that would generate income taxed as capital gain when sold. This type of asset gets a step-up in basis if held until the owner’s death. Non-IRD assets can be gifted during a donor’s lifetime, but the donor’s income tax basis carries over to the recipient. Consequently, any unrealized gain inherent in that asset passes to the recipient. The recipient, therefore, recognizes capital gains when the asset is sold. If the asset is not gifted during the donor’s lifetime, but received by a beneficiary as the result of a transfer by will or trust, the asset gets a step-up in basis at the decedent’s death to the date of death value. However, if applicable, the estate will pay a tax on the stepped-up value of the asset. In sum, non-IRD assets are awarded favorable income tax treatment at the expense of estate taxes. IRD assets, in contrast, are given a favorable income tax treatment during the holder’s lifetime (e.g., a deferral of current recognition for any income build-up) until payments are received from the asset. Under the proposed OZ regulations, the original deferred capital gain is treated as an IRD asset.  IRD assets often cannot be gifted in a tax efficient manner because the IRS does not allow the income from the asset to be assigned to another taxpayer. In other words, the transferring of ownership during the holder’s life, even if allowed under the current law, would accelerate the recognition of income. A QOF investment generally cannot be gifted to another taxpayer without triggering immediate recognition of the original deferred gain, termed an “inclusion event.” However, a QOF investment may be gifted to a grantor trust without triggering an inclusion event.  Proper planning If an investor properly plans for the ultimate disposition of IRD assets to the next generation, the OZ income tax deferral on the original gain remains in place past the investor’s death until reported on the 2026 tax return. The regulations also clarified that the QOF can be transferred at death and the OZ tax benefits are maintained. Since there is no step-up for the original gain that was deferred until 2026, the potential for the tax-free appreciation benefit on the QOF investment remains intact.   For example, an investor that will clearly have a taxable estate could gift their QOF investment to a grantor trust, thus removing the OZ investment from their taxable estate using tax basis instead of fair market value. Upon the grantor’s death and distribution of the QOF investment from the trust, their heir(s) will assume the original tax basis of the QOF investment (no step-up on death), but the tax basis of the QOF will step-up upon disposition by the heirs, if held 10 or more years (measured from the date of the QOF investment by the grantor). Significantly, the heir receives a step-up in basis at the time the asset is sold and not at the decedent’s death. As such, the heir pays no tax on capital gains, even if the QOF interest is held and appreciates in value subsequent to the decedent’s death. Note: The deferred tax on the sale of the original asset will still be reported in 2026 (with the 10% or 15% discount, if applicable). If the grantor is living at that time, the tax can be paid with personal funds, thereby further reducing assets within their taxable estate. If the grantor dies prior to 2026, the resulting tax liability would either fall on the recipient of the QOF, if it is transferred out of the trust, or become the responsibility of the trust if it continues as the holder of the QOF. Caution: There is an instance where the transfer of QOF assets at death can become an inclusion event for purposes of federal taxes. This instance can occur if the QOF investor identified a specific amount to be provided to an heir upon the investor’s death, say $1 million. If the executor for the estate knows a QOF investment is valued at $1 million and fulfills that specific bequest by transferring that investment to the heir, the act will trigger recognition of income on that investment. Anytime an IRD asset is passed on to satisfy a bequest of a specific dollar amount, acceleration of the income is triggered. To avoid this, you can pass on the OZ related investment by name instead of making a dollar amount bequest.  Lifetime transfer planning The preferred way to handle a transfer of a QOF asset during an investor’s lifetime is a transfer into an intentionally defective grantor trust (IDGT). In this type of trust, the grantor is responsible for paying taxes on the income the trust generates, but trust assets are not counted as part of the owner's estate. With an IDGT, the value of the grantor's estate is reduced by the amount of the asset transfer into the trust. The individual can gift or make a combined gift and sale of assets to the IDGT in exchange for a promissory note of some length, such as 10 or 15 years. The note will pay enough interest to classify the note as above market, but the underlying assets are expected to appreciate at a faster rate. The beneficiaries of the IDGT will receive assets that have grown without reductions for income taxes, which the grantor has paid. If structured properly, the IDGT can be an effective estate-planning tool allowing a person to lower his or her taxable estate while gifting assets to beneficiaries at a locked-in value. The trust's grantor can also lower his or her taxable estate by paying income taxes on the trust assets, essentially gifting extra wealth to the beneficiaries. Because of the ability provided by a QOF to shelter post-acquisition appreciation from capital gains after 10 years, these investments, when coupled with an IDGT, can provide a way to layer long-term transfer tax and income tax efficiency inside a multi-generational trust. The ability to exclude post-acquisition capital gains from gross income is a powerful planning tool when coupled with a trust that is excluded from the parent’s estate because the downside to transferring assets out of parent’s estate—the loss of the stepped-up basis at death—is off-set for QOF interests held by the trust for the requisite 10 years. For example, compare a 2019 gift of $5M of partnership units with zero tax basis into an IDGT versus $5M of capital gains deployed into a QOF, which is subsequently gifted to the IDGT.  Assume further a sale of both investments in 2030 for $10M.  In the case of the partnership units, the entire $10M will be subject to capital gains tax in 2030.  In the case of the QOF, the initial $5M of deferred gain will be subject to capital gains tax on 85% of the gain in 2026.  In year 2030, upon sale, however, the remaining $5M of appreciation avoids tax entirely because of the step-up on assets held ten years in a QOF.  With the QOF investment, one avoids the tax on $5.75M of capital gains. Using a tax rate of 20%, this represents a savings of $1.15M. Neither the termination of grantor trust status when the grantor dies nor the distribution by the trust to a beneficiary after the grantor’s death results in the inclusion of the originally deferred gain. In each instance, the OZ tax deferral and the potential for tax-free appreciation continue as a benefit for the recipient. However, termination of the grantor trust status during the lifetime of the grantor would be an inclusion event triggering recognition of the original deferred gain. Conclusion An investment in a QOF may be suitable for older investors when part of a sophisticated estate planning strategy. Investors should think of the QOF investment as “patient capital” or as a “generational asset,” as the tax-free appreciation of the QOF investment is available only after a 10-year hold. Historically, non-IRD assets received a great income tax result (via step-up when the owner dies) but a poor estate tax result (because fair market value is applied for estate tax purposes, rather than tax basis). If structured properly, the QOF gives the best of both worlds. As the result of the complexity of pairing QOF investments with trust instruments, investors should rely on the guidance of both their accountants and attorneys to properly structure a QOF with a trust to provide the maximum return with the least amount of tax liability for both the investor and their heirs.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team. The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

The significant income tax benefits afforded to opportunity zone (OZ) investors create numerous gift and estate tax planning considerations. How can a qualified opportunity fund investment work into your estate planning strategy?

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As we move into the final quarter of 2019, Congress has proposed landmark legislation that would have significant impact in the areas of employee benefits and executive compensation. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 would expand opportunities to increase retirement savings by, for example, repealing the maximum age for IRA contributions, delaying the age for required minimum distributions to age 72, and requiring part-time employees to participate in their employer’s 401(k) plan. In addition, the Tax Cuts and Jobs Act enacted in December 2017 included many provisions that affect the tax treatment of executive compensation and employee benefits. With all of that said, the following topics of interest will be important for you to consider both for year-end tax planning and for 2020: 1. Health reimbursement arrangements (HRA): New HRA rules provide employers with additional flexibility in offering employee health coverage as well as more choice of coverage to employees without the previous requirement that the HRA be integrated with an employer-sponsored group health plan. This is accomplished by creating two new types of HRAs: individual coverage HRA and excepted benefit HRA. With an individual coverage HRA, HRA funds may be used to purchase individual health insurance coverage or Medicare. An employer may fund an excepted benefit HRA up to $1,800 per year to reimburse employees for excepted benefits such as dental and vision benefits.  2. Roth recharacterization: Converting a traditional IRA to a Roth IRA provides the taxpayer with the opportunity to hedge against future higher income tax rates. At the time of the conversion to the Roth IRA, the taxpayer pays income tax on the value of the account, and future increases in value would not be subject to income tax enabling the taxpayer to have tax-free withdrawals in retirement. A Roth recharacterization reverses the Roth IRA conversion. There are several reasons for doing this:  a.      The value of investments in the converted Roth IRA declined since the date of the conversion  b.      Higher-than-expected taxable income and/or the additional income from the Roth IRA conversion resulted in a bump to a higher federal income tax bracket  c.      Taxable income in retirement will likely be lower than expected, reducing the potential benefits of a Roth IRA’s tax-free distributions  d.      Not enough cash on hand to pay the taxes resulting from the conversion

A taxpayer may still make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA, however, the taxpayer cannot later unwind the conversion through a recharacterization.  3. Employer Credit for Paid Family and Medical Leave: The TCJA created a new general business tax credit for employers that voluntarily offer up to 12 weeks of paid family and medical leave annually to qualifying employees. The amount of the tax credit is 12.5% if the leave benefit amount equals 50% of normal pay. The credit increases in 0.25% intervals, up to a maximum of 25%. The credit is a specified credit that may reduce the alternative minimum tax. It is available to employers regardless of their number of employees. To qualify for this temporary credit, the employer must have a written policy and provide at least two weeks’ annual paid family and medical leave at a minimum of 50% of the employee’s wages. Unless extended by Congress, it applies only with respect to wages for an eligible family and medical leave paid in taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2020. 4. Qualified transportation fringe benefits: Qualified transportation fringe benefits include qualified parking (parking on or near the employer’s business premises, or on or near a location from which the employee commutes to work by public transit) and the associated expenses, transit passes and vanpool benefits. A for-profit employer who offers its employees qualified transportation fringe benefits as pre-tax benefits is no longer allowed a corresponding tax deduction. A tax-exempt employer who offers these benefits may have a corresponding increase in its unrelated taxable income.  5. Bicycle commuting expenses: The TCJA also suspends the $20 per month employee tax exclusion for reimbursement of bicycle commuting expenses. Therefore, employer reimbursements for bicycle commuting expenses are taxable to the employee and subject to payroll and income tax withholding. This provision is effective for amounts paid or incurred between Jan. 1, 2018, and Dec. 31, 2025. 6. Executive compensation (for-profit companies): Effective Jan. 1, 2018, the TCJA expanded the scope of the $1 million executive compensation deduction limitation. In addition to publicly traded corporations, it now applies to nonpublic companies with publicly traded debt. The covered employee group was broadened to include the CEO and CFO and the three highest-paid officers (other than the CEO or CFO), and to eliminate the last-day-of-the-year requirement. Under the new rules, once a covered employee, always a covered employee regardless of employee status or death. The TCJA also eliminated the performance-based compensation exception to the $1 million deduction limitation. However, the changes to the performance-based exception will not apply to compensation payable under a written binding contract which was in effect on Nov. 2, 2017, provided the contract is not materially modified after that date.  7. Executive compensation (tax-exempt organizations): The TCJA added a new excise tax at the corporate tax rate of 21% on excess executive compensation by applicable tax-exempt organizations as well as nonpublic companies that have public debt. The tax is applicable to remuneration paid to a covered employee that exceeds $1 million in a tax year and excess parachute payments upon separation from employment. This new law is intended to put tax-exempt organizations in the same position as publicly held companies already subject to limits on the deductibility of high compensation amounts paid to certain executives. It also puts nonpublic companies that have public debt in an equivalent situation to that of public companies. The excise tax does not apply to remuneration made to licensed medical professionals (physicians, nurses and veterinarians), but only to the extent compensation payments relate directly to performance of medical services.  8. Student loan repayments: The Student Loan Repayment Acceleration Act was recently introduced in the Senate and would exclude employer contributions to student loan repayments of up to $10,000 from an employee’s gross income. Congress is also considering the Employer Participation in Repayment Act, which would expand the employer education assistance program by permitting employers to contribute up to $5,250 tax-free to an employee’s student loans.

In 2018, the IRS approved an employer’s proposal to offer a student loan repayment program as a component of its 401(k) plan. The ruling essentially allows employees to receive the equivalent of matching contributions without electing to make their own contributions. Although the ruling is binding only for the employer that sought the ruling, it does provide welcome guidance to employers seeking to provide employees with the opportunity to save for retirement on a tax-deferred basis while repaying their student loans. Employers who wish to add this feature may want to request their own private letter ruling from the IRS, especially if the design differs from the provisions approved in the ruling. In addition, employers that use a prototype or volume submitter plan document are limited by features that may be added and may have to change to an individually designed plan until the IRS issues regulatory guidance.
 9. Expansion of multiple employer plans (MEPs): Treasury and the Department of Labor are working together to expand the use of MEPs, also known as association retirement plans. This would enable groups of smaller employers to band together to offer a retirement plan to their employees while sharing the cost and responsibility with other employers. The IRS recently issued proposed regulations that would allow the removal of a noncompliant employer without the risk of plan disqualification when one of the participating employers fails to follow the tax-qualification requirements.  10. Hardship withdrawals from retirement plans: Hardship withdrawals from 401(k) and 403(b) retirement plans no longer require the six-month prohibition on deferrals after a participant takes a hardship withdrawal. Also eliminated is the requirement that participants first take a loan from their plan account before taking a hardship withdrawal. These provisions could help an individual with a financial need continue saving for retirement without interruption as well as not having to forgo the employer matching contribution. These provisions are effective for plan years beginning on or after Jan. 1, 2019. 11. Distributions from retirement plans: A distribution from a qualified retirement plan, such as a 401(k), is taxable in the year of receipt, regardless of whether it is subsequently cashed in a later year or not cashed at all. The taxpayer’s failure to cash the distribution check has no effect on the plan administrator’s tax withholding obligation or liability for payment of that tax, nor does it alter the reporting obligation. The distribution, including the amount of the check and the amount withheld, must be reported on Form 1099-R for the year in which it was issued. 12. Rollover of retirement plan loans: Participants who have a loan outstanding at the time of plan termination or severance from employment have a longer time frame to pay the amount of an outstanding plan loan to another qualified plan or an IRA in order to accomplish a tax-free rollover of the loan amount. If the unpaid loan balance were not repaid, it would become a taxable distribution subject to the 10% additional income tax on early distributions, unless an exception applies.  13. Required minimum distributions (RMDs): Congress is considering increasing the mandatory age to begin required minimum to age 72 from age 70½.  14. FICA taxation rules for nonqualified deferred compensation: We are still seeing numerous instances where employers are not taking into account deferred compensation for FICA at the appropriate time. Pursuant to the FICA “special timing rule,” deferred compensation is required to be taken into account at the later of the time of the performance of services and at such time when there is no longer a “substantial risk of forfeiture” in entitlement to the benefit — this is usually at such time as the benefit becomes vested. This, of course, is in contrast to the Self-Employment Contributions Act (SECA) rules that generally require the deferred compensation to be taken into account upon actual or constructive receipt of the benefit. Employers should focus on making sure deferred compensation, even if not distributed, is taken into account correctly in accordance with the special timing rule in a setting that requires payment of FICA taxes. 15. Proposed regulations interpreting deferred compensation rules: In the summer of 2016, the Department of the Treasury issued proposed regulations interpreting the deferred compensation rules, which apply to tax-exempt organizations and governmental subdivisions. These proposed regulations primarily address issues attendant with the granting and administration of “ineligible plans of deferred compensation” and are slated to become effective until following such time that final regulations have been issued. As of the time of the preparation of this letter, we have seen no activity by the current administration that would suggest these regulations will be finalized anytime soon. Therefore, for the present, we are regarding these proposed regulations as an indication of the IRS’ interpretation of certain income tax issues attendant with the application of these rules and nothing more. 16. Employer-provided vehicles: The IRS issued proposed regulations aimed at assisting employers in determining the valuation of employer-provided vehicles. The proposed regulations incorporate a higher base value of $50,000 as the maximum value for use of the vehicle cents-per-mile and fleet-average valuation rules effective for the 2018 calendar year — a substantial increase from the prior limitations of $12,800 for the vehicle cents-per-mile valuation method and $16,500 for the fleet-average valuation method. This effectively increases the number of methods that can be used in calculating the noncash compensation attributable to the personal use of employer-provided vehicles. Regardless of the valuation method chosen by an employer, the only way to distinguish between employment-related business driving and personal driving is on the basis of mileage. As such, it is recommended employers require an employee maintain a contemporaneous record with detailed entries for employment-connected business usage of the auto (time, place, mileage, business purpose). 17. Retirement plans and related tax incentives, making sense of the alternatives: Forty-five years ago, Congress passed legislation making long-term savings a priority for individual taxpayers. Over the intervening years, legislation has been enacted to expand saving plans for retirement to include healthcare and education expenses, among others. The following table summarizes the available tax-deferred savings programs:
The complexity of the current system is baffling to many taxpayers. Some savings accounts have caps on permissible savings, others have phase-out thresholds based on income levels and some seem to be duplicative. Additional changes to retirement savings plans may be forthcoming as Congress considers the aforementioned SECURE Act, which would repeal the maximum age for making tax-deductible contributions to IRAs and increase the beginning age for required minimum distributions to 72 from 70½, among many other changes. Stay tuned. View more insights in the 2019 year-end tax planning letter >  Download the 2019 year-end tax planning letter > -- The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

Finally figure out how employee benefits and executive compensation were affected by tax reform? Well, hang on, because Congress is looking at new legislation that could cause another seismic shift. Check out our round up of benefits and compensation considerations for year-end and into 2020. 

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2019 year-end tax letter: employee benefits and executive compensation update

Authored by Paul Dillon and Mike Schiavo Last week, the IRS released final section 199A regulations for the 20 percent pass-through deduction enacted under the Tax Cuts and Jobs Act (TCJA). For taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026, noncorporate taxpayers (individuals, trusts and estates) may take a deduction of up to 20 percent of qualified business income (QBI) from partnerships, S corporations and sole proprietorships, plus 20 percent of qualified REIT dividends and publicly traded partnership (PTP) income. There are a number of important changes and clarifications compared to the proposed regulations, which we will address in future alerts. As part of the regulations package, the IRS also provided a safe harbor in Notice 2019-07 for rental real estate to be treated as a trade or business solely for purposes of section 199A. Key takeaways Under the safe harbor, a rental real estate enterprise will be treated as a trade or business for section 199A purposes if 250 hours per year of rental services are performed with respect to the rental enterprise. Triple net leases are specifically prohibited from using the safe harbor. Triple net leases will need to be analyzed outside of the safe harbor to determine if they are eligible for the section 199A deduction. Taxpayers can rely on the safe harbor until a final revenue procedure is issued. The safe harbor is strictly limited to the application of section 199A. Taxpayers can treat each rental real estate property as a stand-alone enterprise or group together similar properties and treat each group as an enterprise. Although the safe harbor applies solely for purposes of section 199A, clients should be reminded that treating rental properties as a trade or business may require filing Form 1099 to report rental expenses and treating mortgage interest as business interest expense subject to the new limitations on the business interest expense deduction. Safe harbor for rental real estate                                             Under the safe harbor, a “rental real estate enterprise” (defined below) will be treated as a trade or business for section 199A purposes if it meets the following requirements: separate books and records are maintained to reflect income and expenses for each rental real estate enterprise; 250 or more hours of rental services (examples below) are performed per year for tax years beginning before Jan. 1, 2023, and the taxpayer maintains contemporaneous records, including time reports, logs or similar documents regarding hours of all services performed, a description of all services performed, dates on which the services were performed and who performed the services. A rental real estate enterprise is defined as an interest in real property held to produce rents and may consist of an interest in multiple properties. The individual or relevant pass-through entity must hold the interest directly or through a disregarded entity. Taxpayers can treat each rental real estate property as a stand-alone enterprise or group together similar properties and treat each group as an enterprise. Commercial and residential real estate may not be a part of the same rental real estate enterprise. Taxpayers must be consistent with this treatment unless there is a significant change in facts and circumstances. Rental services may be performed by owners, employees, agents or independent contractors. Rental services include: advertising to rent or lease the real estate; negotiating and executing leases; verifying information contained in prospective tenant applications; collecting rent; daily operation, maintenance and repair of the property; managing the real estate; purchasing materials; and supervising employees and independent contractors. Qualifying rental services do not include financial or investment management activities such as arranging financing, procuring property, reviewing financial statements or operations reports, planning, managing or constructing long-term capital improvements or travel to and from the real estate properties. Real estate rented or leased under a triple net lease is not eligible for the safe harbor. Further, real estate used by the taxpayer as a residence for any part of the year is not eligible for the safe harbor. Disclosure requirement. In order to apply the safe harbor, a taxpayer attaches a signed statement, invoking perjury penalties, to the tax return reporting the section 199A deduction. As part of the regulations package, the IRS also provided a safe harbor in Notice 2019-07 for rental real estate to be treated as a trade or business solely for purposes of section 199A. This safe harbor requires rental real estate professionals to contemporaneously track the time spent by rental real estate professionals on rental real estate activities. Baker Tilly’s sample log can be used to identify activities that qualify for the TCJA section 199A safe harbor for rental real estate activities. Please consult your Baker Tilly tax advisor to determine how best to take advantage of this new guidance. For related insights and in-depth analysis, see our Tax Reform Resource Center. For more information on these topics, or to learn how Baker Tilly tax specialists can help, contact our team.

The IRS issued final section 199A regulations with a number of changes and clarifications, including for the rental real estate safe harbor.

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2019 year-end tax letter: employee benefits and executive compensation update

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