Category: Tax

Good News for Offshore Wind Blows in With New Guidance From the Treasury and IRS

The Inflation Reduction Act of 2022 (IRA) includes several tax credits to encourage investment in renewable energy projects, including an Investment Tax Credit (ITC) that is worth up to 30% of the overall project cost. The developer of a renewable energy project can receive a bonus of up to 10% on top of the ITC for a qualified facility that is located or placed in service in an “energy community.” One type of area that can qualify as an energy community under the IRA — the one most relevant to offshore wind projects — is an area that has significant employment or local tax revenues from fossil fuels and a higher-than-average unemployment rate.

In order to apply the criteria to offshore wind facilities, the US Department of Treasury initially proposed that an offshore wind project would be deemed to be located or placed in service at the place closest to the point of interconnection (POI) where there is land-based equipment that conditions the energy generated by the offshore wind project for transmission, distribution, or use.

Stakeholders in the offshore wind industry believed, however, that this approach did not adequately reflect the original intent of the IRA as it neglected to take into account the long-term benefits of activity related to offshore wind projects at locations, particularly ports, that were not at the POI.

Responding to stakeholder advocacy over the past several months, on March 22, the Internal Revenue Service (IRS) released updated guidance in IRS Notice 2024-30 (the Notice). The Notice permits projects with multiple POIs to qualify for the bonus credit, so long as one of the POIs is within an energy community. Stakeholders believe that this will be key in developing the shared transmission infrastructure that will be required for effective use of offshore wind energy.

Further, the Notice permits offshore wind facilities to attribute their nameplate capacity to additional property — namely, to supervisory control and data acquisition system (SCADA) equipment owned by the owner of the offshore wind project and located in an EC Project Port (as defined in the Notice). SCADA equipment is property that is used to remotely monitor and control the operations of the offshore wind project. The SCADA system is effectively the nerve center for an offshore wind project.

An “EC Project Port” is defined in the Notice as a port that is used either full or part time to facilitate maritime operations necessary for the installation or operation and maintenance of the offshore wind project, and that has a significant long-term relationship with the project’s owner by virtue of ownership or lease arrangements. The personnel based at the port need to include staff who are employed by, or who work as independent contractors for, the project’s owner and who perform functions essential to the project’s operations. Staff based at the port will be considered to perform functions essential to the project’s operations only if they collectively perform all the following functions: management of marine operations, inventory and handling of spare parts and consumables, and berthing and dispatch of operation and maintenance vessels and associated crews and technicians.

Finally, the Notice adds two industry codes from the North American Industry Classification System (NAICS) to those that are used to determine a community meets the IRA’s required percentage of its workforce who are employed in the extraction, processing, transport, or storage of coal, oil, or natural gas. These additional NAICS codes designate oil pipeline infrastructure and natural gas distribution infrastructure. These additional codes are intended to bring the benefits of the energy community bonus credit to more communities and the IRS has amended its list of energy communities accordingly.

Advocates note that the updated guidance in the Notice represents a more holistic approach to the energy communities bonus credit that will give offshore wind project developers more flexibility in identifying ports for their investment, The increased flexibility will bring the economic benefit of the offshore wind industry to more communities, which will ultimately reduce the cost burden to ratepayers.

© 2024 Jones Walker LLP
For more news on Tax Credits for Renewable Energy, visit the NLR Tax section.

Weather & Climate Risk Management Part IV: Taxation of Weather Risk Management Products

Are there differences in the way in which weather derivatives and weather insurance are taxed?

Yes. Weather insurance products, including parametric insurance, are taxed as insurance; and derivatives are taxed in accordance with the tax rules applicable to the particular type of derivative product held by the taxpayer. A business needs to carefully consider these tax differences to determine the best product or products to meet its weather risk management needs.

How is insurance taxed to a policyholder?

When a business buys weather insurance, it pays a premium to the insurance company so that the company assumes the business risks set out in the policy. Assuring the policy is purchased to manage a business’s legitimate weather-related risk, the premium is deductible under Internal Revenue Code (Code) § 162 as an ordinary and necessary business expense.

If insurance coverage is triggered and a policyholder receives a payout under the policy, the payout is not taxable up to the policyholder’s tax basis if the payment reimburses the policyholder for property damage or loss. In other words, payments under insurance policies are not taxable up to the policyholder’s tax basis because the payments simply restore (in whole or in part) the policyholder to the financial position it was in before it incurred the loss. If the reimbursement amount under the policy exceeds the policyholder’s tax basis, the amount it receives over its tax basis is treated as taxable income.[1]

Business interruption insurance covers losses (such as lost profits and ongoing expenses) from events that close or disrupt the normal functioning of the policyholder’s business. The payout amount is often based on past business results. Business interruption insurance proceeds are likely to be taxable to the policyholder because they compensate the policyholder for lost revenue.

To ensure that a policyholder receives the most favorable tax treatment, it must carefully document its business purpose for entering into the insurance, the amount of its tax basis, and receipt of the insurance proceeds.

How are derivatives taxed?

It depends on whether the taxpayer has entered into a futures contract, forward contract, option, swap, cap, or floor. The taxpayer must then consider its status in entering into each derivative: is it acting as a hedger, dealer, trader, or investor? The taxpayer must also determine whether it has made all the required tax identifications and elections. In dealing with derivatives, the taxpayer must go through this three-step process for each product it is considering. Hedgers and dealers receive ordinary income and loss on their derivative transactions, while traders and investors receive capital gain and loss.

Why might a taxpayer want to be treated as a hedger with respect to its weather derivatives?

A taxpayer seeking to use weather derivatives to manage its weather-related business risks typically wants to be treated as a tax hedger so that the gain or loss on its derivative transactions qualify as tax hedges. This would allow the taxpayer to match its derivative gains or losses with its weather-related income or losses. Because ordinary property generates ordinary income or loss, a business hedger typically wants to receive ordinary income or loss on its weather derivatives. In other words, a hedger wants to match the tax treatment it receives on its hedges with that of the items it is hedging. Many risk management transactions with respect to weather-related risks do not meet the hedge definition (see the discussed below). For a detailed discussion of the tax hedging rules, see the forthcoming Q&A with Andie, “Business Taxation of Hedging Transactions.”

What is required for a weather derivative to be treated as a tax hedge?

To qualify as a tax hedge, the transaction must manage interest rate fluctuations, currency fluctuations, or price risk with respect to ordinary property, borrowings, or ordinary obligations.[2] In addition to meeting the definition of a tax hedge, the taxpayer must comply with the identification requirements set out at Code §§ 1221(a)(7) and 1221(b)(2) and the tax accounting requirements set out at Treas. Reg. § 1.446-4.[3]

What is the tax analysis that a taxpayer should conduct to determine if its weather derivatives qualify as tax hedges?

When entering into a weather derivative, a taxpayer should conduct the following tax analysis: (1) is the transaction entered into in the ordinary course of its trade or business (2) primarily (3) to manage price risk (4) on ordinary property or obligations (5) held or to be held by the taxpayer. If the answer to all of these questions is “yes,” then the taxpayer has a qualified tax hedge if—but only if—it complies with all of the required identification rules set out in Code §§ 1221(a)(7) and 1221(b)(2) and as explained in Treasury Regulation § 1.1221-2. If the taxpayer cannot answer all of these questions with a “yes,” then the weather derivative transaction is not a tax hedge, and it is subject to the tax rules that apply to capital assets.[4] The requirement that a taxpayer must be hedging ordinary property, borrowings, or obligations means that favorable tax hedging treatment is not available for many legitimate weather risk management activities.

What types of assets, obligations, and borrowings qualify as ordinary property and ordinary obligations for purposes of the tax hedging rules?

Weather derivatives qualify as tax hedges if they can be tied to price risk with respect to ordinary assets or ordinary obligations. In many situations, however, weather derivatives are entered into to manage a taxpayer’s anticipated profitability, sales volume, plant capacity, or similar issues. These risks are not the transactions that receive tax hedge treatment.

Ordinary property includes property that if sold or exchanged by the taxpayer would not produce capital gain or loss without regard to the taxpayer’s holding period. Items included in a taxpayer’s inventory—such as natural gas or heating oil held by a dealer in those products—are treated as ordinary property that can be hedged. Qualifying hedges can also include hedges of purchases and sales of commodities for which the taxpayer is a dealer, such as electricity, natural gas, or heating oil. If a utility agrees to purchase electricity at a fixed price in the future, for example, the utility is exposed to price risk if it cannot resell the fixed-price electricity for at least the amount it paid to purchase that electricity. Accordingly, the utility could agree to sell electricity under a futures contract (short position) that would qualify as a tax hedge.

On the liability side of a business, the hedge could relate to a taxpayer’s price risk with respect to an ordinary obligation. An ordinary obligation is an obligation the performance of which (or its termination) would not produce a capital gain or loss. For example, a forward contract to sell electricity or natural gas at a fixed price entered into by a dealer is treated as an ordinary obligation. In addition, a utility that enters into a fixed price forward sales contract agreeing to sell electricity at a fixed price has an ordinary obligation to deliver electricity at that fixed price.

What sorts of weather derivative transactions are not tax hedges?

Many legitimate risk management activities do not qualify as tax hedges. Weather derivative transactions that protect overall business profitability (such as volume or revenue risk) are not directly related to ordinary property or ordinary obligations. As a result, weather derivatives entered into to protect a business’s revenue stream or its net income against volume or revenue risk are not tax hedges.

Many taxpayers in the normal course of their businesses enter into weather derivatives to manage volume or revenue risks of reduced demand for their products or services. These transactions are not tax hedges. The taxpayer is not managing a price risk (either current or anticipated) attributable to ordinary assets, borrowings, or ordinary obligations.

Take, for example, a ski resort or amusement park operator that enters into a weather derivative to protect itself against adverse weather conditions that are likely to result in a reduction in the number of skiers or amusement park visitors. The taxpayer’s risk management efforts in these cases either relate to its investment in its facility (which for the most part consists of real estate and business assets that are not taxed as ordinary assets) or to its expected revenue. Similarly, a power generator that hedges its plant capacity or its revenue stream with a weather derivative tied to the number of Cooling Degree Days would not meet the definition of a tax hedge.

Why don’t more weather derivatives qualify as tax hedges?

As part of Congress’ efforts to modernize the tax rules with respect to hedging, it specifically authorized the Treasury to issue regulations to extend the hedging definition to include other risks that the Treasury sets out in regulations.[5] The Treasury, unfortunately, has not proposed or issued any regulations extending the benefits of tax hedging. This means that weather derivative transactions entered into to manage weather-related volume or revenue risks do not qualify as tax hedges. In this situation, the taxpayer receives capital gain or loss on the derivative product.

What are some examples of weather derivatives that can qualify as tax hedges?

A weather derivative qualifies as a tax hedge if it manages the taxpayer’s price risks with respect to ordinary assets or obligations. Thus, a taxpayer entering into weather derivatives primarily to manage its price risk with respect to increased supply costs will meet the definition of a hedging transaction. Such a transaction manages the taxpayer’s price risks with respect to ordinary property.

If, for example, a commodity dealer buys a put option (or sells a call option) on a designated weather event to protect it against price risks with respect to its existing inventories or future fixed-price commitments, the dealer has entered into a qualified tax hedge, provided it meets the identification requirements.

A heating oil distributor with heating oil inventory (or forward contracts to purchase heating oil at a fixed price) might enter into a weather swap to protect itself from the risk of an unseasonably warm heating season. This swap should qualify as a tax hedge because the swap manages the distributor’s risk of a decline in the market price for its heating oil inventories (or a decline in its fixed-price forward contract purchase commitments) due to unseasonably warm weather.

If an electric utility enters into forward commitments to sell electricity at fixed prices for delivery in the summer cooling months, it may buy a call option on a designated weather event that would qualify as a tax hedge to the extent the option protects the utility against the risk of being unable to acquire or generate the electricity at a low enough price if the demand for electricity in the cooling season is higher than expected because of unseasonably warm weather resulting in higher electricity prices.

Conclusion

All organizations face weather and climate risks. As part of their enterprise-wide risk management, they have available to them a number of weather risk transfer tools. This series on weather and climate risk provides a detailed review of weather risk management. Organizations can look to standardized futures and option contracts traded on regulated commodity exchanges; they can enter into customized OTC weather derivatives designed with their specific weather risks in mind; they can put in place indemnity insurance; they can purchase parametric insurance; or they can mix and match multiple derivative products and insurance coverages to meet their specific organization’s needs. In Part I of this Q&A series on Weather & Climate Risk Management, we considered the landscape and context within which weather and climate decision making takes place, along with the overarching risk management approaches and principles that apply. In Part II, we looked at the details on the various weather risk management products. In Part III, we addressed the regulation of these products; and in Part IV, we reviewed the taxation of these various classes of products.

[1] Taxability is subject to a nonrecognition provision at Code § 1033(a) if the taxpayer complies with the requirements to purchase “qualified replacement property.” https://irc.bloombergtax.com/public/uscode/doc/irc/section_1033

[2] Treas. Reg. § 1221-2 and Code §§ 1221(a)(7) and 1221(b)(2).

[3] For a detailed discussion of the tax hedging rules see my forthcoming Q&A with Andie, “Business Taxation of Hedging Transactions” due out in Spring 2024.

[4] If the taxpayer is a dealer or a commodity derivatives dealer, the weather derivative would be an ordinary asset in the taxpayer’s hands.

[5] Code § 1221(b)(2)(A)(iii).

© 2024 ASKramer Law
For more news on the Taxation of Weather Risk Management Products, visit the NLR Environmental, Energy & Resources and Tax sections.

How Big is the Permanent Tax Benefit in the Pending Tax Bill for Research Credit?

Congress perhaps made an unintended drafting error in the Tax Cuts and Jobs Act [1] (TCJA) when it required a taxpayer to decrease its deduction for research and experimental expenditures. The apparent drafting error is in IRC §280C(c)(1), which provides that if a taxpayer’s research credit for a taxable year exceeds the amount allowable as a deduction for research expenditures for the taxable year, the amount of research expenses chargeable to capital account must be reduced by the excess and not by the full amount of the credit.

H.B. 7024 (1-17-24) [2] proposes to correct the drafting error for tax year 2023 and expressly states that the amendment made for taxable year 2023 should not be construed to create an inference with respect to the proper application of the drafting error for taxable year 2022. [3] The “no inference” congressional language could be interpreted as inviting the IRS to attempt an administrative fix of the drafting error.

Background of Research Expenditure Deduction and Credit for Increasing Research Activities: Beginning with the Internal Revenue Code of 1954, a taxpayer engaging in research activities in the experimental or laboratory sense in connection with its trade or business could elect to deduct the cost of its research currently rather than capitalizing the cost to the project for which the research was conducted. The Economic Recovery Tax Act of 1981 added a credit for the cost of research incurred in carrying on a trade or business. The manner in which the deduction and credit operated permitted a taxpayer both to deduct and credit the same research dollar.

Pre-TCJA (2017) law: The Omnibus Budget Reconciliation Act of 1989 ended the possibility deducting and crediting the same research dollar. If a taxpayer currently deducted its research expenditures, the taxpayer had to decrease its deduction by the amount of the research credit that it claimed for the taxable year.[4] The policy reason for the decrease was that a taxpayer should not be entitled to a deduction and a credit for the same dollar expended for research. Put another way, if the government “pays” for research by allowing a credit, the taxpayer did not really pay for the research and should not be entitled to deduct the amount for which the government paid.

TCJA Amendment: The TCJA now requires a taxpayer to capitalize research expenditures paid or incurred in the taxable year and claim an amortization deduction for the expenditures ratably over a five-year period.[5] The TCJA also amended IRC §280C(c)(1), the provision that prevents a taxpayer from receiving a credit and a deduction for the same dollar of research expenditure. The amendment provides that if the research credit amount for the taxable year exceeds the amount allowable as a deduction for the taxable year for qualified research expenses, the research expenses chargeable to capital account for the taxable year must be reduced by the excess.[6] This might have been a drafting error. The research credit for the taxable year might not exceed an amortization deduction for the year.[7] If for a taxable year the credit does not exceed the amortization deduction, a taxpayer could reasonably conclude that no reduction in the amount of capitalized research expenditures is required. The taxpayer would be interpreting the deduction for qualified research expenses as meaning the amount of the amortization of the capitalized expenses.

The IRS might have an opposing interpretation. The phrase, “the amount allowable as a deduction for such taxable year for qualified research expenses” in IRC §280C(c)(1) could be interpreted as always equaling zero because the TCJA amendment requiring amortization of research expenditures for the taxable year nullifies the “deduction … for qualified research expenses.” In other words, there were no “deductible” qualified research expenses for the year after enactment of the TCJA for purposes of IRC §280C(c)(1). [8] The result would be that the capitalized research expenses are decreased by the amount of the credit.

H.B. 7024: On January 31, 2024, the House passed 353 to 70 H.B. 7024, “Tax Relief for American Families and Workers Act of 2024.” Action on the bill is pending in the Senate. The bill restores the current deduction for research expenditures (but only for research performed in the United States), beginning with taxable year 2022,[9] and defers the requirement to amortize research expenditures until taxable year 2026. For taxable years beginning in 2023, the bill requires a taxpayer to decrease the research expenditure deduction for domestic research by the amount of the research credit for the year, thus reinstating, for domestic research, IRC §280C(c)(1) as it had read prior to its amendment by the TCJA. [10]

But for taxable year 2022, the bill does not expressly require a taxpayer to reduce its deduction for research expenditures by the amount of the research credit even though the bill permits the taxpayer to deduct it research expenditures currently for taxable year 2022. Thus, for taxable year 2022, a taxpayer may deduct its research expenditures but must decrease the deduction only by the amount, if any, that its 2022 research credit exceeds its 2022 deduction for qualified research expenditures, which amount may be zero. Moreover, the bill provides that the amendment requiring a decreased deduction for research expenditures for taxable years beginning in 2023 should not be construed to create “any inference” with respect to the proper application of IRC §280C(c) to taxable year 2022.

IRS Notice: In Notice 2023-63 – obviously published before H.R. 7024 – the IRS asks for comments about to interpret the current version of IRC §280C(c)(1). If H.R. 7024 is enacted, the IRS request for comments would appear irrelevant.

Taxpayer Actions: If H.R. 7024 is enacted, taxpayers must consider whether to change their accounting method for research expenditures from amortizing them to currently deducting them. A change would affect many tax calculations, and obviously the only means by which to be certain of the effect is to run the change using various scenarios through the taxpayer’s tax software.

One of the effects to consider if the bill passes is the item discussed in the alert in which the taxpayer reads IRC §280C(c)(1) advantageously for taxable year 2022 and reduces its research expenditure deduction by the amount that the research credit exceeds the deduction for research expenditures for the year, which reduction amount may well be zero. The taxpayer would have a substantial permanent tax benefit by not decreasing its credit and not decreasing it deduction.

If H.B. 7024 is not enacted, a taxpayer might moderate the risk that the IRS will prevail on the interpretation of IRC §280C(c)(1) by electing to decease its credit under IRC §280C(c)(2).[11] But the taxpayer could be more aggressive by taking the position that it is applying IRC §280C(c)(1) and rarely, if ever, does it have to reduce its deduction for research expenditures. That means that the taxpayer that had historically decreased its credit in order to take the full deduction might not have to do so. That might be a very substantial permanent tax benefit.

[1] P.L. 115-97 115th Cong. 1st Sess. (12-22-17).

[2] 118th Cong., 2d Sess.

[3] H.B. 7024, Sec. 201(e)(4).

[4] Instead of decreasing the deduction, the taxpayer could elect to decrease its research credit by multiplying the credit amount by the corporate tax rate. IRC §280C(c)(2). Regardless of whether the taxpayer reduced its deduction or its credit, the federal income tax cost was the same. Many taxpayers elect to reduce the credit so that the full amount of the deduction flows into taxable income of states that conform state taxable income to federal taxable income.

[5] IRC §174(a)(2)(B). The deduction is spread over six taxable years because the taxpayer may deduct for the first amortization year only half of a full year’s amortization. If the research is performed outside the United States, the amortization period is fifteen years.

[6] IRC §280C(c)(1).

[7] For example, assume qualified research expenses for the taxable year 2022 of $1,000 and minimum base amount of $500. The research credit is $100 (20% times $500). The credit does not exceed the amortized deduction – $100 for the first taxable year.

[8] Of course, there were qualified research expenses identified for the research credit.

[9] Proposed IRC §174A(a). A taxpayer that had capitalized and amortized its research expenditures as required by the TCJA may file an amended return for tax year 2022 and deduct research expenditures paid or incurred for that year. Alternatively, the taxpayer may elect to adjust its taxable income under IRC § 481 by taking a favorable adjustment into account in taxable year 2023. Alternatively, it may elect to make the adjustment over taxable years 2023 and 2024. H.B. 7024, sec. 201(f)(2).

[10] The taxpayer could still elect to decrease its credit in lieu of reducing its deduction.

[11] See supra note 4.

© 2024 Miller, Canfield, Paddock and Stone PLC
For more on the Research Credit Tax Bill, visit the NLR Tax section.

Staying on Course: Navigating Election Year Issues for Exempt Organizations

With the 2024 election cycle underway, it is important for exempt organizations to understand and comply with relevant restrictions on political campaign activities to safeguard their tax-exempt status and avoid triggering excise tax penalties. This alert provides an overview of the political campaign rules applicable to exempt organizations and specifically highlights the restrictions on political campaign activities applicable to Section 501(c)(3), 501(c)(4), and 501(c)(6) organizations.

Restrictions on Political Activities

Exempt organizations are subject to certain restrictions regarding their participation in political campaign activities, and the amount of permissible participation is a key distinction between Section 501(c)(3), 501(c)(4), and 501(c)(6) organizations. To comply with these restrictions, an exempt organization must (1) know their specific tax-exempt status and the restrictions that apply to them, (2) understand what activities constitute political campaign activities, (3) avoid activities that violate the applicable restrictions, and (4) mitigate the risk that activities conducted by employees in their individual capacities are attributed to the organization.

Prohibited Political Campaign Intervention for Section 501(c)(3) Organizations

Section 501(c)(3) organizations are subject to an absolute prohibition on participation or intervention in political campaign activities. Organizations that violate this ban are subject to the revocation of their tax-exempt status and the imposition of excise tax penalties on both the organization itself and organization managers who approve expenditures used for impermissible political purposes. Therefore, Section 501(c)(3) organizations must avoid activities that violate the prohibition on political campaign intervention.

Prohibited political campaign intervention occurs when an exempt organization “participates in, or intervenes in” a “candidate’s” campaign for “public office” (Section 501(c)(3)).

The term “candidate” refers to any person who has declared an intent to run for national, state, or local office and likely includes incumbents until they announce an intention not to run. A candidate also includes individuals who have yet to declare an intention to run for public office, but whose potential candidacy generates significant public speculation. The term “public office” broadly refers to any national, state, or local elective office, as well as any elected position in a political party.

An organization is considered to “participate in, or intervene in” political campaign activity by making contributions to political campaign accounts or making public statements on behalf of the organization in favor of or in opposition to a candidate for public office. Specifically, the Internal Revenue Service (IRS) regulations define participation in a political campaign as “publication or distribution of written or printed statements or the making of oral statements on behalf of or in opposition to . . . a candidate” (Treas. Reg. § 1.501(c)(3)-1(c)(3)(iii)). The IRS regulations also note that political campaign intervention is not limited to these specified activities.

The IRS has interpreted prohibited political campaign intervention to include even some nonpartisan educational activities. For example, the IRS has ruled that an organization that was formed to promote public education violated the prohibition on political campaign activities when it announced the names of the school board candidates it considered most qualified following an objective review of the candidates’ qualifications (Rev. Rul. 67-71, 1967-1 C.B. 125).

These restrictions on political campaign activities do not extend to the officers, directors, or employees of a 501(c)(3) organization, provided they are acting in their individual capacities. It is particularly important, however, to mitigate the risk that any personal political activities conducted by officers, directors, or employees will be attributed to the organization. An exempt organization should ensure their employees do not use institutional resources to engage in personal political campaign activities or act in a manner that suggests they are speaking on behalf of the organization when engaged in campaign advocacy. Exempt organizations should adopt clear policies regarding political activities and institutional resources and communicate the importance of such policies to employees during an election year.

Permissible Political Activities

Some educational activities that are election-related are permissible, however, and will not be considered prohibited campaign intervention. In order to be considered “educational,” the activities must present “a sufficiently full and fair exposition of the pertinent facts” (Treas. Reg. § 1.501(c)(3)-1(d)(3)). The information presented must “permit an individual or the public to form an independent opinion or conclusion” and not be biased. Activities that satisfy this definition may be considered permissible educational activities rather than prohibited or restricted political activities.

The following types of educational activities, although election-related, are generally permissible:

  • Voter Registration: Voter registration drives are not considered political campaign activities if they are conducted in a nonpartisan and fair manner. An organization conducting the voter registration drive should not expressly advocate for or against any candidates or political parties as part of the voter registration. They also generally should not name candidates or provide their party affiliations. If any candidates are named, all candidates should be named. All persons interested in registering must also be permitted to register, regardless of their political preference or party affiliation.
  • Voter Education: Certain forms of voter education, such as the distribution of voter guides and voting records, may qualify as an educational activity provided the organization avoids editorial commentary and ensures the materials cover a broad range of issues. Organizations must not demonstrate a preference toward a certain candidate or only cover a narrow range of issues when engaging in voter education activities.
  • Candidate Debates and Forums: Providing a fair, neutral forum for candidate debates may qualify as an educational activity so long as the debate provides equal time to all qualified candidates. Organizations should be particularly careful to include all qualified candidates, cover a broad range of topics, have a nonpartisan group compose the questions, and clarify that the candidates’ views are not the views of the exempt organization. The moderator selected by the organization can ensure the candidates follow the ground rules for the debate, but they should not ask questions or comment on the candidate’s statement in a way the indicates support or opposition to the candidate or their positions.

Section 501(c)(4) Organizations

Section 501(c)(4) social welfare organizations have more latitude to engage in political campaign activities than Section 501(c)(3) organizations. Section 501(c)(4) organizations are not subject to an absolute ban on campaign intervention, but instead are permitted to engage in some limited political activities, provided they remain primarily engaged in social welfare activities. The IRS will compare an organization’s political activities and expenditures (plus its non-exempt activities) with its social welfare activities to determine whether the organization remains primarily engaged in promoting social welfare consistent with its tax-exempt status. Accordingly, Section 501(c)(4) organizations should maintain records to ensure they remain primarily engaged in social welfare activities during an election year. If a Section 501(c)(4) organization engages in political activities, it must also provide its members with a notice of how much of their dues were used towards political activities and determine the proxy tax on those expenditures. If member dues are used for political campaign activities, then a portion of the dues may not be a deductible business expense under Section 162.

Section 501(c)(6) Organizations

Business leagues described in Section 501(c)(6) are subject to the same less-stringent rules regarding political campaign activities as Section 501(c)(4) organizations. Section 501(c)(6) organizations may engage in some political activities on a limited basis, provided such political activities are not the organization’s primary activity. If a Section 501(c)(6) organization engages in political activities, it must also provide its members with a notice of how much of their dues were used towards political activities and determine the proxy tax on those expenditures. If member dues are used for political campaign activities, then a portion of the dues may not be a deductible business expense under Section 162.

Related Restrictions

The scope of this alert is limited to restrictions on political campaign activities under federal tax law. Exempt organizations are also subject to campaign finance restrictions and requirements by the Federal Election Commission, as well as rules regarding legislative or lobbying activities imposed by the IRS, the Lobbying Disclosure Act of 1995, and other federal, state, and local laws, which are beyond the scope of this alert.

© 2024 ArentFox Schiff LLP
For more news on Restrictions for Tax-Exempt Organizations during Election Years, visit the NLR Tax section.

House Passes $78 Billion Tax Bill that Includes Affordable Housing Help

How long is something called a “crisis” before it just becomes the “new normal?” It is apparent there has been an affordable housing crisis in the United States for decades. One way that the federal government has addressed this is by motivating developers with the 9% Low Income Housing Tax Credit (the “9% LIHTC”) and the 4% Low Income Housing Tax Credit (the “4% LIHTC”) that a developer can receive for building a “qualified low-income building” described under Section 42 of the Internal Revenue Code of 1986, as amended (the “Code”).

These LIHTCs are awarded by a state government (or political subdivision thereof) to eligible participants to offset a portion of their federal tax liability in exchange for the production or preservation of affordable housing. On average, 50% of the total financing for 9% LIHTC projects comes from equity derived from the credit. Many states have used the 9% LIHTC as their primary tool to facilitate the production and rehabilitation of affordable rental housing. However, the 9% LIHTC is incredibly competitive. Each year the federal government allocates 9% LIHTC to each state on the basis of population.

The 4% LIHTC is another viable (and slightly less competitive) option. Currently, the 4% LIHTC is available for acquisition and rehabilitation of existing buildings and for new construction where 50% of the aggregate basis of the land and the building is financed with proceeds of tax-exempt bonds issued pursuant to Section 142(d) of the Code (“Affordable Housing PABs”). Unlike the 9% LIHTC, the amount of 4% LIHTC available is ostensibly unlimited; however, Affordable Housing PABs come with some strings attached, one of which is a Code Section 146 requirement to obtain an allocation of volume cap equal to the higher of the issue price or the par amount of the Affordable Housing PABs issued.

The federal government places a cap on the volume of certain types of tax-exempt private activity bonds, such as Affordable Housing PABs, that each state can issue. This limit is based on the population of the state. Each state has its own procedure for the allocation of and certification as to volume cap. Bonds that are subject to a volume cap limit are generally subject to an overall issuance limit each calendar year within each state. Each year, the IRS publishes a revenue procedure promulgating the volume cap applicable to each state. States then further apportion their allocable volume cap among various issuers and types of tax-exempt bonds that require volume cap within the state. As of March 2, 2023, the volume cap in 18 states and Washington, D.C. was oversubscribed for 2023.[1] Oversubscribed volume cap leads to competition for Affordable Housing PABs, which must be issued to receive the 4% LIHTCs to fund development for affordable housing.

After that primer, these authors can finally cut to the chase![2] On Wednesday, January 31, 2024, the U.S. House of Representatives passed a bill called the Tax Relief for American Families and Workers Act.

What Would This Legislation Do?

In addition to expanding the child tax credit and loosening restrictions on research and development tax deductions, this new legislation would (1) raise the 9% LIHTC through calendar year 2025 and (2) reduce the amount of Affordable Housing PABs needed for the 4% LIHTC from 50% of a project’s aggregate basis to 30% for a period of time.

For those keeping score at home, that is a 40% reduction in the amount of Affordable Housing PABs needed for the 4% LIHTC! If passed by the Senate, this package would be great news because it would free up bond capacity for more Affordable Housing PABs and for other tax-exempt bonds that require volume cap.[3]

But before you get too excited, note we said for a period of time and the Senate has yet to pass this legislation. How long a period? As drafted, the new legislation provides that the reduction of the Affordable Housing PABs requirement to 30% is applicable to projects, which are financed in part (at least 5% of the aggregate basis of the building and land)[4] by Affordable Housing PABs which have an issue date is in 2024 or 2025. So, the 40% reduction would be much like those endless infomercials we endured during COVID (available for a limited time only!). The reduction would be available from the date that the legislation takes effect for Affordable Housing PABs issued through December 31, 2025 (or for about a year to a year and a half). So, while this is a step in the right direction, this is not a permanent reduction in the amount of Affordable Housing PABs required to obtain the 4% LIHTC.

Recall that Congress has extended programs like this before. For example, the Qualified Zone Academy Bond program was established by the Taxpayer Relief Act of 1997 in order to promote private-sector investment in primary and secondary public education in areas with scarce public resources. Initially authorized only for 1998 and 1999, the program ended up being extended every two years right up through 2017. These types of extensions would make it a lot harder to plan yearly volume cap requests, but the new legislation is still a positive development.

The public policy and municipal bond sectors think this legislation does have a chance in the Senate, but it will likely take a while. Not surprisingly, Congress has other crises to address beyond affordable housing, including the laddered continuing resolutions funding the government that will expire on March 1and March 8. As Brian Egan, the director of government affairs for the National Association of Bond Lawyers said, this “overwhelming House vote demonstrates a momentum that the deal’s advocates will not want to squander. It also proves that members on both sides of the aisle want to get something done on tax before the end of the 118th Congress.”

Stay tuned for more on this and our expanding coverage of affordable and workforce housing in the coming weeks!

[1] https://www.novoco.com/notes-from-novogradac/population-figures-increase-multiplier-mean-record-pab-cap-2023-small-state-recipients-largely.

[2] You probably would never want to listen to the authors of this blog post tell any sort of suspenseful story. You would be here for days!

[3] Like the 25% volume cap requirement for qualified carbon dioxide capture facilities. We are all still waiting for that guidance on how to implement those provisions of the Code; we are looking at you Internal Revenue Service.

[4] Note that the new legislation also attempts to provide a transition rule for projects that already have some Affordable Housing PABs issued (but not the full 50% required prior to the enactment of this legislation) by permitting the reduced 30% requirement to be applied if at least 5 percent or more of the aggregate basis of the building and land is financed by Affordable Housing PABs with an issue date in 2024 or 2025. See the H. Rept. 118-353 – TAX RELIEF FOR AMERICAN FAMILIES AND WORKERS ACT OF 2024.

© Copyright 2024 Squire Patton Boggs (US) LLP
For more on tax bills, visit the NLR Tax section.

Three Individuals Sentenced for $3.5 Million COVID-19 Relief Fraud Scheme

Three Individuals Sentenced for $3.5 Million COVID-19 Relief Fraud Scheme

On February 6, three individuals were sentenced for fraudulently obtaining and misusing Paycheck Protection Program (PPP) loans that the US Small Business Administration (SBA) guaranteed under the Coronavirus Aid, Relief, and Economic Security (CARES) Act.

According to court documents and evidence presented at trial, in 2020 and 2021, defendants Khadijah X. Chapman, Daniel C. Labrum, and Eric J.O’Neil submitted falsified documents to financial institutions for fictitious businesses to fraudulently obtain $3.5 million in PPP loans intended for small businesses struggling with the economic impact of COVID-19. Chapman was convicted in November 2023 of bank fraud. Labrum and O’Neil pleaded guilty in 2023 to bank fraud. Following their convictions, Chapman was sentenced to three years and 10 months in prison, Labrum was sentenced to two years in prison, and O’Neil was sentenced to two years and three months in prison.

Read the US Department of Justice’s (DOJ) press release here.

False Claims Act Complaint Filed Against Former President and Co-Owner of Mobile Cardiac PET Scan Provider

The DOJ filed a complaint in the US District Court for the Southern District of Texas under the False Claims Act (FCA) against Rick Nassenstein, former president, chief financial officer, and co-owner of Illinois-based Cardiac Imaging Inc. (CII), which provides mobile cardiac positron emission tomography (PET) scans.

The complaint alleges that Nassenstein caused CII to pay excessive, above-market fees to doctors who referred patients to CII for cardiac PET scans. The government alleges that the compensation arrangements violated the Stark Law, which prohibits health care providers from billing Medicare for services referred by a physician with whom the provider has a compensation arrangement unless the arrangement meets certain statutory and regulatory requirements. Claims knowingly submitted to Medicare in violation of the Stark Law also violate the federal FCA.

The complaint alleges that CII provided cardiac PET scans on a mobile basis and paid the referring physicians, usually cardiologists, to provide physician supervision as required by Medicare rules. From at least 2017 through June 2023, Nassenstein allegedly caused CII to enter into compensation arrangements with referring cardiologists that provided for payment to the cardiologists as if they were fully occupied supervising CII’s scans, even though they were actually providing care to other patients in their offices or patients who were not even on site. CII’s fees also allegedly compensated the cardiologists for additional services the physicians did not actually provide. The complaint alleges that CII paid over $40 million in unlawful fees to physicians and submitted over 75,000 false claims to Medicare for services provided pursuant to referrals that violated the Stark Law.

The lawsuit was originally a qui tam complaint filed by a former billing manager at CII, and the United States, through the DOJ, filed a complaint in partial intervention to participate in the lawsuit.

The case, captioned US ex rel. Pinto v. Nassenstein, No. 18-cv-2674 (S.D. Tex.), follows an $85.5 million settlement in October 2023 by CII and its current owner, Sam Kancherlapalli, for claims arising from this conduct.

Read the DOJ’s press release here.

San Diego Restaurant Owner Charged with Tax and COVID-19 Relief Fraud Schemes

On February 2, a federal grand jury in San Diego returned a superseding indictment charging a California restaurant owner with wire fraud, conspiracy to commit wire fraud, tax evasion, filing false tax returns, conspiracy to defraud the United States, conspiracy to commit money laundering, and failing to file tax returns.

According to the indictment, Leronce Suel, the majority owner of Rockstar Dough LLC and Chicken Feed LLC, conspired with a business partner to underreport over $1.7 million in gross receipts on Rockstar Dough LLC’s 2020 federal corporate tax return. From March 2020 to June 2022, Suel and the business partner then allegedly used this fraudulent return to qualify for COVID-19-related loans pursuant to the PPP and Restaurant Revitalization Funding program. In connection with those loans, Suel also allegedly certified falsely that he used the loan money for payroll purposes only. The indictment alleges that Suel and his business partner laundered the fraudulently obtained funds through cash withdrawals from their business bank accounts and stashed more than $2.4 million in cash in their home.

The indictment further charges that Suel failed to report millions of dollars received in cash and personal expenses paid for by his businesses as income, in addition to reporting false depreciable assets and business losses.

If convicted, Suel faces prison sentences up to 30 years for each count of wire fraud and conspiracy to commit wire fraud, 10 years for each count of conspiracy to commit money laundering, five years for tax evasion and conspiracy to defraud the United States, three years for each count of filing false tax returns, and one year for each count of failing to file tax returns.

Read the DOJ’s press release here.

© 2024 ArentFox Schiff LLP
For more on Regulated Industries, visit the NLR Biotech, Food, Drug section.

Tax Relief for American Families and Workers Act of 2024

On January 17, 2024, Senate Finance Committee Chairman Ron Wyden (D-Ore.) and House Ways and Means Committee Chairman Jason Smith (R-Mo.) released a bill, the “Tax Relief for American Families and Workers Act of 2024” (“TRAFA” or the “bill”). All of the provisions in the bill are taxpayer favorable, except those that apply to the “employee retention tax credit”.

In short, the bill, if enacted as introduced, would:
• Allow taxpayers to deduct rather than amortize domestic research or experimental costs until 2026. Under current law, domestic research and experimental expenditures incurred after December 31, 2021 must be amortized over a 5-year period. Starting in 2026, taxpayers would once again be required to amortize those costs (as under current law) over five years (rather than deducting them immediately).
• Allow taxpayers to calculate their section 163(j) limitation on interest deductions without regard to any deduction allowable for depreciation, amortization, or depletion (i.e., as a percentage of earnings before interest, taxes, depreciation, and amortization (EBITDA) rather than earnings before interest and taxes (EBIT)) for tax years 2024-2026. This provision would generally increase the limitation and allow greater interest deductions for taxpayers subject to section 163(j).
• Retroactively extend the 100% bonus depreciation for qualified property placed in service after December 31, 2022 until January 1, 2026 (January 1, 2027, for longer production period property and certain aircraft). 100% bonus depreciation, enacted as part of the Tax Cuts and Jobs Act (the “TCJA”), expired for most property placed into service after December 31, 2022. Under existing law, bonus depreciation is generally limited to 80% for property placed into service during 2023, 60% for 2024, and 40% for 2025.
• Increase the maximum amount a taxpayer may expense of the cost of depreciable business assets under section 179 from $1.16 million in 2023 for qualifying property placed in service for the taxable year, to $1.29 million. The $1.16 million amount is reduced by the amount by which the cost of the property placed in service during the taxable year exceeds $2.89 million. Under the bill, the $2.89 amount is increased to $3.22 million. The provision applies to property placed in service in taxable years beginning after December 31, 2023.
• Effectively grant certain tax treaty benefits to residents of Taiwan, including (i) reducing the 30% withholding tax on U.S.-source interest and royalties from 30% to 10%, (ii) reducing the 30% withholding tax on U.S.-source dividends from to 15% or 10% (if the recipient owns at least 10% of the shares of stock in the payor corporation), and (iii) applying the “permanent establishment” threshold (rather than the lower “trade or business” threshold) for U.S. federal income taxation.
• Extend the qualified disaster area rules enacted in 2020 for 60 days after the date of enactment of the bill; exempt from tax certain “qualified wildfire relief payments” for tax years beginning in 2020 through 2025; exempt certain “East Palestine train derailment payments” from tax.
• Enhance the low income housing tax credit and tax-exempt bond financing rules.
• Increase the threshold for information reporting on IRS forms 1099-NEC and 1099-MISC from $600 to $1,000 for payments made on or after January 1, 2024 and increase the threshold for future years based on inflation.
• End the period for filing employee retention tax credit claims for tax years 2020 and 2021 as of January 31, 2024, and increase the penalties for aiding and abetting the understatement of a tax liability by a “COVID–ERTC promoter”.
• Increase the maximum refundable portion of the child tax credit from $1,600 in 2023 (out of the $2,000 maximum per child tax credit under current law) to $1,800 in 2023, $1,900 in 2024, and $2,000 in 2025; modify the calculation of the maximum refundable credit amount by providing that taxpayers first multiply their earned income (in excess of $2,500) by 15 percent, and then multiply that amount by the number of qualifying children (so that a taxpayer with two children would be entitled to double the amount of refundable credit); adjust the $2,000 maximum per child tax credit for inflation in 2024 and 2025; and allow taxpayers in 2024 and 2025 to use earned income from the prior taxable year to calculate their credit. These provisions would be effective for tax years 2023-2025, after which the maximum per child credit would revert to $1,000.

The bill does not increase the $10,000 limit on state and local tax deductions, or increase the $600 reporting threshold for IRS Form 1099-K (gift cards, payment apps, and online marketplaces).
The bill cleared the House Ways and Means Committee by a vote of 40 to 3 and awaits a vote by the full House (which is not expected to occur before January 29). Although the bill appears to have broad partisan support so far, the timing of final passage and enactment is uncertain.
The remainder of this blog post provides a summary of the key business provisions included in TRAFA.

Summary of Key Business Provisions
1. Retroactive extension for current deduction of domestic research or experimental costs that are paid or incurred in tax years beginning after December 31, 2021, and before January 1, 2026 under Section 174.
Under current Section 174, specified research or experimental expenditures incurred in taxable years beginning after December 31, 2021 may not be currently deducted. Instead, the expenditures must be capitalized and amortized ratably over a 5-year period (or, in the case of expenditures that are attributable to research that is conducted outside of the United States, over a 15-year period). Before the TCJA, enacted in 2021, research or experimental expenditures were generally deductible in the year in which they were incurred.
The bill proposes to allow taxpayers to deduct domestic research or experimental costs until 2026. However, foreign research or experimental expenditures would continue to be amortizable over 15 years (as under current law).
Generally, a taxpayer who had already amortized the appropriate portion of its domestic research or experimental costs incurred in the 2022 tax year but wanted to switch to deducting these costs would be able to do so by electing to treat the application of the TRAFA provision as a Section 481(a) adjustment for the 2023 tax year and the adjustment would be taken into account ratably in the 2023 and 2024 federal income tax returns.
2. Retroactive extension to allow depreciation, amortization, or depletion in determining the limitation on business interest expense deduction under Section 163(j) for taxable years beginning before January 1, 2026.
Under current section 163(j), a deduction for business interest expense is disallowed to the extent it exceeds the sum of (i) business interest income, (ii) 30% of adjusted taxable income (“ATI”), and (iii) floor plan financing interest expense in the current taxable year. Any disallowed business interest expense may be carried forward indefinitely to subsequent tax years. The interest limitation generally applies at the taxpayer level (although special rules apply in the case of partnerships and S-corporations). Furthermore, in the case of a group of affiliated corporations that file a consolidated return, the limitation applies at the consolidated tax return filing level.
For tax years beginning before January 1, 2022, the ATI of a taxpayer was computed without regard to (i) any item of income, gain, deduction, or loss that is not properly allocable to a trade or business, (ii) business interest expense and income, (iii) net operating loss deductions under section 172, (iv) deductions for qualified business income under section 199A, and (v) deductions for depreciation, amortization, or depletion (“EBITDA computation”). However, for tax years beginning on or after January 1, 2022, ATI is computed taking into account deductions for depreciation, amortization, or depletion (“EBIT computation”). The EBIT computation generally allows less interest deductions than the EBITDA computation.
The bill proposes to apply the EBITDA computation (instead of the EBIT computation) for taxable years beginning before January 1, 2026. the bill provides that this proposal generally is effective for taxable years beginning after December 31, 2023, but includes an elective transition rule, details to be provided by the Secretary of the Treasury, to allow a taxpayer to elect to apply the EBITDA computation for tax years beginning after December 31, 2021.
3. Extension of 100% bonus depreciation deduction for certain business property placed in service during the years 2023 through 2025 under Section 168(k).
A taxpayer generally must capitalize the cost of property used in a trade or business or held for the production of income and recover the cost over time through annual deductions for depreciation or amortization. Changes to section 168(k), under the TCJA, allowed an additional first-year depreciation deduction, known as bonus depreciation, of 100% of the cost of MACRS property with a depreciable life of 20 years or less, water utility property, qualified improvement property and computer software placed into service after September 27, 2017 and before January 1, 2023. Under current law, property placed in service from January 1, 2023 through December 31, 2026 qualifies for partial bonus depreciation – 80% bonus depreciation for 2023, 60% bonus depreciation for 2024, 40% bonus depreciation for 2025 and 20% bonus depreciation for 2026.
The bill proposes to extend the 100% bonus depreciation for property placed in service during the years 2023 through 2025 and to retain the 20% bonus depreciation for property placed in service in 2026.
4. Increase in limitations on expensing of depreciable business assets under Section 179 to $1.29 million and increase the phaseout threshold amount to $3.22 million.
Generally, under Section 179, a taxpayer may elect to immediately deduct the cost of qualifying property, rather than to claim depreciation deductions over time, subject to limitations discussed below. Qualifying property is generally defined as depreciable tangible personal property, off-the-shelf computer software, and qualified real property (including certain improvements (e.g., roofs, heating, and alarms systems) made to nonresidential real property after the property is first placed in service) that is purchased for use in the active conduct of a trade or business. Under current law, the maximum amount a taxpayer may expense is $1 million of the cost of qualifying property placed in service for the taxable year and the $1 million is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $2.5 million. The $1 million and $2.5 million amounts are indexed for inflation for taxable years beginning after 2018. For taxable years beginning in 2023, the total amount that may be expensed under current law is $1.16 million, and the phaseout threshold amount is $2.89 million.
The bill proposes to increase the maximum amount a taxpayer may expense to $1.29 million, reduced by the amount by which the cost of qualifying property exceeds $3.22 million, each in connection with property placed in service in taxable years beginning after December 31, 2023. The $1.29 million and $3.22 million amounts would be adjusted for inflation for taxable years beginning after 2024.
5. Adoption of the United States-Taiwan Expedited Double-Tax Relief Act, “treaty-like” relief for Taiwan residents and the United States-Taiwan Tax Agreement Authorization Act, a framework for the negotiation of a tax agreement between the President of the United States and Taiwan.
The United States does not have formal diplomatic relations with Taiwan, and therefore negotiating a tax treaty with Taiwan raises significant difficulties.
Under the bill, new section 894A would grant certain tax treaty-like benefits to qualified residents of Taiwan. A reduced rate of withholding tax would apply to interest, dividends, royalties, and certain other comparable payments from U.S. sources received by qualified residents of Taiwan. Instead of the 30% withholding tax rate generally imposed on U.S.-source income received by nonresident aliens and foreign corporations, interest and royalties would be subject to a 10% withholding tax rate and dividends would be subject to a 15% withholding tax rate (or a 10% withholding tax rate if paid to a recipient that owns at least ten percent of the shares of stock in the corporation and certain other conditions are met).
Additionally, under new section 894A, income of a qualified resident of Taiwan that is effectively connected to a U.S. trade or business would be subject to U.S. income tax only if such resident has a permanent establishment in the U.S., which is a higher threshold than the U.S. trade or business standard generally applied to non-U.S. persons under the Internal Revenue Code. Furthermore, only the taxable income effectively connected to the United States permanent establishment of a qualified resident of Taiwan would be subject to U.S. income tax.
No U.S. Tax would be imposed under section 894A on wages of qualified residents of Taiwan in connection with personal services performed in the United States and paid by a non-U.S. person.
Also, the proposal would impose general anti-abuse standards similar to those in section 894(c) to deny benefits when payments are made through hybrid entities. The proposed rules are applicable only if, and when, the Secretary of Treasury determines that reciprocal provisions apply to U.S. persons with respect to income sourced in Taiwan.
The bill also provides a framework for the negotiation of a tax agreement between the President of the United States and Taiwan. Specifically, the bill would authorize the President to negotiate and enter into one or more non-self-executing tax agreements to provide for bilateral tax relief with Taiwan beyond that provided for in proposed section 894A. Any such negotiation would only be permitted after a determination by the Secretary of the Treasury that Taiwan has provided benefits to U.S. persons that are reciprocal to the benefits provided to qualified residents of Taiwan under proposed section 894A. Furthermore, the bill would require that any provisions in such a tax agreement must conform with provisions customarily contained in U.S. bilateral income tax conventions, as exemplified by the 2016 U.S. Model Income Tax Convention, and any such tax agreement may not include elements outside the scope of the 2016 U.S. Model Income Tax Convention.
6. Changes in threshold for reporting on Forms 1099-NEC and 1099-MISC for payments by a business for services performed by an independent contractor or subcontractor and for payments of remuneration for services from $600 to $1,000 and for payments of direct sales from $5,000 to $1,000.
Under current law, a person engaged in a trade or business who makes certain payments aggregating $600 or more in any taxable year to a single recipient in the course of the trade or business is required to report those payments to the IRS. This requirement applies to fixed or determinable payments of income as well as nonemployee compensation, generally reported on Form 1099-MISC, Miscellaneous Information, or Form 1099-NEC, Nonemployee Compensation. In addition, any service recipient engaged in a trade or business and paying for services is required to file a return with the IRS when aggregate payments to a service provider equal $600 or more in a calendar year. Additionally, a seller who sells at least $5,000 in the aggregate of consumer products to a buyer for resale anywhere other than a permanent retail establishment is required to report the sale to the IRS.
The bill proposes to set the reporting threshold for the payments described in the preceding paragraph at $1,000 for a calendar year (indexed for inflation for calendar years after 2024), effective for payments made after December 31, 2023.
7. New Enforcement Provisions with Respect to COVID-Related Employee Retention Tax Credit
Under current law, an eligible employer can claim a refundable Employee-Retention Tax Credit (ERTC) against applicable employment taxes for calendar quarters in 2020 and 2021 in an amount equal to a percentage of the qualified wages with respect to each employee of such employer for such calendar quarter. The percentage is 50% of qualified wages paid after March 12, 2020, and before January 1, 2021, and 70% of qualified wages for calendar quarters beginning after December 31, 2020, and before January 1, 2022, subject to a maximum amount of wages per employee. An eligible employer may claim the ERTC on an amended employment tax return (Form 941-X) if the employer did not claim (or seeks to correct) the credit on its original employment tax return. For tax year 2020, an amended employment tax return must be filed by April 15, 2024, and for tax year 2021, by April 15, 2025.
The bill proposes to end the period for filing ERTC claims for both 2020 and 2021 as of January 31, 2024. Additionally, the bill would impose large penalties on any “COVID–ERTC promoter” who aids or abets the understatement of a tax liability or who fails to comply with certain due diligence requirements relating to the filing status and amount of certain credits. A COVID–ERTC promoter is defined as any person that provides aid, assistance or advice with respect to an affidavit, refund, claim or other document relating to an ERTC or to eligibility or to the calculation of the amount of the credit, if the person (x) charges or receives a fee based on the amount of the ERTC refund or credit, or (y) meets a gross receipts test. The proposed penalties for an ERTC promoter that aids and abets understatement of a tax liability is the greater of $200,000 ($10,000 in the case of an ERTC promoter that is a natural person) or 75% of the gross income of the ERTC promoter from providing aid, assistance, or advice with respect to a return or claim for ERTC refund or a document relating to the return or claim.
Furthermore, the bill would extend the statute of limitations period on assessment for all quarters of the ERTC to six years from the later of (1) the date on which the original return for the relevant calendar quarter is filed, (2) the date on which the return is treated as filed under present-law statute of limitations rules, or (3) the date on which the credit or refund with respect to the ERTC is made.

© 2024 Proskauer Rose LLP.
For more on Taxes, visit the NLR Tax section.

DOL Announces New Independent Contractor Rule

On January 9, 2024, the United States Department of Labor (“DOL”) announced a new rule, effective March 11, 2024, that could impact countless businesses that use independent contractors. The new rule establishes a six-factor analysis to determine whether independent contractors are deemed to be “employees” of those businesses, and thus imposes obligations on those businesses relating to those workers including:  maintaining detailed records of their compensation and hours worked; paying them regular and overtime wages; and addressing payroll withholdings and payments, such as those mandated by the Federal Insurance Contributions Act (“FICA” for Social Security and Medicare), the Federal Unemployment Tax Act (“FUTA”), and federal income tax laws. Further, workers claiming employee status under this rule may claim entitlement to coverage under the businesses’ group health insurance, 401(k), and other benefits programs.

The DOL’s new rule applies to the federal Fair Labor Standards Act (“FLSA”) which sets forth federally established standards for the protection of workers with respect to minimum wage, overtime pay, recordkeeping, and child labor. In its prefatory statement that accompanied the new rule’s publication in the Federal Register, the DOL noted that because the FLSA applies only to “employees” and not to “independent contractors,” employees misclassified as independent contractors are denied the FLSA’s “basic protections.”

Accordingly, when the new rule goes into effect on March 11, 2024, the DOL will use its new, multi-factor test to determine whether, as a matter of “economic reality,” a worker is truly in business for themself (and is, therefore, an independent contractor), or whether the worker is economically dependent on the employer for work (and is, therefore, an employee).

While the DOL advises that additional factors may be considered under appropriate circumstances, it states that the rule’s six, primary factors are: (1) whether the work performed provides the worker with an opportunity to earn profits or suffer losses depending on the worker’s managerial skill; (2) the relative investments made by the worker and the potential employer and whether those made by the worker are to grow and expand their own business; (3) the degree of permanence of the work relationship between the worker and the potential employer; (4) the nature and degree of control by the potential employer; (5) the extent to which the work performed is an integral part of the potential employer’s business; and (6) whether the worker uses specialized skills and initiative to perform the work.

In its announcement, the DOL emphasized that, unlike its earlier independent contractor test which accorded extra weight to certain factors, the new rule’s six primary factors are to be assessed equally. Nevertheless, the breadth and impreciseness of the factors’ wording, along with the fact that each factor is itself assessed through numerous sub-factors, make the rule’s application very fact-specific. For example, through a Fact Sheet the DOL recently issued for the new rule, it explains that the first factor – opportunity for profit or loss depending on managerial skill – primarily looks at whether a worker can earn profits or suffer losses through their own independent effort and decision making, which will be influenced by the presence of such factors as whether the worker: (i) determines or meaningfully negotiates their compensation; (ii) decides whether to accept or decline work or has power over work scheduling; (iii) advertises their business, or engages in other efforts to expand business or secure more work; and (iv) makes decisions as to hiring their own workers, purchasing materials, or renting space. Similar sub-factors exist with respect to the rule’s other primary factors and are explained in the DOL’s Fact Sheet.

The rule will likely face legal challenges by business groups. Further, according to the online newsletter of the U.S. Senate Health, Education, Labor and Pensions Committee, its ranking member, Senator Bill Cassidy, has indicated that he will seek to repeal the rule. Also, in the coming months, the United States Supreme Court is expected to decide two cases that could significantly weaken the regulations issued by federal agencies like the DOL’s new independent contractor rule, Loper Bright Enterprises v. Raimondo and Relentless Inc. v. U.S. Dept. of Commerce. We will continue to monitor these developments.1

In the meantime, we recommend that businesses engaging or about to engage independent contractors take heed. Incorrect worker classification exposes employers to the FLSA’s significant statutory liabilities, including back pay, liquidated damages, attorneys’ fees to prevailing plaintiffs, and in some case, fines and criminal penalties. Moreover, a finding that an independent contractor has “employee” status under the FLSA may be considered persuasive evidence of employee status under other laws, such as discrimination laws. Additionally, existing state law tests for determining employee versus independent contractor status must also be considered.

1 The DOL’s independent contractor rule is not the only new federal agency rule being challenged. On January 12, 2024, the U.S. House of Representatives voted to repeal the NLRB’s recently announced joint-employer rule, which we discussed in our Client Alert of November 10, 2023.

Eric Moreno contributed to this article.

© Copyright 2024 Sills Cummis & Gross P.C.
For more on the Independent Contractor Rule, visit the NLR Labor & Employment section.

Regulatory Update and Recent SEC Actions 2024

REGULATORY UPDATES

RECENT SEC LEADERSHIP CHANGES

Stephanie Allen Named as SEC’s Director of Media Relations and Speechwriting

The Securities and Exchange Commission (the “SEC”) announced the appointment of Stephanie Allen as director of media relations and speechwriting, effective Oct. 1, 2023. Allen served as director of speechwriting and senior adviser to the chair since March 2023, and replaces Aisha Johnson, who recently departed the agency.

Allen will serve as the primary spokesperson for the SEC and for Chair Gensler and will lead media relations for the Office of Public Affairs. Allen was previously the executive director of the Ludwig Institute for Shared Economic Prosperity. Before that, she was the director of strategic communications and marketing at Promontory Financial Group, an IBM company. After working for two senators earlier in her career, she served as Chair Gensler’s speechwriter at the Commodity Futures Trading Commission.

SEC Names Kate E. Zoladz as Regional Director of Los Angeles Office

The SEC named, on November 29, 2023, Kate Zoladz as regional director of the SEC’s Los Angeles Office. Zoladz joined the SEC in 2010 as a staff attorney in the Los Angeles office and later joined the Division of Enforcement’s Asset Management Unit in 2017. Zoladz recently served as acting co-director since June 2023 and the associate regional director for enforcement since October 2019.

Daniel Gregus, Director of the Chicago Regional Office, to Depart the SEC

The SEC announced on December 7, 2023, that Daniel R. Gregus, director of the Chicago Regional Office, would leave the agency at the end of December after more than 30 years of service. Vanessa Horton and Kathryn Pyszka are now the acting co-directors. Horton has been an associate regional director of the Investment Adviser/Investment Company (IA/IC) examination program in the Chicago Regional Office since 2020. She joined the SEC’s Chicago office in 2004 as an accountant and was later an exam manager and an assistant regional director in the Chicago IA/IC examination program. Pyszka has served as an associate regional director for enforcement in the Chicago office since 2017. She began her SEC service in 1997 as a staff attorney and later served in the positions of branch chief, senior trial counsel, and as an assistant director in the Chicago office and the Enforcement Division’s Market Abuse Unit.

SEC Risk Alerts

SEC Announces 2024 Exam Priorities

The SEC’s Division of Examinations (the “Division”) issued its report (the “Report”) on October 16, 2023, regarding exam priorities for the upcoming year concerning investment advisers, broker-dealers, self-regulatory organization, and other market participants.

According to the Report, examination priorities continue to focus on whether investment advisers are adhering to their duty of care and duty of loyalty obligations. Areas of continued focus include:

  • Investment advice provided to clients (with an emphasis on advice to older clients and those saving for retirement) with regard to products, investment strategies, and account types:
    • Complex products, such as derivatives and leveraged exchange-traded funds (“ETFs”);
    • High-cost and illiquid products, such as variable annuities and non-traded real estate investment trusts (“REITs”); and
    • Unconventional strategies, including those that purport to address rising interest rates.
  • Processes for determining that investment advice is provided in clients’ best interest, including:
    • Making initial and ongoing suitability determinations;
    • Seeking best execution;
    • Evaluating costs and risks; and
    • Identifying and addressing conflicts of interest.

Per the Report, assessments will look at the factors that advisers consider in light of the clients’ investment profiles, including investment goals and account characteristics. Examinations will review how advisers address conflicts of interest, including: (i) mitigating or eliminating the conflicts of interest, when appropriate, and (ii) allocating investments to accounts where investors have more than one account (e.g., allocating between accounts that are adviser fee-based, brokerage commission-based, and wrap fee, as well as between taxable and non-taxable accounts).

Additionally, examinations will focus on the economic incentives and conflicts of interest associated with advisers that are dually registered as broker-dealers, use affiliated firms to perform client services, and have financial professionals servicing both brokerage customers and advisory clients to identify, among other things: (i) investment advice to purchase or hold onto certain types of investments (e.g., mutual fund share classes) or invest through certain types of accounts when lower cost options are available; and (ii) investment advice regarding proprietary products and affiliated service providers that result in additional or higher fees to investors. Exams will include review of disclosures made to investors and whether they include all material facts relating to conflicts of interest associated with the investment advice sufficient to allow a client to provide informed consent to the conflict.

Specific areas of focus will include:

  • Marketing Rule and whether advisers, including advisers to private funds, have:
    • Adopted and implemented reasonably designed written policies and procedures to prevent violations of the Advisers Act and the rules thereunder including reforms to the Marketing Rule;
    • Appropriately disclosed their marketing-related information on Form ADV;
    • Maintained substantiation of their processes and other required books and records; and
    • Disseminated advertisements that include any untrue statements of a material fact, are materially misleading, or are otherwise deceptive and, as applicable, comply with the requirements for performance (including hypothetical and predecessor performance), third-party ratings, and testimonials and endorsements.
  • Compensation arrangements:
    • Fiduciary obligations of advisers to their clients, including registered investment companies, particularly with respect to the advisers’ receipt of compensation for services or other material payments made by clients and others;
    • Alternative ways that advisers try to maximize revenue, such as revenue earned on clients’ bank deposit sweep programs; and
    • Fee breakpoint calculation processes, particularly when fee billing systems are not automated.
  • Valuation assessments regarding advisers’ recommendations to clients to invest in illiquid or difficult to value assets, such as commercial real-estate or private placements.
  • Disclosure review for the accuracy and completeness of regulatory filings, including Form CRS, with a particular focus on inadequate or misleading disclosures and registration eligibility.
  • Policies and procedures with respect to:
    • Selecting and using third-party and affiliated service providers;
    • Overseeing branch offices when advisers operate from numerous or geographically dispersed offices; and
    • Obtaining informed consent from clients when advisers implement material changes to their advisory agreements.
Investment Advisers to Private Funds

According to the Report, examinations will prioritize specific topics, such as:

  • Portfolio management risks in connection with exposure to recent market volatility and higher interest rates and effects on funds experiencing poor performance, significant withdrawals, and valuation issues for private funds with more leverage and illiquid assets.
  • Adherence to contractual requirements regarding limited partnership advisory committees or similar structures (e.g., advisory boards), including adhering to any contractual notification and consent processes.
  • Accurate calculation and allocation of private fund fees and expenses (both fund-level and investment-level), including valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures, and potential offsetting of such fees and expenses.
  • Due diligence practices for consistency with policies, procedures, and disclosures, particularly with respect to private equity and venture capital fund assessments of prospective portfolio companies.
  • Conflicts, controls, and disclosures regarding private funds managed side-by-side with registered investment companies and use of affiliated service providers.
  • Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor, and the distribution of private fund audited financial statements.
  • Policies and procedures for reporting on Form PF, including upon the occurrence of certain reporting events.
Registered Investment Companies (including Mutual Funds and ETFs)

Per the Report, exam focus may include the following assessments:

  • Compliance programs and fund governance practices—review boards’ processes for assessing and approving advisory and other fund fees, particularly for funds with weaker performance relative to their peers;
  • Disclosures to investors and accuracy of reporting to the SEC;
  • Valuation practices, particularly for those addressing fair valuation practices (e.g., implementing board oversight duties, setting recordkeeping and reporting requirements, and overseeing valuation designees), and, as applicable, the effectiveness of registered investment companies’ derivatives risk management and liquidity risk management programs;
  • Fees and expenses and whether registered investment companies have adopted effective written compliance policies and procedures concerning the oversight of advisory fees and implemented any associated fee waivers and reimbursements. Areas of particular focus include:
    • Charging different advisory fees to different share classes of the same fund;
    • Identical strategies offered by the same sponsor through different distribution channels but that charge differing fee structures;
    • High advisory fees relative to peers; and
    • High registered investment company fees and expenses, particularly those of registered investment companies with weaker performance relative to their peers.
    • Examinations will also review the boards’ approval of the advisory contract and registered investment company fees.
  • Derivatives risk management and whether registered investment companies and business development companies have adopted and implemented written policies and procedures reasonably designed to prevent violations of the SEC’s fund derivatives rule (Investment Company Act of 1940 (the “Investment Company Act”) Rule 18f-4). Review of compliance with the derivatives rule may include:
    • Review of the adoption and implementation of a derivatives risk management program;
    • Board oversight, and whether disclosures concerning the registered investment companies’ or business development companies’ use of derivatives are incomplete, inaccurate, or potentially misleading; and
    • Procedures for, and oversight of, derivative valuations.

Division staff will also focus on the following areas:

  • Cybersecurity
  • Cryptocurrency assets (focus on a range of activities surrounding crypto assets and related products, including offering, selling, recommending, trading, and providing advice on such assets); and
  • Anti-Money Laundering (“AML”) programs.

Cybersecurity: With respect to cybersecurity, the Division noted that “operational disruption risks remain elevated due to the proliferation of cybersecurity attacks, firms’ dispersed operations, intense weather-related events, and geopolitical concerns.” According to the release, the examination staff will focus on firms’ policies and procedures, internal controls, governance practices, oversight of third-party vendors, and responses to “cyber-related incidents” such as ransomware attacks. Reviews will consider how firms train staff on issues including identity theft prevention and customer records and information protection. Staff will also place a particular focus on “the concentration risk associated with the use of third-party providers, including how registrants are managing this risk and the potential impact to the U.S. securities markets.”

Crypto Assets and Emerging Financial Technology: The release highlights concerns based on the continued growth and popularity of crypto assets (and their associated products and services) and the increase in automated investment tools, artificial intelligence, and trading algorithms or platforms. The Division’s goal is twofold: (1) to ensure that registrants meet their fiduciary duties when recommending or advising about crypto assets; and (2) that compliances, risk disclosures, and operational resiliency practices are routinely reviewed and updated to account for the unique challenges crypto assets provide.

For crypto assets that are funds or securities, this includes ensuring that crypto assets are complying with the custody requirements under the Investment Advisers Act of 1940 (the “Advisers Act”) and whether policies and procedures are reasonably designed, and accurate disclosures are made, relating to technological risks associated with blockchain and distributed ledger technology.

Anti-Money Laundering: The Division will continue to focus on whether broker-dealers and certain registered investment companies have proper AML programs as required by the Bank Secrecy Act. Specifically, the Division will examine whether broker-dealers and investment companies are appropriately tailoring AML programs, conducting independent testing, establishing an adequate customer identification program, and meeting their filing obligations.

SEC Rulemaking

SEC Adopts Amendments to Rules Governing Beneficial Ownership Reporting

The SEC adopted rule amendments governing beneficial ownership reporting under Sections 13(d) and 13(g) of the Securities Exchange Act of 1934 (the “Exchange Act”) on October 10, 2023, requiring market participants to provide more timely information on their positions.

Exchange Act Sections 13(d) and 13(g), along with Regulation 13D-G, require an investor who beneficially owns more than five percent of a covered class of equity securities to publicly file either a Schedule 13D or a Schedule 13G, as applicable. An investor with control intent files Schedule 13D, while “Exempt Investors” and investors without a control intent, such as “Qualified Institutional Investors” and “Passive Investors,” file Schedule 13G.

The adopted amendments (among other things): i) shorten the deadline for initial Schedule 13D filings from 10 days to five business days and require that Schedule 13D amendments be filed within two business days; ii) generally accelerate the filing deadlines for Schedule 13G beneficial ownership reports (the filing deadlines differ based on the type of filer); iii) clarify the Schedule 13D disclosure requirements with respect to derivative securities; and iv) require that Schedule 13D and 13G filings be made using a structured, machine-readable data language.

In addition, the adopting release provides guidance regarding the current legal standard governing when two or more persons may be considered a group for the purposes of determining whether the beneficial ownership threshold has been met, as well as how, under the current beneficial ownership reporting rules, an investor’s use of certain cash-settled derivative securities may result in the person being treated as a beneficial owner of the class of the reference equity securities.

The amendments were published in the Federal Register on November 7, 2023, effective on February 5, 2024. Compliance with the revised Schedule 13G filing deadlines will be required beginning on September 30, 2024. Compliance with the structured data requirement for Schedules 13D and 13G will be required on December 18, 2024. Compliance with the other rule amendments will be required upon their effectiveness.

“Today’s adoption updates rules that first went into effect more than 50 years ago. Frankly, these deadlines from half a century ago feel antiquated,” said SEC Chair Gary Gensler. “In our fast-paced markets, it shouldn’t take 10 days for the public to learn about an attempt to change or influence control of a public company. I am pleased to support this adoption because it updates Schedules 13D and 13G reporting requirements for modern markets, ensures investors receive material information in a timely way, and reduces information asymmetries.”

SEC Adopts Rule to Increase Transparency in the Securities Lending Market

The SEC adopted on October 13, 2023, new Rule 10c-1a, which will require certain persons to report information about securities loans to a registered national securities association (“RNSA”) and require RNSAs to make publicly available certain information that they receive regarding those lending transactions. According to the SEC, the rule is intended to increase transparency and efficiency of the securities lending market.

Rule 10c-1a will require certain confidential information to be reported to an RNSA to enhance the RNSA’s oversight and enforcement functions. The new rule requires that an RNSA make certain information it receives, along with daily information pertaining to the aggregate transaction activity and distribution of loan rates for each reportable security, available to the public. The Financial Industry Regulatory Authority (“FINRA”) is currently the only RNSA.

The adopting release was published in the Federal Register on November 3, 2023. The compliance dates for the new rule are as follows: (1) an RNSA is required to propose rules within four months of the effective date; (2) the proposed RNSA rules are required to be effective no later than 12 months after the effective date; (3) covered persons are required to report information required by the rule to an RNSA starting on the first business day 24 months after the effective date; and (4) RNSAs are required to publicly report information within 90 calendar days of the reporting date.

SEC Adopts Rule to Increase Transparency Into Short Selling and Amendment to CAT NMS Plan for Purposes of Short Sale Data Collection

The SEC adopted, on October 13, 2023, new Rule 13f-2 to provide greater transparency to investors and other market participants by increasing the public availability of short sale related data. Specifically, Rule 13f-2 will require institutional investment managers that meet or exceed certain thresholds to report on Form SHO specified short position data and short activity data for equity securities. The Commission will aggregate the resulting data by security, thereby maintaining the confidentiality of the reporting managers, and publicly disseminate the aggregated data via EDGAR on a delayed basis. This new data will supplement the short sale data that is currently publicly available.

Relatedly, the Commission also adopted an amendment to the National Market System Plan (“NMS Plan”) governing the consolidated audit trail (“CAT”). The amendment to the NMS Plan governing the CAT (“CAT NMS Plan”) will require each CAT reporting firm that is reporting short sales to indicate when it is asserting use of the bona fide market making exception in Rule 203(b)(2)(iii) of Regulation SHO.

The adopting release for Rule 13f-2 and related Form SHO, as well as the notice of the amendment to the CAT NMS Plan, was published in the Federal Register on November 1, 2023. The final rule, Form SHO, and the amendment to the CAT NMS Plan will become effective 60 days after publication of the adopting release in the Federal Register. The compliance date for Rule 13f-2 and Form SHO will be 12 months after the effective date of the adopting release, with public aggregated reporting to follow three months later, and the compliance date for the amendment to the CAT NMS Plan will be 18 months after the effective date of the adopting release.

Clearing Agency Governance and Conflicts of Interest

On November 16, 2023, the SEC adopted Rule 17Ad-25 and related rules under the Exchange Act to improve clearing agency governance to mitigate conflicts of interest that may influence the board of directors or equivalent governing body of a registered clearing agency. The rules identify certain responsibilities of the board of a clearing agency, increase transparency into board governance, and, more generally, improve the alignment of incentives among owners and participants of a registered clearing agency. The rules establish new requirements for board and committee composition, independent directors, management of conflicts of interest, and board oversight.

The adopted rules:

  1. Define independence in the context of a director serving on the board of a registered clearing agency and require that a majority of the board—or 34 percent—be independent directors;
  2. Establish independent director requirements for the compensation of certain other board committees and identify circumstances that would preclude a director from being an independent director;
  3. Require a clearing agency to establish a nominating committee and a written evaluation process for evaluating board nominees and the independence of nominees and directors and specify requirements with respect to its composition, director fitness standards, and documentation of the outcome of the written eval practice;
  4. Require a clearing agency to establish a risk management committee, specify requirements with respect to the committees’ purpose and composition, and include an annual re-evaluation of such composition;
  5. Require policies and procedures for the management of risks from relationships with service providers for core services that directly support the delivery of clearance or settlement functionality or any other purpose material to the business of the registered clearing agency, with delineated roles for senior management and the board; and
  6. Require policies and procedures for the board to solicit, consider, and document its consideration of the views of participants and other relevant stakeholders regarding material developments in the registered clearing agency’s risk management and operations.

The final rule was published in the Federal Register on December 5, 2023, with an expected compliance 12 months after such publication for all requirements except for the independence requirement for the board and board committees, for which the compliance date is 24 months after publication.

SEC Defends Voting Disclosure Changes Before Fifth Circuit

In July of 2022, the SEC adopted amendments to its rules governing proxy voting advice. Specifically, the rule requires mutual funds, ETFs and certain other registered funds to disclose more information about how they cast votes on behalf of investors. (See Blank Rome’s Investment Management Regulatory Update dated October 2022, “SEC Adopts Amendments to Proxy Rules Governing Proxy Voting Advice,” for further discussion). The rule is set to become effective July 1, 2024.

Since passing the rule, four states (Texas, Louisiana, Utah, and West Virginia) have challenged the SEC’s authority to require fund managers to disclose additional information about votes they cast. Their argument to the Fifth Circuit is that the real purpose of the voting disclosure change is to empower corporate activities rather than the investing public. The SEC maintains, however, that the amendments fall within its authority under the Investment Company Act and that the SEC reasonably concluded that the changes would facilitate investors’ ability to access information important to investment decisions and mitigate conflicts of interest.

SEC Adopts Rule to Prohibit Conflicts of Interest in Certain Securitizations

On November 27, 2023, the SEC adopted Dodd-Frank rules against trader conflicts. Securities Act Rule 192 implements Section 27B of the Securities Act of 1933 (the “Securities Act”), a provision added by the Dodd-Frank Act. The Rule seeks to prevent the sale of asset-backed securities (“ABS”) that pose a material conflict of interest. Specifically, it prohibits a securitization participant, for a period of time, from engaging, directly or indirectly, in any transaction that would involve or result in any material conflict of interest between the participant and an investor in the relevant ABS. Rule 192 provides exceptions for risk-mitigating hedging activities, liquidity commitments, and bona fide market-making activities of a securitization participant.

Under new Rule 192, conflicted transactions include a short sale of the relevant ABS, the purchase of a credit default swap or other credit derivative that entitles the securitization participant to receive payments upon the occurrence of specified credit events in respect of the ABS, or a transaction that is substantially the economic equivalent of the aforementioned transactions, other than any transaction that only hedges general interest rate or currency exchange risk.

SEC Adopts Rules to Improve Risk Management in Clearance and Settlement and Facilitate Additional Central Clearing for the U.S. Treasury Market

The SEC adopted rules on December 13, 2023, to enhance risk management practices for central counterparties in the U.S. Treasury market and facilitate additional clearing of U.S. Treasury securities transactions. The rule changes update the membership standards required of covered clearing agencies for the U.S. Treasury market with respect to a member’s clearance and settlement of specified secondary market transactions. Additional rule changes are designed to reduce the risks faced by a clearing agency and incentivize and facilitate additional central clearing in the U.S. Treasury market.

According to the release, the amendments require that covered clearing agencies in the U.S. Treasury market adopt policies and procedures designed to require their members to submit for clearing certain specified secondary market transactions. These transactions include: (i) all repurchase and reverse repurchase agreements collateralized by U.S. Treasury securities entered into by a member of the covered clearing agency, unless the counterparty is a state or local government or another clearing organization or the repurchase agreement is an inter-affiliate transaction; (ii) all purchase and sale transactions entered into by a member of the clearing agency that is an interdealer broker; and (iii) all purchase and sale transactions entered into between a clearing agency member and either a registered broker-dealer, a government securities broker, or a government securities dealer.

Further, the amendments permit broker-dealers to include customer margin required and on deposit at a clearing agency in the U.S. Treasury market as a debit in the customer reserve formula, subject to certain conditions. In addition, the amendments require covered clearing agencies in this market to collect and calculate margin for house and customer transactions separately. Finally, the amendments require policies and procedures designed to ensure that the covered clearing agency has appropriate means to facilitate access to clearing, including for indirect participants. The amendments also include an exemption for transactions in which the counterparty is a central bank, sovereign entity, international financial institution, or natural person.

ENFORCEMENT ACTIONS AND CASES

SEC Charges Investment Adviser with Failing to Properly Disclose Investments by Publicly Traded Fund

The SEC charged an investment adviser, on October 24, 2023, for failing to accurately describe investments in the entertainment industry that comprised a significant portion of a publicly traded fund it advised. The investment adviser settled the charges and agreed to pay a $2.5 million penalty.

According to the SEC’s order, from 2015 to 2019, one of the investment adviser’s trusts made significant investments, through a lending facility, in Aviron Group, LLC, a company that developed print and advertising plans for one to two films per year. According to the SEC’s order, the investment advisor inaccurately described Aviron as a “Diversified Financial Services” company in many of the trust’s annual and semi-annual reports. In addition, according to the order, the investment adviser stated that Aviron paid a higher interest rate than was actually the case, and in 2019, the investment adviser identified these inaccuracies and the trust accurately reported the Aviron investment in reports going forward.

Per the SEC’s order, the investment adviser willfully violated fraud-based disclosure prohibitions under Section 34(b) of the Investment Company Act and Section 206(4) of the Advisers Act and related Rule 206(4)-8. Without admitting or denying the SEC’s findings, the investment adviser agreed to a cease-and-desist order and a censure in addition to a monetary penalty.

Previously, in 2022, the SEC charged and then resolved its action against William Sadleir, the founder of Aviron, for misappropriating the trust’s funds invested in Aviron.

“Retail and institutional investors rely on accurate disclosures of the companies that make up a closed-end or mutual fund’s portfolio to evaluate a current or prospective investment in the fund,” said Andrew Dean, co-chief of the Enforcement Division’s Asset Management Unit. “Investment advisers have a responsibility to provide this vital information, and [the adviser here] failed to do so with the Aviron investment.”

SEC Charges President/CCO of Asset Management Advisory Firm with Fraud

The SEC charged a president and chief compliance officer of registered investment adviser, Prophecy Asset Management LP (“Prophecy”), on November 2, 2023, for his involvement in a multi-year fraud that concealed losses of hundreds of millions of dollars from investors.

Prophecy advised multiple hedge funds and reported more than $500 million in assets under management. The SEC’s complaint alleged that the president and Prophecy misled the funds’ investors, auditors, and administrator about the funds’ trading practices, risk, and performance—all while collecting more than $15 million in fees.

According to the SEC’s complaint, the president led investors to believe that their investments were protected from loss, telling them the funds’ capital was shared among dozens of sub-advisers who traded in liquid securities and posted cash collateral to offset any trading losses they incurred. However, the SEC alleged that in reality, most of the funds’ capital went to one sub-adviser, who incurred massive trading losses that far exceeded the cash collateral he had contributed. In addition, the complaint alleged that the president caused the funds to invest in highly illiquid investments, which also resulted in substantial losses to the funds, concealed these losses by fabricating documents and engaging in a series of sham transactions, and deceived investors about the diversification and trading strategies in two other funds. The complaint pleads by 2020, after losses in funds that Prophecy managed amounted to more than $350 million, the president and Prophecy indefinitely suspended redemptions by investors.

The SEC’s complaint charged the president with violations of Section 17(a) of the Securities Act, Rule 10b-5, Section 206(1) and (2) of the Advisers Act, and Rule 206(4)-8 of the Advisers Act.

SEC Announces Enforcement Results for FY23

The SEC announced on November 14, 2023, its enforcement results for fiscal year 2023. The SEC filed 784 total enforcement actions in fiscal year 2023, a three percent increase over fiscal year 2022. These included 501 original, or “stand-alone,” enforcement actions, an eight percent increase over the prior fiscal year; 162 “follow-on” administrative proceedings seeking to bar or suspend individuals from certain functions in the securities markets based on criminal convictions, civil injunctions, or other orders; and 121 actions against issuers who were allegedly delinquent in making required filings with the SEC.

The stand-alone enforcement actions ranged from billion-dollar frauds to emerging market investments involving crypto asset securities and cybersecurity. The pool of charged individuals or entities included a diverse array of market participants from public companies and investment firms to gatekeepers (such as auditors and lawyers) to social media influencers. Notably, fiscal year 2023 was record-breaking for the SEC’s Whistleblower Program with awards totaling nearly $600 million and more than 18,000 whistleblower tips, which is nearly 50 percent more tips than in the previous fiscal year.

In total, the SEC obtained orders for $4.949 billion in financial remedies, second only to the record-setting $6.439 billion in fiscal year 2022. Of this $4.949 billion, $3.369 billion was obtained in disgorgement and prejudgment interests and $1.580 billion in civil penalties. The SEC also obtained orders barring 133 individuals from serving as officers and directors of public companies, the highest number of bars obtained in a decade.

Crypto Currency Exchange Agrees to pay $4.3 Billion in Fines for Violations of the Bank Secrecy Act

On November 21, 2023, the largest Crypto Currency Exchange (the “Exchange”) in the world agreed to pay a historic $4.3 billion fine for failing to register as a money-transmitting business and allowing users to evade U.S. sanctions against Iran. The Exchange’s founder pled guilty to failing to maintain an effective anti-money laundering program in violation of the Bank Secrecy Act. This agreement marks the end of the Department of Justice’s yearlong investigation over alleged money laundering, bank fraud, and sanctions violations.

The Exchange also agreed to pay several other penalties to resolve enforcement actions by the CFTC and Treasury Department. Under the CFTC’s proposed orders, the Exchange will pay $2.7 billion, the founder will pay $150 million, and former CCO will pay $1.5 million for ignoring potential money launder and terrorists financing on its platform and for failing to register with the CFTC.

Additionally, the FinCEN settlement will require the Exchange to pay $3.4 billion in civil money penalty and will be subject to a five-year monitorship. Office of Foreign Assets Control will require the Exchange to pay a $968 million penalty. The Treasury will also retain access to the company’s books, records, and systems for the five-year monitorship.

SEC Charges Real Estate Fund Adviser with $35 Million Fraud

The SEC filed a complaint in the U.S. District Court for District of Arizona, on November 28, 2023, charging an adviser, his investment company, and related entities controlled by the adviser with violating the antifraud provisions of the federal securities laws.

The SEC alleged that the adviser misappropriated more than $35 million from private real estate funds and other investment vehicles by using a substantial portion of the funds to pay for his family members’ personal expenses and to fund private jets, yachts, and expensive residences. Further, the adviser issued a press release from another wholly owned LLC that stated the company’s intention to purchase 51 percent of all minority shares in an unrelated public company, at $9 a share, more than nine times the company’s then-current trading price. The shares jumped over 150 percent in after-hours trading shortly after the press release was issued. The adviser had purchased more than 72,000 call options in the company at a price far below the stock price in the days leading up to the press release, hoping to exercise the options at a profit after manipulating the stock price.

Global Bank and Affiliated Entities to Pay $10 Million for Providing Prohibited Mutual Fund Services

The SEC announced, on December 13, 2023, that a global bank and two affiliated entities (“Entities”) agreed to pay $10 million to settle the SEC’s charges that they provided prohibited underwriting and advising services to mutual funds.

In October 2022, the Superior Court of New Jersey entered a consent order that resolved a case alleging that the Entities violated the antifraud provisions of the New Jersey securities laws in connection with its role as underwriter to residential mortgage-backed securities. According to the SEC’s order, the global bank and its affiliates were prohibited from serving as a principal underwriter or investment adviser to mutual funds or employees’ securities companies pursuant to the Investment Company Act unless an exemptive order was received. The SEC order found, however, that the Entities continued serving in these prohibited roles until the SEC granted them time-limited exemptions on June 7, 2023. Without admitting or denying the SEC’s findings, the Entities agreed to pay more than $6.7 million in disgorgement and prejudgment interest and civil penalties totaling $3.3 million.

“Today’s action holds the [Entities] accountable for not complying with eligibility requirements,” said Corey Schuster, Asset Management Unit co-chief. “This action reinforces the need for entities to properly monitor for events that may cause disqualification and proactively seek and obtain waivers from the Commission before becoming disqualified, or refrain from performing prohibited services.”

BarnBridge DAO Agrees to Stop Unregistered Offer and Sale of Structured Finance Crypto Product

The SEC announced on December 22, 2023, that BarnBridge DAO (“BarnBridge”), a purportedly decentralized autonomous organization, and its two founders will pay more than $1.7 million to settle charges that they failed to register BarnBridge’s offer and sale of structured crypto asset securities known as SMART Yield bonds. The SEC also charged the respondents with violations stemming from operating BarnBridge’s SMART Yield pools as unregistered investment companies.

According to the SEC’s orders, the respondents compared the SMART Yield bonds to asset-backed securities and marketed them broadly to the public. Investors could purchase “Senior” or “Junior” SMART Yield bonds through BarnBridge’s website application. SMART Yield pooled crypto assets deposited by the investors and used those assets to generate fixed or variable returns to pay investors. A BarnBridge white paper, published by one of the founders, claimed that SMART Yield bonds would “mirror the safety and security of highly rated debt instruments offered by traditional finance…while still providing the outsized return” through its smart contract protocols. According to the orders, SMART Yield attracted more than $509 million in investments from investors, and BarnBridge was paid fees by the investors based on the size of their investment and their choice of yield.

To settle the SEC’s charges, BarnBridge agreed to disgorge nearly $1.5 million of proceeds from the sales, and its two founders each agreed to pay $125,000 in civil penalties.

Without admitting or denying the SEC’s findings, BarnBridge and its two founders agreed to cease-and-desist orders prohibiting them from violating and causing violations of the registration provisions of the Securities Act and the Investment Company Act. The SEC orders referenced remedial actions initiated by the founders.

SEC BuyBack Disclosure Rule Vacated by Appeals Court

The Fifth U.S. Circuit Court of Appeals in New Orleans, on December 19, 2023, granted a motion filed by business groups to vacate the SEC’s new rule that required companies to provide timelier disclosures on stock buybacks. Prior to this ruling, on October 31, 2023, the court found that the SEC “acted arbitrarily and capriciously” and in so doing violated the Administrative Procedure Act by failing to conduct a proper cost-benefit analysis when drafting the rule. The SEC was given 30 days to “correct the defects in the rule” but did not file a new draft. On December 7, 2023, business groups filed a motion for the court to vacate the rule.

The SEC’s finalized rule in May 2023 required companies to disclose daily stock buyback information either quarterly or semiannually to include the number of shares repurchased each day and the average price paid on that day. In addition, the rule required companies to indicate whether certain directors or officers traded the relevant securities within four days before or after public announcement of an issuer’s buyback plan or program.

© 2023 Blank Rome LLP
For more on SEC regulations, visit the NLR Securities & SEC section.

Blazing Trails: Exploring ESOPs in the Cannabis Industry

The budding cannabis industry, despite its rapid growth and gradual acceptance in recent years, still faces a major sustainability challenge: Cannabis businesses cannot deduct most ordinary business expenses. Under Internal Revenue Code Section 280E, no tax deduction or credit is allowed for amounts paid or incurred in carrying on a business if the business consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act) that are prohibited by federal law or the law of any state in which such trade or business is conducted. Since marijuana is a controlled substance, cannabis businesses face a particularly high tax burden. In this context, employee stock ownership plans (ESOPs) emerge as a strategic solution, offering a pathway for cannabis businesses to enhance their cash flows while also retaining and motivating their workforce.

UNDERSTANDING ESOPS

ESOPs are a type of tax-qualified retirement plan with assets held in a tax-exempt trust. If an ESOP is established for an S corporation and acquires all of the stock of the corporation, the ESOP will not be subject to federal income tax (or state income taxes in most states). With an S corporation, any income tax obligation passes through to the shareholder, and, in this case, the shareholder is a tax-exempt entity. ESOPs also provide a way for the owners to obtain liquidity, and they enable employees to become beneficial owners of the company. This is ordinarily achieved through the allocation of company shares to participants over the course of the repayment of a loan that finances the sale.

THE TAXING REALITY OF CODE SECTION 280E

Code Section 280E was initially introduced in the 1980s to prohibit businesses engaged in illegal drug trafficking from deducting ordinary business expenses. Despite the changing legal landscape of cannabis, with numerous states legalizing its use for medical and recreational purposes, Section 280E continues to prohibit federal tax deductions and credits for the business expenses of cannabis companies, including items such as rent and salaries. However, such businesses are generally permitted to deduct the cost of goods sold.

MITIGATING TAX LIABILITY

A 100% ESOP-owned S corporation in the cannabis industry holds a unique advantage in mitigating tax liability. Unlike traditional corporate structures, an ESOP-owned S corporation does not pay federal income tax, does not pay state income tax (in most states), and, perhaps most significantly, is not affected by the Code Section 280E restrictions on deductions and credits. Accordingly, the ESOP structure eliminates a significant expense for many cannabis companies and increases cash flow, allowing the company to reinvest its earnings into the business. This increase in resources can be used for any number of expenses, from growth and development of the business to repayment of its debts.

CONCLUSION

Although the cannabis industry is subject to a significant disadvantage under Code Section 280E with respect to tax deductions and credits, an ESOP offers an alternative that entirely mitigates this disadvantage. Furthermore, the ESOP provides liquidity for the selling shareholders and the opportunity to create an ownership culture among employees who will benefit from participating in a tax-qualified retirement plan.

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© 2023 Bradley Arant Boult Cummings LLP
For more news on ESOPs in the Cannabis Industry, visit the NLR Biotech, Food, Drug section.