Tags: Tax

Year-End Planning for the Solar Energy Investment Tax Credit

Solar energy is a popular choice for businesses looking to reduce their carbon footprint through alternative energy sources. In addition to supporting a company’s environmental, social and governance (ESG) strategy, converting to solar energy can potentially lock-in lower energy rates. Further, Section 48 of the Internal Revenue Code provides businesses that invest in solar energy a 26% Investment Tax Credit (ITC) on qualifying solar property placed in service before January 1, 2026 — but only if construction begins on the property before January 1, 2023. Otherwise, the credit is phased down to as low as 10%.

The IRS has provided special rules to determine when construction begins on solar energy property for ITC purposes. Businesses seeking to maximize the available tax credits should consider beginning solar projects before the end of 2022 to be able to take advantage of the 26% ITC rate.

Phasedown of ITC for Solar Energy Property

Under current rules, the ITC percentage for qualifying solar energy property is determined based on when construction begins, and the credit is taken in the year the qualifying property is placed in service.

For property placed in service prior to January 1, 2026, the credit is as follows:

  • 26%, if construction begins after December 31, 2019, and prior to January 1, 2023;
  • 22%, if construction begins after December 31, 2022, and prior to January 1, 2024; or
  • 10%, if construction begins after December 31, 2023.

For property placed in service after December 31, 2025, the credit is 10% regardless of when construction begins. Unused credits may be carried back one year and carried forward 20 years.

Insight

The Biden Administration has indicated its support of clean energy incentives. While the Build Back Better proposals approved by the U.S. House of Representatives in 2021 would have modified the ITC and extended the credit to qualifying solar projects for which construction begins before 2027, the legislation was not passed by the Senate. Therefore, the above phasedown of the credit remains in force. Solar energy developers and businesses planning to invest in solar energy projects should continue to monitor potential legislative developments in this area.

Determining When Construction Begins

The IRS issued Notice 2018-59 to provide specific guidance on when construction begins for purposes of determining the solar ITC percentage. The notice provides two methods a taxpayer can use to establish when construction begins: (i) the physical work test, or (ii) the 5% safe harbor. Both methods include a continuity requirement.

Physical Work Test

Construction begins under the physical work test when the taxpayer begins physical work of a significant nature on the project. The analysis is based on the nature of the work performed — not the amount or cost of the work — with no minimum requirements. Physical work can occur on-site or off-site and includes, for example, manufacturing components, inverters, transformers or other power conditioning equipment. The notice clarifies that physical work does not include preliminary activities (as defined) or work to produce components of energy property that are included in existing inventory or that are typically held in inventory by a vendor. 

Five Percent Safe Harbor

Under the 5% safe harbor, construction begins when the taxpayer pays or incurs 5% or more of the total cost of the solar energy property. Whether a cost has been incurred for this purpose is based on the taxpayer’s method of accounting. The notice provides special rules for solar energy projects consisting of multiple qualifying properties.    

Continuity Requirement

Both the physical work test and the 5% safe harbor include a continuity requirement, under which the taxpayer must show continuous progress toward completing the project. This means maintaining a continuous program of construction under the physical work test and satisfying a continuous efforts test under the 5% safe harbor. Whether the continuity requirement is satisfied under either method is determined based on the relevant facts and circumstances.

Notice 2018-59 also provides a continuity safe harbor, which allows solar projects to satisfy the continuity requirement if the project is placed in service by the end of the calendar year that is no more than four calendar years after the year construction began. In response to the pandemic and associated supply chain issues, the IRS issued Notice 2021-14 to extend the continuity safe harbor to six years for projects for which construction began during calendar year 2016, 2017, 2018 or 2019 and to five years for projects where construction began in 2020.

Insight

Solar energy developers and businesses investing in solar energy projects are on a tight timeline to determine whether they want to begin construction on projects in their pipeline before the end of 2022 to be able to take advantage of the 26% ITC rate. Given the persistence of supply chain and workforce issues and the potential rush to begin construction prior to the end of the year, taxpayers should keep in mind that contractors and equipment may not be available or could be difficult to secure in time to meet the year-end beginning of construction deadline. In addition, supply chain and inventory issues may drive cost increases and thus cost overruns that must be considered when analyzing when construction begins using the 5% safe harbor.


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    Tags: Tax

    4 Tips for Working with a Resource-Constrained Internal Revenue Service

    Federal tax professionals working to resolve issues with the IRS can attest to the multifaceted impacts of the agency’s resource constraints on taxpayer service. The signs are evident, for example, in the long wait times for calls to be answered, tax return processing delays and increased instances of penalties being assessed against compliant taxpayers. Perhaps most frustratingly, IRS examinations that could have been resolved cooperatively with an adequately staffed agency have become unnecessarily prolonged and, in some cases, contentious.

    The optimists among us see that the process of reform to address these issues has begun with a slow refunding of the IRS. However, it could take years of IRS hiring and training for the organization to manage the full scope of its responsibilities. What do we do while we wait?

    The following are some suggested best practices for dealing with the IRS in the current environment.

    1. Closely monitor your IRS accounts

    The IRS’s most recent filing season was challenging. Even some taxpayers that electronically filed have since discovered that their returns were improperly recorded in the IRS’s system, resulting in incorrect taxable income or net operating loss carryforwards.

    IRS input errors can have significant negative consequences for compliant taxpayers. For taxpayers that remitted the proper amount of income tax (i.e., the income tax liability reported on their return), an IRS input error that results in a higher recorded income tax liability could lead to the improper assessment of late payment penalties. Worse yet, if the IRS input error results in a lower recorded income tax liability, the IRS may refund a taxpayer’s “excess” payment. If the taxpayer inadvertently accepts the refund (by, for example, depositing the refund check), the IRS will assess underpayment interest from the day it sent the refund until the day the taxpayer pays it back.

    IRS input errors can also negatively impact taxpayers that overpaid their current year tax liability and elected to have the excess amount credited to the subsequent tax year. If the input error increases the taxpayer’s current year tax liability, the IRS will credit a lower amount, potentially triggering penalties for late payment in the subsequent year.

    The errors that begin with an IRS input mistake and end with penalty and interest assessments can be caught early by taxpayers that actively monitor their IRS accounts. Specifically, taxpayers that establish access to the IRS’s eServices via the IRS website are able to track most activity on their tax accounts, confirm the IRS has accurately recorded their tax filings and ensure the IRS has not sent any erroneous refund checks. Tax advisors can also easily monitor their clients’ tax accounts with a properly executed Form 2848, Power of Attorney.

    2. Monitor the status of your IRS correspondence

    It generally takes months for the IRS to respond to taxpayer correspondence. The IRS is similarly slow in processing amended tax returns, including amended returns that report a claim for refund. Due to the processing delays, the National Taxpayer Advocate’s office recently announced it had “made the difficult decision to suspend accepting cases where the sole issue involves the processing of amended returns until the IRS is able to work through its backlog.”

    The IRS is also having difficulty keeping track of, or is simply unable to answer, many taxpayer communications. As a general rule, if the IRS has not responded to a taxpayer within eight to ten weeks of initial contact, it is important for the taxpayer to follow up with a phone call to the IRS to determine whether the IRS is taking steps to resolve the taxpayer’s issue. IRS call center representatives can often see notes on the taxpayer’s account that clarify what (if any) action the IRS has taken.

    Although taxpayers may attempt this follow-up call to the IRS themselves, their tax advisors will likely have more efficient lines of communication via the IRS’s Practitioner Priority Service hotline, which is only available to appointed taxpayer representatives.

    3. Avoid paper communication with the IRS whenever possible

    The IRS’s ongoing battle with its paper backlog has been front-page news since the onset of the pandemic. However, despite its efforts to hire and retain employees, the IRS continues to struggle — now promising in a highly optimistic announcement that the backlog will be clear “by the end of calendar year 2022.”

    Although no form of IRS communication may be quick or easy right now, the IRS is generally processing electronic communications, such as electronic filings and faxes, much more quickly than paper communications. Therefore, taxpayers should consider electronic methods of communicating with the IRS whenever possible. If the IRS offers electronic filing of any tax form, whether through a third-party IRS-authorized e-file provider or via a simple fax submission, taxpayers should consider taking advantage of these simple, electronic transmissions. Not only is the IRS processing electronically filed tax forms more quickly than paper filings, it is also typically making fewer mistakes when inputting electronic returns in its systems, thus mitigating the risk of erroneous civil penalties and interest.

    In addition, taxpayers that retain and carefully store their IRS transmission receipts are much better prepared to show proof of filing, for example, if the IRS’s records do not show the taxpayer’s communication was received.

    4. Document and retain every important IRS communication

    The IRS processing centers are not the only area of the agency currently struggling with customer service. Unfortunately, some IRS examination teams appear not to be performing the same comprehensive reviews that used to allow cases to close without the IRS Office of Appeals or tax litigation, which may lead to unnecessary assessments. Examination teams may also be slow to make progress on taxpayers’ cases, then request months-long statute extensions so they have sufficient time to finish their work. These types of examination strategies are also tied to IRS resource constraints – namely, insufficient resources to keep the IRS examination train rolling along efficiently.

    Taxpayers can mitigate these types of examination experiences by being proactive and documenting every important communication with the IRS. Every response to an IRS inquiry and communication with an IRS examiner should be clearly dated, printed to PDF and saved in a safe file. In addition, every important conversation with an IRS examiner should be documented via email—e.g., “Dear IRS Agent, please confirm my understanding of the following discussion we had today ….” It is very important to clearly record and save all important interactions with the IRS, as the simplest of IRS examinations can turn quickly when dealing with the agency’s resource constraints. A taxpayer’s documentation of common understandings and examination delays is now critical to establishing a thorough defense if the case must go to Appeals or litigation.  

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      Tags: Tax

      Standard Mileage Rate Increased for Business Travel

      In recognition of recent fuel price increases, depreciation, insurance, and other costs, the IRS recently announced a special adjustment to the standard mileage rate for the remainder of 2022.

      The optional standard mileage rate, used to calculate the deductible costs of automobile operation for business or other purposes, is now 62.5 cents per mile for business travel, up 4 cents from the beginning of the year. 

      The new rate only applies to travel from July 1 through December 31, 2022. Taxpayers should use the previous 58.5 cents per mile for all business travel from January 1 through June 30, 2022.

      The rate for deductible medical or moving expenses (for active-duty military members) also increased from 18 to 22 cents for the remainder of the year. The rate for charitable organizations remained 14 cents per mile.

      For more information about the increased rates, visit https://www.irs.gov/newsroom/irs-increases-mileage-rate-for-remainder-of-2022.

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        Tags: Tax

        When Interest Rates Rise, Optimizing Tax Accounting Methods Can Drive Cash Savings

        U.S. businesses have been hit by the perfect storm. As the pandemic continues to disrupt supply chains and plague much of the global economy, the war in Europe further complicates the landscape, disrupting major supplies of energy and other commodities. In the U.S., price inflation has accelerated the Federal Reserve’s plans to raise interest rates and commence quantitative tightening, making debt more expensive. The stock market has declined sharply, and the prospect of a recession is on the rise. Further, U.S. consumer demand may be cooling despite a strong labor market and low unemployment. As a result of these and other pressures, many businesses are rethinking their supply chains and countries of operation as they also search for opportunities to free up or preserve cash in the face of uncertain headwinds.

        Enter income tax accounting methods.

        Adopting or changing income tax accounting methods can provide taxpayers opportunities for timing the recognition of items of taxable income and expense, which determines when cash is needed to pay tax liabilities.

        In general, accounting methods either result in the acceleration or deferral of an item or items of taxable income or deductible expense, but they don’t alter the total amount of income or expense that is recognized during the lifetime of a business. As interest rates rise and debt becomes more expensive, many businesses want to preserve their cash, and one way to do this is to defer their tax liabilities through their choice of accounting methods.

        Some of the more common accounting methods to consider center around the following:
        • Advance payments. Taxpayers may be able to defer recognizing advance payments as taxable income for one year instead of paying the tax when the payments are received.
        • Prepaid and accrued expenses. Some prepaid expenses can be deducted when paid instead of being capitalized. Some accrued expenses can be deducted in the year of accrual as long as they are paid within a certain period of time after year end.
        • Costs incurred to acquire or build certain tangible property. Qualifying costs may be deducted in full in the current year instead of being capitalized and amortized over an extended period. Absent an extension, under current law, the 100% deduction is scheduled to decrease by 20% per year beginning in 2023. 
        • Inventory capitalization. Taxpayers can optimize uniform capitalization methods for direct and indirect costs of inventory, including using or changing to various simplified and non-simplified methods and making certain elections to reduce administrative burden.
        • Inventory valuation. Taxpayers can optimize inventory valuation methods. For example, adopting to (or making changes within) the last-in, first-out (LIFO) method of valuing inventory generally will result in higher cost of goods sold deductions when costs are increasing.
        • Structured lease arrangements. Options exist to maximize tax cash flow related to certain lease arrangements, for example, for taxpayers evaluating a sale vs. lease transaction or structuring a lease arrangement with deferred or advance rents.
        Insights

        ​While an individual accounting method may or may not materially impact the cash flow of a company, the impact can be magnified as more favorable accounting methods are adopted. Taxpayers should consider engaging in accounting methods planning as part of any acquisition due diligence as well as part of their regular cash flow planning activities. 

        Optimizing tax accounting methods can be a great option for businesses that need cash to make investments in property, people and technology as they address supply chain disruptions, tight labor markets and evolving business and consumer landscapes. Moreover, many of the investments that businesses make are ripe for accounting methods opportunities — such as full expensing of capital expenditures in new plant and property to reposition supply chains closer to operations or determining the treatment of investments in new technology enhancements. For prepared businesses looking to weather the storm, revisiting their tax accounting methods could free up cash for a period of years, which would be useful in the event of a recession that might diminish sales and squeeze profit margins before businesses are able to right-size costs.

        Example

        The estimated impact of an accounting method is typically measured by multiplying the deferred or accelerated amount of income or expense by the marginal tax rate of the business or its investors.

        For example, assume a business is subject to a marginal tax rate of 30%, considering all of the jurisdictions in which it operates. If the business qualifies and elects to defer the recognition of $10 million of advance payments, this will result in the deferral of $3 million of tax. Although that $3 million may become payable in the following taxable year, if another $10 million of advance payments are received in the following year the business would again be able to defer $3 million of tax.

        Continuing this pattern of deferral from one year to the next would not only preserve cash but, due to the time value of money, potentially generate savings in the form of forgone interest expense on debt that the business either didn’t need to borrow or was able to pay down with the freed-up cash. This opportunity becomes increasingly more valuable with rising interest rates, as the ability to pay significant portions of the eventual liability from the accumulation of forgone interest expense can materialize over a relatively short period of time, i.e., the time value of money increases as interest rates rise.

        Accounting Method Changes

        Generally, taxpayers wanting to change a tax accounting method must file a Form 3115 Application for Change in Accounting Method with the IRS under one of two procedures:

        • The “automatic” change procedure, which requires the taxpayer to file the Form 3115 with the IRS as well as attach the form to the federal tax return for the year of change; or
        • The “nonautomatic” change procedure, which requires advance IRS consent. The Form 3115 for nonautomatic changes must be filed during the year of change.

        In addition, certain planning opportunities may be implemented without a Form 3115 by analyzing the underlying facts.

        What Can Businesses Do Now?

        Taxpayers should keep in mind that tax accounting method changes falling under the automatic change procedure can still be made for the 2021 tax year with the 2021 federal return and can be filed currently for the 2022 tax year.

        Nonautomatic procedure change requests for the 2022 tax year are recommended to be filed with the IRS as early as possible before year end to give the IRS sufficient time to review and approve the request by the time the federal income tax return is to be filed.

        Engaging in discussions now is the key to successful planning for the current taxable year and beyond. Whether a Form 3115 application is necessary or whether the underlying facts can be addressed to unlock the accounting methods opportunity, the options are best addressed in advance to ensure that a quality and holistic roadmap is designed. Analyzing the opportunity to deploy accounting methods for cash savings begins with a discussion and review of a business’s existing accounting methods.

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          Tags: Tax

          Recent Court Decision Reaffirms Importance of Adequately Documenting Deductible Management Fees

          In October 2021, the Internal Revenue Service (IRS) formally launched the Large Partnership Compliance (LPC) Pilot Program. The LPC program represents a focused effort on the part of the U.S. Treasury Department and IRS to improve partnership compliance. Not surprisingly, we are beginning to see an uptick in the number of partnerships under IRS exam.

          One area of focus for these examinations that the IRS has identified is the deductibility of management fees paid by portfolio companies to their private equity fund owners. Although not specifically dealing with private equity funds, a recently decided case nonetheless highlights the relevant issues and presents a cautionary tale for funds and their portfolio companies when structuring these arrangements. Moreover, the court’s decision provides an implicit documentation and substantiation framework for taxpayers looking to enter into similar management fee arrangements.

          In the case, Aspro, Inc. v. Commissioner, issued April 26,  the U.S. Court of Appeals for the Eight Circuit upheld a Tax Court holding that recast a corporation’s deductible “management fees” as disguised dividends. Although the taxpayer argued that at least a portion of the fees were reasonably deductible business expenses, the circuit court agreed with the lower court that the taxpayer failed to demonstrate that any portion of the amounts paid was reasonable compensation for services provided.

          ‘Management fees’ paid to owners but no dividends

          The taxpayer, Aspro, is an Iowa-based C corporation in the asphalt-paving business. During the years at issue, 2012–2014, it had three shareholders – two were corporations and one was an individual, who was also the president of the company. Over a twenty-year period, Aspro consistently paid its shareholders “management fees” purporting to be for services provided in connection with the overall management and growth of the business. During this same period, and despite the company’s profitability, Aspro paid no dividends.  

          Aspro initially sought to deduct the management fees in the three years at issue, but the IRS denied the deductions, contending they were, in fact, profit distributions. The Tax Court agreed with the IRS that the claimed management fees were not deductible as ordinary and necessary business expenses, concluding that Aspro failed, “to connect the dots between the services performed and the management fees it paid.” Instead, the court held that the payments were disguised, non-deductible earnings distributions. In reaching its decision, the Tax Court considered whether the management fees were purely for services (Payment for Services Requirement) and whether the payments were reasonable in nature and amount (Reasonableness Requirement).

          Failure to establish deductibility of fees

          With respect to the Payment for Services Requirement, the Tax Court concluded that the evidence presented indicated a disguised distribution rather than a deductible expense. The Tax Court based its conclusion on the following considerations:

          1. Despite its annual profitability, Aspro made no distributions to its shareholders but paid management fees each year.
          2. The management fee payments roughly corresponded with the shareholder’s ownership interests.
          3. The management fees were paid as lump sums at the end of each year rather than over the course of the year as the purported services were performed.
          4. The managements fee deductions eliminated virtually all of Aspro’s taxable income.
          5. The process of setting management fees was unstructured and had little, if any, relation to the services performed.

          In addition, the Tax Court concluded that Aspro failed to satisfy the Reasonableness Requirement. Aspro failed to provide documentation supporting the existence of a service relationship between the parties. At a most basic level, there were no written management service agreements. In addition, there was no documentation outlining the cost or value of any purported service, and no bills or invoices were provided in connection with the purported management services. Additionally, Aspro failed to provide evidence showing how the amount of the management fees was determined.

          To establish that the fees were actually paid for valuable services performed, Aspro offered two expert witnesses – a contractor in the taxpayer’s industry and an accountant. However, the Tax Court excluded both witnesses, concluding that neither provided expert knowledge based on scientific methods.  Instead, the court believed that each witness merely offered their personal opinions based on their familiarity with the industry and the taxpayer. The circuit court agreed that these exclusions were reasonable.

          In deciding the whether the amount of management fees paid by Aspro was reflective of reasonable compensation for the services performed, the Court considered both an independent investor standard and a multi-factor standard. An independent investor standard evaluates the fee arrangement on the basis of whether an independent investor earning returns after deduction of the management fees would view the quantum of fees as reasonable; a multi-factor standard looks to various criteria such as the nature of work performed and the prevailing rates of compensation for non-shareholders providing similar services to similar businesses. Under both standards, the court noted that the management fee arrangement breached the reasonable compensation threshold, and, thus, Aspro failed to satisfy the Reasonableness Requirement.

          Insights

          The IRS is increasing its audit of large partnerships and is increasingly scrutinizing the validity and deductibility of management fee arrangements. The Aspro case offers a warning to taxpayers, including private equity and venture capital funds seeking to establish similar arrangements with their portfolio companies. But perhaps more importantly, this case provides a roadmap for taxpayers to follow when structuring and documenting these arrangements. Proper documentation and support, including transfer-pricing work done to support the quantum of the fees to be charged pursuant to such an arrangement, is an essential element of sound tax planning in this regard.

          The circuit court’s opinion makes clear that the substantiation of such management fees arrangements requires taxpayers to satisfy the Payment for Services Requirement and the Reasonableness Requirement. To satisfy these requirements, taxpayers should base the economic terms of any such arrangement on some sort of scientific method that transcends mere industry knowledge. Moreover, even in circumstances where the level of management fees is demonstrably reasonable in light of the services provided, failure to adequately document the arrangements will leave taxpayers vulnerable to losing their deductions.

          Written by David Newberry, Justin Follis and Veranda Graham. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com.


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            Tags: Tax

            Debt Refinancing Transactions – Tax Issues and Opportunities

            Debt is an important component of a company’s capital structure since it creates leverage to fund growth without the need to raise capital for every expansion. Although interest rates continue to be historically low, concerns about increasing interest rates have caused many companies to consider refinancing existing indebtedness to “lock-in” current rates.

            When undertaking or contemplating any debt refinancing transactions during the tax year, companies should carefully consider the potential tax implications. Transactions that result in a “significant modification” of the debt under applicable regulations can have disparate tax consequences depending on the specific circumstances.

            Insights

            The U.S. federal income tax treatment of debt refinancing transactions is highly fact-specific and requires careful analysis. Certain refinancing transactions may be treated as a taxable retirement of the existing (refinanced) debt, which may give rise to the ability to write-off any unamortized debt issuance costs and original issue discount, the latter as “repurchase premium.”  However, in certain situations a refinancing transaction may also give rise to taxable ordinary income in the form of “cancellation of indebtedness income.”

            Debt Modifications – Generally

            The tax consequences of a debt refinancing transaction hinge in part on whether the transaction results in a “significant modification” of the debt under rules set out in Treas. Reg. § 1.1001-3. In the case of a significant modification, the materiality of the changes from the modification results in a deemed retirement of the existing debt in exchange for a newly issued debt instrument.

            As a threshold matter, a modification includes not only a change to the terms of an existing debt instrument but would also include an exchange of an old debt instrument for a new one or the retirement of an existing debt instrument using the proceeds of a new debt instrument. Stated differently – it is the substance, not the form, that governs whether debt has been modified for federal income tax purposes.

            Whether a modification of a debt instrument constitutes a significant modification depends on the materiality of the changes. The regulations provide a general “economic significance” rule and several specific rules for testing whether a modification is significant. In practice, most debt modifications are covered by two specific rules governing changes in the yield to maturity of a debt instrument (the change in yield test) and deferrals of scheduled payments (the deferral test).

            Under the change in yield test, a modification will be significant if the yield of the modified debt instrument varies from the yield of the unmodified debt instrument by more than the greater of 25 basis points (i.e., 1/4 of 1%) or 5% of the unmodified yield. The regulations include specific rules for making this determination. However, it is important to observe that a number of changes to a debt instrument may cause a change in the yield. Examples include changes to the interest rate, deferral (or acceleration) of scheduled payments, and payment of a modification or consent fee in connection with the modification. It is not uncommon for a modification with only a minor (or no) change to the stated interest rate to result in a significant modification due to changes in the yield to maturity that result from the payment of modification fees or changes to the due dates for certain payments. This issue is often overlooked. 

            Under the deferral test, a modification will be significant if it results in a material deferral of scheduled payments. Notably, the deferral test does not define what constitutes a material deferral (though it does provide guidance on the factors to be considered), but instead provides a deferral safe harbor. Under the deferral safe harbor, a modification to defer payments will not be significant as long as all deferred payments are unconditionally payable by the end of the safe harbor period. The safe harbor period begins on the due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years or 50% of the original term (e.g., the deferral safe harbor for a five-year debt instrument would be two and a half years).

            In applying both the change in yield test and the deferral test, taxpayers are required to consider the cumulative effect of the current modification with any prior modifications (or, in the case of a change in yield, modifications occurring in the past five years). This cumulative rule is particularly noteworthy for taxpayers who routinely modify their indebtedness (and often incur modification fees in connection with the modification), as the results of certain modifications may not be significant when viewed in isolation but may be significant when combined with prior modifications.

            Tax Implications of Debt Modifications

            A significant modification results in the deemed retirement of the existing debt instrument in exchange for a newly issued debt instrument. The existing debt instrument will be deemed retired for an amount equal to the “issue price” of the newly issued debt instrument, together with any additional consideration paid to the lenders as consideration for the modification.

            The issue price of a debt instrument depends on whether the debt instrument was issued for cash or property. If a significant amount (generally 10%) of the debt was issued for money, the issue price will be the cash purchase price. Otherwise, assuming the debt instrument is in excess of $100 million, the issue price will be its fair market value (or the fair market value of the property for which it was issued) if it is “publicly traded.” In all other cases, the issue price of the debt instrument will generally be its stated principal amount.

            If the issue price of the modified debt instrument (i.e., the repurchase price) is less than the tax adjusted issue price of the old debt instrument, a borrower will incur cancellation of indebtedness income, which is generally taxed as ordinary income. If instead the repurchase price exceeds the adjusted issue price (this may occur when the old debt instrument had unamortized original issue discount or where the debt is publicly traded and has a fair market value in excess of its face amount), the borrower will incur a “repurchase premium.” Repurchase premium is deductible as interest expense. Special rules apply to determine whether such repurchase premium is currently deductible or is instead amortized over the term of the newly issued debt instrument.

            The retirement of an existing debt instrument may also give rise to the ability to deduct any unamortized debt issuance costs. As a general matter, the determination of whether any unamortized debt issuance costs should be written off or carried over and amortized over the term of the new debt instrument generally follows the same analysis as repurchase premium. Notably, debt issuance costs are deducted as ordinary business expenses under section 162, and therefore are not subject to the limitation on business interest expense deductions under section 163(j).

            Finally, a significant modification may give rise to a number of additional tax implications that companies should consider, including the potential for foreign currency gain or loss and the need to “mark-to-market” existing tax hedging transactions.

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              Tags: Tax

              Navigating the Intersection of Tax & ESG

              Although tax credits as subsidies have been a cornerstone catalyst for advancing many ESG policies and technologies over the last several years, tax is often forgotten or minimized in the process of creating and implementing corporate ESG and value creation strategies. Ignoring the symbiotic relationship between tax and ESG is a losing strategy, given increased awareness of the importance of tax transparency among shareholders and other stakeholders as a mechanism for holding companies accountable to their stated ESG commitments. A rise in media and rating agency reports on the topic indicate tax will continue to be under scrutiny in the future and may increasingly have significant corporate reputational impacts as well.

              As leaders of an organization’s tax function, including as vice presidents of tax, tax directors, or CFOs among others, you are the stewards charged with ensuring tax strategy and operations appropriately intersect with the corporate ESG vision and meaningfully advance ESG commitments. However, the 2022 BDO Tax Outlook Survey found that while an overwhelming majority of senior tax executives expressed an understanding of the value of ESG, three quarters of those responsible for tax were not currently involved in the organization’s ESG strategy. The findings indicate that tax leaders will need to insert the tax function into the ESG planning and execution process and take ownership of tax’s role in ESG. Insights from the survey outline how tax fits into ESG, the core principles of an ESG-focused tax strategy and key considerations for transparent reporting.

              How does tax overlap with ESG?

              Because there is some misunderstanding about how tax relates to environmental, social and governance issues, there is a high probability that tax may not be incorporated in responsible business strategy and planning. While not reflected in the ESG acronym, there is an element of tax that is central to each of these principles. For example, environmental behavioral taxes and incentives, such as carbon taxes on greenhouse gas emissions and tax incentives for green energy adoption, are crucial to driving behavior change toward more sustainable practices in the near term while many impacts of climate change are still experienced in indirect ways. In terms of the social element, taxes are a key mechanism for companies to contribute to the societies in which they operate and to build trust among members of the public as a responsible corporate actor. Finally, proper tax governance can ensure that there is appropriate oversight over an organization’s tax strategy and decisions, ensuring they align with overarching business objectives and stakeholder communications around tax reporting.

              Using the Tax ESG Cipher to Unlock a Successful ESG-Driven Tax Strategy

              Aligning the tax function with an overarching ESG strategy across the business is a heavy lift. To build and implement a responsible tax program will take time and requires careful consideration of an organization’s overall approach to tax, tax governance and total tax contribution. Each company will have a unique tax strategy based on its business and stakeholder considerations and may be at varying points along its responsible tax journey. Whether you are just beginning or at the stage of reassessing your approach based on changing market conditions, updates to your ESG strategy, or regulations, the cypher below can be used to guide these critical considerations and help ensure tax is meaningfully incorporated in ESG strategy. The process should be iterative over time and when implemented successfully, will drive improved decision-making on risk mitigation, strengthen risk awareness and increase transparency and accountability.     

              Core Principle 1: Approach to Tax

              The first step to meaningfully incorporating tax in ESG strategy is understanding and articulating the purpose and values that guide the tax function. This process includes defining the organization’s approach to regulatory compliance and the interaction with tax authorities. Writing a tax policy and strategy is an important way to articulate the company’s tax priorities and educate all team members across the organization about the function’s principles. The statement may include commitments to communicate transparently with regulators and disclose more information than required by law in some cases, for example.

              As the organization evolves due to changes in the industry, overall ESG commitments and sustainability strategies, the tax strategy statement should be updated accordingly. Regulatory changes will also necessitate continuous assessment and consideration of whether the strategy meets the current understandings of transparency, risk mitigation and accountability based on new information. Through this set of guiding principles, the tax function can help improve decision-making and reporting actions to align with changes in the broader corporate ESG strategy, purpose and values.

              Core Principle 2: Tax Governance and Risk Management

              Establishing a robust governance, control and risk management framework provides comfort and assurance that the reported approach to tax and tax strategy is well embedded in an organization’s substantiable business strategy and that there are mechanisms in place to effectively monitor its compliance obligations.

              However, it’s important to remember that tax governance and risk management have broad considerations that go beyond the traditional frameworks governing internal controls over financial reporting (ICFR). A common pitfall for many is a narrow focus on governance strategies. Generally, ICFR focuses on accurate and complete reporting in financial statements. While this is an important area of governance, it does not account for or represent the many objectives included in a tax ESG control framework, which is typically broader as it focuses on how and why decisions regarding tax approaches and positions are made.

              The objective of this core principle is to demonstrate to stakeholders how the organization’s tax governance, control and risk management frameworks function are in alignment with the values and principles outlined in the Approach to Tax statement. This can include establishing a risk advisory council, guidelines for including tax in ESG reporting deliverables and any corresponding regulatory requirements, and communications to relevant stakeholders on executive oversight activities related to the tax strategy. 

              However, many organizations have not taken the time to document and define their risk mitigation and executive oversight strategy. Often this is left merely to control procedures that are mechanical and regulatory in nature. Instead, a tax governance and risk management strategy should aim to establish a framework focused on strengthening risk awareness and transparently communicating governance activities to both internal and external audiences when appropriate.

              Core Principle 3: Total Tax Contribution

              While quantifying and providing necessary qualitative context around an organization’s total tax contribution is not an easy task, today, stakeholders from employees and customers to investors and regulators expect transparency around tax strategies, tax-related risks, total tax contribution and country-by-country activities. Recently, tax has received increased scrutiny from these stakeholders because it is a core component of many ESG metrics used to evaluate a business’s tax behaviors and ensure there is accountability across its tax practices. The result is that how a company shares tax information with stakeholders and what it includes in reports has a significant impact on reputation and perceptions of corporate ESG statements.

              However, the increased demand for tax transparency is not without its challenges. Nearly two-thirds of respondents in BDO’s 2022 Tax Outlook Survey (62%) said data collection and analysis (the quantitative component of ESG-focused tax) is the greatest challenge of tax transparency reporting efforts, pointing to an underlying issue of tax data governance and fragmented systems. Often this is an area where tax leaders require outside assistance to establish automated processes that can collect tax data on a periodic basis for regular analysis. The importance of ESG and attention around the topic will only continue to increase over the next several years, so it is critical to begin thinking about adequate data collection and analytic capabilities for tax leaders looking to incorporate tax in ESG practices and strategy. For those just beginning the process, our advice is to partner with in-house IT functions or external consultants for assistance and support.

              Collecting relevant tax data on a regular basis is a critical early step because it affords tax leaders the opportunity to determine which information will be disclosed to various stakeholders and which information can help shape and support broader ESG narratives being developed by corporate leadership. While determining data collection processes, it is also important to consider and seek counsel on communication and information delivery strategies that will best reach and address the concerns of priority stakeholder groups.  

              Although this task can be a heavy lift, it may also result in significant business advantages. A key benefit is that the data and information gathered will help tax leaders further define and evolve ESG-driven tax strategies through tax monetization structures and company core value items, among others. Ultimately, organizations that better understand their total tax contribution across various taxing jurisdictions and country-by-country activities are best equipped to make data-driven tax strategy decisions that are aligned with broader ESG and sustainability objectives, while also avoiding value creation hinderances.

              Key Reporting Considerations

              Once the quantitative data have been collected, the next step is to consider how you report the information. Communicating the numbers themselves is not enough. Communicating the narrative behind the numbers – the qualitative component of reporting – is extremely important. The narrative should always aim to communicate the company’s approach to tax, values guiding decision-making and the impact of the tax strategy to key stakeholders in a straightforward and transparent manner. However, qualitative reporting can vary by organization depending on several factors, from choice of standards to company philosophy.

              The 2022 BDO Tax Outlook Survey also found that challenges and variance in tax transparency reporting are driven by a lack of universal reporting standards and clarity around which ESG frameworks to follow. In the meantime, the best reporting framework for any company is one that drives a deep understanding of the organization’s ESG philosophy and vision, which may require more investment in terms of time and effort. When determining a reporting approach, it is important to consider the goal of the report or disclosure and which data best demonstrate ESG progress and strategy. Because the ESG-related tax reporting is not a mandated process and is currently a voluntary disclosure in the U.S., it can often be helpful to review tax reports related to ESG from other companies already making these disclosures as a baseline.

              Keep in mind that one of the main reasons businesses are electing to publish comprehensive ESG and Sustainability Tax Reports and Global Tax Footprints is to articulate their broader total tax contribution to ensure that the tax narrative speaks to the needs and demands of their stakeholders. Each report must be unique and relevant to the company in terms of content and method of disclosure.

              Currently, there is a relatively small number of companies electing to make such disclosures, based on the findings of the 2022 BDO Tax Outlook Survey outlined below. Of the 150 senior tax executives polled, less than a quarter (23%) are implementing both qualitative and quantitative disclosures:

              Tax Transparency Reporting Disclosures

              Today, tax is an essential component of the ESG metrics that determine how stakeholders perceive an organization. Despite this fact, the movement to incorporate tax in ESG planning and strategies is still in its infancy. This means leaders of tax functions still have time to begin the process of implementing ESG-driven tax strategies and operations to ensure the function evolves with the importance of ESG. While there is no simple one-size-fits-all solution, given the nuances and complications of the tax function for each organization, the general framework in the Tax ESG Cipher can help guide tax leaders at any point on the journey. The cipher outlines key considerations to ensure an organization’s ESG vision is well-structured and appropriately includes tax strategies. While the process requires long-term effort and dedication, it generates high returns in terms of accountability, transparency, and reputational and sustainable value.

              As ESG takes center stage in a rapidly changing business landscape, how is your organization advancing toward true sustainability?

              Written by Daniel Fuller and Jonathon Geisen. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com


              Have questions? We are here to help. Contact us today!

                Tags: Tax

                Mandatory Capitalization of R&E Expenses- The Impact on Technology Companies

                Businesses that invest in research and development, particularly those in the technology industry, should be aware of a major change to the tax treatment of research and experimental (R&E) expenses. Under the 2017 Tax Cuts and Jobs Act (TCJA), R&E expenditures incurred or paid for tax years beginning after December 31, 2021, will no longer be immediately deductible for tax purposes. Instead, businesses are now required to capitalize and amortize R&E expenditures over a period of five years for research conducted within the U.S. or 15 years for research conducted in a foreign jurisdiction. The new mandatory capitalization rules also apply to software development costs, regardless of whether the software is developed for sale or license to customers or for internal use.

                Tax Implications of Mandatory Capitalization Rules

                Under the new mandatory capitalization rules, amortization of R&E expenditures begins from the midpoint of the taxable year in which the expenses are paid or incurred, resulting in a negative year 1 tax and cash flow impact when compared to the previous rules that allowed an immediate deduction.

                For example, assume a calendar-year taxpayer incurs $50 million of U.S. R&E expenditures in 2022. Prior to the TCJA amendment, the taxpayer would have immediately deducted all $50 million on its 2022 tax return. Under the new rules, however, the taxpayer will be entitled to deduct amortization expense of $5,000,000 in 2022, calculated by dividing $50 million by five years, and then applying the midpoint convention. The example’s $45 million decrease in year 1 deductions emphasizes the magnitude of the new rules for companies that invest heavily in technology and/or software development.

                The new rules present additional considerations for businesses that invest in R&E, which are discussed below.

                Cost/Benefit of Offshoring R&E Activities

                As noted above, R&E expenditures incurred for activities performed overseas are subject to an amortization period of 15 years, as opposed to a five-year amortization period for R&E activities carried out in the U.S. Given the prevalence of outsourcing R&E and software development activities to foreign jurisdictions, taxpayers that currently incur these costs outside the U.S. are likely to experience an even more significant impact from the new rules than their counterparts that conduct R&E activities domestically. Businesses should carefully consider the tax impacts of the longer 15-year recovery period when weighing the cost savings from shifting R&E activities overseas. Further complexities may arise if the entity that is incurring the foreign R&E expenditures is a foreign corporation owned by a U.S. taxpayer, as the new mandatory capitalization rules may also increase the U.S. taxpayer’s Global Intangible Low-taxed Income (GILTI) inclusion.

                Identifying and Documenting R&E Expenditures

                Unless repealed or delayed by Congress (see below), the new mandatory amortization rules apply for tax years beginning after December 31, 2021. Taxpayers with R&E activities should begin assessing what actions are necessary to identify qualifying expenditures and to ensure compliance with the new rules. Some taxpayers may be able to leverage from existing financial reporting systems or tracking procedures to identify R&E; for instance, companies may already be identifying certain types of research costs for financial reporting under ASC 730 or calculating qualifying research expenditures for purposes of the research tax credit. Companies that are not currently identifying R&E costs for other purposes may have to undertake a more robust analysis, including performing interviews with operations and financial accounting personnel and developing reasonable allocation methodologies to the extent that a particular expense (e.g., rent) relates to both R&E and non-R&E activities.

                Importantly, all taxpayers with R&E expenditures, regardless of industry or size, should gather and retain contemporaneous documentation necessary for the identification and calculation of costs amortized on their tax return. This documentation can play a critical role in sustaining a more favorable tax treatment upon examination by the IRS as well as demonstrating compliance with the tax law during a future M&A due diligence process.

                Acquisition and Exit Scenario Considerations

                Given the significant differences in timing of deductions between Section 174 R&E costs and other currently deductible costs, this may become a significant consideration in acquisitions.  In a stock acquisition, preexisting tax bases will carry over. Therefore, if a selling company was not compliant in identifying and capitalizing pre-acquisition Section 174 costs, the buyer would not gain the post-acquisition benefit of deducting the amortization of pre-acquisition R&E deferred tax assets that were not identified or capitalized by the seller.  The buyer may also be on the hook upon IRS examination, to pay additional tax liabilities for improper seller deductions of R&E costs in pre-acquisition periods. Accordingly, buyers and sellers should be conscious of this issue in due diligence and preparation for an exit- and consider whether establishing tax contingency/escrow provisions is necessary.

                Impact on Financial Reporting under ASC 740

                Taxpayers also need to consider the impact of the mandatory capitalization rules on their tax provisions. In general, the addback of R&E expenditures in situations where the amounts are deducted currently for financial reporting purposes will create a new deferred tax asset. Although the book/tax disparity in the treatment of R&E expenditures is viewed as a temporary difference (the R&E amounts will eventually be deducted for tax purposes), the ancillary effects of the new rules could have other tax impacts, such as on the calculation of GILTI inclusions and Foreign-Derived Intangible Income (FDII) deductions, which ordinarily give rise to permanent differences that increase or decrease a company’s effective tax rate. The U.S. valuation allowance assessment for deferred tax assets could also be impacted due to an increase in taxable income. Further, changes to both GILTI and FDII amounts should be considered in valuation allowance assessments, as such amounts are factors in forecasts of future profitability.

                Insights

                The new mandatory capitalization rules for R&E expenditures and resulting increase in taxable income will likely impact the computation of quarterly estimated tax payments and extension payments owed for the 2022 tax year. Even taxpayers with net operating loss carryforwards should be aware of the tax implications of the new rules, as they may find themselves utilizing more net operating losses (NOLs) than expected in 2022 and future years, or ending up in a taxable position if the deferral of the R&E expenditures is material (or if NOLs are limited under Section 382 or the TCJA). In such instances, companies may find it prudent to examine other tax planning opportunities, such as performing an R&D tax credit study or assessing their eligibility for the FDII deduction, which may help lower their overall tax liability.

                Will the new rules be delayed?

                The version of the Build Back Better Act that was passed by the U.S. House of Representatives in November 2021 would have delayed the effective date of the TCJA’s mandatory capitalization rules for R&E expenditures until tax years beginning after December 31, 2025. While this specific provision of the House bill enjoyed broad bipartisan support, the BBBA bill did not make it out of the Senate, and recent comments by some members of the Senate have indicated that the BBB bill is unlikely to become law in its latest form. Accordingly, as of the date of this publication, the original effective date contained in the TCJA (i.e., taxable years beginning after December 31, 2021) for the mandatory capitalization of R&E expenditures remains in place.

                How We Can Help

                The changes to the tax treatment of R&E expenditures can be complex. While taxpayers and tax practitioners alike remain hopeful that Congress will agree on a bill that allows for uninterrupted immediate deductibility of these expenditures, at least for now, companies must start considering the implications of the new rules as currently enacted. We can assist taxpayers with determining their R&E expenditures incurred in a given tax year, modeling the impact of the new mandatory capitalization rules on other areas of tax (e.g., FDII, GILTI, allocations relating to Section 704(c) partnership built-in gains and losses, and Section 163(j) business interest expense limitations), performing research tax credit studies and identifying potential opportunities to minimize their total tax liabilities.

                Written by Connie Cunningham and Doug Hart. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com.


                Have questions? The BSB Tax Team is here to help.

                  Tags: Tax

                  ERC Accounting and Reporting

                  Many businesses that were negatively impacted by the pandemic qualified for the Employee Retention Credit (ERC). The ERC was enacted through the CARES Act to encourage businesses to keep employees on their payroll. To be eligible, businesses had a decline in gross receipts and had a full or partial suspension of operations. Like the Payroll Protection Program (PPP), the ERC program led to questions about accounting and reporting.

                  The ERC is a credit to offset payroll taxes, and not an income tax credit, so must be as such. The ERC is claimed on Form 941 for the quarter that the qualified wages are paid.  If the calculated tax credit is more than the amount of the employer’s share of payroll taxes owed for a given quarter, the excess is refunded.  Any credit claimed through the ERC program will result in a reduction of wage expense claimed to the extent of the credit amount (Section 280C). If an employer chooses to amend any 941’s after their income tax return has been filed, then the income tax return will also need to be amended to reflect the credit.

                  There are three different accounting treatments for the ERC. Entities should account for ERCs using one of these standards after considering which standard would provide the most transparency to the users of their financial statements.

                  1. International Accounting Standards (IAS) 20, Accounting for Government Grants and Disclosure of Government Assistance.
                  • Most public companies are using this method and offsetting wages with the credit.
                  • ERCs, unlike PPP loans, are structured as a refundable credit and not a loan.
                  • If an entity accounted for their PPP loans under IAS 20, there is a presumption that they will utilize the same guidance to account for their ERCs. 
                  • Under IAS 20, a business entity recognizes ERCs on a systematic basis over the periods in which the entity recognizes the payroll expenses for which the grant (i.e., tax credit) is intended to compensate the employer when there is reasonable assurance (i.e., it is probable) that the entity will comply with any conditions attached to the grant and the grant (i.e., tax credit) will be received.
                  • IAS 20 permits presentation as a credit in the income statement (either separately or under a general heading, such as “other income”) or as a reduction of the related expense (with appropriate disclosure in the footnotes regarding key features of the grant). This guidance is not available to not- for-profit entities.
                  2. Revenue Recognition (ASC 958-605)
                  • This method should be used by all non-for-profit entities.
                  • If the entity receives ERCs as an advance, it will record a liability for the cash received until such time that the conditions to earn the credit are substantially met.
                  • When conditions are met:
                    • A not-for-profit entity is required to record the income as revenue.
                    • A for-profit entity may record the amount as grant revenue or other income.
                    • 958-605 does not permit an entity to net the grant against qualifying costs.
                  • The evaluation of whether all conditions are substantially met will require the use of judgment. Uncertainty regarding whether an entity qualifies for the credit would generally indicate that the conditions were not substantially met at period end. Since the accounting model under Subtopic 958-605 requires that substantially all conditions are met to recognize the grant into income, entities will need to consider whether preparing and submitting the filing is a “more than administrative task” that would defer recognition until such time that the filing with the Internal Revenue Service is made.
                  • Under 958-605, the entity would present the amount of an employment tax refund receivable or an unearned refund advance as a current asset or liability.
                  • Though some or all qualifying expenses may have occurred in 2020, it may not be appropriate to record them as 2020 income under ASC 958-605, based on other barriers that may not have been overcome until 2021.
                  • In 2021, the Consolidated Appropriations Act, expanded, retroactively to March 12th, 2020, the Employee Retention Credit (ERC) to include those otherwise eligible employers who also received Paycheck Protection Program (PPP) loans. If the entity qualified for the 2020 ERC due to Consolidated Appropriations Act, the income cannot be recorded until 2021.
                  3. Contingencies.
                  • Under ASC 450, entities would treat the ERCs (whether received in cash or as an offset to current or future payroll taxes) as if they were gain contingencies. 
                  • Under ASC 450-30, entities would not consider the probability of complying with the terms of the ERC program but, rather, would defer any recognition in the income statement until all uncertainties are resolved and the income is “realized” or “realizable”.
                  • The AICPA discourages this method due to it providing less specificity on disclosure, measurement, and recognition requirements as compared to other methods.

                  Determining the best accounting method will depend on the type of business and financial statements. Due to the complexity of reporting and accounting of the ERC, it’s important to consult with a tax advisor. The tax professionals at BSB are following the latest guidance to help maximize your tax benefits while remaining compliant with current law. 

                    Tags: Tax

                    Virginia Tax Bills Will Save Taxpayers Money in 2022

                    Recently passed Virginia tax bills will help lower some Virginia taxpayers’ tax liability in upcoming tax seasons.

                    On Feb. 23, 2022, Governor Glenn Younkin signed HB 971, which advances Virginia’s date of conformity with the Internal Revenue Code (IRC) to Dec. 31, 2022. The legislation also includes retroactive tax benefits related to the Restaurant Revitalization Fund, Paycheck Protection Program, and Economic Injury Disaster Loans (EIDL) for tax years beginning Jan. 1, 2021. HB 1121 and SB 692 also passed. The bills enable the ability to pay entity-level taxes for qualifying pass-through entities (PTE), also known as the SALT cap workaround.

                    HB 971 is expected to save Virginia taxpayers more than $200 million and provide relief to small businesses. Fiscal year filers will be able to take advantage of a $100,000 deduction for Rebuild Virginia grants received in 2020, but there is no deductibility for Rebuild Virginia grants in 2021.  Deductibility for PPP loans is based on when expenses were incurred and not when the loan was forgiven. 

                    HB 971 covers several areas:

                    • Income deferral
                    • Suspension of overall limitation on itemized deductions
                    • Depreciation allowance for certain property
                    • Federal adjusted gross income and medical care calculation expenses
                    • CARES Act provisions related to carry-backs and net operating loss limitations
                    • Carry-back of certain net operating losses for five years
                    • Original discount on applicable high yield discount obligations
                    • Provisions related to deductions, tax attributes, and basis increases for business financial assistance or certain loan forgiveness

                    HB 112/ SB 692 permits qualifying PTE to pay elective income tax at 5.75% by annual elections in taxable years 2022 through 2025. The bills also address the out-of-state credit (OSC) disallowance by allowing individuals to claim a credit for similar taxes paid to other states in taxable years 2021 through 2026.

                    Now that the Virginia tax code is more consistent with the federal government, individual and business taxpayers can expect to receive more relief and save more money.

                    If you have questions about how the new bills may impact your taxes, reach out to the tax team at BSB. We are here to help.