The IRS has recently released Form 7217, “Partner’s Report of Property Distributed by a Partnership,” as well as the accompanying instructions, reflecting a new reporting requirement for partners in investment partnerships, among others, for tax years beginning in 2024 or later.

This new reporting requirement applies to any partner in any partnership that receives from the partnership distributions of property other than cash and marketable securities treated as cash. In the context of investment partnerships, it applies to investors in private equity, venture capital, and hedge funds that make in-kind distributions of securities or other property. In addition, funds of funds that receive such distributions will also need to prepare this form. This requirement could also come into play in the context of fund restructurings, such as the formation of continuation funds.

Tax-Free Distributions from Investment Partnerships

Investment partnerships that meet certain requirements can distribute marketable securities to partners on a tax-free basis. The recipient partner can defer income recognition until the securities are later sold. Other partnerships are required to treat marketable securities as cash, resulting in more immediate tax consequences.

Each partner receiving a tax-free distribution of property, including marketable securities from an investment partnership, is required to file the new Form 7217. A separate Form 7217 is required to be filed for each date during the tax year in which a distribution was received and will be attached to the recipient’s tax return. The information reported must include the basis of the distributed property and any required basis adjustments to such property.

Insights

This new filing requirement is part of the IRS’s increased scrutiny of partnerships and basis-shifting transactions.  Fund managers should be prepared to receive additional requests from limited partners as they comply with Form 7217 reporting.

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The IRS releases an annual ‘Dirty Dozen’ list featuring the top taxpayer scams for the coming year. The list is certainly not exhaustive of every potential pitfall out there, but it is an excellent place to start educating yourself (and your team if you’re a business owner). Here’s a summary of the 2023 IRS Dirty Dozen.

Employer Retention Credit Promoters: Businesses have been targeted by companies claiming to help them submit tax returns and adjustments to take maximum advantage of the Employee Retention Credit (ERC). These promoters collect a fee for preparation services, which is often tied to the value of the proposed credit. Usually, the targeted businesses don’t qualify for the credit, so when the adjustment claim is either rejected by the IRS or found to be incorrect during an audit, the business is out the funds paid to the promoter, as well as any monies received from the ERC they were not eligible for and potential IRS fees.

Phishing and Smishing Scams: Emails, texts, phone calls. These are all popular channels for scammers trying to obtain sensitive information from taxpayers by lying and saying they work for the IRS. Please remember that the IRS will always initiate contact with taxpayers by mail.

Online Account Assistance: The IRS Online Account tool provides helpful information to taxpayers. Scammers are using this as an opportunity to learn social security numbers and other sensitive information by calling and offering to help taxpayer set up their online accounts. This can lead to identity theft and a big headache for taxpayers trying to sort everything out.

Fuel Tax Credit Promoters: Like the Employee Retention Credit promotors, Fuel Tax Credit promoters claim that the taxpayer is qualified for the credit when they may not be. These scammers usually charge a big fee to assist the taxpayer in submitting these claims.

Fake Charity Scams: Major disasters like hurricanes, floods, and wildfires can lead to an increase in counterfeit charities to dupe taxpayers. When these disasters occur, people want to help those affected. Scammers take advantage of this generosity by using fake charities as a front for stealing money and private information. Be sure to take the time to thoroughly research any organization before donating.

Shady Tax Preparers: Common warning signs of a shady tax preparer include charging a fee based on the size of the refund or refusing to sign the form as a preparer as required by law. Make sure you’re using a trusted and knowledgeable tax preparer.

Social Media Trends: While this may seem unsurprising to most, it bears repeating – you can’t always trust what you hear on the internet. Social media can circulate misinformation quickly, including ‘hacks’ for getting a bigger tax refund. These trends usually involve lying on tax forms or creating false income. The IRS reminds taxpayers that falsifying tax documents is illegal and penalties are involved.

Spearphishing Email Scams: Bad players have been sending email requests to tax preparers, and payroll and human resources teams to try and gain sensitive client and employee data like W-2 information. These requests can look like they’re from a potential new client, and the scammers then use the data they collect to submit a series of false tax refund filings and collect on the tax returns. Businesses can protect themselves with these cybersecurity tips.

Offer in Compromise Mills: Promoters target taxpayers that owe the IRS money by offering to settle their debts with the IRS at a steep discount for a fee. Many times, the targeted taxpayers don’t meet the technical requirements to obtain an offer, meaning they still owe the IRS the same amount and are paying excessive fees to these companies. Taxpayers can check their eligibility for an Offer in Compromise using this free IRS tool.

Charitable Remainder Annuity Trust Schemes: Promoters can misuse Charitable Remainder Annuity Trusts and monetized installment sales by misapplying the rules, leaving filers vulnerable. These types of schemes are often targeted at wealthy taxpayers.

Tax Avoidance Schemes: The IRS warns taxpayers to be wary of anyone claiming to reduce their taxes owed drastically or even to nothing. This could include micro-captive insurance arrangements, international accounts, and syndicated conservation easements.

Be diligent with your information, teach your employees how to recognize scams, and be sure to discuss any changes in tax strategy with your trusted tax professional. If anyone contacts you with a claim that seems too good to be true, it probably is.

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“Uncertainty” is the keyword as we sit at the beginning of 2023. Rising interest rates, inflation and geopolitical strife continue to challenge economic and market stability. But with about $1 trillion in committed capital sitting on the sidelines, deals will still need to be made.

What is in store for 2023? Will “low-quality” companies comprise a greater proportion of deal volume? Will gaps between buyers and sellers narrow? Will the Federal Reserve begin lowering interest rates mid-year? Here we look at some of the trends we believe will play out over the next 12 months.

Prediction #1: Large-cap deal flow will give way to more middle-market deals

In an inflationary environment in which interest rates are the highest they have been since the Great Recession and lending has tightened, private equity firms will continue to focus their energies on add-ons or carve-outs.

While multi-billion-dollar platform buyouts will still happen — the rout in the public markets last year provides welcome comps for larger buyouts — we predict a sizeable proportion of private equity M&A to be smaller to mid-size strategic plays that allow firms to put their capital to use. Competition over the limited number of quality assets will continue to be fierce, so we will see more deals of lower quality, as we did at the end of 2022.

During this period of ongoing uncertainty, due diligence continues to expand from the compressed timelines we saw during the deal frenzy of late 2020 and 2021. Firms will also continue to look to work with vendors who can supply a majority, if not all, of their due diligence needs.

Prediction #2: Fundraising cycles will continue to be lengthy

The amount of time firms take to raise funds has been increasing, and that dynamic will persist into 2023. The average number of months to final close in 2022 hit 20 months for the first time since 2010, according to Preqin data. That is an increase from 11 months in 2019 pre-pandemic; since then, the average number of months to close has ticked steadily upward, reaching 16 in 2021.

Last year, we saw limited partners (LPs) asking their general partners (GPs) to push some of their fundraising efforts into 2023 because they were unable to keep up with the re-up requests from GPs raising subsequent funds. Given the amount of capital raised in recent years and the fact that many funds that raised in 2022 never activated their funds due to the macro deal environment, we expect to see a delay in the deployment of capital, compounding the calls of capital on LPs if they commit to new funds.

LPs who have experienced the “denominator effect” — becoming overallocated to private equity given the public market decline — will be reluctant to make new commitments and may instead sell their stakes this year.

The declining rate of exits, of course, exacerbates these dynamics. Fewer exits mean fewer distributions to LPs. For LPs re-committing capital, we foresee risk aversion influencing a trend of dollars flowing to fund managers with proven (and lengthy) track records. However, emerging managers specializing in sectors align with LPs’ strategies and values will attract investment.

At the same time, the dynamics around fundraising may help to fuel the secondary market more and increase diversity among private market participants (think retail investors and high-net-worth individuals).

Prediction #3: Firms will take advantage of market slowdown to plan exits

The appetite for exits has steadily declined since the fourth quarter of 2021 as firms have opted to hold onto their investments rather than sell into a weak market. Last year, the majority of exits were secondary buyouts and trade sales, according to Preqin. In 2023, we will see more sponsor-to-sponsor deals as well as a healthy number of GP-led secondaries (continuation funds). However, the SEC’s new rules for registered investment advisors (RIAs) may affect the pace at which GP-led secondaries roll out.

Exits by type. 2021-2022

According to Private Equity News, GP-led secondaries today comprise about half the secondary market transaction volume, up from less than one-quarter of the market in 2017, and by 2025 is estimated to exceed $200 billion.

The trend of PE firms evaluating exit planning strategies earlier in the deal lifecycle will continue through 2023. Fund managers will approach the current market slowdown as an opportunity to prepare their investments for exit and execute on the necessary steps to be in position for an IPO or other exit when the market recovers.

Prediction #4: ESG strategies will remain in the spotlight

Private equity fund managers have been focused on incorporating environmental, social, and governance (ESG) risk factors and policies into their due diligence, operations, and brand identity. ESG will remain a value driver in 2023. As private markets look to ESG as a salve for talent recruitment and retention challenges, macroeconomic volatility, and suboptimal exit values, fund managers are increasingly grounding their investment theses in ESG materiality.

_{Source: BDO Private Capital Pulse Survey – Spring 2022}

According to BDO’s Spring 2022 Private Capital Pulse survey, 50% of fund managers said they would deploy the most capital to setting up impact funds or investing in targets with ESG-focused linked themes. Nearly all (95%) evaluate targets’ ESG potential as part of due diligence. At the other end of the deal lifecycle, 39% identified adopting an ESG strategy and reporting program as a new tactic to facilitate exit strategy.

Private equity’s embrace of ESG is unsurprising: ESG risk assessment is still fairly nascent, and private equity thrives on capturing value from innovation. At the same time, an overwhelming majority of LPs evaluate firms’ ESG risk exposure and practices when making investment decisions (in BDO’s Spring 2021 survey, 94% of LPs said it was either “very” or “somewhat” important that fund managers’ investment strategies include ESG criteria). They see ESG screening as critical to value creation and risk mitigation, protecting investments from risks like health and safety violations, fraudulent governance practices, and extreme weather. And funds, in turn, enjoy more lucrative fundraising opportunities, superior brand reputation, and lower-cost capital.

Prediction #5: Human capital resources will remain tight

The labor market is tight, and employers’ priorities when it comes to their workforce are to retain existing talent and reduce hiring. Of the areas of economic concern fund managers were most concerned about, unemployment rates and the availability of talent ranked above inflation and interest rate increases, according to BDO’s Spring 2022 survey.

Economic Instability Areas of Concern, Ranked

1. Regulatory changes
2. Geopolitical or social instability
3. Unemployment rates and the availability of talent
4. Inflation
5. Interest rate increases
6. Consumer spending
7. Income and wage trends

_{Source: BDO Private Capital Pulse Survey – Spring 2022}

Labor, interest rates, and inflation are caught in a cause-effect cycle. To counter inflation, the Fed raised interest rates seven times in 2022. The goal is to increase borrowing costs for businesses so they cut back on hiring, theoretically slowing wage growth and impeding consumer spending, and ultimately lowering inflation.

Despite the Fed’s focus on the labor market as part of its effort to bring inflation back to 2%, the labor market has not shown signs of slower wage growth just yet. The first jobs report of 2023 showed 223,000 jobs were added to the economy, most of which were in industries the pandemic hit hardest, like hospitality, healthcare, accommodation, and food services. Outside of the technology industry, there have not been massive layoffs.

There is lively debate around whether the Fed will begin reducing interest rates this year. The minutes from the Federal Open Market Committee’s most recent meeting in December 2022 reveal that the timing is not right to reduce interest rates, but some market experts believe the Fed could lower them toward the end of 2023.

Prediction #6: Private credit financing will continue to grow as part of the share of debt — with caveats

With interest rates at the highest they have been in 15 years, leveraged buyouts are an unappealing prospect for many private equity firms. Yet deals must happen. With high-yield bond and syndicated lenders in skittish territory, dealmakers have been turning to private credit financing — loans negotiated outside the traditional track of bank lenders. Though interest rates may be higher than those offered by traditional lenders who may be more risk averse in today’s climate, private credit lenders are less prone to pull out of a deal at the last minute, enabling fund managers to get to deal close.

While we foresee private credit will continue to gain share of debt, if economic conditions do not improve and a recession does take hold, these lenders could look to prioritize deals in sectors or industries considered recession resilient, such as SaaS software solutions and healthcare technologies.

Debt financing in the private markets rose from less than $500 million a decade ago to $1.2 trillion at the end of 2021, according to Preqin. Preqin also predicts that assets in private debt funds will account for $2.3 trillion by 2027.

Prediction #7: Within value creation strategies, the focus will fall on expense control and operating improvements

The high-valuation deal environment of 2021 began to challenge traditional methods of value creation, forcing firms to seek new ways of generating a return on their investments. Fund managers are using more value creation tactics in more combinations than ever before and are more hands-on with their investments — working alongside portfolio company management to develop digital transformation strategies, for example, and increasing their focus on deepening their industry expertise.

Increased costs arising from inflation may not be recoverable by passing them onto the consumer, further compressing margins and pressuring value creation strategies. Looking forward, fund managers will focus on controlling expenses within this high-inflation environment and making operational improvements — their top two biggest post-M&A challenges, according to BDO’s spring 2022 survey.

2023: Further testing ground for private equity — but not without its opportunities

The private equity asset class is nothing if not creative. With plenty of dry powder available, we expect to see deals return to more normal pre-pandemic levels. Quality assets continue to be fewer and further between, so we anticipate more variation in deal makeup — whether minority stakes, deals with greater ratios of equity, sponsor-to-sponsor transactions, or non-platform acquisitions.

To meet the dealmaking challenges of 2023, value creation will be front and center.  We expect firms to continue to leverage data analytics — their top tactic for value creation and exit strategy, according to BDO’s spring 2022 survey — for insights into businesses and to continue to drive innovation.  As in 2022, firms that succeed in 2023 will have a strong value creation plan complemented by a comprehensive understanding of risk and a suite of strategies informed by scenario planning.

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Simply put, eligible entities, those with no foreign activities, foreign partners or shareholders, and without knowledge of partners or shareholders needing information on items of international relevance, will not have to file the new Schedules K-2 and K-3 for tax year 2021.

To qualify for this exception, partnerships and S corps must meet the following:

• Direct partners in the domestic partnership are not foreign partnerships, foreign corporations, foreign individuals, foreign estates, or foreign trusts in tax year 2021.
• The domestic partnership or S corporation has no foreign activity, including foreign taxes paid or accrued or ownership of assets that generate, generated, or may reasonably be expected to generate foreign source income (see section 1.861-9(g)(3)) in tax year 2021.
• In tax year 2020, the domestic partnership or S corporation did not provide to its partners or shareholders, nor did the partners or shareholders request the information on the form or attachments regarding:
  • Line 16, Form 1065, schedules K and K-1 (line 14 for Form 1120-S), and
  • Line 20c, Form 1065, schedules K and K-1 (controlled foreign corporations, passive foreign investment companies, 1120-F, section 250, section 864(c)(8), section 721(c) partnerships, and section 7874) (line 17d for Form 1120-S).
• The domestic partnership or S corporation has no knowledge that partners or shareholders are requesting such information for tax year 2021.

If a partnership or S corporation qualifies for this exception, it does not need to file Schedules K-2 and K-3 with the IRS or its partners or shareholders. However, if a partner or shareholder notifies the partnership or S corporation that all or part of the information contained on Schedule K-3 is needed to complete their tax return, the partnership or S corporation must provide the information to the partner or shareholder.

If a partner or shareholder notifies the partnership or S corporation before the partnership or S corporation files its return, the partnership or S corporation must provide the Schedule K-3 to the partner or shareholder and file the Schedules K-2 and K-3 with the IRS.

Click here to read the IRS notice regarding the relief options. More information can be found in the IRS’ updated Schedule K-2 and K-3 frequently asked questions. Please get in touch with our office today if you need help navigating this new relief or completing your schedules K-2 and K-3.

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One of the best ways to protect your business is understanding the types of scams so you and your employees know what to look for – and how to avoid them.

Electronic signatures

Electronic signatures, or e-signatures, are a convenient and efficient substitute for “wet signatures,” but they can also expose your business to fraud and unauthorized signing. If you use electronic signatures in your business, ensure these two things:

1. Electronic signatures are valid. How do you ensure an electronic signature is valid without an in-person verification? The lengths you go to may depend on the size or nature of the contract. Still, there are several ways to authenticate a signer’s identity, including knowledge-based authentication (KBA), taking a video of the signing, and employing a notary.​
2. Electronic signatures are compliant. In the U.S., electronic signatures must comply with the Electronic Signatures in Global and National Commerce Act and the Uniform Electronic Transaction Act (UETA). These laws generally require an intent to sign, consent to do business electronically, associating the electronic signature with a record, and retaining those records.

Most modern e-signature solutions comply with these requirements, so make sure you use a solution provider that takes appropriate steps to verify a signer’s identity and comply with applicable regulations and best practices.

Client portal access

Client portals make it easy to send and receive documents and collaborate on projects with coworkers, clients, and other third parties, but they can also open the door to data leaks, breaches, and hacking incidents.

There are three elements to help keep data in a client portal secure:

• Authentication. This is how to identify a user. That typically involves entering a valid username and password before granting them access to the portal. Provide each user a unique username and password through a secure channel before logging in.
• Authorization. What authority does the user have to perform specific tasks after logging into a portal? Your employees may be authorized to access more areas or perform more activities than a client or another third party, such as a banker, attorney, or consultant.
• Audit. The final element is an audit trail, which tracks a user’s access and activities while in the portal.

Many pre-built solutions allow your business to quickly deploy a secure client portal and integrate with your existing systems. Again, using a solution provider that takes steps to maintain data integrity will protect your company, customers, and clients.

Tax scams

Tax scams take many forms as scammers try to steal money, identities, tax refunds, and more. Often, these scams start with a phone call, email, or in-person visit from someone claiming to represent the IRS. These scammers may demand payment of back taxes and penalties or ask an individual to confirm their Social Security or bank account number to receive a tax refund.

Knowing how the IRS will and won’t initiate contact is one of the best ways to avoid falling victim to tax scams.

In most cases, IRS contact starts with a letter or notice delivered via the U.S. Postal Service. Following that initial notice, the IRS may call or visit an individual’s home or office to collect an overdue income or employment tax payment, follow up on a delinquent return, or tour a business’ premises as part of an IRS audit or criminal investigation.

The IRS does not:

• Demand payment via a prepaid debit card, gift card, or wire transfer or insist an individual make a payment over the phone.
• Threaten to send local law enforcement or immigration officials to arrest an individual for not paying your tax bill.
• Demand payment without allowing an individual to review or appeal the amount they owe.
• Initiate contact or request personal or financial information via email, text message, or social media channels.

You can learn more about common tax-related scams at Tax Scams/Consumer Alerts. If you believe a scammer has targeted you, you can report IRS impersonation scams online or call the IRS at (800) 366-4484. If your company needs assistance setting up the safeguards addressed above or strengthening your cybersecurity efforts, contact our team of professionals today!

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Corporate tax rates

While corporate tax rates would stay the same under BBB, the proposal includes a 15% minimum tax on book income for corporations reporting more than $1 billion in profits. For corporations with foreign parents, the minimum tax would apply to profits of more than $100 million.

The legislation would also impose a 1% excise tax on the fair market value of any publicly traded U.S. corporation’s stock that the corporation repurchases during the year.

BBB would also change the Foreign-Derived Intangible Income (FDII) deduction and Global Intangible Low-Taxed Income (GILTI) regime, increasing the taxes paid by most, if not all, U.S. multinational corporations.

Applying the Net Investment Income Tax to Trade or Business Income

The net investment income tax (NIIT) levies a 3.8% surtax on net investment income derived from interest, dividends, capital gains, and income from passive activities. NIIT applies when a taxpayer’s modified adjusted gross income (AGI) exceeds a threshold of $200,000 for single filers or $250,000 for married couples filing jointly.

Currently, trade or business income earned by pass-through business owners who materially participate in the business is not subject to NIIT. BBB proposes eliminating that exception for taxpayers with modified AGI greater than $400,000 ($500,000 if married filing jointly).

Limitations on interest expense deductions

The Tax Cuts and Jobs Act of 2017 limited the amount of interest a business can deduct to interest income plus 30% of its adjusted taxable income for the year. The BBB would further limit interest deductions for U.S. members of multinational groups that issue consolidated financial statements. The draft legislation describes the limitation as an “allowable percentage” of 110% of the corporation’s net interest expense.

Paid Family, Medical Leave Requirements

The U.S. is the only industrialized country without federally mandated paid parental leave, but BBB seeks to change that. The legislation guarantees four weeks of paid leave to all workers who are:

• New parents,
• Dealing with a serious medical condition of their own, or
• Caring for a loved one with a serious medical issue.

Employers would not have to foot the bill for that paid leave. States with an existing paid family medical leave mandate equal to or better than the federal benefit would be reimbursed for what it would have cost to cover workers in the federal program.

Employers that voluntarily offer paid leave equal to or better than the federal benefit would be reimbursed for the lesser of:

• 90% of the national average cost of paid leave benefits, or
• 90% of their insurance premium

All other public and private-sector employees would be covered by a public program run by the Social Security Administration.

Investing in small business

Build Back Better also allocates about $3.385 billion to support small businesses by improving access to capital, including:

• Additional funding for SBA 7(a) loans
• Reduced or waived fees for new SBA 7(a) and 504 loan borrowers with loans of $2 million or less
• Additional investments into the Small Business Investment Company (SIBC) program
• Establishing a national network of “uplift incubators” to spur economic development in underrepresented communities
• Additional funding for cash grants to growth accelerators assisting small businesses focused on technology
• Providing funding for grants to help minority-owned businesses launch and expand operations

Although the House passed a version of the Build Back Better bill in November 2021, negotiations over the bill stalled in the Senate, so none of the above proposals have been turned into law as of this publication.

At this point, it’s impossible to say which proposals will survive and in what form, but it is worth keeping an eye on as key portions, like workforce support, are expected to eventually pass. If you have questions in the meantime, please reach out to your tax advisor.

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Set a retirement date

Here is your first question: When do you plan to quit working? You may have a general idea of the age range when you would like to retire, but now is the time to set a precise date. That gives you a timeline to work with, which will make all your other planning easier.

Consider your options

The next essential question: Who do you expect will take over your business? Many companies make one of two choices: either someone buys the company from you or a family member or employee takes over as chief executive when you retire. It is important to consider which one is the most realistic option so that you can ensure a smooth transition down the road. Depending on your plans, there are different steps you should take now to ensure a smooth transition.

If you plan to sell

If you are going to sell your company to another business or individual, you will need an accurate idea of what it is worth. You should get a business appraisal when you are ready to sell; but it may be a good idea to get one now, even if there are many years until your planned retirement. An appraisal can help to spot your company’s strengths and weaknesses so you can analyze how those attributes impact its overall worth.

The information in the appraisal can be used to make changes that improve operations, sales and revenues and make you a more competitive player in the marketplace. Those steps will help increase your company’s value and its appeal to potential buyers at the time you decide to sell.

If you plan to promote from within

It is always a good idea to have a current idea of your company’s worth, but there are also other necessary factors to consider if you are hoping that someone within your company will one day take over the reins of leadership. The first question, of course, is who will that person be? Is there a very talented younger employee who you believe could one day take over? If so, begin grooming him or her now. This includes introducing the employee to key clients, increasing his or her level of responsibility and including the person in decision making whenever possible.

Even if you expect to sell your business, it is a good idea to have a promising future leader ready to take over the reins. In most cases, a potential buyer will be happy to see that there is someone in place to carry on.

There are many possible exit strategies available to small business owners. No matter which you choose, it will be a good idea to have an accurate sense of the company’s worth and to have a strong management team in place. Our firm’s professionals can help you develop a strategy to suit your business. Call us today.

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