JULY 2021 ‘21 summary summary summary summary

Field of Study: Specialized Knowledge SPACs, special purpose acquisition companies, have been around since the early 2000s, yet they have been the biggest trend over the past year. When there is a surge, especially of that magnitude, there is also scrutiny. The SEC looks very closely at filings and disclosures by SPACs to protect the public so investors can make informed investment decisions. Warren Buffet considers the SPAC boom a "killer," but is there another side to SPACs? Opinions are split. SPACs are in the news almost daily, but the question is how long will this boom last and is this really a "killer"? Brian Sarkis, CFA, founder of The Franklin Nova Group discusses SPACs in detail, how they work, and the underlying risks.

Field of Study: Accounting In February 2016, the FASB issued new authoritative guidance on accounting for leases. The new guidance is commonly referred to as Topic 842, which is a reference to the Leases topic of the FASB Accounting Standards Codification. All reporting entities that prepare financial statements in accordance with U.S. GAAP must adopt Topic 842 as a replacement for previous GAAP on accounting for leases. Leases are one of a company’s most significant costs that can directly impact business operations as well as valuation. Joe Fitzgerald, senior vice president of Lease Market Strategy at Visual Lease, discusses the impact of leases on the balance sheet based on the new standard, the underlying risks when leases are neglected or not accounted for, and what to look for when evaluating lease software.

Field of Study: Accounting Economic value, or economic value added, or as some people refer to it, economic profit, is an alternative to net income; many people believe that net income may not be an appropriate measurement to identify value creation for an organization. So an alternative has been developed to evaluate value creation, known as the economic value model. Most companies present their financial statements based on GAAP, generally accepted accounting principles, but there are some weaknesses when we are trying to figure out a company’s value. John Fleming, CPA at Kaplan Financial Education, explains why a net income alternative might be a better measurement in certain situations and to specific companies.

Field of Study: Taxes The Net Investment Income (NII) Tax applies to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts at a rate of 3.8%. The NII Tax was effective beginning on or after January 1, 2013. Individuals who are subject to the NII Tax have modified adjusted gross income over thresholds which are not indexed for inflation. Barbara Weltman, president of Big Ideas for Small Business discusses current updates on NII from various sources including investment income from digital currency transactions. Barbara also reviews the proposed changes in estate and gift tax rules under the new Administration and gives some context on the Administration’s 2022 budget proposals.

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1. SPACs – Worthy Investments or Killers?

2. Topic 842 Leases – Are You Ready?

3. Economic Value Added – A Net Income Alternative

4. Net Investment Income Tax, Trust, Estate & Gift Tax & More

CPA REPORT SUBSCRIBER GUIDE

JULY 2021 Summary Page i [p. 1]

CPE Requirements iii [pp. 3–5]

Segment One 1–1 [pp. 7–36]

Segment Two 2–1 [pp. 37–69]

Segment Three 3–1 [pp. 71–97]

Segment Four 4–1 [pp. 98–131]

Sememt Five 5–1 [pp. 132–162]

Evaluation Form A–1 [pp. 163–164]

Index B–1 [pp. 165–168]

Group Live Attendance Form C–1 [p.169]

68]

CPA Report is a product of www.kaplanfinancial.com

Note: CPA Report now includes one Government/Not-for-Profit segment.

Information regarding COVID-19 changes rapidly; further updates will be in upcoming segments.

http://https://www.kaplanfinancial.com

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Field of Study: Taxes – NFP To be tax-exempt under section 501(c)(3) of the Internal Revenue Code, an organization must be organized and operated exclusively for exempt purposes as set forth in section 501(c)(3). But what are the activities that could potentially jeopardize tax-exempt status? Allen Fetterman, an instructor for Kaplan Financial Education describes the four major areas of concern for 501(c)(3)organizations when it comes to maintaining their tax-exempt status. He reviews in detail inurement, lobbying, politi-cal activities and unrelated business income.

5. Tax-Exempt Status: Jeopardizing Activities

Summary Page (continued)

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1. Select discussion leaders who have the appropriate education and/or experience both to teach the segment subject and conduct the subsequent group discussion.

2. Have each discussion leader review the video segment and the written materials in the Subscriber Guide prior to the presentation of the segment.

3. Make sure that each discussion leader certifies the attendance at his/her discussion group by signing and dating the Group Live Attendance Form.

4. (Individuals) View the video segment (30 to 35 minutes).

5. (Individuals) Discuss the segment materials as they relate to his/her own work and/or organization (20 to 25 minutes).

6. (Individuals) Evaluate the instructor using the criteria listed on the Evaluation Form.

7. Check with your State Board of Accountancy for specific details, including group live sponsorship registration requirements.

Group Live Format

When taking a CPA Report segment on a group live basis, individuals earn CPE credits when they (or their organization) do the following:

CPE RequirementsWhen properly administered, the CPA Report educational program meets the requirements for group live and self-study participation as defined in the Statement for Standards in CPE Reporting.

Please note:

l You cannot earn additional credits by taking the same course in group live format and online self-study format.

l CPE requirements vary from state to state. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. CPAs should contact their state board regarding specific CPE requirements.

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e The following information will help you plan and implement the CPA Report program within your firm:

How to Implement the CPA Report

1. Each quarter, you may receive by email a CPA Report Summary Page in advance of the video segment notifying you of the upcoming Continuing Professional Education topics that will be covered.

2. The CPAR DVD is expected to arrive the month following the end of the quarter. If you do not have a standard day and time each quarter designated as CPE day, issue a memo with the date of your upcoming seminar. (If attendance is not required, please provide plenty of advance notice for optimum participation).

3. Select the topic(s) you wish to cover in your session when the CPAR Summary Page or the actual program arrives.

4. It is best for an organization to have its CPE classes on a regular and consistent basis, so it is easy for the staff to remember when scheduling clients.

5. You may wish to provide each group live attendee a “Certificate of Completion” noting the hours earned and the topic areas.

6. Always check with your State Board of Accountancy for specific details, including group live sponsorship registration requirements.

If you need more information or have any questions, please contact Customer Service at [email protected] or 914-517-1177.

Note: CPE requirements vary from state to state. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. CPAs should contact their state board regarding specific CPE requirements.

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Please note: This issue of CPA Report Online Self-Study is scheduled to go live online on July 29, 2021.

If you need more information or have any questions, please contact Customer Service at [email protected] or 914-517-1177.

Online Self-Study

Kaplan Financial Education is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: www.nasbaregistry.org.

Self-Study Format

Participants can gain self-study credit by enrolling in the CPA Report Online Self-Study library of courses. All components of the program will be hosted online, including the video, interactive review questions, required reading, and final exam.

In order to ensure adherence to NASBA guidelines regarding self-study, the CPA Report and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers are no longer available. Customers should contact their company administrators for information on taking course exams and receiving CPE credit for the courses.

Customers may contact Kaplan Financial Education at [email protected] to obtain certificates previously earned through the CPA Report Self-Study and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers.

Customers interested in the self-study format of the CPA Report can find information on Kaplan Financial Education's self-study libraries at Online Accounting CPE Courses.

http://mailto:[email protected]

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Segment Overview:

Recommended Accreditation:Reading (Optional for Group Study):

Running Time:

Video Transcript:

Course Level:

Course Prerequisites: Advance Preparation:

Expiration Date: September 10, 2022

Work experience in a corporate staff environment, or an introductory course in accounting.

None

1 hour group live 2 hours self-study online

Update

“Winning With SPACs Is a Long Shot” “Are SPACs the second coming of the IPO—or a flash in the pan?” “Who is SPACable? Fashion Companies in the Crosshairs: Brands primed to potentially be taken public by the oncenovel, suddenly everywhere species of investor” “Repeat Spac sponsors will attract best targets “

See page 1–11.

See page 1–19.

35 minutes

SPACs, special purpose acquisition companies, have been around since the early 2000s, yet they have been the biggest trend over the past year. When there is a surge, especially of that magnitude, there is also scrutiny. The SEC looks very closely at filings and disclosures by SPACs to protect the public so investors can make informed investment decisions. Warren Buffet considers the SPAC boom a "killer," but is there another side to SPACs? Opinions are split. SPACs are in the news almost daily, but the question is how long will this boom last and is this really a "killer"? Brian Sarkis, CFA, founder of The Franklin Nova Group discusses SPACs in detail, how they work, and the underlying risks.

Upon successful completion of this segment, you should be able to: l Understand what SPACs are and how they work,

• Recognize the accounting treatment of SPAC warrants in accordance with recent SEC regulations,

• Identify the differences between SPACs and IPOs, and

• Determine steps investors should take prior to investing in SPACs.

Field of Study: Accounting

A. What Are SPACs

i. Investors put in money in a corporation

ii. Corporation looks to acquire a privately held target

iii. Expedited way to take a company public

iv. Allows price negotiations

v. Public companies holding capital

B. Accounting Firms & SPACs

i. Big 4 firms stay away from auditing SPACs

• Don’t opine

ii. Smaller firms do work in SPACs

iii. Larger firms assume advisory roles

• Due diligence

• Assemble proformas

• Not necessary to opine

C. SPAC Warrants & Accounting Treatment

i. Warrants issued recently for SPACs

• Already acquired companies

• Companies are listed as public

ii. Warrants related to SPACs going through the process

iii. Recorded as liabilities on their balance sheet

D. Impact of Warrants as Liabilities

i. Valuation firms have to value the warrants

ii. Slowed down the process

iii. Existing companies have to restate their financials

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I. SPACs: Recent Trends & Accounting Treatment

A. Considerations Prior to Investing in SPACs

i. Read the SPAC’s IPO prospectus and reports

ii. Review terms of an offering and understand

• The investment

• The use of interest on the investment

• The trust account set up

iii. Look at the trading price

iv. At the time of the initial business combination, understand

• Shareholder voting rights

• Redemption options

• Necessity to review the proxy, information or tender offer statement

• The interests of the SPAC sponsors

B. Purpose of the Two-Year Period

i. Ensure there are no guarantees

ii. Holding the money indefinitely creates a public holding company

iii. Majority of funds have a 2-year expiration

iv. No guarantees the SPAC will

• Go public

• Find a company to acquire

• Fitting the investment criteria put forth when the SPAC raised the funds

C. Considerations for Sponsors

i. Get compensated with up to 20% of the shares

• Without putting in significant capital

ii. Get duped by potential acquisition targets

• Fraudulent financials

II. Considering the SPAC Investment

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A. Brian Sarkis’ Pitch to:

i. Investment committees that raised money

• Find companies in your area

• Find companies that fit you best

ii. SPAC sponsors

• Help companies grow without overpricing them

• Make them attractive to entrepreneurs

B. Traditional Private Equity Firms

i. Acquire businesses that need capital

ii. Have due diligence teams & mechanisms

• Understand what they are buying

iii. Can also make bad acquisitions

C. Private Equity Sponsors

i. Will be held accountable by their investors

ii. Don’t have retail investors

• Large pension funds

• Financial institutions

III. The IPO Environment for SPAC

A. Process of SPACs

i. Once capital is raised

• It sits until an acquisition is made

• At $10 per share

ii. When an acquisition is announced

• Investors can come in or go out

iii. Until the deal closes, the trading is at the initial amount raised

iv. After the merger companies can go both ways

B. SPACs vs IPOs

i. SPACs allow investors

• Freedom of picking & choosing

• To find companies that best fit their criteria

• To avoid a painful process

• Buyers & sellers set the price

ii. IPO drawbacks

• The way price is set

• Causes issues for investors when they go out

“The beauty of this process, it allows the buyer and the seller to set the price and agree based on everything that's there and not have these third party market prices in play.”

— Brian Sarkis

C. A Closer Look at SPACs

i. Different way of investing

ii. Sponsors can take equity

iii. Good underlying fundamentals

iv. Pre-SPAC information on financials may not be good

v. Fewer regulatory requirements than IPOs

vi. Important for investors to understand SPACs

IV. Deeper Dive into SPAC Mechanics

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V. Looking Forward A. Prior to Investing in SPACs

i. Understand

• Your risk tolerance

• Areas & industries you want to invest in

• Reasons you want to invest

ii. Do your homework on the SPAC sponsor

iii. Read the disclosures

B. Brian Sarkis’ Takeaways

i. Find what makes sense for the

• Company

• Investor

ii. Is it the right move?

iii. Demystify, understand and know risks involved

iv. Understand the ultimate purpose

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Discussion Questions

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l As the Discussion Leader, you should introduce this video segment with words similar to the following:

“In this segment, Brian Sarkis discusses SPACs in detail, how they work, and the underlying risks.”

l Show Segment 1. The transcript of this video starts on page 1–19 of this guide.

l After playing the video, use the questions provided or ones you have developed to generate discussion. The answers to our discussion questions are on pages 1–7 to 1-8. Additional objective questions are on pages 1–9 and 1–10.

l After the discussion, complete the evaluation form on page A–1.

1. Special purpose acquisition companies (SPACs) have been the biggest trend over the past year. What are the primary features of SPACs? What is your and your organization’s familiarity with these entities?

2. SPACs have received enhanced scrutiny in recent months due to the increased interest in them by investors. How are SPACs viewed by parties who invest in or work with them? What is your organization’s view of these entities?

3. The SEC recently issued guidance on the accounting treatment of SPACs-related warrants. What has been the impact of the SEC’s guidance on existing as well as proposed SPACs? How has the guidance affected your entity’s SPAC investments, if at all?

4. Although SPACs are readily available for investment in the market, they raise a number of issues and questions that investors may wish to consider answering before they decide to invest. What are some of the issues investors should consider prior to investing in a SPAC? How did you and your organization address these issues if you have considered investing?

You may want to assign these discussion questions to individual participants before viewing the video segment.

Instructions for Segment

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5. SPACs, like any other investment, are subject to certain rules and risks. What are the rules and risks related to SPACs? How does your organization mitigate such risks and ensure compliance with the rules when investing?

6. A recent study found that most SPACs trade below the $10 offer price. Why is the $10 threshold the selected benchmark for pricing SPACs? Do you agree with this threshold? Why or why not?

7. Some investors may use SPACs as a means to bypass the traditional expensive and time-consuming IPO process. What are the differences between a SPAC and IPO? Do you and your organization favor one process over the other?

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s1. Special purpose acquisition companies

(SPACs) have been the biggest trend over the past year. What are the primary features of SPACs? What is your and your organization’s familiarity with these entities? l Investors invest money into a public

corporation which in turn looks to acquire a privately held target

l Expedited way to take a private company public

l Allows price negotiations l SPACs are essentially just public

companies holding capital l Participant response based on

personal/organizational experience

2. SPACs have received enhanced scrutiny in recent months due to the increased interest in them by investors. How are SPACs viewed by parties who invest in or work with them? What is your organization’s view of these entities? l SPACs have been promoted by many

celebrities which in turn generates interest from investors

l Pricing is typically $10 per share which makes it affordable to common investors

l Accounting firms & SPACs v Big 4 firms stay away from

auditing SPACs k Don’t opine

v Smaller firms do work in SPACs v Larger firms assume advisory

roles k Due diligence k Assemble proformas k Do not necessarily opine

l Participant response based on personal/organizational experience

3. The SEC recently issued guidance on the accounting treatment of SPACs-related warrants. What has been the impact of the SEC’s guidance on existing as well as proposed SPACs? How has the guidance affected your entity’s SPAC investments, if at all? l SEC guidance on SPAC warrants &

accounting treatment requires: v All warrants issued recently by

SPACs k For already acquired

companies or k Companies that are listed as

public, and v Warrants related to SPACs going

through the process v Must be recorded as liabilities on

their balance sheet l Impact of SEC guidance

v Valuation firms are required to value the warrants

v Slowed down the process v Existing companies must restate

their financial statements l Participant response based on


4. Although SPACs are readily available for investment in the market, they raise a number of issues and questions that investors may wish to consider answering before they decide to invest. What are some of the issues investors should consider prior to investing in a SPAC? How did you and your organization address these issues if you have considered investing? l Considerations prior to investing in

SPACs v Read the SPAC’s IPO prospectus

and reports v Review terms of an offering and

understand k The investment k The use of interest on the

investment k The trust account set up

Suggested Answers to Discussion Questions


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sl Look at the trading price l At the time of the initial business

combination, understand v Shareholder voting rights v Redemption options v Necessity to review the proxy,

information or tender offer statement

v The interests of the SPAC sponsors


5. SPACs, like any other investment, are subject to certain rules and risks. What are the rules and risks related to SPACs? How does your organization mitigate such risks and ensure compliance with the rules when investing? l SPACs must raise money for a stated

goal v The raised money is placed into a

trust and the target company must be identified within a two-year period of the SPAC’s formation

l Purpose of the two-year period v Ensure there are no guarantees v Holding the money indefinitely

creates a public holding company v Majority of funds have a 2-year

expiration v No guarantees the SPAC will

k Go public k Find a company to acquire

b Fitting the investment criteria put forth when the SPAC raised the funds

l Risk considerations for sponsors v Getting compensated with up to

20% of the shares without putting in significant capital

v Getting duped by fraudulent financials prepared by potential acquisition targets


6. A recent study found that most SPACs trade below the $10 offer price. Why is the $10 threshold the selected benchmark for pricing SPACs? Do you agree with this threshold? Why or why not? l The SPAC process

v Once capital is raised, it sits until an acquisition is made

v Historically capital is priced at $10 per share

v When an acquisition is announced, investors can come in or go out until the deal closes, the trading is at the initial amount raised

v After the merger, the price can go up or down, similar to IPOs


7. Some investors may use SPACs as a means to bypass the traditional expensive and time-consuming IPO process. What are the differences between a SPAC and IPO? Do you and your organization favor one process over the other? l SPACs vs IPOs

v SPACs allow investors freedom of picking & choosing to k Find companies that best fit

their criteria k Avoid a painful process

l Allows buyers & sellers to set the price with no market interference.

l IPO drawbacks v The way price is set causes issues

for investors when they go out l Features of SPAC investments

v Different way of investing v Sponsors can take equity v Good underlying fundamentals v Pre-SPAC information on

financials may not be good v Fewer regulatory requirements

than IPOs l Participant response based on


Suggested Answers to Discussion Questions (continued)

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1. Special Purpose Acquisition Corporations (SPACs):

a) are an expedited way to take a company public

b) are a new type of entity that was created in the last 5 years

c) seek other public companies to invest in

d) do NOT allow for price negotiations between parties

2. When it comes to the nature of the work performed by Big 4 accounting firms for SPACs these firms will __________ SPACs.

a) not assemble pro forma financial statements for

b) opine on the financial statements of

c) not opine on the financial statements of

d) perform any type of work for

3. The new SEC rule on the accounting treatment of SPAC warrants requires that warrants issued:

a) only by SPACs that have undergone the acquisition process be recorded as a liability on the financial statements

b) only by SPACs that are currently in the acquisition process be recorded as a liability on the financial statements

c) by any SPAC be recorded as a liability on the balance sheet

d) by any SPAC need only be disclosed in the financial statement footnotes

4. Under current rules, SPACs are required to identify a target within __________ of receiving funds.

a) one year

b) two years

c) five years

d) there is no time frame for SPACs to identify a target

5. The process of SPAC investing:

a) is much more similar to a private equity investment than a typical merger and acquisition (M&A) transaction

b) is no different from a traditional M&A or private equity investment

c) does not have the same risks as traditional investments

d) caters more to large pension funds or financial institutions

6. With respect to the process SPACs go through, once capital is raised:

a) it sits in a trust account until an acquisition is made

b) it must generate an immediate return for investors

c) investors cannot exit the investment until after the acquisition is made

d) the trading price of shares fluctuates

7. When it comes to the comparison of SPACs to traditional IPOs, IPOs:

a) allow investors more freedom to choose companies that meet their investing criteria

b) are less cumbersome from an investing standpoint than SPACs

c) allow buyers and sellers to set the price they want with little market interference

d) have their prices influenced by market events

You may want to use these objective questions to test knowledge and/or to generate further discussion; these questions are only for group live purposes. Most of these questions are based on the video segment; a few may be based on the reading that starts on page 1–11.

Objective Questions


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8. As compared to the S&P 500 index, studies show that the median SPAC return:

a) trailed the S&P 500 within one month post acquisition but eventually surpassed returns posted by the S&P 500 index

b) typically tends to generate a greater return than the S&P 500 index one month post acquisition but then lag behind it

c) trailed the S&P 500 after one month and after 6 months post acquisition

d) was greater than the S&P 500 after one month and after 6 months post acquisition

9. When it comes to the potential gains and losses generated by a SPAC investment:

a) the gains can be infinite if a quality investment is found by the SPAC

b) the gains are capped by SEC rules

c) investors in SPACs can lose more than their original investment amount

d) none of the above

10. According to Michael Toure, a successful SPAC target in fashion would show any one of the following attributes EXCEPT:

a) inclusivity and sustainability

b) strong brand and premium quality products

c) high service and a differentiated experience

d) low cost items

Objective Questions (continued)

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You’re betting on companies with short track records and uncertain futures—and relying on someone else to find them.

Source: EBSCO This article is for educational use only. Please do not use, distribute or share outside this course.

GETTING IN EARLY ON THE next Tesla or Netflix is a major selling point of SPACs, or special purpose acquisition companies. SPACs offer an alternative to traditional initial public offerings and have surged in popularity. But picking a winner is far from a sure thing. Because of the way SPACs are structured— think of them as “blank check companies” whose sole goal is to acquire early stage businesses and take them public—it’s hard for SPAC investors to assess the merits of what they’re buying.

SPAC mania has been driven by cheap money, a soaring market and investors’ search for new opportunities. SPACs had a breakout year in 2020, with a record 248 SPAC IPOs, a fourfold rise from 2019, according to data provider Dealogic. High-profile SPAC IPOs that now trade as regular stocks include sports-betting firm DraftKings and space-tourism company Virgin Galactic. (For more on Virgin Galactic, see “How to Cash In on the Final Frontier,” on page 36.) SPACs got off to a hot start this year, with 315 SPACs listed and $100.4 billion raised through May 7, topping full-year records for 2020. So far this year, SPACs account for 41% of all IPOs

How they work. When you invest in a SPAC, you’re not investing in a company such as Tesla with real products and sales. You’re giving your money to a “sponsor,” or investment team, who will identify and

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Reading (Optional for Group Study)

WINNING WITH SPACS IS A LONG SHOT

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l In order to ensure adherence to NASBA guidelines regarding self-study, the CPA Report and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers are no longer available. Customers should contact their company administrators for information on taking course exams and receiving CPE credit for the courses.

l Customers may contact Kaplan Financial Education at [email protected] to obtain certificates previously earned through the CPA Report Self-Study and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers.

l Customers interested in the self-study format of the CPA Report can find information on Kaplan Financial Education's self-study libraries at Online Accounting CPE Courses.

CPA Report Update


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invest in the next potential Tesla for you. The sponsor has two years to acquire a yetto-be-identified company. Until a business combination is completed, the money raised from investors is held in a trust account.

SPAC shares trade on an exchange while the sponsor searches for a company to take public, and it’s not uncommon for SPACs to trade sharply higher as investors react to rumors about merger candidates. If an acquisition target isn’t found in the allotted time, the SPAC will liquidate. IPO investors will get back their initial investment, and buyers in the secondary market can redeem their shares at the initial offer price, typically $10 a share, dubbed the pro rata share. Once a target company is announced, you must decide whether to stay invested in the new, post merger company, which will trade with its own symbol, or redeem your shares at the pro rata price. You can get burned if you jump into a SPAC at or near a top.

SPAC fever cooled in mid February, as SPACs sold off with tech stocks and other speculative issues. “SPACs were exhibiting bubblelike characteristics, and growing pains were likely,” says Jason Draho, head of asset allocation Americas at UBS Financial Services. The wipeout has been swift, with some of the worst-performing SPACs and post-merger stocks down 50% to 70% from mid February through mid April, according to Bespoke Investment Group. Regulatory scrutiny hurt, too. The Securities and Exchange Commission recently warned SPACs about issuing misleading sales projections and noted that SPAC sponsors may pursue deals that aren’t in the best interests of investors.

Overall, post-merger performance hasn’t been great. Of the SPACs that brought companies public in 2020, the median postacquisition return trailed the S&P 500 index by 13 percentage points after one month and by 27 points after six months, according to investment bank Goldman Sachs. SPACs have also underperformed traditional IPOs by a wide margin. A sizable SPAC pipeline may signal a saturated market. In April, there were

nearly 400 SPACs seeking acquisitions, Goldman Sachs says.

David Sekera, chief market strategist at Morningstar, thinks most retail investors should steer clear of SPACs. “I don’t think this is an appropriate product,” he says. ADAM SHELL

Copyright of Kiplinger's Personal Finance is the property of Kiplinger Washington Editors Inc. and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual Source: EBSCO This article is for educational use only. Please do not use, distribute or share outside this course.

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SPACs are the new buzzword on Wall Street. From Silicon Valley investors to respected businessmen, showbiz stars, and ordinary people, who doesn't love a seemingly great earnings opportunity spiced with a touch of glamor and exclusivity?

These are all among the cast of characters that have promoted or bought into the SPAC fever that has swept the U.S. in the past year. SPACs are special purpose acquisition companies, which means they are companies set up for the purpose of a takeover or business combination. (As the CEO and founder of SPACs Consultancy Ltd., writing about SPACs might benefit me in attracting clients looking for SPAC advice.)

More than 240 SPACs listed in the U.S. (on NASDAQ or the NYSE) last year, raising a record $83 billion, according to SPAC Research. SPACs have already surged past last year's record in the first quarter of 2021, raising $98.1 billion. So far, 2021 has been a good year for traditional IPOs too, with 194 IPOs raising $67 billion, according to Renaissance Capital.

However, the boom that made 2020 the year of the SPAC started to cool this April, following warnings from the U.S. Securities and Exchange Commission. The compelling question today is: Could the trend be here to stay or will SPACs follow dinosaurs toward extinction?

The SPAC craze has been shaking the U.S. for months, mainly because of its simplicity: A bunch of investors decide to buy shares at a fixed price in a company that initially has no assets. In this way, a SPAC, also known as a "blank check company," is created as an empty shell with lots of money to spend on a corporate shopping spree.

It's a bit like a lottery ticket—the initial stake is small, but in terms of potential gains, the sky's the limit. At the same time, every SPAC is finite: If you do not find a target within a preset time frame (usually about a year or two), the SPAC is liquidated, and the investors get their money back. Once the SPAC finds a suitable target company, it merges with it. Then, the business shoulders the same operational, financial, or reputational risks as any other company.

Traditional IPOs are under attack. Look at Deliveroo's IPO in March in the U.K. It closed down 26% on its first day of trading. The share price slump means tens of thousands of retail investors who backed Deliveroo are now sitting on heavy paper losses. Think also of Ant Group's pulled IPO in 2020.

SPACs are emerging as the new IPO, or IPO 2.0. They have everything an IPO has, with fewer formal requirements and at a lower cost.

Some argue that SPACs are the next bubble to burst. Somewhat like a proposal of marriage, a private company will need to consider whether the SPAC approaching it is a worthwhile partner for long-term life as a public company. This might be risky. Also, critics wonder whether companies listing via SPACs can live up to investors' sky-high expectations.

These skeptics should look to the U.K., where electric vehicle firm Arrival, which had yet to record any revenues, went public in March by merging with a SPAC in New York. Today, Arrival is valued at more than $10 billion.

Or look at what is happening with Grab, the Singaporean multinational mobile app leader for deliveries, mobility, and financial services in Southeast Asia. The company, valued at $40 billion, decided in April to use a SPAC to list on NASDAQ. As opposed to traditional IPOs, SPACs offer

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ARE SPACS THE SECOND COMING OF THE IPO—OR A FLASH IN THE PAN?

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more certainty for the target to go public with a consistent valuation process.

It is undeniable that SPACs are a great financial innovation. Through SPACs, private companies gain access to public funds and have an opportunity to be directed by reputable managers who can bet on innovative ideas. What is not often mentioned, though, is that SPACs are also believing in other people's entrepreneurship dreams.

Daniele D'Alvia is a teaching fellow in banking and finance law at Queen Mary University of London and CEO and founder at SPACs Consultancy Ltd.

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WHO IS SPACABLE? FASHION COMPANIES IN THE CROSSHAIRS: BRANDS PRIMED TO POTENTIALLY BE TAKEN PUBLIC BY THE ONCENOVEL, SUDDENLY EVERYWHERE SPECIES OF INVESTOR


Whether it's the return of denim or the rise of the next new investing class on Wall Street, trends all operate the same way.

There's the status quo that's ready to be shaken up (in the case of denim, the rush of athleisure), a catalyst for change (say, a year spent at home in sweatpants), and then an explosion that suddenly has the world lurching toward something new (again).

The difference on Wall Street -- where SPACs are suddenly everywhere and racing to buyout big names -- is that the dollar signs are all much bigger and the future of the companies they target hang in the balance.

And while the dealmaking market in apparel is slow, there are plenty of potential fashion and beauty targets for these new investors, from Warby Parker to The Honest Co.

Special purpose acquisition companies aren't new, but they've taken over the investment imagination and are actively on the hunt for brands that might want some

quick money and a backdoor to the public markets.

Call it what happens when you give former chief executive officers and the Wall Street types too much time at home with low interest rates, a hyperactive stock market and a once-in-a-lifetime business landscape that's ripe with change and opportunity.

SPACs are, at their core, management teams without companies and a bunch of money that's literally burning a hole in their pocket. Typically, it's an industry veteran or two who put together a team, raise money through an initial public offering on the promise of buying a company or giving the funds back to investors in a couple years.

So far this year, SPACs have raised over $98 billion through IPOs, on top of the $82 billion raised last year, according to Dealogic.

Among the players who are on the hunt already or preparing to launch a SPAC are former Gap Inc. CEO Art Peck and Seventh Avenue financier Gary Wassner with Good Commerce Acquisition, private equity veteran Ken Suslow at Sandbridge Acquisition Corp. (with support from Tommy Hilfiger and Domenico De Sole), Matt Higgins' Omnichannel Acquisition

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Corp. (with support from Bobbi Brown), mall giant Simon Property Group, luxury titan Bernard Arnault and many, many more.

And while the launch of new SPACs may have slowed to a trickle in recent weeks from the flood seen earlier, there are plenty of players on the field. Every SPAC has its own specific strategy -- they might buy a minority stake or full control of a company, effectively taking that company public. Or they might seek to invest in a number of businesses that work together on some level, creating a publicly traded holding company.

The deals are just starting to come together now, but it's a heady combination with so much money and so many players looking to buy and companies tempted to take a quick path to an ultra-hot stock market.

Serial CEO Matthew Rubel said: "Every market has its moment of being the Wild West and so we have that moment of being the Wild West, where all things are possible. But it's also possible that your six-shooter backfires and you get killed in the process. To navigate the Wild West you need to be thoughtful about what you do."

Rubel, who has been CEO of Varsity Brands, Payless owner Collective Brands and Cole Haan, is now head of the SPAC Empower, which raised $250 million in October and last month made its first deal, buying auto enthusiast platform Holley.

But companies that choose to go public through a SPAC instead of taking the longer path with an IPO of their own need to be ready to be public companies.

"You have to make sure that, as a company, you have a clear story and that you have future growth, that you can articulate and show that," Rubel said. "If you are just seeking money and you don't have solid unit economicsthen don't go public and don't use a SPAC."

And being ready to be public most often means having a clear path forward since investors want nothing more than a growing company that promises to keep

getting bigger, boosting profits and market share.

Michael Toure, founder and CEO of strategic and M&A advisory boutique Toure Capital, said: "SPAC targets need to approach this process with the ambition to build a $1 billion revenue brand and that the proceeds from the SPAC merger will help them get there. They need to be able to demonstrate to the SPAC sponsor and to their future public shareholders how they will achieve these results and give them confidence that they will keep delivering on this performance, which in return will keep improving the newly merged entity share price."

Toure said successful SPAC targets in fashion would ideally show four key attributes:

• Inclusivity and sustainability.

• Strong brand and premium quality products.

• High service and a differentiated experience.

• Platform, technology and ability to scale.

As the numbers have grown in the SPAC universe, so has the scrutiny.

Regulators at the Securities and Exchange Commission have signaled that they're keeping a close eye on the trend and this month put out a statement pointing out certain "accounting and reporting considerations for warrants" issued by SPACs.

That could slow what has been a headlong rush.

But speed is still a key benefit of going public via SPAC, since it will help a company jump into the markets when valuations are supported by a nearly 44 percent run-up in the Dow Jones Industrial Average over the past year. The index closed up 0.7 percent at 34,043.49 on Friday.

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"It's fast," said Sonia Lapinsky, a managing director in AlixPartners' retail practice, of going public with a SPAC. "They can move quicker and with less scrutiny. It's relying on the [SPAC] investor to do the diligence to make sure these guys are going to come out OK on the other side and be able to perform.

"It seems like there's a lot that could go wrong," Lapinsky said. "But lots of people could also make a lot of money."

Here, five companies that could pique the interest of the suddenly monied SPAC set.

WARBY PARKER

The first-gen d-to-c eyeglass disruptor has long been seen as a candidate for the public market. It is widely seen as having the brand, scale and management team necessary to carry itself on Wall Street. Rumors have been spreading lately that the company could make its move toward the public markets this year.

SAKSFIFTHAVENUE.COM

Hudson's Bay Co., which itself left the public markets in 2020, separated the Saks Fifth Avenue store from the saksfifthavenue.com e-commerce business this year. The web business, which was valued at $2 billion with a $500 million investment from Insight Partners, is seen as a contender in the public market, where competitor Mytheresa staged an IPO in January.

STOCKX

The sneaker and collectibles reseller raised $275 million in Series E funding in December, valuing the company at $2.8 billion. StockX plans to use the money to drive its global expansion, innovation and category diversification -- all things that Wall Street likes to see.

THE HONEST CO.

Jessica Alba's clean beauty company has been through many of its growing pains, but with the help of backer L Catterton, has been revving up operations and now has

over $300 million in sales. The company filed for an IPO this month, signaling it's ready to be public, and the right SPAC could be an alternate route.

FANATICS

The sports licensing company raised $320 million from existing investors last month, valuing it at $12.8 billion and fueling rumors of an IPO. Fanatics was expected to use the new money to build online and chase acquisitions. It would be a big deal, but a SPAC could help the company tap into today's public valuations quickly.

Copyright of WWD: Women's Wear Daily is the property of Penske Business Media, LLC and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use.

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Eagerly courted high-growth private companies will likely go to experienced Spac sponsors

When large investment banks report results for the first quarter of 2021, any of them that delivers weak revenues from equity capital markets should brace for a backlash.

Dealogic numbers show that by mid March issuers had launched 557 IPOs worth $157 billion this year. Citi notes that a usual year would see around 100 to 200 by this point. They are a bigger source of revenues than M&A or debt capital markets.

The largest market has been the US, which accounts for $100 billion of that total with 303 deals. Of these, 74% relate to special purpose acquisition companies.

Last year, Spacs raised $83.3 billion, up from $15.5 billion for 2019 and an annual average of just $6 billion for the last decade. In just the first two-and-a-half months of 2021, they have already raised $47 billion.

Credit Suisse will be the biggest winner here, with a commanding market share ahead of second-ranked Goldman Sachs. Wall Street's second-tier firms, notably Cantor and Jefferies, are muscling ahead of bulge-bracket firms such as Morgan Stanley and JPMorgan.

This will be a fascinating battle. Analysts will have to recalculate their earnings models because just one third of investment banking fees typically pay out when a Spac IPOs, with the larger bounty coming at the de-Spac.

However, the de-Spac only happens when a sponsor agrees a target that the IPO investors approve of.

And so, while the battle between banks to catch up with Credit Suisse in arranging

Spacs will be intense and entertaining, the serious money will go to the winning Spac sponsors.

Euromoney has examined the efforts of former bank chief executives, such as Martin Blessing and Tidjane Thiam, to position their operating experience as a key attraction to founders and managers of fintechs with the greatest potential to achieve global scale.

They shouldn't count their chickens.

The best targets are heavily courted. Some will IPO on their own. Others will go to already-experienced Spac sponsors that promise the greatest likelihood of success and the highest valuation multiple.

Repeat sponsors are better set to win the best targets with each successful trade.

Think of Michael Klein and his track record with the Churchill group of blank-cheque companies; Chamath Palihapitiya who, having taken Virgin Galactic public last year, won SoFi for his fifth Social Capital Hedosophia (SCH) Holdings Spac in January; and Betsy Cohen.

Cohen is the former chief executive of The Bancorp, which she founded at the end of 1999 as a branchless commercial bank, and has become a leading provider of private label banking and technology solutions.

Now as chairman of FinTech Acquisition Corp, Cohen has just announced her fifth de-Spac, having announced her fourth at the end of last year to take Perella Weinberg public, previously doing the same for payments companies Paya and International Money Express, as well as for CardConnect.

Her latest deal, for retail investment platform eToro, values it at $10.4 billion. Cohen and the sponsors will own 0.8% of it for a likely 10-times return on risk capital.

The Spac business may look like the Wild West today. Individuals can take their shot, but expect it to institutionalize soon, just as

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REPEAT SPAC SPONSORS WILL ATTRACT BEST TARGETS

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private equity did in the 1990s around a few leaders.

The new Spac equivalents to Apollo, KKR and Carlyle are already appearing.

©Euromoney Institutional Investor PLC. This material must be used for the customer's internal business use only and a maximum of ten (10) hard copy print-outs may be made. No further copying or transmission of this material is allowed without the express permission of Euromoney Institutional Investor PLC. Source: Euromoney and http://info.euromoney.com.

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SURRAN: SPACs, special purpose acquisition companies, have been around since the early 2000s, yet they have been the biggest trend over the past year, and when there is a surge, especially of that magnitude, there is also scrutiny. The SEC looks very closely at filings and disclosures by SPACs to protect the public so investors can make informed investment decisions.

The SEC also issued an investor alert in March 2021 warning investors that celebrity involvement in a particular SPAC or SPACs is not appropriate for all investors and it continues by saying that:

"Celebrities, like anyone else, can be lured into participating in a risky investment or may be better able to, to sustain the risk of loss. It is never a good idea to invest in a SPAC just because someone famous sponsors or invests in it or says it is a good investment."

SPACs are also known as "blank check companies" as they raise money but are listed on an exchange before they even own any assets. SPAC investors trust management to pick a business to acquire within two years.

On Saturday, May 1st, 2021, at Berkshire Hathaway's annual meeting, Warren Buffet told shareholders that, "SPACs generally have to spend their money in two years… if you put a gun to my head and said you have to buy a company in two years, I'd buy one but it wouldn't be much of one." He considers the SPAC boom a "killer", but is there another side to this? Opinions are split!

MORIARTY: SPACs may be in the news almost daily but the question is how long will this boom last and is this really a "killer"? Brian Sarkis, CFA, founder of The Franklin Nova Group joins us this month and starts our conversation by defining SPACs and how they work.

SARKIS: SPACs have been around a long time and essentially what they are and what it stands for is Special Purpose Acquisition Corporation. So, essentially these are corporations that are set up, investors put in money and they wait to find a privately held target which they will acquire. So, in their simplest form, they've been there a long time. It's an expedited way to take a company public.

It also allows for there to be negotiation between the parties in terms of the actual price.

So, in a traditional IPO, the price is really set by the market. In a SPAC setting, this can be negotiated by the SPAC sponsor in the company being acquired.

These are essentially public companies that just hold capital that look for private companies to acquire that then makes those private companies through the acquisition become a public entity.

MORIARTY: There have been a number of celebrities investing in SPACs; however, the SEC issued an alert advising investors not to make decisions based on celebrity involvement, but rather to make an educated decision. Brian gives us his insights as to what makes SPACs so appealing to investors.

Video Transcript


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t SARKIS: I think there's been a trend in the world and I think COVID and the shutdowns accelerated this, but there has been, I'll call it anti-big bank sentiment for a number of years and with the rise of the retail investor and this perfect storm that happened at the outset of COVID. You had a lot of attention from retail investors due to I think people being at home for extended periods of time, there being no sports on TV and with no sports, there was no gambling. And you had the crash of the market and then a very quick rebound for a number of stocks in March and April of 2020.

I think you had a number of people looking for things to do, being stuck inside and all of a sudden there was a lot of attention on the market. Couple that then with retail investors, there being stimulus packages and things coming out where some people frankly got money they maybe didn't need to live.

So, use that money almost like free money to go into the retail investing side. We've always seen celebrities pitch financial instruments, things like think about reverse mortgages and Tom Selleck and others that we find on TV and so the SPAC world's no different in that and you've got some people such as Shaquille O'Neal that's crossed over into the business world very recognizable, who then can put together and put his name behind a SPAC that generates interest from investors that may otherwise not have paid any attention to this.

The SPAC pricing is typically $10 a share, relatively affordable. And so it's again, that environment is set for retail investors being attracted. There's a bit of let's say non Wall Street feel to this, the common man can invest and then the ability to invest in some companies that are maybe a little bit outside of the mainstream. So, there have been companies that have gone public through SPACs, they've involved online gaming entities, they've involved in some cases, marijuana entities, whether it be medical or retail, there've been some green energy entities, electric automobile manufacturers, so on and so forth. So, it's a very popular area and I think it's very fitting or fits nicely into having celebrities involved.

MORIARTY: When it comes to SPACs, is there a profile of firms that are assisting, and are traditional accounting and law firms that serve traditional IPOs involved?

SARKIS: Currently it's a bit of a different spectrum of companies. So, the SPAC, I don't want to say has been looked down upon, but it's not been considered as the traditional path of an IPO. So, it's considered an easier way to IPO.

Currently the big four accounting firms have stayed away from auditing SPAC companies, so being the signing company on that opinion. However, the firm that I'm involved with, we do some work in the SPAC space and we've seen your larger accounting firms being involved in an advisory role. So, they've been involved in the due diligence, they've been involved in assembling proformas but not necessarily signing the opinions.

And so it appears that the big firms and big law firms and accounting firms have seats at the table, it's just maybe that the chairs have been rearranged and instead of being at the head of the table, they might be at a bit on the side right now, almost taking a bit of a wait and see approach and some of these while they're established firms, but maybe nontraditional firms have taken the lead role as auditors as this develops.

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t I would expect that maybe to change. The bigger firms might be a little more selective, but as the world I think accepts that SPACs that are not necessarily a fad or they're here to stay or there's a lot of success with them, I think you'll see anything that it'll come back to even if you will and you'll see the larger firms being involved in a number of different roles not just as advisors.

MORIARTY: The SEC in mid-April had issued some guidance on SPACs related warrants and the accounting treatment. Brian discusses the impact that this has had on existing as well as proposed SPACs.

SARKIS: In mid-April of 2021, the SEC came out and basically said all of the warrants that had been issued recently for SPACs that have already gone through the acquisition process and now have companies listed as public, as well as those that are going through that process, that the warrants that they had issued needed to be recorded as a liability on their balance sheets.

So, this was a significant change from what all the hundreds of companies that had gone public through a SPAC, as well as the hundreds that were contemplating it basically had to totally change their accounting. It essentially ground the new SPAC offerings to a halt. So, as we sit here basically a month later, we are in a situation where the audit firms are having to interpret what the SEC has said.

The valuation firms are having to value these warrants and come up with a way that's acceptable. It really slowed that process down. For existing companies that have already done this, they have to restate their financials.

So, as you can imagine, we've got this situation in which a limited number of firms are having to figure this out, do it real time. A limited number of valuation firms are having to put these together. So, there's a lot of people working a lot of hours and trying to figure out what this all means.

MORIARTY: But could that have been done on purpose by the SEC to slow down the rate of SPACs?

SARKIS: I think there could be some validity to that. These warrants were not a secret. So, anybody that read the financial statements knew these warrants existed, whether or not they were recorded as liability or equity, I don't want to say it didn't matter, but you would have to be a very uninformed investor to not know these were there. So, it's a restatement of the obvious, but you're correct it did definitely slow the process down and make everyone take a deep breath here.

SURRAN: SPACs by nature are listed on the stock market and they are seeking investments to buy. But how easy it is to find a privately operating company to merge with and for how long are those companies available to buy? If investments dry out, what happens to SPACs if they are unable to complete an acquisition? And if SPACs shareholders are rushing on a vote to acquire or combine with an operating company when close to the deadline, how viable is that investment?

There are certainly a lot of questions around SPACs which is why investors need to consider a number of issues when evaluating an investment in SPACs, such as:

• Read the SPAC's IPO prospectus and reports.

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t • Review the specific terms of an offering and understand the investments, the use of interest on the investment, and the trust account SPACs set up to hold the IPO proceeds.

• Look at the trading price. Even though the SPACs are priced at $10 or less, when common stock shares and warrants begin to trade on the market, price may fluctuate. However, that fluctuation may not necessarily coincide with the success of the SPAC.

• Understand important factors at the time of the initial business combination.

o Shareholders have to vote on the business opportunity and redeem their shares or remain a shareholder of the company.

o When the SPAC changes from a trust account into an operating company, investors can decide to redeem their shares or remain an investor based on the way they view the acquired company and its valuation.

o Review the proxy, information or tender offer statement at the time of the initial business combination. Such information can also be found in the SEC's EDGAR database.

o Understand the interests of the SPAC sponsors.

Do your due diligence!

MORIARTY: Earlier Brian Sarkis mentioned that SPACs have a specific period of time to identify and merge with a private company. But why is there a limit and what happens if they can't identify the right investment in that timeframe?

SARKIS: So, the way the SPAC works legally is it raises money for a stated goal. That money goes into a trust and there are legal reasons as to why the company can't be identified prior to the SPACs.

So, this two year timeframe has been put in place really to make sure that there's no guarantees. So, if you raise the money and say we're going to hold it for an indefinite period of time, you essentially have a public holding company. So, these have been set up as funds that have an expiration not all of them are two years, but the majority are. The majority go out at $10 a share and that $10 a share typically accrues interest until an acquisition is made or the money is refunded.

So, there's no guarantee that this SPAC will go public or find a company to acquire that it will take public and there have been some where that has happened. In fact, when you start to get toward the expiration, it can put some pressure on the sponsors and there's some give and take there where people have to be careful as well and some investors don't want to feel as if they're taking the next... It almost becomes a bit of a shotgun wedding, which I think investors start to get a little nervous about if you're within that 18 or 20 months and don't have a target yet. But essentially the money is pledged for two years and the sponsors go and look to find someone to acquire that fits the investment criteria that was put forth when the SPAC raised the funds.

So, these are investors in theory that are looking for vehicles in an area of interest. So, if somebody is looking to do a SPAC that's focused on gambling or green energy or anything in between, you can find a place to go, put your money and once you find that and like the criteria and the

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t team, you're along for the ride for a period of time. That being said, if the team finds an acquisition they don't like or you don't like as the investor, you have the ability to withdraw and take out your original investment.

MORIARTY: Brian discusses the underlying risks associated with SPACs.

SARKIS: As with any investment, there is always risk of course. This is becoming a very hot topic. So, we're living in this world with cryptocurrencies that are out there, we've got short squeezes, we're living in the world of this retail investor that is willing to make bets.

And we saw what happened with GameStop that frankly didn't take a whole heck of a lot of research to figure out what could have happened. It just needed people coordinated to act in a uniform way. The same could be true for some of these SPACs. There are opportunities here for the sponsors to take.

Typically, the sponsors are compensated with up to 20% of the shares that go to the sponsor without putting in significant capital. So, you could have sponsors that are underhanded. It won't last long, but there could be that situation. You could have sponsors that maybe aren't underhanded, but are being duped by potential acquisition targets.

So, keep in mind the SPAC is acquiring a company. There are companies out there that do things that have fraudulent financials, that aren't found in due diligence, there are many risks that can happen there. And essentially the financials that are put out, the proformas are not at the same level as an IPO. So, it's not the same level of scrutiny and you could have issues that arise along the way. That being said, I think a lot of people understand those cons. The pros are there's more flexibility, ability to properly price. There are a lot of things that make it attractive, but as in any investment, it's buyer beware and you need to make sure that you've done your homework before you dive into these.

MORIARTY: Looking at IPO activity over the last 20 years, SPACs increased exponentially, especially after 2015. Brian touched upon some of the reasons, and he continues by giving us his thoughts as to why there is such a huge interest in SPACs in recent years.

SARKIS: There are a number of companies. So, we're living in a technological age where we've all lived through at this point, the internet boom and we saw the winners and the losers and we saw some people get incredibly wealthy through companies, Google, Apple and so on and so forth. We've lived through that internet boom and now we're entering a boom of potentially revolutionizing power let's say, let's just use that as an example. And there's a number of companies out there racing to come up with the next battery technology or the next car or the next whatever it may be that fits into this electric vehicles, self-driving, frontier that I think people are seeing and the SPAC has become an interesting way for these entrepreneurs and investors to find one another. So, in the IPO setting, you've got to get to a point where you can raise the funds and go out and do a road show. It takes up the entrepreneur's time. They've got to go to all these banks. And I think in some cases there's been this prevailing thought that maybe the banks are out to get us or the banks are unfairly pricing us.

So, now I can do an end run and make my pitch to an investment committee that has raised money to go out and find companies that are in your area. And there's a bit of I'll call it a rebel feel here. It allows there to be maybe more of this organic entrepreneur to investor speak. You're

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t not going to go shopping for it, you're going to find someone that fits you best.

There have even been some talks here recently of some very well-known SPAC sponsors that maybe use these vehicles to help the companies grow without overpricing them if you will maybe even underpricing them, but that's attractive to the entrepreneur because the terms and what's going on are better fit for them.

So, this allows a little more flexibility than what we see in a traditional IPO market. And I just think given the technology that's out there, the changing economy, the changing thoughts about some of the banks that are controlling, the IPO process this has become a preferred way for certain companies.

MORIARTY: Even though SPACs are in the news as investment opportunities, they also have had a negative reputation as they may often promote business that may not be investable and unsuspecting investors go in. Brian gives us some background.

SARKIS: Interestingly enough, when you really break down what a SPAC is or the mechanism of a company to go public, it's essentially a traditional merger and acquisition transaction and it's no different than what private equity firms do every day and I'll use that as an example.

A traditional private equity firm is looking to acquire businesses that need capital to grow or whatever it is they're looking to do. Those traditional private equity firms have due diligence teams, they've got things in place and mechanisms to understand what it is they're buying. They're going through the customer contracts, they're going through the IP protection, all of these things before they make their final decision. There are times where those companies that do this every day, those private equity sponsors make bad acquisitions sometimes or get duped or just things don't break their way.

The same thing can be true in the SPAC space, the private equity sponsors are going to be held accountable by their investors and in the SPAC market and typically your private equity firms don't have retail investors. It's large pension funds, it's financial institutions, whatever. So, maybe a more sophisticated level.

When we go into the SPAC world, there are opportunities especially where you have maybe more celebrity sponsors or celebrity organizers of SPACs that aren't as well versed in this, this isn't the way they've come up through where they've made their wealth, it's a way they've enjoyed investing their wealth, but maybe they don't have the best due diligence team, maybe they're not able to see through these things, maybe it's just bad luck, maybe it is frankly being speculative and making an investment in a speculative industry where it just doesn't work out.

A famous example of how this can happen through an IPO is someone like Enron. There are bad actors out there. You've got a lot of capital slogging around and if there's bad actors out there, they potentially are going to try to attract SPAC investment, any investment. But this is a nice way to do it, exit the company and walk away with money. So, because you've got more money, because you've got more visibility into this, because it's a little bit easier to do it, anytime that happens, there are bad actors that will potentially show up and this is an area where they can be right now.

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t MORIARTY: Back in August 2020, the Financial Times did an analysis and found that the majority of SPAC mergers trade below the $10 IPO price and that the most successful SPAC mergers have occurred in the past two years. So, why $10 and below and is that a good thing or a bad thing? Brian elaborates.

SARKIS: So, when the SPAC started, and I don't know exactly where the $10 came from other than I think it makes the math easy, so, when the investment is set, it's essentially let's just say a SPAC comes out and says "we're going to raise $100 million dollars of equity to go out and acquire a company in XYZ industry that we're going to take public." They're simply in that instance going to take the $100 million dollar equity price and divide by 10 million shares and that's the way it will be.

They'll raise the capital and it will sit there. And typically, if you go look at SPAC that hasn't made an acquisition, they will sit there at $10 a share. Sometimes a little bit below, sometimes a little bit above but typically stay in that space. Once they find a target and announce the acquisition, investors have the opportunity to come in or go out.

So, you may have certain investors that say, I want out, I'm going to sell my shares, now I've got more shares on the market. Therefore, my price is going to come down or you've got others that think hey, this is the deal of the century I want in and the price will go up. But until that deal closes, really all the trading in that SPAC is $100 million of cash. So, in my example, that should just sit there at $10 a share until something happens and the acquisition goes one way or another.

After that and the merger has happened, we've seen companies go both ways. There've been some very successful ones and some ones that aren't as successful.

I think it's fair to say that general M&A trends should hold here. And what those tell us is a lot of deals frankly can destroy value. Typically, that's a synergistic one company acquiring another and overpaying. In theory, this should not work that way but as we know, sometimes IPO prices go up, sometimes IPO prices go down. This is really no different.

MORIARTY: Several high profile investors are using SPACs as a vehicle to skip over the expensive and time-consuming IPO process. Brian gives us his insights.

SARKIS: There are a number of investors that could take a company public. They could choose to do this. Bill Ackman for example, is becoming very public in his SPACs that he has out there. So, why do it this way?

Well, one is it allows you to have the freedom of picking and choosing and finding the companies that best fit your criteria. And now these individuals could likely do that and step in and other ways, but it allows them to get to market without going through this painful long IPO process.

One of the big drawbacks to the IPO process is the way the price is set for the IPO. You can disagree with the price, it can be set too high, too low and it can cause issues for the investors when they go out.

The beauty of this process, it allows the buyer and the seller to set the price and agree based on everything that's there and not have these third party market prices in play. So, the banks aren't necessarily setting the price. In this instance, it's buyers and sellers that frankly believe they

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t can do it better. And so that's been an area where some very successful investors have decided that this is a better vehicle for them rather than taking companies public through an IPO.

MORIARTY: Investors in SPACs need to tread with caution but there have been some high profile success stories with companies like DraftKings, Nikola and more with very high valuations currently. Did their success change the way investors look at SPACs?

SARKIS: When we really break this down to its fundamentals, a SPAC is no different than really almost an IPO. It's a way to get a company public. It's just two ways to do it. It's been around a long time and there's clearly pros and cons to both. So, yes we've been in this situation where we've seen a huge spike in the number of companies doing this. And we hear it in the news every day and so on and so forth and it becomes and feels like this big scary thing.

But when we really break it down, it's simply a way to invest in a company with some different bells and whistles and there's the sponsors can take some equity and so on and so forth but at the end of it really is going to boil down to and let's use DraftKings as an example, DraftKings is now a public company that went there through a SPAC mechanism. Whether it had gone through an IPO or a SPAC mechanism, it's still just a public company.

So, at the end of this, it's really understanding are the fundamentals of that company good? Is there a little more wild west than the SPAC world? Absolutely. So, any investor should understand, it's not quite as regulated.

There are things that can go on in the financials, kind of pre-SPAC, that you may not have great information about. There are a number of companies that are going public through SPACs that frankly could never get through the regulatory requirements of an IPO. So, these are companies that may not be able to project revenue for a number of years.

As long as investors understand that, there should be no difference at the end of the day. That's why you have seen success stories. There were good underlying fundamentals to those companies and they could have done it either way. So, really it just comes down to preference of how companies want to become public but if they're good fundamental companies, it really shouldn't matter. You just have to understand that in one way, there's a chance that you can have more companies that maybe aren't quite as fundamentally sound. It might be easier for them to go this SPAC route and therefore there's more risk, which is what does tend to catch people's attention and maybe give the entire vehicle to go public through a SPAC a bad name, but it's really unfair. At the end of the day, it boils down to how good is the underlying asset, the underlying company.

MORIARTY: Brian discusses steps investors should take prior to investing in SPACs.

SARKIS: First and foremost, as with anything, understand your risk tolerance, understand what areas you want to invest in. So, understanding what are the industries I want to go invest in, why do I want to invest in those so on and so forth and then really do your homework on the SPAC sponsors.

So, the individuals that are running this SPAC that are going to make that determination, what is their track record? Are they a celebrity? Did you just think it was cool because hey, Shaquille O'Neal has a size 18 sneaker and I think that's great. Does that mean anything about investment? No.

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t But maybe there's a reason you want to do that. I'm not here to say Shaquille O'Neal isn't qualified but what I am here to say is you've got to be smart about what you're looking into but at the end, it really boils down to understanding, reading the disclosures. SPACs are putting disclosures out there. Are they as good as what's an IPO? Potentially yes, potentially no, but understanding there's those risks but really understanding your risk tolerance and ultimately your ability to get out. That is one thing that is very nice in the SPAC world is that if you're not comfortable, you can back out really up until the very end.

MORIARTY: Brian Sarkis concludes our segment on SPACs and leaves us with his final thoughts.

SARKIS: As we sit here today, we're living in a world where there are a lot of buzz words and I think SPAC is another one of those buzzwords and I don't mean to lump it in with COVID or GameStop or crypto or bitcoin or whatever, but it gets lumped into that world.

When you really demystify it and break it down, the fundamentals are the same. It's just a different vehicle, a different way to get there. Are there risks that may be greater than more traditional methods? Sure. Are there opportunities that are maybe greater? I would argue potentially yes.

So, if it's something that you have a client that is considering, if it's something you're considering, I would not necessarily prefer it one way over another, meaning prefer an IPO or a SPAC.

I think it is just finding what makes sense for the company, finding what makes sense for the investor and really going down that path is the right move here. It's just again, demystifying it, understanding it, knowing what the risks are and understanding what it ultimately accomplishes at the end of the day. Once you do that, it's just another vehicle and just another way to become public and it's really not that different than other mechanisms that have been out there.

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Segment Two

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two 2. Topic 842 Leases – Are You Ready?

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Segment Overview:

Field of Study:

Recommended Accreditation:

Reading (Optional for Group Study):

Running Time:

Video Transcript:

Course Level:

Course Prerequisites:

Advance Preparation:

Accounting

Work experience in financial reporting or accounting, or an introductory course in accounting.

None


Update

“Lease Accounting Practice Guide”

See page 2–12.

See page 2–21.

32 minutes

In February 2016, the FASB issued new authoritative guidance on accounting for leases. The new guidance is commonly referred to as Topic 842, which is a reference to the Leases topic of the FASB Accounting Standards Codification. All reporting entities that prepare financial statements in accordance with U.S. GAAP must adopt Topic 842 as a replacement for previous GAAP on accounting for leases. Leases are one of a company’s most significant costs that can directly impact business operations as well as valuation. Joe Fitzgerald, senior vice president of Lease Market Strategy at Visual Lease, discusses the impact of leases on the balance sheet based on the new standard, the underlying risks when leases are neglected or not accounted for, and what to look for when evaluating lease software.

Upon successful completion of this segment, you should be able to: l Understand the requirements when transitioning to Topic 842

and the definitions of Day 1 and Day 2, l Identify the underlying risks when leases are not properly

managed, l Recognize the challenges in adopting Topic 842, and the

lessons learned from public companies, and l Determine the key considerations when evaluating lease

software.

Expiration Date: September 10, 2022

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A. Transitioning to Topic 842

i. Requires reporting entities to l Change their accounting policies

& practices l Both lessee & lessor

ii. Reporting entity must apply standard l To existing leases l In effect but not expired when

standard is applied l To new leases l Commencing after standard is

applied

iii. Day 1 – One-time accounting adjustment for existing leases

iv. Day 2 – Accounting after standard is first applied

B. Steps for a Successful Transition

i. Getting everyone involved in the process

ii. Making a large number of granular decisions

iii. Documenting decisions

iv. Proper planning

C. Impact of Leases on the Balance Sheet

i. Increasing liabilities l Adverse effect on valuation l Impact on debt covenants

D. Types of Leases

i. Real estate leases l Fewer but with greater dollar

value

ii. Equipment leases or non-real estate leases l Higher in volume with smaller

dollar values

I. Topic 842: Adopting & Adapting

Outline

A. Underlying Risks

i. End-of-term concerns

ii. Getting the best lease rate during initial negotiations l Not returning equipment at end of

lease l Evergreen period l Lease terms change

iii. Neglecting ancillary costs beyond base rent l Common area maintenance

charges l Hidden overcharges

iv. Follow up on tenant incentives l Ensure you get the check

B. When Leases Are Not Managed

i. Clauses on property taxes may entitle

• Tenants to credits

ii. Continue payments after initial lease term l While having the equipment l Even without having the asset

C. Challenges in Adopting Topic 842

i. Completeness of your lease population l Do a scoping exercise

ii. Look for embedded leases l Agreements with a tangible piece

of property l Treated as a service or

consumable agreement

iii. Extract relevant data l Calculate the journal entries for

accounting

iv. Leasing will affect several departments l Socialization & education of the

standard

v. Assess your current state

D. Lessons Learned from Public Companies

i. Complexity l Permutations & combinations of

leases

ii. Completeness

II. Understanding the Risks & Challenges

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A. Key Considerations on Lease Software

i. Automated lease classification

ii. Capture & calculate correct information for lease disclosure

iii. Software with roll forward reporting capabilities to

• Handle both foreign & U.S. standards

• Update interest rates for IBRs

iv. Cross-functional activity

B. Other Considerations on Lease Software

i. Vendor with 3rd-party SOC Type 2 report

• Test of controls

ii. Meeting your criteria

iii. Segregation of department responsibilities

• Separate controls on transactions

C. Scoping Exercise & Completeness

i. Start with departments where you expect leases

• Real estate

• IT procurement

ii. Continue with other departments within the organization

• Give them examples of what to look for

iii. Ensure the system is updated for

• New leases coming in

• Current leases going out

iv. Run reports to test completeness & accuracy

III.Lease Software: Moving beyond Excel

iii. Accurately abstracting relevant data

iv. Don’t treat as Day 1 exercise

v. Understand the terms, amendments & changes

l Especially during the pandemic

v Accounting impact from modifications

v Subsequent lease remeasurement

vi. Statutory reporting in foreign countries

vii. Ensure proper handoff during employee turnover

viii. Avoid using Excel

II. Understanding the Risks & Challenges (Cont.)

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Outline (continued)

A. Leases & The Pandemic

i. Initially l Payment deferrals l Intent to make up on the

backend

ii. Subsequently l Reductions in rents l Abatements l Lease restructuring l Lease terminations

“I would say three in five had some level of negotiation with their landlords going on, which is pretty substantial.”

— Joe Fitzgerald

B. The “New Normal” on Leases

i. Flexibility l Get an early out l Shorter terms l In exchange for higher lease

rates

ii. Focusing more on the fine print

iii. Co-working facilities

C. Modifications & Lease Accounting

i. Change on lease terms is a modification l Requires subsequent

measurement l Considered a new lease

IV. Lease Adaptations to New Circumstances

A. Lease Optimization

i. Notifications on upcoming critical days l Allows you to make decisions

ahead of time

ii. Be aware of ancillary costs l May affect the right of use of

the asset

iii. Understand lease components l Fixed vs variable expenses l Common area maintenance

charges

B. Lease Optimizations & Accounting

i. Data accuracy

ii. Functionality across systems & departments

iii. Lease accounting is going to improve the way leases are handled

iv. New lease agreements will be analyzed l More closely and differently

C. Joe Fitzgerald’s Final Thoughts

i. Compliance can turn into a profit center

ii. Never too soon to start

iii. Incorporate technology into the process

iv. Better collaboration across the organization

V. Optimizing Leases & Looking Forward

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1. The Financial Accounting Standards Board (FASB) recently issued Topic 842, an authoritative guidance on accounting for leases. How must reporting entities prepare their financial statements going forward to adopt Topic 842? What steps has you’re your organization taken to comply with Topic 842?

2. Leases are one of a company’s most significant costs that can directly impact business operations as well as valuation. What is the impact of leases on the balance sheet based on the new standard? How significant are leases to your organization?

3. Leases, once signed, can present risks for the both parties to the arrangement. What are some of the risks associated with leases? How does your company identify and mitigate such risks?

4. Companies may face challenges when seeking to adopt the new lease accounting standard. What are some of the main challenges faced by reporting entities? What challenges do you and your organization foresee in implementing the standard?

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“In this segment, Joe Fitzgerald discusses the impact of leases on the balance sheet based on the new standard Topic 842, the underlying risks when leases are neglected or not accounted for, and what to look for when evaluating lease software.”


l After playing the video, use the questions provided or ones you have developed to generate discussion. The answers to our discussion questions are on pages 2–7 through 2–9. Additional objective questions are on pages 2–10 and 2–11.





Group Live Option


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5. As many public companies have already complied with the requirements of Topic 842, there have been many observations made regarding implementation. What lessons can private companies take from the adoption of Topic 842? What lessons or observations has your organization made, if any?

6. Companies may consider implementing lease software to manage their leases. What are the key considerations companies should look for while shopping for lease software? What factors, if any, does your company look for?

7. COVID-19 has had a definitive impact on leases. What issues has the pandemic created for leases? How have your organization’s leases and lease accounting been impacted?

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sDiscussion Questions (continued)

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1. The Financial Accounting Standards Board (FASB) recently issued Topic 842, an authoritative guidance on accounting for leases. How must reporting entities prepare their financial statements going forward to adopt Topic 842? What steps has you’re your organization taken to comply with Topic 842? l Transitioning to Topic 842 requires

reporting entities to: v Change their accounting policies

& practices v From both lessee & lessor

perspectives l Reporting entity must apply standard:

v To existing leases in effect but not expired when standard is applied

v To new leases commencing after standard is applied

l Day 1 – One-time accounting adjustment for existing leases

l Day 2 – Accounting after standard is first applied

l Steps for a Successful Transition to Topic 842 v Getting everyone involved in the

process v Making a large number of

granular decisions v Documenting decisions v Proper planning


2. Leases are one of a company’s most significant costs that can directly impact business operations as well as valuation. What is the impact of leases on the balance sheet based on the new standard? How significant are leases to your organization? l Impact of Topic 842

v Leases are a form of financing k Historically, many leases were

not on the balance sheet

v Topic 842 requires the assets and related liability to be placed on the balance sheet

v Increasing liabilities may have an adverse effect on a company’s valuation

v It can also upset some of their debt covenants

v It could have an impact on their credit ratings


3. Leases, once signed, can present risks for the both parties to the arrangement. What are some of the risks associated with leases? How does your company identify and mitigate such risks? l End-of-term concerns l Getting the best lease rate during

initial negotiations v Not returning equipment at end of

lease v Evergreen period

k Lease terms change l Neglecting ancillary costs beyond

base rent v Common area maintenance

charges k Hidden overcharges

l Follow up on tenant incentives v Ensure you get the check

l When leases are not managed v Clauses on property taxes may

entitle tenants to credits v Risk of continued payments after

initial lease term k While having the equipment k Even without having the asset


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s Suggested Answers to Discussion Questions 2. Topic 842 Leases – Are You Ready?

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4. Companies may face challenges when seeking to adopt the new lease accounting standard. What are some of the main challenges faced by reporting entities? What challenges do you and your organization foresee in implementing the standard? l Assessing completeness of the lease

population v Conduct scoping exercises to find

all leases l Look for embedded leases

v Agreements with a tangible piece of property

v Treated as a service or consumable agreement

l Extracting relevant data v Calculate the journal entries for

accounting l Leasing will affect several

departments v Socialization & education of the

standard l Assess the current state, think about

what the future state needs to look like, and then focus on gaps


5. As many public companies have already complied with the requirements of Topic 842, there have been many observations made regarding implementation. What lessons can private companies take from the adoption of Topic 842? What lessons or observations has your organization made, if any? l Lessons Learned from Public

Companies v Lack of appreciation for the

complexity created from permutations & combinations of leases

v Ensuring completeness of the lease population

v Accurately abstracting relevant data

v Don’t treat implementation as a Day 1 exercise only

v Understand that most leases never go to term. Have a system and process in place to: k Understand the terms,

amendments & changes k Revaluate leases (especially as

a result of the pandemic) k Assess accounting impact

from modifications k Perform subsequent lease

remeasurements v Statutory reporting in foreign

countries v Ensure proper handoff during

employee turnover v Avoid using Excel


6. Companies may consider implementing lease software to manage their leases. What are the key considerations companies should look for while shopping for lease software? What factors, if any, does your company look for? l Automated lease classification l Capture & calculate correct

information for lease disclosure l Software with roll forward reporting

capabilities to: v Handle both foreign & U.S.

standards v Update interest rates for IBRs

l Software should have cross-functional capabilities

l Vendor with 3rd-party SOC Type 2 report v Test of controls

l Segregation of department responsibilities v Separate controls on transactions


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sSuggested Answers to Discussion Questions (continued)

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7. COVID-19 has had a definitive impact on leases. What issues has the pandemic created for leases? How have your organization’s leases and lease accounting been impacted? l Impact of the pandemic on leases

v Initially, many lessees requested deferrals of payments requests with the intent to make up the payments at the end of the lease

v Subsequently, lessees requested: k Reductions in rents k Abatements k Lease restructuring k Lease terminations

l Concessions requested of landlords v Flexibility

k Get an early out k Shorter terms k In exchange for higher lease

rates v Focusing more on the fine print v Co-working facilities


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sSuggested Answers to Discussion Questions (continued)

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1. Topic 842 requires _________ to change their accounting policies and practices related to leases.

a) lessors and lessees

b) only lessors

c) only lessees

d) neither lessors or lessees

2. Entities reporting Topic 842 must apply the new standard to:

a) only leases in effect but not expired at the effective date of the standard

b) only prospective leases

c) leases in effect but not expired at the effective date of the standard as well as prospective leases

d) any lease, in effect or expired, at the entity’s discretion

3. Underlying risks associated with leases include all of the following EXCEPT:

a) end of term concerns

b) failure to return equipment at the end of the lease term

c) landlord incentives

d) ancillary costs

4. Agreements that are not referred to as leases but contain some tangible piece of property that would require them to be treated as leases are known as:

a) consulting agreements

b) embedded leases

c) consumable agreements

d) service agreements

5. Typical mistakes that companies make when it comes to managing their leases include:

a) failing to receive credits owed for overpayment of incremental expenses

b) underpaying the landlord for property taxes owed on the lease

c) payments made prior to the commencement of the actual lease term

d) all of the above

6. During the adoption of Topic 842 many public companies learned:

a) the process of adoption was quite simple

b) most companies could adequately account for all their leases

c) most companies can sufficiently gather information related to their leases

d) that the adoption was not a one-day exercise

7. When considering whether to purchase lease software companies should:

a) NOT rely on automated lease classifications as this process is better accomplished using a manual review

b) realize that most software is NOT able to assist with the new disclosures required under Topic 842

c) rely on different software providers for leases recorded under foreign standards

d) select software that is able to update interest rates for the incremental borrowing rates (IBRs)

You may want to use these objective questions to test knowledge and/or to generate further discussion; these questions are only for group live purposes. Most of these questions are based on the video segment, a few may be based on the reading for self-study that starts on page 2–12.

Objective Questions


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8. Under Topic 842, a modification of the term of an existing lease:

a) will have accounting implications for the income statement

b) is NOT considered to be a new lease

c) will have accounting implications on the balance sheet

d) does NOT require remeasurement of the lease

9. For the purpose of determining a reporting entity’s latest permissible period of adoption, Subtopic 842-10 specifically identifies _________ different entity types.

a) three

b) five

c) ten

d) more than 10

10. Starting in the period of adoption, the reporting entity must _________ the prior-period financial information that is presented on a comparative basis.

a) neither recast nor restate

b) choose to either restate or recast

c) restate

d) only recast


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Self-Study Option


LEASE ACCOUNTING PRACTICE GUIDE

Accounting Continuing Education 2020 Kaplan Inc. Bruce G. Pounder, CPA, CMA, CFM, DipIFR (ACCA), MBA Executive Director, GAAP Lab

INTRODUCTION In February 2016, the Financial Accounting Standards Board (FASB) issued new authoritative guidance on accounting for leases. The new guidance is commonly referred to as “Topic 842,” which is a reference to the Leases topic of the FASB Accounting Standards Codification®. All reporting entities that prepare financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP) must adopt Topic 842 as a replacement for previous GAAP on accounting for leases (i.e., Topic 840).

This course assumes you have a role in helping your organization and/or your clients with the process of transitioning to Topic 842. In particular, this course is

designed to guide preparers of financial statements through the transition process.

“Lessee” versus “Lessor” The transition to Topic 842 requires reporting entities to change their accounting policies and practices, from both lessee and lessor perspectives. Although a reporting entity might be a lessee with regard to some leases and, at the same time, a lessor with regard to other leases, this course focuses on the transition to Topic 842 primarily from the lessee’s perspective. A high-level overview of the transition from the lessor’s perspective is provided in the Appendix to this course.

“Day 1” versus “Day 2” Upon adopting Topic 842, a reporting entity must apply it to existing leases, i.e., those already commenced but not expired when the standard is first applied. Then, after adopting Topic 842, a reporting entity must also apply it to new leases, i.e., those

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l In order to ensure adherence to

NASBA guidelines regarding self-study, the CPA Report and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers are no longer available. Customers should contact their company administrators for information on taking course exams and receiving CPE credit for the courses.



CPA Report Update


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commencing after the standard is first applied.

For each existing lease, a reporting entity must:

• Record one-time, transitional accounting adjustments when Topic 842 is first applied; and

• Apply Topic 842 in accounting for all relevant events over the lease’s remaining life after the standard is first applied.

For each new lease, reporting entities must apply Topic 842 in accounting for all relevant events over the lease’s entire life.

The recording of one-time accounting adjustments for existing leases when Topic 842 is first applied is often referred to as “Day 1” accounting. Accounting for all leases after the standard is first applied is often referred to as “Day 2” accounting. The transition to Topic 842 must eventually address both

“Day 1” and “Day 2” accounting. However, this course focuses primarily on the portion of the transition process up to and including “Day 1.” A high-level overview of “Day 2” accounting is provided at the end of this course.

Overcoming transition challenges

The process of transitioning to Topic 842 has been very difficult for the vast majority of reporting entities that have transitioned—and are still transitioning—to the standard. The main reason for the difficulties is that Topic 842 provides very little detail on how to execute an effective and efficient transition, especially when the reporting entity's financial statements are subject to external audit. As a result, preparers who are responsible for helping their reporting entities transition to the standard should expect the following:

• The transition process will require much more work than what is explicitly described in Topic 842 (for example,

additional efforts to identify and manage inherent risks of misstatement in the financial statements).

• It will be necessary to supplement the authoritative guidance in Topic 842 with practical knowledge and procedures based on the experiences of accounting professionals who have been through the transition process (for example, knowing that certain specific accounting policy options are significantly more cost-effective than others).

• Much of a preparer’s transition efforts will involve:

− Getting everyone involved in the transition “on the same page” with regard to what Topic 842 requires, allows, and prohibits (in particular, preparers and auditors have found it challenging to reconcile their different perspectives on how the standard should be interpreted and applied in practice)

− Making a large number of granular decisions

− Documenting various decision-making processes and their outcomes in detail

Fortunately, this course provides actionable details that the standard itself lacks. Here you will find explanations of every essential “Day 1” transition task for lessees—what to do, why, when, and how. The recommendations in this course originated in practice and have been proven in practice. They are based on lessons learned from dozens of successful transitions—and a few unsuccessful ones as well. Upon completing the course, you will have learned to develop and execute critical business capabilities that are needed for an effective and efficient transition to Topic 842.

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Transition Timing: Key

Conclusions and Policy Decisions

LEARNING OBJECTIVES

The purpose of this unit is to help you determine the timing of a reporting entity's transition to Topic 842. When you have completed this unit, you will be able to accomplish the following:

• Identify the three reporting periods that are relevant to the timing of a reporting entity’s transition to Topic 842 and recall their significance.

• For a particular reporting entity, apply authoritative guidance to determine the reporting entity’s latest permissible period of adoption.

• For a particular reporting entity, evaluate policy choices for the reporting entity’s period of adoption and period of initial application.

• Prepare useful documentation to summarize and support key conclusions and policy decisions pertaining to the timing of a reporting entity’s transition to Topic 842.

OVERVIEW With regard to a reporting entity’s transition to Topic 842, there are two key timing questions that management must answer early in the transition process:

1. When will the reporting entity start applying Topic 842 to its financial accounting and reporting?

2. To which reporting periods will the reporting entity apply Topic 842 once the reporting entity starts applying it?

Topic 842’s “effective date” guidance is meant to address these questions, but the term “effective date” as used in Topic 842 is confusing and the guidance surrounding it is difficult to understand. The first step toward

obtaining a clear understanding of the guidance is to become familiar with the three reporting periods that are relevant to the timing of a reporting entity’s transition to Topic 842.

RELEVANT REPORTING PERIODS

The three reporting periods that are relevant to the timing of a reporting entity’s transition to Topic 842 are:

1. Latest permissible period of adoption: This is the latest reporting period in which a reporting entity may start applying Topic 842 in compliance with the standard’s requirements regarding the timing of the reporting entity’s transition. Stated another way, Topic 842 requires the reporting entity to start applying the standard either in this period or in an earlier period. Although Topic 842 provides certain fixed “effective dates,” the nature of the guidance is such that the latest permissible period of adoption can and does vary among reporting entities.

2. Period of adoption: This is the reporting period (i.e., fiscal year or interim period within a fiscal year) in which a reporting entity will (or did) actually start applying Topic 842. The reporting entity’s period of adoption can precede the reporting entity’s latest permissible period of adoption because Topic 842 allows “early adoption,” i.e., a reporting entity may adopt the standard in a reporting period that is earlier than the reporting entity’s latest permissible period of adoption.

3. Period of initial application: This is the earliest reporting period to which a reporting entity applies Topic 842 once the reporting entity starts to apply the standard. Topic 842 allows the reporting entity to choose between two transition methods, with that choice determining whether the period of initial application precedes the period of adoption or is the same as the period of adoption.

Accordingly, the three key conclusions and policy decisions that a reporting entity’s management must reach regarding the

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timing of its transition to Topic 842 are, in sequence:

1. Determining the reporting entity’s latest permissible period of adoption

2. Choosing the reporting entity’s period of adoption

3. Selecting the reporting entity’s transition method, which will in turn determine the reporting entity’s period of initial application

Each of these key conclusions and policy decisions will now be addressed in detail.

LATEST PERMISSIBLE PERIOD OF ADOPTION

Authoritative guidance on determining a reporting entity’s latest permissible period of adoption is located in Subtopic 842-10 subparagraph 65-1(a), subparagraph 65-1(b), and paragraph S65-1. According to that guidance, a reporting entity’s latest permissible period of adoption depends on the reporting entity’s type and annual reporting cycle (i.e., fiscal year). This in turn requires management to determine its type with regard to the possible entity types that are specifically identified in Topic 842; presumably, the reporting entity’s annual reporting cycle is already known.

Entity Types For the purpose of determining a reporting entity’s latest permissible period of adoption, subparagraph 842-10-65-1(a) specifically identifies three different entity types:

1. Public business entity (as defined in Section 842-10-20)

2. Not-for-profit entity (as defined in Section 842-10-20) that has issued (or is a conduit bond obligor for) securities that are traded, listed, or quoted on an exchange or an over-the-counter market

3. Employee benefit plan that files or furnishes financial statements with or to the U.S. Securities and Exchange Commission

This set of specifically identified entity types is not collectively exhaustive, that is, it does not include all possible types of entities. There is no discretion or judgment with regard to determining a particular entity’s type; it is solely a matter of which of the specifically identified types—if any—the reporting entity matches.

NOTE: As of 2020, it is highly unlikely that an established reporting entity that has not yet adopted Topic 842 matches any of the three entity types specifically identified in subparagraph 842-10-65-1(a). In particular, most privately-held business entities do not match any of these types and therefore can be considered to fall into a catch-all type of “other entities.”

Implications of Entity Type and Annual Reporting Cycle

A reporting entity’s type, in conjunction with the reporting entity’s annual reporting cycle, necessarily determines the reporting entity’s latest permissible period of adoption:

• The latest permissible period of adoption for a reporting entity that is one of the three types specifically identified above (e.g., a public business entity) was the reporting entity’s first fiscal year that began after December 15, 2018. Upon adoption, such a reporting entity was required to apply Topic 842 to:

− Annual financial statements beginning with that fiscal year and

− Interim-period financial statements within that fiscal year and every fiscal year thereafter

• The latest permissible period of adoption for all other entities (e.g., most privately-held business entities) is the reporting entity’s first fiscal year that

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begins after December 15, 2021. Upon adoption, such entities must apply Topic 842 to:

− Annual financial statements beginning with that fiscal year and

− Interim-period financial statements within fiscal years after—but not including—that fiscal year

Note: For 'all other entities', the latest permissible period of adoption indicated above and throughout the course reflects the deferral documented in ASU No. 2020-05 (issued June 3, 2020.)

Documenting Management’s Determination of the Reporting Entity’s Latest Permissible Period of Adoption

Management’s assertions about the reporting entity’s type, fiscal year, and latest permissible period of adoption should be formally documented in order to (1) avoid internal control deficiencies and (2) maximize audit efficiency. Here is an example of relevant language that could be used in an accounting whitepaper or memo.

EXAMPLE

The Company is not any of the types of entities specifically identified in subparagraph 842-10-65-1(a). The Company interprets subparagraph 842-10-65-1(b) as requiring all other entities—including the Company —to apply Topic 842 to financial statements issued for fiscal years beginning after December 15, 2021. The Company’s first fiscal year that begins after December 15, 2021 begins on February 1, 2022 and ends on January 31, 2023. Accordingly, the Company has determined that its fiscal year beginning February 1, 2022 and ending January 31, 2023 is the Company’s latest permissible period of adoption.

[Before using this language in practice, it should be modified to appropriately reflect a reporting entity’s particular facts and circumstances.]

Exercise 1

1. A reporting entity is a privately-held business that is not one of the three types of entities specifically identified in subparagraph 842-10-65-1(a). Its annual reporting cycle is the calendar year (i.e., its fiscal year is the calendar year). What is the reporting entity’s latest permissible period of adoption?

2. A reporting entity is a not-for-profit entity that is not one of the three types of entities specifically identified in subparagraph 842-10-65-1(a). Its annual reporting cycle is a fiscal year that ends on June 30th. What is the reporting entity’s latest permissible period of adoption?

Once a reporting entity’s latest permissible period of adoption has been determined, management must decide whether to adopt Topic 842 in that period or in an earlier period. Early adoption is permitted per subparagraphs 842-10-65-1(a) and (b) for all types of entities. However, early adoption of Topic 842 has not been a popular choice in practice. For example, recent studies of SEC registrants that have adopted Topic 842 found the standard was adopted early by:

• 1.5% of 395 S&P 500 companies [http://leaseaccounting.com/the-first-quarter-of-asc-842- infographic]

• 0.0% of 199 companies having market capitalizations between $500 million and $1 billion [http://www.connorgp.com/asc-842-lease-disclosure-study-500m-1b-mkt-cap-vfinal]

• 2.6% of 78 companies having market capitalizations above $30 billion [http://www.connorgp.com/asc-842-lease-disclosure-study-over-30b-mkt-cap-final]

There are many reasons for the rarity of early adoption in practice. For example, even if early adoption is perceived as desirable, it is often perceived as infeasible due to scarce resources being needed for more urgent projects, initiatives, and operational tasks. Additionally, there are some distinct advantages to not adopting

http://leaseaccounting.com/the-first-quarter-of-asc-842- infographic

http://leaseaccounting.com/the-first-quarter-of-asc-842- infographic

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early, such as having the time to run new lease accounting processes in parallel with legacy processes in order to identify and solve any problems before cutting over.

In practice, you might encounter the phrase “date of adoption.” When used correctly, the phrase refers to the first day of the period of adoption.

Regardless of which period of adoption management chooses, some stakeholders (executive leadership, audit committees, users, etc.) might want insight into the basis for management’s policy decision on whether to adopt early, and ideally management should be prepared to document and communicate that basis regardless of what the decision is. At a minimum, the decision about early adoption should be formally documented in order to (1) avoid internal control deficiencies and (2) maximize audit efficiency.

PERIOD OF INITIAL APPLICATION

After a reporting entity’s period of adoption has been chosen, management must select one of the two alternative transition methods that are allowed under subparagraph 842-10-65-1(c). That selection will, in turn, determine the reporting entity’s period of initial application, i.e., the earliest reporting period to which the reporting entity will apply Topic 842 once the reporting entity starts to apply the standard. Nearly everything else in the transition process depends heavily on this determination of the period of initial application.

The language used both inside and outside of Topic 842 to refer to the two alternative transition methods has been confusing. Regardless of the terminology you encounter, keep in mind that under both methods:

• In the period of adoption, accounting adjustments are applied as of the beginning of the period of initial application to recognize leases that existed at initial application. In this course, the phrase “date of initial application” will be used to refer to the

beginning of the period of initial application.

• Starting in the period of adoption, the reporting entity applies Topic 842 to the current financial statements for the period of adoption.

As such, the two transition methods are similar to each other. But there is also a significant difference between the methods:

1. Under the method described in sub-subparagraph 842-10-65-1(c)(1), the period of initial application is the earliest period presented in the financial statements that are issued for the period of adoption. Starting in the period of adoption, the reporting entity applies Topic 842 to prior-period financial information that is presented on a comparative basis in conjunction with the current-period financial information. This requires the reporting entity to recast (not restate) the prior-period financial information that is presented on a comparative basis, which will therefore differ from the information that was originally reported for those periods on a current basis.

2. Under the method described in sub-subparagraph 842-10-65-1(c)(2), the period of initial application is the same as the period of adoption. In the period of adoption, the reporting entity does NOT apply Topic 842 to prior-period financial information that is presented on a comparative basis in conjunction with the current-period financial information. The comparative financial information is not recast—it is the same as when it was originally reported on a current basis.

The “no recast” transition method of sub-subparagraph 842-10-65-1(c)(2) has been the near universal choice in practice. For example, recent studies of SEC registrants that have adopted Topic 842 found the “no recast” method was used by:

• 100% of 199 companies having market capitalizations between $500 million and $1 billion [http://www.connorgp.com/asc-842-lease-disclosure-study-500m-1b-mkt-cap-vfinal]




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• 97% of 78 companies having market capitalizations above $30 billion [http://www.connorgp.com/asc-842-lease-disclosure-study-over-30b-mkt-cap-final]

• 100% of 50 companies in the top quartile of the Fortune 500 [https://dart.deloitte.com/USDART]

Clearly, the “recast” method is almost never selected in practice, and it is easy to understand why. Although there might be nominal benefits to users of the financial statements, recasting previously prepared and audited financial information—rather than simply carrying it forward—would:

• Elevate the inherent risk of material misstatement in the financial statements

• Require incremental effort and costs for preparation, control, and audit

• Result in comparative information that is less comparable among peer companies if peers do not recast their comparative information

Regardless of which transition method management selects, some stakeholders (executive leadership, audit committees, users, etc.) might want insight into the basis for that selection, and ideally management should be prepared to document and communicate that basis. At a minimum, management’s policy decision about the transition method should be formally documented in order to (1) avoid internal control deficiencies and (2) maximize audit efficiency.

UNIT SUMMARY You can now use what you have learned in this unit to (1) determine the timing of your reporting entity’s transition to Topic 842 and (2) prepare the related documentation. These are two critical business capabilities that must be developed and executed sooner rather than later for a successful transition.

KEYS TO A LESS STRESSFUL TRANSITION • In almost every case, choosing the “no

recast” transition method will greatly reduce the resources that will be needed throughout the transition process.

• Documentation that summarizes and supports this transition task is essential to avoiding internal control deficiencies and enhancing audit efficiency.

Determining the Transition Population of Leases

LEARNING OBJECTIVES

The purpose of this unit is to help you determine a reporting entity's "transition population" of leases, i.e., the existing leases to which the reporting entity will apply Topic 842 as of the date of initial application. When you have completed this unit, you will be able to accomplish the following:

• Apply authoritative guidance to determine which arrangements should be considered for potential inclusion in the transition population of leases.

• For a given arrangement, apply authoritative guidance to determine whether to include the arrangement in the transition population.

• Manage risks of material misstatement associated with management’s determination of the transition population.

• Prepare useful documentation to summarize and support (1) relevant practical expedient elections; (2) the composition of the transition population; and (3) how the transition population was determined to be correct and complete.

OVERVIEW When a reporting entity adopts Topic 842, management must apply the standard to




http://dart.deloitte.com/USDART

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leases that exist as of the date of initial application. In order to do so, management must first identify those leases, which are collectively referred to in this course and elsewhere as the reporting entity’s “transition population” of leases.

The task of determining a reporting entity’s transition population of leases under Topic 842 might seem to be straightforward, but it is actually very easy to get wrong. At the same time, the amount of effort required to get it right has the potential to be overwhelming. Because both errors and inefficiencies can have significant adverse consequences for the reporting entity, the task of determining the reporting entity’s transition population deserves management’s attention at least as much as any other task in the process of transitioning to Topic 842.

The Hard Way Given the potential adverse consequences of getting a reporting entity’s transition population of leases wrong, what should management consider doing to get the transition population right? A rigorous approach would involve a “process of elimination,” i.e.:

• Identifying the population of the reporting entity’s arrangements in force as of the date of initial application: A reporting entity’s population of arrangements includes every kind of arrangement between the reporting entity and external parties. If the reporting entity is a consolidated group, its population of arrangements also includes arrangements between/among members of the group. In most cases, a reporting entity will be a party to a large number of arrangements with customers, suppliers, etc.; very large reporting entities can and do have millions of such arrangements. Consequently, identifying a reporting entity’s complete arrangement population would almost always require substantial time and effort.

• Assessing each arrangement to determine whether it is a “contract”: The term “contract” is defined in Section 842-10-20 as an “agreement between

two or more parties that creates enforceable rights and obligations.” Most, if not all, of a reporting entity’s arrangements are likely to meet this definition, but assessing each individual arrangement to identify the “contract” subset of arrangements would likely be very time-consuming.

• Assessing each contract to determine whether it is a “lease”: The term “lease” is defined in Section 842-10-20 as a “contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.” This simple definition is heavily qualified by an extensive body of additional authoritative guidance that is spread throughout various sections of the standard. As a result, even though leases might form only a relatively small subset of a reporting entity’s contracts, assessing every individual contract in order to identify that subset would likely be very difficult and time-consuming.

• Documenting every step of this approach: From internal control and external audit perspectives, a financial statement preparer’s work isn’t done if it isn’t documented. The need for adequate documentation further increases the resource burden on the preparer.

This approach would likely be very effective at accurately determining the transition population of leases. However, most reporting entities would find it impossible to execute due to the overwhelming amount of time and resources that would be required. And so, as a matter of practicality, management should consider alternative approaches to determining a reporting entity’s transition population.

A Much Easier Way Fortunately, there is a more practical approach to determining a reporting entity’s transition population of leases:

• By electing certain practical expedients, as permitted by Topic 842, management can profoundly reduce the amount of

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time, effort, and cost for this and other transition tasks.

• Effective and efficient procedures for determining a reporting entity’s transition population of leases have emerged from practice and have been proven in practice.

• Practice has also shown that documentation of the transition population and how management determined it does not need to be voluminous in order to be effective at avoiding internal control deficiencies and enhancing audit efficiency.

This unit will now explain these elements and also provide risk management context for them.

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For the full class material, please contact Kaplan Accounting Continuing Education

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SURRAN: In February 2016, the Financial Accounting Standards Board (FASB) issued new authoritative guidance on accounting for leases. The new guidance is commonly referred to as "Topic 842," which is a reference to the Leases topic of the FASB Accounting Standards Codification. All reporting entities that prepare financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP) must adopt Topic 842 as a replacement for previous GAAP on accounting for leases (i.e., Topic 840).

The transition to Topic 842 requires reporting entities to change their accounting policies and practices, from both lessee and lessor perspectives. Upon adopting Topic 842, a reporting entity must apply it to existing leases, i.e., those already in effect but not expired when the standard is first applied.

Then, after adopting Topic 842, a reporting entity must also apply it to new leases, i.e., those commencing after the standard is first applied.

The recording of one-time accounting adjustments for existing leases when Topic 842 is first applied is often referred to as "Day 1" accounting. Accounting for all leases after the standard is first applied is often referred to as "Day 2" accounting. The transition to Topic 842 must eventually address both "Day 1" and "Day 2" accounting. The transition process will require much more work than what is explicitly described in Topic 842.

Much of the companies' transition efforts will involve:

• Getting everyone involved in the transition "on the same page" with regard to what Topic 842 requires, allows, and prohibits

• Making a large number of granular decisions

• Documenting various decision-making processes and their outcomes in detail

But before even starting the process, it will require proper planning and an effort to gather all available leases, real estate related and others, for cars, equipment, and the like and ensure completion. It is a very involved and tedious process that has been underestimated. Are you ready?

MORIARTY: Leases are one of a company's most significant costs that can directly impact business operations as well as valuation. Joe Fitzgerald, senior vice president of Lease Market Strategy at Visual Lease, joins us this month and starts off our conversation by discussing the impact of leases on the balance sheet based on the new standard.

FITZGERALD: So, as we realize leasing is a form of financing. It's a way that one company can get the use of another company's assets for a period of time. The fact it's a form of financing, historically, many leases were not on the balance sheet. But with the new lease standards now, one of the first things, what we call transition, is we're going to put the assets and related liability on the balance sheet. Increasing the liabilities on a balance sheet, sometimes has an adverse effect on the valuation of a company, just for starters.


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What I would say is that when I think about leases, really, I think about two buckets. There's the real estate leases, and then there's equipment. I call it everything else. With real estate, those are really large transactions, so there's typically fewer of them, but they can be greater in dollar volume, dollar amount.

Then on the other side, you've got a lot of equipment leases, or non-real estate leases, typically smaller in dollar amount, but higher in volume. Companies lease all sorts of things. I don't think, really, prior to the standard, companies really thought about how much they actually did lease and what they were leasing.

The other thing, in terms of valuation, I might add, is many companies have debt agreements. By this new standard and having to put the asset and liability on the balance sheet, it can upset some of their debt covenants. It could have an impact on their credit ratings. There's a lot of things that can happen as a result of the new standard.

MORIARTY: Leases are often complex contracts that can create a good deal of exposure for enterprises if they are not properly managed. Companies tend to focus more on real estate leases than all other types, which are often neglected or not accounted for. Joe discusses the underlying risks.

FITZGERALD: In US-based companies, the US real estate is centralized, so there's a little bit of a better view of what's going on in the real estate side, where on equipment, it's decentralized. There are leases in drawers, et cetera.

One of the biggest things that you see when folks don't focus on the lease, everybody wants to get the deal done, but then after it's done, the lease agreement will go into a file cabinet or the back seat of somebody's car, and they'll never think about it again, never look at it. You really have end of term concerns, I think, is one of the primary things that we see.

The other thing we find is, again, end of term around equipment is, everybody is worried about getting the best deal they can, so to speak, on a lease rate on the way in. Then what happens, you got a three year term, and you don't return the equipment in three years, and you go into, what we call, an evergreen period.

Once you go into the first evergreen period, you've kind of blown the hard work you did to get the best lease rate you could, because now your term is no longer 36 months.

It's 39 months or 42 months, and oftentimes, equipment lessors kind of count on that. They actually figure that into their economics. That's one thing I would say we've seen quite a bit of, is the end of term.

During the lease term, particularly in the real estate side, there's a lot of other ancillary costs that are associated beyond the base rent that folks don't really think about. There's something called common area maintenance charges, where some of those get passed on to the tenants. So, nobody is really paying attention to those, and sometimes there's overcharges. It's not unusual.

It's particularly in certain industries where landlords will give tenants incentives, such as tenant improvement incentives, to build out leasehold improvements. What we see is that the fine print in the lease said you had to do certain X, Y, and Z in order to get the incentive, and you don't do Z, and you never get the check, but nobody has got their hands on a lease anymore, so they don't really realize that.

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t I think what we're going to find is that a lot of these things that we're talking about during the term of the lease and end of lease term, now with lease accounting and everything being on balance sheet, there will be higher scrutiny around these items.

MORIARTY: There are some common mistakes that companies make when it comes to managing their leases. So what is the potential impact?

FITZGERALD: Sometimes there are clauses in a lease where if there's, what we call, an escalation, so a company will typically have a base year set when they first enter into a lease, and all the operating expenses above that base year will be charged back to the tenant, typically on an annual basis. There may be another clause in the lease that if the property taxes go down, the tenant would get a credit.

But nobody is paying attention to that side. We've seen situations where a company paid the incremental operating expenses and didn't get the offset for the property taxes, so perfect example. We had one customer/client, where they were paying for a lease for 12 years after the initial lease term.

In another situation, we had a client that was paying for a lease where they couldn't find the asset. Even if they had wanted to return it, they should've just bought it out because they didn't know where it was, so those situations. But a lot of that, again, it's really bubbling up as a result of the lease accounting standard, or folks never would've paid attention to them.

MORIARTY: Joe gives us his insights as to some of the challenges that companies face when they are preparing to adopt the new lease accounting standard.

FITZGERALD: Leases have not gotten a great deal of scrutiny, prior to the standard. The first issue you have is, really, around completeness of your lease population, and that's the obvious leases like we said, real estate leases tend to be centralized. You have a pretty good idea where they are. Even though you may not have all the amendments to the leases, or if you have them, they may not be kind of in a system on a timely basis that you can capture everything. You've got a completeness issue, so you've got to go around first and do, what I call, a scoping exercise and find all the leases that you know are leases.

Then beyond that, the standard has this concept, particularly in the new FASB standard, around, what we call, embedded leases. This is an agreement where it doesn't say "lease" at the top, so nobody has been treating it like a lease, and yet there's a tangible piece of property that's in there that really should be a lease, but folks have been treating it more like a service agreement or some kind of other consumable arrangement. Those need to be accounted for as leases under the new standard. So, you need to get a complete population.

Once you get the complete population, you need to think about, how are you going to get all the data that's relevant for lease accounting, out of those contracts, and into a form that ultimately can be used to calculate the journal entries for accounting.

Data is probably, what we always call, the long pole on the tent. It's the biggest issue that companies have, because it's tough to come up with a strategy to, one, get all the data elements that are contained in the contracts. Not all elements are contained in the contracts, maybe about half. There's other elements that are either judgment that need to be made

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or from other sources that need to be brought in to get a complete dataset, so you can do your accounting.

Leasing will affect the real estate folks, the procurement folks, the IT folks, the legal folks. I mean, you name it, everybody is going to be involved. So, there really needs to be, first, a socialization of the standard, and it's going to impact everybody, not just for day one, but also beyond, and the second thing is an educational aspect. Folks need to really understand, to some level, even non-finance folks, how the accounting is, so they appreciate the implications to their own area.

The last thing I would say is that a company who is thinking about getting prepared for the standard should look to assess their current state. Everybody has a leasing process before adopting the standard. I would say it's lacking in a lot of ways. They need to look at the current state. They need to think about what the future state needs to look like, and then to really focus on what those gaps are, because those gaps are the things they're going to need to fill in. They're going to need to plug those holes in their process in order to get to an effective future state.

MORIARTY: Topic 842 has already been adopted by publicly traded companies. What can privately-held companies learn to better prepare prior to the adoption of the standard?

FITZGERALD: What I would say is a couple things. When the public companies were getting ready to adopt, I think there was really a lack of appreciation of how involved and how complex leases really were. Nobody thought about it. It turns out, there are a lot of permutations, combinations of leases, that folks hadn't thought about.

We had the whole completeness issue, right, where you got to first find everything. We have the data issue. You have to abstract and make sure all that information is accurate.

A lot of companies, and even public companies, looked at it as a day one exercise, meaning that on day one, I have all my leases in effect as of the last day of my prior fiscal year, and let's say it's December 31st of 2018, because most public companies adopted in 2019. So, 1/1/2019, I put up, really, what's an asset, a right of use asset, and a related liability on my balance sheet, and then I wiped my hands, and I'm done. Well, that was a mistake, right, because what happens is, the next day... You want to call it day two. So, day one is booking the initial journal entry.

Day two, what happens is, leases are fairly dynamic. It's not a set it and forget it, but folks seem to not understand that, even real estate. A lot of real estate leases never go to term. There are amendments. There are changes. Space gets increased, downsized.

Typically now, what's going on with the pandemic, there's a lot of reevaluation of leases.

With all those changes and those modifications, you need a system in place, a process to track all the changes, and then to determine if those changes will have further accounting consequences. We think about that, so a lease has a modification of some sort, whatever that is, some change in one of the terms. Does that modification, is it substantial enough to require, what we call, in accounting terms, we call a subsequent remeasurement of that lease, right, and effectively a new lease now.

Many companies, that was one of the biggest surprises, is they didn't really plan for, I'll call it, day two.

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t Another thing with public companies that we saw, particularly here in the US, which is where I'm headquartered, is a lot of companies focus pretty closely on their US operations and didn't think about some of their international operations and some of the impacts. We talk about IFRS 16, which is the international equivalent for ASC 842.

Well, companies need to think about the implications for their statutory reporting in other countries, and a lot of them hadn't set up for that, so they've had some challenges around, we call, stat reporting, or as leases relate to statutory reporting. That's been another area.

The other thing that's happened with companies, and companies need to think about this with the process sustainable is, oftentimes with companies, whoever set up the process day one, those folks might have moved on, and there really was no kind of change management plan in place.

There was no handoff of the institutional knowledge of the folks who started the process, and so we would find that new people would come into the roles and not understand what was going on, so again, a lot of that was not thought through very well.

Then the last thing I would say, and maybe we'll talk about this a little later is, some companies, believe it or not, chose, and big companies, chose to adopt using Excel, which is kind of amazing now because I can't tell you how many, after they adopted using Excel, then came back to us and said, "Hey, we talked to you about it a year and a half ago. We'd like to talk to you again, because we found out Excel is just really too static, and leases are dynamic." I would say those are some of the things that private companies will need to think about.

SURRAN: Topic 842 adoption and the work involved were underestimated and enterprises did not really grasp the magnitude of information required to be tracked in order to accurately report on their financials.

Many resorted to using Excel to capture the information needed. The use of Excel was always, and still is, people's first choice. Several companies made the decision not to invest in lease software for that reason, only to learn the hard way that Excel couldn't provide the level of detail needed. While spreadsheets may be great for data analysis, they are not designed to handle complex data processes such as lease accounting. They are simply not sufficient.

MORIARTY: Joe Fitzgerald discusses why the use of Excel may not be adequate based on the number of leases a company has and some of the key considerations to look for while shopping for lease software.

FITZGERALD: The assessment of your current state and thinking about your future state and your gaps. Many of the gaps that you're going to find in your process today can be solved with the right technology.

For instance, we've got to think about lease classification, which has always been an exercise under the current standard or the previous standard. But really, it's got to have a higher degree of focus now under the new standard as we are going on a balance sheet. You want to have a software that will do the automated lease classification, for instance.

Disclosure, and I'll give you a perfect example, we have a customer, prior to the standard, up to the standard public company, their lease footnote, which is the five year table, which I know you know what that is. It was about a half a page. That disclosure was half a page long in their

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t financial statements. Today, it's three pages because there's so much more disclosure under the new standard that the FASB is looking for that wasn't required previously.

So, how are you going to capture and calculate all this additional information through Excel? It's almost impossible to really do that effectively, but companies don't always realize that until they get to that point. You want a company that's got very robust reporting and can handle things, like disclosure report. You want to understand the activities. I mentioned modifications.

So, day two modifications. You want a software solution that has very effective roll forward reporting capabilities. You want a solution that, as I said, can do the IFRS16, as well as ASC842, to the extent you have a global footprint. You want to be able to do both. You want to have the ability to update interest rates for the incremental borrowing rates, or IBRs, we refer to it in the solution.

The other thing, too, is, as I said earlier, this is a cross-functional activity. So, to have a software that the accountants could not only be hands-on, but also folks in real estate and procurement could be hands-on, putting in their information.

Think about it, kind of the front end. So, the real estate folks would update the system, for instance, for lease management and lease administration, and put in all the relevant information they need to operate the real estate. Then that information, a portion of that, would then go feed the accounting all on a real time basis. It would be accurate. It would be timely, being updated for finance. That would be very important, as well. Those are just a few of the things that you would want to look for in accounting, and really, lease management and lease accounting software.

MORIARTY: But are there any other areas companies should focus on while evaluating lease software and what controls should be in place?

FITZGERALD: First off, as part of your evaluation of software, you'll want a vendor that has a third-party SOC report. We have a SOC 1, type 2, the test of controls.

Ours goes a little further in that we also test the calculations as part of that. You'll, first off, want that, and then you'll want to evaluate that, whether it meets your criteria.

Just the way the accountants don't want the real estate folks in their side of the system, so to speak, the real estate folks don't want the accountants in their side, either.

There are going to be authorizations, approvals, as the transactions move through, and the controls will be in place. You may want an example. You may have a foreign subsidiary where you'd like them to put their leases into the system from a point of lease contract point of view, and they'll put them in, but you don't want them to be able to see the consolidated view. So, again, the system like we have is set up for that. They can only touch their piece of the puzzle and only see what involves their entity.

MORIARTY: As Joe discussed earlier, it is important for companies to properly manage the leases they have, so, when they start accounting for all available lease agreements, how can they ensure completion?

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t FITZGERALD: Really, that's kind of, I would say, two pieces. One is day one. Getting to day one, you really take, I call it a scoping exercise. There's different procedures that you put in place. I mean, there's leases that are obvious, that we all know about.

They say lease at the top to get the real estate folks. They'll have a lot of the real estate ones. The other areas in maybe IT procurement might have theirs, so really, you kind of get the ones you know, and then you go through the exercise with the folks in the organization, kind of giving them some examples of what to expect, what to look for, and then you might run some tests on your accounts payable, looking for some consistency in payment types.

You might have a procurement system that you might run some tests through. Again, trying to bubble up leases that may have gotten missed. Not uncommon in certain industries are P cards where they actually have recurring purchase arrangements where they're putting something on a credit card, for instance, that's actually a lease. So, you go through a series of procedures as getting ready for the standard to see if you have completeness.

Then from a day two perspective, you need to have a process in place, now, that all the folks who were made aware of what's a lease, right, that there's a process in place. Maybe it's through procurement or real estate to make sure that as new leases come in, or current leases go out, that there's a process to ensure that they get into the system, let's say, they get into the system at a timely fashion. And then again, those sign offs occur.

Then once everything is in the system, there are certain reports that are either standard in the system or ones you may develop for yourself to test completeness, to test accuracy.

Again, we encourage that with our customers, typically when they're setting up, to run user acceptance tests on not just individual scenarios of lease types. Most lease types are pretty similar, company-to-company, but there are customers that have unique lease types, and we want them to run scenarios to make sure that they're happy with the way things are being calculated, and then to run certain reports, so that they can check the completeness.

MORIARTY: Joe Fitzgerald discusses the impact of COVID-19 that his customers had to deal with.

FITZGERALD: Aside from, obviously, folks getting downsized, people cost is probably number one in most companies, but there really was a heavy focus on real estate. I mean, look, everybody had to go to work from home, so you've got a lot of empty space. Certain industries, like retail, food and beverage industry, are really down quite a bit. So, companies started to take a look at their real estate, look at their leases.

They would go to their landlords, I think, initially asking for some deferral of payments that they intended to make up on the backend. Then it got to be maybe a little more serious, and they may have looked for reductions in their rents or abatements in those rents. Some folks looked to restructure leases. Some actually had to terminate leases.

There was a lot of, I'll call it, negotiating with landlords that we saw. This came through when we did a survey with our 700+ customers back late in 2020, the fourth quarter. I would say three in five had some level of negotiation with their landlords going on, which is pretty substantial.

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t MORIARTY: The pandemic has caused companies to look at their leases and ask for concessions from their landlords. Joe gives us his insights as to the nature of the concessions and how they can benefit tenants.

FITZGERALD: There was a request for rent deferrals and abatements, reductions, some renegotiation. I think the other side of that is that what companies started to think about is what the future will look like in their real estate footprint.

They're thinking about wanting flexibility. The next time, they sign a lease. They'll want flexibility. Maybe they want to get an early out or some other kind of flexible. Maybe they want shorter lease terms, and they don't want to sign up for long lease terms. Now, obviously, anything that the landlord is going to give up is going to come at a cost. So, there may be some premium to pay higher lease rates for the ability to get out early, right, or the ability to have a flexible termination. They're starting to think a little more about the fine print. Again, it's not a set it and forget it.

The other thing we're seeing with companies, in I guess about 18%, if I recall, of the respondents, said that they are looking at co-working more closely, where they hadn't necessarily in the past. They're thinking about these co-working facilities and how they might leverage that in their future real estate footprints.

MORIARTY: But what is the difference between co-working and subleasing?

FITZGERALD: We have a number of our customers, in certain industries, particularly, they'll be the, I'll call it, the master lessee on a hospital system. There will be a master lessee on a medical office building, and then what they, in turn, might do is, they might sublease a section of that building to physician groups or to ancillary services, maybe a dialysis or a radiology group. That's been fairly common. That's been going on for a long time.

Now, it's interesting. With the pandemic and the downsizing, working from home, there's a lot of companies that have a lot more space that they need to figure out how to minimize the financial impact, so I think you're going to find a lot more sublease space available where companies that are on the hook for a lease or looking to sublease to other companies. That's kind of one thing.

Separately, in the co-working space, there's companies that have a business.

Everybody talks about Wework, being the most well-known one, I think. Wework, it goes out, and with the intention they lease an entire building, and then they will ... if you want to call it a sublease, but they will almost rent to companies, sometimes on a daily basis or a very short-term basis. They'll have all the services, all the amenities that you would need if you were in an office, but the only thing you have to do is rent the desk or the office for some period of time. I think that's what companies are looking for, is these more short-term, temporary arrangements, as opposed to permanent leases.

MORIARTY: Earlier, Joe referred to lease modifications. How will those modifications impact lease accounting?

FITZGERALD: If there's a change in the terms, I would say that's deemed significant, and an example, you have a lease that has a five year term, and due to whatever, you changed the term to seven years after adopting the new

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t lease theory, that's effectively a lease modification that requires, what we call, a subsequent remeasurement. It's like a new lease. You have to kind of end the old one and then book a new lease. That's going to have accounting implications under ASC 842, whereas prior to ASC 842, companies would do that, but there's no balance sheet effect, right, because it wasn't on the balance sheet. It would just continue to flow through the P&L. That's the thing that companies need to evaluate, and it's a judgment call, but they need to evaluate when there's a change in terms to leases, and whether we're going to require some kind of a subsequent remeasurement to that lease.

MORIARTY: And how about impairment? How is that impacted? Joe explains.

FITZGERALD: There's also the concept of impairment. Once you've booked, again, it doesn't really come into play until after you've booked the asset on the balance sheet, but once you've done that, that asset, like any other asset, needs to be evaluated for impairment. If you start to think about having booked a lease right of use asset, as we call it for the leases, and then there's a decline, that you may have to take, I call it a hit. You may have to take a hit of some kind for the impairment on the valuation of that asset. That's a significant implication that really wasn't there before the adoption of ASC 842.

MORIARTY: Joe discusses ways that companies can optimize their leases.

FITZGERALD: I think about this as day one, day two, day three. Day one, for me, is that, first, debit and credit, getting it up on the balance sheet, and then day two, as we talked about, is coming up with a process to really sustain as the changes take place in your lease portfolio, but it's still very accounting and compliance-focused. Once you get that all kind of under your belt, really, the thing is, folks will then look at it and say, "Okay, how can I improve the economics or the use of these assets?"

In the past, maybe I'll set up something now that it's on balance sheet where I'm making sure that all the assets that I'm leasing, I actually have, and I can find them. You set up some process for the folks in the field to say, "Okay." You start to pay attention to the end of term.

Our system has notification features built in where we can notify any asset owner about an upcoming critical date. With that kind of a feature, you would hope that nobody would miss an end of term issue. If you have to notify the landlord six months before, you do that, or you have to think about returning the asset about three months before it's due, or you make a conscious decision that you're not going to return it. You're going to go into an evergreen period or negotiate some renewal. That, in and of itself, would be a better optimization of the lease.

The other thing is, you and I talked about earlier, is there's a lot of these ancillary costs, associated particularly on the real estate side, that now... tenant improvement credits, so for us accountants, so that TIs, they affect the right of use asset. They go to reduce the right of use asset.

There's a level of scrutiny, now, around them. We all know they're there, where in the past, they might have sat somewhere else, or sometimes they weren't even kept track of. Now, in theory, companies should be less likely to miss those. I would hope that there would be some better tracking, and because they're going on balance sheet, there's going to be more of a finance lens, which I think is a good thing on the leases, themselves, and the terms, where in the past, maybe there wasn't.

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t The other thing, again, not to get too technical with accounting, but there's this concept of leased and non-leased components of fixed versus variable expenses and the common area maintenance charges that we talked about.

Folks weren't really necessarily focused on those. Bills would just come in and get paid, but through accounts payable, if somebody would approve them, but there was no correlation between that and what was going on in the lease agreement.

Now, I would think folks are going to pay a little more attention to it, because again, it's on balance sheet, and there's something to reference it back to. Plus, all the leases are going to be ... again, another feature we have, is we have a central repository to capture all the leases, so you can go back, and you can actually go to the clause that deals with common area maintenance charges.

MORIARTY: Joe discussed several ways to optimize leases. He continues by giving us his insights as to the impact on lease accounting.

FITZGERALD: Well, I think with the lease accounting, like I said, first off, the data is going to be more accurate. That's the first thing.

The other thing I kind of remind folks is that, there sometimes can be a lack of timeliness in just updating the systems, or their systems, there's a disconnect in the systems. The folks who were handling the real estate for lease admin purposes had one system in accounting somewhere else, and so they do something, and it doesn't make its way to accounting for months, or it never makes its way because there's a disconnect. I think that just the fact that the ASC 842 is in place, and it is cross-functional, is just going to have... There's going to be more of a, what happens on the front end is going to impact the backend from that perspective.

I do believe that, like I said, lease accounting is going to really improve the way that folks do leasing. I think not only that, but I think they're going to start paying closer attention to leases and think about the next time they enter into a lease. We talked about flexible options on real estate. Folks are thinking about that, a shorter term, versus longer term. I think there's going to be just more attention to those things, where they didn't happen in the past.

MORIARTY: Joe Fitzgerald concludes our segment and leaves us with his final thoughts.

FITZGERALD: Look, there's no question, and I've literally interacted with hundreds and hundreds of companies over the last several years. This is a lot more complicated than folks appreciate. The finance folks, I know, I'm a CPA. I've been on both sides. We've got a lot going on. This is one more headache in some respects, but it's one that if you deal with, like we said on the optimization side, it can have real value. I used to say, you can turn compliance into a profit center. I mean, to be honest, you could really do that if you went all the way through to day three, but it's going to be a lot more complicated.

If you haven't yet adopted, you can never start too soon. Technology, having technology can clearly enable your process to be better than it would be, otherwise, and I just think it also is going to create better collaboration across the organization with folks that, again, like I said, this is not just accounting-centric. This is really a collaborative effort on real estate, procurement, legal, IT, you name it. It really is going to be a collaborative effort, and I think just improve communication across the organization.

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Segment Three

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3. Economic Value Added – A Net Income

Alternative


Segment Overview:

Field of Study:


Running Time:

Video Transcript:

Course Level:



Expiration Date:

Accounting

September 10, 2022

Work experience in financial reporting or accounting, or an introductory course in accounting.

None


Update

See page 3–19.

32 minutes

Economic value, or economic value added, or as some people refer to it, economic profit, is an alternative to net income; many people believe that net income may not be an appropriate measurement to identify value creation for an organization. So an alternative has been developed to evaluate value creation, known as the economic value model. Most companies present their financial statements based on GAAP, generally accepted accounting principles, but there are some weaknesses when we are trying to figure out a company’s value. John Fleming, CPA at Kaplan Financial Education, explains why a net income alternative might be a better measurement in certain situations and to specific companies.

Upon successful completion of this segment, you should be able t l Identify the differences between net income or earnings per

share and economic profit, l Identify related performance metrics associated with

understanding economic profit, l Recognize how to apply economic profit to a live situation

and how the treatment of certain expenses differs when using economic profit vs. GAAP, and

• Determine the strengths and weaknesses of economic profit.


“Digital Due Diligence” “Insurers Face Evolving Cyberrisk From Costly Hacks, Deepfake Attacks and Sophisticated Ransomware” See page 3–12.

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A. Economic Value Model

i. Better measurement to identify value

ii. Performance metrics l Return on investment l Earnings per share of net income l Discounted cash flow l Market value added

B. EVA Three Basic Assumptions

i. GAAP is a poor measure of an entity’s value

ii. Primary objective of an entity is to maximize shareholders’ wealth

iii. Value of an entity is based on economic profits l Exceeding cost of capital for

both debt and equity

C. Traditional Approach vs EVA

i. Traditional income statement

• Net income derives from revenues & expenses

ii. EVA Model

• Determines economic profit if it exceeds cost of capital

I. Measurement of Value Creation

A. The Basis of GAAP

i. Matching of revenue and expenses l Recognized and incurred in the

same period

ii. Hybrid accounting basis with measurements based on l Cost l Fair value l Market value l Book value l Impaired value

iii. Establishes rules to allow comparability

“… but it (GAAP) doesn't provide us with the amount of decision-useful information that could be acquired if we had a common valuation base for our assets and liabilities.”

— John Fleming

B. Net Income Limitations Under GAAP

i. Ignores the cost of equity returns required by equity shareholders

ii. Can be manipulated to achieve predetermined goals

C. Net Income – A GAAP Measurement

i. Measures revenue and expenses l Different measurement bases l Sensitive to accounting estimates

ii. Looks at the past

iii. Focuses on accrual rules

iv. Reflects period charges l Rather than investments in

entity’s future

D. Why GAAP Combines Apples & Oranges

i. Total assets and total equity are not based on current value

ii. Based on a potpourri of valuations l Assets are based on various

acquisition dates l Different purchasing power

equivalents

E. Economic Profit

i. Measures the value the company creates in excess of l The required return to the

entity’s shareholders

ii. After tax adjusted cash flows less the cost of capital

iii. No real earnings are achieved unless earnings exceed the cost of capital

II. The GAAP Legacy

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A. ROI Strengths & Weaknesses

i. Strengths of ROI l Ease of calculation l Ability to identify sources of

change in the ratio

ii. Weaknesses of ROI l Influence of accounting methods

followed l Amounts reflecting different l Period purchasing powers l Valuation bases l Has a historical emphasis

B. How to Calculate Earnings Per Share

Reported net income

Outstanding common shares

C. EPS – Another GAAP Measurement

i. Focus on outstanding common shares l May prevent issue of additional

common shares

ii. Entities may issue more costly debt than equity to maintain their EPS l Will decrease shareholder

wealth

iii. Heavy reliance on EPS measurement l Fraudulent financial reporting

III. Analysis of Return on Investment and EPS

A. Intrinsic Value of an Entity

NPV= PV of expected cash flows

minus

Initial projected cost

B. Discounted Cash Flow – Not a GAAP measurement

i. Closer to an economic value measurement

ii. It’s not using l Net income l Revenues and expenses l Assets other than cash

C. Net Present Value

i. Similar to economic profits

ii. Measures a project’s net cash flows

iii. Does not factor in the total cost of capital of the project

D. Market Value Added

i. Entity’s market value minus invested capital

ii. Does not l Account for any cash payments

to shareholders l Measure the opportunity cost

relative to alternative investments

iii. Provides a snapshot of the how well the entity has maximized shareholder value

IV. Analysis of Discounted Cash Flow and Market Value

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Outline

A. Expenses vs Investments

i. Types of expenses treated differently l Research & development l Marketing & advertising l Development of customer

relationships

ii. Economic profit – investments

iii. GAAP – expensed

B. Economic Profit & Future Adjusted Cash Flows

i. Economic profit l Intrinsic value when considering l Invested capital l Present value of future adjusted

cash flows

ii. Future adjusted cash flows l Adjustments for non-cash

expenses l Plus, expenses reflecting future

investments

C. Invested Capital

i. Addition of financing provided by stockholders and lenders

ii. Items NOT considered invested capital l Accounts payable l Accrued liabilities l Deferred revenue l Deferred tax liabilities

D. Economic Profit Components

i. Net operating profit after taxes (NOPAT)

ii. NOPAT adjustment for any expenses that reduce the operating profit

iii. Deduction of capital costs for both debt and equity

E. Starting with Operating Cash Flow

i. Might be more efficient

ii. Based on cash flow instead of GAAP measurement

F. Capital Cost of Debt & Equity

i. Capital cost for debt and equity is subtracted from NOPAT to obtain economic profit

ii. Capital cost is based on the weighted average cost of capital

V. Determining Economic Profit

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A. Assumptions About the Cost of Equity

i. Risk-free rate

ii. Beta l Measure of volatility or risk of l Individual security in

comparison to the market as a whole

iii. Equity premium l Excess return that investors

expect l Above a risk-free investment

B. Getting to Economic Profit

GAAP operating profit

Plus

Adjustments to convert accrual to cash

Plus

Capitalized investment expenses

Equals

Net operating profit after taxes

Minus

Capital costs

C. Economic Profit Strengths & Weaknesses

i. Strengths l Corrects GAAP net income and

earnings per share deficiencies l Contributes to continuous

improvement l Creates a single performance

metric

ii. Weaknesses l Subjectivity in the calculation of l Accrual to cash conversions l Determining expenses as

investments l Calculating implicit cost of

equity

D. Use of Economic Profit as an Alternative

i. Many companies do calculate economic profit l Different ways of calculating it l Use of different assumptions

about l Adjustments l Cost of capital

Outline

VI.Using Economic Profit

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“In this segment, John Fleming explains why a net income alternative might be a better measurement of value creation in certain situations and to specific companies than EVA.”


l After playing the video, use the questions provided or ones you have developed to generate discussion. The answers to our discussion questions are on pages 3–8 and 3–9. Additional objective questions are on pages 3–10 and 3–11.


1. Why might GAAP not be the best measurement for figuring out a company’s value according to John Fleming? How does your organization or clients use GAAP results for determining entity values?

2. What are some specific limitations to measuring net income under GAAP in regards to the entity’s value to shareholders?

3. What are the differences between net income or earnings per share and economic profit? How might your organization or clients benefit from considering economic profit instead of or in addition to net income and earnings per share?

4. What is discounted cash flow and market value added and how might they be used for economic value measurement? What has been the experience of your organization or clients in conducting this type of analysis?




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s5. What are the basic components of

economic profit and what are some considerations for the initial calculations?

6. What types of expenses may need to be considered differently between GAAP and economic profit because they could be perceived as valuable assets or investments for an entity’s future?

7. What should be considered when determining the weighted average cost of capital for calculating economic profit for an entity? What has been the experience of your organization or clients with assumptions and calculations of weighted average cost of capital?

Discussion Questions (continued)

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s1. Why might GAAP not be the best

measurement for figuring out a company’s value according to John Fleming? How does your organization or clients use GAAP results for determining entity values? l GAAP:

v Accrual-based framework designed to measure past financial performance

v Designed to allow for comparison of performance among companies in the same industry or the same size

v Hybrid accounting basis v Ignores purchasing power

differences and the time assets are acquired or developed

v Rules are consistently applied but are applied to different valuation measurement bases

v Doesn’t provide useful information that could be acquired with common valuation base for assets and liabilities


2. What are some specific limitations to measuring net income under GAAP in regards to the entity’s value to shareholders? l Net income ignores the cost of equity

returns required by equity shareholders

l Net income can be manipulated to achieve predetermined goals

l GAAP is based on an accrual concept based on significant estimates and permitted alternatives

l Revenue and expenses valued with different measurement bases

l Net income looks to the past and focuses on accrual rules rather than cash flow outcomes

l Net income reflects period charges such as R&D, marketing, or developing customer relationships

rather than investments in the future of the entity

l GAAP has difficulty measuring intangible assets so it expenses such costs

3. What are the differences between net income or earnings per share and economic profit? How might your organization or clients benefit from considering economic profit instead of or in addition to net income and earnings per share? l Differences:

v EPS does not completely measure the cost of financing an entity’s profits

v Total assets and total equity are not based on current values but rather different valuations and asset acquisition dates

v Economic profit measures the value created in excess of the required return to shareholders

v Economic profit is based on after-tax adjusted cash flows less the cost of capital

v Premise of economic profit is that no earnings are achieved or value created unless cash flows earned exceed the cost of financing its capital


4. What is discounted cash flow and market value added and how might they be used for economic value measurement? What has been the experience of your organization or clients in conducting this type of analysis? l DCF and market value added:

v DCF forecasts the present value of expected future cash flows discounted at a rate equal to an entity’s cost of capital less the initial project value



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sv DCF is based on a cash flow

measurement as opposed to GAAP income which is based on an accrual concept

v If net present value of a project exceeds zero, it will increase shareholder wealth

v Market value added equals market value of an entity minus its invested capital, which includes all debt including leases and all equity

v Market value added does not account for any cash payments paid to shareholders

v Market value added does not measure opportunity cost of alternative investments

v Market value added provides snapshot of how well the entity has maximized shareholder value


5. What are the basic components of economic profit and what are some considerations for the initial calculations? l Net operating profit after taxes

(NOPAT) is a cash flow proxy requiring adjustments to convert accrual accounting profits to cash profits

l Adjustment to NOPAT for expenses that reduce operating profit but are really investments in the future of the entity

l Deduction of capital cost of both debt and equity

l May be more efficient to base economic profit calculations initially with operating cash flow rather than GAAP operating profit

l Conversion of accrual profits to cash profits might include items like bad debt expense, deferred taxes, LIFO reserve additions, warranty expenses, and others.

6. What types of expenses may need to be considered differently between GAAP and economic profit because they could be perceived as valuable assets or investments for an entity’s future? l Examples include research and

development, marketing and advertising, and development of customer relationships

l GAAP expenses these because they are difficult to measure

l Ignored under GAAP when they appear to be investments benefitting a company and should probably be reflected as an entity’s assets

l Most valuable asset in most corporations is their people which does not get measured because GAAP does not know how to measure human capital

7. What should be considered when determining the weighted average cost of capital for calculating economic profit for an entity? What has been the experience of your organizatio n or clients with assumptions and calculations of weighted average cost of capital? l WACC Considerations:

v Cost of capital is a combination of the cost of debt and the cost of equity

v The returns expected by investors have varied over time

v Invested capital is the product of FASB’s interpretation of debt and equity, but off-balance sheet capital may make the calculation a little more difficult

v The average cost of long-term debt should be adjusted for its tax effect

v Implicit cost of equity is based on assumptions for the risk-free interest rate, beta, and equity risk premiums



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1. What are GAAP rules designed to do, according to John Fleming?

a) measure an entity's value

b) predict future performance

c) compare financial performance among similar companies

d) provide information needed to project future cash flows

2. Which of the following measures the value the company creates in excess of the required return to the entity's shareholders?

a) earnings per share

b) economic profit

c) return on investment

d) total equity

3. Aside from the ease of calculation, which of the following is considered a strength of the return-on-investment statistic?

a) ability to identify sources of change in the ratio

b) influence by accounting methods followed

c) different period purchasing powers

d) historical emphasis

4. Which of the following is correct regarding market value added?

a) accounts for cash dividend payments

b) measures the opportunity cost relative to alternative investments

c) changes in the inverse direction of shareholder wealth

d) equals market value of the entity minus its invested capital

5. What did John Fleming identify as the most valuable asset of most corporations that does NOT get measured under GAAP?

a) people

b) R&D

c) brand

d) off-balance sheet capital

6. Which of the following does NOT run through an entity's financial statements and has to be calculated in order to arrive at economic profit?

a) debt

b) equity

c) cost of debt

d) cost of equity

7. Which of the following represents the excess rate of return investors expect above a risk-free investment?

a) equity risk premium

b) beta

c) NOPAT

d) cost of capital

8. Which of the following represents an expense that may be better perceived as an investment for the future as opposed to a period cost?

a) bad debt expense

b) marketing and advertising

c) deferred taxes

d) additions to LIFO inventory reserves


Objective Questions


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9. Which of the following answers the question of how much shareholder wealth has been generated over time?

a) retained earnings

b) economic profit

c) return on investment

d) discounted net cash flow

10. Using which of the following as the initial measurement could reduce the subjectivity involved in the calculation of economic profit?

a) NOPAT

b) operating cash flow

c) earnings before interest and taxes

d) gross profit


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ECONOMIC VALUE ADDED (EVA) OR ECONOMIC PROFIT

By: John Fleming, CPA Discussion Leader Kaplan Financial Education

Most times, companies prepare their financial statements based on GAAP generally accepted accounting principles, and we'll see in a moment where there may be some weaknesses there when we're taking a look or trying to figure out the company's value. And another alternative that some folks like to use is economic value. So we're going to take a look at that today just to present another alternative to you in terms of when we might be looking for value as it might relate to a specific company. So the learning objectives for this are to identify the differences between net income or earnings per share and economic profit, identify related performance metrics associated with understanding economic profit, recognize how to apply economic profit to a live situation and indicate the strengths and weaknesses of economic profit.

So the topics we will include an introduction, then we'll take a look at various performance metrics, including return on investment, earnings per share

and net income, discounted cash flow, and market value added. We'll then move into economic profit, and we'll look at a simple economic profit example that I prepared, and then we'll reach a conclusion. So, certain assumptions I think, I am making and others make when they speak about this alternative of economic profit, the assumptions are one, GAAP is a poor measure of an entity's value, two the primary objective of an entity is to maximize shareholder wealth, and three, the value of an entity is based on economic profits exceeding the entity's cost of capital for both debt and equity. And cost of capital obviously, is the interest factor associated with both debt and equity. So the first one, GAAP is a poor measure of an entity's value. Why don't we take a look at that one first. Generally accepted accounting principles is an accrual based accounting framework designed to measure past financial performance based on a set of rules and disclosures established by FASB, the Financial Accounting Standards Board.

Now, this suggests that a focus on historical performance might not be the most meaningful way of coming up with a




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corporation's value. The stock or performance doesn't necessarily predict future performance or future value. Second bullet, these rules are designed to allow management and users to compare financial performance among companies in the same industry or that are approximately the same size. So, if the focus is on comparing financial performance, that focus limits the ability of GAAP to provide useful value information. So, GAAP is based on the matching of revenue and expenses recognized and incurred in the same time periods. GAAP is a hybrid accounting basis with measurements based on cost, for example, land, fair value, for example, investments or impairment values, market value, book value, which is the cost less accumulated depreciation, or impaired value which is going to be at fair value. It's also a possibility of present value where you're got a present value, the stream of future cash flows and that will also give you a valuation. The point being is that when you look at total assets, for example, you're not adding up all the same values or all the same purchasing powers.

So in other words GAAP adds and subtracts apples and oranges in its financial statements, and then concludes that the results, which could be total assets, net income, stockholders equity are relevant as decision useful information. These results, though, are generally not decision useful. So if I'm adding up different measurement bases, if I'm adding up different purchasing powers, I'm not getting as meaningful a number as I would get if we were adding up all the numbers using the same measurement base for example, fair value. So GAAP net income, given these different measurement bases and different purchasing powers, GAAP net income has two additional limitations. Net income ignores the cost of equity returns required by equity shareholders, and net income can be manipulated by accounting managers to achieve predetermined goals, and this is normally done by manipulating estimates that are used to generate the financial statement outcomes. So the first bullet there was really the focus of economic value. If net income ignores the cost of equity returns required by equity shareholders, then the

alternative that we're looking at today will measure those equity returns.

Continuing with GAAP, the decision used for GAAP information managers have traditionally used include net income or accounting profit, earnings per share, and return on investment. So let's look at these three GAAP measurements. Net income measures revenues and expenses with different measurement bases as we said earlier, and it is sensitive to accounting estimates and alternatives within GAAP. Net income looks to the past and focuses more on accrual rules, rather than cash flow outcomes. Accrual, recognizing revenue when it's earned or expenses when they're incurred, not when the cash comes in or out. Net income reflects period charges such as research and development, marketing, or developing customer relationships as expenses rather than in investments and the future of the entity. Again, GAAP doesn't have any room if you will, for somehow measuring investments that may be taking place, that can benefit the future, because it is a historical basis of accounting.

Earnings per share is a product of net income and is influenced by the number of shares outstanding. Earnings per share, it does not completely measure the cost of financing, and related profits. And return on investment is also a by-product of net income with the denominator of total assets or total equity, incorporating the result of GAAP's apples and oranges measurements. So, let's look at economic profit. Economic profit as opposed to accounting profit measures the value the company creates in excess of the required return to the entity shareholders. I'll say that again. Economic profit as opposed to accounting profit measures the value the company creates in excess of the required return to the entity shareholders. Economic profit is the after tax adjusted cash flows generated by an entity, less the cost of capital the entity has deployed to generate that cash flow. So it's the after tax adjusted cash flows. The premise behind economic profit is that no real earnings are achieved or real entity value created, and so dollars, that is adjusted cash flow earned by the entity, exceed the entity's cost of financing its capital. This

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creates a minimum required rate of return for both shareholders and creditors.

Accounting profit of a million dollars is earned and the entity has $10 million of stockholders equity or a 10% return. So in a simple GAAP measurement, one million divided by 10 million is 10%. Now remember, one million is generally speaking in current dollars, 10 million is generally speaking made up of many, many different purchasing powers as well as many different accounting measurements. If the entity's cost of capital, considering both debt and equity happens to be 12%, then shareholder wealth decreases by 2%. The entity will create economic value for shareholders only if accounting profit exceeds a million too. Now, at this point, it's clear that economic value is using as a basis those same numbers that generated net income. There's going to be some adjustments made to them, of course, but we're using the same accounting measurement basis, which suffer from the same purchasing power issues we mentioned earlier. So as I said at the outset, this is an alternative that some people like in order to better measure value, but even that measurement has a weakness because included in the calculation are going to be GAAP outcomes to some degree that are influenced by these different purchasing powers and different measurement bases. So it's an improvement many believe, but it's not perfect.

Continuing with economic profit, economic value is created when the return on the entity's capital employed is greater than the cost of that capital. Economic values principle focus is creating shareholder wealth over time. This is a concept different from GAAP income. And I think that's why so many folks like economic profit, because it is a form of measuring shareholder wealth that doesn't have the same type of measurement in generally accepted accounting principles. So it's an improvement again, it's not perfect, but it's an improvement. Economic profit answers the question how much shareholder wealth has been generated over time. A positive economic profit

indicates that entity value that is shareholder wealth is being created. Shareholders gain when the return from capital deployed is greater than the cost of capital. A negative economic profit indicates that real value is not being created, because the cost of capital deployed in the business exceeds the return realized from the overall investment.

So if we just think about that a little bit here, instead of arriving at a bottom line of accounting profit, we're going to arrive at a bottom line of economic profit. Stated as I said earlier, this is an improvement over accounting profit or accounting income even though it may not be a perfect measurement. To illustrate the differences in certain performance metrics, this section takes a look at return on investment, earnings per share and net income, discounted cash flow, and market value added. So return on investment, typical return on investment compares returns that are benefits with certain resources, usually assets and equity, that are generating return. So for example, we have earnings before interest and taxes divided by total assets, we could have net income divided by total assets, we could have net income divided by total equity. Now those are example measurements that we would see as return on investment.

Strengths of return on investment. It's an easy calculation, and you can identify the sources of change in the ratio. Weaknesses though of return on investment is it's influenced by accounting methods followed, the amount reflect different period purchasing powers and different valuation bases, and it has a historical emphasis. So let's go back one slide. And just take net income divided by total assets for example. Net income is generally a by-product of current purchasing power. It's a revenue stream with short term expenses reducing it, and then there's some other items like depreciation that are impacted by the cost of long term assets. But that income is a better current measurement basis, than say total assets, because total assets have all of those items at different measurement bases. Cost, fair value, present value, impaired value, market

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value, book value. So, when you do return on investment calculation, total assets as you see on your screen or total equity suffers from not being a current value number. It's more based on past purchasing power and past book values particularly for property, plant and equipment.

Earnings per share and net income. Earnings per share, as we said, is the product of dividing reported net income, accounting income, by the outstanding common shares. The use of net income for measurement has the same weakness as return on investment, including its use of accounting methods, purchasing power differences, and historical emphasis. So, again, we have a net income number that is more current than say total assets, but it still has some purchasing power issues as well as the potential for manipulation by management, where they can manipulate estimates. Earnings per share and net incomes focused on outstanding common shares can cause an entity to not issue additional common shares even though the entity may need the resources for growth and the creation of shareholder value. In other words, if we issue more shares, earnings per share will likely go down. Entities may issue more costly debt than equity in order to maintain EPS. This will decrease shareholder wealth due to the difference between cost of debt versus cost of equity. What we're suggesting here is that none of these measurements are perfect, and, well, they're not completely bad, they do have some criticisms of them, even though they are commonly used.

Additional problems looking at earnings per share, are frequently caused by heavy reliance on an EPS measurement, such as those caused by fraudulent financial reporting. So what we're saying here is that a management group may desire a higher EPS or a higher EPS growth because it potentially influences the stock price, and it may also give them a better financial view if they want to borrow more money or issue more shares. And various frauds have demonstrated that, I just had four on the screen. Tyco, Rite Aid, Xerox, all of which were focused on increasing earnings per share, and they each did it in a fraudulent

manner. And that's, again, something that we need to also focus on when we're thinking about the usefulness of measurements.

Discounted cash flow. Discounted cash flow is the forecasted present value of expected future cash flows, discounted at a rate equal to the entity's cost of capital, less any initial project cost. And that's where the net present value comes from. Net present value equals the present value of expected cash flows, minus whatever the initial project cost is. So, in effect, net present value could be expressed as the intrinsic value of the entity. In other words, if we're going to do a cash flow measurement, and say this is the value of our organization based on the expectation of generating future cash flows, that's a meaningful measurement, that is probably a better alternative than using GAAP for some type of value measurement. In other words, I'm suggesting that a discounted cash flow measurement is useful. I'm also suggesting it's more useful than a GAAP measurement. This program today is on economic value, so I'm not going to speak much more about discounted cash flows, but I'd be remiss if I didn't show this as another alternative that many folks would rather use. That is they'd rather have a cash flow measurement.

The weakness is that you're predicting future cash flows, and the further away you get from the predictive period, the less likely the outcomes are. And of course, you're using sort of an arbitrary discount rate, while it's based on the organization's long term interest rates, they can vary as time goes on, and they can create some subjectivity to the measurement. But in my opinion, it's a better measurement than GAAP when you're looking at value. So, if the net present value exceeds zero, the entity will increase shareholder wealth, because the return will exceed its initial project cost. If the net present value is negative, the project should be rejected, because the return will not exceed its initial project cost. Net present Value is similar to economic profits, because it measures a project's net cash flows, but it is different from economic profit, because it does not factor in the total cost of capital associated with the project.

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Meaning it just factors in the project cost, not necessarily the financing of that project cost.

Then there is market value added. Market value added is the difference between the entity's market value and the amount of capital invested in the entity. So market value is the stock price multiplied by the number of outstanding shares. So market value minus invested capital. Invested capital is normally the sum of all debt, including leases and all stockholder's equity. So we've got debt, we have long term leases that are on the balance sheet, and then you'd have the corresponding lease payment liability and stockholder's equity. So if the market value of the entity is greater than the invested capital, then you have something called market value added. Another way of looking at that is why would the market value of the company be more than its invested capital? And the answer is because the stock market is pricing in future expectations for the organization, not just current historical results.

Market value added does not account for any cash payments that the entity may have paid out to shareholders. That's just ignored. Market value added also does not measure the opportunity cost relative to any alternative investments. So you could have alternatives that would generate greater returns than what's currently being done. Market value added provides a snapshot of how well the entity has maximized shareholder value, since its inception, and the higher the measure, the more shareholder wealth created, but keep in mind, it's a product of the stock price, and that's going to fluctuate based upon the market's future expectations of an organization. So, looking more closely at economic profit, economic profit is not accounting profit. FASB's accounting rules do not have to be applied to calculating economic profit. But as we'll see in a moment, we're going to begin with a GAAP net income number, so it does and is influenced. Certain expenses may be better perceived as investments in the future, as opposed to period costs to be expensed. Research and development,

marketing and advertising, development of customer relationships, these are just examples of cost that get expensed because you as GAAP doesn't know how to capitalize and measure these and arrive at a time frame for their benefits. So they basically just get expensed as period costs. The reality is, they may be better classified as an asset rather than classified as an expense.

Economic profit can be considered the intrinsic value again of an entity when you consider the entity's invested capital, and the present value of future adjusted cash flows. Future adjusted cash flows are after adjustments for noncash expenses and adding back expenses that reflect future investments. So basically we're going to be adjusting this number. Invested capital is the addition of financing provided by both stockholders and lenders. Account items not considered invested capital might include accounts payable, accrued liabilities, deferred revenue, deferred tax liabilities. So economic profit has three basic components. One is net operating profit after taxes. Now, as I said, the beginning measurement is a GAAP income measurement. Yes, we're going to adjust it, but it begins with a base number that's influenced by those weaknesses in US GAAP. Again, this is an alternative, and many believe a better alternative, though, than just looking at US GAAP.

So net operating profit after taxes the acronym NOPAT is what we have. This is a cash flow proxy, requiring some adjustments to convert accrual accounting profits to cash profits, and it's calculated before interest expense. Now, just aside, when you look at this in a theoretical sense, when you're discussing the advantages or disadvantages or the merits of net operating profit as a beginning number for economic profit, many have argued why start out with net operating profit, why not just start out with operating cash flow? So, it begins this way, and it is expressed as a cash flow proxy after making certain adjustments to it. Some have argued that we should begin step one with simply operating cash flow. Now, I'm not illustrating that example in this course,

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but I'm simply making a point that there are some that believe that's a more meaningful way of doing this calculation. Two, adjust net operating profit after taxes, for the expenses that reduced operating profit, that are really investments in the future of the entity as we illustrated earlier, and deduct the capital cost for the cost of debt and equity capital.

Now, my example, I use relatively low interest rates, I'm just going to keep the example easy, and you'll see that as we go forward. So if the economic profit has three basic components, here's what it looks like. You have GAAP operating profit, plus adjustments to convert accrual to cash, plus investment expenses that we'll capitalize. This gives us net operating profit after taxes, and we subtract from that the capital cost, that is interest as it relates to both debt and equity, and that gives us economic profit. So if we don't like beginning with GAAP operating profit, then we could begin with an operating cash flow period. Just operating cash flow, and subtract the capital cost to get economic profit. That's an alternative that you'll see in some articles written about economic profit.

I'm making a point of it, because the way the presentation is usually presented is the way you see on the screen right now, but there are some others that would prefer just to use operating cash flow in lieu of making these adjustments to get to net operating profit after taxes. So let's look at a couple of things. One set of adjustments to convert accrual profit to cash profits might include these examples, bad debt expense, deferred taxes, or additions to any LIFO reserve. Again, some will call them non-cash adjustments. Investment expenses capitalized might include these examples I stated previously, research and development, marketing and advertising, and development of customer relationships. So both of these two screams are adjusting GAAP operating profit. The capital cost for debt and equity is subtracted from net operating profit after taxes to obtain economic profits. Capital cost is based on the weighted average cost of capital, it is a combination of the cost of debt and the cost of equity. Prior to calculating the capital cost, capital cost amount, invested capital must first be

developed. So, we'll just look at this for a moment. Capital cost is for debt and equity, it's based on the weighted average cost of capital, and it is a combination of the cost of debt and cost of equity.

Prior to calculating the capital cost amount, invested capital must first be developed. So that's what we're doing. Invested capital is the product of FASB's debt and stockholder's equity amounts adjusted for accounts not considered invested capital. And that's generally referred to as not being funding sources. So adjustments made to convert accrual net profits to cash profits, adjustments made to account for any off balance sheet sources for capital that may exist. So invested capital primarily debt and equity. The weighted average cost of capital is calculated as follows. Calculate the average cost of long term debt and reduce this cost by its tax effect. All right? So that's going to be the interest rate reduced by the tax benefit. And two, calculate the implicit cost of equity by determining the risk free interest rate plus beta plus an equity premium, reflecting the risk of the investment. So let's look more closely at that.

Beta is a measure of the volatility or risk of an individual security in comparison to the market as a whole. So if that volatility is 105, and the market as a whole is a hundred, then beta is five. Equity premium is the excess return that investors expect above a risk free investment. And a risk free investment is normally a treasury note of some sort, at a relatively low interest rate. So if we go back to the template that we had earlier, we start out with GAAP operating profit, plus adjustments to convert accrual to cash, plus investments and expenses capitalized, this equals net operating profit after taxes minus capital costs, and that gives us the answer, economic profit.

If we're not measuring economic profit, then that will not contribute to continuous improvement. So it's important, I think, to not just say it contributes to continuous improvement processes, but economic profit has to be measured to achieve that. It creates a single performance metric, as a measure of shareholder wealth. And well, I have that as

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a strength on the screen because it serves as almost a snapshot at a point in time.

It could be somewhat of a weakness also, because it might be more useful to have multiple measurements at times, in order to determine shareholder value, like, for example, discounted cash flow, like for example, market value added, it might be helpful to have more measurements now I recognize. More measurements cause or could cause some confusion. That's why this is here as a strength, because it's a single performance metric. But oftentimes, more inputs are preferred over a limited number or one input. So I'm simply making the point that if you had a market value added, that was positive, if you had a net present value calculation that was positive, if you had economic profit that was positive, that suggests to you that the value creation is positive also. So it may mean that more measurements are sometimes helpful.

Economic profit weaknesses, it includes some subjectivity in the calculation, that's the accrual to cash conversions, determining expenses as investments, calculating the implicit cost of equity, and we could reduce some of that subjectivity by using operating cash flow as the initial measurement. It only provides a single period measurement based on historical results, and again, the criticism of US GAAP is that it basically is providing you with a scorecard for past performance. Well, some of that, past performance is also included in economic profit, if we begin the calculation with adjusted net income. It does not translate effectively for entities that are not heavily invested in capital assets, such as property, plant and equipment. Although it is more difficult to actually be able to do an economic profit calculation if the company is primarily a service business, and equity does not reflect the asset base that a property, plant, and equipment company would reflect, and that's really what that's commenting on.

Economic profit is an alternative to US GAAP. It is an alternative, it is not the only alternative. And while it is perceived by many to be a better measurement than US GAAP, it also has its own weakness,

because it can be based on US GAAP's net income measurement, so it has the same inherent weaknesses of purchasing power, or et cetera that US GAAP has. We can correct for that by using operating cash flow, rather than coming up with a net operating profit after taxes, and operating cash flow many perceive is a better tool than using something that's a by-product of US GAAP. There's other alternatives. As I said, economic value added, discounted cash flow. There's also the alternative of just re-measuring all assets and liabilities on the balance sheet at fair value. And if we re-measure all those at fair value, then we have a common purchasing power, and we have a common measurement base. And that very well may be a useful tool, and we know that some companies actually do that. They have their assets and liabilities, appraised every so often, to come up with a valuation for the business, and then they use that as a comparison to see how well they're doing or not doing moving forward. So that's another alternative.

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tSURRAN: Economic value, or economic value added, or as some people refer to it,

economic profit, is an alternative to net income; many people believe that net income may not be an appropriate measurement to identify value creation for an organization. So an alternative has been developed to evaluate value creation, known as the economic value model.

There are some underlying reasons why this alternative might be appropriate in many cases. Performance metrics, including return on investment, earnings per share of net income, discounted cash flow and market value added, often lead into economic profit.

The economic profit model has three basic assumptions. One, GAAP is a poor measure of an entity's value. Two, the primary objective of an entity is to maximize shareholder wealth. And three, the value of an entity is based on economic profits exceeding the entity's cost of capital for both debt and equity.

Let's pause here for a moment. The traditional income statement takes revenues and expenses and arrives at net income. Economic profit, notice, is going to look at the entity's cost of capital and determine whether economic profit as defined exceeds that cost of capital. It's a different type of measurement.

MORIARTY: Most companies present their financial statements based on GAAP, generally accepted accounting principles, but there are some weaknesses when we are trying to figure out a company's value. John Fleming, CPA at Kaplan Financial Education, explains why a net income alternative, known as economic value, might be a better measurement in certain situations and to specific companies.

FLEMING: Generally Accepted Accounting Principles is an accrual based accounting framework designed to measure past financial performance based on a set of rules and disclosures established by FASB. These rules are designed to allow management and users to compare financial performance among companies in the same industry or that are approximately the same size.

GAAP is based on the matching of revenue and expenses recognized and incurred in the same time periods. GAAP, though, is a hybrid accounting basis with measurements based on cost, fair value, market value, book value, impaired value.

And notice, all these various measurement bases have in common that they are ignored under Generally Accepted Accounting Principles, meaning the differences are ignored. The purchasing power differences are ignored. The time that the item was acquired or developed is ignored.

So GAAP is a hybrid accounting basis, and what that means is GAAP adds and subtracts apples and oranges in its financial statements and then concludes that the results, total assets, net income, stockholders' equity, et cetera, are relevant as decision-useful information. Unfortunately though, these GAAP results are generally not decision-useful.

Remember what GAAP is doing. It's establishing rules to allow comparability. Those rules, consistently applied, are applied to different

Video Transcript


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t valuation measurement bases. So to phrase a comment here, "adding apples and oranges," meaning we're not adding and subtracting like measurements. And we've done that for years and years and years, of course, but it doesn't provide us with the amount of decision-useful information that could be acquired if we had a common valuation base for our assets and liabilities.

MORIARTY: John discusses net income additional limitations under GAAP.

FLEMING: GAAP net income, therefore, has two additional limitations. One, net income ignores the cost of equity returns required by equity shareholders. Net income can be manipulated by accounting managers to achieve predetermined goals.

So the equity return, so if we buy a share of stock, we're looking for an expected return of some amount. If that expected return is not achieved, we will sell that share of stock and buy another. Net income, under GAAP, doesn't reflect any measurements for the cost of equity returns.

Of course, we know that Generally Accepted Accounting Principles based on an accrual concept, based on significant estimates, based on permitted alternatives, can lend itself to manipulation by those that are preparing financial statements. The decision-useful, in quotes, GAAP information managers have traditionally used include net income, and we'll call that accounting profit, earnings per share, and return on investment.

Let's look at these three GAAP measurements. Net income measures revenue and expenses with different measurement bases and it is sensitive to accounting estimates and alternatives within GAAP, as we said previously.

Net income looks to the past and focuses more on accrual rules rather than cash flow outcomes. Net income reflects period charges such as research and development, marketing, or developing customer relationships as expenses rather than investments in the future of the entity.

Notice that now. GAAP traditionally has a difficulty in measuring assets that are more intangible rather than tangible. So when we incur cost for R&D, for marketing, for developing customer relationships, that feels like investments, it feels like assets, but under GAAP, we expense those costs because we have no meaningful way of measuring them.

MORIARTY: Earnings per share is a byproduct of net income and is influenced by the number of shares outstanding. John explains why earnings per share do not completely measure an entity's cost of financing.

FLEMING: Earnings per share does not completely measure the cost of financing an entity's profits, meaning it doesn't measure the equity returns. Return on investment is also a byproduct of net income, with the denominator, total assets or total equity, incorporating the result of GAAP's apples and oranges measurements.

In other words, total assets and total equity is not based on current value. It's based on a potpourri of valuations and a potpourri of asset acquisition dates, leading to different purchasing power equivalents.

Economic profit, as opposed to accounting profit, measures the value the company creates in excess of the required return to the entity's shareholders. Notice it measures the value the company creates in excess of these required returns to both debt and equity holders.

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t Economic profit is the after tax adjusted cash flows generated by an entity less the cost of capital the entity has deployed to generate that cash flow. The premise behind economic profit is that no real earnings are achieved or a real entity value created until dollars, that is adjusted cash flows, earned by the entity exceed the entity's cost of financing its capital. And again, financing its capital is both debt and equity. This creates a minimum required rate of return for both shareholders and creditors.

MORIARTY: John analyzes the following measurements: return on investment and earnings per share of net income.

FLEMING: So looking at return on investment. Typical return on investment compares returns, benefits, with the resources, assets, capital, generating the returns. So for example, earnings before interest and taxes over total assets, net income over total assets, net income over total equity. These are examples of return on investment calculations.

The strengths of return on investment include an ease of calculation and the ability to identify sources of change in the ratio. Weaknesses of return on investment include its influence by accounting methods followed, the amounts reflecting different period purchasing powers and different valuation bases, and it has a historical emphasis.

Looking at earnings per share and net income, earnings per share is the product of dividing reported net income, accounting income, by the outstanding common shares. The use of net income for measurement has the same weaknesses as return on investment, including the various use of accounting methods, the purchasing power differences and historical emphasis.

Earnings per share's focus on outstanding common shares can cause an entity to not issue additional common shares, even though the entity may need the resources for growth and the creation of shareholder value.

Entities may issue more costly debt than equity in order to maintain their earnings per share. This will decrease shareholder wealth due to the difference between cost of debt versus cost of equity. Additional problems with earnings per share are frequently caused by heavy reliance on an EPS measurement such as those caused by fraudulent financial reporting.

Examples include, and these are infamous, if you will, cases in the past where significant financial fraud took place in order to maintain the earnings per share amount, Tyco, Rite Aid, WorldCom, IN 18:07 Xerox. All were trying to achieve the same thing, higher or growing earnings per share, and they manipulated their financial information so that they were reporting greater earnings, greater net income than they had really earned, causing earnings per share to go up but also not reflecting appropriate increases or decreases in shareholder wealth.

MORIARTY: John continues his analysis on discounted cash flow and market value added.

FLEMING: Looking at discounted cash flow, discounted cash flow is forecasting a present value of expected future cash flows, discounted at a rate equal to the entity's cost of capital less the initial project cost, that is net present value. Net present value equals the present value of expected cash flows minus initial project cost. This net present value is referred to frequently as the intrinsic value of the entity.

Now, let's stop with this just for a moment. This is a cash flow measurement. It is not a GAAP income based on accrual concept

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t measurement. So this is a bit closer, at the end of the day, to an economic value measurement than certainly net income. This measurement is not using net income. It's not using revenues and expenses. It's not using assets other than cash for its measurements.

So this provides a better measurement of entity value based on the organization's ability to generate future cash flows as it relates to its operations, as it relates to its projects that it's considering. If a net present value exceeds zero, the entity will increase shareholder wealth because the return will exceed its initial project cost. If the net present value is negative, the project should be rejected because the return will not exceed its initial project cost. Net present value is similar to economic profits because it measures a project's net cash flows, but it is different from economic profit because it does not factor in the total cost of capital associated with the project.

Market value added equals market value of the entity minus its invested capital. Invested capital is normally the sum of all debt, including leases, and all stockholders' equity. Market value added does not account for any cash payments that the entity may have paid out to shareholders. Market value added also does not measure the opportunity cost relative to any alternative investments. Market value added provides a snapshot of how well the entity has maximized shareholder value since its inception. The higher the measure, the more shareholder wealth has been created. Again, market value, who holds the shares? The answer, stockholders. So this becomes a measurement, if you will, of shareholder wealth as market value added may increase.

SURRAN: Economic profit is not accounting profit. FASB's accounting rules do not have to be applied to calculating economic profit. Certain expenses may be better perceived as investments in the future as opposed to period cost to be expensed.

A few examples may be research and development, marketing and advertising and the development of customer relationships. Again, GAAP expenses these, because they have a difficult time measuring them. They're not tangible, so they are ignored under GAAP when they appear to be investments benefiting a company and should be reflected as assets, but again, GAAP does not know how to do that.

Economic profit could be considered the intrinsic value of an entity when considering the entity's invested capital and the present value of future adjusted cash flows. Future adjusted cash flows are the after adjustments for non-cash expenses and adding back expenses that reflect future investments.

If you look at any of the models, if you do any kind of literature search on economic profit, they always speak about future adjusted cash flows, meaning that they take a net income measure, which is based on GAAP, and then they adjust it for a number of items.

The question is, rather than adjusting net income, GAAP income, in order to arrive at an adjusted cash flow number, might it not be more reasonable to begin a calculation with cash flows off of the cash flow statement? Meaning, take operating cash flows off the cash flow statement and use that as a measurement rather than adjusting net income to arrive at adjusted cash flows?

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t MORIARTY: Going through a process of adjusting net income to get to adjusted cash flows may not be necessary if we have access to operating cash flow for a period. John Fleming elaborates.

FLEMING: Invested capital is the addition of financing provided by stockholders and lenders. We're looking at the issue of calculating this value by considering the entity's invested capital. So we're going to have present value of cash flows and we're going to have invested capital as part of our calculation.

So again, invested capital is the addition of financing provided by stockholders and lenders. Items that would not be considered invested capital would include accounts payable, accrued liabilities, deferred revenue and deferred tax liabilities. They don't fall into the debt or equity calculations for invested capital.

MORIARTY: John discusses the three basic components of economic profit.

FLEMING: Economic profit has three basic components. One, net operating profit after taxes. So this, for this calculation, is a cash flow proxy requiring some adjustments to convert accrual accounting profits to cash profits, and it's calculated before interest expense, otherwise there'd be some double counting.

Two, adjust NOPAT for any expenses that reduce the operating profit that are really investments in the future of the entity. And three, deduct a capital cost for the cost of both debt and equity.

So if we just focus on this for a moment, the calculation approach is to arrive at net operating profit before taxes, make some cash flow adjustments to it, then again adjust this for investments that may have been expensed and then deduct a capital cost for this. So if, for example, our adjusted answer is $5 million and our capital cost is $3 million, then we've created $2 million of shareholder wealth.

So looking at it in this way, we start out with GAAP operating profit plus adjustments to convert accrual to cash, plus investment expenses that should be capitalized. This gives us NOPAT minus the capital cost, which then gives us economic profit.

So what I was saying earlier, might it be more appropriate to begin with operating cash flow rather than GAAP operating profit? Again, that might be a bit more efficient.

It might be a more correct answer, since we would not be basing our economic profit calculation on a GAAP measurement but instead on a cash flow measurement. So again, just something to think about as you're considering the usefulness of economic profit as a measurement to arrive at shareholder wealth or increases or decreases in shareholder wealth.

Looking a little more closely at NOPAT, adjustments to convert accrual profits to cash profits might include these examples: bad debt expense, deferred taxes, additions to any LIFO reserve. Again, those are all non-cash expenses. There are others, of course, warranty expense, for example, credit losses, for example. So taking a look at those, this gets added back. Now, again, not to constantly repeat this, but if you were to start out with operating cash flow, this would not be necessary.

MORIARTY: Capitalized investment expenses might include R&D, marketing and advertising, and development of customer relationships. John continues by discussing a type of valuable asset that can't be measured by GAAP.

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t FLEMING: Investment expenses capitalized might include these examples I stated previously. I mentioned R&D, marketing and advertising, development of customer relationships. And again, there could be other things that would fall under a category of intellectual capital that may get expensed where it might be more meaningful if they could be capitalized.

When we look at most corporations, their most valuable asset is their people. But their people do not get measured under Generally Accepted Accounting Principles. Again, they don't get measured because GAAP doesn't know how to measure human capital. So again, another item that we might want to think about in terms of adding back.

Capital cost is based on the weighted average cost of capital. It is a combination of the cost of debt and the cost of equity. Now obviously, cost of equity is going to be an assumption. It's going to be based on, what would investors expect as a return for their money? And that, of course, has varied over time. And some years in the past that cost of equity may have been 10, 12%. More recently it's in the area of two or 3%. So we need to recognize that that's going to vary over time.

Prior to calculating the capital cost amount, invested capital must first be developed, meaning we have to come up with this number. We know what debt is, it's on the balance sheet. We know what equity is, it's also on the balance sheet. But we haven't calculated the cost of equity. Cost of debt is running through the income statement, interest. The cost of equity is not recognized under GAAP, so it's an amount that has to be calculated in order to arrive at economic profit.

SURRAN: Invested capital is the product of FASB's interpretation of debt and stockholders' equity amounts adjusted for accounts not considered invested capital, meaning not funding sources like accounts payable, adjustments made to convert accrual net profits to cash profits, and adjustments made to account for any off-balance sheet sources of capital that may exist.

Now, that gets touchy because sometimes that off-balance sheet capital is in another legal entity and that other legal entity may not be consolidated. So it may make that calculation a little bit more difficult under those circumstances.

MORIARTY: To calculate the weighted average cost of capital, calculate the average cost of long-term debt and reduce this cost by its tax effect. Calculate the implicit cost of equity by determining the risk-free interest rate, plus beta, plus an equity premium reflecting the risk of the investment. John Fleming elaborates.

FLEMING: We have to make some assumptions about the cost of equity. And the assumptions we're making, we begin with what is the risk-free rate, plus beta, plus any equity premium that can be developed as it relates to this investment?

Beta is a measure of the volatility or risk of an individual security in comparison to the market as a whole, meaning if we assume the market is 100, this individual organization, based on its volatility, may be at 102 or 103.

Next, equity premium is the excess return that investors expect above a risk-free investment.

To identify how to get to economic profit, take GAAP operating profit, plus adjustments to convert accrual to cash, plus investment expenses

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t capitalized, which then equals NOPAT minus the capital cost, which we just looked at, combining the cost of debt and the cost of equity, and that will give us an economic profit.

MORIARTY: John Fleming ends our segment on economic profit and leaves with his final thoughts.

FLEMING: So economic profits provide a direct link to performance. Think about that. Performance is based upon generating cash flows and those cash flows have a cost to them. And the cost in the economic profit world is the cost of debt and the cost of equity.

The greater our economic profit is, the greater shareholder wealth is. Positive changes in economic profit increase shareholder value. Positive changes in economic profits also reflect continuous improvement at the entity level. So again, compared to GAAP, there's no focus, if you will, on shareholder value. There's no focus, again, if you will, on continuous improvement. Economic profits, though, on the other hand, provide those measurements and enable an organization to measure how well it is managing its assets and liabilities in order to generate shareholder wealth.

So economic profit strengths include the following: it corrects for GAAP net income and earnings per share deficiencies as it accounts for the cost of equity capital. It contributes to continuous improvement processes at the entity level and it creates a single performance metric as a measure of shareholder value, and that might be a positive because of its simplicity.

Economic profit weaknesses, if you will, include some subjectivity in the calculation. That is accrual to cash conversions, determining expenses as investments and calculating the implicit cost of equity.

So what we try to do is just take a look at an alternative, that's all, the alternative being economic profit. And when you take a look at, again, a literature search on the topic, you can see that many companies do calculate economic profit. They don't always calculate it the way I have in this program.

But the way it's presented in this program is based upon how economic profit is calculated in the literature. But looking at individual companies, they may arrive at this measurement in a different way because they make different assumptions about adjustments and different assumptions about the cost of capital.

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Segment Four

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4. Net Investment Income Tax, Trust, Estate &

Gift Tax & More

Segment Overview:

Field of Study:



Running Time:

Video Transcript:

Course Level:



Expiration Date:

Taxes

September 10, 2022

Work experience in tax planning or tax compliance, or an introductory course in taxation.

None


Update

“Questions and Answers on the Net Investment Income Tax”

“Detailed Questions and Answers on ARPA COBRA Premium Assistance and Credit Issued”

See page 4–13.

See page 4–22.

35 minutes

The Net Investment Income (NII) Tax applies to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts at a rate of 3.8%. The NII Tax was effective beginning on or after January 1, 2013. Individuals who are subject to the NII Tax have modified adjusted gross income over thresholds which are not indexed for inflation. Barbara Weltman, president of Big Ideas for Small Business discusses current updates on NII from various sources including investment income from digital currency transactions. Barbara also reviews the proposed changes in estate and gift tax rules under the new Administration and gives some context on the Administration’s 2022 budget proposals.


Upon successful completion of this segment, you should be able to: l Understand the different types of transactions that can trigger

investment income,

● Identify the limits in 2022 of HSAs and the limits of other insurance coverages,

● Recognize potential tax exposure for individuals even after their death, and

● Understand the definition of the tax gap and how the Treasury is planning to fix it.

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ine Outline

A. MAGI Thresholds

i. Single

$200,000

ii. Married filing jointly

$250,000

iii. Married filing separately

$125,000

iv. Head of household

$200,000

v. Qualifying widow(-er) with dependent child

$250,000

B. Individuals NOT Subject to NII

i. Nonresident aliens

ii. Dual residents

iii. Dual status individuals

C. Trusts & Estates NOT Subject to NII

i. Trusts exempt from income taxes under Subtitle A

ii. Trusts or decedents’ estate with unexpired interest devoted to specific purposes

iii. Grantor trusts

iv. Trusts NOT classified as “trusts” under federal income tax

v. Electing Alaska Native Settlement Trusts

vi. Perpetual Care Trusts

I. Net Investment Income: Who’s Subject to It?

A. What Does That Mean?

i. Not adjusting thresholds for inflation means l As income rises annually l More individuals fall subject to

NII tax

B. C Corporation Dividends

i. Treated as investment income l Publicly or privately held

corporations l With or without material

participation

C. Exceptions to the Rule

i. Dividends derived from l Ordinary course of business l Disregarded entity l Passthrough entity

D. In the Absence of a Proposal

i. NII tax added to ordinary income tax rates

ii. Top rate will increase to 43.4%

II. NII: Applicability to C Corporations

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eA. IRS Treatment of Digital Currency

i. Property instead of currency l Hard fork signifies a digital

transaction v Change in blockchain network

protocols

ii. Receipt of Bitcoin cash results in gross income l Wealth accession

iii. Dominion and control over Bitcoin cash depends on l Date of receipt l Fair market value

B. Determining Bitcoin Cash FMV

i. Using any reasonable method l Adopting publicly published

price value v Cryptocurrency exchange v Cryptocurrency data

aggregator

C. CEX Initiated Support

i. Almost six months later l Allowing for first sale, transfer or

exchange

ii. Income reported at initiation time

iii. Determining fair market value l Consulting CEX pricing data l Reasonable method

III. Income from Digital Currency Transactions

A. 2022 Insurance Limits

i. Deductible not less than l $1,400 self coverage l $2,800 family coverage

ii. Annual out of pocket limits no more than l $7,050 self coverage l $14,100 family coverage

iii. Annual contribution limits l $3,650 self coverage l $7,300 family coverage

iv. Supplemental coverage l $1,800 per employee

B. DCAPs Limit for 2021

i. Higher dollar limit of $10,500

ii. Limits will be reduced again in 2022

IV. Health Benefits Limits

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A. Claiming Advanced Child Tax Credit

i. 2020 tax return filed l Nothing else to file to receive

v Advanced child tax credit v EIP3 v Claim a 2020 recovery rebate

credit

B. Notice 2021-31 Examples of Q&As

i. Assistance eligible individual qualification

ii. Qualified beneficiary in becoming an assistance eligible individual

iii. Becoming an assistance eligible individual more than once

C. Key Areas on IRS Q&As

i. Individual’s eligibility for premium assistance l Employers may ask a person to

v Self-certify v Test to their eligibility

l Employers need to retain records

ii. Applicability of premium assistance

iii. Extended election period

iv. Employer calculation of COBRA premium assistance credit

D. Tax Gap

i. Spread between taxes federal government collects and what it should be collecting

E. Fixing the Tax Gap

i. More resources for IRS examinations

ii. Increase information reporting l Including cryptocurrency

transactions

iii. Regulate tax return preparers

“The debate in Congress ... will include not only which tax measures to include and when to make them effective, but also the impact ... On GDP, the federal debt and job creation. We'll be watching.”

— Barbara Weltman

V. Claiming Tax Credits, IRS Q&A and the Tax Gap

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A. Digital Signatures Extended

i. Expanded list of forms, including l Estate and gift tax returns l Forms for changes in accounting

methods & tax year l Check-the-box form of entity

classification election l Section 83(b) election

B. Safe Harbor

i. Applicable to taxpayers who filed l Income tax or information

returns l On or before December 27, 2020

C. Advertising Cost Deduction

i. Ordinary and necessary business deduction

ii. Proximate relationship between expense and taxpayer

VII. Regulations & Policies Looking Forward

4–6


“In this segment, Barbara Weltman discusses current updates on NII from various sources including investment income from digital currency transactions.”


l After playing the video, use the questions provided or ones you have developed to generate discussion. The answers to our discussion questions are on pages 4–8 to 4–10. Additional objective questions are on pages 4–11 and 4–12.


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1. What types of transactions trigger investment income? How does the Net Investment Income Tax affect your organization’s clients?

2. What are the 2022 HDHP and 2021 DCAP limits? How will these new limits benefit your clients?

3. When do estate and gift taxes apply and what are the proposed changes in the estate and gift tax rules?

4. How is the IRS handling the advance child tax credit of 2021? How will your clients benefit from the advanced child tax credit?

5. What are the rules regarding COBRA assisted payments and what updates are included in the recent IRS guidance? How does the guidance affect your organization or clients?

6. What is the tax gap and how is the Treasury planning to fix it?




Group Live Option


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s7. What are the conditions the IRS and Tax

Court use to determine if innocent spouse relief applies and what does the case illustrate about innocent spouse relief? How do the conditions of innocent spouse relief apply to your clients?


4–8



1. What types of transactions trigger investment income? How does the Net Investment Income Tax affect your organization’s clients? l Interest income l Dividends

v From publicly or privately help corporations

v With or without material participation

l Annuities v Royalties v Rents v Business income from pass-

through entities in which an individual does not materially participate

v Digital currency k Treated as property instead of

currency k Hard fork signifies a digital

transaction l Participant response based on


2. What are the 2022 HDHP and 2021 DCAP limits? How will these new limits benefit your clients? l HDHP must have minimum

insurance deductible of not less than: v $1,400 for self-coverage only v $2,800 for family coverage

l HDHP must also limit annual out-of-pocket costs for deductibles, co-pays and other amounts other than premiums to no more than: v $7,500 for self-only coverage v $14,100 for family coverage

l HDHP annual contribution limit: v $3,650 for self-only coverage v $7,300 for family coverage v Those aged 55 by the end of the

year can add another $1,000 in contributions

v No contributions can be made once a person is on Medicare

l HDHP supplemental coverage limit is $1,800 per employee

l DCAP limits for 2021: v A higher dollar limit for

contributions of $10,500, instead of the usual $5,000 limit, or $2,500 for married filing separately

v Limits will be reduced in 2022 to the limits that applied in 2020, assuming Congress does not extend the higher limit

v Special carryover rules apply to dependent care benefits that would have been excluded from income, if used during the preceding taxable year


3. When do estate and gift taxes apply and what are the proposed changes in the estate and gift tax rules? l Estates valued at over $11.7 million

for decedents dying in 2021 are required to file Form 706 v Whether the estate is subject to

tax depends on deduction and credits

v If the entire estate passes to a surviving spouse or charity there is no estate tax

l The gift tax exclusion is $15,000 in 2021 v The lifetime exemption may be

used for larger gifts v Gifts to a spouse or a charity are

excluded l Under the proposed changes, death

would trigger realization of tax on gains held in a decedent’s estate

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4–9Suggested Answers to Discussion Questions (continued)

4. How is the IRS handling the advance child tax credit of 2021? How will your clients benefit from the advanced child tax credit? l Starting in mid-July the IRS will

send payments to an estimated 36 million households for half of their child tax credit

l Payments up to $250 for a child 6 years or older and up to $300 for a younger child will be spread over 6 months

l The IRS is encouraging eligible taxpayers to file returns, even if they are not required to do so

l Taxpayers who receive advanced child tax credit payments will have to reconcile them on their 2021 return


5. What are the rules regarding COBRA assisted payments and what updates are included in the recent IRS guidance? How does the guidance affect your organization or clients? l Employers who are subject to federal

COBRA are required to pay premiums for involuntarily terminated employees or those subject to reduced hours v Applies to those enrolled in

COBRA, who may now elect to be enrolled if eligible

v Divorce or losing dependent status are not qualifying events

l Individual’s eligibility for premium assistance v Employers may ask a person to

self-certify or test their eligibility v Employers need to retain a record

of an attestation l Applicability of premium assistance

v Applies for vision only or dental only plan

v Does not apply to QSEHRA l Extended election period

v Applies only to federal COBRA, not to continuation coverage under state law

l Employer calculation of COBRA premium assistance credit

v Amount is equal to the amount that an assistance-eligible individual would pay, including the administrative fee


6. What is the tax gap and how is the Treasury planning to fix it? l Tax gap is the spread between what

the federal government collects in taxes and what it thinks it should be collecting

l Non-filing, under-reporting income, overstating deductions, and non-payment are causing the tax gap

l To fix the tax gap, the Treasury wants: v More resources to help with

examinations of large corporations, partnerships, as well as global high wealth and high income individuals

v Increased reporting for “Shining light on opaque income streams, including proprietorships and partnerships”

v The IRS to be able to regulate tax return preparers

7. What are the conditions the IRS and Tax Court use to determine if innocent spouse relief applies and what does the case illustrate about innocent spouse relief? How do the conditions of innocent spouse relief apply to your clients? l Whether the requesting spouse is

separated or divorced from the non-requesting spouse

l Whether the requesting spouse will suffer economic hardship if relief is not granted

l Whether on the date the joint return was filed, the requesting spouse did not know and had no reason to know that the non-requesting spouse would not or could not pay the tax liability

l Whether the requesting or non-requesting spouse has a legal obligation to pay the tax liability, pursuant to a decree of divorce or other arrangement or agreement

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l Whether the requesting spouse received a significant benefit from the unpaid income tax liability

l Whether the requesting spouse has made a good faith effort to comply with the federal income tax laws for the taxable years following the taxable year or years to which the request for relief relates

l Whether the non-requesting spouse abused the requesting spouse

l Whether the requesting spouse was in poor mental or physical health when the joint return was filed, or when the requesting spouse requested relief

l The case illustrates that relief is not automatic, even if it initially appears to be the only fair thing


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1. What type of income may be subject to the net investment income tax?

a) Dividends from a disregarded entity

b) Dividends from a passthrough entity

c) Dividends from a C corporation

d) Dividends derived from the ordinary course of business

2. The 2022 annual contribution limit for self-only coverage for a high deductible health plan is:

a) $1,400

b) $2,800

c) $3,650

d) $7,050

3. An estate is required to file Form 706 when the estate is valued over what amount?

a) $1 million

b) $11.7 million

c) $15 million

d) $37.4 million

4. A taxpayer with a child aged six or older may receive an advance child tax credit for 2021, spread over six months, up to what amount?

a) $250

b) $300

c) $500

d) $750

5. Which of the following is a reason for the tax gap?

a) Too many taxpayers in lower tax brackets

b) Taxpayers taking advantage of deductions, such as the qualified business income deduction

c) Taxpayers reporting income they have not received yet

d) Taxpayers underreporting income

6. One of the conditions the IRS and Tax Court use to determine if innocent spouse relief applies is:

a) Whether the requesting spouse claims itemized deductions

b) Whether the requesting spouse is separated or divorced from the non-requesting spouse

c) Whether the requesting and non-requesting spouses have dependents

d) Whether the non-requesting spouse has made a good faith effort to comply with the federal income tax laws

7. The Net Investment Income Tax rate is:

a) 2.9%

b) 3.8%

c) 5.0%

d) 7.0%

8. What income is included in Net Investment Income?

a) Interest

b) Wages

c) Unemployment compensation

d) Social Security benefits



Objective Questions

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9. Who may qualify as an assistance eligible individual for COBRA Premium Assistance?

a) An individual that voluntarily terminated her employment

b) An individual that was involuntarily terminated for gross misconduct

c) An individual that had to work an increased amount of hours

d) An individual that had his hours reduced

10. Which of the following is true regarding the COBRA Assistance Premium?

a) An individual cannot become assistance eligible more than once.

b) An employer cannot require an employee to self-certify that he/she meets the requirements for the benefits.

c) An employer may rely on an individual’s self-certification as to their eligibility status.

d) Employers are required to obtain a self-certification from the employees.


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Self-Study Option


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QUESTIONS AND ANSWERS ON THE NET INVESTMENT INCOME TAX

Source: https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax

Basics of the Net Investment Income Tax

1. What is the Net Investment Income Tax (NIIT)? The Net Investment Income Tax is imposed by section 1411 of the Internal Revenue Code. The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.

2. When did the Net Investment Income Tax take effect?

The Net Investment Income Tax went into effect on Jan. 1, 2013. The NIIT affects income tax returns of individuals, estates and trusts, beginning with their first tax year beginning on (or after) Jan. 1, 2013. It does

not affect income tax returns for the 2012 taxable year filed in 2013.

Who Owes the Net Investment Income Tax

3. What individuals are subject to the Net Investment Income Tax? Individuals will owe the tax if they have Net Investment Income and also have modified adjusted gross income over the following thresholds:

Filing Status Threshold Amount

Married filing jointly $250,000

Married filing separately $125,000

Single $200,000

Head of household (with qualifying person) $200,000

Qualifying widow(er) with dependent child $250,000




CPA Report Gov/Not-for-Profit Update

http://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax




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Taxpayers should be aware that these threshold amounts are not indexed for inflation.

If you are an individual who is exempt from Medicare taxes, you still may be subject to the Net Investment Income Tax if you have Net Investment Income and also have modified adjusted gross income over the applicable thresholds.

4. What is modified adjusted gross income for purposes of the Net Investment Income Tax?

For the Net Investment Income Tax, modified adjusted gross income is adjusted gross income (Form 1040, Line 37) increased by the difference between amounts excluded from gross income under section 911(a)(1) and the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d)(6) for amounts described in section 911(a)(1). In the case of taxpayers with income from controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), they may have additional adjustments to their AGI. See section 1.1411-10(e) of the final regulations.

5. What individuals are not subject to the Net Investment Income Tax?

Nonresident Aliens (NRAs) are not subject to the Net Investment Income Tax. If an NRA is married to a U.S. citizen or resident and has made, or is planning to make, an election under section 6013(g) or 6013(h) to be treated as a resident alien for purposes of filing as Married Filing Jointly, the final regulations provide these couples special rules and a corresponding section 6013(g)/(h) election for the NIIT.

A dual-resident individual, within the meaning of regulation §301.7701(b)-7(a)(1), who determines that he or she is a resident of a foreign country for tax purposes pursuant to an income tax treaty between the United States and that foreign country and claims benefits of the treaty as a nonresident of the United States is considered a NRA for purposes of the NIIT.

A dual-status individual, who is a resident of the United States for part of the year and a NRA for the other part of the year, is subject to the NIIT only with respect to the portion of the year during which the individual is a United States resident. The threshold amount (described in # 3 above) is not reduced or prorated for a dual-status resident.

6. What estates and trusts are subject to the Net Investment Income Tax?

Estates and trusts are subject to the Net Investment Income Tax if they have undistributed Net Investment Income and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year under section 1(e) (for tax year 2013, this threshold amount is $11,950). Generally, the threshold amount for the upcoming year is updated by IRS each fall in a revenue procedure. For 2014, the threshold amount is $12,150 (See Rev. Proc. 2013-35 PDF).

There are special computational rules for certain unique types of trusts, such as Qualified Funeral Trusts, Charitable Remainder Trusts and Electing Small Business Trusts, which can be found in the final regulations (see # 20 below).

7. What estates and trusts are not subject to the Net Investment Income Tax?

The following trusts are not subject to the Net Investment Income Tax:

1. Trusts that are exempt from income taxes imposed by Subtitle A of the Internal Revenue Code (e.g., charitable trusts and qualified retirement plan trusts exempt from tax under section 501, and Charitable Remainder Trusts exempt from tax under section 664).

2. A trust or decedent’s estate in which all of the unexpired interests are devoted to one or more of the purposes described in section 170(c)(2)(B).

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3. Trusts that are classified as “grantor trusts” under sections 671-679.

4. Trusts that are not classified as “trusts” for federal income tax purposes (e.g., Real Estate Investment Trusts and Common Trust Funds).

5. Electing Alaska Native Settlement Trusts.

6. Perpetual Care (Cemetery) Trusts.

What is Included in Net Investment Income

8. What is included in Net Investment Income? In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer (within the meaning of section 469). To calculate your Net Investment Income, your investment income is reduced by certain expenses properly allocable to the income (see #13 below).

9. What are some common types of income that are not Net Investment Income?

Wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends (see Rev. Rul. 90-56, 1990-2 CB 102) and distributions from certain Qualified Plans (those described in sections 401(a), 403(a), 403(b), 408, 408A or 457(b)).

10. What kinds of gains are included in Net Investment Income?

To the extent that gains are not otherwise offset by capital losses, the following gains are common examples of items taken into account in computing Net Investment Income:

1. Gains from the sale of stocks, bonds, and mutual funds.

2. Capital gain distributions from mutual funds.

3. Gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence).

4. Gains from the sale of interests in partnerships and S corporations (to the extent the partner or shareholder was a passive owner). See section 1.1411-7 of the 2013 proposed regulations.

11. Does this tax apply to gain on the sale of a personal residence?

The Net Investment Income Tax does not apply to any amount of gain that is excluded from gross income for regular income tax purposes. The pre-existing statutory exclusion in section 121 exempts the first $250,000 ($500,000 in the case of a married couple) of gain recognized on the sale of a principal residence from gross income for regular income tax purposes and, thus, from the NIIT.

Example 1: A, a single filer, earns $210,000 in wages and sells his principal residence that he has owned and resided in for the last 10 years for $420,000. A’s cost basis in the home is $200,000. A’s realized gain on the sale is $220,000. Under section 121, A may exclude up to $250,000 of gain on the sale. Because this gain is excluded for regular income tax purposes, it is also excluded for purposes of determining Net Investment Income. In this example, the Net Investment Income Tax does not apply to the gain from the sale of A’s home.

Example 2: B and C, a married couple filing jointly, sell their principal residence that they have owned and resided in for the last 10 years for $1.3 million. B and C’s cost basis in the home is $700,000. B and C’s realized gain on the sale is $600,000. The recognized gain subject to regular income taxes is $100,000 ($600,000 realized gain less the $500,000 section 121 exclusion). B and C have $125,000 of other

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Net Investment Income, which brings B and C’s total Net Investment Income to $225,000. B and C’s modified adjusted gross income is $300,000 and exceeds the threshold amount of $250,000 by $50,000. B and C are subject to NIIT on the lesser of $225,000 (B’s Net Investment Income) or $50,000 (the amount B and C’s modified adjusted gross income exceeds the $250,000 married filing jointly threshold). B and C owe Net Investment Income Tax of $1,900 ($50,000 X 3.8%).

Example 3: D, a single filer, earns $45,000 in wages and sells her principal residence that she has owned and resided in for the last 10 years for $1 million. D’s cost basis in the home is $600,000. D’s realized gain on the sale is $400,000. The recognized gain subject to regular income taxes is $150,000 ($400,000 realized gain less the $250,000 section 121 exclusion), which is also Net Investment Income. D’s modified adjusted gross income is $195,000. Since D’s modified adjusted gross income is below the threshold amount of $200,000, D does not owe any Net Investment Income Tax.

12. Does Net Investment Income include interest, dividends and capital gains of my children that I report on my Form 1040 using Form 8814?

The amounts of Net Investment Income that are included on your Form 1040 by reason of Form 8814 are included in calculating your Net Investment Income. However, the calculation of your Net Investment Income does not include (a) amounts excluded from your Form 1040 due to the threshold amounts on Form 8814 and (b) amounts attributable to Alaska Permanent Fund Dividends.

13. What investment expenses are deductible in computing NII?

In order to arrive at Net Investment Income, Gross Investment Income (items described in items 7-11 above) is reduced by deductions that are properly allocable to items of Gross Investment Income. Examples of deductions, a portion of which may be properly allocable to Gross Investment Income, include investment

interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees, fiduciary expenses (in the case of an estate or trust) and state and local income taxes.

14. Will I have to pay both the 3.8% Net Investment Income Tax and the additional .9% Medicare tax?

You may be subject to both taxes, but not on the same type of income.

The 0.9% Additional Medicare Tax applies to individuals’ wages, compensation and self-employment income over certain thresholds, but it does not apply to income items included in Net Investment Income. See more information on the Additional Medicare Tax.

How the Net Investment Income Tax is Reported and Paid

15. If I am subject to the Net Investment Income Tax, how will I report and pay the tax?

Individuals, estates, and trusts will use Form 8960 PDF and instructions PDF to compute their Net Investment Income Tax.

For individuals, the tax will be reported on, and paid with, the Form 1040. For estates and trusts, the tax will be reported on, and paid with, the Form 1041.

16. Is the Net Investment Income Tax subject to the estimated tax provisions?

The Net Investment Income Tax is subject to the estimated tax provisions. Individuals, estates and trusts that expect to be subject to the tax in 2013 or thereafter should adjust their income tax withholding or estimated payments to account for the tax increase in order to avoid underpayment penalties. For more information on tax withholding and estimated tax, see Publication 505, Tax withholding and Estimated Tax.

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17. Can tax credits reduce my NIIT liability?

Any federal income tax credit that may be used to offset a tax liability imposed by subtitle A of the Code may be used to offset the NII. However, if the tax credit is allowed only against the tax imposed by chapter 1 of the Code (regular income tax), those credits may not reduce the NIIT. For example, foreign income tax credits (sections 27(a) and 901(a)) and the general business credit (section 38) are allowed as credits only against the tax imposed by chapter 1 of the Code, and therefore may not be used to reduce your NIIT liability. If you take foreign income taxes as an income tax deduction (versus a tax credit), some (or all) of the deduction amount may deducted against NII.

18. Does the tax have to be withheld from wages?

No, but you may request that additional income tax be withheld from your wages.

Examples of the Calculation of the Net Investment Income Tax

19. Single taxpayer with income less than the statutory threshold.

Taxpayer, a single filer, has wages of $180,000 and $15,000 of dividends and capital gains. Taxpayer’s modified adjusted gross income is $195,000, which is less than the $200,000 statutory threshold. Taxpayer is not subject to the Net Investment Income Tax.

20. Single taxpayer with income greater than the statutory threshold.

Taxpayer, a single filer, has $180,000 of wages. Taxpayer also received $90,000 from a passive partnership interest, which is considered Net Investment Income. Taxpayer’s modified adjusted gross income is $270,000.

Taxpayer’s modified adjusted gross income exceeds the threshold of $200,000 for single taxpayers by $70,000. Taxpayer’s Net Investment Income is $90,000.

The Net Investment Income Tax is based on the lesser of $70,000 (the amount that Taxpayer’s modified adjusted gross income exceeds the $200,000 threshold) or $90,000 (Taxpayer’s Net Investment Income). Taxpayer owes NIIT of $2,660 ($70,000 x 3.8%).

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Source: https://www.currentfederaltaxdevelopments.com/blog/2021/5/20/detailed-questions-and-answers-on-arpa-cobra-premium-assistance-and-credit-issued

In Notice 2021-31[1] the IRS provided a series of questions and answers related to the COBRA Premium Assistance program enacted as part of the American Rescue Plan Act (ARPA).

Eligibility for COBRA Premium Assistance

The first set of questions and answers deal with eligibility issues, beginning with who qualifies as an assistance eligible individual.

Q-1. Who qualifies as an Assistance Eligible Individual?

A-1. An Assistance Eligible Individual is any individual who is (1) a qualified beneficiary as the result of (A) the reduction of hours of a covered employee’s employment or (B) the involuntary termination of a covered employee’s employment (other than by reason of an employee’s gross misconduct), (2) is eligible for COBRA continuation coverage for some or all of the period beginning on April 1, 2021, through September 30, 2021, and (3) elects the COBRA continuation coverage. This includes qualified beneficiaries who are the spouse or dependent child of the employee who had the reduction in hours or involuntary termination of employment resulting in a loss of coverage, as well as the employee, if that reduction in hours or involuntary termination of employment caused the qualified beneficiary to lose coverage and the other requirements are satisfied.[2]

The next definition presented is that of a qualified beneficiary.

Q-2. Who qualifies as a qualified beneficiary for purposes of becoming an Assistance Eligible Individual?

A-2. In order to be a qualified beneficiary who is eligible to become an Assistance Eligible Individual, an individual must (1) be covered under the group health plan on the day before the reduction in hours or involuntary termination of the covered employee’s employment, and (2) lose eligibility for the coverage due to the reduction in hours or involuntary termination of the covered employee’s employment. An individual who loses group health coverage in connection with the termination of a covered employee’s employment by reason of the employee’s gross misconduct is not a qualified beneficiary and, thus, cannot be an Assistance Eligible Individual.[3]

However, in a footnote the IRS notes that there are exceptions to this rule:

There are exceptions to this rule in the case of a child born to or adopted by a covered employee during a period of COBRA continuation coverage or in certain circumstances where coverage was wrongfully denied to the individual (see § 54.4980B-3, Q&A-1).[4]

The third question notes that it is possible to become an assistance eligible individual more than once.

Q-3. Can an individual become an Assistance Eligible Individual more than once?

A-3. Yes. An individual who becomes a qualified beneficiary as the result of a reduction in hours or involuntary termination of employment, and who otherwise meets the requirements to be an Assistance Eligible Individual, is treated as an Assistance Eligible Individual regardless of whether the individual was also treated as an Assistance Eligible Individual at an earlier date.[5]

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DETAILED QUESTIONS AND ANSWERS ON ARPA COBRA PREMIUM ASSISTANCE AND CREDIT ISSUED

http://www.currentfederaltaxdevelopments.com/blog/2021/5/20/detailed-questions-and-answers-on-arpa-cobra-premium-assistance-and-credit-issued




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Q&A 3 contains the following example of this situation taking place.

Example, Q&A 3, Notice 2021-31

On April 1, 2021, the individual’s employment is terminated, and the individual becomes a qualified beneficiary. The individual elects COBRA continuation coverage and becomes an Assistance Eligible Individual with COBRA continuation coverage beginning on April 1, the date the individual lost coverage. On July 1, 2021, the individual becomes eligible for coverage under a group health plan sponsored by the employer of the individual’s spouse and ceases to be an Assistance Eligible Individual. The individual ceases COBRA continuation coverage as of July 1, 2021, and enrolls in coverage in the group health plan sponsored by the employer of the individual’s spouse. On August 1, 2021, the individual’s spouse has an involuntary termination of employment and as a result the individual and spouse lose coverage. The individual and spouse become qualified beneficiaries due to the loss of coverage and elect COBRA continuation coverage with the plan sponsored by the spouse’s employer. The individual and spouse become Assistance Eligible Individuals with respect to COBRA continuation coverage as of August 1, 2021.

The Notice provides that an employer can require the employee to self-certify that he/she meets the requirements for this benefit.

Q-4. May the employer require individuals to self-certify or attest that they are eligible for COBRA continuation coverage with COBRA premium assistance due to a reduction in hours or involuntary termination of employment and, if so, may the self-certification or attestation be used to assist the employer in substantiating its entitlement to the premium assistance credit?

A-4. Yes. Employers may require individuals to provide a self-certification or attestation regarding their eligibility status with respect to a reduction in hours or involuntary

termination of employment, which may assist the employer in substantiating its entitlement to the credit. Employers are not required to obtain a self-certification or attestation; however, employers who claim the credit must retain in their records either a self-certification or attestation from the individual regarding the individual’s eligibility status, or other documentation to substantiate that the individual was eligible for the COBRA premium assistance (see Q&A-7; see also Q&A-84)[6]

Q-5. May the employer require individuals to self-certify or attest as to their eligibility status regarding other disqualifying group health plan coverage or Medicare, and if so, may the self-certification or attestation be used to assist the employer in substantiating its entitlement to the premium assistance credit?

A-5. Yes. Employers may require individuals to provide a self-certification or attestation as to their eligibility status for other disqualifying group health plan coverage or Medicare, which may assist the employer in substantiating its entitlement to the premium assistance credit. Employers are not required to obtain a self-certification or attestation; however, employers who claim the credit must retain in their records either a self-certification or attestation from the individual regarding the individual’s eligibility status, or other documentation to substantiate that the individual was eligible for the COBRA premium assistance (see Q&A-7; see also Q&A-84).[7]

The notice also allows the employer to generally rely on this certification:

Q-6. May an employer rely on an individual's attestation regarding a reduction in hours or involuntary termination of employment, or regarding eligibility for other disqualifying coverage, for the purpose of substantiating eligibility for the premium assistance credit?

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A-6. Yes. An employer may rely on an individual's attestation regarding a reduction in hours or involuntary termination of employment, and eligibility for other disqualifying coverage, for the purpose of substantiating eligibility for the credit, unless the employer has actual knowledge that the individual's attestation is incorrect.[8]

However, if an employer plans to rely on that certification, the employer must keep a copy of it:

Q-7. Must an employer keep a record of an individual's attestation?

A-7. Yes. If the employer is relying on an individual's attestation regarding a reduction in hours or involuntary termination of employment, or regarding eligibility for other disqualifying coverage, the employer must keep a record of the attestation in order to substantiate eligibility for the premium assistance credit. An employer may rely on other evidence to substantiate eligibility, such as records concerning a reduction in hours or involuntary termination of employment.[9]

The Notice provides that only involuntary termination or a reduction in hours will qualify an individual for COBRA premium assistance:

Q-8. Does a qualifying event other than a reduction in hours or an involuntary termination of employment qualify an individual for COBRA premium assistance?

A-8. No. Qualifying events other than a reduction in hours or an involuntary termination of employment, such as divorce or a covered dependent child ceasing to be a dependent child under the generally applicable terms of the plan (such as loss of dependent status due to aging out of eligibility), are not events qualifying an individual for COBRA premium assistance.

The Notice also deals with the case where the individual was eligible to enroll in another health plan prior to April 1, 2021, but no longer had that option on April 1, 2021.

Q-9. If a potential Assistance Eligible Individual was eligible for other group health plan coverage before April 1, 2021, but on and after April 1, 2021, has not been permitted to enroll in that other group health plan coverage, is COBRA premium assistance available for the individual's COBRA continuation coverage?

A-9. Yes. COBRA premium assistance is available to a potential Assistance Eligible Individual until the individual is permitted to enroll in coverage under any other group health plan (including during a waiting period for any other plan).[10]

Example 1, Q&A 9

An individual’s employment was involuntarily terminated and as a result the individual lost health coverage on October 1, 2020. On November 1, 2020, the individual was eligible to enroll in the group health plan provided by the employer of the individual’s spouse as part of that group health plan’s annual open enrollment period, but the individual did not enroll. The open enrollment period for the spouse’s group health plan ended December 1, 2020, and the individual has not been permitted to enroll in coverage under the spouse’s group health plan at any time on or after April 1, 2021. Under these facts, the individual is not considered eligible for coverage under the plan of the spouse’s employer until the first available enrollment period, if any, that begins on or after April 1, 2021. Therefore, the individual may elect COBRA continuation coverage under the plan of the individual’s former employer during the ARP extended election period and may receive COBRA premium assistance as an Assistance Eligible Individual under the plan of the individual’s former employer, beginning on or after April 1, 2021.[11]

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Example 2, Q&A 9

Same facts as Example 1, except that the spouse’s group health plan has an open enrollment period from June 1, 2021, to June 14, 2021, with coverage elected during the open enrollment period beginning July 1, 2021. The spouse does not elect coverage for the individual under the plan of the spouse’s employer, and the individual continues COBRA continuation coverage under the plan of the individual’s former employer. Under these facts, COBRA premium assistance is not available for the individual’s COBRA continuation coverage under the plan of the individual’s former employer for periods of coverage beginning on or after July 1, 2021 (the date on which the individual was first eligible to enroll in the group health plan of the spouse’s employer).[12]

Example 3, Q&A 9

An individual’s employment was involuntarily terminated and as a result the individual lost health coverage on October 1, 2020. The individual received a COBRA notice on October 1, 2020. The individual qualified for a special enrollment period for loss of coverage under the group health plan of the spouse’s employer. Under the Emergency Relief Notices, the individual remains eligible to elect COBRA continuation coverage or enroll in the spouse’s plan. Additionally, on November 1, 2020, the individual was eligible to enroll in the spouse’s plan under that plan’s annual open enrollment period. The open enrollment period for the spouse’s plan ended December 1, 2020. However, the individual remains eligible to enroll in coverage under the spouse’s plan under the loss of coverage special enrollment period due to the Emergency Relief Notices. Under these facts, the individual is considered eligible for coverage under the plan of the spouse’s employer due to the special enrollment period for loss of coverage as extended by the Emergency Relief Notices. Therefore, while the individual could elect COBRA continuation coverage from the former employer’s plan, the individual may not receive COBRA premium assistance as an Assistance Eligible Individual under the

plan of the individual’s former employer.[13]

Even if the individual had actually enrolled in other coverage prior to April 1, 2021, but was not eligible to be covered by the other plan on April 1, the individual can qualify for the COBRA premium assistance.

Q-10. If a potential Assistance Eligible Individual does not elect COBRA continuation coverage and enrolls in coverage under another group health plan, but has ceased to be covered by the other group health plan as of April 1, 2021, is COBRA premium assistance available if the individual elects COBRA continuation coverage under the ARP extended election period?

A-10. Yes. Enrollment in other group health plan coverage before electing COBRA continuation coverage does not end the period of eligibility for COBRA continuation coverage. If the individual is no longer covered by (or eligible to enroll in) the other group health plan coverage as of April 1, 2021, that prior coverage by a group health plan does not disqualify the individual from COBRA premium assistance. However, beginning on April 1, 2021, coverage by (or eligibility to enroll in) another group health plan would disqualify the individual from COBRA premium assistance, even though it does not end the period of eligibility for COBRA continuation coverage.[14]

For the full Notice 2021-31 please visit https://www.currentfederaltaxdevelopments.com/blog/2021/5/20/detailed-questions-and-answers-on-arpa-cobra-premium-assistance-and-credit-issued

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SURRAN: The Net Investment Income (NII) Tax applies to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts at a rate of 3.8%. The NII Tax was effective beginning on or after January 1, 2013. Individuals who are subject to the NII Tax have modified adjusted gross income over the following thresholds and are not indexed for inflation:

l Single $200,000

l Married filing jointly $250,000

l Married filing separately $125,000

l Head of household $200,000

l Qualifying widow(er) with dependent child $250,000

Individuals not subject to NII tax are nonresident aliens, dual residents and dual status individuals.

However, there are certain qualifications that need to be met for each category under the Internal Revenue Code and need to be discussed with your tax practitioners prior to making such a determination.

Trusts and estates not subject to NII tax include:

l Trusts exempt from income taxes imposed by Subtitle A of the Internal Revenue Code

l A trust or decedent’s estate in which all of unexpired interests are devoted to one or more of the purposes described in section 170(c)(2)(B)

l Grantor trusts under sections 671 to 679

l Trusts NOT classified as “trusts” under federal income tax purposes

l Electing Alaska Native Settlement Trusts, and

l Perpetual Care Trusts

MORIARTY: There's been a lot of talk about changing the tax rates for C corporations and top bracket individuals, but the Net Investment Income tax hasn't been discussed. Barbara Weltman, president of Big Ideas for Small Business, joins us this month and starts our conversation with updates on Net Investment Income.

WELTMAN: There's a 3.8% tax on net investment income for individuals with net investment income and MAGI over a threshold amount, $250,000 for married filing jointly, $200,000 for singles, and $125,000 for married filing separately.

The threshold amounts were set years ago. The NII tax began on January 1, 2013. They aren't adjusted annually for inflation. If they had been adjusted, that $250,000 for joint filers in 2013, it would be over $283,000 this year. And we've had only modest inflation in these intervening years.

Video Transcript


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t Not adjusting the thresholds for inflation means that each year as income rises, even just keeping pace with inflation, more individuals fall subject to the NII tax.

This tax applies to interest income, dividends, annuities, royalties, rents and certain business income. Individuals who own interest in pass-through entities, in which they don't materially participate, are treated as receiving investment income subject to the NII tax.

MORIARTY: But what about dividend income from a C corporation?

WELTMAN: Dividends from a C corporation are treated as investment income. This is so whether the corporation is publicly held or privately held, and whether the taxpayer does or does not materially participate in the business.

In a legal memorandum, a shareholder employee in a privately held C corporation had to treat dividends as investment income for the NII tax.

Dividends may be excepted from this rule only if derived in the ordinary course of business, meaning the activity is conducted directly by the taxpayer, or through a disregarded entity owned by the taxpayer, or a pass through entity.

Because the C corporation isn't a pass through entity, this exception doesn't apply. Dividends aren't derived from the ordinary course of business. The legal memorandum didn't provide any facts other than that the individual shareholder was an owner employee in the C corporation, who participated in the day-to-day operations of the business.

The Administration wants to tax dividends at ordinary income rates. There's no proposal to change the NII tax. So this would be on top of the ordinary income tax rates. If the top tax rate rises to 39.6%, the addition of the NII tax brings the rate to 43.4%. That's not counting state income taxes.

MORIARTY: Another type of investment income is from transactions in digital currency. Barbara explains.

WELTMAN: You may recall that several years ago, the IRS said it would treat Bitcoin and other digital currency as property, rather than currency.

And the IRS ruled that a digital transaction occurs when there is a hard fork, which is a transaction that splits a single cryptocurrency in two.

It's a change in the protocols of a blockchain network. Don't ask me to explain all these terms, because I’m not clear exactly when transactions in digital currency produce income isn't always clear.

The IRS ruled that taxpayers who receive Bitcoin cash as a result of the August 1, 2017 Bitcoin hard fork had gross income. The reason? The transaction gave rise to an accession to wealth under Code Section 61. The date of receipt and the fair market value of this depends on when the taxpayer had dominion and control over the Bitcoin cash.

MORIARTY: So how do we know when to report these transactions and at what value? Barbara explains the two situations given by the IRS.

WELTMAN: The IRS gave two situations. In the first, a taxpayer had sole control over a private key to a distributed ledger address, that as of August 1, 2017 at 9:16 a.m. Eastern Daylight Savings Time, EDT, held one unit of Bitcoin.

Following the hard fork, her distributed ledger address continued to hold one unit of Bitcoin, while also holding one unit of Bitcoin cash.

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t At that time, the taxpayer had the ability to initiate a transaction to dispose of some or all of her Bitcoin cash holdings. Here, the taxpayer received one unit of Bitcoin cash at the time of the hard fork, and had dominion and control over that unit, as evidenced by her ability to sell, exchange or transfer the Bitcoin cash. So ordinary income resulted in 2017 equal to the fair market value of the Bitcoin cash, as of August 1 2017 at 9:16 a.m. EDT.

You can determine the Bitcoin cash's fair market value using any reasonable method, such as adopting the publicly published price value at a cryptocurrency exchange or a cryptocurrency data aggregator.

In the second situation, a taxpayer is a customer of CEX, a cryptocurrency exchange that provides hosted wallet services. OUT

As of August 1, 2017, at 9:16 a.m. EDT, he owned one unit of Bitcoin which was held by CEX in a hosted wallet. CEX had sole control over the private key to a distributed ledger address that as of August 1, 2017 at 9:16 a.m. EDT held 100 units of Bitcoin.

According to CEX's off chain internal ledger, one unit of the 100 units of Bitcoin was owned by the taxpayer. After the hard fork, CEX's distributed ledger address continued to hold the 100 units of Bitcoin while also holding 100 units of Bitcoin cash.

CEX however, was uncertain of Bitcoin cash's security and long-term viability and chose not to support Bitcoin cash at that time of the hard fork. As a result, he was unable to buy, sell, send, receive, transfer or exchange any Bitcoin cash through his CEX account. And CEX did not update its internal ledger to reflect that the taxpayer owned any Bitcoin cash.

On January 1, 2018 at 1:00 p.m. EDT, CEX initiated the support of the Bitcoin cash, allowing him at that time for the first time to sell, transfer or exchange his one unit of Bitcoin cash.

So that's the time for reporting the income. He can determine the fair market value by consulting CEX's pricing data. If CEX lacks such information, he can use any reasonable method.

MORIARTY: The IRS has started to look even more closely at digital currency transactions and has even engaged a company to analyze data. Barbara gives us more details.

WELTMAN: The IRS engaged a company called TaxBit to help analyze data and tax calculations for audits involving cryptocurrency.

And how is the IRS finding these taxpayers for audit, you might ask? It is successfully serving John Doe summons on various cryptocurrency exchanges. This started in 2018, when it won a case against Coinbase.

Courts have been upholding these summons. In early May, a federal district court in California upheld a summons serviced on Kraken, which is a cryptocurrency exchange.

The point to keep in mind is that clients shouldn't think that digital currency transactions are anonymous, and don't have to be reported or that they can't be found. Digital currency should be treated like any other property transaction, and reported as such.

SURRAN: Revenue Procedure 2021-25 provides the 2022 inflation adjusted amounts for Health Savings Accounts (HSAs) as determined under section 223 of the Internal Revenue Code as well as the maximum

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t amount that may be made newly available for excepted benefit health reimbursement arrangements (HRAs) provided under the IRC section of the Pension Excise Tax Regulations.

MORIARTY: Many tax items are adjusted annually for inflation. Barbara Weltman discusses the 2022 inflation adjustment for Health Savings Accounts and Excepted Benefit Health Reimbursement Accounts.

WELTMAN: Because of slight inflation, there are slightly higher limits for health savings accounts in 2022. Knowing these limits now can help employers plan ahead. Of course, we won't know the cost of group health insurance coverage, individual plans, or even health FSAs for 2022 until later in the year. For 2022, a high deductible health plan, an HDHP, must have minimum insurance deductible of not less than $1,400 for self only coverage, and $2,800 for family coverage, the same as it was for 2021. The HDHP must also limit annual out of pocket costs for deductibles, co-pays and other amounts other than premiums to no more than $7,050 for self only coverage and $14,100 for family coverage, a little higher than in 2021.

The annual contribution limit for self only coverage in 2022 is $3,650, $50 more than in 2021. For family coverage in 2022, $7,300 or $100 more than in 2021. Remember, those aged 55 by the end of the year, can add another $1,000 in contributions. But no contributions may be made once a person is on Medicare.

Employers large and small can offer employees a special arrangement to cover medical costs not covered by insurance, so-called accepted benefits, like vision, dental and hearing costs. This arrangement is called an accepted benefit health reimbursement arrangement. It supplements, not supplants health coverage. For 2021, the limit is $1,800 per employee. The IRS announced that the limit will be unchanged for 2022.

MORIARTY: One of the items that's not adjusted annually for inflation is the limit on a dependent care assistance plan. Barbara explains the new guidance and the special rules that apply for 2021 and 2022.

WELTMAN: As you recall, the Consolidated Appropriations Act 2021 and the American Rescue Plan Act greatly enhanced dependent care assistance plans or DCAPs.

There's a higher dollar limit for contributions for the plan year for 2021. That's $10,500, instead of the usual $5,000 limit, or $2,500 for married filing separately. The lower limits applied in 2020, and will again in 2022, assuming Congress doesn't extend the higher limit.

But special carryover rules apply. IRS guidance makes it clear that if these dependent care benefits would have been excluded from income, if used during the preceding taxable year, that is during the taxable year ending in 2020 or 2021, as applicable, they will remain excludable from gross income and are not wages of the employee for the taxable years ending in 2021 and 2022.

MORIARTY: Barbara gives us an example of how these carryovers are going to work.

WELTMAN: The IRS offers an example of how an employee who elected no dependent care plan benefits for 2019, but elected to contribute $5,000 for 2020. She didn't have any dependent care expenses in 2020. Likely, COVID-19 made her child stay home with her while she worked remotely. The plan allows her to carry over her contribution to 2021. In 2021, she elects to contribute $10,500. Let's assume her childcare expenses in 2021 are

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t $15,500, which is reimbursed by the DCAP. All of this is excluded from gross income, because the $10,500 was the excludable amount for 2021, and the $5,000 carryover is allowed under CAA.

Things get a little more complicated when the DCAP isn't on a calendar year. There's a good example in the IRS notice explaining how this works.

MORIARTY: There is usually not much talk about estate and gift taxes. The rules only apply when someone dies, or when someone gives away cash or property over set limits. Barbara Weltman reminds us of the limits for 2021.

WELTMAN: For 2021, estates valued at over $11.7 million for a decedent dying in 2021 is required to file Form 706, the federal estate tax return. Whether the estate is subject to estate tax depends of course on deductions and credits. If the entire estate passes to a surviving spouse or charity, no estate tax.

Still, the return is used to elect portability for a surviving spouse for the part of the estate tax exemption not used by the first spouse to die. For gift taxes, the annual gift tax exclusion is $15,000 in 2021, and the lifetime exemption may be used for larger gifts. Again, gifts to a spouse or charity don't count.

MORIARTY: Estate and gift taxes depend on value. Barbara discusses how it might be difficult to determine such value.

WELTMAN: Securities that are publicly traded are easy to value for estate and gift tax purposes. Other property, not so easy.

Recently, the Tax Court was called upon to determine the value of Michael Jackson's estate. In dispute was the value of Jackson's name and image. The estate lowballed it at $3 million, while the IRS claimed it was more like $500 million, although the amount was later reduced to $61 million. As often depends in these situations, it comes to a matter of dueling appraisers. The Tax Court thought the estate had the better case and settled on the value of $4 million.

Remember, Jackson died in 2009. So this case has been going on for a long time. The lesson? Get good appraisals.

MORIARTY: A new administration always brings changes in the tax law. Barbara reviews the proposed changes in estate and gift tax rules.

WELTMAN: Under the Administration's proposal, death would trigger realization of tax on gains held in a decedent's estate. There'd be some exemptions. All the details haven't been presented. The so-called Step Act that's been introduced in the Senate would also tax unrealized appreciation at death.

Should we be doing estate planning for our clients now? Not sure what the effective date would be. As of the date of the proposal, we need to watch proposed changes to estate taxes closely.

MORIARTY: Death, even though final, does not necessarily end a person’s tax problems. Barbara explains.

WELTMAN: When a person dies, the estate tax isn't the only federal tax matter. There may be income tax issues to resolve.

The IRS is now in dispute with the estate of Lavern Gaynor, the granddaughter of John Gates, who founded Texaco in 1902, and which is now a subsidiary of Chevron. She died in April of this year.

The issue before a district court, $18.4 million in penalties and interest for the willful failure to comply with FBAR reporting.

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t The case hasn't been decided yet, but I want to point out some of the things raised by the government in support of its case. She knew that her Swiss accounts held more than $30 million, but she did her best to hide them.

She never told her accountants, and in fact, checked no on schedule B to having foreign accounts. She instructed the foreign bank officials she dealt with to be secretive about her holdings in their meetings. Her son visited the bank. She made what's been characterized as a quiet disclosure of some of her offshore assets, by amending returns and paying additional taxes as a way to try to avoid penalties.

There's a lot for the government to hang its hat on. There are a number of cases supporting the idea that FBAR penalties don't end with death. We'll see what happens here.

MORIARTY: Barbara Weltman gives us an update on the IRS plan to adjust 2020 returns that had reported all unemployment benefits and excess advance premium tax credits.

WELTMAN: The IRS said it started to issue refunds related to unemployment benefits, but it will take the rest of the summer to complete this. The IRS estimates that more than 2.8 million refunds will be issued. Remember, the $10,200 exclusion for unemployment benefits in 2020 wasn't enacted until March 2021, after some taxpayers had already paid tax on all their benefits.

MORIARTY: Another way the IRS is sending money to taxpayers is for the Advance Child Tax Credit of 2021. Barbara explains.

WELTMAN: Starting mid-July, the IRS will send payments to an estimated 36 million households for half of their 2021 Child Tax Credit. The payments of up to $250 for a child six or older and up to $300 for a child younger, will be spread over six months. The payments will be sent automatically. Eligible taxpayers don't have to do anything.

The payments will be made via direct deposit, paper check or debit cards. The IRS started sending out letters informing them of the payments. OUT

The first letter says they're entitled to the payments. The second letter personalized to them, estimating what their monthly benefits will be, beginning July 15th of this year.

MORIARTY: So how will the IRS know who to send payments to?

WELTMAN: The IRS is encouraging eligible taxpayers to file returns, even if they haven't yet done so, or even if they aren't required to file. The IRS suggests they e-file even if they are filing what the service is calling a simplified return. Those filing by mail should write at the top of the paper return, Rev. Proc. 2021-24 to note that it's a simplified return, and include all required information about dependents.

These taxpayers may leave most lines one through 38 blank, even if there could be a value in any of these lines. Enter $1 on lines 2B, 9 and 11, and their standard deduction amount on line 12. A simplified return filer may enter the sum of the filer's 2020 recovery rebate credit and additional 2020 recovery rebate credits on line 30, 32, 33 and 34 and 35A. The credit amounts should be computed using the recovery rebate credit worksheet found in the instructions to the form. A simplified return filer should include information for direct deposit, but may not split a direct deposit into more than one account.

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t MORIARTY: What about those who want to file electronically, instead of mailing in a paper return or those who already filed their 2019 or 2020 income tax returns?

WELTMAN: Those with adjusted gross income of zero may file electronically by reporting $1 as taxable interest, and the same for total income and AGI. The IRS will use this information to generate the applicable payments to the taxpayer.

Similar rules are provided for those filing Form 1040 NR and 1040 SR. The IRS cautions that the information provided on these simplified filings must be accurate and may be subject to penalties if not.

Anyone who already filed an income tax return for 2020 doesn't have to file anything else to receive the advanced child tax credit, the EIP3 or claim a 2020 recovery rebate credit.

Anyone who filed a federal income tax return for taxable year 2019, including by entering information into the non-filer's “enter payment info here” tool in 2020 does not need to file any additional forms or otherwise contact the IRS to receive the advanced child tax credit payment for 2020, the CTC qualifying child shown on that return, or to receive a third round economic impact payment for themselves, and for each dependent child shown on that return. Such taxpayer can claim the 2020 EIPs on a 2020 return.

MORIARTY: But there is more when it comes to the advanced child tax credit payments. Barbara explains.

WELTMAN: Taxpayers who receive advanced child tax credit payments will have to reconcile them on their 2021 return with the total credit amount to which they are entitled. Changes in taxpayers' income and dependents could mean an additional credit or tax liability.

SURRAN: In Notice 2021-31 the IRS provided a series of questions and answers related to the COBRA Premium Assistance program enacted as part of the American Rescue Plan Act (ARPA). The first set of questions and answers deals with issues, such as

l Who qualifies as an assistance eligible individual

l Who qualifies as a qualified beneficiary for purposes of becoming an assistance eligible individual, including exceptions to this rule, and

l Notes the possibility of becoming an assistance eligible individual more than once, and also contains several examples of those situations taking place.

The Notice provides that an employer can require the employee to self-certify that he or she meets the requirements for this benefit and allows the employer to rely on that certification. However, if the employer relies on that certification, the employer needs to keep a copy of it. It is important to note that only involuntary termination or a reduction in hours will qualify an individual for COBRA premiums assistance under Notice 2021-31.

MORIARTY: In a previous segment, Barbara told us about COBRA assisted payments that employees must make for certain individuals. She continues with an update on the recent IRS guidance.

WELTMAN: You may recall that the American Rescue Plan Act requires employers who are subject to federal estate COBRA to pay premiums for involuntarily terminated employees or those subject to reduced hours. This applies to those enrolled in COBRA, who may now elect to be enrolled if

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t eligible. Job loss or reduced hours, including being furloughed, are the only qualifying events. Divorce or losing dependent status doesn't qualify.

These payments run from April 1, 2021 through September 30th, 2021. The employer can claim a refundable employment tax credit to cover the cost. The IRS released guidance in the form of 86 Q&As with lots of examples.

MORIARTY: Barbara covers some of the key points of the IRS released Q&As.

WELTMAN: The Q&As are designed to help employers and plan sponsors comply with the law. The first set of questions deals with an individual's eligibility for this premium assistance. Such person is called an assistance eligible individual.

Employers may ask a person to self-certify or test to their eligibility. Employers need to retain a record of an attestation. The balance of the questions address other issues. For example, premium assistance applies for vision only or dental only plan, if it's a group plan. It doesn't apply to a QSEHRA which is not a group plan.

The extended election period applies only to federal COBRA, not to continuation coverage under state law. And there are questions related to the employer's calculation of the COBRA premium assistance credit. This is the amount equal to the amount that an assistance eligible individual would pay, including the administrative fee.

MORIARTY: Barbara reminds us how the COBRA premium assistance credit impacts employment tax deposits?

WELTMAN: An employer may reduce employment tax deposits in anticipation of receiving the COBRA premium assistance credit. Obviously, this will be reflected on Form 941. Remember that the IRS has provided penalty relief for failing to deposit employment taxes. This relief applies not only for purposes of COBRA assistance, but also for the employee retention credit, and the paid sick leave and paid family leave credits.

MORIARTY: But will we know what we'll have to do with the 2021 W-2s with respect to COBRA premium assistance?

WELTMAN: COBRA premium assistance is not includible in gross income. How this will be reported or not reported on the W-2 remains to be seen. But the premium assistance credit is included in the gross income of the employer for the taxable year, which includes the last day of any quarter, with respect to which the credit is allowed.

MORIARTY: The IRS has also updated and introduced some new forms. Barbara gives us further details.

WELTMAN: The IRS has released a revised Form 7200 and instructions, so that employers may obtain an advance of the employment tax credits to cover COBRA payments they make. The form is used if employment taxes aren't sufficient to cover the premiums for eligible individuals, those involuntarily terminated or had reduced hours.

For the same reason, the IRS has released revised instructions to Form 941-X, which is the form used by employers to adjust their quarterly employment taxes or claim a refund.

The IRS has released a draft of schedules K2 and K3 for the 1065 and 1120-S. The K2 for the 1065 is the partner distributive share items international.

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t The K3 for the 1065 is the partner share of income deductions, credits, et cetera, international. It runs 20 pages.

There are similar drafts for the 1120-S. They're going to be filed with the 2020 returns by partnerships and S corporations, reporting international items. The K2 is what would normally be on the schedule K, the entity's foreign items. The K3 is like the K1, only for foreign items. We don't yet have drafts for the 2021 1065 or 1120-S and their K1s, but I'm sure they're going to be different than what we're used to.

MORIARTY: Barbara discusses the tax gap, what it is and how it may affect tax policy going forward.

WELTMAN: The tax gap is the spread between what the federal government collects in taxes and what it thinks it should be collecting, were it is not for non-filing, under reporting income or overstating deductions and non-payment.

A recent Treasury report estimated the tax gap to be about $583 billion. Put in perspective, the IRS has lacked the resources it needs to enforce the tax laws and best serve taxpayers. It has cost the government around 3% of GDP each year in owed but uncollected taxes.

MORIARTY: What does the report suggest should be done to fix the tax gap?

WELTMAN: To fix the tax gap, the Treasury suggests several things. First, it wants more resources for the IRS, in part to help with examinations of large corporations, partnerships, global high wealth and high income individuals.

Second, it wants increased information reporting for, and I quote, "Shining light on opaque income streams, including proprietorships and partnerships," close quote.

Reporting would be created for cryptocurrency transactions. And remember, we already have increased reporting on schedule 1099-K for merchant transactions starting in 2023 for 2022 transactions, a $600 threshold for reporting without regard to the number of transactions.

Third, the Treasury wants the IRS to be able to regulate tax return preparers.

MORIARTY: Barbara Weltman gives us some context on the current administration’s 2022 budget proposals.

WELTMAN: We talked today and previously about some of the administration's proposed tax changes. The Treasury released the so-called Green Book containing a general explanation of the administration's fiscal year 2022 revenue proposals.

These proposals include both the American Jobs Plan, which would include raising the corporate tax rate to 28%, and incentives to encourage clean energy, and the American Families Plan, which would kill the carried interest rule and cap deferral for like kind exchanges. But there are numerous other proposed changes.

Altogether, the budget would be $6 trillion, representing the largest federal spending since World War Two, some of which would be offset by tax increases.

The debate in Congress when enacting a new budget undoubtedly will include not only which tax measures to include and when to make them effective, but also the impact they will have on GDP, the federal debt and job creation. We'll be watching.

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Segment Five – Government / Not-for-Profit

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rofit 5. Tax-Exempt Status: Jeopardizing Activities

Segment Overview:

Field of Study:

Recommended Accreditation:Reading (Optional for Group Study):

Running Time:

Video Transcript:

Course Level:



Expiration Date:

Taxes – NFP

September 10, 2022

Work experience in tax planning or tax compliance, or an introductory course in taxation.

None


Update

”Exemption Requirements - 501(c)(3) Organizations”

“Exempt Organization Types”

“Application for Recognition of Exemption”

“Lifecycle of an Exempt Organization”

“Automatic Revocation - How to Have Your Tax-Exempt Status Reinstated”

“Social Welfare Organizations”

“Churches, Integrated Auxiliaries, and Conventions or Associations of Churches”

See page 5–12.

See page 5–21.

35 minutes

To be tax-exempt under section 501(c)(3) of the Internal Revenue Code, an organization must be organized and operated exclusively for exempt purposes as set forth in section 501(c)(3). But what are the activities that could potentially jeopardize tax-exempt status? Allen Fetterman, an instructor for Kaplan Financial Education describes the four major areas of concern for 501(c)(3)organizations when it comes to maintaining their tax-exempt status. He reviews in detail inurement, lobbying, political activities and unrelated business income.


Upon successful completion of this segment, you should be able to:

● Identify the four major areas of concern with regards to jeopardizing tax-exempt status,

● Describe what is meant by the term “inurement”,

● Recognize the lobbying and political activities that could jeopardize tax-exempt status, and

● Describe the unrelated business income activities that nonprofit organizations need to be aware of

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Outline

A. To Be Tax-Exempt: An Organization

i. Must be organized and operated exclusively for exempt purposes

ii. None of its earnings may inure to shareholders/individuals

iii. May not influence legislation or participate in political activity

B. Four Areas That Could Jeopardize Tax-Exempt Status

i. Inurement

ii. Lobbying

iii. Political activities

iv. Unrelated business income

I. Tax-Exempt Status

A. What is Inurement?

i. Benefits conferred on insiders

ii. Examples l Unreasonable compensation l Transfer of real or personal

property for less than FMV

B. Excess Benefit Transaction

i. Transaction between a 501(c)(3) or a 501(c)(4) and a disqualified person

ii. Economic benefit is greater than value of the consideration

iii. Example: Unreasonable compensation for services

C. Excess Benefit Transactions: Penalties

i. 25% of the excess benefit transaction on each transaction

ii. If excess benefit transaction isn’t corrected, an additional 200%

iii. 10% on an organization manager who knowingly participated in the transaction

D. Rebuttable Presumption of Reasonableness

i. Approved by authorized body of the entity without conflict of interest

ii. Authorized body uses appropriate date to make determination

iii. Authorized body adequately documents basis of determination

II. Four Areas that may Jeopardize Tax-Exempt Status

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A. Lobbying: Two Ways

i. Direct

ii. Grassroots

B. Examples of What is Not Lobbying

i. Nonpartisan analysis, public education and provision of advice in response to a request

ii. Grassroots organizing, litigation and communications, unless the communication urges members to lobby

iii. Self-defense lobbying

C. Substantiality: Two Tests

i. Substantial part test

ii. Expenditure test

D. IRS Considers Many Factors

i. Time devoted by compensated employees

ii. Time devoted by volunteer workers

iii. Expenditures devoted to the activity

E. The Expenditure Test

i. Objective test using formulas to set ceilings for lobbying expenditures

ii. Ceilings vary from 5-20% of exempt purpose expenditures

iii. Lobbying amount capped at $1 million per year

III.What Constitutes Lobbying

IV. Non-Exempt Political & Business ActivitiesA. Political Campaign Activity:

Prohibitions

i. Making or soliciting contributions for candidate for public office

ii. Endorsing or opposing a candidate or party

iii. Rating a candidate

iv. Making statements in support or in opposition to a candidate or party

v. Using resources to engage in political campaign activity

vi. Not inviting all candidates to speak at a public forum

B. Non-Partisan Activities Allowed

i. Presenting at public forums

ii. Publishing voter education guides that are non-partisan

C. Unrelated Business Income

i. Use of profits derived from activity in furtherance of exempt purposes does not make such activity substantially related to exempt purposes

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Outline (continued)

A. Unrelated Business Requirement

i. The activity constitutes a trade or business

ii. The trade or business is regularly carried on

iii. The trade or business is not related to furthering the exempt purpose of the organization

B. Unrelated Business Activities: Examples

i. Sale of merchandise

ii. Sale of publications

iii. Advertising

iv. Debt management plan services

v. Gaming except bingo

vi. Rental income

C. Excluded from Unrelated Business Income

i. Dividends

ii. Interest and other investment income

iii. Royalties

iv. Rents from real property

v. Gains from dispositions of property

V. Unrelated Business Income Specifics

A. Exclusions from a Trade or Business

i. Bingo, if it meets certain requirements

ii. Activities conducted for the convenience of members, students, etc.

iii. Convention and trade show activity

iv. Distribution of low-cost articles incidental to the solicitation of contributions

v. Exchange or rental of member or donor lists between certain organizations

vi. Sales of donated merchandise

vii. Substantially all work performed without compensation

B. Business Activities Regularly Carried On

i. A hospital auxiliary’s operation of a sandwich shop for two weeks at a state fair would not be regular conduct

ii. Operating a commercial parking lot every Saturday would be regular conduct

C. Determining Whether Activities Contribute Importantly

i. Consider size and extent of the exempt purpose

ii. In relation to extent of intended exempt purpose

D. Unrelated Business Income: Related Acronyms

i. UBI – unrelated business income

ii. UBIT – unrelated business income tax

iii. UBTI – unrelated business income taxable income

E. Four Areas That Could Jeopardize Tax-Exempt Status

i. Inurement

ii. Lobbying

iii. Political activities

iv. Unrelated business income

“I've always felt that auditors and accountants serving the needs of the tax-exempt community should be aware of more than just how to prepare a 990.”

—Allen Fetterman

VI. Definition of ‘Trade or Business’

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“In this segment, Allen Fetterman describes the four major areas of concern for 501(c)(3)organizations when it comes to maintaining their tax-exempt status."


l After playing the video, use the questions provided or ones you have developed to generate discussion. The answers to our discussion questions are on pages 5–7 through 5–9. Additional objective questions are on pages 5–10 and 5–11.


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1. What are the four major areas of concern with regards to jeopardizing tax-exempt status? How do these areas impact your clients or organization?

2. What is meant by the term inurement?

3. What constitutes an excess benefit transaction, what are the penalties for participating in such a transaction, and what are the three conditions for a rebuttable presumption of

reasonableness? What excess benefit transactions or rebuttable presumptions of reasonableness do you see at your organization?

4. What are the lobbying activities that could jeopardize tax-exempt status and what activities are not treated as lobbying? What type of activities could be considered lobbying at your organization?




Group Live Option


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s5. What are the political activities that

could jeopardize tax-exempt status and what non-partisan activities are allowed? How do the rules about political activities impact your organization?

6. What happens when an organization conducts unrelated business income activities?

7. What are some examples of unrelated business activities, what is excluded from unrelated business income, and what are some exclusions from the definition of trade or business? What types of activities might be considered unrelated business activities within your organization?

Discussion Questions (continued)di

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1. What are the four major areas of concern with regards to jeopardizing tax-exempt status? How do these areas impact your clients or organization? l Inurement

v 501(c)(3) organizations may not be used for the private benefit of any individual

l Lobbying v 501(c)(3) organizations may only

participate in legislative activities to a limited extent

l Political activities v 501(c)(3) organizations are

forbidden to engage in political activities

l Unrelated business income v A 501(c)(3) will lose its tax

exempt status if it operates for the primary purpose of carrying on an unrelated trade or business


2. What is meant by the term inurement? l Inurement refers to benefits conferred

on insiders, such as officers, directors, or key employees

l No part of a 501(c)(3) organization’s net earnings may inure to the benefit of a private individual

l Examples of prohibited inurement include: v Unreasonable compensation v The transfer of real or personal

property for less than fair market value

v Any amount of inurement is grounds for loss of tax-exempt status

v Prohibited inurement does not include reasonable payments for services rendered or payments made for the fair market value of property

3. What constitutes an excess benefit transaction, what are the penalties for participating in such a transaction, and what are the three conditions for a rebuttable presumption of reasonableness? What excess benefit transactions or rebuttable presumptions of reasonableness do you see at your organization? l Excess benefit transaction –

transaction between a 501(c)(3) or a 501(c)(4) organization and a disqualified person v Where the economic benefit is

greater than the value of the consideration provided for the benefit

l For example, unreasonable compensation for services or a non-fair market value transaction

l A disqualified person is any person in a position to exercise substantial influence over the affairs of the organization at any time during a five-year period ending on the date of the transaction i

l The penalties for participating in an excess benefit transaction are: v 25% of the excess benefit

transaction on each transaction v If the excess benefit transaction is

not corrected, an additional 200% excise tax on the excess benefit is imposed in any disqualified person involved

v 10% on an organization manger who knowingly participated in the transaction

l Rebuttable presumptions of reasonableness: v The transaction needs to be

approved by an authorized body of the entity without a conflict of interest

v Before making the determination of reasonableness, the authorized body obtains and relies upon appropriate data for comparability

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v The authorized body adequately documents the basis for the determination concurrent to making the determination


4. What are the lobbying activities that could jeopardize tax-exempt status and what activities are not treated as lobbying? What type of activities could be considered lobbying at your organization? l Lobbying is defined as an attempt to

influence legislation l There are two ways to lobby

v Direct – contacting legislators directly

v Grassroots – urging the public to contact legislators

l Examples of what is not lobbying: v Nonpartisan analysis, research,

public education, public meetings, distributing public materials, and the provision of advice to a governmental body in response to a request

v Grassroots organizing, such as litigation and communications between the organization and its members with respect to legislation

v Self-defense lobbying, for example, communications to legislators regarding the organization’s existence or tax-exempt status


5. What are the political activities that could jeopardize tax-exempt status and what non-partisan activities are allowed? How do the rules about political activities impact your organization? l Making or soliciting contributions

for, on behalf of, or against any

candidate for public office, whether state, local, or national, or to a political party

l Endorsing or opposing a particular candidate or political party

l Rating a candidate, no matter how objective the rating

l Making statements in support of or in opposition to a candidate or political party

l Using the organization’s resources, for example, office space, telephones, employee time, to engage in political campaign activities

l Not inviting all candidates to speak in a public forum

l Non-partisan activities allowed: l Presenting at public forums l Publishing voter education guides as

long as that activity is conducted in a non-partisan manner


6. What happens when an organization conducts unrelated business income activities? l An organization may be subject to

tax on income from trades or businesses regularly carried on that are not substantially related to its exempt purpose

l Use of the profits derived from this activity in furtherance of its exempt purpose does not make the activity substantially related to its exempt purpose

l The trade or business must be directly related to an exempt purpose in order to avoid UBIT

l An organization that has $1,000 or more of gross income from an unrelated business must file Form 990-T, in addition to the filing the annual information return Form 990, 990-EZ, or 990-PF

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7. What are some examples of unrelated business activities, what is excluded from unrelated business income, and what are some exclusions from the definition of trade or business? What types of activities might be considered unrelated business activities within your organization? l Sale of merchandise l Sale of publications l Advertising l Debt management plan services l Gaming, except bingo l Rental income l Excluded from unrelated business

income: v Dividends v Interest and other investment

income v Royalties v Rents from real property v Gains from disposition of

property l Exclusions from trade or business l Bingo, if it meets certain

requirements l Activities conducted for the

convenience of members, students, etc.

l Convention and trade show activity l Distribution of low-cost articles

incidental to the solicitation of contributions

l Exchange or rental of member or donor lists between certain organizations

l Sales of donated merchandise l Substantially all work performed

without compensation v As a general rule of thumb,

substantially is 85% l Participant response based on


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1. One of the four major areas of concern with regards to jeopardizing tax-exempt status is:

a) investment income

b) inurement

c) contributions

d) net assets

2. An example of prohibited inurement includes:

a) payments made for the fair market value of property

b) contacting legislators directly

c) unreasonable compensation

d) rating a candidate

3. Which type of lobbying activity could jeopardize tax-exempt status?

a) nonpartisan analysis

b) grassroots organizing

c) self-defense lobbying

d) direct lobbying

4. A political activity that could jeopardize tax-exempt status is:

a) endorsing a particular candidate

b) presenting at public forums

c) publishing voter education guides that are non-partisan

d) inviting all candidates to speak in a public forum

5. When an organization conducts unrelated business income activities:

a) it immediately loses its tax-exempt status

b) it must pay a penalty on unrelated business income proceeds

c) it may be subject to tax on the unrelated business income

d) it must separately incorporate the unrelated activity and operate it as a for-profit entity

6. Income EXCLUDED from unrelated business income includes:

a) sale of publications

b) rents from real property

c) advertising

d) debt management plan services

7. Churches and religious organizations may qualify for exemption from federal income tax under Section:

a) 501(c)(3)

b) 501(c)(4)

c) 501(c)(7)

d) 527

8. Which of the following is true regarding streamlined retroactive reinstatement?

a) organizations that use form 990-pf are eligible

b) there is no user fee

c) the organization has 24 months from the date of its revocation to submit for revocation

d) the IRS will NOT impose the section 6652(c) penalty



Objective Questions

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9. An example of a social welfare organization is:

a) an organization that restricts the use of its facilities to employees of selected corporations and their guests

b) an organization formed to represent member-tenants of an apartment complex

c) an organization formed to promote the legal rights of all tenants in a particular community

d) an organization whose primary activity is operating a social club for the benefit of its members

10. Churches that meet the requirements of Section 501(c)(3) of the Internal Revenue Code:

a) are required to file an annual statement with the irs

b) are automatically considered tax-exempt

c) are required to apply for recognition of exempt status with the irs

d) cannot receive charitable donations that are deductible by the donor


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Self-Study Option


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EXEMPTION REQUIREMENTS – 501(C)(3) ORGANIZATIONS




CPA Report Gov/Not-for-Profit Update

Source: https://www.irs.gov/charities-non-profits/charitable-organizations/exemption-requirements-501c3-organizations

To be tax-exempt under section 501(c)(3) of the Internal Revenue Code, an organization must be organized and operated exclusively for exempt purposes set forth in section 501(c)(3), and none of its earnings may inure to any private shareholder or individual. In addition, it may not be an action organization, i.e., it may not attempt to influence legislation as a substantial part of its activities and it may not participate in any campaign activity for or against political candidates.

Organizations described in section 501(c)(3) are commonly referred to as charitable organizations. Organizations described in section 501(c)(3), other than testing for public safety organizations, are eligible to receive tax-deductible contributions in accordance with Code section 170.

The organization must not be organized or operated for the benefit of private interests, and no part of a section 501(c)(3)

organization's net earnings may inure to the benefit of any private shareholder or individual. If the organization engages in an excess benefit transaction with a person having substantial influence over the organization, an excise tax may be imposed on the person and any organization managers agreeing to the transaction.

Section 501(c)(3) organizations are restricted in how much political and legislative (lobbying) activities they may conduct. For a detailed discussion, see Political and Lobbying Activities. For more information about lobbying activities by charities, see the article Lobbying Issues PDF; for more information about political activities of charities, see the FY-2002 CPE topic Election Year Issues PDF.

Interactive Training Learn more about the benefits, limitations and expectations of tax-exempt organizations by attending 10 courses at the online Small to Mid-Size Tax Exempt Organization Workshop.


http://www.irs.gov/charities-non-profits/charitable-organizations/exemption-requirements-501c3-organizations



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Additional Information

l Application Process Step-by-Step: Questions and answers that will help an organization determine if it is eligible to apply for recognition of exemption from federal income taxation under IRC section 501(a) and, if so, how to proceed.

l Private foundations – requirements for exemption

l Tax-Exempt Status: Online training available at the IRS microsite StayExempt.irs.gov.

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Source: https://www.irs.gov/charities-non-profits/exempt-organization-types

Charitable Organizations Organizations organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, educational, or other specified purposes and that meet certain other requirements are tax exempt under Internal Revenue Code Section 501(c)(3).

Churches and Religious Organizations

Churches and religious organizations, like many other charitable organizations, may qualify for exemption from federal income tax under Section 501(c)(3).

Private Foundations

Every organization that qualifies for tax-exempt status under Section 501(c)(3) is classified as a private foundation unless it meets one of the exceptions listed in Section 509(a). Private foundations typically have a single major source of funding (usually gifts from one family or corporation rather than funding from many sources) and most have

as their primary activity the making of grants to other charitable organizations and to individuals, rather than the direct operation of charitable programs.

Political Organizations

A political organization subject to Section 527 is a party, committee, association, fund or other organization (whether or not incorporated) organized and operated primarily for the purpose of directly or indirectly accepting contributions or making expenditures, or both, for an exempt function.

Other Nonprofits

Organizations that meet specified requirements may qualify for exemption under subsections other than 501(c)(3). These include social welfare organizations, civic leagues, social clubs, labor organizations and business leagues.

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EXEMPT ORGANIZATION TYPES

http://www.irs.gov/charities-non-profits/exempt-organization-types

http://www.irs.gov/charities-non-profits/exempt-organization-types

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Source: https://www.irs.gov/charities-non-profits/application-for-recognition-of-exemption

To apply for recognition by the IRS of exempt status under section 501(c)(3) of the Code, use a Form 1023-series application. The application must be submitted electronically on www.pay.gov and must, including the appropriate user fee. See Application Process for a step-by-step review of what an organization needs to know and to do in order to apply for recognition by the IRS of tax-exempt status. Frequently asked questions about applying for exemption are also available. You may also want to view some of our tools designed to help you apply for exemption.

The organization should also request an employer identification number, even if it does not have any employees. See Form SS-4, Application for Employer Identification Number PDF, and its related instructions PDF to learn how to obtain an EIN. You may obtain an EIN by applying online, by fax or by mail. International applicants may call 267-941-1099 (not a toll-free number).

Except for churches, their integrated auxiliaries, and public charities whose annual gross receipts are normally less than $5,000, organizations will not be treated as described in section 501(c)(3) unless they notify the IRS by applying for recognition of section 501(c)(3) status. Generally, organizations required to apply for recognition of exemption must notify the Service within 27 months from the date of their formation to be treated as described in section 501(c)(3) from the date formed. When the IRS determines that an organization qualifies for exemption under section 501(c)(3), it will also be classified as a private foundation, unless it meets the requirements to be treated as a public charity.

A charitable organization must make available for public inspection its approved

application for recognition of exemption with all supporting documents and its last three annual information returns. The organization must provide copies of these documents upon request without charge (other than a reasonable fee for reproduction and copying costs). Penalties are provided for failure to comply with these requirements. For more information, see our frequently asked questions, the final regulations published in Internal Revenue Bulletin 1999-17 PDF, or Disclosure Requirements PDF.

Learn more about the benefits, limitations and expectations of tax-exempt organizations by attending the courses at the online Small to Mid-Size Tax Exempt Organization Workshop.

Additional information: l Online courses – Tools designed to help you apply for exemption.

l Publication 557, Tax-Exempt Status for Your Organization PDF

l Publication 4220, Applying for 501(c)(3) Tax-Exempt Status PDF

l Publication 1635, Understanding Your EIN PDF

l Publication 4573, Group Exemptions PDF

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APPLICATION FOR RECOGNITION OF EXEMPTION

http://www.irs.gov/charities-non-profits/application-for-recognition-of-exemption



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Source: https://www.irs.gov/charities-non-profits/life-cycle-of-an-exempt-organization

Organizations that meet the requirements of Internal Revenue Code section 501(a) are exempt from federal income taxation. In addition, charitable contributions made to some section 501(a) organizations by individuals and corporations are deductible under Code section 170.

This website provides information about points of intersection between organizations and the IRS. The content includes explanatory information, and links to forms that an organization may need to file with the IRS. The materials cover five stages in an organization's life cycle:

1. Starting Out: Creating an organization under state law, acquiring an employer identification number, and identifying the appropriate federal tax classification.

2. Applying for Exemption: Acquiring, completing, and submitting application forms; how the IRS processes applications; and getting help from the IRS during the application process.

3. Required Filings: Annual exempt organization returns, unrelated business income tax filings, Form 8976 – Notice of Intent to Operate Under Section 501(c)(4), and other returns, reports and notices that an organization may have to file.

4. Ongoing Compliance: How an organization can avoid jeopardizing its tax-exempt status, disclosure requirements, employment taxes, and other ongoing compliance issues.

5. Significant Events: Audits, private letter rulings, and termination procedures.

Lifecycle pages — including requirements for exemption — are available for the following types of organizations:

l Charitable organizations (Code section 501(c)(3))

b Public charities

b Private foundations

l Social welfare organizations (section 501(c)(4))

l Agricultural/horticultural organizations (section 501(c)(5))

l Labor organizations (section 501(c)(5))

l Business leagues (trade associations) (section 501(c)(6))

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LIFECYCLE OF AN EXEMPT ORGANIZATION

http://www.irs.gov/charities-non-profits/life-cycle-of-an-exempt-organization

http://www.irs.gov/charities-non-profits/life-cycle-of-an-exempt-organization

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AUTOMATIC REVOCATION – HOW TO HAVE YOUR TAX-EXEMPT STATUS REINSTATED

Source: https://www.irs.gov/charities-non-profits/charitable-organizations/automatic-revocation-how-to-have-your-tax-exempt-status-reinstated

Organizations whose tax-exempt status was automatically revoked because they did not file required Form 990 series returns or notices for three consecutive years can apply for reinstatement of their tax-exempt status.

Revenue Procedure 2014-11 explains the four procedures an organization may use to apply for reinstatement.

Streamlined retroactive reinstatement

Organizations that were eligible to file Form 990-EZ or 990-N (ePostcard) for the three years that caused their revocation may have their tax-exempt status retroactively reinstated to the date of revocation if they:

● Have not previously had their tax-exempt status automatically revoked.

● Complete and submit Form 1023 , Form 1023-EZ, Form 1024 PDF or Form 1024-A with the appropriate user fee not later than 15 months after the later of the date of the organization’s Revocation Letter (CP-120A) or the date the organization appeared on the Revocation List on the IRS website.

For organizations electronically submitting Form 1023, see Schedule E, Section 4; 1023-EZ see Part V; or 1024-A, see Part VI. For organizations submitting Form 1024, they should write on the top of the form “Revenue Procedure 2014-11, Streamlined Retroactive Reinstatement,” and mail the application and user fee to:

Internal Revenue Service P.O. Box 12192 TE/GE Stop 31A Team 105 Covington, KY 41012-0192

In addition, the IRS will not impose the Section 6652(c) penalty for failure to file annual returns for the three consecutive taxable years that caused the organization to be revoked if the organization is retroactively reinstated under this procedure and files properly completed and executed paper Forms 990-EZ for all such taxable years. (For any year for which the organization was eligible to file a Form 990-N, the organization is not required to file a prior year Form 990-N or Form 990-EZ to avoid penalties.) The organization should write “Retroactive Reinstatement” on the Forms 990-EZ and mail them to:

Department of the Treasury Internal Revenue Service Ogden, UT 84201-0027

Retroactive reinstatement process (within 15 months)

Organizations that cannot use the Streamlined Retroactive Reinstatement Process (such as those that were required to file Form 990 or Form 990-PF for any of the three years that caused revocation or those that were previously auto-revoked) may have their tax-exempt status retroactively reinstated to the date of revocation if they:

● Complete and submit Form 1023, Form 1024 PDF or Form 1024-A with the appropriate user fee not later than 15 months after the later of the date on the organization’s revocation letter (CP-120A) or the date the organization appeared on the Revocation List on the IRS website.

● Include with the application a statement establishing that the organization had reasonable cause for its failure to file a required annual return for at least one of the three consecutive years in which it failed to file.

● Include with the application a statement confirming that it has filed required

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returns for those three years and for any other taxable years after such period and before the post-mark date of the application for which required returns were due and not filed.

● File properly completed and executed paper annual returns for the three consecutive years that caused the revocation and any following years. The organization should write “Retroactive Reinstatement” on these returns and mail them to:

Department of the Treasury Internal Revenue Service Center Ogden, UT 84201-0027

These organizations should check the box on Schedule E for Section 5 when submitting Form 1023 electronically. For organizations submitting 1024-A electronically, check the box for Section 5 in Part VI. For organizations submitting Form 1024, they should write on the top of the Form 1024, “Revenue Procedure 2014-11, Retroactive Reinstatement,” and mail the application and user fee to:


In addition, the IRS will not impose the Section 6652(c) penalty for failure to file annual returns for the three consecutive taxable years that caused the organization to be revoked if the organization is retroactively reinstated under this procedure.

Retroactive reinstatement (after 15 months)

Organizations that apply for reinstatement more than 15 months after the later of the date on the organization’s revocation letter (CP-120A) or the date the organization appeared on the Revocation List on the IRS website may have their tax-exempt status retroactively reinstated to the date of revocation if they:

● Satisfy all of the requirements described under the “Retroactive reinstatement (within 15 months)” procedure EXCEPT that the reasonable cause statement the organization includes with its application must establish reasonable cause for its failure to file a required annual return for all three consecutive years in which it failed to file.

These organizations should check the box on Schedule E for Section 6 when submitting Form 1023 electronically. For organizations submitting 1024-A electronically, check the box for Section 6 in Part VI. For organizations submitting Form 1024, they should write on the top of the Form 1024, “Revenue Procedure 2014-11, Retroactive Reinstatement,” and mail the application and user fee to:


In addition, the IRS will not impose the Section 6652(c) penalty for failure to file annual returns for the three consecutive taxable years that caused the organization to be revoked if the organization is retroactively reinstated under this procedure.

Post-mark date reinstatement

Organizations may apply for reinstatement effective from the post-mark date of their application if they:

● Complete and submit Form 1023, Form 1023-EZ PDF, Form 1024 PDF or Form 1024-A with the appropriate user fee.

These organizations should check the box ) for Section 7 on Schedule E for Form 1023 or Part V for Form 1023-EZ. For organizations submitting 1024-A electronically, check the box for Section 7 in Part VI. For organizations submitting Form 1024, they should write on the top of the Form 1024, “Revenue Procedure 2014-11, Reinstatement Post-Mark Date,” and mail the application and user fee to:

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What’s a reasonable cause statement?

A reasonable cause statement establishes that an organization exercised ordinary business care and prudence in determining and attempting to comply with its annual reporting requirement. The statement should have a detailed description of all the facts and circumstances about why the organization failed to file, how it discovered the failure, and the steps it has taken or will take to avoid or mitigate future failures. For a detailed explanation see Section 8 of Revenue Procedure 2014-11.

Reinstatements granted prior to January 2, 2014

Organizations that applied for and received reinstatement of exempt status effective from the post-mark date prior to January 2, 2014 (the effective date of Revenue Procedure 2014-11), and that would have satisfied the retroactive reinstatement requirements of Section 4, will be reinstated from the revocation date. Those organizations should keep their determination letters reinstating tax exempt

status and a copy of Revenue Procedure 2014-11 with their books and records. See Section 10 of Revenue Procedure 2014-11 for details.

Avoid being automatically revoked again – file annual returns

An organization can be automatically revoked again if it fails to file required returns for three consecutive years beginning with the year in which the IRS approves the application for reinstatement. Organizations seeking reinstatement of tax-exempt status after a subsequent revocation are not eligible to use the Streamlined Retroactive Reinstatement Process.

Additional information ● Annual Reporting and Filing

● Online course- Applying for Section 501(c)(3) Status – An Overview (37 minutes)

● Revoked? Reinstated? Learn more.

Revenue Procedure 2014-11 modified and superseded Notice 2011-44, Application for Reinstatement and Retroactive Reinstatement for Reasonable Cause under Internal Revenue Code Section 6033(j).

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SOCIAL WELFARE ORGANIZATIONS

Source: https://www.irs.gov/charities-non-profits/other-non-profits/social-welfare-organizations

To be tax-exempt as a social welfare organization described in Internal Revenue Code (IRC) section 501(c)(4), an organization must not be organized for profit and must be operated exclusively to promote social welfare. The earnings of a section 501(c)(4) organization may not inure to the benefit of any private shareholder or individual. If the organization engages in an excess benefit transaction with a person

having substantial influence over the organization, an excise tax may be imposed on the person and any managers agreeing to the transaction. See Introduction to IRC 4958 PDF for more information about this excise tax. For a more detailed discussion of the exemption requirements for section 501(c)(4) organizations, see IRC 501(c)(4) Organizations PDF.

New legislation enacted at the end of 2015 added Section 506 to the Internal Revenue Code. Section 506 requires an organization to notify the IRS of its intent to operate as a

http://www.irs.gov/charities-non-profits/other-non-profits/social-welfare-organizations



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Section 501(c)(4) organization. The IRS has developed a new form – Form 8976 – that organizations should use to provide this notification. For information about applying for exemption, see Application for Recognition of Exemption.

This requirement only applies to organizations intending to operate under Section 501(c)(4). Organizations operating under any other 501(c) section should not file this notice.To be operated exclusively to promote social welfare, an organization must operate primarily to further the common good and general welfare of the people of the community (such as by bringing about civic betterment and social improvements). For example, an organization that restricts the use of its facilities to employees of selected corporations and their guests is primarily benefiting a private group rather than the community and, therefore, does not qualify as a section 501(c)(4) organization. Similarly, an organization formed to represent member-tenants of an apartment complex does not qualify, because its activities benefit the member-tenants and not all tenants in the community, while an organization formed to promote the legal rights of all tenants in a particular community may qualify under section 501(c)(4) as a social welfare organization. An organization is not operated primarily for the promotion of social welfare if its primary activity is operating a social club for the benefit, pleasure or recreation of its members, or is carrying on a business with the general public in a manner similar to organizations operated for profit.

Seeking legislation germane to the organization's programs is a permissible means of attaining social welfare purposes. Thus, a section 501(c)(4) social welfare organization may further its exempt purposes through lobbying as its primary activity without jeopardizing its exempt status. An organization that has lost its section 501(c)(3) status due to substantial attempts to influence legislation may not thereafter qualify as a section 501(c)(4) organization. In addition, a section 501(c)(4) organization that engages in lobbying may be required to either provide notice to its members

regarding the percentage of dues paid that are applicable to lobbying activities or pay a proxy tax. For more information, see Lobbying Issues PDF .

The promotion of social welfare does not include direct or indirect participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office. However, a section 501(c)(4) social welfare organization may engage in some political activities, so long as that is not its primary activity. However, any expenditure it makes for political activities may be subject to tax under section 527(f). For further information regarding political and lobbying activities of section 501(c) organizations, see Election Year Issues PDF, Political Campaign and Lobbying Activities of IRC 501(c)(4), (c)(5), and (c)(6) Organizations PDF, and Revenue Ruling 2004-6.

Additional information

l Life Cycle of a Social Welfare Organization

l Electronically Submit Your Form 8976, Notice of Intent to Operate Under Section 501(c)(4)

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Source: https://www.irs.gov/charities-non-profits/churches-integrated-auxiliaries-and-conventions-or-associations-of-churches

Churches (including integrated auxiliaries and conventions or associations of churches) that meet the requirements of section 501(c)(3) of the Internal Revenue Code are automatically considered tax exempt and are not required to apply for and obtain recognition of exempt status from the IRS. Donors are allowed to claim a charitable deduction for donations to a church that meets the section 501(c)(3) requirements even though the church has neither sought nor received IRS recognition that it is tax exempt. In addition, because churches and certain other religious organizations are not required to file an annual return or notice with the IRS, they are not subject to automatic revocation of exemption for failure to file. See Annual Return Filing Exceptions for a complete list of organizations that are not required to file.

Nevertheless, many churches do seek IRS recognition of tax-exempt status because that recognition provides reliance to church leaders, members and contributors that a church is recognized as exempt from taxation and is eligible to receive tax-deductible contributions. (For more information, see Publication 1828, Tax Guide for Churches and Religious Organizations PDF.)

Some organizations that identify themselves as churches may appear on the Automatic Revocation of Exemption List (Auto-Revocation List) because IRS records do not identify them as churches, but rather as some other type of organization that has an annual

filing requirement. Because these organizations failed to file annual returns or notices for three consecutive years, they appear on the Auto-Revocation List. Donors to these organizations may no longer rely on an IRS determination letter dated before the effective date of revocation or a prior listing in Exempt Organizations Select Check (Pub. 78 database) or in the IRS Business Master File (BMF) extract for purposes of claiming tax-deductible contributions. However, if an organization on the Auto-Revocation List is a church that meets the requirements of section 501(c)(3), it remains exempt from taxation and eligible to receive tax-deductible charitable contributions even though the IRS no longer recognizes the exempt status of the organization in Exempt Organizations Select Check (Pub. 78 database), in the BMF extract or in a determination letter.

A church on the Auto-Revocation List that wishes to receive a determination letter from the IRS recognizing its exempt status and to appear in Exempt Organizations Select Check (Pub. 78 database) and to have its exempt status reflected in the BMF extract must apply for reinstatement of tax-exempt status. Because the list is an official IRS record of organizations that lost their exempt status for failing to file for three consecutive years, an organization whose exempt status is reinstated remains on the list, however.

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CHURCHES, INTEGRATED AUXILIARIES, AND CONVENTIONS OR ASSOCIATIONS OF CHURCHES

http://www.irs.gov/charities-non-profits/churches-integrated-auxiliaries-and-conventions-or-associations-of-churches



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SURRAN: In order to be tax-exempt, an organization must meet certain criteria that are specifically defined by the Internal Revenue Code. Organizations that receive exemption from taxes under the IRC are charities, churches, and any other organizations which are operated for tax-exempt purposes. A 501(c)(3) nonprofit organization is a charitable organization that the IRS recognizes as tax-exempt. This type of organization does not pay income tax on its earnings or on the donations it receives. Any taxpayer’s donation may reduce a taxpayer’s taxable income by the donation amount.

To be tax-exempt under section 501(c)(3), an organization must be organized and operated exclusively for exempt purposes as set forth in section 501(c)(3) and none of its earnings may inure to any private shareholder or individual. In addition, it may not attempt to influence legislation as a substantial part of its activities and it may not participate in any campaign activity for or against political candidates.

MORIARTY: Accountants and auditors need to be knowledgeable in the area of tax exemption rules and regulations, and most are. However, they also need to be aware of the things that could potentially jeopardize an organization’s tax-exempt status. In this segment we’ll explore four requirements that, if not satisfied, can affect an organization’s tax-exempt status.

They are inurement, lobbying, political activities and unrelated business income. Helping us to understand these potential minefields is Allen Fetterman.

Allen lectures extensively throughout the country on not-for-profit accounting related issues and is a CPA and long-time discussion leader for Kaplan Financial Education,

Allen reviews the four areas of concern for tax-exempt organizations I just highlighted.

FETTERMAN: Tax-exempt organizations really have four areas they need to be concerned with that could jeopardize their tax-exempt status.

The first one is that 501(c)(3) organizations may not be used for the private benefit of any individual, nor may their earnings inure to the benefit of others, or insiders. Secondly, 501(c)(3) organizations may only engage in legislative activities to a limited extent. I'm going to say this clearly, 501(c)(3) organizations may lobby, but they're limited. Thirdly, 501(c)(3) organizations are forbidden to engage in political activities.

And last, number four, a 501(c)(3) organization will lose its exempt status if it operates for the primary purpose of carrying on an unrelated trade or business.

MORIARTY: The first area of concern Allen mentioned was inurement. So what constitutes inurement? To whom does it refer? What are some examples? Allen Fetterman explains

FETTERMAN: No part of a 501(c)(3) organization's net earnings may inure to the benefit of a private individual. I mentioned that already.

Video Transcript


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t Inurement refers to benefits conferred on insiders, such as officers, directors, or key employees.

Examples of prohibited inurement include unreasonable compensation and the transfer of real or personal property for less than fair market value.

Now, understand that the prohibition on inurement is absolute. Any amount of inurement is grounds for loss of tax-exempt status. But on the other side, prohibited inurement does not include reasonable payments for services rendered or payments made for the fair market value of property.

MORIARTY: So what actually constitutes an excess benefit transaction? How does an organization know that what it is doing is crossing the line? Allen discusses the key issues

FETTERMAN: An excess benefit transaction is any transaction between a 501(c)(3) or a 501(c)(4) organization and a disqualified person in which the economic benefit is greater than the value of the consideration provided for the benefit.

For example, unreasonable compensation for services or a non-fair market value transaction. So, what we really need to know is, okay, great, what is a disqualified person? A disqualified person is any person at any time during a five-year period ending on the date of the transaction, so it's a five-year lookback, in a position to exercise substantial influence over the affairs of the organization.

MORIARTY: Next Allen tells us what the penalties are for participating in an excess benefit transaction.

FETTERMAN: There's an excise tax equal to 25% of the excise benefit that is imposed on each excess benefit transaction between the tax-exempt organization and a disqualified person.

If the transaction itself is not corrected within the taxable period, then there's an additional excise tax equal to 200% of the excess benefit imposed on any disqualified person involved.

If the tax is imposed on a disqualified person, that means the person that received the excess benefit, not necessarily the charity, for any excess benefit transaction then there's an excise tax equal to 10% of the excess benefit that's imposed on an organization manager who knowingly participated in an excess benefit transaction, unless such participation was not willful and was due to a reasonable cause.

An organization manager includes officers, directors, trustees of a tax-exempt organization, or for that matter, any individual having similar powers or responsibilities regardless of title. So, this is a very pervasive excise tax. It's on the recipient, it's on the managers. It could theoretically, a disqualified person, I didn't mention this a moment ago, but a thought just occurred to me. It could be a substantial donor, any person that's able to exercise influence over the organization.

MORIARTY: An organization can create what’s called a rebuttable presumption of reasonableness and payments under a compensation arrangement are presumed to be reasonable if three conditions are met. Allen describes what those three conditions are.

FETTERMAN: Number one, the transaction needs to be approved by an authorized body of the entity that is composed of individuals who do not have a conflict of interest concerning the transaction, that's usually the governing board.

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t Number two, before making that determination of reasonableness, the authorized body, that is the governing board, obtains and relies upon appropriate data as to comparability.

They might look at other organizations' 990s, but they have to be similar size, similar structure, similar programs, similar geographic location, so they can rely on that data or they could hire, for example, a compensation consultant and rely on data provided by that person.

Then number three, the authorized body, the board, adequately documents the basis for the determination concurrently with making the determination.

So, to summarize, approval by the board based on appropriate data as to comparability and documented. Do all three of those, we create a rebuttable presumption of reasonableness, and then should the IRS challenge the reasonableness of the compensation, the burden of proof falls on the IRS. If however, we do not establish this rebuttable presumption of reasonableness and the IRS challenges the reasonableness of a compensation of, let's say, the CEO, then the burden of proof that it's reasonable falls on the charity. And this is such a simple way to transfer the burden of proof to the IRS.

MORIARTY: The second area that an organization needs to be concerned with that could jeopardize their tax-exempt status is lobbying. Allen Fetterman explains what constitutes lobbying and whether or not there are any exceptions.

FETTERMAN: Well, simply put, lobbying is defined as an attempt to influence legislation. Influencing legislation, there really are two ways they can do it, direct lobbying, in which case where we're contacting legislators directly or grassroots lobbying, where we are urging the public to contact legislators. It could be members or employees of a legislative body, all for the purpose of proposing, supporting or opposing legislation.

The following are not treated as lobbying, nonpartisan analysis, research, public education, public meetings, distributing public materials or educational materials and the provision of advice to a governmental body in response to a request. Grassroots organizing is not considered lobbying such as litigation and communications between the organization and its members with respect to legislation. Unless of course, that communication is urging its members to lobby, then it would be considered lobbying.

Also, self-defense lobbying is not considered lobbying, for example, communications to legislators regarding the organization's existence or tax-exempt status. That self-defense lobbying is permitted in all cases.

SURRAN: If lobbying activities are substantial, a 501(c)(3) organization risks losing its tax-exempt status, and may be subject to an excise tax.

Substantiality is measured by one of the following two tests, either the substantial part test or the expenditure test. The substantial part test determines the substantiality of lobbying on the basis of all the pertinent facts and circumstances in each case.

The IRS considers many factors in this determination, including the time devoted, including not only compensated employees, but volunteer workers and the expenditures devoted to the activity. And under the substantial part test, an organization that conducts excessive lobbying in

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t any taxable year may lose its tax-exempt status, and may be subject to an excise tax.

Public charities may elect to use what's called the expenditure test under section 501(h), which is an objective test using formulas to set ceilings for lobbying expenditures that varies from 5% to 20% of exempt purpose expenditures. The lobbying amount is capped under this test at $1 million per year.

Churches and private foundations may not use the expenditure test, they must rely on the substantial part test.

Organizations may elect to use the expenditure test by filing form 5768 at any time during the year for which they want it to become effective. And the election remains in effect until it's revoked by the organization.

MORIARTY: As Allen indicated, if lobbying expenditures are substantial a 501(c)(3) organization risks losing its tax-exempt status. However, there are other types of organizations that can lobby. Allen offers some examples.

FETTERMAN: Sections 501(c)(4), (c)(5) and (c)(6) organizations may lobby. However, there is no deduction allowed for donations or membership dues used for lobbying. Section 501(c)(4), (5) and (6) organizations must notify their members that a portion of dues that are not deductible, that portion of the dues are not deductible because they relate to lobbying activities.

Now, for example, I am a member of the American Institute of CPAs, which is a 501(c)(6) organization. Obviously, it's an organization that does lobby to support the profession, the lobbying is done predominantly in Washington DC. They have an obligation to notify its members what amount of their dues or what proportion of their dues has been used by the AICPA to go to lobbying, because that amount of dues is no longer tax deductible on a tax on the payer's tax return.

That said, however, an organization does not have to provide the notice to its members if it establishes that substantially all the dues paid to it are not deductible by its members, for any reason, it's not a business type of organization and the members are not entitled to a business deduction or a charitable contribution deduction. And remember, they're not (c)(3), so it wouldn't apply in that case, then the 501(c)(4), (5), or (6) organization does not have to provide that notice.

And if member dues are used for lobbying and the dues are deductible by the members and notifications are not sent to the members by the 501(c)(4), (5), or (6) organization, in that case, then the organization must pay a proxy tax on the lobbying expenditures. And the proxy tax is paid at the corporate rate. And it's paid on form 990-T, which is the unrelated business income tax form, which we'll talk about later.

So, many 501(c)(6) organizations elect not to notify their members that some portion of their dues are not tax deductible. They just pay the proxy tax.

MORIARTY: So far we have covered two of the four areas that could jeopardize an organization’s tax-exempt status: inurement and lobbying. The next area we will consider is political activities. Allen tells us whether or not 501(c)(3) organizations can participate in those.

FETTERMAN: Section 501(c)(3) organizations, as I mentioned right up front in this session, are prohibited from directly or indirectly participating or

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t intervening in any political campaign on behalf of or in opposition to any candidate for elective public office.

That includes making or soliciting contributions for, on behalf of, or against any candidate for public office, state, or local or national, or to a political party. It includes endorsing or opposing a particular candidate or political party, rating a candidate, no matter how objective the rating may be. It also includes making statements in support of or in opposition to a candidate or political party using the organization's resources for example, office space, telephones, employee time, to engage in political campaign activities. And not inviting all candidates to speak in a public forum. All those are examples of political campaign activity that's prohibited.

Generally, 501(c)(3) organizations are allowed to conduct non-partisan activities that educate the public and help them participate in the electoral process.

For example, presenting at public forums and publishing voter education guides so long as that activity is conducted in a non-partisan manner, that would not be considered political campaign activity.

MORIARTY: Allen tells us what the penalties are if a 501(c)(3) engages into political activities.

FETTERMAN: Well, violation of the prohibition on political campaign activity may result in the revocation of tax-exempt status and/or the imposition of an excise tax on the political expenditures. An excise tax may also be imposed against the organization managers who agree to the expenditures knowing that they were political. Once again, organization managers could include officers, directors, trustees, et cetera. So, just like again with lobbying and with inurement, there are potential penalties against the organization managers beside the organization.

MORIARTY: What about the other types of organizations? Are there any similar prohibitions from participating in political campaign activities? Allen Fetterman answers these questions.

FETTERMAN: 501(c)(4), (c)(5) and (c)(6) organizations are allowed to be involved in campaign activity so long as it is not their primary activity. The expenses incurred with such political activities are subject to attacks. However... So, (4)s, (5)s and (6)s just can do it, but they have to be careful. However, and this is tricky. If a 501(c)(3) organization provides funds to a 501(c)(4), (c)(5) or (c)(6) organization that engages in political activity, then the 501(c)(3) organization must assure that the funds that they've provided to these other organizations are used solely for 501(c)(3) type exempt activities and not for political campaign activities.

So this eliminates the possibility of a (c)(3) setting up a (c)(4) controlled organization, funneling its money into the (c)(4) and the (c)(4) using that for campaign activity, that cannot be done.

MORIARTY: We know that an exempt organization is not taxed on its income from activities substantially related to its exempt purpose. Next Allen tells us what happens if the organization conducts activities that are not related to its exempt purpose.

FETTERMAN: Well, an exempt organization is not taxed on its income from an activity substantially related to its charitable, educational or other purpose that constitutes the basis of its tax exemption. Such income is exempt, by the

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t way, even if the activity is a trade or business so long as it's related to the basis for their exemption, it's not taxed, the profit is not taxed.

However, if an exempt organization regularly carries on one or more trades or businesses not substantially related to its exempt purposes, the organization may be subject to a tax on its income from these activities. And that's called unrelated business income. The tax on it is unrelated business income tax. So, we've got UBI and UBIT.

So, use by the organization of the profits derived from this activity in furtherance of its exempt purposes does not make the activity substantially related to its exempt purposes.

I've had over the years that I've been in the tax-exempt world, which is now 54 years, I've had many exempt organizations ask me, "Well, wait a minute. If we run a trade or business simply to generate funds to carry out our exempt purpose, doesn't that make the trade or business related?" And the answer is no.

A trade or business does not become directly related to your exempt purpose just because you're using the money for its exempt purpose. The trade or business must be directly related to your exempt purpose in order to avoid unrelated business income tax. The tax on unrelated business income applies to most organizations exempt from tax under section 501(a). Remember, organizations are exempt under 501(a), not 501(c). 501(c) describes organizations exempt under 501(a), I just want to make sure everyone understands that.

These organizations include charitable, religious, scientific and other organizations described in 501(c). 501(c)(3) organizations may engage in income-producing activities unrelated to their tax-exempt purpose, so long as the unrelated activities are not a substantial part of the organization's overall activities. That's a brief summary overview of the unrelated business income activities rules.

SURRAN: As Allen Fetterman stated, even though an organization is recognized as tax-exempt, it still may be liable for tax on its unrelated business income.

Unrelated business income is the fourth area of concern for tax-exempt organizations that could jeopardize its tax-exempt status.

And again the other three are inurement, lobbying and political activities. For most organizations, unrelated business income is income from a trade or business that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization’s exemption.

An exempt organization that has $1,000 or more of gross income from an unrelated business must file Form 990-T. The obligation to file Form 990-T is in addition to the obligation to file the annual information return, Form 990, 990-EZ or 990-PF.

MORIARTY: For most organizations, an activity is an unrelated business if it meets three requirements.

One is that it is a trade or business. Two it is regularly carried on and three it is not substantially related to furthering the exempt purpose of the organization.

Allen describes what constitutes a trade or business in greater detail.

FETTERMAN: The first requirement is that it constitutes a trade or business. The term trade or business includes any activity carried on for the production of

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t income from selling goods or services; an activity must be conducted with the intent to make a profit to constitute a trade a business. I mean, think about it. If anybody, any organization or person, goes into an activity without the intent to make a profit, sounds like a hobby, it's not a trade or business.

So, okay. That's the first thing. An activity doesn't lose its identity as a trade or business merely because it is conducted within a larger group of similar activities that may or may not be related to the exempt purposes of the organization. For example, soliciting, selling and publishing commercial advertising is a trade or business, even though the advertising is published in an exempt organization's periodical that contains editorial matter related to the organization's exempt purposes.

Think of a church or synagogue's monthly bulletin. It has a lot of editorial information, that's great, all related to the program, what they're doing for the community, for their members. And on the back maybe they accept advertisements from local vendors and merchants. Advertising is an unrelated business activity, even if conducted within the monthly bulletin, which is part of their program.

Examples of unrelated trade or business activities include things such as sale of merchandise, sale of publications, advertising, debt management plan services, even if the debt management plan services are held for other tax-exempt organizations.

Gaming, except bingo, bingo is unique, we'll touch on bingo in a little while, and rental income, but only when there's an associated acquisition indebtedness, so- called unrelated debt-financed income, which we can chat about if you wish in a few moments.

MORIARTY: Next Allen describes the activities that are excluded from unrelated business income.

FETTERMAN: Generally the following are excluded from unrelated business income.

Dividends, interest, and other investment income, royalties, rents from real property. However, rents from personal property are not excluded from unrelated business income and there are special rules for mixed leases of both real and personal property.

Also excluded from UBI is gains from the disposition of property. So, those are the general exclusions: rent, royalties, interest, dividends, gains, but these exclusions do not apply to debt-financed income. That is when there is acquisition indebtedness related to the property.

MORIARTY: Allen describes what activities are excluded from the definition of a trade or business.

FETTERMAN: There are a number of areas that are excluded from the definition of a trade or business. Remember I said, it has to be a trade or business. So, here's what is not considered a trade or business.

Bingo, if it meets certain requirements, activities conducted for the convenience of members, students, patients, officers, employees, think hospital gift shop, think school store, college bookstore. Convention and trade show activity is excluded, distribution of low-cost articles incidental to the solicitation of contributions. You send in a $100 contribution, you get a T-shirt, that's not considered a trade or business.

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t Exchange or rental of member or donor lists between organizations described in section 501 that are eligible to receive charitable contributions, mostly (c)(3)s obviously. (OUT)

This is one that is frequently overlooked, that you can rent your member or donor list to another 501(c)(3), and that's not considered a trade or business.

Sales of donated merchandise is not considered a trade or business. And if substantially all the work is performed without compensation. Again, substantially is not defined. I would look at it as more than 50%. I wouldn't look at that as substantially at all, but I would look at 85% as a general rule of thumb.

So, for bingo, remember, I've mentioned now twice that bingo may be excluded. For bingo to be excluded from the definition of a trade or business, the bingo game must meet the legal definition of bingo.

Instant bingo, that's where you get these pull tabs, you buy a pre-packaged card, you pull the tabs and the player removes them to determine if he or she is a winner, that does not qualify as bingo, that instant bingo game.

Also, in order for bingo to be excluded, it has to be legal where it's played and it has to be played in a jurisdiction where bingo games are not regularly conducted by for-profit organizations. And that gets back to the commerciality doctrine. The IRS doesn't want to give nonprofits or tax-exempt entities an unfair advantage over taxable entities. So, they say bingo is conducted regularly by for-profit organizations in your area, then it doesn't qualify. Then it doesn't qualify as exempt from a definition of a trade or business.

MORIARTY: Allen indicated that the second requirement that an organization must meet in order to be considered unrelated business is that the trade or business must be regularly carried on. He elaborates on that issue.

FETTERMAN: Well, now that we've discussed what constitutes and does not constitute a trade or business, we get to that second requirement, it has to be regularly carried on. Business activities are considered regularly carried on if they show a frequency and continuity and are pursued in a manner similar to commercial activities of non-exempt organizations.

Here are some examples, a hospital auxiliary’s operation of a sandwich stand for two weeks at a state fair would not be the regular conduct of a trade or business, since the stand would not compete with similar activities that non-exempt organizations would ordinarily operate year round.

On the other hand, operating a commercial parking lot every Saturday year round would be the regular conduct of a trade or business, because it is going to compete with for-profit parking lots. That's, again, that commerciality doctrine.

MORIARTY: Allen mentioned earlier that the trade or business must not be substantially related to the organization's exempt purpose to be subject to the unrelated business income tax. Next he explains further what this means.

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t FETTERMAN: Well, an activity is not substantially related to an organization's exempt purpose if it does not contribute importantly to accomplishing that purpose, other than through the production of income. And I touched on it briefly when we first started talking about unrelated business income. Remember, if an organization runs a trade or business that's regularly carried on, but they say, "Well, we're only running it to make some money so we can improve our programs or spend more on our programs," that does not by itself make that activity related to its exempt purpose. The activity has to contribute importantly directly to the exempt purpose. And whether the activity does do that really depends in each case on the facts involved.

In determining whether activities contribute importantly to the accomplishment of an exempt purpose, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt purpose that they are intended to serve.

Now, many of you are probably familiar with the form 990 Part VIII, which is revenue, and other than contribution revenue, we are asked to allocate each revenue line into one of three columns related to the exempt purpose, exempt, and that's usually the interest, dividends, rents and royalties exception, and unrelated, and the unrelated becomes potentially unrelated business taxable income.

MORIARTY: Are there any deductions allowed against gross unrelated business income? Allen explains.

FETTERMAN: Well, just like businesses are allowed to deduct expenses related to generating their revenue, nonprofits are allowed to take certain deductions of expenses against their unrelated business income. To qualify as an allowable deduction in computing UBTI, unrelated business taxable income. That's the third acronym.

We've talked about UBI, unrelated business income, UBIT, unrelated business income tax. Now I mentioned UBTI, unrelated business taxable income. So, that's the gross income less deductions.

They're allowed expenses and losses that generally can be directly connected with carrying out the unrelated trade or business to which they relate. For example, trade or business expenses, interest expense, losses. In addition, deductions are allowed for charitable contributions and there's a $1,000 specific deduction that nonprofits are permitted to take.

MORIARTY: Allen tells us where to go to obtain more information on unrelated business income and the resultant tax.

FETTERMAN: The IRS publishes Publication 598 entitled Tax on Unrelated Business Income of Exempt Organizations. I strongly recommend that if you are with an organization or you're an auditor or advisor to an organization that may be subject to unrelated business income tax, read that publication.

Also, the IRS has created a page for information about Publication 598. You can find that at a website, irs.gov/pub, P-U-B, 598, and it has information about any future developments affecting Publication 598, such as legislation enacted after the publication is released. And it will be posted on that site.

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t MORIARTY: Allen Fetterman leaves us with his final thoughts on the topic of tax-exempt status and jeopardizing activities.

FETTERMAN: I've always felt that auditors and accountants serving the needs of the tax-exempt community should be aware of more than just how to prepare a 990. They should be knowledgeable in the area of tax exemption, rules, regulations, and laws. I've been stressing lately that many organizations and their auditors are aware of what they need to do to maintain their exempt status and obtain it in the first place.

But they're still not quite sure about these four areas, inurement, lobbying, political activities and unrelated business income.

I was actually told by the CEO of a charity, not a small organization, let's call it a mid-sized charity and a wonderful organization by the way. She told me, "We are not permitted to lobby." And I said, "Yes, you are." She said, "No, we're not permitted to lobby." And I said, "Well, you actually are, there are limitations, but you are permitted to lobby."

And this is a very intelligent person, the CEO, and she didn't know she was allowed to lobby. And obviously she was told that by somebody. So there are other people who don't know. So I think it's important, as a takeaway from this session, that these are four areas that we should be familiar with. If we're involved with tax-exempt organizations, either as management or as advisors, consultants, auditors, we should have a general understanding of what we've discussed today. And for unrelated business income, I would take a careful look at Publication 598.

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Evaluation Form

Please rate the segments on the July 2021 issue 5 = Excellent, 4 = Very Good, 3 = Good, 2 = Fair, 1 = Poor

Please comment on each segment you used. (Attach additional pages if needed.)

I. Segment

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4. Net Investment Income Tax, Trust, Estate & Gift Tax & More _____ _____ _____ _____ _____

5. Tax-Exempt Status: Jeopardizing Activities _____ _____ _____ _____ _____

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rm Please rate the discussion leaders 5 = Excellent, 4 = Very Good, 3 = Good, 2 = Fair, 1 = Poor

II. Discussion Leader

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A. By Citation Accounting Standards Update – see: ASU

ASU No. 2014-09 June – 5

SU No. 2016-13 April – 2

ASU No. 2017-02 October – 1

FASB or Financial Accounting Standards Board – see: ASU

IRS Notice 2020-32 January – 2

IRS Notice 2020-50 August – 3

IRS Notice 2020-51 August – 3

IRS Notice 2020-65 December – 4

IRS Rev. Proc. 2016-47 December – 1

IRS Rev. Proc. 2020-23 October – 4

IRS Rev. Proc. 2020-46 December – 1

IRS Rev Proc 2020-51 January – 2

SSARS No. 25 December – 1

Statement on Standards for Accounting & Review Services – see: SSARS

Tibble v. Edison August – 4

B. By Topic Accounting, diversity in December – 2

AICPA Audit Guide, 2020 May – 5

American Families Plan, key proposals of the June – 4

American Rescue Plan Act (ARPA) April – 4; May – 4; June – 4

ASC Topic 326, FASB's reasons for issuing April – 2

ASC Topic 606, implementation of January – 4

ASC Topic 718 August – 1

ASC Topic 842, pandemic and October – 1

ASC Topic 842, transition to Jult – 2

Automobile depreciation September – 3

Bankruptcy, COVID-19 and September – 1

Big data, finance and January – 4

Bitcoin and Ethereum December – 3

Blockchain, accounting and June – 1

Blockchain, managing inventory & transactions with June – 1

Blockchain, tax implications of December – 3

Brand licensing, ethics and January – 3

Brand, personal May – 3

Business roundtable statement May – 2

Businesses, effect of COVID-19 on September – 2

Index

Note: At the request of several subscribers, this Index reflects the most recent 11 months of CPAR programming rather than the current calendar year.

August 2020 – July 2021

B–2

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CAA, disaster relief and February – 4

CAA, tax relief and February – 4

CAMs, auditor independence and September – 4

CAMs, inventory observation challenges October – 2

CARES Act February – 1

CARES Act, not-for-profits and February – 5

CECL, COVID-19 and April – 2

Chapter 11 September – 1

Common Reporting Standard (CRS) November – 2

Consolidated Appropriations Act 2021 (CAA) Feb. – 4; April – 4

Corporate misconduct, reasons for May – 2

COVID-19, challenges companies face due to Aug. – 1; Sept. – 2

COVID-19, economy and August – 1

Critical audit matters – see: CAM

Cryptocurrency June – 1

Current Expected Credit Losses (CECL) April – 2

Cybersecurity, internal audit and Jan. – 1; June – 1

Data analytics, business vs. audit May- 1

Data security and privacy November – 3

Debt Instruments, significant modifications of October – 4

De minimis use rule November – 1

Digital assets, tax implications of December – 3

Digital currency transactions, IRS and July – 4

Dirty Dozen Tax Scams and COVID-19 September – 3

Distributions & loans, CARES Act August – 3

Diversity, equity and inclusion (DEI) December – 2

Dodd-Frank Act, transparency and October – 4

Dodd-Frank Act, whistleblower complaints and September – 4

Earnings management, reasons to perform September – 4

Earnings per share (EPS) July- 3

Economic Aid Act Feb. – 1; Feb. – 2

Economic Impact Payments, third round (EIP3) May – 4

Economic value added (EVA) July – 3

Employee and employer donations, special August – 3

Employee Retention Credit April – 4

Employee stock options April – 1

Employee stock ownership plan (ESOP) November – 4

Environmental, social and governance (ESG) issues Oct. – 4; April – 3

Ethics and compliance, management of May – 2

Ethics, tax planning and August – 2

ETSC, definition of November – 4

Executive compensation, COVID-19 and Aug. – 1; Oct. – 2

FASB & GASB Chairman Collaboration April – 5

FASB and IASB convergence project June – 5

FASB, pandemic and February – 3

FATCA, Common Report Standard and November – 2

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/ JU

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1

B–3

Fiduciary litigation, key issues August – 4

Financial statements, COVID-19 and August – 1

Five-year lookback rule November – 1

Flexible Spending Account (FSA) April – 4

Fraud triangle October – 2

FTE Safe Harbor February – 2

GASB revenue and expense recognition project June – 5

Global Forum on Transparency and Exchange of Information November – 2

Going concern analysis October – 2

Going concern considerations February – 5

Goodwill impairment, COVID-19 and October – 1

Governmental Accounting Standards Board (GASB) April – 5

Human capital April – 3

IESBA Technology Project August – 2

Internal audit and internal controls, difference between November – 3

Internal auditing, COVID-19 and January – 1

Internal auditing, technology and January – 1

Internal controls programs, advantages and disadvantages of November – 3

Internal controls, not-for-profits and February – 5

Internal controls, risk assessment and November – 3

International Ethics Standards Board for Accountants August – 2

International Ethics Standards Board for Accountants – see: IESBA

International Standard for Review Engagements 2400 December – 1`

IPOs and SPACs July – 1

IRC Section 409A April – 1

IRC section 501(c)(3), tax-exempt organizations and July – 5

IRC section 501(c)(6), tax-exempt status and Feb. – 1

IRS Form 941X, existing and revised October – 3

IRS Notice 2020-69, purpose of GILTI under November – 1

Lease-based donation , special tax breaks for August – 3

Leases, accounting for July – 2

Licensing, impact of technology on January – 3

Net Investment Income (NII) Tax July – 4

Next generation internal auditing December – 2

Next Generation Internal Audit study, 2020 January- 1

No Action Letter, SEC and September – 4

Not-for-profits, finance and accounting challenges for February – 5

OMB Compliance Supplement, 2020 May – 5

OSHA, whistleblower complaints and September – 4

Payroll tax deferral Oct. – 3; Dec. – 4

Personal brand, auditing your May – 3

PPP loan forgiveness, deductability of expenses for January – 2

PPP loan obligations January – 2

PPP, changes to February – 4

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B–4B–4B–4

PPP, second draw Feb. – 1; Feb. – 2

Principal-Agent problem April – 1

Privacy, social media and January – 4

Qualified retirement plans November – 4

Qualified opportunity zones, tax benefits of August – 3

Regulation S-K April – 3

Retirement plan regulations, changes to February – 4

Return on investment (ROI) July – 4

Revenue and expense recognition, three approaches June – 5

Revised Uniform Unclaimed Property Act (RUUPA) June – 2; June – 3

SSARS No. 25, purpose of December – 1

SBA PPP loans September – 1

SBA, second program February – 1

Schedules K-2 & K-3 September – 3

SECURE Act Aug.- 3; Nov. – 4

Small Business Reorganization Act of 2019 Sept. – 1

Social credit model January – 4

SOX, whistleblower complaints and September – 4

Special purpose acquisition companies (SPACs) July – 1

State and local taxes, limit on deductibility of September – 1

Stock options, primary forms of April – 1

Strength, weaknesses, opportunities and threats (SWOT) analysis December – 2

Sustainability Accounting Standards Board (SASB) Oct. – 4; April – 3

Sustainability, long-term April – 3

Task Force on Climate-related Financial Disclosures (TCFD) October – 2

Tax Cuts and Jobs Act – see: TCJA

Tax-exempt status, activities that jeopardize July – 5

TCJA, IRC Section 118 and October – 4

Technology, GASB and April – 5

Triggers, single vs. double stock option April – 1

Trusts and estates, final regulations for November – 1

Unclaimed property, audits and June – 3

Unclaimed property laws June – 2; June – 3

Unclaimed property, types of June – 2

Uniform Prudent Management of Institutional Funds Act (UPMIFA) February – 5

Valuation analysis, COVID-19 and September – 2

Virtual currencies, valuation of December – 3

Whistleblower complaints September – 4

W-2 reporting & deferral, IRS guidance on December – 4

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Group Attendance and CPE Recordgr

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d Company __________________________________________________ Date __________________

Segment Title _______________________________________________________________________

Location of Seminar _______________________________________________________________

SS# Name State Hours Earned

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I hereby certify that the above individuals viewed this portion of CPA Report, participated in the group discussion, and earned the recommended hours of CPE credit.

Discussion leader _______________________________ Date completed ____________

All CPE hours listed are recommended. They are developed in a manner consistent with AICPA guidelines. Since CPE requirements vary by state and/or professional organization, we suggest you contact the appropriate organization for information about their requirements.

JULY 2021 ‘21 summary summary summary summary

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