The Act contains several provisions that affect pass-through entities. The most substantial change is a provision that creates a 20 percent deduction for certain kinds of “qualified business income” (Section 199A). Other changes might be better characterized as technical corrections or legislative reversals of court decisions that upended long-standing IRS positions.
Deduction for Qualified Business Income of Pass-Through Entities (IRC Section 199A)
The following discussion references “partners” but the deduction applies to partners in entities taxed as partnerships and shareholders in entities electing to be taxed as S-corporations.
- Generally speaking, partners are taxable on the income of a partnership and they pay tax based on their applicable federal rate which, in the case of individual partners, is going to be their individual tax rate. The highest individual rate is 37%. The deduction allows a taxpayer to claim a deduction to reduce the effective rate of tax. The provision is hugely complicated and subject to numerous limitations and exceptions.
- Briefly, the deduction is equal to the sum of:
- The lesser of (i) the taxpayer’s “combined qualified business income amount” or (ii) 20 percent of the excess of the taxpayer’s taxable income for the taxable year over any net capital gain plus the aggregate amount of qualified cooperative dividends, plus
- The lesser of (i) 20 percent of the aggregate amount of the qualified cooperative dividends of the taxpayer for the taxable year or (ii) the taxpayer’s taxable income (reduced by the net capital gain).
- A taxpayer’s “combined qualified business income” amount is generally equal to the sum of (i) 20 percent of the taxpayer’s qualified business income with respect to each qualified trade or business plus (ii) 20 percent of the aggregate amount of qualified real estate investment trust dividends and qualified publicly traded partnership income.
- “Qualified Business Income” is subject to a limitation equal to the greater of (i) 50 percent of the partner’s allocable share of W-2 wages paid by the partnership for a qualified trade or business or (ii) the sum of 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis of qualified property determined immediately after its acquisition (i.e., its undepreciated cost basis). The limitation for qualified business income is not applicable to taxpayers who file jointly and have less than $315,000 in taxable income ($157,500 for other filers). A taxpayer’s wages are not considered to be qualified business income.
- A “Qualified Trade or Business” is any business other than a “specified service trade or business” or the trade or business of providing services as an employee. For the most part, the deduction is not available to professionals or other services where the income producing element is the sale of the skill, expertise or reputation of the partnership and its employees providing the services (e.g., health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services). Financial service firms are also excluded. However, the exclusion does not apply for taxpayers with income below certain thresholds ($415,000 for joint filers and $207,500 for other filers). Application of this exclusion is phased in for income exceeding $315,000 and $157,500, respectively.
- “Qualified Property” is generally tangible property used in a qualified trade or business and subject to depreciation under IRC Section 167(i), provided it is used to generate qualified trade or business income and that it is still within the applicable depreciation period from when it was originally placed in service. This is generally viewed as a gift to the real estate industry although it would also be of help to any partners in partnerships that are highly asset intensive.
- Loss carryovers from a qualified trade or business will reduce the deduction in the following year.
- The new deduction will put a huge emphasis on what is considered to be reasonable compensation and will create yet another reason for taxpayers to want to be taxed as independent contractors rather than employees.
Recharacterization Of Certain Long-Term Capital Gains (IRC Sections 1061 and 83)
- Under prior law, no matter how long an individual was a partner in a partnership, the character of the gain or loss on the sale of partnership assets was characterized as short term or long term based on how long the partnership has held the asset. The gain or loss on the sale of the partnership interest was gain from the sale of a capital asset and was characterized as long term or short term capital gain based on how long the partner had held the interest. In either case, assets or an interest held for more than one year produced long term capital gain.
- The Act provides that if a partner receives an interest in a partnership for services and the partnership is engaged in an “applicable trade or business,” the partnership interest will be an “applicable partnership interest.” As a consequence,
- Assets sold by the partnership must be held by the partnership for more than three years before the gain will be characterized as long term capital gain; and
- An applicable partnership interest must be held for at least three years by the transferor partner before the gain on the sale of the interest will be characterized as long term capital gain.
- A partnership is engaged in “applicable trade or business” if the activity is conducted on a regular, continuous, and substantial basis consisting of raising or returning capital and either
- investing in, or disposing of, “specified assets” or
- developing such “specified assets.”
- “Specified assets” include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing.
- An “applicable partnership interest” for purposes of the gain on the sale of the interest does not include
- interests held by a corporation or
- other interests to the extent (a) the partner made a capital contribution in exchange for a capital interest or (b) recognized gain on the receipt of the interest as a result of a Section 83(b) election.
- The exception for an interest that is the subject of a Section 83(b) election is limited to the holding period for the interest itself, meaning gain on the sale of the interest has a holding period of only one year. However, if the interest subject to a Section 83(b) election is otherwise an “applicable partnership interest,” the holder of that interest still has short term capital gain if the partnership sells assets that it held for three years or less.
- The provision is targeted at hedge funds and real estate funds that generally have a short term holding period for assets but it can also have an unfortunate impact in other businesses if the three year holding period is not met.
- In the already complicated world of partnership reporting, this provision will add an additional layer of complexity since so many of the consequences are partner specific. It also remains to be seen how the rules will flow through tiered partnerships.
Taxation of Gain on the Sale of Partnership Interest by a Foreign Person (IRC Sections 864(c) and 1446)
- A 2017 US Tax Court case, Grecian Magnesite Mining, Indus. & Shipping Co., SA v. Commissioner, 149 T.C. No. 3 (2017), ruled against the IRS and overturned longstanding rulings holding that the sale of an interest engaged in a US trade or business by foreign taxpayer gives rise to effectively connected income taxable in the United States. The Court ruled that the partnership interest was a capital asset and under normal sourcing rules and the treaty in effect, the gain on the sale was allocable solely to the country where the foreign partner was a resident.
- The Act legislatively reversed the Tax Court for transactions effective after November 27, 2017. Gain or loss from the sale or exchange of a partnership interest is effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange.
- In addition, the Act requires the transferee of a partnership interest to withhold 10 percent of the gross purchase price on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation. If the transferee fails to withhold the correct amount, the partnership is required to deduct and withhold from distributions to the transferee partner an amount equal to the amount the transferee failed to withhold.
Repeal of the Technical Termination Rules Under IRC Section 708(b)(1)(B)
- The IRS and the Treasury Department have long sought to do away with the so-called “technical termination” rules for partnerships.
- The rules were largely a trap for the unwary and invalidated certain elections and forced a restart of depreciation periods for partnership assets if 50 percent or more of the capital and profits interests were the subject of certain transfers within a twelve month period. The rules also allowed partnerships to get rid of undesirable elections and create new entities for tax purposes without forming a new entity. The Treasury scored the change as being a revenue raiser.
Modification of the Definition of Substantial Built-In Loss in the Case of a Transfer of a Partnership Interest (IRC Section 743(d))
- Partnerships are required to adjust the basis of certain assets upon the sale or exchange of an interest in a partnership if there is a substantial built-in loss in the assets (i.e., the adjusted basis in property exceeds by $250,000 the fair market value of that property). Otherwise, adjustments are not mandated unless a partnership has an election in place under IRC Section 754.
- Under prior law, a substantial built-in loss was defined as the partnership having an aggregate adjusted basis in all of its assets of at least $250,000 more than the fair market value of all of its assets. This meant that a partnership could have particular assets with built-in losses of more than $250,000 and still not have a built-in loss in the aggregate that would trigger a mandatory basis adjustment.
- Under the Act, in addition to the present-law definition, the definition of a substantial built-in loss is expanded to include a hypothetical disposition by the partnership of all partnership’s assets in a fully taxable transaction for cash equal to the assets’ fair market value, if immediately after the transfer of the partnership interest, the transferee would be allocated a net loss upon such hypothetical disposition in excess of $250,000. Thus, where individual assets might trigger partner-specific allocations of built-in losses, the partnership would be required to reduce the basis of those assets with respect to that transferee.
Charitable Contributions and Foreign Taxes Taken into Account in Determining Basis Limitation (Section 704(D))
- The Act limits the ability of a partner to deduct charitable contributions or foreign taxes paid by a partnership to the extent they exceed the partner’s basis in its partnership interest. For purposes of charitable contributions, there is an exception that allows a partner to deduct its allocable share of the fair market value of property.
S Corporation Conversion to C Corporation (IRC Sections 481 and 1371)
- For a two year period starting on December 22, 2017, S corporations with earnings and profits derived during prior C corporation status may convert back to a C corporation, and subsequent distributions from that entity will be treated as paid from its accumulated adjustment account and from its earnings and profits on a proportional basis. This will enable a portion of post-conversion distributions to be made tax-free until the accumulated adjustment account is reduced to zero. This tax treatment under the Act is only available if the entity has the same owners and those same owners hold the identical proportional stock interests on both December 22, 2017 and on the date of revocation of the S election. Under prior law, all distributions made after the post-termination transition period (i.e., one year period after conversion) were treated as having been taken from earnings and profits only and would be included as taxable dividends in the year of distribution.
- The Act also gives shareholders the ability to spread the impact of any income adjustment resulting from a conversion to C corporation status over six years under Section 481(a) by deeming it to be a change in accounting method.
Changes Affecting Electing Small Business Trusts (ESBTS) (IRC Sections 1361, 641, 642 and 170)
- ESBTs can now include foreign taxpayers as beneficiaries. Note, a foreign taxpayer still cannot be an S corporation shareholder, so termination provisions of the trust have to be drafted to avoid that possibility.
- The charitable deduction of an ESBT will be determined by the rules applicable to individuals instead of the rules applicable to trusts. The percentage limitations and carryforward provisions applicable to individuals will apply to charitable contributions made by the portion of an ESBT holding S corporation stock.