The Tax Cuts and Jobs Act of 2017 contain several provisions applicable to pass-through business entities (“PTEs”), which include partnerships (and LLCs that are treated as partnerships for federal income tax purposes), S corporations, and sole proprietorships, and the owners of the PTEs. Without an understanding and careful planning, navigating the new tax law can be like driving on a busy highway and not knowing which exit is your best option.
QUALIFIED BUSINESS INCOME DEDUCTION
For tax years beginning after December 31, 2017, and before January 1, 2026, an individual taxpayer who owns an equity interest in a PTE that is engaged in a qualified trade or business may deduct up to 20% of the qualified business income allocated to him from the PTE. The deduction, set out in new Section 199A of the Internal Revenue Code, unlike most deductions, is not applied in computing adjusted gross income (AGI); rather, it reduces taxable income.
The starting point to calculate the deduction is “qualified business income,” or QBI, and generally defined as domestic business income other than (1) investment-related income (such as dividends, investment interest income, capital gains, etc.) and (2) income in the nature of compensation (including guaranteed payments). The deduction is determined under a complex set of rules but, for most taxpayers, the deduction will equal the lesser of 20% of QBI or 20% of the excess of taxable income over net capital gain.
The deduction is limited to 50% of the taxpayer’s share of W-2 wages with respect to the business (or, if greater, 25% of such W-2 wages plus 2.5% of the basis of certain tangible depreciable property of the business). This limitation applies for taxpayers with taxable income exceeding $315,000 (for married individuals filing jointly) or $157,500 (for other individuals), and there is a phase-in of the limitation above those thresholds.
This benefit or incentive is restricted to favor businesses that invest in machinery, equipment, and other tangible assets. Thus, this deduction is not available to certain service business sectors including health, law, consulting, athletics, financial services, and brokerage services, but excludes engineering and architecture.
Planning opportunities to qualify for or maximize this deduction may be limited. First, some commentators have suggested that an S corporation shareholder or a partner in a partnership could reduce the amount paid to them by the entity for their services, thereby increasing the amount of their QBI and in turn, increasing the amount of the deduction under Section 199A. In the case of an S corporation, however, such planning may result in the Internal Revenue Service questioning the reasonableness of the compensation paid to the shareholder-employee.
A second potential planning opportunity is for the PTE to invest in more tangible property than it otherwise would have in order to set up a greater cap for the deduction. Such planning, however, would seem to fall under the category of the tax tail wagging the business dog. A third planning option suggested by some commentators is for an already organized C corporation to convert to PTE status. While such a conversion might allow the entity to take advantage of new Section 199A, the conversion of a C corporation to any other business form for tax purposes generally results in a myriad of adverse tax consequences.
With respect to certain partnership “profits interests” (sometimes called “carried interests”) received in exchange for services, the Act denies preferential long-term capital gain treatment unless the profits interest is held for 3 years. The 3-year holding period rule applies notwithstanding the rules of Internal Revenue Code Section 83 governing the taxation of property transferred in connection with the performance of services, and is unaffected by an election under Code Section 83(b) to potentially convert ordinary income into capital gains. The rule does not apply to C corporations or capital interests.
This rule only applies to profits interests in partnerships engaged in raising or returning capital and investing in, disposing of or developing so-called “specified assets” (including securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or certain derivative contracts, as well as interests in other partnerships to the extent of the investing partnership’s proportionate interest in the other partnerships). Further, to the extent the Secretary of the Treasury provides in Regulations or other guidance, this provision does not apply to income or gain attributable to any asset that is not held for portfolio investment on behalf of third party investors.
This provision applies to taxable years beginning after December 31, 2017.
For tax years of a partnership beginning after December 31, 2017, the new tax act repeals Internal Revenue Code Section 708 under which a partnership was treated as terminated (a technical termination) upon a sale or exchange of 50% or more of the total interests in partnership capital and profits within a one-year period. Under prior law, such a technical termination caused termination of certain tax attributes of the old partnership, closed the partnership’s tax year, terminated partnership-level elections, and reset depreciation recovery periods.
“SUBSTANTIAL BUILT-IN LOSS” MODIFIED
For transfers of partnership interests after December 31, 2017, the Act expands the definition of “substantial built-in loss” for purposes of determining when a partnership must adjust the basis of its property following the transfer of a partnership interest. A substantial built-in loss will exist if the transferee of a partnership interest would be allocated a net loss in excess of $250,000 upon a hypothetical disposition by the partnership of all of its assets in a fully taxable transaction for cash equal to the assets’ fair market value immediately after the transfer.
The current definition of “substantial built-in loss” remains in effect (i.e., a substantial built-in loss exists if the partnership’s adjusted basis in its property exceeds the property’s fair market value by $250,000). Thus, under the Act, the test for substantial built-in loss applies both at the partnership level and at the transferee partner level.
BASIS LIMITATION ON PARTNER LOSSES
As a general rule, a partner may only deduct a distributive share of partnership loss to the extent of the partner’s basis in the partnership. For taxable years of a partnership beginning after December 31, 2017, a partner’s distributive share of partnership charitable contributions and foreign taxes will be included in determining partnership loss, and therefore, the deductibility of these items will be subject to the basis limitation (the items are not part of the basis limitation calculation under current law). This change in the tax law is designed to address an inconsistency in the law prior to the Act between the basis limitation rules applicable to S corporation shareholders and partners in partnerships.
DISTRIBUTIONS AFTER S-CORPORATION CONVERSION TO C CORPORATION
Effective as of the Act’s enactment date, for certain S corporations that convert to C corporation status, distributions are treated as paid from the entity’s accumulated adjustments account (AAA) by the terminated S corporation in the same ratio as the AAA bears to the amount of the accumulated earnings and profits (E&P) on a pro-rata basis. Further, such entities will recognize any adjustments required due to a change in accounting method over a six-taxable-year period (an increase from the four-taxable-year period prescribed under old law). These provisions apply to a C corporation that was an S corporation on the day before the enactment of the Act, revoked the S-election during the following two-year period, and had the same owners (in the same proportions) on the enactment date and termination date. Prior to the Act, distributions of cash by a former S corporation to its shareholders (to the extent of the AAA) were tax-free to the shareholders.
QUALIFYING BENEFICIARIES OF ELECTING SMALL BUSINESS TRUST (ESBT)
Effective January 1, 2018, a non-resident alien individual may be a potential current beneficiary of an ESBT, which is a permissible shareholder of an S corporation. A non-resident alien individual, however, may not be a direct owner of an S corporation. Thus, an ESBT may not distribute the S corporation stock it holds to the nonresident alien beneficiary without terminating the S corporation election.
CHARITABLE CONTRIBUTIONS AND ESBTS
For tax years beginning after December 31, 2017, the charitable contribution deduction of an ESBT will be subject to the rules applicable to individuals, rather than the rules applicable to trusts. The individual rules include the percentage-of-AGI limitation on the deduction for charitable contributions, and a 5-year carryforward for contributions in excess of the limitation. Trusts are not subject to a percentage-of-AGI limitation.