2018 Tax Alert - Taxation of Pass-Through Entities
The following is the Taxation of Pass-Through Entities section of the 2018 client advisory "Tax Alert: How the New Tax Laws Will Affect You Now and in the Future."
The full version of this client advisory is available here.
New Deduction – For tax years after 2017 and before 2026, the new law permits certain non-corporate owners (i.e., owners who are individuals, trusts, or estates) of certain partnerships, S corporations and sole proprietorships to claim a 20% deduction against "qualified business income". This can be a significant benefit to individuals who are owners of these businesses and are in a high tax bracket. For a taxpayer who is in the highest tax bracket under the new law of 37%, this provision reduces the tax rate on "qualified business income" to 29.5%.
There are numerous limitations on the income that is eligible to qualify for this deduction. First, the income must be "qualified business income." "Qualified business income" is all domestic business income other than investment income (e.g., dividends (other than qualified REIT dividends and cooperative dividends)), investment interest income, short-term capital gains, long-term capital gains, commodities gains, foreign currency gains, etc. Qualified business income does not include an amount paid to the taxpayer by an S corporation as reasonable compensation. Further, it does not include a payment by a partnership to a partner in exchange for services (regardless of whether that payment is characterized as a guaranteed payment or one made to a partner acting outside his or her partner capacity.
Qualified business income also does not include income from a "specified service trade or business." A specified service trade or business is any trade or business activity involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services; any trade or business of which the principal asset is the reputation or skill of one or more of its owners or employees; or any business that involves the performance of services that consist of investment and investment managing trading or dealing in securities, partnership interest, or commodities. There is a question regarding whether architecture and engineering companies are included since at the last minute these industries were dropped from the specified list, but still could fall under the general catch-all provision. However, the deduction may apply to income from a specified service trade or business if the taxpayer's taxable income does not exceed $315,000 (for married individuals filing jointly or $157,500 for other individuals). Under the new law, this benefit is phased out over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals).
For each qualified trade or business, the taxpayer is allowed to deduct 20% of the qualified business income for that trade or business. Generally, the deduction is limited to 50% of the W-2 wages paid with respect to the business. Alternatively, capital-intensive businesses may get a higher benefit under a rule that takes into consideration 25% of wages paid plus a portion of the business's basis in its tangible assets. Each business is treated separately and so it appears that taxpayers will not be able to aggregate separate business units in computing W-2 wages and/or capital basis. Although the benefit may be limited, this provision does allow the 20% deduction if a taxpayer's taxable income is below the threshold amount of $157,500 for individuals and $315,000 for joint filers.
The 20% deduction is not used in computing adjusted gross income. Rather the deduction is allowed as a deduction reducing taxable income. Thus, the deduction does not affect limitations based on adjusted gross income. Moreover, the deduction is available to taxpayers that itemize deductions, as well as those that do not.
Partnership Terminations – Another change affecting pass-through entities includes the elimination of the technical termination rules for partnerships with tax years beginning after December 31, 2017. Under current law, a partnership had a technical termination if 50% or more of the total interests in partnership capital and profits were sold or exchanged within a 12-month period. Thus, the partnership's taxable year closed, any partnership-level elections terminated, and the partnership's depreciation recovery periods were restarted. The new law changes these rules by treating the partnership as continuing even if more than 50% of the total capital and profit interests of partnership are sold or exchanged. New elections would not be required or permitted.
Gain on the Sale of a Partnership Interest – For partnerships with foreign partners, the Act requires withholding on the sale or exchange of an interest in a partnership engaged in a U.S. trade or business. These sales are treated as generating income 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. Thus, for sales and exchanges of an interest in a partnership engaged in a US. trade or business after December 31, 2017, the transferee is required to withhold 10% of the amount realized.
Carried Interest – The Act also made changes to the taxation of a "carried interest." "Carried interest" refers to the share of profits or gains from investment received by a manager of a private equity fund, hedge fund, or similar investment vehicle, which is typically unrelated to any capital investment by the manager. Currently, carried interest is generally taxed at favorable long-term capital gain rates. Under the Act, the holding period in order to realize the favorable capital gain treatment is increased from 12 months to 3 years. Failure to satisfy the 3-year holding requirement results in treatment as short-term capital gain.
S Corporation Conversion to C Corporation – The Act provides beneficial tax treatment to an "eligible terminated S corporation", which is any C corporation: (i) that was an S corporation on the day before the date of enactment and revokes its S election in the two-year period beginning on the date of such enactment (so, applicable to revocations in 2018 and 2019); and (ii) the owners of the stock of which (determined on the date on which such revocation is made) are the same and such owners hold the stock in the same proportions as on the date of enactment.
Under the new law, an eligible terminated S corporation would receive a more favorable IRC Section 481 adjustment arising from an accounting method change attributable to the corporation's revocation of its S corporation election. Prior to the Act, an S corporation that converted to a C corporation was required to include any income resulting from that change over four tax years. Pursuant to the Act, income recognition is stretched out and taken into account ratably during the six-year tax period beginning with the year of the method change.
In addition, the Act revises the treatment of distributions made by S corporations following their conversion to C corporation status. Prior to the Act, distributions by an S corporation made within a certain time period known as PTTP, (the period which ends on the later of one year from the last day the corporation was an S corporation, or the due date for filing the last return of the S corporation) generally are treated as coming first from the S corporation's accumulated adjustments account ("AAA"), which is an account that tracks the income of the S corporation that already has been taxed to its shareholders but has not yet been distributed to its shareholders. Once AAA is reduced in its entirety by the distribution, then any excess distribution is treated as coming from any earnings and profits ("E&P") of the corporation generated when it was a C corporation. For a shareholder, distributions out of AAA generally are more favorable, as such distributions are tax-free to the extent of the shareholder's basis in its S corporation stock and then as giving rise to capital gain for the shareholder whereas distributions out of E&P are treated as dividends.
The Act extends the beneficial treatment of distributions for eligible terminated S corporations beyond the PTTP. Pursuant to the Act, when there is a distribution of money by an eligible terminated S corporation, the accumulated adjustments account is allocated to such distribution, and the distribution is chargeable to accumulated earnings and profits, in the same ratio as the amount of the accumulated adjustments account to the amount of the accumulated earnings and profits.
Substantial Built-in Loss Rules – Prior to the Act, a partnership does not automatically adjust the basis of partnership property following the transfer of a partnership interest unless either the partnership has made an election under IRC Section 754 to make the basis adjustments, or the partnership has a substantial built-in loss immediately after the transfer. If an election is in effect, or if the partnership has a substantial built-in loss immediately after the transfer, adjustments are made with respect just to the transferee partner.
Prior to the Act, a substantial built-in loss exists if the partnership's adjusted basis in its property exceeds the fair market value of the partnership property by more than $250,000. The Act modifies the definition of a substantial built-in loss to include a situation where 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 the partnership's assets in a fully taxable transaction for cash equal to the assets' fair market value. This new definition takes into consideration whether the transfer of the interest has the effect of transferring a loss in excess of $250,000 to the transferee, rather than just whether the partnership itself has an overall loss in its assets. Therefore, even if the partnership has an overall gain upon the sale of all of its assets, if the transferee would be allocated more than $250,000 in losses, as a result of its share of gain or loss with respect to particular assets, then a mandatory adjustment is required.
Basis Limitation on Partner Losses – The basis limitation on the deductibility of partner losses applies to a partner's distributive share of charitable contributions and foreign taxes, which were previously excluded prior to the Act.
Limitation of Excess Business Losses – The Act changes the treatment of losses of taxpayers other than C corporations. Under the new law, an excess business loss is disallowed for the tax year. An "excess business loss" for the tax year is $500,000 for married individuals filing jointly or $250,000 for other individuals. Any excess business loss of the taxpayer is treated as part of an NOL and carried forward to subsequent tax years.
In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Therefore, each partner or shareholder's share of the items of the entity is taken into account in calculating the partner or shareholder's limitation.
The Act has made substantial changes to the tax laws. There are many "glitches" in the Act that will need to be addressed in technical correction legislation. Since technical correction legislation requires a 60% vote in the Senate (it cannot come under reconciliation rules), there will need to be bi-partisan cooperation to fix the problems that such fast paced passage of the Act produced. Second, technical corrections require unanimous consent by both the majority and minority staffs of the House Committee on Ways and Means and the Senate Finance Committee. If anyone disagrees about the legislative intent of a provision and whether the statute reflects that intent, then the provision is not a technical correction but, rather, a change in policy. Thus it may take quite a while for any technical correction legislation to be passed.
Effective tax planning including choice of entity structures will be made based on the new laws that are now in effect. Only time will tell how these changes will impact individuals, businesses, and the economy.
If you have any particular area of interest or concern regarding how these changes directly affect you or your business, please feel free to contact our tax attorneys, Cheryl Johnson or Jen Green.
This communication is intended for general information purposes and as a service to clients and friends of Verrill Dana, LLP. This publication, which may be considered advertising under the ethical rules of certain jurisdictions, should not be construed as legal advice or a legal opinion on any specific facts or circumstances, nor does it create attorney-client privilege.