By Darden Bell, CPA, Tax Senior Manager
This article was written with information available as of February 16, 2018. The article covers a code section which was included in the “Tax Cuts and Jobs Act” signed into law on December 22, 2017. The IRS is expected to release regulations and other publications to clarifying the specific provisions covered in this Act. Please consult your tax advisor for up-to-date information and to discuss how this provision affects your specific situation.
The Tax Cuts and Jobs Act enacted the most comprehensive tax reform our country has seen in over 30 years. While there has been a major focus on corporate taxation, there are also major changes that will impact pass-through entities and their owners. While there are numerous changes that will impact all businesses regardless of entity type, this article will focus on the changes specific to pass-through entities.
Certain changes, such as the interest expense limitation, full expensing of shorter lived assets (100% bonus depreciation), the expanded Section 179 deduction, changes to the depreciation rules, changes to how Net Operating Losses can be utilized, and a handful of other regulations will impact all businesses regardless of entity type. You can find articles addressing these topics on our blog.
The major changes that are specific to pass-through entities and their owners include:
- The 20% Qualified Business Income Deduction,
- The Excess Business Loss Limitation,
- The Elongated Holding Period for Carried Interest Partners,
- The Repeal of the Partnership Technical Termination Rule,
- The Modification of the “Substantial Built-In Loss” Rule,
- The Modification of how Charitable Contributions Impact Partnership Basis,
- The “Look-Through Rule” Application to Gain on Sale of Partnership Interests, and
- The Treatment of Revocations of S Corporation Elections.
Pass-Through Deduction and Excess Business Loss Limitations
The 20% Qualified Business Income Deduction and the Excess Business Loss Limitations will be extremely impactful on the owners of pass-through entities. Otherwise known as the “Pass-through Deduction,” the 20% deduction of qualified business income was enacted to place pass-through business in similar footing to C Corporations with the corporate tax rate dropping. The Excess Business Loss Limitations prevent taxpayers from utilizing more than $500,000 of losses from their pass-through businesses to offset other sources of income in any given year. Due to their breadth and significance of these topics, our firm produced separate articles for each topic, which you can find here:
Elongated Holding Period for Carried Interest Partners
Many businesses in the investment and real estate industries elect to be taxed as partnerships due to favorable tax laws. One of those favorable laws has always been the availability of carried interests. A carried interest is a profits interest in a partnership in exchange for services. Depending on the facts and circumstances at the time of issuance, these carried interests can often be issued taxed free. Many hedge fund managers have made substantial amounts of income but pay the least amount of tax possible by utilizing carried interests. Prior to the new law, a taxpayer who held a carried interest in a partnership only needed to hold that interest for one year to receive long-term capital gain treatment on the gain from disposition of that interest. This allowed these taxpayers to convert what otherwise would have been ordinary income compensation into long-term capital gain by holding the interest for at least one year. The new law now requires that owners of carried interests hold their interests for at least three years in order to get the favorable long-term capital gain treatment. That three year holding period now also applies to the underlying assets of the partnership in addition to the partnership interest. This rule was put in place to stop perceived abuses, but in reality, it may not have that much of an impact. Most carried interest holders typically hold their carried interest for three years or more anyway, but the look through to the underlying assets’ holding period could snag quite a few taxpayers.
Repeal of the Partnership Technical Termination Rule
Prior to the Tax Cuts and Jobs Act, any partnership that experienced a 50% or more change in total ownership percentages over a rolling twelve month period was deemed to have terminated under the technical termination rules of IRC Sec. 708. Those rules required that depreciation restart on all fixed assets held by the company and that all previous tax elections be considered void. Those rules also resulted in many short-period tax years requiring a final tax return be filed for the old partnership as of the date of the technical termination. These old rules caused a lot of headache for taxpayers and resulted in loads of late filing penalties because taxpayers often did not realize they had inadvertently “terminated” the business during the year. The new law has repealed those old technical termination rules related to a change of 50% or more of total ownership in a twelve month period. We no longer have to worry about filing final tax returns for short periods, no longer have to restart depreciation, nor have to remake all tax elections. This change provides taxpayers substantial relief from administrative burden. Partnerships are now only considered terminated when the business actually shuts down.
Modification of the “Substantial Built-In Loss” Rule
Under the old rules, if there was a sale or exchange of a partnership interest, and at that time, the fair market value (FMV) of all partnership assets was below the partnership’s basis in the assets in the magnitude of $250,000 or more, the partnership was required to step down the basis in their assets to equal the lower fair market value at the date of the sale or exchange. This comparison of fair market value versus basis is for all assets combined, not each asset separately. Under the new law, the old rule still applies, but they’ve added a second test to apply. Now, in addition to considering aggregate FMV versus basis, we also have to consider how losses would be allocated to the partners if there were a hypothetical sale of all partnership assets for cash equal to their FMV. If the transferee of the partnership interest would have been allocated a loss of $250,000 or more under the hypothetical sale analysis, then we now have to step down the basis of partnership assets to equal FMV. Partnerships whose assets may have declined in value need to consider this issue before approving the sale or exchange of any partner’s interest. This step down in basis is mandatory, not elective, and it applies to all partnership assets. Therefore, one exiting partner could essentially trigger a very bad tax outcome for the partnership they are leaving behind. Partnerships may want to consider enhancing their restrictions on transfers of ownership should they feel this may apply to them.
Modification of How Charitable Contributions Impact Partnership Basis
Under the old law, a partner in a partnership had to reduce their basis (capital account) by their share of the fair market value of charitable contributions made by the entity. This was the case regardless of what the partnership’s basis in the asset(s) donated. The new law has modified this treatment so that partnerships are aligned with S Corporations on how donations impact basis. Now, when a partnership donates an appreciated asset, the partners only have to reduce their basis in their partnership interest by their share of the partnership’s basis in the asset – not by the fair market value. This allows partnerships to take advantage of the same benefit allowed to S Corporations and Individual taxpayers; there is no taxable recognition of the asset’s appreciation, a deduction is still allowed for the full fair market value, and the taxpayer only has to reduce their partnership basis by their share of the partnership’s basis in the donated asset. This was a big win for partnerships, especially since charitable donations will likely be utilized far more often moving forward given the restrictions on most other itemized deductions at the individual level.
“Look-Through” Rule Application to Gain on Sale of Partnership Interests
If a partnership has a foreign partner, and that partner sells their interest in the partnership, we now have to apply the “Look-Through” rule at the time of sale. We now have to analyze a hypothetical sale of all partnership property equal to fair market value as of the date of the sale or exchange. If under that hypothetical sale the foreign partner would be allocated income from the sale of business assets, they are deemed to have income that is effectively connected with a U.S. trade or business. The sale of their partnership interest would no longer be considered the sale of just a capital asset. Should that foreign investor be allocated income under the hypothetical sale scenario and thus have effectively connected income, the partnership must now withhold 10% of the amount realized on the sale or exchange unless the transferor certifies that they are not a nonresident alien individual or foreign corporation. In other words, partnerships may now have to withhold 10% of sales proceeds from a foreign partner’s sale of their partnership interest because there is effectively connected income built in to the underlying partnership they are selling. This is mandatory, and the responsibility falls squarely on the partnership, not on the foreign partner selling their interest.
Treatment of Revocations of S Corporation Elections
There were not many changes that specifically impacted S Corporations, but there were two significant changes related to changing the S Status to C Corporation status. With the reduction of the C Corporation tax rate, the IRS expected many S Corporations to terminate or invalidate their S elections to be taxed as a C Corporation moving forward. When an S Corporation coverts to a C Corporation, there are many things that could change from a tax accounting perspective. Should any accounting methods change upon conversion, and that change results in the corporation recognizing additional income relative to the change in method, the IRS will allow eligible converted corporations to spread that positive income adjustment over a six year period instead of the normal four year period. There are a few criteria that must be met to be considered an eligible converted corporation, but none are difficult to achieve.
The other major change related to S to C Corp conversions involves distributions made from the corporation after conversion. Under old law, when an S Corporation converted to a C Corporation, the first distributions that came out of the entity were allocated to AAA (i.e. prior cumulative undistributed earnings) of the S Corporation before being allocated to Earnings & Profit (E&P) of the C Corp, thus keeping them tax free until all S Corporation AAA had been utilized. Under the new law, distributions made by an eligible converted corporation will be allocated to AAA and E&P proportionately. Therefore, a portion of the distributions after conversion will be treated as nontaxable distributions from the S Corp AAA, but a portion may also be treated as taxable dividends from the C Corporation relative to the C Corporations E&P.
Due to the pervasive nature the Tax Cuts and Jobs Act, it is imperative that all taxpayers be aware of what changes will impact them and how. In most cases, the facts and circumstances of a taxpayer’s situation will dictate the ultimate impact of these changes.
Should you have any questions or need any clarity on the matters discussed in this article, feel free to reach out to me, or your Keiter professional for further assistance. Email | Phone: 804.747.0000. We are here to help.
About the Author
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.