Yes, it sounds odd.
It is also seems to be at odds with this blog’s constant refrain of “Thou shalt not pursue any undertaking solely for tax purposes, but thou shalt first consider the business purpose for such undertaking and, if thou findeth such purpose worthy of attainment, then, and only then, shalt thou contemplate the tax benefit, but never shalt thou lose sight of your primary business purpose.”[i]
OK. How does that tie in to the title of this post? Well, all things being equal, the point during the tax year that a pass-through entity (“PTE”) sells its qualified business may have a significant impact upon the Sec. 199A deduction that may be claimed by the PTE’s non-corporate owners.
A quick review of some Sec. 199A basics may be helpful.[ii]
Section 199A Limitations
In general, Section 199A provides non-corporate taxpayers with a deduction for a tax year equal to 20% of their qualified business income (“QBI”) for such year.
There are, however, certain limitations that may reduce the amount of the deduction that may be claimed by a taxpayer. One of these is tied to the taxpayer’s taxable income for the year; the other – which only applies to a taxpayer with taxable income in excess of a prescribed threshold and phase-in amount – is tied to (1) the W-2 wages paid by the business to its employees during the tax year, and (2) the unadjusted basis of certain depreciable tangible property (“qualified property”) held by the business at the close of the tax year.
199A Applied at Shareholder/Partner Level
Generally speaking, for purposes of Section 199A, a non-corporate taxpayer – meaning an individual, a trust, or an estate – is treated as being engaged in any qualified trade or business carried on by a PTE of which the taxpayer is an owner.
Thus, the Section 199A rules are applied at the level of the S corporation shareholder, or at the level of the partner/member of the partnership/LLC, with each shareholder or partner taking into account their allocable share of the PTE’s QBI, as well as their share of the PTE’s W-2 wages and unadjusted basis (for purposes of applying the above-referenced limitations).[iii]
Qualified Business Income – In General
Section 199A is primarily concerned with the operating (i.e., ordinary) income that is generated by the PTE entity, and passed through to its owners, during the ordinary course of its business. Thus, investment income is excluded from an entity’s QBI; this would include any capital gain recognized by the PTE.
A PTE does not typically generate capital gain in the ordinary course of its business; rather, it generates ordinary income from the sale of products or services, or from the leasing/licensing of its property. That is not to say that it never has such gain; for example, a business that sells vacant land, that it had previously held for purposes of a possible future expansion, may recognize capital gain on such sale. This gain would not constitute an item of QBI.
Sale of Assets – In General
Of course, a PTE is most likely to recognize capital gain on the sale of all, or substantially all, of its business assets. This sale may be effected in a number of ways.
Actual Sale. The business may simply sell its assets to a buyer, or it may merge into the buyer, in exchange for cash and/or a promissory note (or other deferred payment, such as an earn-out) and/or other property.
Deemed Sale. Alternatively, in the case of an S corporation, the shareholders may sell its stock and then elect (either jointly with the buyer, or on their own) to treat the stock sale as a sale of the corporation’s assets. Similar treatment may be accorded to the partners of a partnership who sell all of their partnership interests to a buyer, though without the need for a special election.
Nature of the Gain. The nature of the gain recognized by the PTE will depend upon the character of the assets being sold; the amount of such gain will depend upon the allocation of the purchase price among the assets being sold and the entity’s adjusted basis for such assets. The character of the gain included in a shareholder’s or a partner’s allocable share of S corporation or partnership gain is determined as if it were realized directly from the source from which it was realized by the PTE.
Thus, any income realized on the sale of accounts receivable or inventory will be treated as ordinary income. The gain realized on the sale of a capital asset, on the sale of property used in the trade or business of a character that may be depreciable, or on the sale of real property used in a trade or business, will generally be treated as capital gain.
Section 199A and the Sale of a Business
As indicated above, the tax treatment of an M&A transaction, like the actual or deemed sale of assets by a business, was certainly not what Congress was focused on when Section 199A was conceived.
After all, the non-corporate owners of PTEs already enjoy a single level of tax (generally no tax at the entity-level, unlike a C corporation) and a preferential 20% tax rate for capital gains.[iv]
That being said, Section 199A will play a role in the sale of a business owned by a PTE with non-corporate owners where the transaction is treated as a sale of assets for tax purposes.
At the same time, the sale of the business, and the timing of such sale – i.e., the point in the tax year at which the sale occurs – may impact a non-corporate owner’s ability to fully enjoy the benefit of a Section 199A deduction.
Let’s review each of these points.
Although the Section 199A deduction is often described in shorthand as being equal to 20% of a taxpayer’s QBI, the actual formulation is much more involved.
Specifically, a non-corporate taxpayer’s Section 199A deduction for a tax year is equal to the lesser of:
(1) the taxpayer’s “qualified business income amount” for that tax year, or
(2) 20% of the excess of:
(a) the taxpayer’s taxable income, over
(b) the taxpayer’s capital gain, for the tax year.
Assume for this purpose that the taxpayer owns equity in only one PTE, and that there are no REIT dividends or PTP income. Assume also that the limitations based on W-2 wages and the “unadjusted basis” of qualified property are fully applicable because the taxpayer’s taxable income exceeds the prescribed threshold and phase-in amounts.
Qualified Business Income Amount. In that case, the taxpayer’s qualified business income amount for the tax year is equal to the lesser of:
(1) 20% of the taxpayer’s QBI, or
(2) the greater of:
(a) 50% of the W-2 wages with respect to the business, or
(b) 25% of such wages plus 2.5% of the unadjusted basis of its qualified property.
Thus, the greater the amount of W-2 wages paid by a business during the tax year, and the greater the unadjusted basis of the property held by the business at the close of its tax year, the closer to the full 20% deduction the taxpayer is likely to come.
Income from the Sale of Assets. Assume that the PTE sells its assets to an unrelated party in a fully taxable exchange for cash at closing.
As we saw above, the nature of the gain recognized by the pass-through entity on the sale of its assets – which will be passed through to its owners for tax purposes – will depend upon the nature of the asset sold.
Thus, the gain from the sale of inventory and receivables will be treated as ordinary; the gain from the sale of tangible personal property which has been depreciated is likely to be ordinary as well (so-called “depreciation recapture”).
The gain from the sale of real property that is used in the pass-through entity’s business will be treated as capital, as will the gain from the sale of the goodwill and going concern value of the business. In many cases, the single largest component of the gain resulting from the sale of a business is attributable to its goodwill.
Qualified Business Income – Sale of Assets
What does this treatment mean for purposes of Section 199A?
The Code provides that the term QBI means, for any tax year, the net amount of “qualified items” of income, gain, deduction and loss with respect to a qualified trade or business of the taxpayer.
Qualified items does not include any item of capital gain or capital loss. According to the Regulations, to the extent an item is not treated as an item of capital gain or capital loss under any provision of the Code, such item shall be taken into account as a qualified item of income, gain, deduction or loss for purposes of determining QBI.
Thus, gain generated from the sale of assets that is treated as ordinary income will be included in QBI, while gain that is treated as capital will not be; both will be included in taxable income for purposes of applying the above limitation (based on 20% of the excess of a taxpayer’s taxable income over the taxpayer’s capital gain).
W-2 Wages and Unadjusted Basis
What about the limitations based upon W-2 wages and unadjusted basis? How will these be affected by the sale of a business?
After a PTE sells its assets, it will usually cease to have a significant number of employees. For instance, if the sale was to a strategic buyer, that buyer may consolidate the PTE’s workforce with its own, or it may terminate many of the PTE’s former employees; in the case of a private equity buyer, its acquisition vehicle will typically hire the PTE’s workforce.
The Code recognized that where a qualified business was sold, the ability of the selling PTE to claim the Section 199A deduction would be impacted. Thus, the Code directed the IRS to issue regulations to address the application of the limitations in the case where the entity sold its business during the tax year.
W-2 Wages. According to the regulations issued by the IRS, when a business is sold, and the employees of the business thereby become employees of the buyer, their W-2 wages for the year of the sale must be allocated between the two employers (the seller and the buyer) based on the period during which they were employed by one and then the other.
In other words, in determining its limitation based on W-2 wages, the seller-employer can look only to the W-2 wages it paid to its employees through the date of the sale.
Unadjusted Basis. As regards the limitation that is based, in part, on the unadjusted basis of qualified property, the Code states that the property must be held by the business at the close of its tax year.
The Regulations conform to this position, having rejected a suggestion that they include a rule for determining the unadjusted basis of qualified property following the sale of a business similar to the guidance provided for purposes of calculating W-2 wages (based on the number of days the qualified property was held by the seller during the year – see above).
Thus, if a selling PTE does not hold any qualified property at the close of its taxable year, its owners cannot avail themselves of the alternative limitation based on the unadjusted basis of such property (i.e., 25% of W-2 wages, plus 2.5% of unadjusted basis).
This raises an interesting question.
S Corps & Section 338(h)(10)
When a PTE sells its assets, its tax year does not automatically close; something more is required. Specifically, the entity must liquidate, which will include the distribution to its owners of the net proceeds from the sale of the business.
But what if the PTE is an S corporation? When the shareholders of an S corporation sell their stock to a corporate buyer, and they join the buyer in electing to treat the stock sale as a sale of assets (under Section 338(h)(10) of the Code), the S corporation is treated as having sold its assets just before, and as having liquidated at, the end of the day that the sale occurred. That is the same day that the S corporation’s tax year closes.
Will the S corporation be treated as having held its assets as of the close of its tax year for purposes of applying the unadjusted basis limitation? The Regulations don’t tell us.
If so, will a PTE that actually sells its assets have to liquidate immediately afterward, on the day of the sale, so as to force the close of its tax year? That remains to be seen.
Timing of the Sale
As you may have gathered from the foregoing, the point during the year at which the PTE sells its business may impact the Section 199A deduction that may be claimed by its owners.
Let’s take the extreme: a sale on January 1 by an entity that uses the calendar year as its tax year. It has no QBI on that date except to the extent the sale generates ordinary income that is treated as QBI. If the bulk of the sale gain – and the bulk of the entity’s income for the year – is treated as capital gain, then the owners may be out of luck insofar as a Section 199A deduction is concerned.
Even the qualified business income generated in the sale may not result in a Section 199A deduction because the entity may not have paid much in the way of W-2 wages by the time of the sale. Remember: the taxpayer’s qualified business income amount for the tax year is equal to the lesser of: (i) 20% of the taxpayer’s QBI, or (ii) 50% of the W-2 wages[v] with respect to the business.[vi]
What’s more, the limitation based on 20% of the excess of (1) the taxpayer’s taxable income, over (2) the taxpayer’s capital gain, for the tax year, may be even lower than the limitation based on W-2 wages, where the taxpayer’s capital gain far exceeds their ordinary income.
On the other hand, if the sale occurs midyear, for example, the business will have generated more ordinary income from its normal operations, in addition to the gain from the sale of its assets. In other words, there will be more QBI that the owners will take into account in determining their Section 199A deduction, though there will also be more ordinary income on which they will be taxed.
At the same, the entity will have paid more W-2 wages by that time, so that the limitation is also increased.
Following this reasoning, a sale that occurs in December (again, assuming the entity uses a calendar year as its tax year) will allow the entity to generate almost a full year’s worth of QBI; it will also allow it to pay almost a full year’s worth of W-2 wages. Both these items should result in a larger Section 199A deduction for the owners of the PTE.
The one item that generally does not change during the course of the tax year, but which must be held at the end of the tax year in order to be accounted for in determining the limitation on the Section 199A deduction is the unadjusted basis for qualified property.
When this property is sold, then, by definition, the selling entity will not hold it at the end of its tax year. That being said, should it make a difference in the application of the rule where the sale of the business and the immediate liquidation of the seller (actual or deemed) occur on the same date, with the liquidation marking the end of the tax year; should the seller be treated as having held the property on such date for purposes of the rule? The IRS has not addressed this point.
In light of the foregoing, might a PTE owner that is being pressured by a buyer to sell its business early in its tax year argue for an increase in the sales price to the extent of any Section 199A tax benefit expected to be “lost?” As always, it will depend upon the taxpayer’s unique facts and circumstances, but prudence may dictate that the seller accept the deal being offered without regard to Section 199A.[vii]
[i] Yes, I saw “Spamalot” last week and I am still imitating Arthur and his knights, not to mention the taunting Frenchmen. Remember the Holy Hand Grenade? “And the Lord spake, saying, ‘First shalt thou take out the Holy Pin. Then, shalt thou count to three, no more, no less. Three shall be the number thou shalt count, and the number of the counting shall be three. Four shalt thou not count, nor either count thou two, excepting that thou then proceed to three. Five is right out! Once the number three, being the third number, be reached, then lobbest thou thy Holy Hand Grenade of Antioch towards thou foe, who being naughty in my sight, shall snuff it.'”
[ii] A reminder: the provision disappears after 2025.
[iii] Because the Section 199A limitations are applied at the level of the non-corporate shareholder or partner, without regard to the owner’s degree of involvement or participation in the conduct of the business, it is possible for owners with identical equity interests in the same pass-through entity to have very different Section 199A deductions; for example, one partner may have more taxable income than another (perhaps because they receive a so-called “guaranteed payment” for services rendered to the partnership), such that the limitations apply to the former but not to the latter.
[iv] If the non-corporate owner is a material participant in the business, they also avoid the 3.8% surtax on net investment income.
[v] Or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.
[vi] Query whether a change in control bonus payment made to the seller’s employees in connection with the sale would address this limitation. These must be attributable to QBI in order to be taken into account as W-2 wages. https://www.taxlawforchb.com/2017/04/beyond-purchase-price-the-tax-treatment-of-ma-deal-costs/ Of course, if the employer was not already planning for such a bonus in the first place, is the 199A juice worth the squeeze?
[vii] Bird in hand, and all that.