In the weeks preceding the introduction of the bill that was just enacted as the Tax Cuts and Jobs Act (the “Act”), my colleagues teased me, “Lou, what are you going to do when Congress simplifies the Code?”

“Simplify?” I responded as I reached for the Merriam-Webster’s Dictionary that I have used since 1980 – it resides next to the HP scientific calculator that I have used since 1987 – change is not always a good thing – “Congress is incapable of simplifying anything.”

Tax Cuts and Jobs Act

“The word ‘simplify’,” I continued, “is defined as follows: to make simple or simpler; to reduce to basic essentials; to diminish in scope or complexity; to make more intelligible.”

After reviewing the final version of the legislation, two thoughts came to mind: first, Congress must not have a dictionary and, second, the most influential lobbying organization in Washington must be comprised entirely of tax professionals.

In order to better appreciate – if not fully understand – the changes wrought by the Act regarding the Federal taxation of trade or business income that is recognized, “directly or indirectly,” by non-corporate taxpayers, the reader should be reminded of the existing rules, and should also be made aware of the policy underlying the changes.


A business that is conducted by an individual as a sole proprietorship (whether directly or through a single-member LLC that is disregarded for tax purposes) is not treated as an entity separate from its owner. Rather, the owner is taxed directly on the income of the business.

A business that is conducted by two or more individuals as a general partnership, a state law limited partnership, or a state law limited liability company, is treated as a pass-through entity for tax purposes – a partnership. The partnership is not itself taxable on the income of the business. Rather, each partner/member is taxed on their distributive share of the partnership’s business income.

A corporation that is formed under state law to conduct a business is not itself taxable on the income of the business if it is a “small business corporation” and its shareholders elect to treat it as an S corporation. In that case, the corporation is treated as a pass-through entity for tax purposes. In general, it is not taxable on its business income; rather, its shareholders are taxed on their pro rata share of the S corporation’s business income.

In each of the foregoing situations, the business income of an individual owner of a sole proprietorship, a partnership, or an S corporation (each a “Pass-Through Entity” or “PTE”) is treated for tax purposes as though the owner had realized such income directly from the source from which it was realized by the PTE.

In determining the taxable business income generated by a PTE, the Code allows certain deductions that are “related” to the production of such income, including a deduction for the ordinary and necessary expenses that are paid or incurred by the PTE in carrying on the business.

Because business income is treated as ordinary income (as opposed to capital gain) for tax purposes, the taxable business income of the PTE is taxed to its individual owner(s) at the regular income tax rates.[1]

What’s Behind the Change?

The vast majority of closely-held businesses are organized as PTEs, and the vast majority of newly-formed closely-held businesses are organized as limited liability companies that are treated as partnerships or that are disregarded for tax purposes.[2]

In light of this reality, Congress sought to bestow some unique economic benefit or incentive upon the non-corporate owners of PTEs in the form of a new deduction, and reduced taxes.[3]

However, Congress restricted this benefit or incentive in several ways that reflect a bias in favor of businesses that invest in machinery, equipment, and other tangible assets:[4]

  • in general, it is limited to PTEs that do not involve only the performance of services;
  • it benefits only the net business income of the PTE that flows through to the taxpayer; it does not apply to any amount paid by the PTE to the taxpayer in respect of any services rendered by the taxpayer to the PTE;
  • it does not apply to the PTE’s investment income; it is limited to the PTE’s business income; and
  • the benefit is capped, based upon how much the PTE pays in wages or invests in machinery, equipment, and other tangible property.

Beginning in 2018: New Sec. 199A of the Code

For taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer[5] (a “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.

Qualified Trade or Business

Taxpayer’s qualified business income (“QBI”) is determined by each qualified trade or business (“QTB”) in which Taxpayer is an owner.[6] A QTB includes any trade or business conducted by a PTE other than a specified service trade or business.[7]

A “specified service trade or business” means any trade or business involving the performance of services in the fields of health, law, accounting, consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or which involves the performance of services that consist of investing and investment management, or trading or dealing in securities.[8] However, a trade or business that involves the performance of engineering or architectural services is not a “specified service.”

Qualified Business Income

Taxpayer’s QBI from a QTB for a taxable year means Taxpayer’s share of the net amount of qualified items of income, gain, deduction, and loss that are taken into account in determining the taxable income of the QTB for that year.[9]

Items of income, gain, deduction, and loss are “qualified items” only to the extent they are effectively connected with the PTE’s conduct of a QTB within the U.S.[10]

“Qualified items” do not include specified investment-related income, gain, deductions, or loss; for example, items of gain taken into account in determining net long-term capital gain, dividends, and interest income (other than that which is properly allocable to a trade or business) are not included[11]; nor are items of deduction or loss allocable to such income.

Taxpayer’s QBI also does not include any amount paid to Taxpayer by an S corporation that is treated as reasonable compensation for services rendered by Taxpayer. Similarly, Taxpayer’s QBI does not include any “guaranteed payment” made by a partnership to Taxpayer for services rendered by Taxpayer.[12]

The Deduction

In general, Taxpayer is allowed a deduction for any taxable year of an amount equal to the lesser of:

(a) Taxpayer’s “combined QBI amount” for the taxable year, or

(b) an amount equal to 20% of the excess (if any) of

(i) Taxpayer’s taxable income for the taxable year, over

(ii) any net capital gain for the taxable year.

The combined QBI amount for the taxable year is equal to the sum of the “deductible amounts” determined for each QTB “carried on” by Taxpayer through a PTE.[13]

Taxpayer’s deductible amount for each QTB is the lesser of:

(a) 20% of the Taxpayer’s share of QBI with respect to the QTB, or

(b) the greater of:

(i) 50% of the “W-2 wages” with respect to the QTB, or

(ii) the sum of:

(A) 25% of the W-2 wages with respect to the QTB, plus

(B) 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property”.[14]

In general, the W-2 wages with respect to a QTB for a taxable year are the total wages subject to wage withholding, plus any elective deferrals, plus any deferred compensation paid by the QTB with respect to the employment of its employees during the calendar year ending during the taxable year of Taxpayer.[15]

“Qualified property” means, with respect to any QTB for a taxable year, tangible property of a character subject to depreciation that is held by, and available for use in, the QTB at the close of the taxable year, which is used at any point during the taxable year in the production of QBI, and for which the depreciable period[16] has not ended before the close of the taxable year.


The taxpayer is single. She is a member of an LLC (“Company”) that is treated as a partnership for tax purposes (a PTE). The company is engaged in a QTB that is not a specified service trade or business.

Taxpayer’s taxable income for 2018 is $500,000 (i.e., gross income of $520,000 less itemized deductions of $20,000), which includes a guaranteed payment from Company of $120,000, for services rendered to Company during 2018, and her allocable share of QBI from Company for 2018 of $400,000. She has no investment income for 2018.

Her allocable share of W-2 wages with respect to Company’s business for 2018 is $300,000.

During 2018, Company purchases machinery and immediately places it into service in its QTB (the machinery is “qualified property”). Taxpayer’s allocable share of the purchase price is $750,000.

The taxpayer is allowed a deduction for the taxable year of an amount equal to the lesser of:

(a) her “combined QBI amount” for the taxable year (the guaranteed payment of $120,000 is not included in QBI), or

(b) 20% of her taxable income of $500,000 for the taxable year, or $100,000.

Taxpayer’s combined QBI amount for 2018 is equal to her “deductible amount” with respect to Company. The deductible amount is the lesser of:

(a) 20% of Taxpayer’s QBI (20% of $400,000 = $80,000), or

(b) the greater of:

(i) 50% of the W-2 wages with respect to the QTB (50% of $300,000 = $150,000), or

(ii) the sum of: 25% of the W-2 wages with respect to the QTB ($75,000), plus (B) 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (2.5% of $750,000 = $18,750): $75,000 + $18,750 = $93,750.

Thus, Taxpayer’s deductible amount is $80,000. Because this amount is less than $100,000 (20% of her taxable income of $500,000 for the taxable year), Taxpayer will be allowed to deduct $80,000 in determining her taxable income for 2018.

Looking Ahead

It remains to be seen whether the “20% deduction” based upon the QBI of a PTE will be a “game changer” for the individual owners of the PTE.

After all, the deduction is subject to several limitations that may dampen its effect. For example, QBI does not include the amount paid by the PTE to Taxpayer in respect of services rendered by Taxpayer. In addition, the losses realized in one QTB may offset the income realized in another, thereby reducing the amount of the deduction. Finally, the deduction is subject to limits based upon the wages paid and the capital investments made by the QTB.

Maximizing the Deduction?

Might an S corporation shareholder or a partner in a partnership reduce the amount paid to them by the entity for their services so as to increase the amount of their QBI and, so the amount of the deduction? In the case of an S corporation, this may result in the IRS’s questioning the reasonableness (i.e., insufficiency) of the compensation paid to the shareholder-employee.[17]

Or might a PTE decide to invest in more tangible property than it otherwise would have in order to set a greater cap on the deduction?

In any case, the business must first be guided by what makes the most sense from a business perspective.

Becoming a Pass-Through?

What if a business is already organized as a C corporation? Should the QBI-based deduction tip the scales toward PTE status?

Before taking any action with respect to changing its status for tax purposes, a C corporation will have to consider much more than the effect of the deduction for PTEs.

For example, does it even qualify as a small business corporation? If not, what must it do to qualify? Must it redeem the stock owned by an ineligible shareholder, or must it recapitalize so as to eliminate the second class of stock? Either option may prove to be economically expensive for the corporation and the remaining shareholders.

If the corporation does qualify, what assurances are there that all of its shareholders will elect to treat the corporation as an S corporation? Even if the election is made, will the presence of earnings and profits from “C” taxable years implicate the “excess passive income” rules?

In any case, a C corporation that is not otherwise contemplating a change in its tax status, should probably not become an S corporation solely because of the PTE-related changes under the Act, especially if the corporation does not contemplate a sale of its business in the foreseeable future.

Wait and See?

The deduction based on the QBI of a PTE will expire at the end of 2025 unless it is extended before then. It is also possible that it may be eliminated by Congress after 2020.

An existing PTE and its owners should continue to operate in accordance with good business practice while they and their tax advisers determine the economic effect resulting from the application of the new deduction to the PTE.

They should also await the release of additional guidance from the IRS regarding “abusive” situations, tiered entities, and other items.[18]

*This post is the first of several that will be dedicated to those portions of the Tax Cuts and Jobs Act of 2017 (H.R. 1) that are most relevant to the closely-held business and it owners.

[1] The Act reduces the highest income tax rate applicable to the individual owner of a PTE to 37% (from 39.6%) for taxable years beginning after December 31, 2017 and before January 1, 2026. Note that the 3.8% surtax continues to apply to the distributive or pro rata share of an individual partnership or shareholder who does not materially participate in the trade or business conducted by the PTE.

[2] Though occasionally, the owner(s) will elect to treat the LLC as a corporation for tax purposes; for example, to reduce employment taxes.

[3] The Act includes a number of business-related benefits that are applicable to both corporate and non-corporate taxpayers. It also includes some that are unique to corporations, such as the reduction of the corporate income tax rate from a maximum of 35% to a flat 21%.

[4] As we will see in the coming weeks, that Act contains a number of such provisions.

[5] More accurately, the benefit is available to non-corporate owners; basically, individual taxpayers, though trusts and estates are also eligible for the deduction.

[6] A PTE may conduct more than one QTB – different lines of business – or Taxpayer may own equity is more than one PTE.

[7] Also excluded is the trade or business of being an employee.

[8] The exclusion from the definition of a qualified business for specified service trades or businesses is phased in for a taxpayer with taxable income in excess of a “threshold amount” of $157,500 ($315,000 in the case of a joint return). The exclusion is fully phased in for a taxpayer with taxable income at least equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[9] If the net amount of the QBI is a loss (negative), it is treated as a loss from a QTB in the succeeding taxable year.

[10] Generally, when a person engages in a trade or business in the U.S., all income from sources within the U.S. connected with the conduct of that trade or business is considered to be effectively connected income.

[11] Qualified items should include the gain recognized on the sale of business assets.

[12] The IRS is authorized to issue regulations that would exclude any amount paid or incurred by the partnership to Taxpayer for services provided by Taxpayer to the partnership other than in his capacity as a partner.

[13] Taxpayer does not need to be active in the business in order to qualify for the deduction.

[14] This “wage limit” is phased in for a taxpayer with taxable income in excess of the threshold amount. The limit is fully applicable for a taxpayer with taxable income equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[15] In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner or shareholder, as the case may be, takes into account his allocable or pro rata share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages and unadjusted basis for the taxable year equal to his allocable or pro rata share of the W-2 wages and unadjusted basis of the partnership or S corporation, as the case may be.

[16] The “depreciable period” is the period beginning with the date the qualified property is first placed in service and ending on the later of the date that is 10 years after such date, or the last day of the last full year in the applicable recovery period for the property.

[17] State and local taxes also need to be considered; for example, NYC’s unincorporated business income tax and its general corporation tax.

[18] “What we do in haste, we regret at leisure?”

What is It?
It is a frequently recurring issue for those who advise the owners of rental real property, but one that is rarely raised by the owners themselves: does the ownership arrangement constitute a partnership for income tax purposes?

The question appears to be fairly straightforward – just ask any client. “We haven’t executed a partnership agreement, “ they may say, or “we haven’t filed a certificate of limited partnership, or articles of organization.” Therefore, there is no partnership.

Alternatively, they may respond that they have been filing partnership tax returns for years, on which they have been reporting the rental income and associated expenses of the “partnership.” Thus, there is a partnership.

Too often, the taxpayer-owners discover the likely consequences of their actions late in the game, when it may be difficult to redress any problems.

Why Does It Matter?
Taxpayers may be bound by the form of their agreed-upon ownership arrangement, if such form benefits the IRS.

On the other hand, the IRS is free to consider the facts and circumstances surrounding the ownership and operation of the real property for purposes of determining whether the ownership arrangement should be re-characterized as a partnership for tax purposes.

The availability of such facts and circumstances necessarily implies a history of dealings among the owners with respect to the property, on the basis of which the existence of a partnership may be determined. When this happens, it will usually be the case that the owners did not “intend” to form a tax partnership, and failed to consult with a tax adviser before engaging in such dealings.

As a result, taxpayers who believed they owned a TIC interest, the proceeds from the sale of which could be used to acquire replacement property as part of a like-kind exchange, instead find that what they owned was a partnership interest the sale of which does not qualify for like kind exchange treatment.

Fortunately, for the well-advised client, his or her adviser will be familiar with the factors on which the IRS has historically relied in establishing the existence of a partnership. Of course, this knowledge will only benefit the client if he or she consults the adviser before getting into trouble.

A recent IRS ruling describes a complex business arrangement that must have concerned the taxpayer and its advisers enough to lead them to seek the “opinion” of the IRS. [PLR 201622008]

Specifically, the taxpayer requested a ruling that undivided fractional interests in a property were not interests in a partnership for purposes of qualifying the undivided fractional interests as eligible relinquished property under the like kind exchange rules.

The Facts
Taxpayer was a business entity that owned 100% of the fee title to Property. Taxpayer operated Property as a commercial rental property.

Taxpayer triple net leased Property to an unrelated third party (“Co-Owner”). Taxpayer represented that the lease for the Property was a bona fide lease for tax purposes and that the rent due under the lease reflected the fair market value (“FMV”) for the use of Property. Further, Taxpayer represented that the rent under the lease was not determined, in whole or in part, based on the income or profits derived by any person from Property.

Contemporaneously with the triple net lease, Taxpayer and Co-Owner entered into an Option Agreement under which Taxpayer had an option to sell any or all of its interest in Property to Co-Owner at any time before the fifth anniversary of the effective date of the Option Agreement (the “Put”). If Taxpayer exercised the Put with respect to a part of its interest in Property, it could exercise the Put again with respect to another part of its interest in Property and continue to do so until all interests in Property were transferred or the Put expired.

Under the Option Agreement, Co-Owner had an option to acquire the entire remaining interest then held by Taxpayer beginning on the seventh anniversary of the effective date of the Option Agreement, and ending X days later (the “Call”).

The purchase price for the exercise of the Put or the Call would be based on the FMV of Property at the time of the execution of the Option Agreement, increased at each anniversary date of such execution by Y% of the then-current exercise price, as increased by any prior Y% increases. Taxpayer represented that Y% was a reasonable appreciation factor for Property.

Within six months of executing the triple net lease and the Option Agreement, Taxpayer could exercise its right under the Put to sell a Z% tenancy-in-common (“TIC”) interest in the Property to Co-Owner. Taxpayer represented that neither co-owner would provide financing to the other to acquire a TIC interest in the Property.

When Taxpayer sold the Z% TIC interest to Co-Owner, Taxpayer and Co-Owner would either (i) refinance the existing indebtedness encumbering the Property by borrowing from an unrelated lender and creating a blanket lien on the Property, or (ii) cause the debt agreement to be amended to provide that the lien was a blanket lien and that the cost would be shared proportionately. Each co-owner would share the indebtedness on Property in proportion to that co-owner’s interest in Property.

Property would be owned by the Taxpayer and Co-Owner pursuant to a TIC agreement (the “Co-Ownership Agreement”) that would run with the land. Taxpayer represented that Taxpayer and Co-Owner would not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying the co-owners as members of a business entity, or otherwise hold themselves out as members of a business entity. The Co-Ownership Agreement would be consistent with these representations.

Under the Co-Ownership Agreement: any sale or lease of all or a portion of Property, any negotiation or renegotiation of indebtedness secured by a blanket lien, and the hiring of a manager, required the unanimous approval of the co-owners; all actions not otherwise required to be taken by unanimous consent would require the vote of co-owners holding more than 50 percent of the undivided interests in Property; there would be no buy-sell agreement; there would be no waiver of partition rights among co-owners unless required by the lender; a co-owner would be free to partition its interest in Property unless prohibited by the lender; a co-owner would be able to create a lien upon its own interest without the agreement or approval of any person, subject to the terms of the Co-Ownership Agreement, provided it did not create a lien on any other co-owner’s interest; in the event Property was sold or refinanced, each co-owner would receive its percentage interest in the net proceeds from the sale or refinancing of Property; upon the sale of Property, the co-owners would have to satisfy any blanket lien encumbering Property in proportion to their respective interests in Property; the Taxpayer and the Co-Owner would share in all revenues generated by Property and have an obligation to pay all costs associated with Property in proportion to their respective interests in Property; if either co-owner advanced funds necessary to pay expenses associated with Property, the other co-owner would have to repay such advance within 30 days of the date the expense, obligation, or liability was paid; to secure such an advance repayment obligation, each co-owner would grant each other co-owner a lien against such granting co-owner’s interest in Property and the rents and income therefrom and the leases thereof.

Taxpayer represented that the co-owners could, but were not required to, enter into a management agreement with Manager. The Co-Ownership Agreement would provide that the term of any management agreement entered into by the co-owners would be for one year, and would be automatically renewed for one-year periods unless either the Manager or any co-owner otherwise gave timely written notice to the other parties prior to the then-current expiration date.

Any such management agreement would: authorize the Manager to maintain a common bank account for the collection and deposit of rents and to offset expenses associated with Property against any revenues before disbursing each co-owner’s share of net revenues; provide that the Manager disburse the co-owner’s share of net revenues from Property within three months from the date of receipt of those revenues (subject to holding back reserves for anticipated expenses of Property, with each co-owner’s share of such reserves being proportionate to that co-owner’s interest in Property); authorize the Manager to prepare statements for the co-owners showing their shares of revenue and costs from Property; authorize the Manager to obtain or modify insurance on Property, and to negotiate modifications of the terms of any lease or any indebtedness encumbering Property, subject to the approval of the co-owners; provide that the fees paid by the co-ownership to the Manager would not depend in whole or in part on the income or profits derived from Property, and would not exceed the FMV of the Manager’s services.

Taxpayer represented that the activities of the Manager in managing Property would not result in non-customary services with respect to Property, taking into account the activities of the co-owners’ agents and any person related to the co-owners with respect to Property.

Taxpayer represented that the Co-Owner would acquire its interest in Property through the use of its own capital or through funds from an unrelated lender. Taxpayer also represented that, when the Put or Call was exercised, the Co-Owner would be required to pay the full purchase price of the interest in cash.

A Separate Entity?
Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.

A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture, and divide the profits therefrom, but the mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes.

The term “partnership” includes any joint venture or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of the Code, a corporation, trust or estate.

The IRS has enumerated certain conditions under which it would consider ruling that an undivided fractional interest in rental real property is not an interest in a business entity for federal tax purposes. The conditions relate to, among other things, TIC ownership of the property, number of co-owners, no treatment of the co-ownership as an entity, co-ownership agreements, voting by co-owners, restrictions on alienation, sharing of proceeds and liabilities upon sale of the property, proportionate sharing of profits and losses, proportionate sharing of debt, options, no business activities by the co-owners, management agreements, leasing agreements, and loan agreements.

TIC or Partnership?
The IRS determined that the Co-Ownership Agreement and Management Agreement would satisfy all of the conditions set forth above.

Regarding the condition that a co-owner may not acquire a put option to sell the co-owner’s undivided interest to another co-owner, the IRS distinguished the facts in the ruling, stating that the Put would not cause the fractional interests in Property to constitute interests in a business entity. The Taxpayer’s Put was not an option to sell an existing undivided interest that was previously acquired by the Taxpayer. Rather, the put option was an option to sell property held by the Taxpayer prior to entering into the proposed transaction.

Regarding the exercise price, and the requirement that the exercise price be the FMV at the time of exercise, the IRS found that the Y% appreciation factor adequately approximated the FMV of Property.

Regarding business activities, the IRS stated that the co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property. Activities will be treated as “customary activities” for this purpose if the activities would not prevent the amount received from qualifying only as rent, as opposed to compensation (in part) for services. In determining the co-owners’ activities, all activities of the co-owners, their agents, and any persons related to the co-owners with respect to the property are taken into account, whether or not those activities are performed by the co-owners in their capacities as co-owners.

The Taxpayer represented that the co-owners’ activities with respect to Property, conducted directly or through the Manager, would be limited to customary activities.

Based on the foregoing, the IRS concluded that, if Taxpayer sold a TIC interest in Property to Co-Owner, an undivided fractional interest in Property would not constitute an interest in a business entity for purposes of qualifying the undivided fractional interests as eligible relinquished property under the like-kind exchange rules.

Before You Act
Of course, there may be good business reasons for using an LLC; for example, a lender may require the use of a single business entity to hold the real property, or the business relationship among the owners may be such that the terms of a mere TIC agreement will not suffice.

However, it bears repeating: the mere co-ownership of real property that is maintained, kept in repair, and rented does not constitute a partnership for tax purposes. Too often, such an arrangement is formed as an LLC and is thereby treated as a partnership for tax purposes, subject to the rules and limitations applicable to such business entities.

Under certain conditions, however, an unincorporated organization may be excluded from the application of all or a part of the partnership rules. Such an organization must be availed of for investment purposes only and not for the active conduct of a business. The members of such organization must be able to compute their income without the necessity of computing partnership taxable income.

Where the participants in the joint purchase, retention, sale, or exchange of investment property: own the property as co-owners; reserve the right separately to take or dispose of their shares of any property acquired or retained; and do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase, sell, or exchange such investment property, then such group may elect to be excluded from the application of the partnership tax rules.

Any such unincorporated organization that wishes to be excluded from these rules must elect not later than the time prescribed (including extensions thereof) for filing the partnership return for the first taxable year for which exclusion from the partnership rules is desired.