Yesterday’s post examined various changes to the taxation of S corporations, partnerships, and their owners.

Today, we will focus on a number of partnership-specific issues that were addressed by the Act.

Profits Interests2017 Tax Act

A partnership may issue a profits (or “carried”) interest in the partnership to a service or management partner in exchange for their performance of services.[1] The right of the profits interest partner to receive a share of the partnership’s future profits and appreciation does not include any right to receive money or other property upon the liquidation of the partnership immediately after the issuance of the profits interest. The right may be subject to various vesting limitations.[2]

In general, the IRS has not treated the receipt of a partnership profits interest for services as a taxable event for the partnership or the partner. However, this favorable tax treatment did not apply if: (1) the profits interest related to a substantially certain and predictable stream of income from partnership assets (i.e., one that could be readily valued); or (2) within two years of receipt, the partner disposed of the profits interest. More recent guidance clarified that this treatment would apply with respect to a substantially unvested profits interest, provided the service partner took into income his share of partnership income (i.e., the service provider is treated as the owner of the interest from the date of its grant), and the partnership did not deduct any amount of the FMV of the interest as compensation, either on grant or on vesting of the profits interest.[3]

By contrast, a partnership capital interest received for services has been includable in the partner’s income if the interest was transferable or was not subject to a substantial risk of forfeiture.[4] A capital interest for this purpose is an interest that would entitle the receiving partner to a share of the proceeds if the partnership’s assets were sold at fair market value (“FMV”) immediately after the issuance of the interest and the proceeds were distributed in liquidation.

Under general partnership tax principles, notwithstanding that a partner’s holding period for his profits interest may not exceed one year, the character of any long-term capital gain recognized by the partnership on the sale or exchange of its assets has been treated as long-term capital gain in the hands of the profits partner to whom such gain was allocated and, thus, eligible for the lower applicable tax rate.

The Act

In order to make it more difficult for some profits interest partners to enjoy capital gain treatment for their share of partnership income, for taxable years beginning after December 31, 2017, the Act provides for a new three-year holding period for certain net long-term capital gain allocated to an applicable partnership interest.

Specifically, the partnership assets sold must have been held by the partnership for at least three years[5] in order for a profits interest partner’s share of such gain to enjoy the lower tax rate applicable to long-term capital gains.

If the assets sold had not been held by the partnership for at least three years, the entire amount of any capital gain allocated to the profits interest would be treated as short-term capital gain, and would be taxed up to a maximum rate of 37% as ordinary income.[6]

An “applicable partnership interest” is any interest in a partnership that is transferred to a partner in connection with the performance of “substantial” services in any applicable trade or business.[7]

In general, an “applicable trade or business” means any activity conducted on a regular, continuous, and substantial basis that consists in whole or in part of: (1) raising or returning capital, and (2) investing in, or disposing of, or developing specified assets.

“Developing” specified assets takes place, for example, if it is represented to investors or lenders that the value, price, or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider or of others acting in concert with the service provider.

“Specified assets” means securities, commodities, real estate held for rental or investment, as well as other enumerated assets.

If a profits interest is not an applicable partnership interest, then its tax treatment should continue to be governed by the guidance previously issued by the IRS.[8]

Adjusting Inside Basis

In general, a partnership does not adjust the basis of partnership property following the transfer of a partnership interest unless the partnership has made an election under Code Sec. 754 to make such basis adjustments, or the partnership has a substantial built-in loss[9] immediately after the transfer.

If an election is in effect, or if the partnership has a substantial built-in loss immediately after the transfer, inside basis adjustments are made only with respect to the transferee partner. These adjustments account for the difference between the transferee partner’s proportionate share of the adjusted basis of the partnership property and the transferee’s basis in its partnership interest. The adjustments are intended to adjust the basis of partnership property to approximate the result of a direct purchase of the property by the transferee partner, and to thereby eliminate any unwarranted advantage (in the case of a downward adjustment) or disadvantage (in the case of an upward adjustment) for the transferee.

For example, without a mandatory reduction in a transferee partner’s share of a partnership’s inside basis for an asset, the transferee may be allocated a tax loss from the partnership without suffering a corresponding economic loss. Under such circumstances, if a Sec. 754 election were not in effect, it is unlikely that the partnership would make the election so as to wipe out the advantage enjoyed by the transferee partner.

The Act

In order to further reduce the potential for abuse, the Act expands the definition of a “substantial built-in loss” such that, in addition to the present-law definition, for transfers of partnership interests made after December 31, 2017, a substantial built-in loss also exists if the transferee would be allocated a 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’ FMV, immediately after the transfer of the partnership interest.

Limiting a Partner’s Share of Loss

A partner’s distributive share of partnership loss is allowed only to the extent of the adjusted basis (before reduction by current year’s losses) of the partner’s interest in the partnership at the end of the partnership taxable year in which the loss occurred.

Any disallowed loss is allowable as a deduction at the end of succeeding partnership taxable years, to the extent that the partner’s adjusted basis for its partnership interest at the end of any such year exceeds zero (before reduction by the loss for the year).

In general, a partner’s basis in its partnership interest is decreased (but not below zero) by distributions by the partnership and the partner’s distributive share of partnership losses and expenditures. In the case of a charitable contribution, a partner’s basis is reduced by the partner’s distributive share of the adjusted basis of the contributed property.

In computing its taxable income, no deductions for foreign taxes and charitable contributions are allowed to the partnership – instead, a partner takes into account his distributive share of the foreign taxes paid, and the charitable contributions made, by the partnership for the taxable year.

However, in applying the basis limitation on partner losses, the IRS has not taken into account the partner’s share of partnership charitable contributions and foreign taxes.

By contrast, under the S corporation basis limitation rules (see above), the shareholder’s pro rata share of charitable contributions and foreign taxes are taken into account.

The Act

In order to remedy this inconsistency in treatment between S corporations and partnerships, the Act modifies the basis limitation on partner losses to provide that the limitation takes into account a partner’s distributive share of partnership charitable contributions (to the extent of the partnership’s basis for the contributed property)[10] and foreign taxes. Thus, effective for partnership taxable years beginning after December 31, 2017, the amount of the basis limitation on partner losses is decreased to reflect these items.

What’s Next?

This marks the end of our three-post review of the more significant changes in the taxation of pass-through entities resulting from the Act.

In general, these changes appear to be favorable for the closely held business and its owners, though they do not deliver the promised-for simplification.

Indeed, the new statutory provisions raise a number of questions for which taxpayers and their advisers must await guidance from the IRS and, perhaps, from the Joint Committee (in the form of a “Blue Book”).

However, in light of the administration’s bias against the issuance of new regulations, and given its reduction of the resources available to the IRS, query when such guidance will be forthcoming, and in what form.

Until then, it will behoove practitioners to act cautiously, to keep options open, and to focus on the Act’s legislative history (including the examples contained therein) in ascertaining the intent of certain provisions and in determining an appropriate course of action for clients.

As they used to say on Hill Street Blues, “Let’s be careful out there.”

[Next week, we’ll take a look at the Act’s changes to the estate and gift tax, and how it may impact the owners of a closely held business, as well as the changes to the taxation of C corporations.]

[1]It may be issued in lieu of a management fee that would be taxed as ordinary income.

[2]See Sec. 83 of the Code.

[3]Rev. Proc. 93-27, Rev. Proc. 2001-43.

[4]In general, property is subject to a substantial risk of forfeiture if the recipient’s right to the property is conditioned on the future performance of substantial services, or if the right is subject to a condition other than the performance of services, provided that the condition relates to a purpose of the transfer and there is a substantial possibility that the property will be forfeited if the condition does not occur.

[5]Notwithstanding Code Sec. 83 or any election made by the profits interest holder under Sec. 83(b); for example, even if the interest was vested when issued, or the service provider elected under Sec. 83(b) of the Code to include the FMV of the interest in his gross income upon receipt, thus beginning a holding period for the interest.

[6]Query whether this will have any impact on profits interests that are issued in the context of a PE firm or a real estate venture, where the time frame for a sale of the underlying asset will likely exceed three years.The Act also provides a special rule for transfers by a taxpayer to related persons

[7]A partnership interest will not fail to be treated as transferred in connection with the performance of services merely because the taxpayer also made a capital contribution to the partnership. An applicable partnership interest does not include an interest in a partnership held by a corporation.

[8]Rev. Proc. 93-27, Rev. Proc. 2001-43, Prop. Reg. REG-105346-03.

[9]Prior to the Act, a “substantial built-in loss” existed only if the partnership’s adjusted basis in its property exceeded by more than $250,000 the FMV of the partnership property.

[10]The basis limitation does not apply to the excess of the contributed property’s FMV over its adjusted basis.

Our last post reviewed the “20% deduction” that may now be available to the owners of certain pass-through entities based upon their qualified business income; as we saw, there are many questions that remain unanswered.[1]

Tax Cuts and Jobs Act of 2017

Today’s post is the first of two[2] this week in which we continue our consideration of those income tax provisions of the Tax Cuts and Jobs Act of 2017[3] that most directly relate to pass-through entities – S corporations, partnerships, and sole proprietorships – and their owners.

Excess Business Losses

In determining their taxable income for a taxable year, the shareholders of an S corporation and the partners of a partnership[4] are allocated their share of the pass-through entity’s losses for such year. However, there are a number of rules that limit the ability of these owners to deduct these losses.

As a threshold matter, the aggregate amount of losses taken into account by a shareholder or partner for a taxable year cannot exceed, (i) in the case of an S corporation, the sum of the shareholder’s adjusted basis for his stock, plus his adjusted basis of any corporate indebtedness owed to the shareholder, and, (ii) in the case of a partnership, the adjusted basis of such partner’s interest in the partnership. Any excess for which a deduction is not allowed in a taxable year is carried forward.

Any pass-through loss that is allowed under the above “basis-limitation rule” must also be tested under the “at-risk” and, then, the “passive activity” loss rules before it may be utilized by a shareholder or partner in determining his taxable income. A loss that is disallowed under either of these rules is “suspended” and is carried forward indefinitely to succeeding taxable years until the taxpayer has more amounts at risk, or realizes more passive income, or disposes of his interest in the pass-through entity.

If the loss is not limited by the foregoing rules, it may be applied against the shareholder’s or the partner’s other income.

The Act

The Act imposes another limitation on a non-corporate taxpayer’s ability to utilize a pass-through loss against other income – whether it is realized through a sole proprietorship, S corporation or partnership – which is applied after the basis-limitation, at-risk, and passive loss rules.

Specifically, for taxable years beginning after December 31, 2017 and before January 1, 2026, the excess business losses of a non-corporate taxpayer are not allowed for the taxable year.

A taxpayer’s “excess business loss” for a taxable year is the excess of:

(a) the taxpayer’s aggregate deductions attributable to his trades or businesses for the year, over

(b) the sum of:

(i) the taxpayer’s aggregate gross income or gain for the year attributable to such trades or businesses, plus

(ii) $250,000 (or $500,000 in the case of a joint return).[5]

In the case of a partnership or S corporation, this provision (as in the case of the at-risk and passive activity rules) is applied at the partner or shareholder level. Each partner’s and each S corporation shareholder’s share of the pass-through entity’s items of income, gain, deduction, or loss are taken into account in applying the limitation for the taxable year of the partner or S corporation shareholder.

The non-corporate taxpayer’s excess business loss for a taxable year is carried forward and treated as part of the taxpayer’s net operating loss (“NOL”) carryforward in subsequent taxable years.[6]

Thus, consistent with the principle underlying the new rules applicable to NOLs, the excess business loss rule seeks to limit and defer the tax benefit attributable to the “excess” loss.[7]

Accounting Methods

Taxpayers using the cash method of accounting generally recognize items of income when actually or constructively received and items of expense when paid. The cash method is administratively easy and provides the taxpayer flexibility in the timing of income recognition. It is the method used by most individual taxpayers, including sole proprietorships.

Taxpayers using an accrual method generally accrue items of income when “all the events” have occurred that fix the right to receive the income, and the amount of the income can be determined with reasonable accuracy.

Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to when all events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and “economic performance” has occurred.

In general, a C corporation, or a partnership that has a C corporation as a partner, may not use the cash method. Prior to the Act, an exception was made to the extent the average annual gross receipts of a C corporation, or of a partnership with a C corporation partner, did not exceed $5 million for all prior years (the “gross receipts test”).

The Act

Under the Act, C corporations and partnerships with C corporation partners may use the cash method of accounting if their annual average gross receipts that do not exceed $25 million for the prior three-taxable-year period (not for all periods, as under prior law), regardless of whether the purchase, production, or sale of merchandise is an income-producing factor.[8]

The Act retains the exceptions from the required use of the accrual method for qualified personal service corporations and for taxpayers other than C corporations. Thus, S corporations, and partnerships without C corporation partners, are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the cash method clearly reflects income.

Changes in Accounting Method

Because an S corporation may be able to use the cash method of accounting while an otherwise identical C corporation may be required to use the accrual method, the voluntary or involuntary conversion of an S corporation into a C corporation may cause the corporation to switch its accounting method.[9]

In general, any resulting net adjustments that increase taxable income are generally taken into account by the corporation ratably, over a four-year period beginning with the year of the change.

The Act

Under the Act, any adjustment for an eligible terminated S corporation that is attributable to the revocation of its S corporation election – i.e., a change from the cash method to the accrual method, notwithstanding the new $25 million gross receipts test – is taken into account ratably during the six-taxable-year period beginning with the year of change.

An “eligible terminated S corporation” is any C corporation which (1) was an S corporation the day before the enactment of the Act, (2) during the two-year period beginning on the date of such enactment revokes its S corporation election, and (3) all of the owners of which, on the date the S corporation election is revoked, are the same owners (and in identical proportions) as the owners on the date of enactment.

Post-S-Termination Distributions

Prior to the Act, distributions of cash by a former S corporation to its shareholders during the one-year post-termination transition period (to the extent of the accumulated adjustment account, or “AAA”) were tax-free to the shareholders and reduced the adjusted basis of the stock.

The Act

Under the Act, in the case of a distribution of money by an “eligible terminated S corporation” (see above) after the post-termination transition period, the AAA will be “allocated to such distribution,” and the distribution will be “chargeable to” the corporation’s accumulated earnings and profits, in the same ratio as the amount of the AAA bears to the amount the accumulated earnings and profits.

Thus, some portion of the distribution may be treated as a taxable dividend to the shareholders.

Electing Small Business Trust (“ESBT”)

Only certain types of trusts are eligible to be shareholders of an S corporation. One such trust is the ESBT. Generally, the eligible beneficiaries of an ESBT include individuals, estates, and certain charitable organizations eligible to hold S corporation stock directly. Prior to the Act, a nonresident alien individual could not be a potential current beneficiary[10] of an ESBT.

The Act

Beginning January 1, 2018, a nonresident alien individual may be a potential current beneficiary of an ESBT.

Of course, the S corporation stock held by the ESBT may not, itself, be distributed to the nonresident alien without terminating the S corporation election, though the income therefrom may be.

ESBTs and Charitable Contributions

In addition to its non-separately computed income or loss, an S corporation reports to its shareholders their pro rata share of certain separately stated items of income, loss, deduction, and credit, including charitable contributions made by the S corporation. The treatment of such charitable contributions depends on the tax status of the shareholder.

Generally, a trust is allowed a charitable contribution deduction for amounts of gross income, without limitation, which pursuant to the terms of the governing instrument are paid for a charitable purpose. No carryover of excess contributions is allowed. An individual, by contrast, is allowed a charitable contribution deduction limited to certain percentages of adjusted gross income, generally, with a five-year carryforward of amounts in excess of this limitation.

Prior to the Act, the deduction for charitable contributions applicable to trusts – rather than the deduction applicable to individuals – applied to an ESBT.

The Act

Effective for taxable years beginning after December 31, 2017, the Act provides that the charitable contribution deduction of an ESBT is not determined by the rules generally applicable to trusts but, rather, by the rules applicable to individuals.

Thus, the percentage limitations and carryforward provisions applicable to individuals apply to charitable contributions made by the portion of an ESBT holding S corporation stock.

Technical Termination of Partnerships

Prior to the Act, a partnership was considered “technically terminated” for tax purposes if, within a 12-month period, there was a sale or exchange[11] of fifty percent or more of the total interest in the partnership’s capital or income. Upon a technical termination, the partnership’s taxable year closed, resulting in a short taxable year, partnership-level elections generally ceased to apply, and the partnership’s depreciation recovery periods for its assets started anew.[12]

In other words, a “trap for the unwary” as the saying goes.

However, a technical termination could often prove a “blessing,” as where the sale of a fifty percent interest afforded the terminating partnership an opportunity to make an irrevocable “Section 754 election, thereby generating a beneficial upward inside basis adjustment for the acquiring partner, following which the otherwise irrevocable Section 754 election (and its potential for a downward adjustment on a later transfer), as well as any other “unwanted” elections, would disappear as a result of the termination.

The Act

The Act repeals the technical termination rule, effective for partnership taxable years beginning after December 31, 2017. Thus, the partnership in which a 50% of more interest was sold would be treated as continuing, and its tax elections would remain in effect.[13]

Tomorrow’s Post

Tomorrow, we will continue our discussion regarding the treatment of pass-through entities under the Act, including the revised taxation of profits interests.

[1] For example, when is an employee’s reputation or skill the “principal asset” of a trade or business, such that the trade or business should be treated as a specified service trade or business that does not qualify for the deduction? Should we be looking to the “personal goodwill” line of cases for guidance? For example, would the absence of an employment or non-competition agreement negate the existence of a trade or business “asset?” Or should we wait for the IRS to issue guidance?
[2] The next post will appear tomorrow.
[3] Pub. L. 115-97; the “Act.”
[4] Including a limited liability company that is treated as a partnership for tax purposes.
[5] Indexed for inflation after 2018.
[6] As we will see in a later post, NOL carryovers generally are allowed for a taxable year up to the lesser of (i) the carryover amount or (ii) 80 percent of taxable income determined without regard to the deduction for NOLs. In general, carrybacks are eliminated, and carryovers to other years may be carried forward indefinitely.
[7] Query whether any excess business loss that is carried forward will be allowed in full upon the taxpayer’s disposition of the trade or business to which such loss is attributable.
[8] The $25 million amount is indexed for inflation for taxable years beginning after 2018.
[9] Congress may believe that the reduction in the C corporation tax rate to a flat 21% may cause the shareholders of some S corporations (for example, those that generate ordinary income – as opposed to capital gain – and that do not make dividend distributions) to revoke the S election.
[10] One who is entitled to, or in the discretion of the trustee may, receive a distribution from the principal or income of the trust on a current basis.
[11] A liquidation of an interest was not counted in applying the 50% test, nor was a gift or a bequest.
[12] The terminated partnership retained its EIN.
[13] Of course, if all of the partnership interests were sold to a single person, the partnership would cease to be treated as such for tax purposes under Code Sec. 708(b)(1)(A). See Rev. Rul. 99-6.