Earlier this month, the IRS proposed regulations regarding the additional first-year depreciation deduction that was added to the Code by the Tax Cuts and Jobs Act (“TCJA”).[i] The proposed rules provide guidance that should be welcomed by those taxpayers that are considering the purchase of a closely held business or, perhaps, of an interest in such a business, and that are concerned about their ability to recover their investment.

Cost Recovery

In general, a taxpayer must capitalize the cost of property acquired for use in the taxpayer’s trade or business – in other words, the cost must be added to the taxpayer’s basis for the property.[ii] The taxpayer may then recover its acquisition cost (its investment in the property) over time – by reducing its taxable income through annual deductions for depreciation or amortization, depending upon the property.[iii] The recovery period (i.e., the number of years) and the depreciation method (for example, accelerated or straight-line) are prescribed by the Code and by the IRS.

In general, the “net cost” incurred by a taxpayer in the acquisition of a business or investment property will be reduced when such cost may be recovered over a shorter, as opposed to a longer, period of time.

In recognition of this basic principle, and in order to encourage taxpayers to acquire certain types of property, Congress has, over the years, allowed taxpayers to recover their investment in such property more quickly by claiming an additional depreciation deduction for the tax year in which the acquired property is placed in service by the taxpayer.[iv]

Pre-TCJA

Prior to the TCJA, the Code allowed a taxpayer to claim an additional first-year depreciation deduction equal to 50% of the taxpayer’s adjusted basis for “qualified” property.[v]

Qualified property included tangible property with a recovery period of twenty years or less, the original use of which began with the taxpayer.[vi] It did not include a so-called “section 197 intangible,” such as the goodwill of a business.

TCJA

In general, for property placed in service after September 27, 2017, the TCJA increased the amount of the additional first-year depreciation deduction to 100% of the taxpayer’s adjusted basis for the qualified property.[vii]

Significantly for transactions involving the purchase and sale of a business, the TCJA also removed the requirement that the original use of the qualified property had to commence with the taxpayer.

Specifically, the additional first-year depreciation deduction became available for “used” property, provided the property was purchased in an arm’s-length transaction, it was not acquired in a nontaxable exchange (such as a corporate reorganization), and it was not acquired from certain “related” persons.

Asset Deals

It is axiomatic that the cost of acquiring a business is reduced where the purchaser can recover such cost, or investment, over a short period of time.

By eliminating the “original use” requirement, the TCJA made the additional first-year depreciation deduction available for qualifying “used” properties purchased in connection with a taxpayer’s acquisition of a business from another taxpayer.

Thus, in the acquisition of a business that is structured as a purchase of assets,[viii] where the purchaser’s basis is determined by reference to the consideration paid for such assets, a portion of the consideration that is allocated to qualifying “Class V” assets (for example, equipment and machinery) may be immediately and fully deductible by the purchaser, instead of being depreciated over each asset’s respective recovery period.

The purchaser’s ability to expense (i.e., deduct) what may be a significant portion of the consideration paid to acquire the business will make the transaction less expensive (and, perhaps, more attractive) for the purchaser by reducing its overall economic cost.

Depending on the circumstances, it may also enable the buyer to pay more for the acquisition of the business.[ix]

Beyond Asset Deals?

Although the application of the expanded first-year depreciation deduction was fairly obvious in the case of a purchase of assets in connection with the acquisition of a business, the TCJA and the related committee reports were silent as to its application in other transactional settings, including, for example, those involving the acquisition of stock that may be treated as the purchase of assets for tax purposes.

Thankfully, the proposed regulations address these situations and provide other helpful guidance as well.

Proposed Regulations

Used Property

The proposed regulations provide that the acquisition of “used”[x] property is eligible for the additional first-year depreciation deduction if the acquisition satisfies the requirements described above – it was acquired in a taxable, arm’s-length transaction – and the property was not used by the taxpayer or a predecessor at any time prior to the acquisition.

The proposed regulations provide that property is treated as used by the taxpayer or a predecessor before its acquisition of the property only if the taxpayer or the predecessor had a depreciable interest in the property at any time before the acquisition,[xi] whether or not the taxpayer or the predecessor claimed depreciation deductions for the property.[xii]

Related Persons

In determining whether a taxpayer acquired the property at issue from a related person – for example, an entity in control of, or by, the taxpayer – the proposed regulations provide that, in the case of a series of related transactions, the transfer of the property will be treated as directly transferred from the original transferor to the ultimate transferee, and the relation between the original transferor and the ultimate transferee will be tested immediately after the last transaction in the series. Thus, a sale of assets between related persons will not qualify for the additional first-year deduction.

Deemed Asset Sales by Corporations

It may be that the assets of the target corporation include assets the direct acquisition of which may be difficult to effectuate through a conventional asset deal. In that case, the buyer may have to purchase the issued and outstanding shares of the target’s stock. Without more, the buyer would only be able to recover its investment on a later sale or liquidation of the target.

In recognition of this business reality, Congress has provided special rules by which the buyer may still obtain a recoverable basis step-up for the target’s assets.

In general, provided: (i) the buyer is a corporation, (ii) the buyer acquires at least 80% of target’s stock, (iii) the target is an S-corporation, or a member of an affiliated or consolidated group of corporations, and (iv) the target’s shareholders consent (including, in the case of an S-corporation target, any non-selling shareholders), then the stock sale will be ignored, and the buyer will be treated, for tax purposes, as having acquired the target’s assets with a basis step-up equal to the amount of consideration paid by the buyer plus the amount of the target’s liabilities (a so-called “Section 338(h)(10) election”).

Where a Sec. 338(h)(10) election is not available – for example, because the buyer is not itself a corporation – the buyer may want to consider a different election (a so-called “Section 336(e) election”).

The results of a Section 336(e) election are generally the same as those of a Section 338(h)(10) election in that the target, the stock of which was acquired by the buyer, is treated as having sold its assets to the buyer, following which the target is deemed to have made a liquidating distribution to its shareholders.

This election, however, may only be made by the seller’s shareholders – it is not an election that is made jointly with the buyer (in contrast to a Section 338(h)(10) election). In the case of an S-corporation target, all of its shareholders must enter into a binding agreement to make the election, and a “Sec. 336(e) election statement” must be attached to the S-corporation’s tax return for the year of the sale.[xiii]

The proposed regulations provide that assets deemed to have been acquired as a result of either a Section 338(h)(10) election or a Section 336(e) election will be treated as having been acquired by purchase for purposes of the first-year depreciation deduction. Thus, a buyer will be able to immediately expense the entire cost of any qualifying property held by the target, while also enjoying the ability to amortize the cost of the target’s goodwill and to depreciate the cost of its non-qualifying depreciable assets.

Partnership Transactions – Cross-Purchase

In general, the purchase of an interest in a partnership has no effect on the basis of the partnership’s assets.

However, in the case of a sale or exchange of an interest in a partnership interest that has made a so-called “Section 754 election,” the electing partnership will increase the adjusted basis of partnership property by the excess of the buyer’s cost basis in the acquired partnership interest over the buyer’s share of the adjusted basis of the partnership’s property.[xiv]

This increase is an adjustment to the basis of partnership property with respect to the acquiring partner only and, therefore, is a “partner-specific” basis adjustment to partnership property.

The basis adjustment is allocated among partnership properties based upon their relative built-in gain.[xv] Where the adjustment is allocated to partnership property that is depreciable, the amount of the adjustment itself is treated as a newly purchased property that is placed in service when the purchase of the partnership interest occurs. The depreciation deductions arising from this “newly acquired” property are allocated entirely to the acquiring partner.

Unfortunately, prior to the TCJA, this basis adjustment would always fail the “original use” requirement because the partnership property to which the basis adjustment related would have been previously used by the partnership and its partners prior to the sale that gave rise to the adjustment.

However, because this basis adjustment is a partner-specific basis adjustment to partnership property, the proposed regulations under the TCJA are able to take an “aggregate view” and provide that, in determining whether a basis adjustment meets the “used property acquisition requirements” described above, each partner is treated as having owned and used the partner’s proportionate share of partnership property.

Thus, in the case of a sale of a partnership interest, the requirement that the underlying partnership property not have been used by the acquiring partner (or by a predecessor) will be satisfied if the acquiring partner has not used the portion of the partnership property to which the basis adjustment relates at any time prior to the acquisition – that is, the buyer has not used the seller’s portion of partnership property prior to the acquisition[xvi] – notwithstanding the fact that the partnership itself has previously used the property.

Similarly, for purposes of applying the requirements that the underlying partnership property not have been acquired from a related person and that the property take a cost basis, the partner acquiring a partnership interest is treated as acquiring a portion of partnership property, the partner who is transferring a partnership interest (the seller) is treated as the person from whom that portion of partnership property is acquired, and the acquiring partner’s basis in the transferred partnership interest may not be determined by reference to the transferor’s adjusted basis.

The same result will apply regardless of whether the acquiring partner is a new partner or an existing partner purchasing an additional partnership interest from another partner. Assuming that the selling partner’s specific interest in partnership property that is acquired by the acquiring partner has not previously been used by the acquiring partner or a predecessor, the corresponding basis adjustment will be eligible for the additional first-year depreciation deduction in the hands of the acquiring partner, provided all other requirements are satisfied.[xvii]

Partnership Transactions – Redemption

By contrast, a distribution of cash and/or property from a Section 754 electing partnership to a departing partner in liquidation of that partner’s interest in the partnership will be treated very differently, even where it results in an increase of the adjusted basis of partnership property.[xviii]

The amount of this increase – equal to the sum of (a) the amount of any gain recognized to the departing partner,[xix] and (b) the excess of (i) adjusted basis (in the hands of the partnership) of any property distributed to the departing partner, over (ii) the basis of the distributed property to the departing partner[xx] – is made to the basis of partnership property (i.e., non-partner-specific basis), and the partnership used the property prior to the partnership distribution giving rise to the basis adjustment.

Thus, the proposed regulations provide that these basis adjustments are not eligible for the additional first-year depreciation deduction.

Planning?

The regulations are proposed to apply to qualified property placed in service by the taxpayer during or after the taxpayer’s taxable year in which the regulations are adopted as final.

However, pending the issuance of the final regulations, a taxpayer may choose to apply the proposed regulations to qualified property acquired and placed in service after September 27, 2017.

Informed by this guidance, a taxpayer that is thinking about purchasing a business may consider the economic savings – and the true cost of the acquisition – that may be realized by structuring the transaction so as to acquire a recoverable cost basis in the assets of the business, whether through depreciation/amortization and/or through an additional first-year depreciation deduction.

Similarly, a seller that recognizes the buyer’s ability to quickly recover a portion of its investment in acquiring the seller’s business may be able to share a portion of that economic benefit in the form of an increased purchase price. Whether the seller will be successful in doing so will depend upon several factors – for example, does the buyer need the seller to make a Section 338(h)(10) election – including their relative bargaining power and their relative desire to make a deal.

As for the buyout of a partner from a Section 754 electing partnership, query whether an acquiring partner’s ability to immediately expense a portion of the basis adjustment to the partnership’s underlying qualifying assets will make a cross-purchase transaction more attractive than a liquidation of the departing partner’s interest by the partnership.

In any case, the buyer and the seller will have to remain mindful of how they allocate the purchase price for the assets as issue. Let’s just say that pigs get fat and hogs get slaughtered.


[i] Public Law 115-97.

[ii] IRC Sec. 263, 1012.

[iii] IRC Sec. 167, 168, 197.

[iv] It should be noted that this so-called “bonus” depreciation is not subject to limitations based on the taxpayer’s taxable income or investment in qualifying property. Compare IRC Sec. 179.

It should also be noted that the “recapture” rules will apply to treat as ordinary income that portion of the taxpayer’s gain from the sale of the property equal to the amount of the bonus depreciation.

[v] The property had to have been placed in service before January 1, 2020. The 50% was phased down over time, beginning in 2018.

A taxpayer’s adjusted basis for a property is a measure of the taxpayer’s unrecovered investment in the property.

In general, the taxpayer’s starting basis will be equal to the amount of consideration paid by the taxpayer to acquire the property; the “cost basis.” It is “adjusted” (reduced) over time for depreciation.

[vi] Among the other properties that qualified is any improvement to an interior portion of a building that is nonresidential real property if such improvement was placed in service after the date the building was first placed in service. However, an improvement attributable to the enlargement of a building, or to the internal structural framework of the building, did not qualify.

[vii] IRC Sec. 168(k). Provided the property is placed in service before January 1, 2023. The amount of the deduction is phased down for property placed in service thereafter.

The TCJA also extended the additional first-year depreciation deduction, from 2020 through 2026.

[viii] IRC Sec. 1060.

The asset purchase may be effected in many different forms; for example, a straight sale, a merger of the target into the buyer in exchange for cash consideration, a merger of the target into a corporate or LLC subsidiary of the buyer, the sale by the target of a wholly-owned LLC that owns the business.

[ix] An important consideration for sellers.

[x] Should we say “pre-owned” but having undergone a painstaking certification process?

[xi] If a lessee has a depreciable interest in the improvements made to leased property and subsequently the lessee acquires the leased property of which the improvements are a part, the unadjusted depreciable basis of the acquired property that is eligible for the additional first-year depreciation deduction, assuming all other requirements are met, must not include the unadjusted depreciable basis attributable to the improvements.

[xii] The IRS is considering whether a safe harbor should be provided on how many taxable years a taxpayer or a predecessor should look back to determine if the taxpayer or the predecessor previously had a depreciable interest in the property.

[xiii] In a complete digression, here is another reason that a controlling shareholder will want to have a shareholders’ agreement in place that contains a drag-along and a requirement to elect as directed.

[xiv] IRC Sec. 743. Without such an election, any taxable gain resulting from an immediate sale of such property would be allocated in part to the buyer notwithstanding that the buyer had not realized an accretion in economic value.

[xv] IRC Sec. 755.

[xvi] Query how this will be determined.

[xvii] This treatment is appropriate notwithstanding the fact that the transferee partner may have an existing interest in the underlying partnership property, because the transferee’s existing interest in the underlying partnership property is distinct from the interest being transferred.

[xviii] IRC Sec. 734.

[xix] In general, because the amount of cash distributed (or deemed to have been distributed) to the departing partner exceeds the partner’s adjusted basis for its partnership interest.

[xx] An amount equal to the adjusted basis of such partner’s interest in the partnership reduced by any money distributed in the same transaction.

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.