This is the fourth[i] and final in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction/

Earlier posts considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one , the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A, https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ , and the meaning of “qualified business income.” https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-three/. Today, we turn to the calculation of the deduction, the limitations on the amount of the deduction, and some special rules.

 Threshold and Phase-In Amounts

Let’s assume for the moment that our taxpayer (“Taxpayer”) is a married individual, files a joint return with their spouse, and owns an equity interest in a qualified trade or business (“QTB”) that is conducted through a pass-through entity (“PTE”), such as a sole proprietorship,[ii] a partnership, or an S corporation.

At this point, Taxpayer must determine their joint taxable income for the taxable year.[iii]

There are three categories of taxpayers for purposes of Section 199A – those whose joint taxable income[iv]:

  • does not exceed $315,000 (the “threshold”),
  • exceeds $315,000 but does not exceed $415,000 (the “phase-in range”),[v] and
  • exceeds $415,000.[vi]

 

 

 

Below the Threshold

If Taxpayer falls within the first category – joint taxable income that does not exceed $315,000 – they determine their Section 199A deduction by first calculating 20% of their QBI with respect to their QTB (Taxpayer’s “combined QBI amount”).[vii] For this first category of taxpayer, their share of income from a specified service trade or business (“SSTB”) qualifies as QBI.

Taxpayer must then compare their

  • combined QBI amount (determined above) with
  • an amount equal to 20% of the excess of:
    • their taxable income for the taxable year, over
    • their net capital gain for the year.

The lesser of these two amounts is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain. Taxpayer’s Section 199A deduction is equal to the lesser of these two amounts.

Thus, if Taxpayer’s only source of income was their QTB, Taxpayer would be entitled to claim the full “20% of QBI” deduction, with the result that their QBI would be subject to an effective top federal income tax rate of 29.6%[viii]

Above the Threshold and Phase-In

If Taxpayer falls within the third category – joint taxable income for the taxable year in excess of $415,000 – they face several additional hurdles in determining their Section 199A deduction.[ix] It is with respect to these taxpayers that the application of the Section 199A rules becomes even more challenging, both for the taxpayers and their advisers.

To start, no SSTB in which Taxpayer has an equity interest will qualify as a QTB as to Taxpayer.

Moreover, there are other limitations, in addition to the ones described above, that must be considered in determining the amount of Taxpayer’s Section 199A deduction.

N.B.

Before turning to these limitations, it is important to note the following:

  • the application of the threshold and phase-in amounts is determined at the level of the individual owner of the QTB[x], which may not be where the trade or business is operated; and
  • taxpayers with identical interests in, and identical levels of activity with respect to, the same trade or business may be treated differently if one taxpayer has more taxable income from sources outside the trade or business than does the other;
    • for example, a senior partner of a law firm, who has had years to develop an income-producing investment portfolio, vs a junior partner at the same firm, whose share of partnership income represents their only source of income.[xi]

Limitations

The additional limitations referred to above are applied in determining Taxpayer’s “combined QBI amount.”

Specifically, the amount equal to 20% of Taxpayer’s QBI with respect to the QTB must be compared to the greater of:

  • 50% of the “W-2 wages” with respect to the QTB, or
  • The sum of (i) 25% of the W-2 wages plus (ii) 2.5% of the unadjusted basis (“UB”) of qualified property immediately after the acquisition of all qualified property (“a” and “b” being the “alternative limitations”).

The lesser of Taxpayer’s “20% of QBI” figure and the above “W-2 wages-based” figure may be characterized as Taxpayer’s “tentative” Section 199A deduction; it is subject to being further reduced in accordance with the following caps:

  • The Section 199A deduction cannot be greater than 20% of the excess (if any) of:
    • Taxpayer’s taxable income for the taxable year, over
    • Taxpayer’s net capital gain for the year.
  • The resulting amount – i.e., the tentative deduction reduced in accordance with “a” – is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain.

Taxpayer’s Section 199A deduction is equal to the lesser of the two amounts described in “b”, above.

Applied to Each QTB

Under the PR, an individual taxpayer must determine the W-2 wages and the UB of qualified property attributable to each QTB contributing to the individual’s combined QBI. The W-2 wages and the UB of qualified property amounts are compared to QBI in order to determine the individual’s QBI component for each QTB.

After determining the QBI for each QTB, the individual taxpayer must compare 20% of that trade or business’s QBI to the alternative limitations for that trade or business.

If 20% of the QBI of the trade or business is greater than the relevant alternative limitation, the QBI component is limited to the amount of the alternative limitation, and the deduction is reduced.

The PR also provide that, if an individual has QBI of less than zero (a loss) from one trade or business, but has overall QBI greater than zero when all of the individual’s trades or businesses are taken together, then the individual must offset the net income in each trade or business that produced net income with the net loss from each trade or business that produced net loss before the individual applies the limitations based on W-2 wages and UB of qualified property.

The individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. Then, for purposes of applying the limitation based on W-2 wages and UB of qualified property, the net income with respect to each trade or business (as offset by the apportioned losses) is the taxpayer’s QBI with respect to that trade or business.

The W-2 wages and UB of qualified property from the trades or businesses which produced negative QBI for the taxable year are not carried over into the subsequent year.

W-2 Wages

The PR provide that, in determining W-2 wages, the common law employer (such as a PTE) may take into account any W-2 wages paid by another person – such as a professional employer organization – and reported by such other person on Forms W-2 with the reporting person as the employer listed on the Forms W-2, provided that the W-2 wages were paid to common law employees of the common law employer for employment by the latter.[xii]

Under this rule, persons who otherwise qualify for the deduction are not limited in applying the deduction merely because they use a third party payor to pay and report wages to their employees.

The W-2 wage limitation applies separately for each trade or business. Accordingly, the PR provides that, in the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined to be in the same proportion to total W-2 wages as the ordinary business deductions associated with those wages are allocated among the particular trades or businesses.

W-2 wages must be properly allocable to QBI (rather than, for example, to activity that produces investment income). W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.

Where the QTB is conducted by a PTE, a partner’s or a shareholder’s allocable share of wages must be determined in the same manner as their share of wage expenses.

Finally, the PR provide that, in the case of an acquisition or disposition of (i) a trade or business, (ii) the major portion of a trade or business, or (iii) the major portion of a separate unit of a trade or business, that causes more than one individual or entity to be an employer of the employees of the acquired or disposed of trade or business during the calendar year, the W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated between each individual or entity based on the period during which the employees of the acquired or disposed of trade or business were employed by the individual or entity.

 UB of Qualified Property

The PR provides that “qualified property” means (i) tangible property of a character subject to depreciation that is held by, and available for use in, a trade or business at the close of the taxable year, (ii) which is used in the production of QBI, and (iii) for which the depreciable period has not ended before the close of the taxable year.

“Depreciable period” means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property without regard to whether any bonus depreciation was claimed with respect to the property. Thus, it is possible for a property to be treated as qualified property even where it is no longer being depreciated for tax purposes.

The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased or contributed.

UB is determined without regard to any adjustments for any portion of the basis for which the taxpayer has elected to treat as an expense (for example, under Sec. 179 of the Code). Therefore, for purchased or produced qualified property, UB generally will be its cost as of the date the property is placed in service.

For qualified property contributed to a partnership in a “tax-free” exchange for a partnership interest and immediately placed in service, UB generally will be its basis in the hands of the contributing partner, and will not be changed by subsequent “elective” basis adjustments.

For qualified property contributed to an S corporation in a “tax-free” exchange for stock and immediately placed in service, UB generally will be its basis in the hands of the contributing shareholder.[xiii]

Further, for property inherited from a decedent and immediately placed in service by the heir, the UB generally will be its fair market value at the time of the decedent’s death.

In order to prevent trades or businesses from transferring or acquiring property at the end of the year merely to manipulate the UB of qualified property attributable to the trade or business, the PR provides that property is not qualified property if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the deduction.

For purposes of determining the depreciable period of qualified property, the PR provide that, if a PTE acquires qualified property in a non-recognition exchange, the qualified property’s “placed-in-service” date is determined as follows: (i) for the portion of the transferee-PTE’s UB of the qualified property that does not exceed the transferor’s UB of such property, the date such portion was first placed in service by the transferee-PTE is the date on which the transferor first placed the qualified property in service; (ii) for the portion of the transferee’s UB of the qualified property that exceeds the transferor’s UB of such property, if any, such portion is treated as separate qualified property that the transferee first placed in service on the date of the transfer.

Thus, qualified property acquired in these non-recognition transactions will have two separate placed in service dates under the PR: for purposes of determining the UB of the property, the relevant placed in service date will be the date the acquired property is placed in service by the transferee-PTE (for instance, the date the partnership places in service property received as a capital contribution); for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the transferor first placed the property in service (for instance, the date the partner placed the property in service in their sole proprietorship).

The PR also provide guidance on the treatment of subsequent improvements to qualified property.[xiv]

Finally, in the case of a trade or business conducted by a PTE, the PR provide that, in the case of qualified property held by a PTE, each partner’s or shareholder’s share of the UB of qualified property is an amount that bears the same proportion to the total UB of qualified property as the partner’s or shareholder’s share of tax depreciation bears to the entity’s total tax depreciation attributable to the property for the year.[xv]

Computational Steps for PTEs

The PR also provide additional guidance on the determination of QBI for a QTB conducted by a PTE.

A PTE conducting an SSTB may not know whether the taxable income of any of its equity owners is below the threshold amount. However, the PTE is best positioned to make the determination as to whether its trade or business is an SSTB.

Therefore, reporting rules require each PTE to determine whether it conducts an SSTB, and to disclose that information to its partners, shareholders, or owners.

In addition, notwithstanding that PTEs cannot take the Section 199A deduction at the entity level, each PTE must determine and report the information necessary for its direct and indirect individual owners to determine their own Section 199A deduction.

Thus, the PR direct PTEs to determine what amounts and information to report to their owners and the IRS, including QBI, W-2 wages, and the UB of qualified property for each trade or business directly engaged in.

The PR also require each PTE to report this information on or with the Schedules K-1 issued to the owners. PTEs must report this information regardless of whether a taxpayer is below the threshold amount.

“That’s All Folks!”[xvi]

With the series of posts ending today, we’ve covered most aspects of the new Section 199A rule, as elaborated by the PR, though the following points are also worth mentioning:

  • the Section 199A deduction has no effect on the adjusted basis of a partner’s interest in a partnership;
  • the deduction has no effect on the adjusted basis of a shareholder’s stock in an S corporation or the S corporation’s accumulated adjustments account;
  • the deduction does not reduce (i) net earnings from self-employment for purposes of the employment tax (for example, a partner’s share of a partnership’s operating income), or (ii) net investment income for purposes of the surtax on net investment income (for example, a shareholder’s share of an S corporation’s business in which the shareholder does not materially participate); and
  • for purposes of determining an individual’s alternative minimum taxable income for a taxable year, the entire deduction is allowed, without adjustment.

Stay tuned. Although taxpayers may rely upon the PR, they are not yet final. A public hearing on the PR is scheduled for October 16; the Republicans recently proposed to make the deduction “permanent” (whatever that means); midterm elections are scheduled for November 6; we have a presidential election in 2020; the deduction is scheduled to disappear after 2025. Oh, bother.

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[i] Yes, I know – where has time gone? The fourth already? Seems like just yesterday, I was reading the first. Alternatively: Oh no, not another! It’s like reading . . . the Code? Where are those definitions of SSTB covered? The first or the second installment?

[ii] Including a single-member LLC that is disregarded for tax purposes.

[iii] Of course, we are only considering taxable years beginning after December 31, 2017, the effective date for Section 199A of the Code.

[iv] Regardless of the source or type of the income.

[v] See EN ix, below.

[vi] For our purposes, it is assumed that Taxpayer has no “qualified cooperative dividends,” no “qualified REIT dividends,” and no “qualified publicly traded partnership income.”

[vii] If Taxpayer has more than one QTB, this amount is determined for each such QTB, and these amounts are then added together.

[viii] I.e., 80% of the regular 37% rate.

[ix] Yes, we skipped the second category – taxpayers with taxable income in excess of the threshold amount but within the phase-in range amount.

The exclusion of QBI (for SSTBs), W-2 wages, and UB of qualified property from the computation of the Section 199A deduction is subject to a phase-in for individuals with taxable income within the phase-in range.

[x] Thus, we look at the taxable income of the individual member of the LLC or shareholder of the S corporation – not at the taxable income of the entity.

[xi] Compare to the passive activity loss rules (material participant or not?), and the net investment income surtax rules (modified adjusted gross income in excess of threshold; material participant?).

[xii] In such cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person.

[xiii] The PR also provide special rules for determining the UB and the depreciable period for property acquired in a “tax-free” exchange.

Specifically, for purposes of determining the depreciable period, the date the exchanged basis in the replacement qualified property is first placed in service by the trade or business is the date on which the relinquished property was first placed in service by the individual or PTE, and the date the excess basis in the replacement qualified property is first placed in service by the individual or PTE is the date on which the replacement qualified property was first placed in service by the individual or PTE. As a result, the depreciable period for the exchanged basis of the replacement qualified property will end before the depreciable period for the excess basis of the replacement qualified property ends.

Thus, qualified property acquired in a like-kind exchange will have two separate placed in service dates under the PR: for purposes of determining the UBIA of the property, the relevant placed in service date will be the date the acquired property is actually placed in service; for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the relinquished property was first placed in service.

[xiv] Rather than treat them as a separate item of property, the PR provides that, in the case of any addition to, or improvement of, qualified property that is already placed in service by the taxpayer, such addition or improvement is treated as separate qualified property that the taxpayer first placed in service on the date such addition or improvement is placed in service by the taxpayer for purposes of determining the depreciable period of the qualified property. For example, if a taxpayer acquired and placed in service a machine on March 26, 2018, and then incurs additional capital expenditures to improve the machine in May 2020, and places such improvements in service on May 27, 2020, the taxpayer has two qualified properties: The machine acquired and placed in service on March 26, 2018, and the improvements to the machine incurred in May 2020 and placed in service on May 27, 2020.

[xv] In the case of qualified property of a partnership that does not produce tax depreciation during the year (for example, property that has been held for less than 10 years but whose recovery period has ended), each partner’s share of the UB of qualified property is based on how gain would be allocated to the partners if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property. In the case of qualified property of an S corporation that does not produce tax depreciation during the year, each shareholder’s share of the UB of the qualified property is a share of the UB proportionate to the ratio of shares in the S corporation held by the shareholder over the total shares of the S corporation.

[xvi] And so ended every episode of Looney Tunes. Thank you Mel Blanc.

This is the third in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

So far, we’ve considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/, and the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ Today we’ll turn to the meaning of “qualified business income.”

Qualified Business Income – In General

In general, under Section 199A of the Code, a non-corporate taxpayer is allowed a deduction (the “Section 199A deduction”) for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such year.

The term “QBI” means, for any taxable year, the net amount of “qualified items of income, gain, deduction, and loss” attributable to any QTB of the taxpayer, which in turn means those items of income, gain, deduction, and loss to the extent they are (i) “effectively connected with” the conduct of a trade or business within the U.S., and (ii) included or allowed in determining taxable income for the taxable year.

QBI items must be determined for each QTB by the individual or pass-through entity (“PTE”) that directly conducts the trade or business before applying the aggregation rules. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/

Exclusion from QBI for Certain Items

The PR provide a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, and certain other items; similarly, items of deduction or loss attributable to these items of income or gain are also not taken into account in determining a taxpayer’s QBI.

Compensation for Services

In general, S corporations must pay their shareholder-employees “reasonable compensation” for services rendered before making “dividend” distributions with respect to shareholder-employees’ stock in the S corporation.

The PR provide that QBI does not include the amount of reasonable compensation paid to the shareholder-employee of an S corporation that operates a QTB for services rendered by the shareholder-employee with respect to such trade or business.

However, the S corporation’s deduction for such reasonable compensation reduces QBI if such deduction is properly allocable to the trade or business and is otherwise deductible.

Guaranteed Payments

Similarly, the PR provide that QBI does not include any guaranteed payment – one determined without regard to the income of the partnership – made by a partnership to a partner for services rendered with respect to the partnership’s trade or business.

However, the partnership’s related expense deduction for making the guaranteed payment may constitute an item of QBI. [i]

The PR clarify that QBI does not include any guaranteed payment paid to a partner for services rendered, regardless of whether the partner is an individual or a PTE. Therefore, a guaranteed payment paid by a lower-tier partnership to an upper-tier partnership retains its character as a guaranteed payment and is not included in QBI of a partner of the upper-tier partnership regardless of whether it is guaranteed to the ultimate recipient.

Other Payments to “Partners”

QBI does not include any payment to a partner, regardless of whether the partner is an individual or a PTE, for services rendered with respect to the partnership’s trade or business where the partner engages with the partnership other than in their capacity as a partner. Thus, it is treated similarly to guaranteed payments, reasonable compensation, and wages, none of which is includable in QBI.

Guaranteed Payments for the Use of Capital

Because guaranteed payments for the use of capital are determined without regard to the income of the partnership, the PR provide that such payments are not considered attributable to a trade or business, and thus do not constitute QBI.

However, the partnership’s related expense for making the guaranteed payments may constitute an item of QBI.

Interest Income

QBI does not include any interest income other than interest income that is properly allocable to a trade or business.

According to the PR, interest income received on working capital, reserves, and similar accounts is income from assets held for investment and is not properly allocable to a trade or business.

In contrast, interest income received on accounts or notes receivable for services or goods provided by the trade or business is not income from assets held for investment, but income received on assets acquired in the ordinary course of the trade or business.

QBI – Special Rules

In addition to the foregoing exclusions, the PR clarify the treatment of certain items that may be of interest to taxpayers that are disposing of their interest in a trade or business.

“Hot Asset” Gain

Under the partnership rules, the gain realized by a partner on the exchange of all or part of their interest in a partnership is treated as ordinary income to the extent it is attributable to the unrealized receivables or inventory items (“hot assets”) of the partnership. These are items that eventually would have been recognized by the partnership and allocated to the partner in the ordinary course; the exchange by the partner of their partnership interest merely accelerates this recognition and allocation.

Similarly, a distribution of property by a partnership to a partner in exchange for the partner’s interest in the “hot assets” of the partnership may be treated as sale or exchange of such hot assets between the partner and the partnership, thereby generating ordinary income.

According to the PR, any gain that is attributable to the hot assets of a partnership – thereby giving rise to ordinary income in the circumstances described above – is considered attributable to the trade or business conducted by the partnership, and therefore, may constitute QBI to the partner.

Of course, the term “unrealized receivables” is defined to include not only receivables, but other items as well; for example, depreciation recapture. This may be significant in the sale of a business by a PTE where the gain arising from the sale would otherwise be excluded from QBI.

Change in Accounting Adjustments

If a taxpayer changes their method of accounting, the Code requires that certain adjustments be made in computing the taxpayer’s taxable income in order to prevent amounts of income or deduction from being duplicated or omitted. In general, these adjustments are taken into account by the taxpayer over a three-year period.

The PR provide that when such adjustments (whether positive or negative) are attributable to a QTB, and arise in a taxable year ending after December 31, 2017, they will be treated as attributable to that trade or business. Accordingly, such adjustments may constitute QBI.

Previously Suspended Losses

Several sections of the Code provide for the disallowance of losses and deductions to a taxpayer in certain cases; for example, the “at risk” rules and the “passive activity loss” rules. Generally, the disallowed amounts are suspended and carried forward to the following year, at which point they are re-tested and may become allowable; of course, when the taxpayer disposes of their interest in the business to an unrelated party in a fully taxable transaction, the loss will cease to be suspended.

Likewise, losses may be suspended because an individual shareholder of an S corporation does not have sufficient stock or debt basis to utilize them; however, the actual or deemed sale of the assets of the S corporation’s business may generate enough gain to increase such basis and enable the shareholder to use the suspended losses.

The PR provide that, to the extent that any previously disallowed losses or deductions, attributable to a QTB, are allowed in the taxable year, they are treated as items attributable to the trade or business. Thus, losses that cease to be suspended under one of the above “disposition rules” may be treated as QBI. However, losses or deductions that were disallowed for taxable years beginning before January 1, 2018 are not taken into account for purposes of computing QBI in a later taxable year.

Net Operating Losses

Generally, items giving rise to a net operating loss (“NOL”) are allowed in computing taxable income in the year incurred. Because those items would have been taken into account in computing QBI in the year incurred, the NOL should not be treated as QBI in subsequent years.

However, to the extent the NOL is comprised of amounts attributable to a QTB that were disallowed under the new “excess business loss” rule – which are not allowed in computing taxable income for the taxable year but which are, instead, carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years – the NOL is considered attributable to that trade or business, and may constitute QBI. https://www.taxlawforchb.com/2018/01/the-real-property-business-and-the-tax-cuts-jobs-act/

Property Used in the Trade or Business

QBI does not include any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss.

The Code provides rules under which gains and losses from the sale or exchange of certain property used in a trade or business are either treated as long-term capital gains or long-term capital losses, or are not treated as gains and losses from sales or exchanges of capital assets.[ii]

The PR clarify that QBI excludes short-term and long-term capital gains or losses, regardless of whether those items arise from the sale or exchange of a capital asset, including any item treated as one of such items taken into account in determining net long-term capital gain or net long-term capital loss.

Conversely, if the gains or losses are not treated as gains and losses from sales or exchanges of capital assets, the gains or losses may be included in QBI.

Effectively Connected With a U.S. Trade or Business

Section 199A applies to all non-corporate taxpayers, whether such taxpayers are domestic or foreign. Accordingly, Section 199A applies to both U.S. citizens and resident aliens, as well as nonresident aliens (“NRA”) that have QBI.

QBI includes items of income, gain, deduction, and loss to the extent such items are (i) included or allowed in determining the U.S. person’s or NRA’s taxable income for the taxable year, and (ii) effectively connected with the conduct of a trade or business within the U.S.

Determining Effectively Connected Income

In general, whether a QTB is engaged in a trade or business within the U.S., partially within the U.S., or solely outside the U.S., is based upon all the facts and circumstances.[iii]

If a trade or business is not engaged in a U.S. trade or business, items of income, gain, deduction, or loss from that trade or business will not be included in QBI because such items would not be effectively connected with the conduct of a U.S. trade or business.

Thus, a shareholder of an S corporation, or a U.S. partner of a partnership, that is engaged in a trade or business in both the U.S. and overseas would only take into account the items of income, deduction, gain, and loss that would be effectively connected with the business conducted by the S corporation, or partnership, in the U.S.

In determining whether income or gain from U.S. sources is effectively connected with the conduct of a trade or business within the U.S., a number of factors have to be considered, including whether the income, gain or loss is derived from assets used in or held for use in the conduct of such trade or business, or the activities of such trade or business were a material factor in the realization of the income, gain or loss.

If an NRA’s QTB is determined to be conducted in the U.S., the Code generally treats all non-investment income of the NRA from sources within the U.S. as effectively connected with the conduct of a U.S. trade or business.[iv]

Income from sources without the U.S. is generally not treated as effectively connected with the NRA’s conduct of a U.S. trade or business. Thus, a trade or business’s foreign source income, gain, or loss, (and any deductions effectively connected with such foreign source income, gain, or loss) would generally not be included in QBI.[v]

However, this rule does not mean that any item of income or deduction that is treated as effectively connected with an NRA’s conduct of a trade or business with the U.S. is necessarily QBI. Indeed, certain provisions of the Code allow items to be treated as effectively connected, even though they are not “items” with respect to a trade or business. For example, the Code allows an NRA to elect to treat income from rental real property in the U.S. that would not otherwise be treated as effectively connected with the conduct of a trade or business within the U.S. as effectively connected. However, if items are not attributable to a QTB, they do not constitute QBI.

Allocation of QBI Items

The PR provides that, if an individual or a PTE directly conducts multiple trades or businesses, and has items of QBI that are properly attributable to more than one trade or business, the taxpayer or entity must allocate those items among the several trades or businesses to which they are attributable using a reasonable method that is consistent with the purposes of Section 199A.

The chosen reasonable method for each item must be consistently applied from one taxable year to another, and must clearly reflect the income of each trade or business.

There are several different ways to allocate expenses, such as direct tracing, allocating based on gross income, or some other method, but whether these are reasonable depends on the facts and circumstances of each trade or business.

Next week, we’ll bring together the basic elements of Section 199A, which we covered in the last three posts, to see how the “20% deduction” is determined.

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[i] The PR provides that QBI does not include reasonable compensation paid by an S corporation but does not extend this rule to partnerships. Because the trade or business of performing services as an employee is not a QTB, wage income received by an employee is never QBI.

The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in QBI.

[ii] IRC Sec. 1231.

[iii] Because an NRA cannot be a shareholder on an S corporation, the NRA’s effectively connected income must arise from the NRA’s direct conduct of a trade or business in the U.S. (including through a disregarded entity; if the NRA is a resident of a treaty country, the NRA’s business profits will not be subject to U.S. tax unless the NRA operates the business through a permanent establishment in the U.S.); in addition, an NRA is considered engaged in a trade or business within the U.S. if the partnership of which such individual is a member is so engaged.

[iv] However, any “FDAP” income or “portfolio interest” income from sources within the U.S., and any gain or loss from the sale of capital assets, may be effectively connected only if the income meets certain requirements.

[v] There are exceptions.

This is the second in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

 Yesterday, we considered the elements of a “qualified” trade or business under Section 199A. Today, we’ll pick up with those trades or businesses that may be excluded from its coverage, and tomorrow we’ll turn to the meaning of qualified business income. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/ Hold on to your seats as we continue to look at more . . . definitions.

Effect of Specified Service Trade or Business Status

A qualified trade or business (“QTB”) – the qualified business income (“QBI”) of which provides the basis for the Section 199A deduction – includes any trade or business other than a “specified service trade or business” (“SSTB”).

Thus, if a trade or business is an SSTB, no QBI, W-2 wages, or unadjusted basis (“UB”) of qualified property from the SSTB may be taken into account by an individual owner of the SSTB whose taxable income exceeds a threshold amount plus a phase-in range, even if the taxable income is derived from an activity that is not itself an SSTB.

If the trade or business conducted by a PTE is an SSTB, this limitation will apply to any direct or indirect individual owners of the business, regardless of whether the owner is passive or participated in any SSTB activity. However, the SSTB limitation will not apply to an individual with taxable income below the threshold amount.[i]

SSTB Defined

Conceptually, the definition of an SSTB emphasizes the direct provision of services by the employees or owners of a trade or business, rather than the application of capital.

Although the Code does not require a certain quantum of specified service activity is necessary to find an SSTB, the PR provide a de minimis rule under which a trade or business will not be considered an SSTB merely because it provides a small amount of services in a specified service activity.[ii]

An SSTB means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, 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 owners, and any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

Some of these services are considered below.

Health

The PR provide that the term “performance of services in the field of health” means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient.

The performance of services in the field of health does not include the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient.

For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.

Law

The term “performance of services in the field of law” means the provision of services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals in their capacity as such.

It does not include the provision of services that do not require skills unique to the field of law; for example, the provision of services in the field of law does not include the provision of services by printers, delivery services, or stenography services.

Accounting

The PR provides that the term “performance of services in the field of accounting” means the provision of services by accountants, enrolled agents, return preparers, financial auditors, and similar professionals in their capacity as such.

Provision of services in the field of accounting is not limited to services requiring state licensure as a certified public accountant (CPA). The aim of the PR is to capture the common understanding of accounting, which includes bookkeeping services.

The field of accounting does not include payment processing and billing analysis.

Consulting

The term “performance of services in the field of consulting” means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.

Consulting includes providing advice and counsel regarding advocacy with the intention of influencing decisions made by a government or governmental agency and all attempts to influence legislators and other government officials on behalf of a client by lobbyists and other similar professionals performing services in their capacity as such.

The performance of services in the field of consulting does not include the performance of services other than advice and counsel, such as sales or economically similar services, or the provision of training or educational courses. The determination of whether a person’s services are sales or economically similar services is made based on all the facts and circumstances of that person’s business, including the manner in which the taxpayer is compensated for the services.

In recognition of the fact that, in certain kinds of sales transactions, it is common for businesses to provide consulting services in connection with the purchase of goods by customers – for example, a company that sells computers may provide customers with consulting services relating to the setup, operation, and repair of the computers – the PR provide a de minimis rule under which a trade or business is not an SSTB if less than 10% of the gross receipts (5% if the gross receipts are greater than $25 million) of the trade or business for a taxable year are attributable to the performance of services in a SSTB.

However, the IRS also recognized that this de minimis rule may not provide sufficient relief for certain trades or business that provide ancillary consulting services. Thus, the PR also provide that the field of consulting does not include the performance of consulting services that are embedded in, or ancillary to, the sale of goods or the performance of services on behalf of a trade or business that is other than an SSTB if there is no separate payment for the consulting services.

Financial Services

The PR limits the definition of financial services to services including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings (including in title 11 or similar cases), and raising financial capital by underwriting, or acting as the client’s agent in the issuance of securities, and similar services.

This includes services provided by financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals.

Brokerage Services

The PR provide that the field of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee. This includes services provided by stock brokers and other similar professionals, but does not include services provided by real estate agents and brokers, or insurance agents and brokers.

Principal Asset of the Business: Reputation or Skill of Employees or Owners

Thankfully, the PR rejected a broad, service-based approach to the meaning of what could have been the catch-all “reputation or skill” clause by limiting it to fact patterns in which the individual or PTE is engaged in the trade or business of: (1) Receiving income for endorsing products or services, including an individual’s distributive share of income or distributions from an PTE for which the individual provides endorsement services; (2) licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, including an individual’s distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual’s image; or (3) receiving appearance fees or income.[iii]

Investing and Investment Management

The PR provide that any trade or business that involves the “performance of services that consist of investing and investment management” means a trade or business that earns fees for investment, asset management services, or investment management services, including providing advice with respect to buying and selling investments. The performance of services that consist of investing and investment management would include a trade or business that receives either a commission, a flat fee, or an investment management fee calculated as a percentage of assets under management.

The performance of services of investing and investment management does not include directly managing real property.

Trading

The PR provide that any trade or business involving the “performance of services that consist of trading” means a trade or business of trading in securities, commodities, or partnership interests. Whether a person is a trader is determined taking into account the relevant facts and circumstances. Factors that have been considered relevant to determining whether a person is a trader include the source and type of profit generally sought from engaging in the activity regardless of whether the activity is being provided on behalf of customers or for a taxpayer’s own account.

Dealing in Securities

The “performance of services that consist of dealing in securities” means regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. For purposes of the preceding sentence, a taxpayer that regularly originates loans in the ordinary course of a trade or business of making loans but engages in no more than “negligible” sales of the loans is not dealing in securities for purposes of Section 199A.

The fact that businesses are operated across entities raises the question of whether, in defining a “trade or business” for purposes of Section 199A, trades or businesses should be permitted or required to be aggregated, or disaggregated, and if so, whether such aggregation, or disaggregation, should occur at the entity level or at the individual-owner level.

Services or Property Provided to an SSTB

The IRS observed that some taxpayers have contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the Section 199A deduction. Such a strategy, the IRS has stated, is inconsistent with the purpose of Section 199A.

Therefore, the PR provide an anti-abuse rule pursuant to which an SSTB will include any trade or business (not otherwise an SSTB) with 50% or more common ownership (direct or indirect) with an SSTB, that provides 80% or more of its property or services to the SSTB.

Additionally, if a trade or business provides less than 80% of its property or services to an SSTB, but has 50% or more common ownership with an SSTB, that portion of the trade or business of providing property or services to the SSTB will be treated as part of the SSTB (meaning the income will be treated as income from an SSTB). For example, dentist A owns a dental practice and also owns an office building. A rents half the building to the dental practice and half the building to unrelated persons. The renting of half of the building to the dental practice will be treated as an SSTB.

The PR also provide a rule that if a trade or business (that would not otherwise be treated as an SSTB) has 50% or more common ownership with an SSTB, and has shared expenses with an SSTB, including wages or overhead expenses, it is treated as incidental to the SSTB and, therefore, as part of the SSTB, if the gross receipts of the trade or business represent no more than 5% of the gross receipts of the combined business in a taxable year.

Example. A, a dermatologist, provides medical services to patients on a regular basis through LLC, a disregarded entity owned by A. In addition to providing medical services, LLC also sells skin care products to A’s patients. The same employees and office space are used for the medical services and sale of skin care products. The gross receipts with respect to the skin care product sales do not exceed 5% of the gross receipts of LLC. Accordingly, the sale of the skin care products is treated as incidental to A’s SSTB of performing services in the field of health and is treated as part of such SSTB.

————————————————————————————————

[i] For purposes of this post, it is assumed that the threshold amount ($315,000 in the case of married taxpayers filing jointly) and phase-in range are exceeded. It should be noted, however, that an individual with taxable income in excess of the threshold amount but within the phase-in range will be allowed to take into account a certain “applicable percentage” of QBI, W-2 wages and QB of qualified property from an SSTB in determining their Section 199A deduction. Thus, some owners of an SSTB may qualify for the Section 199A deduction while others may not.

[ii] For more details on this de minimis rule, see the discussion below, under “consulting” services.

[iii] Oh, to be a celebrity!

What follows is the first in a series of posts that will review the long-awaited proposed regulations under Sec. 199A of the Code – the “20% deduction” – which was enacted by the Tax Cuts and Jobs Act to benefit the individual owners of pass-through business entities.

Today’s post will summarize the statutory provision, and will then consider some of the predicate definitions and special rules that are key to its application.

We will continue to explore these definitions and rules in tomorrow’s post.

Congress: “I Have Something for You”

The vast majority of our clients are closely-held businesses that are organized as pass-through entities (“PTEs”), and that are owned by individuals. These PTEs include limited liability companies that are treated as partnerships for tax purposes, as well as S corporations.

As the Tax Cuts and Jobs Act (“TCJA”)[i] moved through Congress in late 2017, it became clear that C corporations were about to realize a significant windfall.[ii] In reaction to this development, many individual clients who operate through partnerships began to wonder whether they should incorporate their business (for example, by “checking the box”[iii]); among those clients that operated their business as S corporations, many asked whether they should revoke their “S” election.

After what must have been a substantial amount of grumbling from the closely-held business community, Congress decided to add a new deduction to the TCJA – Section 199A – that was intended to benefit the individual owners of PTEs for taxable years beginning after 2017 and before 2026.[iv]

“Here It Is”

In general, under new Section 199A of the Code, a non-corporate taxpayer is allowed a deduction (the “Section 199A deduction”) for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such year.

A QTB includes any trade or business other than a “specified service trade or business” (“SSTB”)[v]. It also does not include the trade or business of rendering services as an employee.

An SSTB includes, among other things, any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, 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.

The QBI of a QTB means, for any taxable year, the net income or loss with respect to such trade or business of the taxpayer for the year, provided it is effectively connected with the conduct of a trade or business in the U.S. (“effectively connected income,” or “ECI”).

Investment income is not included in determining QBI, nor is any reasonable compensation paid to a shareholder, nor any guaranteed payment made to a partner, for services rendered to the QTB.

If an individual taxpayer-owner’s taxable income for a taxable year exceeds a threshold amount, a special limitation will apply to limit that individual’s Section 199A deduction.

Assuming the limitation rule is fully applicable, the amount of the Section 199A deduction may not exceed the greater of:

  • 50% of the W-2 wages with respect to the QTB that are allocable to QBI, or
  • 25% of such W-2 wages, plus 2.50% of the “unadjusted basis” (“UB”)[vi] of all depreciable tangible property held by the QTB at the close of the taxable year, which is used at any point in the year in the production of QBI, and the depreciable period for which has not ended before the close of the taxable year (“qualified property”).

If the individual taxpayer carries on more than one QTB (directly or through a PTE), the foregoing calculation is applied separately to each such QTB, and the results are then aggregated to determine the amount of the Section 199A deduction.

Thus, a loss generated in one QTB may offset the net income generated in another, thereby denying the taxpayer any Section 199A deduction.

If the taxpayer carries on the business indirectly, through a partnership or S corporation, the rule is applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of QBI, as well as their allocable share of W-2 wages and UB (for purposes of applying the above limitation).

Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitation, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than others, even where they have the same percentage equity interest in the QTB.[vii]

Finally, the amount of a taxpayer’s Section 199A deduction for a taxable year determined under the foregoing rules may not exceed 20% of the excess of (i) the taxpayer’s taxable income for the taxable year over (ii) the taxpayer’s net capital gain for such year.

Taxpayer: “Thank You, But I Have Some Questions”

It did not take long after Section 199A was enacted as part of the TCJA, on December 22, 2017, for many tax advisers and their PTE clients to start asking questions about the meaning or application of various parts of the rule.

For example, what constitutes a “trade or business” for purposes of the rule? Would taxpayers be allowed to group together separate but related businesses for purposes of determining the Deduction? Would they be required to do so? Under what circumstances, if any, would a PTE be permitted to split off a discrete business activity or function into a different business entity? When is the reputation or skill of an employee the principal asset of a business?

Because of these and other questions, most advisers decided it would be best to wait for guidance from the IRS before advising taxpayers on how to implement and apply the new rules.[viii]

The IRS assured taxpayers that such guidance would be forthcoming in the spring of 2018; it subsequently revised its target date to July of 2018; then, on August 16, the IRS issued almost 200 pages of Proposed Regulations (“PR”). https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

The Proposed Regulations

The PR will apply to taxable years ending after the date they are adopted as final regulations; until then, however, taxpayers may rely on the PR.

Trade or Business – In General

The PR provide that, for purposes of Section 199A, the term “trade or business” shall mean an activity that is conducted with “continuity and regularity” and “with the primary purpose of earning income or making profit.” This is the same definition that taxpayers have applied for decades for purposes of determining whether expenses may be deducted as having been incurred in the ordinary course of a trade or business (so-called “ordinary and necessary” expenses).

However, in recognition of the fact that it is not uncommon, for legal or other bona fide non-tax reasons (for example, to limit exposure to liability), for taxpayers to segregate rental properties from operating businesses, the PR extend the definition of “trade or business” for purposes of Section 199A by including the rental or licensing of tangible or intangible property to a related trade or business – which may not otherwise satisfy the general definition of “trade or business” adopted by the PR (for example, where the entire property is rented only to the operating business) – if the “lessor/licensor trade or business” and the “lessee/licensee trade or business” are commonly controlled (generally speaking, if the same person or group of persons, directly or indirectly, owns 50% or more of each trade or business).

Trade or Business – Aggregation Rules

The above line of reasoning also informed the IRS’s thinking with respect to the “grouping” of certain trades or businesses for purposes of applying Section 199A.

Specifically, the IRS recognized that some amount of aggregation should be permitted because it is not uncommon, for what are commonly thought of as single trades or businesses, to be operated across multiple entities for various legal, economic, or other bona fide non-tax reasons.

Allowing taxpayers to aggregate trades or businesses offers taxpayers a means of combining their trades or businesses for purposes of applying the “W-2 wage” and “UB of qualified property” limitations (described above) and potentially maximizing the deduction under Section 199A. The IRS was concerned that if such aggregation were not permitted, taxpayers could be forced to incur costs to restructure solely for tax purposes. In addition, business and non-tax legal requirements may not permit many taxpayers to restructure their operations.

Therefore, the PR permits the aggregation of separate trades or businesses, provided certain requirements are satisfied; aggregation is not required.[ix]

An individual may aggregate trades or businesses only if the individual can demonstrate that certain requirements are satisfied:

  • Each “trade or business” must itself be a trade or business for purposes of Section 199A.
  • The same person, or group of persons, must directly or indirectly, own a majority interest in each of the businesses to be aggregated for the majority of the taxable year in which the items attributable to each trade or business are included in income. All of the items attributable to the trades or businesses must be reported on tax returns with the same taxable year.
    • The PR provides rules allowing for family attribution.
    • Because the proposed rules look to a group of persons, minority owners may benefit from the common ownership and are permitted to aggregate.
  • None of the aggregated trades or businesses can be an SSTB (more on this tomorrow).
  • Individuals must establish that the trades or businesses to be aggregated meet at least two of the following three factors, which demonstrate that the businesses are in fact part of a larger, integrated trade or business:
    • The businesses provide products and services that are the same (for example, a restaurant and a food truck) or they provide products and services that are customarily provided together (for example, a gas station and a car wash);
    • The businesses share facilities or share significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources); or
    • The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).

Trade or Business – Aggregation by Individuals

An individual is permitted to aggregate trades or businesses that the individual operates directly and trades or businesses operated indirectly – or, more appropriately, they may aggregate the businesses they operate directly with their share of QBI, W-2 wages and UB of qualified property from trades or businesses operated through PTEs of which the individual is an owner.

Individual owners of the same PTEs are not required to aggregate in the same manner.

An individual directly engaged in a trade or business must compute QBI, W-2 wages, and UB of qualified property for each such trade or business before applying the aggregation rules.

If an individual has aggregated two or more trades or businesses, then the combined QBI, W-2 wages, and UB of qualified property for all aggregated trades or businesses is used for purposes of applying the W-2 wage and UB of qualified property limitations.

Example. Individual A wholly owns and operates a catering business and a restaurant through separate disregarded entities. The catering business and the restaurant share centralized purchasing to obtain volume discounts and a centralized accounting office that performs all of the bookkeeping, tracks and issues statements on all of the receivables, and prepares the payroll for each business. A maintains a website and print advertising materials that reference both the catering business and the restaurant. A uses the restaurant kitchen to prepare food for the catering business. The catering business employs its own staff and owns equipment and trucks that are not used or associated with the restaurant.

Because the restaurant and catering business are held in disregarded entities, A will be treated as operating each of these businesses directly. Because both businesses offer prepared food to customers, and because the two businesses share the same kitchen facilities in addition to centralized purchasing, marketing, and accounting, A may treat the catering business and the restaurant as a single trade or business for purposes of applying the limitation rules.

Example. Assume the same facts as above, but the catering and restaurant businesses are owned in separate partnerships and A, B, C, and D each own a 25% interest in the capital and profits of each of the two partnerships. A, B, C, and D are unrelated.

Because A, B, C, and D together own more than 50% of the capital and profits in each of the two partnerships, they may each treat the catering business and the restaurant as a single trade or business for purposes of applying the limitation rules.

Trade or Business – Aggregation by PTEs

PTEs must compute QBI, W-2 wages, and UB of qualified property for each trade or business. A PTE must provide its owners with information regarding QBI, W-2 wages, and UB of qualified property attributable to its trades or businesses.

The PR do not address the aggregation by a PTE in a tiered structure.

Trade or Business – Aggregation – Reporting and Consistency

The PR requires that, once multiple trades or businesses are aggregated into a single aggregated trade or business, individuals must consistently report the aggregated group in subsequent tax years.

The PR provides rules for situations in which the aggregation rules are no longer satisfied, as well as rules for when a newly-created or newly-acquired trade or business can be added to an existing aggregated group.

Finally, the PR provides reporting and disclosure requirements for individuals that choose to aggregate, including identifying information about each trade or business that constitutes a part of the aggregated trade or business. The PR allows the IRS to disaggregate trades or businesses if an individual fails to make the required disclosure.


[*] Anyone remember the following scene from “The Jerk”?

Navin: “The new phone book’s here! The new phone book’s here!”
Harry: “Well I wish I could get so excited about nothing.”
Navin: “Nothing? Are you kidding?! Page 73, Johnson, Navin, R.! I’m somebody now! Millions of people look at this book every day! This is the kind of spontaneous publicity, your name in print, that makes people. I’m in print! Things are going to start happening to me now.”

[i] Pub. L. 115-97.

[ii] See, e.g., https://www.taxlawforchb.com/2018/01/some-of-the-tcjas-corporate-tax-changes/ ; https://www.taxlawforchb.com/2018/01/will-tax-reform-affect-domestic-ma/ ; https://www.taxlawforchb.com/2018/06/s-corps-cfcs-the-tax-cuts-jobs-act/.

[iii] https://www.law.cornell.edu/cfr/text/26/301.7701-3

[iv] That’s right – the provision is scheduled to disappear in a few years. However, on July 24, the House Ways and Means Committee released “Tax Reform 2.0 Listening Session Framework” which would make the deduction permanent. These proposals will not be considered until after the Congressional elections this fall. Enough said. https://waysandmeansforms.house.gov/uploadedfiles/tax_reform_2.0_house_gop_listening_session_framework_.pdf

[v] It should be noted that a SSTB will not be excluded from QTB status with respect to an individual taxpayer-owner of the SSTB if the taxpayer’s taxable income does not exceed certain thresholds. It is assumed herein that these thresholds, as well as the range of taxable income above such thresholds within which the benefit of Section 199A is scaled back, are exceeded for every owner of the SSTB.

[vi] In general, the unadjusted basis, immediately after acquisition, of all qualified property.

[vii] Query whether this may influence business and investment decisions.

[viii] Others, however, saw a wasting opportunity, given the scheduled elimination of the deduction after the year 2025, and may have acted hastily. Among other things, many of these advisers and taxpayers sought to bootstrap themselves into a QTB by separating its activities from a related SSTB.

[ix] The IRS is aware that many taxpayers are concerned with having multiple regimes for grouping. Accordingly, it has requested comments on the aggregation method described in the PR, including whether this would be an appropriate grouping method for purposes of the passive activity loss limitation and net investment income surtax rules, in addition to Section 199A.

 

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.

Decisions, Decisions

The reduction in the Federal income tax rate for C corporations, from a maximum of 35-percent to a flat 21-percent, along with several other changes made by the Tax Cuts and Jobs Act (the “Act”) that generally reflect a pro-C corporation bias, have caused the owners of many pass-through entities (“PTEs”) to reconsider the continuing status of such entities as S corporations, partnerships, and sole proprietorships.

Among the factors being examined by owners and their advisers are the following:

  • the PTE is not itself a taxable entity, and the maximum Federal income rate applicable to its individual owners on their pro rata share of a PTE’s ordinary operating income is 37-percent[i], as compared to the 21-percent rate for a C corporation;
  • the owners of a PTE may be able to reduce their Federal tax rate to as low as 29.6-percent if they can take advantage of the “20-percent of qualified business income deduction”;
  • a PTE’s distribution of income that has already been taxed to its owners is generally not taxable[ii], while a C corporation’s distribution of its after-tax earnings will generally be taxable to its owners at a Federal rate of 23.8%, for an effective combined corporate and shareholder rate of 39.8%;
  • the capital gain from the sale of a PTE’s assets will generally not be taxable to the PTE[iii], and will generally be subject to a Federal tax rate of 20-percent in the hands of its owners[iv], while the same transaction by a C corporation, followed by a liquidating distribution to its shareholders, will generate a combined tax rate of 39.8%.[v]

The application of these considerations to the unique facts circumstances of a particular business may cause its owners to arrive at a different conclusion than will the owners of another business that appears to be similarly situated.

Even within a single business, there may be disagreement among its owners as to which form of business organization, or which tax status, would optimize the owners’ economic benefit, depending upon their own individual tax situation and appetite.[vi]

In the past, this kind of disagreement in the context of a closely held business has often resulted in litigation of the kind that spawned the discovery issue described below. The changes made by the Act are certain to produce more than their share of similar intra-business litigation as owners disagree over the failure of their business to make or revoke certain tax elections, as well as its failure to reorganize its “corporate” structure.

A Taste of Things to Come?

Corporation was created to invest in the development, production, and sale of a product. Among its shareholders was a limited partnership (“LP”), of which Plaintiff was the majority owner.

Plaintiff asserted that Corporation’s management (“Defendants”) had breached their fiduciary duty to LP and the other shareholders. This claim was based upon the fact that Corporation was a C corporation and, as such, its dividend distributions to LP were taxable to LP’s members, based upon their respective ownership interest of LP.[vii]

Plaintiff claimed that this “double taxation” of Corporation’s earnings – once to Corporation and again upon its distribution as a dividend to its shareholders – had cost the business and its owners millions of dollars over the years, was “unnecessary,” had reduced the value of LP, and could have been avoided if Corporation had been converted into an S corporation, at which point LP would have distributed its shares of Corporation stock to its members, who were individuals.

Plaintiff stated that it had made repeated requests to Defendants to “eliminate this waste,” but to no avail.

Thus, one of the forms of relief requested by Plaintiff was “[p]ermanent injunctive relief compelling the Defendants to take all appropriate actions necessary to eliminate the taxable status of [Corporation] that results in an unnecessary level of taxation on distributions to the limited partners of [LP].”

“Prove It”

Defendants asked the Court to compel Plaintiff to produce Plaintiff’s tax returns for any tax year as to which Plaintiff claimed to have suffered damages based upon Corporation’s tax status.

Defendants asserted that, in order to measure any damages that were suffered by Plaintiff by reason of Corporation’s status, Defendants needed certain information regarding Plaintiff’s taxes, including Plaintiff’s “tax rate, deductions, credits and the like.”

Plaintiff responded that their “tax returns have no conceivable relevance to any aspect of this case.” Among other reasons, Plaintiff asserted that the action was brought derivatively on behalf of LP such that Plaintiff’s personal tax returns were not germane.

Defendants countered that, even if Plaintiff’s claims were asserted derivatively, the tax returns nevertheless were relevant since Plaintiff was a member of LP, the entity on whose behalf the claims were made.

The Court’s Decision

According to the Court, tax returns in the possession of a taxpayer are not immune from civil discovery. It noted, however, that courts generally are “reluctant to order the production of personal financial documents and have imposed a heightened standard for the discovery of tax returns.”

The Court explained that a party seeking to compel production of tax returns in civil cases must meet a two-part test; specifically, it must demonstrate that:

  • the returns are relevant to the subject matter of the action; and
  • there is a compelling need for the returns because the information contained therein is not otherwise readily obtainable.

Limited partnerships, the Court continued, “are taxed as ‘pass-through’ entities, do not pay any income tax, but instead file information returns and reports to each partner on his or her pro-rata share of all income, deductions, gains, losses, credits and other items.” The partner then reports those items on his or her individual income tax return. “The limited partnership serves as a conduit through which the income tax consequences of a project or enterprise are passed through to the individual partners.”

The Court found that Plaintiff’s tax returns were relevant to the claims asserted. The crux of Plaintiff’s argument regarding Corporation’s status, the Court stated, was that LP’s partners, including Plaintiff, were subject to “double taxation” and were thereby damaged.

The Court also found that Defendants had established a compelling need. The Court was satisfied that, in order for Defendants to ascertain whether or not Plaintiff, who owned a majority interest in LP, would have paid less tax if Corporation had been converted to an S corporation, Plaintiff had to produce their tax returns to Defendants. The tax returns would disclose, among other things, Plaintiff’s tax rate, deductions and credits that affected the tax due by Plaintiff.

Furthermore, the Court continued, Plaintiff failed to demonstrate that there were alternative sources from which to obtain the information. “While the party seeking discovery of the tax returns bears the burden of establishing relevance, the party resisting disclosure should bear the burden of establishing alternative sources for the information.”

Any concerns that existed regarding the private nature of the information contained in the tax returns could be addressed, the Court stated, by making the tax returns subject to the terms of the “stipulation and order of confidentiality” previously entered in the case.[viii]

Accordingly, the Court granted Defendants’ motion.

What’s Good for the Goose?

For years, oppressed or disgruntled shareholders and partners have often found in the tax returns of the business, of which they are owners, the clues, leads, or circumstantial evidence that help support their claims of mismanagement or worse by those in control of the business.

As a result of the Act, it is likely that some non-controlling owners will find cause for questioning or challenging the “choice of entity” decisions made on behalf of the business by its controlling owners.[ix]

In some cases, their concerns will be validated by what turn out to be true instances of oppression intended to cause economic harm and, perhaps, to force out the intended target.

In others, however, the controlling owner’s decision will have been reached only after a lot of due diligence, including financial modelling and consulting with tax advisers. In such cases, the controlling owner may want to examine the complaining party’s tax return, as in the Court’s decision described above, so as to ascertain whether the loss claimed was actually suffered.

It bears repeating, though, that even if the tax return information may be relevant to the controlling owner’s defense, there is a judicial bias against the disclosure of such information that is manifested in the application of “a heightened standard for the discovery of tax returns.” As stated earlier, the requesting party has to demonstrate that there is a “strong necessity” for the returns, and that the return information is not readily obtainable from other sources.

In the end, the best course of action for the “choice-of-entity” decision-maker, and their best defense against any claims of oppression or mismanagement, is to demonstrate that they acted reasonably and responsibly; they should thoroughly document the decision-process, and explain the basis for their decision. With that, a potential owner-claimant would be hard-pressed to second-guess them with any reasonable likelihood of success.


[i] If the PTE’s business is a passive activity with respect to the owner, the 3.8% Federal surtax on net investment income may also apply, bumping their maximum Federal tax rate up from 37% to 40.8%.

[ii] Because of the upward basis adjustment to the owner’s partnership interest or S corp. stock resulting from the inclusion of the PTE’s income or gain in the owner’s gross income.

[iii] There are exceptions; for example, the built-in gains tax for S corps. https://www.taxlawforchb.com/2013/09/s-corp-sales-built-in-gain-and-2013/ . In addition, the gain from the sale of certain assets may generate ordinary income that would be taxable to the PTE’s owners at a Federal rate of 37%; for example, depreciation recapture.

[iv] But see endnote i, supra.

[v] The operating income and capital gain of a C corporation are taxed at the same rate; there is no preferential Federal capital gain rate as in the case of individuals.

[vi] You may have heard your own clients debating the pros and cons of spinning off “divisions” so as to position themselves for maximizing the deduction based on qualified business income. All this before the issuance of any guidance by the IRS (which is expected later this month), though the Service intimated last month that taxpayers may not be pleased with its position regarding such spin-offs.

[vii] See the third bullet point, above.

[viii] Such an order may be used in cases requiring the exchange, as part of the discovery process, of what the parties to the law suit believe is confidential information.

[ix] For example, a shareholder of an S corporation that does not make distributions, who is not employed by the business, who is a passive investor in the business, and whose pro rata share of the corporation’s income is subject to federal tax at a rate of 40.8%, may wonder why the controlling shareholder does not agree to revoke the “S” election, to at least start making tax distributions.

Pro “C” Corporation Bias?

Although closely-held businesses have generally welcomed the TCJA’s[i] amendments to the Code relating to the taxation of business income, many are also frustrated by the complexity of some of these changes. Among the provisions that have drawn the most criticism on this count are the changes to the taxation of business income arising from the foreign (“outbound”) activities of U.S. persons.

Because more and more closely-held U.S. businesses, including many S corporations, have been establishing operations overseas – whether through branches or corporate subsidiaries[ii] – the impact of these changes cannot be underestimated.

Moreover, their effect may be more keenly felt by closely-held U.S. businesses that are treated as pass-through entities[iii]; in other words, there appears to be a bias in the TCJA in favor of C corporations.

Overview: Deferred Recognition of Foreign Income – Pre-TCJA

In general, the U.S. has taxed U.S. persons on their worldwide income, although there has been some deferral of the taxation of the foreign-sourced income[iv] earned by the foreign corporate (“FC”) subsidiaries of U.S. businesses.[v]

The Code defines a “U.S. person” to include U.S. citizens and residents.[vi] A corporation or partnership is treated as a U.S. person if it is organized or created under the laws of the U.S. or of any State.[vii]

In general, income earned directly by a U.S. person from the conduct of a foreign business – for example, through the operation of a branch in a foreign jurisdiction – is taxed on a current basis.[viii]

Historically, however, active foreign business income earned indirectly by a U.S. person, through a FC subsidiary, generally has not been subject to U.S. tax until the income is distributed as a dividend to the U.S. person – unless an anti-deferral rule applies.

The CFC Regime

The main U.S. anti-tax-deferral regime, which addresses the taxation of income earned by controlled foreign corporations (“CFC”), may cause some U.S. persons who own shares of stock of a CFC to be taxed currently on certain categories of income earned by the CFC, regardless of whether the income has been distributed to them as a dividend.[ix]

CFC

A CFC is defined as any FC if U.S. persons own (directly, indirectly, or constructively[x]) more than 50-percent of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons who own at least 10-percent of the FC’s stock (measured by vote or value; each a “United States shareholder” or “USS”).[xi]

Subpart F Income

Under the CFC rules, the U.S. generally taxes the USS of a CFC on their pro rata shares of the CFC’s “subpart F income,” without regard to whether the income is distributed to the shareholders. In effect, the U.S. treats the USS of a CFC as having received a current distribution of the CFC’s subpart F income.

In the case of most USS, subpart F income generally includes “foreign base company income,” which consists of “foreign personal holding company income” (such as dividends, interest, rents, and royalties), and certain categories of income from business operations that involve transactions with “related persons,” including “foreign base company sales income” and “foreign base company services income.”[xii]

One exception to the definition of subpart F income permits continued U.S.-tax-deferral for income received by a CFC in certain transactions with a related corporation organized and operating in the same foreign country in which the CFC is organized (the “same country exception”). Another exception is available for any item of income received by a CFC if the taxpayer establishes that the income was subject to an effective foreign income tax rate greater than 90-percent of the maximum U.S. corporate income tax rate (the “high-tax exception”).[xiii]

Actual Distributions

A USS may exclude from its income actual distributions of earnings and profits (“E&P”) from the CFC that were previously included in the USS’s income under the CFC regime.[xiv] Ordering rules provide that distributions from a CFC are treated as coming first out of E&P of the CFC that were previously taxed under the CFC regime, then out of other E&P.[xv]

Foreign Tax Credit

Subject to certain limitations, U.S. persons are allowed to claim a credit for foreign income taxes they pay. A foreign tax credit (“FTC”) generally is available to offset, in whole or in part, the U.S. income tax owed on foreign-source income included in the U.S. person’s income; this includes foreign taxes paid by an S corporation on any of its foreign income that flows through to its shareholders.

A domestic corporation is allowed a “deemed-paid” credit for foreign income taxes paid by the CFC that the domestic corporation is deemed to have paid when the related income is included in the domestic corporation’s income under the anti-deferral rules.[xvi]

Unfortunately for S corporations, they are treated as partnerships – not corporations – for purposes of the FTC and the CFC rules; thus, they cannot pass-through any such deemed-paid credit to their shareholders.

However, any tax that is withheld by the CFC with respect to a dividend distributed to an S corporation will flow through to the S corporation’s individual shareholders.

TCJA Changes

The TCJA made some significant changes to the taxation of USS that own stock in CFCs.

Transition Rule: Mandatory Inclusion

In order to provide a clean slate for the application of these new rules, the TCJA provides a special transition rule that requires all USS of a “specified foreign corporation” (“SFC”) to include in income their pro rata shares of the SFC’s “accumulated post-1986 deferred foreign income” (“post-1986-DFI”) that was not previously taxed to them.[xvii] A SFC means (1) a CFC or (2) any FC in which a domestic corporation is a USS.[xviii]

The mechanism for the mandatory inclusion of these pre-effective-date foreign earnings is the CFC regime. The TCJA provides that the subpart F income of a SFC is increased for the last taxable year of the SFC that begins before January 1, 2018.

This transition rule applies to all USS of a SFC, including individuals.

Consistent with the general operation of the CFC regime, each USS of a SFC must include in income its pro rata share of the SFC’s subpart F income attributable to the corporation’s post-1986-DFI.

Reduced Tax Rate

Fortunately, the TCJA allows a portion of that pro rata share of deferred foreign income to be deducted. The amount deductible varies, depending upon whether the deferred foreign income is held by the SFC in the form of liquid or illiquid assets. To the extent the income is not so deductible – i.e., is included in the income of the USS – the USS may claim a portion of the foreign tax credit attributable thereto.

The total deduction from the amount included under the transition rule is the amount necessary to result in a 15.5-percent tax rate on post-1986-DFI held by the SFC in the form of cash or cash equivalents,[xix] and an 8-percent tax rate on all other earnings.

The calculation of the deduction is based on the highest rate of tax applicable to domestic corporations in the taxable year of inclusion, even if the USS is an individual.

However, an individual USS – including the shareholder of an S corporation – will be taxed on the amount included in their income at the higher federal tax rate applicable to individuals.[xx]

That being said, an individual USS, including one who is a shareholder of an S corporation, generally may elect application of the corporate tax rates for the year of inclusion.[xxi]

Deferred Payment of Tax

A USS may elect to pay the net tax liability resulting from the mandatory inclusion of post-1986-DFI in eight unequal installments.[xxii] The timely payment of an installment does not incur interest.[xxiii]

The provision also includes an acceleration rule. If (1) there is a failure to pay timely any required installment, (2) there is a liquidation or sale of substantially all of the USS’s assets, (3) the USS ceases business, or (4) another similar circumstance arises, the unpaid portion of all remaining installments will become due immediately.

Special Deferral for S corporation Shareholders

A special rule permits deferral of the above transitional tax liability for shareholders of a USS that is an S corporation.

The S corporation is required to report on its income tax return the amount includible in gross income by reason of this provision, as well as the amount of deduction that would be allowable, and to provide a copy of such information to its shareholders.

Any shareholder of the S corporation may elect to defer their portion of the tax liability until the shareholder’s taxable year in which a “triggering event” occurs.[xxiv]

Three types of events may trigger an end to deferral of this tax liability. The first is a change in the status of the corporation as an S corporation. The second category includes liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, including reorganization in bankruptcy. The third type of triggering event is a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees to be liable for tax liability in the same manner as the transferor.[xxv]

If a shareholder of an S corporation has elected deferral under this special rule, and a triggering event occurs, then the S corporation and the electing shareholder will be jointly and severally liable for any tax liability (and related interest or penalties).[xxvi]

After a triggering event occurs, an electing shareholder may elect to pay the tax liability in eight installments, subject to rules similar to those generally applicable absent deferral. Whether a shareholder may elect to pay in installments depends upon the type of event that triggered the end of deferral. If the triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, the installment payment election is not available. Instead, the entire tax liability is due upon notice and demand.[xxvii]

The New CFC Regime

With the mandatory “repatriation” of the post-1986-DFI of SFC, the TCJA implemented a new “participation exemption” regime for the taxation of USS of “specified 10-percent-owned FCs,”[xxviii] effective for taxable years of FCs beginning after December 31, 2017.

Dividends Received Deduction

Specifically, it allows an exemption for certain foreign income by means of a 100-percent deduction for the foreign-source portion of dividends[xxix] received from a specified-10%-owned FC by a domestic corporation that is a USS of such FC.[xxx]

The term “dividends received” is intended to be interpreted broadly; for example, if a domestic corporation indirectly owns stock of a FC through a partnership, and the domestic corporation would qualify for the DRD with respect to dividends from the FC if the domestic corporation owned such stock directly, the domestic corporation would be allowed a DRD with respect to its distributive share of the partnership’s dividend from the FC.[xxxi]

This DRD is available only to regular domestic C corporations that are USS, including those that own stock of a FC through a partnership; it is not available to C corporations that own less than 10% of the FC. The DRD is available only for the foreign-source portion of dividends received by a qualifying domestic corporation from a speficied-10-percent-owned FC.

No foreign tax credit or deduction is allowed to a USS for any foreign taxes paid or accrued by the FC (including withholding taxes) with respect to any portion of a dividend distribution that qualifies for the DRD.[xxxii]

Significantly, the DRD is not available to individuals; nor is it available to S corporations or their shareholders. Considering that an S corporation is not entitled to the deemed-paid credit for foreign income taxes paid by its foreign subsidiary, the income of the foreign subsidiary may be taxed twice: once by the foreign country and, when distributed, by the U.S.[xxxiii]

Holding Period

A domestic corporation is not permitted a DRD in respect of any dividend on any share of stock of a specified-10-percent-owned FC unless it satisfies a minimum holding period.

Specifically, the FC’s stock must have been held by the domestic corporation for at least 365 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. For this purpose, the holding period requirement is treated as met only if the specified-10-percent-owned FC qualifies as such at all times during the period, and the taxpayer is a USS with respect to such FC at all times during the period.

GILTI

Having captured and taxed the post-1986-DFI of SFC (through 2017), and having introduced the DRD, the TCJA also introduced a new class of income – “global intangible low-taxed income” (“GILTI”) – that must be included in income by a USS of a CFC, and which further erodes a taxpayer’s ability to defer the U.S. taxation of foreign income.

Amount Included

This provision requires the current inclusion[xxxiv] in income by a USS of (i) their share of all of a CFC’s non-subpart F income (other than income that is effectively connected with a U.S. trade or business and income that is excluded from foreign base company income by reason of the high-tax exception),[xxxv] (ii) less an amount equal to the USS’s share of 10-percent of the adjusted basis of the CFC’s tangible property used in its trade or business and of a type with respect to which a depreciation deduction is generally allowable (the difference being GILTI).[xxxvi]

In the case of a CFC engaged in a service business or other business with few fixed assets, the GILTI inclusion rule may result in the U.S taxation of the CFC’s non-subpart F business income without the benefit of any deferral.

This income inclusion rule applies to both individual and corporate USS.

In the case of an individual, the maximum federal tax rate on GILTI is 37-percent.[xxxvii] This is the rate that will apply, for example, to a U.S. citizen who directly owns at least 10-percent of the stock of a CFC, or to one who indirectly owns such CFC stock through an S corporation.

C Corporations

More forgiving rules apply in the case of a USS that is a C corporation. For taxable years beginning after December 31, 2017, and before January 1, 2026, a regular domestic C corporation is generally allowed a deduction of an amount equal to 50-percent of its GILTI; thus, the federal corporate tax rate for GILTI is actually 10.5% (the 21% flat rate multiplied by 50%).[xxxviii]

In addition, for any amount of GILTI included in the gross income of a domestic C corporation, the corporation is allowed a deemed-paid credit equal to 80-percent of the foreign taxes paid or accrued by the CFC with respect to such GILTI.

Based on the interaction of the 50-percent deduction and the 80-percent foreign tax credit, the U.S. tax rate on GILTI that is included in the income of a regular C corporation will be zero where the foreign tax rate on such income is 13.125%.[xxxix]

S Corporations

Because an S corporation’s taxable income is computed in the same manner as an individual, and because an S corporation is treated as a partnership for purposes of the CFC rules, neither the 50-percent GILTI deduction nor the 80-percent deemed-paid credit apply to S corporations or their shareholders. Thus, individuals are treated more harshly by the GILTI inclusion rules than are C corporations.

What is an S Corp. to Do?

So what is an S corporation with a FC subsidiary to do when confronted with the foregoing challenges and the TCJA’s pro-C corporation bias?

C Corporation?

One option is for the S corporation to contribute its FC shares to a domestic C corporation, or the S corporation itself could convert into a C corporation (its shareholders may revoke its election, or the corporation may cease to qualify as a small business corporation by providing for a second class of stock or by admitting a non-qualifying shareholder).

However, C corporation status has its own significant issues (like double taxation), and should not be undertaken lightly, especially if the sale of the business is reasonably foreseeable.

Branch?

Another option is for the S corporation to effectively liquidate its foreign subsidiary and to operate in the foreign jurisdiction through a branch, or through an entity for which a “check-the-box election” may be made to disregard the entity for tax purposes.

This would avoid the CFC and GITLI rules entirely, and it would allow the shareholders of the S corporation to claim a credit for foreign taxes paid by the branch.

Of course, operating through a branch would also prevent any deferral of U.S. taxation of the foreign income, and may subject the U.S. person to a branch profits tax in the foreign jurisdiction.[xl]

It should be noted, however, that the liquidation or reorganization of a CFC into a branch will generally be a taxable event, with the result that the accumulated foreign earnings and profits of the CFC will be included in the income of the USS as a “deemed dividend.”

That being said, the rules for determining such accumulated earnings and profits generally exclude amounts previously included in the gross income of the USS under the CFC rules. To the extent any amount is not so excluded, the S corporation shareholder of the CFC will not be able to utilize the DRD to reduce its tax liability.[xli]

Section 962 Election?

Yet another option to consider – which pre-dates the TCJA, but which seems to have been under-utilized – is a special election that is available to an individual who is a USS, either directly or through an S corporation.

This election, which is made on annual basis, results in the individual being treated as a C corporation for purposes of determining the income tax on their share of GILTI and subpart F income; thus, the electing individual shareholder would be taxed at the corporate tax rate.[xlii]

The election also causes the individual to be treated as a C corporation for purposes of claiming the FTC attributable to this income; thus, they would be allowed the 80-percent deemed-paid credit.

Of course, like most elections, this one comes at a price. The E&P of a FC that are attributable to amounts which were included in the income of a USS under the GILTI or CFC rules, and with respect to which an election was made, shall be included in gross income, when such E&P are actually distributed to the USS, to the extent that the E&P so distributed exceed the amount of tax paid on the amounts to which such election applied.[xliii]

No Easy Way Out[xliv]

We find ourselves in a new regime for the U.S. taxation of foreign income, and there is still a lot of guidance to be issued.

In the meantime, an S corporation with a foreign subsidiary would be well-served to model out the consequences of the various options described above, taking into account its unique circumstances – including the possibility of a sale – before making any changes to the structure of its foreign operations.


[i] “TCJA”. Public Law No. 115-97.

[ii] These may be wholly-owned, or they may be partially-owned; the latter often represent a joint venture with a foreign business.

[iii] The “20% of qualified business income deduction” for pass-through entities does not apply to foreign-source income.

[iv] The Code provides sourcing rules for most categories of business income. It should be noted that, in certain cases, a foreign person that is engaged in a U.S. trade or business may have limited categories of foreign-source income that are considered to be effectively connected such U.S. trade or business.

[v] Special rules apply where the foreign subsidiary engages in business transactions with its U.S. parent or with another affiliated company. A basic U.S. tax principle applicable in dividing profits from transactions between related taxpayers is that the amount of profit allocated to each related taxpayer must be measured by reference to the amount of profit that a similarly situated taxpayer would realize in similar transactions with unrelated parties. The “transfer pricing rules” of section 482 seek to ensure that taxpayers do not shift income properly attributable to the U.S. to a related foreign company through pricing that does not reflect an arm’s-length result.

[vi] Noncitizens who are lawfully admitted as permanent residents of the U.S. (“green card holders”) are treated as residents for tax purposes. In addition, noncitizens who meet a “substantial presence test” (based upon the number of days spent in the U.S.) are also, generally speaking, taxable as U.S. residents.

[vii] It should be noted that an unincorporated entity, such as a partnership or limited liability company, may elect its classification for Federal tax purposes – as a disregarded entity, a partnership or an association – under the “check-the-box” regulations. See Treas. Reg. 301.7701-3.

[viii] The same goes for income that is treated as having been earned directly, as through a partnership. IRC Sec. 702(b).

[ix] The other main anti-deferral regime covers Passive Foreign Investment Companies (“PFIC”). There is some overlap between the CFC and PFIC regimes; the former trumps the latter.

[x] The TCJA amended the applicable ownership attribution rules so that certain stock of a FC owned by a foreign person is attributed to a related U.S. person for purposes of determining whether the related U.S. person is a USS of the FC and, therefore, whether the FC is a CFC. The pro rata share of a CFC’s subpart F income that a USS is required to include in gross income, however, continues to be determined based on direct or indirect ownership of the CFC, without application of the new downward attribution rule. In making this amendment, the TCJA intended to render ineffective certain transactions that were used to as a means of avoiding the CFC regime. One such transaction involved effectuating “de-control” of a foreign subsidiary, by taking advantage of the prior attribution rule that effectively turned off the constructive stock ownership rules when to do otherwise would result in a U.S. person being treated as owning stock owned by a foreign person.

[xi] The TCJA expanded the definition of USS under subpart F to include any U.S. person who owns 10 percent or more of the total value of shares of all classes of stock of a FC. Prior law looked only to voting power. The TCJA also eliminated the requirement that a FC must be controlled for an uninterrupted period of 30 days before subpart F inclusions apply.

[xii] The 10-percent U.S. shareholders of a CFC also are required to include currently in income for U.S. tax purposes their pro rata shares of the CFC’s untaxed earnings invested in certain items of U.S. property. This U.S. property generally includes tangible property located in the U.S. stock of a U.S. corporation, an obligation of a U.S. person, and certain intangible assets, such as patents and copyrights, acquired or developed by the CFC for use in the U.S. The inclusion rule for investment of earnings in U.S. property is intended to prevent taxpayers from avoiding U.S. tax on dividend repatriations by repatriating CFC earnings through non-dividend payments, such as loans to U.S. persons.

[xiii] Before the TCJA reduced the tax rate on C corporations to a flat 21 percent, that meant more than 90 percent of 35 percent, or 31.5 percent. The reduced corporate tax rate should make it easier for a CFC to satisfy this exception; 90% of 21% is 18.9%.

[xiv] This concept, as well as the basis-adjustment concept immediately below, should be familiar to anyone dealing with partnerships and S corporations.

[xv] In order to ensure that this previously-taxed foreign income is not taxed a second time upon distribution, a USS of a CFC generally receives a basis increase with respect to its stock in the CFC equal to the amount of the CFC’s earnings that are included in the USS’s income under the CFC regime. Conversely, a 10-percent U.S. shareholder of a CFC generally reduces its basis in the CFC’s stock in an amount equal to any distributions that the 10-percent U.S. shareholder receives from the CFC that are excluded from its income as previously taxed under subpart F.

[xvi] The deemed-paid credit is limited to the amount of foreign income taxes properly attributable to the subpart F inclusion. The foreign tax credit generally is limited to a taxpayer’s U.S. tax liability on its foreign-source taxable income. This limit is intended to ensure that the credit serves its purpose of mitigating double taxation of foreign-source income without offsetting U.S. tax on U.S.-source income.

[xvii] Basically, foreign earnings that were not previously taxed, that are not effectively connected to the conduct of a U.S. trade or business, and that are not subpart F income.

[xviii] Such entities must determine their post-1986 deferred foreign income based on the greater of the aggregate

post-1986 accumulated foreign earnings and profits as of November 2, 2017 or December 31,

[xix] The cash position of an entity consists of all cash, net accounts receivables, and the fair market value of similarly liquid assets, specifically including personal property that is actively traded on an established financial market, government securities, certificates of deposit, commercial paper, and short-term obligations.

[xx] It should be noted that the increase in income that is not taxed by reason of the deduction is treated as income that is exempt from tax for purposes of determining (i.e., increasing) a shareholder’s stock basis in an S corporation, but not as income exempt from tax for purposes of determining the accumulated adjustments account (“AAA”) of an S corporation (thus increasing the risk of a dividend from an S corporation with E&P from a C corporation).

[xxi] IRC Sec. 962. However, there are other consequences that stem from such an election that must be considered,

[xxii] The net tax liability that may be paid in installments is the excess of the USS’s net income tax for the taxable year in which the pre-effective-date undistributed CFC earnings are included in income over the taxpayer’s net income tax for that year determined without regard to the inclusion. https://www.taxlawforchb.com/?s=foreign

[xxiii] If a deficiency is determined that is attributable to an understatement of the net tax liability due under this provision, the deficiency is payable with underpayment interest for the period beginning on the date on which the net tax liability would have been due, without regard to an election to pay in installments, and ending with the payment of the deficiency.

[xxiv] The election to defer the tax is due not later than the due date for the return of the S corporation for its last taxable year that begins before January 1, 2018.

[xxv] Partial transfers trigger the end of deferral only with respect to the portion of tax properly allocable to the portion of stock sold.

[xxvi] Query how the shareholders’ agreement for an S corporation should be amended to address this possibility.

[xxvii] If an election to defer payment of the tax liability is in effect for a shareholder, that shareholder must report the amount of the deferred tax liability on each income tax return due during the period that the election is in effect. Failure to include that information with each income tax return will result in a penalty equal to five-percent of the amount that should have been reported.

[xxviii] In general, a “specified 10-percent owned foreign corporation” is any FC (other than a PFIC) with respect to which any domestic corporation is a USS.

[xxix] A distribution of previously-taxed income does not constitute a dividend, even if it reduced earnings and profits.

[xxx] The “dividends received deduction” (“DRD”).

[xxxi] In the case of the sale or exchange by a domestic corporation of stock in a FC held for one year or more, any amount received by the domestic corporation which is treated as a dividend for purposes of Code section 1248, is treated as a dividend for purposes of applying the provision. Thus, the DRD will be available to such a deemed dividend. Sec. 1248 is intended to prevent the conversion of subpart F income into capital gain.

[xxxii] In addition, the DRD is not available for any dividend received from a FC if the dividend is a “hybrid dividend.” A hybrid dividend is an amount received from a FC for which a DRD would otherwise be allowed and for which the specified-10-percent-owned FC received a deduction (or other tax benefit) with respect to any income taxes imposed by any foreign country.

[xxxiii] Of course, we also have to consider any withholding tax that the foreign country may impose of the foreign corporation’s dividend distribution to its S corporation shareholder. This tax will be creditable by the shareholders of the S corporation.

[xxxiv] For purposes of the GILTI inclusion, a person is treated as a U.S. shareholder of a CFC for any taxable year only if such person “owns” stock in the corporation on the last day, in such year, on which the corporation is a CFC. A corporation is generally treated as a CFC for any taxable year if the corporation is a CFC at any time during the taxable year.

[xxxv] Thus, subpart F income, effectively connected income, and income that is subject to foreign tax at a rate greater than 18.9% is not GILTI. For example, the corporate tax rate is 19% in the U.K., 24% in Italy, 25% in Spain 25%, 18% in Luxembourg, and 25% in the Netherlands.

[xxxvi] “Qualified business asset investment (“QBAI”). The CFC’s intangible property is not included in QBAI.

The 10% represents an arbitrary rate of return on the “unreturned capital” (i.e., tangible property) of the CFC, represented by its adjusted basis, for which continued deferral is permitted. Anything in excess thereof must be included in the gross income of the USS on a current basis.

[xxxvii] The maximum individual tax rate applicable to ordinary income.

[xxxviii] For taxable years beginning after December 31, 2025, the deduction is lowered to 37.5-percent.

It should be noted that it is intended that the “50-percent of GILTI deduction” be treated as exempting the deducted income from tax. Thus, for example, the deduction for GILTI could give rise to an increase in a domestic corporate partner’s basis in a domestic partnership that holds stock in a CFC.

[xxxix] 13.125% multiplied by 80% equals 10.5 percent.

[xl] Of course, an income tax treaty between the U.S. and the foreign jurisdiction may affect this result.

[xli] The applicable regulations have yet to be amended to reflect the changes made by the TCJA.

[xlii] However, the shareholder will not be allowed the 50-percent GILTI deduction. This deduction is not part of the CFC or FTC rules.

[xliii] In other words, the regular double taxation rules for C corporations will apply; the corporation is treated as having distributed its after-tax E&P.

[xliv] Remember “Rocky IV”?

We’ve all heard about the profits that publicly-held U.S. corporations have generated overseas, and how those profits have, until now, escaped U.S. income taxation by virtue of not having been repatriated to the U.S.

It should be noted, however, that many closely-held U.S. corporations are also actively engaged in business overseas, and they, too, have often benefited from such tax deferral.

What follows is a brief description of some of the rules governing the U.S. income taxation of the foreign business (“outbound”) activities of closely-held U.S. businesses, and the some of the important changes thereto under the Tax Cuts and Jobs Act.[1]

Taxation of Foreign Income

U.S. persons[2] are subject to tax on their worldwide income, whether derived in the U.S. or abroad.

In general, income earned directly (or that is treated as earned directly[3]) by a U.S. person from its conduct of a foreign business is subject to U.S. tax on a current basis; for example, the income generated by the U.S. person’s branch in a foreign jurisdiction.

However, income that is earned indirectly, through the operation of a foreign business by a foreign corporation (“FC”), is generally not subject to U.S. tax on a current basis; instead, the foreign business income earned by the FC generally is not subject to U.S. tax until the income is distributed as a dividend to a U.S. owner.[4]

CFC Anti-Deferral Regime

That being said, the controlled foreign corporation (“CFC”) anti-deferral regime may cause a U.S. owner of a CFC to be taxed currently in the U.S. on its pro rata shares of certain categories of income earned by the CFC (“Subpart F income”) regardless of whether the income has been distributed as a dividend to the U.S. owner.

A CFC generally is defined as any FC if U.S. persons own (directly, indirectly, or constructively) more than 50% of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons that are “U.S. Shareholders” – i.e., U.S. persons who own at least 10% of the CFC’s stock (which, prior to the Act, was measured by vote only).

In effect, the U.S. Shareholders of a CFC are treated as having received a current distribution of the CFC’s Subpart F income[5], which includes foreign base company income, among other items of income.

“Foreign base company income” includes certain categories of income from business operations, including “foreign base company sales income,” and “foreign base company services income,” as well as certain passive income.

The U.S. Shareholders of a CFC also are required to include currently in income, their pro rata shares of the CFC’s untaxed earnings that are invested in certain items of U.S. property, including, for example, tangible property located in the U.S., stock of a U.S. corporation, and an obligation of a U.S. person.[6]

Several exceptions to the definition of Subpart F income, including the “same country” exception, may permit continued deferral for income from certain business transactions.[7] Another exception is available for any item of business income received by a CFC if it can be established that the income was subject to an effective foreign income tax rate greater than 90% of the maximum U.S. corporate income tax rate.[8]

A U.S. Shareholder of a CFC may also exclude from its income any actual distributions of earnings from the CFC that were previously included in the shareholder’s income.

The Act

For the most part, the Act did not change the basic principles of the CFC regime; these anti-deferral rules will continue to apply[9], subject to certain amendments.

However, the Act also introduced some significant changes to the taxation of certain U.S. persons who own shares of stock in FCs.

CFCs

The Act amended the ownership attribution rules so that certain stock of a FC owned by a foreign person may be attributed to a related U.S. person for purposes of determining whether the U.S. person is a U.S. Shareholder of the FC and, therefore, whether the FC is a CFC.[10] For example, a U.S. corporation may be attributed shares of stock owned by its foreign shareholder.

The Act also expanded the definition of U.S. Shareholder to include any U.S. person who owns 10% or more of the total value – as opposed to 10% of the vote – of all classes of stock of a FC. It also eliminated the requirement that a FC must be controlled for an uninterrupted period of 30 days before the inclusion rules apply.

Dividends Received Deduction (“DRD”)

The Act introduced some new concepts that are aimed at encouraging the repatriation of foreign earnings by U.S. taxpayers; stated differently, it removes an incentive for the overseas accumulation of such earnings.[11]

The keystone provision is the DRD, which allows an exemption from U.S. taxation for certain foreign income by means of a 100% deduction for the foreign-source portion of dividends received from specified 10%-owned FCs by regular domestic C corporations[12] that are U.S. Shareholders of those FCs.

In general, a “specified 10%-owned FC” is any FC with respect to which any domestic corporation is a U.S. Shareholder.[13]

The term “dividend received” is intended to be interpreted broadly. For example, if a domestic corporation indirectly owns stock of a FC through a partnership, and the domestic corporation would qualify for the participation DRD with respect to dividends from the FC if the domestic corporation owned such stock directly, the domestic corporation would be allowed a participation DRD with respect to its distributive share of the partnership’s dividend from the FC. In addition, any gain from the sale of CFC stock that would be treated as a dividend would also constitute a dividend received for which the DRD may be available. That being said, it appears that a deemed dividend of subpart F income from a CFC will not qualify for the DRD.

In general, the DRD is available only for the foreign-source portion of dividends received by a domestic corporation from a specified 10%-owned FC; i.e., the amount that bears the same ratio to the dividend as the undistributed foreign earnings bear to the total undistributed earnings of the FC.[14]

The DRD is not available for any dividend received by a U.S. Shareholder from a FC if the FC received a deduction or other tax benefit from taxes imposed by a foreign country. Conversely, no foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to any portion of a distribution treated as a dividend that qualifies for the DRD, including any foreign taxes withheld at the source.[15]

It should be noted that a domestic C corporation is not permitted a DRD in respect of any dividend on any share of FC stock unless it satisfies a holding period requirement. Specifically, the share must have been held by the U.S. corporation for at least 366 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. The holding period requirement is treated as met only if the specified 10%-owned FC is a specified 10%-owned FC at all times during the period and the taxpayer is a U.S. Shareholder with respect to such specified 10%-owned foreign corporation at all times during the period.

Transitional Inclusion Rule[16]

In order to prevent the DRD from turning into a “permanent exclusion rule” for certain U.S. corporations with FC subsidiaries, the accumulated earnings of which have not yet been subject to U.S. income tax – and probably also to generate revenue – the Act requires that any U.S. Shareholder (including, for example, a C corporation, as well as an S corporation, a partnership, and a U.S. individual) of a “specified FC” include in income its pro rata share of the post-1986 deferred foreign earnings of the FC.[17] The inclusion occurs in the last taxable year beginning before January 1, 2018.[18]

This one-time mandatory inclusion applies to all CFCs, and to almost all other FCs in which a U.S. person owns at least a 10% voting interest. However, in the case of a FC that is not a CFC, there must be at least one U.S. Shareholder that is a U.S. corporation in order for the FC to be a specified FC.

The deferred foreign earnings of such a FC are based on the greater of its aggregate post-1986 accumulated foreign earnings as of November 2, 2017[19] or December 31, 2017, not reduced by distributions during the taxable year ending with or including the measurement date.[20]

A portion of a U.S. taxpayer’s includible pro rata share of the FC’s foreign earnings is deductible by the U.S. taxpayer, thereby resulting in a reduced rate of tax with respect to the income from the required inclusion of accumulated foreign earnings. Specifically, the amount of the deduction is such as will result in a 15.5% rate of tax on the post-1986 accumulated foreign earnings that are held in the form of cash or cash equivalents, and an 8% rate of tax on those earnings held in illiquid assets. The calculation is based on the highest rate of tax applicable to U.S. corporations in the taxable year of inclusion, even if the U.S. Shareholder is an individual.[21]

Installment Payments

A U.S. Shareholder may elect to pay the net tax liability resulting from the mandatory inclusion of a FC’s post-1986 accumulated foreign earnings in eight equal installments. The net tax liability that may be paid in installments is the excess of the U.S. Shareholder’s net income tax for the taxable year in which the foreign earnings are included in income over the taxpayer’s net income tax for that year determined without regard to the inclusion.

An election to pay the tax in installments must be made by the due date for the tax return for the taxable year in which the undistributed foreign earnings are included in income. The first installment must be paid on the due date (determined without regard to extensions) for the tax return for the taxable year of the income inclusion. Succeeding installments must be paid annually no later than the due dates (without extensions) for the income tax return of each succeeding year.[22]

The Act also provides that if (1) there is a failure to pay timely any required installment, (2) there is a liquidation or sale of substantially all of the U.S. Shareholder’s assets, (3) the U.S. Shareholder ceases business, or (4) another similar circumstance arises, then the unpaid portion of all remaining installments is due on the date of such event.

S corporations

A special rule permits continued deferral of the transitional tax liability for shareholders of a U.S. Shareholder that is an S corporation. The S corporation is required to report on its income tax return the amount of accumulated foreign earnings includible in gross income by reason of the Act, as well as the amount of the allowable deduction, and it must provide a copy of such information to its shareholders. Any shareholder of the S corporation may elect to defer his portion of this tax liability until the shareholder’s taxable year in which a prescribed triggering event occurs.

This shareholder election to defer the tax is due not later than the due date for the return of the S corporation for its last taxable year that begins before January 1, 2018 (i.e., by March 15, 2018 for an S corporation with a taxable year ending December 31, 2017).

Three types of events may trigger an end to deferral of the tax liability: (i) a change in the status of the corporation as an S corporation; (ii) the liquidation, sale of substantially all corporate assets, termination of the of business, or similar event; and (iii) a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees with the IRS to be liable for tax liability in the same manner as the transferor.[23]

If a shareholder of an S corporation has elected deferral, and a triggering event occurs, the S corporation and the electing shareholder are jointly and severally liable for any tax liability and related interest or penalties.[24]

In addition, the electing shareholder must report the amount of the deferred tax liability on each income tax return due during the period that the election is in effect.[25]

After a triggering event occurs, a shareholder may be able elect to pay the net tax liability in eight equal installments, unless the deferral-ending triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, in which case the installment payment election is not available, and the entire tax liability is due upon notice and demand.[26]

Observations

As stated earlier, many closely-held U.S. companies (“CH”) are engaged in business overseas, and many more will surely join them.

Although the Act ostensibly focused on the tax deferral enjoyed by large, publicly-traded multinationals, its provisions will also have a significant impact on CH that do business overseas.

Regardless of its form of organization, a CH has to determine fairly soon the amount of its 2017 U.S. income tax liability resulting from the inclusion in income of any post-1986 accumulated foreign earnings of any CFC of which it is a U.S. Shareholder.

Similarly, in the case of any FC of which the CH is a U.S. Shareholder, but which is not a CFC, the CH must determine whether there is a U.S. corporation (including itself) that is a U.S. Shareholder of the FC. If there is, then the CH will be subject to the mandatory inclusion rule for its share of the FC’s post-1986 accumulated foreign earnings.

The CH and its owners will then have to determine whether to pay the resulting income tax liability at once, in 2018, or in installments.

Of course, if the CH is an S corporation, each of its shareholders will have to decide whether to defer the tax liability until one of the “triggering event” described above occurs.

After the mandatory inclusion rule has been addressed, the CH may decide whether to repatriate some of the already-taxed foreign earnings.

Looking forward, if the CH is a regular C corporation, any dividends it receives from a FC of which it is a U.S. Shareholder may qualify for the DRD.

C corporation CHs that may be operating overseas through a branch or a partnership may want to consider whether incorporating the branch or partnership as a FC, and paying any resulting tax liability, may be warranted in order to take advantage of the DRD – they should at least determine the tax exposure.

Still other CHs, that may be formed as S corporations or partnerships, must continue to be mindful of the CFC anti-deferral regime.

It’s a new tax regime, and it’s time for old dogs to learn new “tricks.” Woof.


[1] Pub. L. 115-97 (the “Act”). We will not cover the “minimum tax” provided under the new “base erosion” rules applicable to certain U.S. corporations – those with more than $500 million of average annual gross receipts – that make certain payments to related parties.

[2] Including all U.S. citizens and residents, as well as U.S. partnerships, corporations, estates and certain trusts. For legal entities, the Code determines whether an entity is subject to U.S. taxation on its worldwide income on the basis of its place of organization. For purposes of the Code, a corporation or partnership is treated as domestic if it is organized under U.S. law.

[3] As in the case of a U.S. partner in a partnership that is engaged in business overseas.

[4] It should be noted that certain foreign entities are eligible to elect their classification for U.S. tax purposes under the IRS’s “check-the-box” regulations. As a result, it is possible for such a foreign entity to be treated as a corporation for foreign tax purposes, but to be treated as a flow-through, or disregarded, entity for U.S. tax purposes; the income of such a hybrid would be taxed to the U.S. owner.

[5] Prior to the Act, and subject to certain limitations, a domestic corporation that owned at least 10% of the voting stock of a FC was allowed a “deemed-paid” credit for foreign income taxes paid by the FC that the domestic corporation was deemed to have paid when the related income was distributed as a dividend, or was included in the domestic corporation’s income under the anti-deferral rules.

[6] This inclusion rule is intended to prevent taxpayers from avoiding U.S. tax on “dividends” by repatriating CFC earnings through non-dividend payments, such as loans to U.S. persons.

[7] For example, the CFC’s purchase of personal property from a related person and its sale to another person where the purchased property was produced in the same foreign country under the laws of which the CFC is organized.

[8] This rate was 35% prior to the Act; the Act reduced the rate to 21%, which should make it easier for some CFCs to satisfy this exception. In that case, the U.S. Shareholder of a CFC will not be subject to the CFC inclusion rules – in other words, it can continue to enjoy tax deferral for the foreign earnings – if the foreign corporate tax rate is at least 19%; i.e., 90% of 21%. This will benefit U.S. persons who otherwise do not qualify for the DRD, discussed below.

[9] For example, CFCs should continue to refrain from guaranteeing their U.S. parent’s indebtedness.

[10] The pro rata share of a CFC’s subpart F income that a U.S. Shareholder is required to include in gross income, however, will continue to be determined based on direct or indirect ownership of the CFC, without application of the new attribution rule.

[11] This moves the U.S. toward a “territorial” system under which the income of foreign subsidiaries is not subject to U.S. tax.

[12] The DRD is available only to regular C corporations. As in the case of dividends paid by U.S. corporations to individuals or to an S corporation, no DRD is available to such shareholders.

[13] Query whether the DRD, combined with the new 21% tax rate for C corporations will encourage U.S. corporations that have substantial foreign operations to remain or become C corporations and to operate overseas only through foreign subsidiary corporations. Unfortunately, the Act also denies non-recognition treatment for the transfer by a U.S. person of property used in the active conduct of a trade or business to a FC.

[14] “Undistributed earnings” are the amount of the earnings and profits of a specified 10%-owned FC as of the close of the taxable year of the specified 10%-owned FC in which the dividend is distributed. A distribution of previously taxed income does not constitute a dividend.

[15] In this way, the Act seeks to avoid bestowing a double benefit upon the U.S. taxpayer; however, foreign withholding tax may prove to be a costly item.

[16] See IRS Notice 2018-13 for additional guidance.

[17] Any amount included in income by a U.S. Shareholder under this rule is not included a second time when it is distributed as a dividend.

[18] Beware, calendar year taxpayers.

[19] The date the Act was introduced.

[20] The portion of post-1986 earnings and profits subject to the transition tax does not include earnings and profits that were accumulated by a FC prior to attaining its status as a specified FC.

[21] A reduced foreign tax credit is also allowed.

[22] If installment payment is elected, the net tax liability is not paid in eight equal installments; rather, the Act requires lower payments for the first five years, followed by larger payments for the next three years. The timely payment of an installment does not incur interest.

[23] Partial transfers trigger the end of deferral only with respect to the portion of tax properly allocable to the portion of stock sold.

[24] The period within which the IRS may collect such tax liability does not begin before the date of an event that triggers the end of the deferral.

[25] Failure to include that information with each income tax return will result in a penalty equal to five-percent of the amount that should have been reported.

[26] The installment election is due with the timely return for the year in which the triggering event occurs.

Perhaps the single most important day in the life of any closely held business is the day on which it is sold. The occasion will often mark the culmination of years of effort on the part of its owners.

The business may have succeeded to the point that its competitors seek to acquire it in furtherance of their own expansion plans; alternatively, private equity investors may view it as a positive addition to their portfolio of growth companies.

On the flip side, the owners of the business may not have adequately planned for their own succession; consequently, they may view the business as a “wasting asset” that has to be monetized sooner rather than later.

Worse still, the business may be failing and the owners want to recover as much of their investment as possible.

In any of the foregoing scenarios, the tax consequences arising from the disposition of the business will greatly affect the net economic result for its owners.

The following outlines a number of provisions included in the recently enacted Tax Cuts and Jobs Act[1] that should be of interest to owners of a closely held business that are considering the sale of the business, as well as to the potential buyers of the business.

Corporate Tax Rate

In general, the individual owner of a C corporation, or of an S corporation that is subject to the built-in gains tax, would prefer to sell his stock to a buyer – and thereby incur only a single level of federal income tax, at the favorable 20% capital gain rate[2] – rather than cause the corporation to sell its assets.

An asset sale generally results in two levels of tax: (a) to the corporation based upon the gain recognized by the corporation on the disposition of its assets; and (b)(i) to the shareholder of a C corporation upon his receipt of the after-tax proceeds in liquidation of the corporation, or (ii) to the shareholder of an S corporation under the applicable flow-through rules.

Prior to the Act, the maximum federal corporate tax rate was set at 35%; thus, the combined effective maximum rate for the corporation and shareholder was just over 50% (assuming the sale generated only capital gain).

The Act reduced the federal corporate tax rate to a flat 21%; consequently, the combined maximum federal rate has been reduced to 39.8%.

From the tax perspective of a seller, the reduced corporate rate will make asset deals[3] less expensive. For the buyer that agrees to gross-up the seller for the additional tax arising out of an asset deal (as opposed to a stock deal), the immediate out-of-pocket cost of doing so is also reduced.

Individual Ordinary Income Rate

The Act reduced the rate at which the ordinary income recognized by an individual is taxed, from 39.6% to 37%.[4]

In the case of an S corporation shareholder, or of an individual member of an LLC taxable as a pass-through entity[5], any ordinary income generated on the sale of the corporate assets – for example, depreciation recapture[6] – will be taxed at the reduced rate.

Any interest that is paid by a buyer to a seller in respect of a deferred payment of purchase price – i.e., an installment sale – or that is imputed to the seller[7], as in the case of an earn-out, will be taxable at the reduced rate for ordinary income.

Similarly, if the seller or its owners continue to hold the real estate on which the business operates, the rental income paid by the buyer will be subject to tax at this reduced rate.

Finally, any compensation paid to the owners, either as consultants or employees, or in respect of a non-compete, will be taxable at the reduced rate.

Self-Created Intangibles

The Act amended the Code to exclude a patent, invention, model or design (whether or not patented), and a secret formula or process which is held either by the taxpayer who created the property, or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created), from the definition of a “capital asset.”

Thus, gains or losses from the sale or exchange of any of the above intangibles will no longer receive capital gain treatment.

NOLs

Prior to the Act, the net operating losses (“NOLs”) for a taxable year could be carried back two years and forward 20 years. The Act eliminates the carryback and allows the NOLs to be carried forward indefinitely, though it also limits the carryover deduction for a taxable year to 80% of the taxpayer’s taxable income for such year.

The Act did not change the rule that limits a target corporation’s ability to utilize its NOLs after a significant change in the ownership of its stock.[8] However, the Act’s elimination of the “NOL-20-year-carryover-limit” reduces the impact of the “change-in-ownership-loss-limitation” rule on a buyer of the target’s stock; even though the annual limitation imposed by the rule will continue to apply, the NOL will not expire unused after twenty years – rather, it will continue to be carried over until it is exhausted.

At the same time, however, the Act’s limitation of the carryover deduction for a taxable year, to 80% of the corporation’s taxable income, may impair a target’s ability to offset some of the gain recognized on the sale of its assets.

Interest Deduction Limit

The Act generally limits the deduction for business interest incurred or paid by a business for any taxable year to 30% of the business’s adjusted taxable income for such year.[9] Any interest deduction disallowed under this rule is carried forward indefinitely.

In the case of a buyer that will incur indebtedness to purchase a target company – for example, by borrowing the funds, or by issuing a promissory note as part of the consideration for the acquisition – this limitation on its ability to deduct the interest charged or imputed in respect of such indebtedness could make the acquisition more expensive from an economic perspective.[10]

Immediate Expensing

Prior to the Act, an additional first-year depreciation deduction was allowed in an amount equal to 50% of the adjusted basis of qualified property acquired and placed in service before January 1, 2020. Property qualifying for the additional first-year depreciation deduction had to meet requirements; for example, it had to be tangible personal property, certain computer software, or qualified improvement property. Moreover, the “original use” of the property had to commence with the taxpayer.

The Act, extended and modified the additional first-year depreciation deduction for qualifying property through 2026. It also increased the 50% allowance to 100% for property placed in service after September 27, 2017, and before January 1, 2023.[11]

It also removed the requirement that the original use of the qualifying property had to commence with the taxpayer. Thus, the provision applies to purchases of used as well as new items; in other words, the additional first-year depreciation deduction is now allowed for newly acquired used property.

The additional first-year depreciation deduction applies only to property that was not used by the taxpayer prior to the acquisition, and that was purchased in an arm’s-length transaction. It does not apply to property acquired in a nontaxable exchange such as a reorganization, or to property acquired from certain related persons, including a related entity (for example, from a person who controls, is controlled by, or is under common control with, the taxpayer).

Thus, a buyer will be permitted to immediately deduct the cost of acquiring “used” qualifying property[12] from a target business, thereby recovering what may be a not insignificant portion of its purchase price, and reducing the overall cost of the acquisition.

Pass-Throughs?

Query whether the owners of an S corporation (or of another target that is treated as a pass-through entity for tax purposes) will be allowed to claim the 20% deduction based on qualified business income in determining their tax liability from the sale of the assets of the business. Stated differently, and assuming that the owner’s income for the taxable year is derived entirely from the operation and sale of a single business, will the gain from the sale be included in determining the amount of the deduction?

It appears not. The definition of “qualified business income” excludes items of gain even where they are effectively connected with the conduct of a qualified trade or business; this would cover any capital gain arising from the sale of assets used in the trade or business. Moreover, it appears that the presence of such gain in an amount in excess of the taxable income of the business for the year of the sale (exclusive of the gain) would disallow any such deduction to the taxpayer.[13]

What Does It All Mean?

It remains to be seen whether these changes will influence the structure of M&A transactions. After all, most buyers would prefer to cherry-pick the target assets to be acquired and to assume only certain liabilities; they will consider a stock deal only if necessary. The reduction in the corporate tax rate will likely reinforce that fundamental principle, and may cause certain corporate sellers and their shareholders to be more amenable to an asset deal.

However, the pricing of an M&A transaction will likely be affected by the reduced corporate tax rate, by the limitation on a buyer’s deduction of acquisition interest, and by a buyer’s ability to immediately expense a portion of the purchase price. Each of these factors should be considered by a buyer in evaluating its acquisition of a target, the amount the buyer can offer in consideration, and its ability to finance the acquisition.

Only time and experience will tell.

As was mentioned in an earlier post, the Act was introduced on November 2, 2017, was enacted on December 22, 2017 – without the benefit of meaningful hearings and of input from tax professionals – and became effective on January 1, 2018 (just three weeks ago). The Congress is already discussing technical corrections, and the tax bar is asking for guidance from the IRS. Much remains to be discovered.

Stay tuned.


[1] Pub. L. 115-97 (the “Act”).

[2] The shareholder of a C corp, or of an S corp in which he does not materially participate, will also incur the additional 3.8% surtax on net investment income.

[3] Including sales of stock that are treated as asset sales for tax purposes under Sec. 338(h)(10) or Sec. 336(e) of the Code.

[4] The rate may be greater if the 3.8% surtax also applies to the item of income in question; for example, interest income.

[5] For example, a partnership.

[6] Sec. 1245 of the Code.

[7] Sec. 1274 of the Code.

[8] Code Sec. 382.

[9] In general, before 2022, the limitation is tied to EBITDA; thereafter, it is tied to EBIT.

[10] In general, the limitation does not apply to a corporation if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million.

[11] The allowance is thereafter reduced, and phased out, through 2026.

[12] This should cover both actual and deemed acquisitions of assets (as under a Sec. 338(h)(10) election).

[13] Although the underlying basis for the result is not discussed in the Congressional committee reports, it is likely attributable to favorable capital gain rate that applies to the individual owners of a pass-through entity.

Introduction

The Tax Cuts and Jobs Act of 2017[1] went into effect only two weeks ago. Many of its provisions represent significant changes to the Code, and it will take most of us several months to fully digest them,[2] to appreciate their practical consequences, and to understand how they may best be utilized for the benefit of our clients.

Among the businesses on which the Act will have a significant and immediate effect is real estate. What follows is a summary of the principal effects of the Act on a closely held real estate business and its owners.[3]

There are many facets to a closely held real estate business, including the choice of entity in which to operate the business, the acquisition and disposition of real property, the construction or other improvement of the property, the financing of the foregoing activities, the rental of the property, the management of the business, and the transfer of its ownership.

The Act touches upon each of these activities. It is the responsibility of the business’s tax advisers to analyze how the changes enacted may affect the business, and to prepare a coherent plan that addresses these changes.

Individual Income Tax Rates

The Act reduced the maximum individual income tax rate from 39.6% (applicable, in the case of married joint filers, to taxable income in excess of $470,700) to 37% (applicable, in the case of married joint filers, to taxable income in excess of $600,000).

This reduced rate will apply to an individual owner’s net rental income. It will also apply to any depreciation recapture recognized on the sale of a real property.[4]

Income Tax

The Act did not change the 20% maximum rate applicable to individuals on their net capital gains and qualified dividends, nor did it change the 25% rate applicable to unrecaptured depreciation.

The Act also left in place the 3.8% surtax on net investment income that is generally applicable to an individual’s rental income, unless the individual can establish that he is a real estate professional and that he materially participates in the rental business.

Deduction of Qualified Business Income

The Act provides that an individual who owns an equity interest in a pass-through entity (“PTE”)[5] that is engaged in a qualified trade or business (“QTB”)[6] may deduct up to 20% of the qualified business income (“QBI”) allocated to him from the PTE.

The amount of this deduction may be limited, based upon the W-2 wages paid by the QTB and by the unadjusted basis (immediately after acquisition) of depreciable tangible property used by the QTB in the production of QBI (provided its recovery period has not expired).[7]

The issue of whether an activity, especially one that involves the rental of real property, is a “trade or business” (as opposed to an “investment”) of a taxpayer is ultimately one of fact in which the scope of a taxpayer’s activities, either directly or through agents, in connection with the property, is so extensive as to rise to the stature of a trade or business.

A taxpayer’s QBI from a QTB for a taxable year means his 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.

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. “Qualified items” do not include specified investment-related income, gain, deductions, or loss. [8]

Excess Business Losses

The Act imposes another limitation on an individual’s ability to utilize a pass-through loss against other income, whether it is realized through a sole proprietorship, S corporation or partnership; this limitation is applied after the at-risk and passive loss rules.

Specifically, the taxpayer’s excess business losses are not allowed for the taxable year. An individual’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).

In the case of a partnership or S corporation, this provision is applied at the individual partner or shareholder level. Each partner’s and each S corporation shareholder’s share of the PTE’s items of income, gain, deduction, or loss is taken into account in applying the limitation for the taxable year of the partner or shareholder.

The individual’s excess business loss for a taxable year is carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years.[9]

Technical Termination of a Partnership

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 of 50% or more of the total interest in the partnership’s capital or income. Upon a technical termination, the partnership’s taxable year closed, partnership-level elections generally ceased to apply, and the partnership’s depreciation recovery periods for its assets started anew.

The Act repealed the technical termination rule, which makes it easier for partners to transfer their partnership interests.

Profits Interest

A partnership may issue a profits interest (a “promote”) in the partnership to a service or management partner in exchange for the performance of services. 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.[10]

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.

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.[11]

In order to make it more difficult for certain 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.[12]

Specifically, the partnership assets sold must have been held by the partnership for at least three years in order for a profits interest partner’s share of such gain to enjoy the lower tax rate applicable to long-term capital gains.[13]

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.

An “applicable partnership interest” is one that is transferred to a partner in connection with his performance of “substantial” services in a trade or business that consists in whole or in part of (1) raising or returning capital, and (2) investing in, or disposing of, or developing real estate held for rental or investment.

This holding-period rule should not apply to a taxpayer who only provides services to a so-called “portfolio company.”

Real Property Taxes

Under the Act, State and local taxes are generally not allowed to an individual as a deduction[14] unless they are paid or accrued in carrying on a trade or business, or an activity for the production of income. Thus, for instance, in the case of property taxes, an individual may deduct such items if these taxes were imposed on business assets, such as residential rental property.

Additional Depreciation

Prior to the Act, the Code allowed an additional first-year depreciation deduction equal to 50% of the adjusted basis of “qualified property”[15] – including certain improvements to real property – for the year it was placed in service.

The Act modified the additional first-year depreciation deduction, expanded it to include the acquisition of used property, and increased the allowance to 100% for property placed in service after September 27, 2017, and before January 1, 2023.[16]

Election to Expense

Prior to the Act, a taxpayer could elect to deduct the cost of qualifying property, rather than to recover such costs through depreciation deductions, subject to certain limitations. The maximum amount a taxpayer could expense was $500,000 of the cost of qualifying property placed in service for the taxable year. This amount was reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeded $2 million. The $500,000 and $2 million amounts were indexed for inflation for taxable years beginning after 2015.

Qualifying property was defined to include, among other things, “qualified leasehold improvement property.”

The Act increased the maximum amount a taxpayer may expense to $1 million, and increased the phase-out threshold amount to $2.5 million. Thus, the maximum amount a taxpayer may expense, for taxable years beginning after 2017, is $1 million of the cost of qualifying property placed in service for the taxable year. The $1 million amount is reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $2.5 million. The $1 million and $2.5 million amounts are indexed for inflation for taxable years beginning after 2018.

The Act also expanded the definition of qualifying real property to include any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.

Interest Deduction

The Act limits the deduction that a business may claim for “business interest” paid or accrued in computing its taxable income for any taxable year. In general, the deduction is limited to 30% of the adjusted taxable income of the business for such year. The amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely.

“Adjusted taxable income” means the taxable income of the business computed without regard to (1) any item of income, gain, deduction, or loss which is not properly allocable to the business; (2) any business interest or business interest income; (3) the amount of any NOL deduction; (4) the 20% of QBI deduction; and (5) certain other business deductions.[17]

The limitation does not apply to a business – including a real estate business – if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million.

In addition, a real estate business may elect that any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business in which it is engaged not be treated as a trade or business for purposes of the limitation, in which case the limitation would not apply to such trade or business.[18]

Like-Kind Exchange

For years, the Code has provided that no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a “like kind” which is to be held for productive use in a trade or business or for investment.

Over the last few years, several proposals had been introduced into Congress to eliminate the favorable tax treatment for like-kind exchanges.

The Act amended the tax-deferred like-kind exchange rules such that they will apply only to real property.

Corporate Tax Changes

Real property should rarely be held in a corporation, yet the fact remains that there are many such corporations.

In the case of a C corporation, or in the case of an S corporation for which the built-in gain recognition period has not yet expired, the Act provides some relief by reducing the corporate income tax rate from a maximum rate of 35% to a flat rate of 21%.

Although this reduction is significant, it likely is not enough to cause investors to contribute their real property to a corporation, or to “check the box” to treat their partnership or single-member LLC as an association (i.e., a corporation) for tax purposes. The benefits of ownership through a partnership are too great.

Moreover, the Act also takes away a benefit from certain corporate real estate developers. Specifically, these corporations may no longer exclude from their gross income any contribution of cash or property from a governmental entity or civic group.[19]

Estate Planning

Although the Act did not repeal the federal estate tax, it greatly increased the exemption amount, from $5.6 million to $11.2 million per person for 2018. It also left intact the portability election between spouses, and the exemption amount remains subject to adjustment for inflation.[20]

Importantly, the beneficiaries of a decedent’s estate continue to enjoy a stepped-up basis in the assets that pass to them upon his death, thereby providing income tax savings to the beneficiaries in the form of reduced gain or increased depreciation.[21]

For a more detailed discussion, click here.

A foreign individual investing in U.S. real property will often do so through a foreign corporate parent and a U.S. corporate subsidiary. The stock of the foreign corporation will not subject the foreigner to U.S. estate tax upon his demise. The U.S. corporation will be subject to U.S. corporate income tax – now at a 21% federal rate (down from a maximum of 35%) – and its dividend distributions, if any, will be subject to U.S. withholding at 30% or at a lower treaty rate. The disposition of the real property will be subject to U.S. corporate tax, but the subsequent liquidation of the U.S. subsidiary will not be subject to U.S. tax.[22]

Will the reduction of the federal corporate tax rate cause more foreign corporations to invest directly in U.S. real property, or through a PTE, rather than through a U.S. subsidiary? In general, no, because such an investment may cause the foreign corporation to be treated as engaged in a U.S. trade or business[23], and may subject the foreign corporation to the branch profits tax.

How about the limitation on interest deductions? The exception for a real estate trade or business should alleviate that concern.

Will the deduction based on qualified business income cause a foreign individual to invest in U.S. real property through a PTE?[24] Probably not, because this form of ownership may cause the foreigner to be treated as engaged in a U.S. trade or business, and an interest in such a PTE should be includible in his U.S. gross estate for estate tax purposes.

Where Will This Lead?

It’s too soon to tell – the Act has only been in force for just over two weeks.

That being said, and based on the foregoing discussion, there’s a lot in the Act with which the real estate industry should be pleased.[25]

Notwithstanding that fact, there are certain questions that many taxpayers are rightfully starting to ask regarding the structure of their real estate business. To give you a sense of the environment in which we find ourselves, I have been asked:

  • Whether an S corporation should convert into a C corporation (to take advantage of the reduced corporate tax rate);
  • Whether a C corporation should elect S corporation status (to enable its individual shareholders to take advantage of the 20%-of-QBI deduction);
  • Whether a partnership/LLC should incorporate or check the box (to take advantage of the reduced corporate rate);
  • Whether a corporation should convert into a partnership or disregarded entity (to enable its individual shareholders to take advantage of the 20%-of-QBI deduction)?

In response to these questions, I ask: who or what are the business owners, what is its capital structure, does it make regular distributions to its owners, what is the appreciation inherent in its assets, does it plan to dispose of its property in the relative short-term, etc.? The point is that each taxpayer is different.

I then remind them that some of the recently-enacted provisions are scheduled to expire in the not-too-distant future; for example, the QBI-based deduction goes away after 2025.

Generally speaking, however, and subject to the unique circumstances of the business entity, its owners, and its property, a real estate business entity that is treated as a partnership for tax purposes should not change its form; an S corporation should not revoke its “S” election; a C corporation should elect “S” status (assuming it will not be subject to the excise tax on excess passive investment income), and a corporation should not convert into a partnership.


[1] Pub. L. 115-97 (the “Act”).

[2] Do you recall the history of the TRA of 1986? Committee reports beginning mid-1985, the bill introduced late 1985, the law enacted October 1986, lots of transition rules. Oh well.

[3] Some of these provisions have been discussed in earlier posts on this blog. See, for example, this post and this post.

[4] For example, personal property identified as part of a cost segregation study that benefited from accelerated depreciation.

[5] A sole proprietorship, partnership/LLC, or S corporation.

[6] A QTB includes any trade or business conducted by a PTE other than specified businesses that primarily involve the performance of services.

[7] Query how much of a benefit will be enjoyed by an established real estate business which may not have many employees, and the property of which may have been fully depreciated.

[8] Investment-type income is excluded from QBI; significantly, investment income includes capital gain from the sale or other disposition of property used in the trade or business.

[9] 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.

This may be a significant consideration for a C corporation that elects to be an S corporation, and vice versa, in that “C-corporation-NOLs” will not expire until they are actually used.

See the discussion of the recently enacted “excess business loss” rule applicable to individuals.

[10] The right may be subject to various vesting limitations.

[11] 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.

[12] This rule applies even if the partner has made a sec. 83(b) election.

[13] It is unclear whether the interest must have been held for three years by the partner.

[14] There is an exception under which a joint return may claim an itemized deduction of up to $10,000 for the aggregate of (i) State and local property taxes not paid or accrued in carrying on a trade or business, or in an activity carried on for the production of income, and (ii) State and local income taxes (or sales taxes in lieu of income taxes) paid or accrued in the taxable year.

[15] Among other things, “qualified improvement property” includes any improvement to an interior portion of a building that was nonresidential real property if such improvement was placed in service after the date such building was first placed in service.

Qualified improvement property does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building.

The Act also provides a 15-year MACRS recovery period for qualified improvement property.

[16] The allowance is phased out through 2025.

[17] Among these deductions is depreciation. Beginning in 2022, depreciation is accounted for.

[18] An electing business will not be entitled to bonus depreciation and will have to extend, slightly, the depreciation period for its real properties.

[19] Such contributions may be made in order to induce a business to move to, and establish itself in, a particular jurisdiction, the idea being that its presence would somehow benefit the public.

[20] Unfortunately, the exemption amount returns to its pre-Act levels after 2025.

[21] In the case of a partnership interest, the partnership must have a Sec. 754 election in effect in order to enjoy this benefit.

[22] Thanks to the so-called “cleansing rule.”

[23] Or it may elect to be so treated.

[24] Other than an S corporation, of course.

[25] Our focus has been on the tax benefits bestowed upon a closely held real estate business. Of course, there are other, non-business provisions that apply to individuals that may have some impact on the real estate market and real estate businesses generally.

Obviously, I am referring to the limitations on itemized deductions for real property taxes imposed on a personal residence and residential acquisition indebtedness, both of which may adversely affect higher-income individual taxpayers.

Against these changes, one must weigh the alternative minimum tax (which often reduces the benefit of deducting property taxes anyway), and the elimination of the so-called “Pease limitation” (which reduced the benefit of itemized deductions for higher-income individual taxpayers).