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).

When the Tax Cuts and Jobs Act[1] was introduced on November 2, 2017, perhaps the single most important issue on the minds of many closely held business owners was the future of the estate tax: was it going to be repealed as had been promised? A closely related question – and perhaps of equal significance to these owners’ tax advisers – was whether an owner’s assets would receive a so-called “stepped-up” basis in the hands of those persons to whom the assets passed upon the owner’s death?

When the smoke cleared (only seven weeks later), the estate tax remained in place, but its reach was seriously limited, at least temporarily. Moreover, the stepped-up basis rule continued to benefit the beneficiaries of a decedent’s estate.

To better understand the change wrought by the Act – and to appreciate what it left intact – we begin with an overview of the federal transfer taxes.

The Estate and Gift Tax

The Code imposes a gift tax on certain lifetime transfers, an estate tax on certain transfers at death, and a generation-skipping transfer (“GST”) tax when such transfers are made to a “skip person.”

Estate Tax

The Code imposes a tax on the transfer of the taxable estate of a decedent who is a citizen or resident of the U.S. The taxable estate is determined by deducting from the value of the decedent’s gross estate any deductions provided for in the Code. After applying tax rates to determine a tentative amount of estate tax, certain credits are subtracted to determine estate tax liability.

Estate Tax

A decedent’s gross estate includes, to the extent provided for in other sections of the Code, the date-of-death value of all of a decedent’s property, real or personal, tangible or intangible, wherever situated. In the case of a business owner, the principal asset of his gross estate may be his interest in a closely held business. In general, the value of the property for this purpose is the fair market value of the property as of the date of the decedent’s death.

A decedent’s taxable estate is determined by subtracting from the value of his gross estate any deductions provided for in the Code. Among these deductions is one for certain transfers to a surviving spouse, the effect of which is to remove the assets transferred to the surviving spouse from the decedent’s estate tax base.

After accounting for any allowable deductions, a gross amount of estate tax is computed, using a top marginal tax rate of 40%.

In order to ensure that a decedent only gets one run up through the rate brackets for all lifetime gifts and transfers at death, his taxable estate is combined with the value of the “adjusted taxable gifts” made by the decedent during his life, before applying tax rates to determine a tentative total amount of tax. The portion of the tentative tax attributable to lifetime gifts is then subtracted from the total tentative tax to determine the gross estate tax.

The estate tax liability is then determined by subtracting any allowable credits from the gross estate tax. The most significant credit allowed for estate tax purposes is the unified credit.

The unified credit is available with respect to a taxpayer’s taxable transfers by gift and at death. The credit offsets the tax up to a specified cumulative amount of lifetime and testamentary transfers (the “exemption amount”). For 2017, the inflation-indexed exemption amount was set at $5.49 million; prior to the Act, it was set to increase to $5.6 million in 2018.

Any portion of an individual taxpayer’s exemption amount that is used during his lifetime to offset taxable gifts reduces the exemption amount that remains available at his death to offset the taxable value of his estate. In other words, the unified credit available at death is reduced by the amount of unified credit used to offset gift tax incurred on gifts made during the decedent’s life.

In the case of a married decedent, an election is available under which any exemption amount that was not used by the decedent may be used by the decedent’s surviving spouse (the so-called “portability election”) during her life or at her death.

The estate tax generally is due within nine months of a decedent’s death. However, in recognition of the illiquid nature of most closely held businesses, the Code generally allows the executor of a deceased business owner’s estate to elect to pay the estate tax attributable to an interest in a closely held business in up to ten installments. An estate is eligible for payment of the estate tax in installments if the value of the decedent’s interest in a closely held business exceeds 35 percent of the decedent’s adjusted gross estate (i.e., the gross estate less certain deductions).

If the election is made, the estate may defer payment of principal and pay only interest for the first five years[2], followed by up to 10 annual installments of principal and interest. This provision effectively extends the time for paying estate tax by 14 years from the original due date of the estate tax.

Gift Tax

The Code imposes a tax for each calendar year on the transfer of property by gift during such year by any individual. The amount of taxable gifts for a calendar year is determined by subtracting from the total amount of gifts made during the year: (1) the gift tax annual exclusion; and (2) allowable deductions.

The gift tax for a taxable year is determined by: (1) computing a tentative tax on the combined amount of all taxable gifts for such year and all prior calendar years using the common gift tax and estate tax rate (up to 40 percent); (2) computing a tentative tax only on all prior-year gifts; (3) subtracting the tentative tax on prior-year gifts from the tentative tax computed for all years to arrive at the portion of the total tentative tax attributable to current-year gifts; and, finally, (4) subtracting the amount of unified credit not consumed by prior-year gifts.

The amount of a taxpayer’s taxable gifts for the year is determined by subtracting from the total amount of the taxpayer’s gifts for the year the gift tax annual exclusion amount and any available deductions.

Donors of lifetime gifts are provided an annual exclusion of $15,000 per donee in 2018 (indexed for inflation from the 1997 annual exclusion amount of $10,000) for gifts of “present interests” in property. Married couples can gift up to $30,000 per donee per year without consuming any of their unified credit.

GST Tax

The GST tax is a separate tax that can apply in addition to either the gift tax or the estate tax. The tax rate and exemption amount for GST tax purposes are set by reference to the estate tax rules. The GST tax is imposed using the highest estate tax rate (40%). Tax is imposed on cumulative generation-skipping transfers in excess of the generation-skipping transfer tax exemption amount in effect for the year of the transfer. The generation-skipping transfer tax exemption for a given year is equal to the estate tax exemption amount in effect for that year ($5.49 million in 2017).

Basis in property received at death

A bequest, or other transfer at death, of appreciated (or loss) property is not an income tax realization event for the transferor-decedent or his estate, but the Code nevertheless provides special rules for determining a recipient’s income tax basis in assets received from a decedent.

Property acquired from a decedent or his estate generally takes a stepped-up basis in the hands of the recipient. “Stepped-up basis” means that the basis of property acquired from a decedent’s estate generally is the fair market value on the date of the decedent’s death. Providing a fair market value basis eliminates the recognition of income on any appreciation in value of the property that occurred prior to the decedent’s death (by stepping-up its basis).[3]

In the case of a closely held business, depending upon the nature of the business entity (for example, a partnership or a corporation) and of its assets, the income tax savings resulting from the basis step-up may be realized as reduced gain on the sale of the decedent’s interest in the business, or as a reduced income tax liability from the operation of the business (for example, in the form of increased depreciation or amortization deductions).

The Act

To the disappointment of many, the Act did not repeal the federal estate tax.

However, the Act greatly increased the federal estate tax, gift tax, and GST tax exemption amount – for decedents dying, and for gifts made, after December 31, 2017 and before January 1, 2026 – and it preserved portability.

The “basic exemption amount” was increased from $5 million (as of 2010) to $10 million; as indicated above, this amount is indexed for inflation occurring after 2011, and was set at $5.6 million for 2018 prior to the Act.

As a result of the Act, this exemption amount was doubled to $11.2 million per person beginning in 2018 – basically, $22.4 million per married couple – and will be adjusted annually for inflation through 2025.

To put this into perspective, over 109,000 estate tax returns were filed in 2001, of which approximately 50,000 were taxable. Compare this with 2016, when approximately 11,000 returns were filed, of which approximately 5,000 were taxable. The decline appears to be due primarily to the increase in the filing threshold (based on the exemption amount) from $675,000 in 2001 to $5.45 million in 2016.[4] An increase from $5.49 million in 2017 to $11.2 million in 2018 should have a similar effect.

In addition, and notwithstanding the increased exemption amount, the Act retained the stepped-up basis rule for determining the income tax basis of assets acquired from a decedent. As a result, property acquired from a decedent’s estate generally will continue to take a stepped-up basis.

Implications

As stated immediately above, the owners of many closely held businesses will not be subject to the federal estate tax – at least not through 2025[5] – thanks to the greatly increased exemption amount and to continued portability.

Thus, a deceased owner’s taxable (not gross) estate in 2018 – even if we only account for conservative valuations of his business interests and for reasonable estate administration expenses – may be as great as $22.4 million (assuming portability) without incurring any federal estate tax.

Moreover, this amount ignores the benefits of fairly conservative gift planning including, for example, the long-term impact of regular annual exclusion gifting (and gift-splitting between spouses), the effect of transfers made for partial consideration (as in a QPRT), or for full and adequate consideration (as in zeroed-out GRATs and installment sales), as well as the benefit of properly-structured life insurance that is not includible in the decedent’s estate.

With these tools, otherwise taxable estates[6], that potentially may be much larger than the new exemption amount, may be brought within its coverage.

The increased exemption amount will also allow many owners to secure a basis step-up for their assets upon their death without incurring additional estate tax, by allowing these owners to retain assets.

Of course, some states, like New York, will continue to impose an estate tax on estates that will not be subject to the federal estate tax.[7] In those cases, the higher federal exemption amount, coupled with the absence of a New York gift tax, provides an opportunity for many taxpayers to reduce their New York taxable estate without any federal estate or gift tax consequences, other than the loss of a basis step-up. The latter may be significant enough, however, that the taxpayer may decide to bear the 16% New York estate tax on his taxable estate rather than lose the income tax savings.[8]

Planning

In light of the foregoing, taxpayers should, at the very least, review their existing estate plan and the documents that will implement it – “for man also knoweth not his time.”[9]

For example, wills or revocable trusts that provide for a mandatory credit shelter or bypass trust may have to be revised, depending upon the expected size of the estate, lest the increased exemption amount defeat one’s testamentary plan.

A more flexible instrument may be warranted – perhaps one that relies upon a disclaimer by a surviving spouse – especially given the December 31, 2025 expiration date for the increased exemption amount, and the “scheduled” reversion in 2026 to the pre-2018 exemption level (albeit adjusted for inflation).

The buy-out provisions of shareholder, partnership and operating agreements should also be reviewed in light of what may be a reduced need for liquidity following the death of an owner. For example, should such a buy-out be mandatory?[10]

Some taxpayers, with larger estates, may want to take advantage of the increased exemption amount before it expires in 2026 so as to remove assets, and the income and appreciation thereon, from their estates.[11] This applies for both estate and GST tax purposes; a trust for the benefit of skip persons may be funded now using the temporarily increased GST exemption amount.

Of course, gifting comes at a cost: the loss of stepped-up basis upon the death of the taxpayer.

Conversely, some taxpayers may want to consider bringing certain appreciated assets (for example, assets that they may have previously gifted to a family member) back into their estates in order to attain the benefit of a basis step-up.

Those taxpayers who decide to take advantage of the increased exemption amount by making lifetime gifts should consider how they may best leverage it.

Some New York taxpayers – who may otherwise have to reduce their gross estates in order to reduce their NY estate tax burden – may want to consider changing their domicile so as to avoid the New York estate tax entirely while holding on to their assets (that would be sheltered by the increased exemption amount) and thereby securing the step-up in basis upon their passing.

There may also be other planning options to consider, some of which have been considered in earlier posts to this blog. For example, ESBTs may now include nonresident aliens as potential current beneficiaries without causing the S corporation to lose its “S” election.

As always, tax savings, estate planning, and gifting strategies have to be considered in light of what the taxpayer is comfortable giving up. In the case of a closely held business owner, any loss of control may be untenable, as may the reduction of cash flow that is attributable to his ownership interest.

Moreover, there are non-tax reasons for structuring the disposition of one’s estate that may far outweigh any tax savings that may result from a different disposition. Tails, dogs, wagging – you know the idiom.


*  At least until 2026 – keep reading.  With apologies to St. Paul. 1 Corinthians, 15:55.

[1] Pub. L. 115-97 (the “Act”); signed into law on December 22, 2017.

[2] The interest rate applicable to the amount of estate tax attributable to the taxable value of the closely held business in excess of $1 million (adjusted for inflation) is equal to 45 percent of the rate applicable to underpayments of tax (i.e., 45 percent of the Federal short-term rate plus three percentage points). This interest is not deductible for estate or income tax purposes.

[3] It also eliminates the tax benefit from any unrealized loss (by stepping-down its basis to fair market value).

[4] http://www.taxpolicycenter.org/briefing-book/how-many-people-pay-estate-tax

[5] This provision expires after 2025. Assuming the provision survives beyond 2020 (the next presidential election), query whether the exemption amount will be scaled back. Has the proverbial cat been let out of the proverbial bag?

[6] Including individuals who had already exhausted their pre-2018 exemption amount.

[7] The NY estate tax exemption amount for 2018 is $5.25 million.

[8] In the case of a NYC decedent, for example, the tax savings to be considered would include the federal capital gains tax of 20%, the federal surtax on net investment income of 3.8%, the NY State income tax of 8.82%, and the NYC income tax of 3.876%. Of course, the likelihood of an asset’s being sold after death also has to be considered.

[9] Ecclesiastes, 9:12. As morbid as it may sound, planning for an elderly or ill taxpayer is different from planning for a younger or healthier individual – it is especially so now given the 2026 expiration of the increased exemption amount.

[10] Of course, there may be overriding business reasons for such a buy-out.

[11] If the exemption amount were to return to its pre-2018 levels in 2026, query how the IRS will account for any pre-2026 gifts that were covered by the increased exemption amount. The Act directs the IRS to issue regulations addressing this point.

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

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

Profits Interests2017 Tax Act

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

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

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

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

The Act

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

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

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

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

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

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

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

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

Adjusting Inside Basis

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

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

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

The Act

In order to further reduce the potential for abuse, the Act expands the definition of a “substantial built-in loss” such that, in addition to the present-law definition, for transfers of partnership interests made after December 31, 2017, a substantial built-in loss also exists if the transferee would be allocated a loss in excess of $250,000 upon a hypothetical disposition by the partnership of all of its assets in a fully taxable transaction for cash equal to the assets’ FMV, immediately after the transfer of the partnership interest.

Limiting a Partner’s Share of Loss

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

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

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

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

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

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

The Act

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

What’s Next?

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

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

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

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

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

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

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


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

[2]See Sec. 83 of the Code.

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

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

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

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

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

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

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

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

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

Tax Cuts and Jobs Act of 2017

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

Excess Business Losses

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

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

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

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

The Act

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

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

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

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

(b) the sum of:

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

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

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

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

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

Accounting Methods

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

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

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

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

The Act

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

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

Changes in Accounting Method

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

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

The Act

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

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

Post-S-Termination Distributions

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

The Act

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

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

Electing Small Business Trust (“ESBT”)

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

The Act

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

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

ESBTs and Charitable Contributions

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

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

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

The Act

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

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

Technical Termination of Partnerships

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

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

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

The Act

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

Tomorrow’s Post

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


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