The Joy – and Tax Benefits – of Gifting

As we enter the “season of giving” and the end of yet another year, the thoughts of many tax advisers turn to . . . tax planning.(i) In keeping with the spirit of the season, an adviser may suggest that a client with a closely held business consider making a gift of equity in the business to the owner’s family or to a trust for their benefit.(ii)

Of course, annual exclusion gifts(iii) are standard fare and, over the course of several years, may result in the transfer of a not insignificant portion of the equity in a business.

However, the adviser may also recommend that the client consider making larger gifts, thereby utilizing a portion of their “unified” gift-and-estate tax exemption amount during their lifetime. Such a gift, the adviser will explain, may remove from the owner’s gross estate not only the current value of the transferred business interests, but also the future appreciation thereon.(iv)

The client and the adviser may then discuss the “size” of the gift and the valuation of the business interests to be gifted, including the application of discounts for lack of control and lack of marketability. At this point, the adviser may have to curb the client’s enthusiasm somewhat by reminding them that the IRS is still skeptical of certain valuation discounts, and that an adjustment in the valuation of a gifted business interest may result in a gift tax liability.

The key, the adviser will continue, is to remove as much value from the reach of the estate tax as reasonably possible, and without incurring a gift tax liability – by utilizing the client’s remaining exemption amount – while also leaving a portion of such exemption amount as a “cushion” in the event the IRS successfully challenges the client’s valuation.

“Ask and Ye Shall Receive”(v)

Enter the 2017 Tax Cuts and Jobs Act (the “Act”).(vi) Call it an early present for the 2018 gifting season.

One of the key features of the Act was the doubling of the federal estate and gift tax exemption for U.S. decedents dying, and for gifts made by U.S. individuals,(vii) after December 31, 2017, and before January 1, 2026.

This was accomplished by increasing the basic exemption amount (“BEA”) from $5 million to $10 million. Because the exemption amount is indexed for inflation (beginning with 2012), this provision resulted in an exemption amount of $11.18 million for 2018, and this amount will be increased to $11.4 million in 2019.(viii)

Exemption Amount in a Unified System

You will recall that the exemption amount is available with respect to taxable transfers made by an individual taxpayer either during their life (by gift) or at their death – in other words, the gift tax and the estate tax share a common exemption amount.(x)

The gift tax is imposed upon the taxable gifts made by an individual taxpayer during the taxable year (the “current taxable year”). The gift tax for the current taxable year is determined by: (1) computing a “total tentative tax” on the combined amount of all taxable gifts made by the taxpayer for the current and all prior years using the common gift tax and estate tax rate table; (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 the taxpayer’s unified credit (derived from the unused exemption amount) not consumed by prior-year gifts.

Thus, taxable gift transfers(xi) that do not exceed a taxpayer’s exemption amount are not subject to gift tax. However, any part of the taxpayer’s exemption amount that is used during their life to offset taxable gifts reduces the amount of exemption that remains available at their death to offset the value of their taxable estate.(xii)

From a mechanical perspective, this “unified” relationship between the two taxes is expressed as follows:

• the deceased taxpayer’s taxable estate is combined with the value of any taxable gifts made by the taxpayer during their life;
• the estate tax rate is then applied to determine a “tentative” estate tax;
• the portion of this tentative estate tax that is attributable to lifetime gifts made by the deceased taxpayer is then subtracted from the tentative estate tax to determine the “gross estate tax” – i.e., the amount of estate tax before considering available credits, the most important of which is the so-called “unified credit”; and
• credits are subtracted to determine the estate tax liability.

This method of computation is designed to ensure that a taxpayer only gets one run up through the rate brackets for all lifetime gifts and transfers at death.(xiii)

What Happens After 2025?(xvi)

However, given the temporary nature of the increased exemption amount provided by the Act, many advisers questioned whether the cumulative nature of the gift and estate tax computations, as described above, would result in inconsistent tax treatment, or even double taxation, of certain transfers.

To its credit,(xv) Congress foresaw some of these issues and directed the IRS to prescribe regulations regarding the computation of the estate tax that would address any differences between the exemption amounts in effect: (i) at the time of a taxpayer’s death and (ii) at the time of any gifts made by the taxpayer.

Pending the issuance of this guidance – and pending the confirmation of what many advisers believed was an expression of Congressional intent not to punish individuals who make gifts using the increased exemption amount – many taxpayers decided not to take immediate advantage of the greatly increased exemption amount, lest they suffer any of the consequences referred to above.

Proposed Regulations

In response to Congress’s directive, however, the IRS proposed regulations last week that should allay the concerns of most taxpayers,(xvi) which in turn should smooth the way to increased gifting and other transfers that involve an initial or partial gift.

In describing the proposed regulations, the IRS identified and analyzed several situations that could have created unintended problems for a taxpayer, though it concluded that the existing methodology for determining the taxpayer’s gift and estate tax liabilities provided adequate protection against such problems:

Whether a taxpayer’s post-2017 increased exemption amount would be reduced by pre-2018 gifts on which gift tax was paid. If the taxpayer makes additional gifts during the post-2017 increased exemption period, would the gift tax computation apply the increased exemption to the pre-2018 gifts, thus reducing the exemption otherwise available to shelter gifts made during the post-2017 period, effectively allocating credit to a gift on which gift tax in fact was already paid, and denying the taxpayer the full benefit of the increased exemption amount for transfers made during the increased exemption period?

Whether the increased exemption amount available during the increased exemption period would be reduced by pre-2018 gifts on which gift tax was paid. If the taxpayer died during the increased exemption period, would the estate tax computation apply the increased exemption to the pre-2018 gifts, thus reducing the exemption otherwise available against the estate tax during the increased exemption period and, in effect, allocating credit to a gift on which gift tax was paid?

Whether the gift tax on a post-2025 transfer would be inflated by the theoretical gift tax on a gift made during the increased exemption period that was sheltered from gift tax when made. Would the gift tax determination on the post-2025 gift treat the gifts made during the increased exemption period as gifts that were not sheltered from gift tax given that the post-2025 gift tax determination is based on the exemption amount then in effect, rather than on the increased exemption amount, thereby increasing the gift on the later transfer and effectively subjecting the earlier gift to tax even though it was exempt from gift tax when made?

With respect to the first two situations described above, the IRS determined that the current methodology by which a taxpayer’s gift and estate tax liabilities are determined ensures that the increased exemption will not be reduced by a prior gift on which gift tax was paid. As to the third situation, the IRS concluded that the current methodology ensures that the tax on the current gift will not be improperly inflated.

New Regulations

However, there was one situation in which the IRS concluded that the methodology for computing the estate tax would, in effect, retroactively eliminate the benefit of the increased exemption that was available for gifts made during the increased exemption period.

Specifically, the IRS considered whether, for estate tax purposes, a gift made by a taxpayer during the increased exemption period, and that was sheltered from gift tax by the increased exemption available during such period, would inflate the taxpayer’s post-2025 estate tax liability.

The IRS determined that this result would follow if the estate tax computation failed to treat such gifts as sheltered from gift tax.

Under the current methodology, the estate tax computation treats the gifts made during the increased exemption period as taxable gifts not sheltered from gift tax by the increased exemption amount, given that the post-2025 estate tax computation is based on the exemption in effect at the decedent’s death rather than the exemption in effect on the date of the gifts.

For example, if a taxpayer made a gift of $11 million in 2018, (when the BEA is $10 million; a taxable gift of $1 million), then dies in 2026 with a taxable estate of $4 million (when the BEA is $5 million), the federal estate tax would be approximately $3,600,000: 40% estate tax on $9 million – specifically, the sum of the $4 million taxable estate plus $5 million of the 2018 gift that was sheltered from gift tax by the increased exemption. This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from gift tax by the increased exemption allowable at that time.

Alternatively, what if the taxpayer dies in 2026 with no taxable estate? The taxpayer’s estate tax would be approximately $2 million, which is equal to a 40% tax on $5 million – the amount by which, after taking into account the $1 million portion of the 2018 gift on which gift tax was paid, the 2018 gift exceeded the BEA at death. This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from the gift tax by the excess of the 2018 exemption over the 2026 exemption.

The IRS determined that this problem arises from the interplay between the differing exemption amounts that are taken into account in the computation of the estate tax.

Specifically, after first determining the tentative tax on the sum of a decedent’s taxable estate and their adjusted taxable gifts,(xvii)

i. the decedent’s estate must then determine the credit against gift taxes for all prior taxable gifts, using the exemption amount allowable on the dates of the gifts (the credit itself is determined using date of death tax rates);
ii. the gift tax payable is then subtracted from the tentative tax, the result being the net tentative estate tax; and
iii. the estate next determines a credit based on the exemption amount as in effect on the date of the decedent’s death, which is then applied to reduce the net tentative estate tax.

If this credit (based on the exemption amount at the date of death) is less than the credit allowable for the decedent’s taxable gifts (using the date of gift exemption amount), the effect is to increase the estate tax by the difference between the two credit amounts.

In this circumstance, the statutory requirements for computing the estate tax have the effect of imposing an estate tax on gifts made during the increased exemption period that were sheltered from gift tax by the increased exemption amount in effect when the gifts were made.

In order to address this unintended result, the proposed regulations would add a special computation rule in cases where (i) the portion of the credit as of the decedent’s date of death that is based on the exemption is less than (ii) the sum of the credits attributable to the exemption allowable in computing the gift tax payable. In that case, the portion of the credit against the net tentative estate tax that is attributable to the exemption amount would be based upon the greater of those two credit amounts.

Specifically, if the total amount allowable as a credit, to the extent based solely on the BEA, in computing the gift tax payable on the decedent’s post-1976 taxable gifts, exceeds the credit amount based solely on the BEA in effect at the date of death, the credit against the net tentative estate tax would be based on the larger BEA.

For example, if a decedent made cumulative taxable gifts of $9 million, all of which were sheltered from gift tax by a BEA of $10 million applicable on the dates of the gifts,(xviii) and if the decedent died after 2025 when the BEA was $5 million, the credit to be applied in computing the estate tax would be based upon the $9 million of exemption amount that was used to compute the gift tax payable.

Time to Act?

By addressing the unintended results presented in the situation described – a gift made the decedent during the increased exemption period, followed by the death of the decedent after the end of such period – the proposed regulations ensure that the decedent’s estate will not be inappropriately taxed with respect to the gift.

With this “certainty,” an individual business owner who has been thinking about gifting a substantial interest in their business may want to accelerate their gift planning. As an additional incentive, the owner need only look at the results of the mid-term elections, which do not bode well for the future of the increased exemption amount. In other words, it may behoove the owner to treat 2020 (rather than 2025) as the final year for which the increased exemption amount will be available, and to plan accordingly. Those owners who decide to take advantage of the increased exemption amount by making gifts should consider how they may best leverage it.

And as always, tax savings, estate planning, and gifting strategies have to be considered in light of what is best for the business and what the owner is comfortable giving up.

—————————————————————
(i) What? Did you really expect something else? Tax planning is not a seasonal exercise – it is something to be considered every day, similar to many other business decisions.
(ii) Of course, the interest to be gifted should be “disposable” in that the owner can comfortably afford to give up the interest. Even if that is the case, the owner may still want to consider the retention of certain “tax-favored” economic rights with respect to the interest so as to reduce the amount of the gift for tax purposes.
(iii) Usually into an irrevocable trust, and coupled with the granting of “Crummey powers” to the beneficiaries so as to support the gift as one of a “present interest” in property. A donor’s annual exclusion amount is set at $15,000 per donee for 2018 and $15,000 for 2019.
(iv) In other words, a dollar removed today will remove that dollar plus the appreciation on that dollar; a dollar at death shields only that dollar.
The removal of this value from the reach of the estate tax has to be weighed against the loss of the stepped-up basis that the beneficiaries of the decedent’s estate would otherwise enjoy if the gifted business interest were included in the decedent’s gross estate.
(v) Matthew 7:7-8. Actually, many folks asked for the repeal of the estate tax. “You Can’t Always Get What You Want,” The Rolling Stones.
(vi) P.L. 115-97.
(vii) For purposes of the estate tax, this includes a U.S. citizen or domiciliary. The distinction between a U.S. individual and non-resident-non-citizen is significant. In the absence of any estate and gift tax treaty between the U.S and the foreign individual’s country, the foreign individual is not granted any exclusion amount for purposes of determining their U.S. gift tax liability, and only a $60,000 exclusion amount for U.S. estate tax purposes.
(viii) https://www.irs.gov/pub/irs-drop/rp-18-57.pdf
(ix) Only individual transferors are subject to the gift tax. Thus, in the case of a transfer from a business entity that is treated as a gift, one or more of the owners of the business entity will be treated as having made the gift.
(x) They also share a common tax rate table.
(xi) As distinguished, for example, from the annual exclusion gift – set at $15,000 per donee for 2018 and for 2019 – which is not treated as a taxable gift (it is not counted against the exemption amount).
(xii) An election is available under which the federal exemption amount that was not used by a decedent during their life or at their death may be used by the decedent’s surviving spouse (“portability”) during such spouse’s life or death.
(xiii) A similar approach is followed in determining the gift tax, which is imposed on an individual’s transfers by gift during each calendar year.
(xiv) As indicated above, the increased exemption amount is scheduled to sunset after 2025, at which point the lower, pre-TCJA basic exclusion amount is reinstated, as adjusted for inflation through 2025. Of course, a change in Washington after 2020 could accelerate a reduction in the exemption amount.
(xv) I bet you don’t hear that much these days.
(xvi) https://www.federalregister.gov/documents/2018/11/23/2018-25538/estate-and-gift-taxes-difference-in-the-basic-exclusion-amount; the regulations are proposed to be effective on and after the date they are published as final regulations in the Federal Register.
(xvii) Defined as all taxable gifts made after 1976 other than those included in the gross estate.
(xviii) Post-TCJA and before 2026.

If there was one part of the Tax Cuts and Jobs Act (“TCJA”) that estate planners were especially pleased to see, it was the increase in the basic exclusion amount from $5.49 million, in 2017, to $11.18 million for gifts made, and decedents dying, in 2018.[i] However, many estate planners failed to appreciate the potential impact of an income tax provision that came late to the party and that was specifically intended to benefit the individual owners of pass-through entities (“PTEs”).

A Brief History

As it made its way through Congress, the TCJA was billed[ii] as a boon for corporate taxpayers, and indeed it was. The corporate tax rate was reduced from 35% to 21%. The corporate AMT was eliminated. The system for the taxation of foreign income was changed in a way that skews in favor of C corporations.

But what about the closely held business – the sole proprietorships, the S corps, the partnerships and LLCs that are owned primarily by individual taxpayers and that often represent the most significant asset in their estates?

These businesses are usually formed as PTEs for tax purposes, meaning that the net operating income generated by these entities is generally not subjected to an entity-level tax; rather, it flows through to the individual owners, who are taxed thereon as if they had realized it directly.

With the introduction of the TCJA, the owners of many PTEs began to wonder whether they should revoke their S corporation elections, or whether they should incorporate[iii] their sole proprietorships and partnerships.

In response to the anxiety felt by individual business owners, Congress enacted a special deduction for PTEs in the form of Sec. 199A.[iv] However, shortly after its enactment on December 22, 2017, tax advisers starting peppering the IRS with questions about the application of 199A.

The IRS eventually proposed regulations in August, for which hearings were held in mid-October.[v]

In September, House Republicans introduced plans for making Sec. 199A “permanent.” Then, during the first week of November, the Republicans lost control of the House.[vi]

Notwithstanding this state of affairs, the fact remains that 199A is the law for at least two more years,[vii] and estate planners will have to deal with it; after all, the income tax consequences arising from an individual’s transfer of an interest in a PTE in furtherance of their estate plan will either enhance or reduce the overall economic benefit generated by the transfer.

In order to better appreciate the application of 199A to such “estate planning transfers,” a quick refresher may be in order.

Sec. 199A Basics

Under Sec. 199A, a non-corporate taxpayer[viii] – meaning an individual, a trust, or an estate – who owns an interest in a PTE that is engaged in a qualified trade or business (“QTB”),[ix] may claim a deduction for a taxable year equal to 20% of their qualified business income (“QBI”)[x] for the taxable year.[xi]

This general rule, however, is subject to a limitation that, if triggered, may reduce the amount of the 199A deduction that may be claimed by the non-corporate taxpayer (the “limitation”).

What triggers the limitation? The amount of the taxpayer’s taxable income from all sources[xii] – not just the taxpayer’s share of the QTB’s taxable income. Moreover, if the taxpayer files a joint return with their spouse, the spouse’s taxable income is also taken into account.

Specifically, once the taxpayer’s taxable income exceeds a specified threshold amount, the limitation becomes applicable, though not fully; rather, it is phased in. In the case of a single individual, the limitation starts to apply at taxable income of $157,500 (the so-called “threshold amount”). The limitation is fully phased in when taxable income exceeds $207,500.[xiii]

This $157,500 threshold amount also applies to non-grantor trusts and to estates.

These thresholds are applied at the level of each non-corporate owner of the business – not at the level of the entity that actually conducts the business. Thus, some owners of a QTB who have higher taxable incomes may be subject to the limitations, while others with lower taxable incomes may not.

The Limitation

As stated earlier, the Sec. 199A deduction for an individual, a trust, or an estate for a particular tax year is generally equal to the 20% of the taxpayer’s QBI for the year.

However, when the above-referenced limitation becomes fully applicable, the taxpayer’s 199A deduction for the year is equal to the lesser of:

  • 20% of their QBI from a QTB, and
  • The greater of:
      • 50% of the W-2 Wages w/r/t such QTB, or
      • 25% of the W-2 Wages w/r/t such QTB plus 2.5% of the “unadjusted basis” of the “qualified property” in such QTB.

In considering the application of this limitation, the IRS recognized that there are bona fide non-tax, legal or business reasons for holding certain properties – such as real estate – separate from the operating business, and renting it to such business. For that reason, the proposed regulations allow the owners of a QTB to consider the unadjusted basis of such rental property in determining the limitations described above – even if the rental activity itself is not a QTB – provided the same taxpayers control both the QTB and the property.[xiv]

Thus, assuming the presence of at least one QTB,[xv] much of the planning for 199A will likely involve the taxpayer’s “management” of (i) their taxable income (including their wages and their share of QBI) and, thereby, their threshold amount for a particular year, (ii) the W-2 Wages paid by the business, (iii) the unadjusted basis of the qualified property[xvi] used in the business, and (iv) the aggregation of QTBs.

Of the foregoing items, the management of the unadjusted basis of qualified property may be especially fruitful in the context of estate planning, as may the management of the threshold amount.

Unadjusted Basis

Generally speaking, the unadjusted basis of qualified property is its original basis in the hands of the QTB as of the date it was placed into service by the business.

Where the business purchased the property, its cost basis would be its unadjusted basis – without regard to any adjustments for depreciation or expensing subsequently claimed with respect to the property – and this amount would be utilized in determining the limitation on an owner’s 199A deduction.

However, where the property was contributed to a PTE in a tax-free exchange for stock or a partnership interest, the PTE’s unadjusted basis would be the adjusted basis of the property in the hands of the contributor at the time of the contribution – i.e., it will reflect any cost recovery claimed by such person.

In the case of an individual who acquires property from a decedent before placing it into service in a QTB, the stepped-up basis becomes the unadjusted basis or purposes of 199A.

However, if the qualified property is held in a partnership, no Section 754 adjustment made at the death of a partner will be taken into account in determining the unadjusted basis for the transferee of the decedent’s interest for purposes of 199A.[xvii]

Based on the foregoing, and depending upon the business,[xviii] a taxpayer who can maximize the unadjusted basis of the QTB’s qualified property will increase the likelihood of supporting a larger 199A deduction in the face of the limitation.

Toward achieving this end, there may be circumstances in which qualified property should be owned directly by the owners of the PTE (say, as tenants-in-common[xix]), rather than by the PTE itself, and then leased by the owners to the business.

For example, if a sole proprietor is thinking about incorporating a business, or converting it into a partnership by bringing in a partner, and the business has qualified property with a relatively low unadjusted basis (say, the original cost basis), the sole proprietor may want to retain ownership of the depreciable property and lease it (rather than contribute it) to the business entity, so as (i) to preserve their original unadjusted cost basis and avoid a lower unadjusted cost basis in the hands of the entity (based on the owner’s adjusted basis for the property) to which it would otherwise have been contributed, and (ii) to afford their successors in the business and to the property an opportunity to increase their unadjusted basis in the property, assuming it has appreciated – basically, real estate – after the owner’s death.

Trusts – the Threshold Amount

A non-grantor trust is generally treated as a form of pass-through entity to the extent it distributes (or is required to distribute) its DNI (“distributable net income;” basically, taxable income with certain adjustments) to its beneficiaries, for which the trust claims a corresponding distribution deduction. In that case, the income tax liability for the income that is treated as having been distributed by the trust shifts to the beneficiaries to whom the distribution was made.

To the extent the trust retains its DNI – i.e., does not make (and is not required to make) a distribution to its beneficiaries – the trust itself is subject to income tax.

In the case of a non-grantor trust, at least in the first instance, the 199A deduction is applied at the trust level. Because the trust is generally treated as an individual for purposes of the income tax, the threshold amount for purposes of triggering the application of the limitation is set at $157,500 (with a $50,000 phase-in range).

Distribution

However, if the trust has made distributions during the tax year that carry out DNI to its beneficiaries, the trust’s share of the QBI, W-2 Wages, and Unadjusted Basis of the QTB in which it owns an interest are allocated between the trust and each beneficiary-distributee.

This allocation is based on the relative proportion of the DNI of the trust that is distributed, or that is required to be distributed, to each beneficiary, or that is retained by the trust. In other words, each beneficiary’s share of the trust’s 199A-related items is determined based on the proportion of the trust’s DNI that is deemed distributed to the beneficiary.

The individual beneficiary treats these items as though they had been allocated to them directly from the PTE that is engaged in the QTB.

Following this allocation, the trust uses its own taxable income for purposes of determining its own 199A deduction, and the beneficiaries use their own taxable incomes.

Based on the foregoing, a trustee may decide to make a distribution in a particular tax year if the trust beneficiaries to whom the distribution is made are in a better position to enjoy the 199A deduction than are the trust and the other beneficiaries.[xx]

In any case, the beneficiaries to whom a distribution is not made may object to the trustee’s decision notwithstanding the tax-based rationale.

Of course, where the trustee does not consider the tax attributes of an individual beneficiary, and makes a distribution to such individual which pushes them beyond the threshold amount, or disqualifies their SSTB from a 199A deduction, the beneficiary may very well assert that the trustee did not act prudently.

Limitations Applied to Non-grantor Trusts

The 199A threshold and phase-in amounts are applied at the level of the non-grantor trust.[xxi]

Because of this, the IRS is concerned that taxpayers will try to circumvent the threshold amount by dividing assets among multiple non-grantor trusts, each with its own threshold amount.

In order to prevent this from happening, the IRS has proposed regulations that introduce certain anti-abuse rules.[xxii]

Specifically, if multiple trusts are formed with a “significant purpose” – not necessarily the primary purpose – of receiving a deduction under 199A, the proposed regulations provide that the trusts will not be “respected” for purposes of 199A.[xxiii] Unfortunately, it is not entirely clear what this means: will the trusts not qualify at all, or will they be treated as a single trust for purposes of the deduction?

In addition, two or more trusts will be aggregated by the IRS, and treated as a single trust for purposes of 199A, if:

  • The trusts have substantially the same grantor(s),
  • Substantially the same “primary” beneficiary(ies), and
  • “A” principal purpose for establishing the trusts is the avoidance of federal income tax.

For purposes of applying this rule, spouses are treated as one person. In other words, if a spouse creates one trust and the other spouse creates a second trust, the grantors will be treated as the same for purposes of the applying this anti-abuse test, even if the trusts are created and funded independently by the two spouses.[xxiv]

If the creation of multiple trusts results in a “significant income tax benefit,” a principal purpose of avoiding tax will be presumed.

This presumption may be overcome, however, if there is a significant non-tax (or “non-income tax”) purpose that could not have been achieved without the creation of separate trusts; for example, if the dispositive terms of the trusts differ from one another.

Grantor Trust

The application of 199A to a grantor trust is much simpler because the individual grantor is treated as the owner of the trust property and income, and the trust is ignored, for purposes of the income tax.[xxv] Thus, any QTB interests held by the trust are treated as owned by the grantor for purposes of applying 199A.

In other words, the rules described above with respect to any individual owner of a QTB will apply to the grantor-owner of the trust; for example, the QBI, W-2 Wages, and Unadjusted Basis of the QTB operated by the PTE in which the trust holds an interest will pass through to the grantor.

Planning?

As we know, many irrevocable trusts to which completed gifts have been made are nevertheless taxed as grantor trusts for income tax purposes. The grantor has intentionally drafted the trust so that the income tax liability attributable to the trust will be taxed to the grantor, thereby enabling the trust to grow without reduction for income taxes, while at the same time reducing the grantor’s gross estate for purposes of the estate tax.

This may prove to be an expensive proposition for some grantors, which they may remedy by renouncing the retained rights or authorizing the trustee to toggle them on or off, or by being reimbursed from the trust (which defeats the purpose of grantor trust status).

The availability of the 199A deduction may reduce the need for avoiding or turning off grantor trust status, thus preserving the transfer tax benefits described above. In particular, where the business income would otherwise be taxed at a 37% federal rate,[xxvi] the full benefit of 199A would yield a less burdensome effective federal rate of 29.6%.

In addition to more “traditional” grantor trusts – which are treated as such because the grantor has retained certain rights with respect to the property contributed to the trust – there are other trusts to which the grantor trust rules may apply and which may, thereby, lend themselves to some 199A planning.

For example, a trust that holds S corporation stock may qualify as a subchapter S trust for which the sole current beneficiary of the trust may elect under Sec. 1361(d) (a “QSST” election) to be treated as the owner of such stock under Sec. 678 of the Code.[xxvii] Or a trust with separate shares for different beneficiaries, each of which is treated as a separate trust for which a beneficiary may elect treatment as a QSST.

Another possibility may be a trust that authorizes the trustee to grant a general power of appointment to a beneficiary as to only part of the trust – for example, as to a portion of one of the PTE interests held by the trust – thereby converting that portion of the trust into a grantor trust under Sec. 678.[xxviii]

What’s Next?

It remains to be seen what the final 199A regulations will look like.[xxix] That being said, estate planners should have enough guidance, based upon what has been published thus far, to advise taxpayers on how to avoid the anti-abuse rules for non-grantor trusts, how to take advantage of the grantor trust rules, and how to maximize the unadjusted basis for qualified property.

Hopefully, the final regulations will provide examples that illustrate the foregoing. Absent such examples, advisers will have to await the development of some Sec. 199A jurisprudence. Of course, this presupposes that 199A will survive through the 117th Congress.[xxx]


[i] The exclusion amount increases to $11.4 million in 2019. It is scheduled to return to “pre-TCJA” levels after 2025. See the recently proposed regulations at REG-106706-18.

[ii] Pun intended. P.L. 115-97.

[iii] Or “check the box” under Reg. Sec. 301.7701-3.

[iv] This provision covers tax years beginning after 12/31/2017, but it expires for tax years beginning after 12/31/2025.

[v] More recently, the IRS announced its 2018-2019 priority guidance project, which indicated that it planned to finalize some of the regulations already proposed, but that more regulations would be forthcoming; it also announced that a Revenue Procedure would be issued that would address some of the computational issues presented by the provision.

[vi] Thus, we find ourselves at the end of November 2018 with a provision that expires after December 31, 2025, for which the issued guidance is still in proposed form.

[vii] Through the next presidential election.

[viii] The deduction is not determined at the level of the PTE – it is determined at the level of each individual owner of the PTE, based upon each owner’s share of qualified business income.

[ix] In general, a QTB includes any trade or business other than a specified service trade or business (“SSTB”) and the provision of services as an employee.

If an individual taxpayer does not exceed the applicable taxable income threshold (described below), their QBI from their SSTB will be included in determining their 199A deduction. If the taxpayer exceeds the applicable threshold and phase-in amounts, none of the income and deduction items from the SSTB will be included in determining their 199A deduction.

[x] Basically, the owner’s pro rata share of the QTB’s taxable income.

[xi] This deduction amount is capped at 20% of the excess of (i) the owner’s taxable income for the year over (ii) their net capital gain for the year.

[xii] Business and investment, domestic and foreign.

[xiii] In the case of a joint return between spouses, the threshold amount is $315,000, and the limitation becomes fully applicable when taxable income exceeds $415,000.

[xiv] Consistent with this line of thinking, and recognizing that it is common for taxpayers to separate into different entities, parts of a business that are commonly thought of as a single business, the IRS will also allow individual owners – not the business entities themselves – to elect to aggregate (to treat as one business) different QTBs if they satisfy certain requirements, including, for example, that the same person or group of persons control each of the QTBs to be aggregated.

It should be noted that owners in the same PTEs do not have to aggregate in the same manner. Even minority owners are allowed to aggregate. In addition, a sole proprietor may aggregate their business with their share of a QTB being conducted through a PTE.

[xv] Whether a QTB exists or not is determined at the level of the PTE. An owner’s level of involvement in the business is irrelevant in determining their ability to claim a 199A deduction. A passive investor and an active investor are both entitled to claim the deduction, provided it is otherwise available.

[xvi] Basically, depreciable tangible property that is used in the QTB for the production of QBI, and for which the “depreciation period” has not yet expired.

[xvii] The Section 754 adjustment is not treated as a new asset that is placed into service for these purposes. Compare Reg. Sec. 1.743-1(j)(4).

[xviii] For example, is it labor- or capital-intensive?

[xix] Of course, this presents its own set of issues.

[xx] Of course, this assumes that the trustee has the relevant beneficiary information on the basis of which to make this decision, which may not be feasible.

[xxi] For purposes of determining whether the trust’s taxable income exceeds these amounts, the proposed regulations provide that the trust’s taxable income is determined before taking into account any distribution deduction. Query whether this represents a form of double counting? The distributed DNI is applied in determining the trust’s threshold, and it is applied again in determining the distributee’s.

[xxii] Under both IRC Sec. 199A and Sec. 643(f).

[xxiii] Prop. Reg. Sec. 1.199A-6(d)(3).

[xxiv] Prop. Reg. Sec. 1.643(f)-1.

[xxv] IRC Sec. 671 through 679.

[xxvi] The new maximum federal rate for individuals after the TCJA.

[xxvii] See Reg. Sec. 1.1361-1(j).

[xxviii] A so-called “Mallinckrodt trust.”

[xxix] The proposed regulations also address the treatment of ESBTs under Sec. 199A. According to the proposed regulations, an ESBT is entitled to the deduction. Specifically, the “S portion” of the ESBT takes into account its share of the QBI and other items from any S corp owned by the ESBT.

The grantor trust portion of the trust, if any, passes its share to the grantor-owner.

The non-S/non-grantor trust portion of the trust takes into account the QBI, etc., of any other PTEs owned by the trust. Does that mean that the ESBT is treated as two separate trusts for purposes of the 199A rules? It is not yet clear.

[xxx] January 2021 to January 2023.

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.

—————————————————————————————————-

[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.

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[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.