Congress has passed and President Trump has signed into law sweeping tax reform legislation commonly known as the Tax Cuts and Jobs Act. TCJA took effect January 1, 2018. Business lawyers need to be acquainted with TCJA’s far reaching impact to properly advise clients, especially when forming or re-organizing business entities.
TCJA affects all businesses, whether operating as C corporations, sole proprietorships (including one-member LLCs) or pass-through business entities (e.g., S corporations, partnerships and LLCs taxed as partnerships). A C corporation’s income is subject to double taxation: first it is taxed at the corporate-level, then again at the shareholder-level when the corporation distributes dividends. By comparison, income of a pass-through entity is reported on the owners’ or shareholders’ individual income tax returns whether or not distributed, effectively subjecting this income to one level of tax at individual income tax rates. For some perspective, according to the Joint Committee on Taxation, pass-through business owners in 2014 filed 34.4 million pass-through tax returns which accounted for approximately 40.6% of net income reported by businesses overall.
Permanent Tax Reform for C Corporations.
Corporate Tax Rate. Under pre-TCJA law, a C corporation’s taxable income was taxed at graduated rates reaching upwards to 35%. If a C corporation was a personal service corporation, its taxable income was taxed at a flat 35% rate. A personal service corporation is one where substantially all its activities involve services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting. Beginning 2018, the taxable income of all C corporations is permanently lowered to a flat 21% rate.
Corporate AMT Repealed. Furthermore, the prior law’s 20% corporate alternative minimum tax on certain tax preference items is permanently repealed.
When forming a new entity, you should alert your client to the new lower C corporation rate and compare that to the tax treatment of pass-through entity income being taxed at an owner’s or shareholder’s individual rate. That choice of entity decision is further complicated by TCJA’s new pass-through entity deduction described below.
Temporary Tax Reform Affecting Business Owners of Pass-Through Entities.
Regular Individual Income Tax Rates. For the vast majority of Colorado businesses that conduct operations either as sole proprietorships or pass-through entities, for taxable years 2018 through 2025 TCJA temporarily reduces the top individual rate from 39.6% to 37% for married individuals filing jointly having taxable income in excess of $600,000, and for unmarried individuals with taxable income in excess of $500,000.
Individual AMT Exemption Amounts and Phase-Out Thresholds. Unlike C corporations, the alternative minimum tax for individuals remains in effect subject to the following modifications. For taxable years 2018 through 2025, Congress has temporarily increased the exemption amount from $84,500 to $109,400 for joint filers and from $54,300 to $70,300 for unmarried individuals, with the exemption phase-out threshold being temporarily raised to $1,000,000 for joint filers and $500,000 for unmarried individuals, all as indexed for inflation starting 2019.
New 20% Pass-Through Entity Business Deduction. As a general rule for taxable years 2018 through 2025, certain pass-through business owners, shareholders and sole proprietors (including individuals, estates and trusts) may deduct 20% of their “qualified business income.” This deduction is available to both non-itemizers as well as itemizers. In short, the deduction is available on top of the taxpayer’s newly raised standard deduction. Assuming full deductibility, which may often not be the case, the top rate on qualified business income would be 29.6%.
“Qualified Business Income” Defined. Generally, the term “qualified business income” means the net amount of qualified items of income, gain, deduction and loss with respect to a business operating within the United States in pass-through form. Excluded from this calculation, however, is (i) any amount paid by an S corporation that is treated as reasonable compensation of the shareholder, (ii) any IRC § 707(c) guaranteed payment for services rendered to the partnership by a partner acting in his or her partner capacity, (iii) any amount paid or incurred by a partnership as an IRC § 707(a) payment to a partner who is acting other than in his or her capacity as a partner for services to the extent provided in regulations, as well as (iv) specified investment-related income, deduction or losses (e.g., capital gains, dividends or interest unless the interest is allocable to a trade or business, etc.).
Qualified business income is determined for each qualified trade or business of the taxpayer. If a qualified trade or business is conducted through a partnership or S corporation, this provision is not applied at the entity level, but at partner or shareholder level. Consequently, each partner or shareholder must take into account his or her share of each item of qualified business income and W-2 wages of the partnership or S corporation.
If the net amount of qualified business income from all qualified trades or businesses during the taxable year is a loss, it is carried forward as a loss from a qualified trade or business to the next taxable year. As a result, any deduction allowed in a subsequent year is reduced by 20% of any carryover qualified business loss.
W-2 Wage Limitation. For non-corporate taxpayers whose taxable incomes do not exceed prescribed thresholds (i.e., $315,000 for joint filers and $157,500 for all others, both as indexed for inflation starting 2019), the deduction is generally limited to 20% of qualified business income. For joint filers with taxable income between the prescribed threshold plus $100,000, and for other taxpayers with taxable income between the prescribed threshold plus $50,000, this aspect of the limitation is phased out and gradually transitions to one based on a percentage of W-2 wages. For those with taxable incomes in excess of the prescribed threshold plus $100,000/$50,000, the deduction will be the greater of (i) 50% of W-2 wages, or (ii) the sum of 25% of W-2 wages plus 2.5% of the unadjusted basis (determined immediately after acquisition) of all qualified property, defined generally as currently depreciable tangible property held or used in the production of qualified business income. These limitations will result in the pass-through deduction not applying to all pass-through income. Many pass-through business owners, shareholders and sole proprietors otherwise eligible but conducting a business with few wage earners and/or with limited depreciable tangible property will be taxed on qualified business income at a rate higher than the 29.6% noted earlier.
Specified Service Company Limitation. Not all sole proprietors and pass-through business owners and shareholders can benefit by this new deduction. For those who perform services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services, including investing and investment management, trading or dealing in securities, partnership interest or commodities, along with any trade or business where the principal asset is the reputation or skill of one or more of its employees, owners or shareholders, this deduction is available only if prescribed thresholds are not exceeded. For joint filers that threshold is $315,000 (as indexed) plus $100,000; for all other filers it is $157,500 (as indexed) plus $50,000. If a specified service provider exceeds the threshold, no deduction is allowed.
Thanks to a last minute change, architects and engineers are specifically excluded from this threshold rule. Their lobbyists successfully argued that subjecting architects and engineers to this threshold rule was unfair, that they face higher capital costs (e.g., tenant finishes, computers, software, furniture, errors and omissions insurance, etc.) than other service providers and that imposing this threshold would cause them to lose other tax breaks. Why the tax writers found this argument more persuasive in the context of architects and engineers than for other service providers who can just as forcefully argue unfairness, higher capital costs (e.g., doctors, lawyers and accountants incur high costs for tenant finishes, computers, software, furniture and omissions insurance, etc.) and loss of other tax breaks will probably remain unanswered as a by-product of the closed-door manner in which TCJA was negotiated.
Separate 20% Qualified Deductions. In addition to the deduction of qualified business income, a 20% deduction is also available for aggregate dividends from real estate investment trusts that are not a capital gain dividend or a qualified dividend, qualified cooperative dividends and net qualified income from publicly traded partnerships. This 20% deduction is allowed without regard to the limitations mentioned above other than the taxable income limitation.
Overall Limitation. Be mindful though that an overall limitation applies. The 20% deduction in the aggregate cannot exceed a business owner’s, shareholder’s and sole proprietor’s taxable income for the year reduced by net capital gain. In short, the 20% deduction cannot exceed a taxpayer’s ordinary income.
Which of our clients are most likely to benefit by this new but temporary pass-through business deduction? Passive investors in businesses (other than specified service trades or businesses) that generate ordinary income should benefit the most. This would include investors in large real estate development partnerships. By contrast, partners of management companies of private equity funds will not benefit with respect to management fee income insofar as such income is from a specified service trade or business.
100% Bonus Depreciation Temporarily Extended. For new or used qualifying property (generally, depreciable property other than intangible property and buildings) acquired and placed in service after September 27, 2017 and before 2023 (before 2024 for “longer production period” property and certain aircraft), taxpayers can claim a 100% first-year bonus depreciation deduction. For taxable years 2023, 2024, 2025 and 2026, the first-year bonus depreciation is 80%, 60%, 40% and 20%, respectively.
Limitation on Use of Excess Business Losses. Enthusiasm over increased business deductions is tempered by a new loss limitation rule applicable to non-corporate taxpayers. This new rule is applied after application of the “passive activity loss” rules introduced in 1986.
For taxable years 2018 through 2025, “excess business losses” of a taxpayer other than a corporation are disallowed for the taxable year in which they were incurred. The disallowed losses are treated as part of a taxpayer’s net operating loss (“NOL”) and carried forward to subsequent years. An excess business loss is a taxpayer’s aggregate trade or business deductions, less the sum of aggregate trade or business gross income or gain plus $500,000 for joint filers or $250,000 for all others, both as indexed for inflation starting 2019. In the case of a pass-through entity, this loss limitation applies at the shareholder or owner level rather than at the entity level. This rule seems to have the effect of accelerating income into the first eight years of the tax bill.
Tax Reform Possibly of a More Permanent Nature.
Carried Interests and the New 3-Year Rule. Prior to TCJA, a partner who received a “profits interest” in a partnership in exchange for services, colloquially referred to as a carried interest, recognized long-term capital gains with respect to that interest upon the partnership selling a long-term capital gain asset. This fact is most notable in the context of management companies of private equity investment funds. In exchange for services rendered by the managing general partner to the fund, the general partner (and in turn, its partners) are able to report a large portion of their compensation income as long-term capital gains.
“Applicable Partnership Interest” Defined. With passage of TCJA, a service partner’s share of long-term capital gains will now be re-characterized as short-term capital gains taxed at ordinary income rates if the service partner has not held its applicable partnership interest for at least three years. The term “applicable partnership interest” is generally defined as any interest in a partnership transferred to (or held by) a non-corporate taxpayer in connection with the performance of substantial services in any “applicable trade or business.” This term does not include an interest in a partnership held directly or indirectly by a corporation. Nor does it include any capital interest giving the partner a right to share in partnership capital proportionate to the amount of capital contributed as of the time the partnership interest was received, or proportionate to the value of the partnership interest taxed under IRC § 83 on receipt or vesting. IRC § 83 provides rules taxing the receipt of property in exchange for services rendered to an employer.
“Applicable Trade or Business” Defined. An “applicable trade or business” generally includes raising or returning capital and either (i) investing in or disposing of specified assets or (ii) developing specified assets. Specified assets are developed if it is represented to investors, lenders, regulators or others that the value, price or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider or of others acting in concert with or at the direction of the service provider. Merely voting shares of stock owned does not amount to development.
“Specified Assets” Defined. For purposes of defining an applicable trade or business, the term “specified assets” includes securities (itself a defined term), commodities (itself a defined term), real estate held for rental or investment (other than that on which the holder operates an active farm), cash or cash equivalents, and options or derivative contracts. This definition applies in tiered partnership structures to the extent of a partnership’s interest in the foregoing, including an interest in a partnership that is not widely held or publicly traded.
Intended Targets. As the applicable trade or business definition suggests, this 3-year holding period requirement is primarily aimed at profit interests held by investment managers. It does not apply to income or gain attributable to any asset that is not held for portfolio investment on behalf of third-party investors. Thus, a profits interest award to management of non-investment services businesses only has to comply with a 1-year holding period requirement for long-term capital gain treatment on allocations from the partnership. Likewise, limited partners holding capital interests in private equity investment funds are unaffected by this new carried interest rule and thus retain the 1-year holding period requirement.
Related Party Transfers. If during the 3-year holding period a carried interest holder transfers any applicable partnership interest, directly or indirectly, to a person related to the holder, then so much of the holder’s net long-term capital gain attributable to the sale or exchange of an asset held for not more than three years as is allocable to the interest is re-characterized as short-term capital gains taxed at ordinary income rates. A related person is a family member (e.g., spouse, parents, children and grandchildren) or a colleague, who is a person who performed a service within the current calendar year or the preceding three calendar years in any applicable trade or business in which or for which the holder performed a service.
Existing and Newly Granted Profits Interests. It is important to point out that this new 3-year carried interest limitation applies to both newly granted as well as existing profits interests since there is no grandfathering for profits interests received prior to enactment of TCJA. Additionally, pass-through items other than capital gains (e.g., qualified dividend income) are unaffected by this new rule and continue to be taxed at preferential rates.
Technical Terminations of Partnerships. TCJA repeals the IRC § 708(b)(1)(B) rule providing for technical terminations of partnerships whenever 50% or more of total interests in partnership capital and profits is sold or exchanged within a 12-month period. The repeal is permanent so those provisions in both partnership agreements and operating agreements dealing with the consequences of technical terminations are no longer necessary.
Like-Kind Exchanges. Generally, the exchange of property, like a sale, is a taxable event. However, IRC § 1031 permits the tax-free exchange of relinquished property held for productive use in a trade or business or for investment, for replacement property of “like-kind” which is to be held for productive use in a trade or business or for investment. Prior to TCJA, like-kind exchange treatment extended to both real and personal property. Under TCJA, like-kind exchange treatment will be limited to real property that is not held primarily for sale.
Because personal property is now excluded from IRC § 1031 treatment, it will be necessary to identify the personal property components of both relinquished and replacement properties, and the practicalities of having cash with which to pay the resulting tax liability. This issue will be most acute for clients who have had cost segregation studies performed for purposes of accelerating depreciation deductions. These studies have the effect of reclassifying components of nonresidential real property improvements as something other than nonresidential real property depreciable over a recovery period of less than 39 years.
IRC § 179 Expense Election. Business taxpayers of all types can now elect to currently expense (rather than capitalize and depreciate) in the year the property is placed in service the cost of acquiring up to $1,000,000 of (i) depreciable tangible personal property (now including property used predominantly to furnish lodging or in connection with furnishing lodging); (ii) off-the-shelf computer software; (iii) certain leasehold/retail improvement and restaurant property; and (iv) nonresidential real property improvements consisting of roofs, heating, ventilation and air-conditioning property, fire protection and alarm systems, and security systems. This expensing amount is not scheduled to sunset; however, it is reduced by the amount by which the cost of such property in any one year exceeds $2,500,000.
Interest Deduction Limitation. Under pre-TCJA law, interest paid or accrued by a business was generally deductible in the computation of taxable income, subject to a number of limitations. Beginning 2018, the net interest expense of every business, regardless of its form, is limited to 30% of the business’s adjusted taxable income computed without regard to depreciation, amortization or depletion deductions for taxable years 2018 through 2021, and for later taxable years without regard to the deductions for depreciation, amortization, depletion or the new 20% pass-through entity qualified business income deduction. Any disallowed interest expense is carried forward indefinitely.
Generally, the net interest expense disallowance is determined at the tax filer level. However, a special rule applies to pass-through entities requiring the determination to be made at the entity level rather than at the shareholder, partner or member level.
Importantly, TCJA contains a small business interest expense exception. The interest disallowance rule does not apply to businesses with average annual gross receipts for the 3-year period ending with the prior taxable year that does not exceed $25,000,000 (the “$25 million gross receipts test”). But for those businesses with average annual gross receipts over $25,000,000, various complicated and detailed rules and exceptions will apply in calculating the new interest deduction limitation.
Expanded Cash Method of Accounting. Building on the $25 million gross receipts test, TCJA expands the universe of taxpayers who may use the cash (versus the accrual) method of accounting. Under TCJA, the cash method may be used by taxpayers (other than tax shelters) that satisfy the $25 million gross receipts test, regardless of whether or not the purchase, production or sale of merchandise is an income-producing factor. Included in this expanded universe are any farming C corporations or farming partnerships/LLCs with a C corporation partner/member that meets the $25 million gross receipts test.
Net Operating Losses. Prior to TCJA, NOLs could be carried back two years and carried over 20 years offsetting 100% of taxable income. Starting 2018, except for certain losses incurred in the trade or business of farming, NOLs can no longer be carried back but can be carried forward indefinitely, limited however, to 80% of taxable income.
Qualified Equity Grants. TCJA adds new subsection (i) to IRC § 83 entitled “Qualified Equity Grants.” This new provision provides employees with an opportunity to defer the recognition of income with respect stock options or restricted stock units (“RSUs”). New IRC § 83(i) contains many defined terms, qualifiers and restrictions, and it only applies for income tax purposes, not for FICA or FUTA purposes. In essence, it grants a “qualified employee” receiving “qualified stock” from an “eligible corporation” with respect to the exercise of options or settlement of RSUs, a 30-day election window to defer the recognition of income for a maximum period of five years from the date the employee’s rights to the stock become substantially vested.
TCJA introduces significant changes to the tax laws. This article describes only a sampling of those changes. Business clients of all types, especially those forming new entities, should consult with their tax advisors for a more in-depth explanation of this sweeping tax reform legislation.
Originally posted in the Colorado Bar Association Business Law Section Newsletter