Disruption and Uncertainty in Partnership Tax

Transcription

1 Disruption and Uncertainty in Partnership Tax Chair: Phillip Gall, Ernst & Young LLP, New York City Karen Lohnes, PricewaterhouseCoopers LLP, Washington, DC Bryan Rimmke, Attorney- Treasury, Washington, DC Michael Shulman, Shearman & Sterling LLP, New York City Passthroughs and Special Industries, Internal Revenue Service, Washington, DC

2 New 199A 20% Deduction for Domestic Qualified Business Income Individual taxpayer generally may deduct 20 percent of combined qualified business income from a partnership, S corporation, or sole proprietorship The amount of the deduction is capped at the greater of o 50 percent of the W-2 wages paid with respect to the qualified trade or business and o The sum of 25 percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property W-2 wage limit phases in for taxpayers with taxable income more than $157,500 (single)/$315,000 (married filing jointly). Limit is fully phased in at $207,500/$415,000 respectively. Qualified income does not include: o income from specified services trades or businesses (for taxpayers with income above the income thresholds) o S corp reasonable compensation and partnership guaranteed payments o Investment-type income (e.g., capital gains and dividends) REIT dividends, cooperative dividends, and qualified publicly traded partnership income are qualified income not subject to the wage limitations. 1

3 Example: 20% Deduction Partnership allocates $100 of qualified business income to Partner A Partner A s allocable share of partnership s W-2 wages is $50 A entitled to deduct $20 (50% of Partner A s allocable share of Partnership s W-2 wages is $25, which is greater than deduction) Uncapped 199A deduction reduces effective rate of taxpayer taxed at top marginal rate to 29.6% ((100-20) x 37%) Deduction does not reduce NII 2

4 What are specified service activities? Any trade or business activity which is described in section 1202(e)(3)(A) (applied without regard to the words engineering, architecture ), or services that consist of investing, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)). Section 1202(e)(3)(A): any trade or business involving the performance of services in the fields of health, law, engineering, architecture, 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 1 or more of its employees. It is unclear how much prohibited services activity taints a business activity and when reputation and skill will be a principal asset. 3

5 Tax on Sale of Partnership Interest by Non-U.S. Persons 864(c)(8) The U.S. Tax Court s decision in the Grecian Magnesite (2017) case held that gain from the complete redemption of a foreign person s interest in a partnership owning U.S. trade or business assets was not subject to U.S. tax as ECI. This decision refused to follow IRS Rev. Rul , which would have treated a portion of the foreign person s gain as ECI. New section 864(c)(8) effectively overrides Grecian Magnesite by providing that gain (or loss) of a foreign partner from its sale, exchange or other disposition of all or any portion of its interest in a partnership that conducts a U.S. trade or business is ECI (or effectively connected loss) to the extent of the partner s distributive share of the partnership s gain or loss that would have been ECI (or effectively connected loss) if the partnership had sold all of its assets at their FMV as of the date of the sale, exchange or other disposition. 4

6 Tax on Sale of Partnership Interest by Non-U.S. Persons 1446(f) New section 1446(f) requires the transferee of a partnership interest to withhold 10% of the amount realized on the transfer, if any portion of the gain (if there were any gain) from the transferor s disposition of the interest would be treated under section 864(c)(8) as ECI and the transferor does not certify that it is a U.S. person. If a transferee fails to withhold any amount required to be withheld under section 1446(f), the partnership is required to deduct and withhold from distributions to the transferee a tax in an amount equal to the amount the transferee failed to withhold (plus interest). Under Notice , no withholding is required under section 1446(f) with respect to an interest in a publicly traded partnership that is of a class of interest that is publicly traded, until regulations or other guidance have been issued. 5

7 Carried Interest Reform 1061 The Act provides that where a taxpayer holds an applicable partnership interest at any time during the taxable year, the excess of: o the taxpayer s net LTCG with respect to such interest over o the taxpayer s net LTCG with respect to such interest computed by changing the LTCG holding period from 1 year to 3 years is recharacterized as STCG. An applicable partnership interest is any partnership interest that, directly or indirectly, is transferred to (or held by) the taxpayer in connection with the performance of substantial services in any applicable trade or business. An applicable trade or business is any activity conducted on a regular, continuous and substantial basis that consists in whole or in part of: o raising or returning capital, and o either (i) investing in or disposing of specified assets or (ii) developing specified assets. 6

8 Carried Interest Reform 1061 (continued) The term applicable partnership interest does not include: o Any partnership interest directly or indirectly held by a corporation, or o Any capital interest in a partnership that provides the taxpayer with a right to share in partnership capital commensurate with (i) the amount of capital contributed, or (ii) the value of such interest subject to tax under section 83. The term specified asset is defined generally to include securities, commodities, rental or investment real estate, cash or cash equivalents, options or derivative contracts on the foregoing, and partnership interests to the extent attributable to any of the foregoing. The recharacterization rule will not apply, to the extent provided by the Secretary, to income or gain attributable to any asset not held for portfolio investment on behalf of third party investors. If a taxpayer transfers an applicable partnership interest to a related person, the taxpayer must include in gross income as short-term capital gain the portion of the taxpayer s net long-term capital gain that is attributable to underlying partnership assets held for not more than three years. 7

9 Limitation on Deduction of Interest Expense New 163(j) Under new section 163(j), interest deductions for most businesses generally are limited to 30% of the business s adjusted taxable income. Adjusted taxable income is computed without regard to any NOL carryovers, business interest income or expense, and, solely for taxable years beginning before January 1, 2022, any depreciation, amortization or depletion deductions. o Thus, adjusted taxable income is similar to EBITDA for taxable years beginning before January 1, o For taxable years beginning on or after January 1, 2022, adjusted taxable income is similar to EBIT. Disallowed interest deductions can be carried forward indefinitely. No grandfathering is provided for pre-2018 debt instruments. Regulated public utilities are not subject to the 30% cap. Real estate businesses are generally subject to the 30% cap but can elect not to be subject to the 30% cap provided that they then use a longer depreciation recovery period for their assets. 8

10 Limitation on Deduction of Interest Expense New 163(j) (continued) In the case of any partnership, the limitation is applied at the partnership level. Thus, any deduction for business interest of the partnership is taken into account in determining the nonseparately stated taxable income or loss of the partnership. A partner s limitation is increased by the partner s distributive share of the partnership s excess amount of unused adjusted taxable income limitation. o The adjusted taxable income of each partner is determined without regard to such partner s distributive share of any items of income, gain, deduction, or loss of such partnership. o The business interest income of the partnership is not included in adjusted taxable income and therefore does not get passed through to the partners to increase the amount of their cap. Therefore, any partnership with business interest income should consider using leverage to ensure that it does not have business interest income in excess of its business interest expense. 9

11 Limitation on Deduction of Interest Expense New 163(j) (continued) If a partnership has excess business interest deductions for a year that are disallowed under new section 163(j), the disallowed deductions will not be carried forward at the partnership level but instead will be allocated among the partners for that tax year and suspended at the partner level until a later year in which the partnership has unused business interest limitation, if the partner has remained in the partnership. The excess business interest of the partnership is not deductible by the partnership until such later year. o The partner takes into account an amount of suspended business interest expense as paid or accrued by it in that later year equal to its share of the excess taxable income of the partnership for that later year. Excess taxable income is essentially the amount by which the adjusted taxable income of the partnership exceeds the amount of adjusted taxable income that the partnership needed in order to be able to deduct its business interest for that year. The basis of each partner in its partnership interest is decreased by the amount of the excess business interest of the partnership that is allocated to it. To the extent the suspended business interest has not been treated as paid or accrued by the partner before the partner exits the partnership, the basis of the partner s interest is increased, with the result that the exiting partner is permitted to use that portion of the partnership s disallowed interest expense to reduce its gain or increase its loss from the exit. 10

12 Bonus Depreciation Sections 743, 734 and 704(c) New section 168(k)(2)(A)(ii) qualified property is property the original use of which begins with the taxpayer or the acquisition of which the taxpayer meets the requirements of (E)(ii). Section 168(k)(2)(E)(ii) requires: (1) property was not used by the taxpayer at any time prior to the acquisition, (2) property is not acquired from a related person as determined under 267(b) (with certain modifications) and 707(b), (3) the property is not purchased within a controlled group, (4) the basis of the property in the hands of the acquirer is not determined in whole or in part by reference to the adjusted basis of such property in the hands of the person from whom acquired or under Section 1014, and (5) the cost of property does not include so much of the basis of the property as if determined by reference to the basis of other property held at the time by the person acquiring the property. 11

13 Bonus Depreciation Sections 743, 734 and 704(c) For purposes of section 168, basis adjustments under sections 734 and 743 are treated as if they were newly purchased property placed in service when the transfer occurred. Reg. Section (j)(4)(i)(B) and (c)(1). But see Reg. Section 1.168(k)-1(f)(9). Treas. Reg (d)(2) (addressing the remedial method under Section 704(c)) provides for recovery of excess book basis using any recovery period and depreciation method available to the partnership for newly purchased property (of the same type as the contributed property) that is placed in service at the time of contribution. 12

14 Other Pass-through Provisions Repeal of technical termination rules for partnerships, for taxable years beginning after 12/31/17 Modification of the definition of substantial built-in loss under section 743(d) to provide that a substantial built-in loss also exists if the transferee partner would be allocated a net loss in excess of $250,000 upon a hypothetical sale and liquidation of the partnership. (Not an issue for partnerships making a section 754 election.) Modification of section 704(d) to apply the outside basis limitation to a partner s distributive share of charitable contributions and foreign tax credits. 13