Update on Partnership Audit Provisions and Certain Deductions

Transcription

1 Update on Partnership Audit Provisions and Certain Deductions Jennifer O Leary, Philadelphia Office olearyj@pepperlaw.com Ph Annette Ahlers, Los Angeles Office ahlersa@pepperlaw.com Ph May 11, 2018, l Tax Executives Institute Needham, Massachusetts # v 2

2 New Deductions (and Limitations) Section 163(j) 2

3 The New Net Interest Limitation Applies to all business regardless of form, with exceptions for taxpayers with average annual gross receipts of less than $25M for the prior three-year period. - No exception for financial services businesses - Applies regardless of tax status of payee or payee s relationship to taxpayer 3

4 Section 163(j) Limits the deduction for net business interest expense to 30% of adjusted taxable income - Provides that the annual deduction shall not exceed the sum of (A) the business interest income of such taxpayer for such taxable year, (B) 30 percent of the adjusted taxable income of such taxpayer for such taxable year, plus (C) the floor plan financing interest of such taxpayer for such taxable year. 4

5 Section 163(j) Adjusted taxable income is taxable income computed without regard to: - any item of interest, gain, deduction or loss that is not properly allocable to a trade or business - any business interest or business interest income - the amount of any net operating loss deduction - the new 20% deduction for certain pass-through income - in the case of tax years beginning prior to Jan. 1, 2022, any deduction allowable for depreciation, amortization or depletion Disallowed interest is treated as interest paid or incurred in the succeeding taxable year. 5

6 Notice Guidance issued on April 2, 2018 indicates certain technical issues will be addressed when the regulations under Section 163(j) are issued. Highlights interaction between 163(j) and the base erosion provisions of Section 59(e). - In general - allowed interest paid or accrued to a foreign person that is a related party is subject to the rules under Section 59A(c)(3). The to-be-issued regulations under Section 163(j) will generally be applied at the partnership level, except in certain limited circumstances where the rules will apply at the partner level and will prohibit a partner from including such partner s share of the partnership s floor plan financing interest in determining the partner s annual business interest expense deduction under section 163(j). (italics added) 6

7 Application to Partnerships and S corps Limitation is computed for partnerships and S corps at the entity level Double counting rule prevents a partners/shareholder from double counting the entity s adjusted taxable income when determining the partner s/shareholder s business interest limitation. Excess business interest is not carried over by the partnership. Instead, excess business interest is allocated to each partner and is treated as business interest paid by the partner in the next year in which the partner is allocated excess taxable income. Excess limitation is permitted to increase the limitation of each partner 7

8 Partnership Example Corp A B 50% 50% P-Ship $200 Adjusted Taxable Income $50 Net interest Expense Corp A and Individual B compute their limitations separately without regard to interest or income of P-ship In this example, no limitation as $50 of net interest expense is less than 30% of ATI $5 excess limitation is added to each of Corp A and B s computation of their respective limitation 8

9 Section 199A 9

10 New 20% Deduction Section 199A New pass-through deduction in Section 199A for noncorporate taxpayers (including estates and trusts) The deductible amount for a qualified trade or business (QTB) is limited to the lesser of - 20% of Qualified Business Income, or - the greater of (i) 50% of W-2 wages for QTB or (ii) sum of 25% of W-2 wages for QTB and 2.5% of unadjusted basis of all qualified property immediately after acquisition Result is that the 20% deduction may be reduced if there aren t sufficient W-2 wages or assets supporting the business In most cases, effectively reduces rate to 29.6% Only applies

11 Pass Through Details The deductible amount for a qualified trade or business (QTB) is limited to the lesser of - 20% of Qualified Business Income, or - the greater of (i) 50% of W-2 wages for QTB or (ii) sum of 25% of W-2 wages for QTB and 2.5% of unadjusted basis of all qualified property immediately after acquisition 11

12 Service Business Exception Specified service business that are NOT QTB - include performance of services in law, health, accounting, actuarial science, consulting, athletics, financial services, etc. and any trade or businesses where the principal asset of such trade or business is the reputation or skill of one or more of its employees. - Also includes certain investment management services These exclusions have a limited exception for specified service businesses, but only up to a threshold of ($157, ,000 for a single filer of $315, ,000 for married filing jointly) - This threshold amount also applies to QTB. If the QBI is under the threshold amount, the wage limitations don t apply - Solo practitioner lawyers and other professionals may use this 12

13 The 20% Deduction (2018 through 12/31/25) Available to individuals, trusts & estates Individuals deduct up to 20% of qualified business income ( QBI ) - from S corps, LLCs, sole proprietorships Also applies to qualified REIT dividends and qualified PTP income 13

14 Taxation of Pass Through Income The Basics USP (Assumed tax rate 37%) Corp 50% 50% US LLC income $20MM US LLC is actively involved in a qualified business (other than a specified business), $10MM is allocated to USP on her K-1 Assuming US LLC has sufficient W-2 wages or assets, USP may be able to claim 20% deduction of taxable income - if USP can claim deduction of 20% of $10MM, USP has reduced the assumed tax rate of 37%, to an effective tax rate of 29.6% 14

15 What Will The IRS Look For In Your Tax Files For Both the Section 163(j) and Section 199A calculations, new schedules and information documentation will be required. - Interest Income Very specific category of income-segregated - Interest Deductions Excludes, for example, unamortized costs of obtaining financing only look to the interest paid - Separate Out Qualified Business Income Identify any income that is unclear and develop an methodology for capturing the amounts and theory for classification - For certain individuals or partnerships or S-Corps, make sure you are aggregating all the businesses relevant to the calculations. 15

16 What Will The IRS Look For In Your Tax Files - Identify if any interest payments are made to related parties that are foreign persons. - Each tax year new calculations are required thus no same as last year 16

17 New Partnership Audit Rules 17

18 Congress Enacts New Partnership Audit Rules Bipartisan Budget Act of 2015 Congress Repealed Partnership Audit and Litigation Provisions (TEFRA) and Instituted New Partnership Level Determinations and Assessments Effective for tax years beginning after 12/31/17 Game changer that is going to force most partnerships to amend partnership agreements to take into account the potential partnership entity-level tax assessments.

19 Congress Enacts New Partnership Audit Rules Highlights of New Partnership Procedures - Default rule that the partnership is assessed tax liability on the Imputed Underpayment Amount - Partnership generally assessed tax at highest rate applicable to individuals, but can demonstrate that tax should be lower (corporate partners or individual partners subject to lower capital gains or dividend rate) - Partnership can reduce Imputed Underpayment Amount by showing that partners filed amended returns - Partnerships with 100 or fewer partners can opt out (restriction on types of partners) - Partnership can elect to file statements (equivalent to amended K-1s) to each partner for the reviewed year

20 Congress Enacts New Partnership Audit Rules Partnership Level Determination Controlled by Partnership Representative - All partners are bound by a final resolution in the partnership proceeding - Partners do not have the right to participate in the proceeding - Penalties determined at the partnership level, no partner level defenses to penalties

21 Alternatives To Partnership-Level Assessment Partner Amended Tax Returns - Partners who were partners during the Reviewed Year file amended returns taking into account their distributive share of partnership adjustments and pay the applicable tax (notwithstanding statute of limitations issues with respect to the partners return) - Partnership is permitted reduce the Imputed Underpayment Amount by such applicable tax attributable to the partners file amended returns - Reduction in Imputed Underpayment is based on the partners distributive share of partnership adjustments

22 Alternatives to Partnership-Level Assessment Opt-Out for Small Partnerships - Partnerships with 100 partners or less can opt out of the entitylevel partnership determination - Partners must be individuals, C corporations, S Corporations or estates of deceased partners (no upper-tier partnerships) - S corporation shareholders must be counted for purposes of the 100 partner test - If election is made, IRS must make determinations at the partner level (similar to the TEFRA small partnership rules) - Query whether 100 partners is too many for the small partnership rule. IRS administrative burden controlling 100 partner returns would be quite onerous

23 Alternatives to Partnership-Level Assessment Partnership Election to Issue Amended K-1s - Any partnership is permitted an election to issue partnership statements (essentially amended K-1s) to the partners who were partners during the reviewed year - Election must be made with in 45 days of receiving the Notice of Final Partnership Adjustment - Partnership must then issue amended K-1s for each partner for the reviewed year - Partners subject to tax in the year of the statement (not the Reviewed Tax Year) - Partners liable for penalties - Interest is charged at higher rate (2 percentage points higher than normal rate)

24 Alternatives to Partnership-Level Assessment - Partners have no right to an administrative or judicial review. Bound by partnership-level determination. - Can pass-through multiple levels of Partnerships

25 Partnership Representative Partnership Representative - Each partnership must designate a Partnership Representative (PR) - PR must be a person with substantial U.S. presence - IRS will appoint a PR if the partnership does not designate one - Under 7701(a)(1), the term person includes, an individual, trust, estate, partnership, association, company or corporation. Partnership Representative binds partnership and partners Preamble to Proposed Regulations states that the broad authority of the partnership representative may not be limited by state law, partnership agreement, or any other document or agreement. - Thus, if PR doesn t follow what Partnership Agreement says have to do, only recourse is contractual

26 Partnership Representative If an entity is designated as the PR, Proposed Regulations require that Partnership must appoint an individual to act on behalf of that entity 26

27 Default Rule: Partnership Pays Tax Partnership will want to control decision whether partnership pays the tax liability, interest and penalties, or alternatively shifts the burden to the partners. Paying at the partnership level shifts economic burden to current partners from former partners who may have left since the audit year. Partnership agreement must address the allocation of the tax liability; presumably partnership allocates tax payments to partners who bear economic burden. Investor may not want to treat as partnership liability, especially if Investor has significant losses from other sources

28 Who Selects Partnership Representative? Partnership will want to control; Investors will also want to control Significant investors will want control and smaller investors may also demand input; consider voting provisions May need provisions limiting ability of Partnership Representative to make certain decisions that bind partnership; consider whether only significant investors have input or if voting provisions should be implemented All investors will want notice provisions, although new rules do not require notice. Partnership agreement should provide for some type of notice to partners.

29 Considerations When Amending Partnership Agreements Who is going to be PR? - Indemnification for PR - Who decides what PR can do Notification of Partners - New Audit provisions have no statutory notice requirements for partners Can Partners compel a push-out? Do Partners have a veto on certain decisions? 29

30 Considerations for Audited Partnership Under New IRS Audit Procedures Opting out for Partnerships with 100 or less Partners Issuing Amended K-1s at the conclusion of the audit Amended Return Provisions Information requirements for partners and upper-tier entities 1. Partnership will want to control decision. 1. Partnership will want to control decision. 1. Partnership cannot control whether partners file amended returns to take into account audit adjustments. 1. Partnership will need to obtain information on the ultimate owners of the partnership and whether those owners are individuals, corporations or tax exempts. 2. Opting out means partners will be subject to the audit adjustments. IRS might also audit partners returns for other items of interest. (Partners may not want their individual returns subject to possible greater scrutiny by IRS.) 2. This could be a significant administrative burden on partnership. 2. Consider agreement with certain large partners to have them amend returns in order to reduce the partnership. Consider requirement for certain partners to amend returns? 2. Partnership should consider information sharing provisions in the partnership agreement so that upper-tier flow-through entities are required to provide information about their partners and the ultimate owners of the partnership. 3. Partner will be subject to hot interest rate 2 percent greater than the normal IRS interest rate on tax deficiencies. 3. Need to address administrative considerations such as partners providing partnership proof of filing amended return and paying tax on partnership adjustments.

31 Considerations for Taxable U.S. Investors Under New IRS Audit Procedures Opting out for Partnerships with 100 or less Partners Issuing Amended K-1s at the conclusion of the audit Amended Return Provisions Information requirements for partners and upper-tier entities 1. If available, preferable unless sensitive to potential for greater scrutiny by IRS. 1. May be preferred, unless sensitive to potential for greater scrutiny by IRS. 2. Investor may want ability to compel issuance of amended K-1s. 3. Partner will be subject to hot interest rate 2 percent greater than the normal IRS interest rate on tax deficiencies. 1. Investor may want partnership to give it opportunity to file amended return to take into account audit adjustments. 2. Need to address administrative considerations such as partners providing partnership proof of filing amended return and paying tax on partnership adjustments. 1. Although Investor will want partnership to be able to lower rates on audit adjustment if being paid at partnership level, not clear yet what type of information the Investor will have to provide partnership to give to IRS to get benefit of lower rates when applicable. 2. Issues also arise regarding Investor obtaining information from others in tiered situation.

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36 Jennifer O Leary Annette Ahlers