Changes to S Corporation, Partnership and LLC Taxation under the Tax Cuts and Jobs Act

Transcription

1 Changes to S Corporation, Partnership and LLC Taxation under the Tax Cuts and Jobs Act Morgan Klinzing, Pepper Hamilton LLP, Philadelphia, PA Mike Hauswirth, PwC, Washington, DC Ryan Dobens, PwC, Washington, DC Laura E. Krebs Al-Shathir, Capes Sokol Goodman & Sarachan PC, St. Louis, MO Bryan Keith, Grant Thornton, Washington, DC Thomas J. Phillips, von Briesen & Roper, s.c., Milwaukee, WI Wednesday, January 24, :00 PM Eastern Sponsored by the ABA Section of Taxation

2 Tax Cuts and Jobs Act of 2017 Key Provisions Affecting S Corporations Section 199A: 20% Deduction Against Flow-Through Income Section 1361(c)(2): Non-resident Aliens as ESBT Beneficiaries Section 642(c): Charitable Contribution Deductions of ESBTs Section 481(a): Adjustments and S Corporation Conversions Section 1371(f): Post-PTTP Distributions of AAA Section 168(k): Full Expensing (Temporary Bonus Depreciation Rule) Section 965(a): Basis Adjustments to S Corporation Stock Section 965(i): Special Deferral Election Section 461(l): Limitation on Excess Business Losses 2

3 Section 199A QBI Deduction Overview Deduction equal to 20% of domestic qualified business income ("QBI") from a sole proprietorship, partnership, or S corporation i.e, taxpayer's QBI deduction is generally the total of 20% times the QBI from each qualified trade or business Deduction available to individuals, estates, and trusts, with certain limitations Intended to reduce overall tax burden on flow-through income in a manner proportionate to the reduction of C corporation tax rate Effective for taxable years beginning after December 31,

4 Section 199A Net Effective Rate Effective rate on QBI from a flow-through entity as a result of 20% QBI deduction reduced from 37% (new top individual marginal rate) to 29.6% Flow Through Entity Example Old Law New Law Non-QBI QBI Taxable income $ $ $ Sec. 199A 20% deduction N/A $ - $ (20.00) Adj. taxable income $ $ $ Individual rate on O.I % 37.00% 37.00% Individual tax liability $ $ $ Net cash to taxpayer $ $ $

5 Section 199A Definition of QBI QBI (qualified business income): Net amount of qualified items of income, gain, deduction, and loss Must be from a qualified trade or business Must be effectively connected with the conduct of a trade or business within the United States QBI generally does not include capital gains and losses, dividends, or interest income (unless interest is properly allocable to a trade or business) (and does not appear to include section 1231 gain treated as capital gain) If the net QBI attributed to a taxpayer is negative, the negative amount is treated as a QBI loss in the following year (appears to be indefinite carryover, which decreases potential deduction in subsequent year) 5

6 Section 199A Active vs Passive QBI deduction is not affected by whether the owner is active or passive QBI deduction does not apply against wages of an S corporation owner (or guaranteed payments to partners for services rendered) Note reasonable compensation authorities 6

7 Section 199A Comparison of C Corp to Flow- Through Entity (prior vs new law) C CORORATION Prior Law New Law FLOW-THROUGH ENTITY Prior Law (Active) New Law (Active) Prior Law (Passive) New Law (Passive) Taxable income $ $ Taxable income $ $ $ $ Corporate rate 35.00% 21.00% Corporate rate 0.00% 0.00% 0.00% 0.00% Corporate tax liability $ $ Corporate tax liability $ - $ - $ - $ - Net cash to distribute $ $ Net cash to distribute $ $ $ $ Sec. 199A 20% deduction $ - $ (20.00) $ - $ (20.00) Adj. taxable income $ $ $ $ Individual rate on cap gain 20.00% 20.00% Individual rate on O.I % 37.00% 39.60% 37.00% NII rate 3.80% 3.80% NII rate (active vs passive) 0.00% 0.00% 3.80% 3.80% Individual tax liability $ $ Individual tax liability $ $ $ $ Total tax liability $ $ Total tax liability $ $ $ $ Net cash to individual $ $ Net cash to individual $ $ $ $ Extra cash under new law $ Extra cash under new law $ $ [1] assumes distribution by C corporation of all net after-tax cash (Note: stock or asset divestiture issues not shown) [2] assumes flow-through income is QBI for sec 199A [3] assumes all passive K-1 income subject to 3.8% NII rate (i.e., no reduction because of sec 199A) 7

8 Section 199A W-2 Wages Limit Limitation on QBI deduction based on W-2 wages of business: QBI deduction is limited to the greater of (i) 50% of the owner s allocable share of W-2 wages paid by the business OR (ii) 25% of that W-2 wage share plus 2.5% of the original cost basis of qualified property Note that this limitation does not apply to a taxpayer with less than $157,000 (single) or $315,000 (joint) in taxable income Limitation phase-in begins at $157,500 (single) or $315,000 (joint) over the next $50,000 (single) or $100,000 (joint) in taxable income complete phase-in of limitation at $207,500 (single) or $415,000 (joint) 8

9 Section 199A Specified Services QBI does not include income from certain disqualified service businesses, defined as: 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 is the reputation or skill of one or more of its employees or owners (section 1202(e)(3)(A), but without regard to engineering or architecture); or services that consist of investing and investment management; trading; or dealing in securities, partnership interests, or commodities. Note that this limitation does not apply to a taxpayer with less than $157,500 (single) or $315,000 (joint) in taxable income Limitation phase-in begins at $157,500 (single) or $315,000 (joint) over the next $50,000 (single) or $100,000 (joint) in taxable income complete phase-in of limitation at $207,500 (single) or $415,000 (joint) 9

10 Section 199A QBI Deduction Overall Limitation Taxpayer's total QBI deduction for the year cannot exceed 20% of the excess of the taxpayer's taxable income over the sum of net capital gains for the year Other Rules QBI deduction is a reduction to taxable income (i.e., not to adjusted gross income) QBI deduction is available regardless of whether a taxpayer itemizes deductions Section 199A QBI deduction applies to taxable years beginning after December 31, 2017 (and expires in 2026) 10

11 Section 199A Choice of Entity Flow-through entity vs C corporation: Operational Issues Projections (taxable income, distributions of cash or property) AMT (alternative minimum tax) Accounting methods (e.g., no longer eligible for cash method) Trade or business (e.g., disqualified specified services business) Owner-level Items (e.g., active vs passive; section 199A limitation thresholds) Estate Planning Items Section 1411 NII issues (e.g., sale of C corp stock subject to NII even if owners are active) International Items (e.g., international operations, foreign DREs & CFCs, State Tax Items (e.g., states with entity level taxes on flow-throughs; composite filings, etc.) 11

12 Section 199A Choice of Entity Flow-through entity vs C corporation: Exit Issues Plans to sell business in near future (generally favors flow-through entity status) Consider NII tax on sale of C corporation stock (versus sale of partnership interests or S corporation stock if active owners) Consider potential increase in sales price if seller can retain single level of tax but offer actual or deemed asset sale (such as section 338(h)(10) or 336(e)) to prospective buyers of assets, stock, or partnership interests (especially if buyer will get immediate expensing of certain assets) Potential double taxation on reversion back to flow-through entity if future change in taxpayer circumstances or future change in tax law 12

13 Section 1361(c)(2) Expansion of Qualifying Beneficiaries of an Electing Small Business Trust Effective January 1, 2018, a nonresident alien can be a beneficiary of an electing small business trust. 13

14 Section 642(c) Charitable Contribution Deduction for Electing Small Business Trusts Effective for tax years beginning after December 31, 2017, the charitable contribution deduction of an electing small business trust is determined by the rules applicable to individuals instead of the rules generally applicable to trusts. as a result the percentage limitations and carry forward provisions applicable to individuals will apply to electing small business trusts. 14

15 Sections 481(a) and 1371(f) Modifications of Treatment of S to C Corporation Conversions Section 481(a) Effective December 22, 2017 Normally such adjustments would be taken into account over four years. Any accounting adjustment under Section 481(a) of an eligible terminated S Corporation attributable to the revocation of the S election is taken into account ratably during the six taxable year period beginning with the year of change. Eligible terminated S corporation means a C corporation which (i) is an S corporation on December 21, 2017, (ii) during the two year period beginning on December 22, 2017 revokes its S election, and (iii) all owners on the date of revocation are the same owners (and in identical proportions) as the owners on December 22, Generally an S corporation may use the cash method of accounting. When cash basis S corporation converts to a C corporation it may be required to use the accrual method of accounting. 15

16 Sections 481(a) and 1371(f) Modifications of Treatment of S to C Corporation Conversions (cont.) Under Section 448, as amended by the Tax Cuts and Jobs Act, a C corporation or a partnership which has a C corporation as a partner must use the accrual method of accounting unless it s in the farming business, it s a qualified personal service corporation or meets the new gross receipt test A corporation or partnership meets the gross receipts test if for any taxable year it s average annual gross receipts for the three taxable year period which precedes such taxable year does not exceed $25,000,000 So when a cash basis S corporation converts to a C corporation and the C corporation does not qualify for an exemption it is required to change to an accrual basis. 16

17 Sections 481(a) and 1371(f) Modifications of Treatment of S to C Corporation Conversions (cont.) Effective on and after December 22, 2017 For a distribution of money by an eligible terminated S corporation after the posttermination transaction period the accumulated adjustments account ( AAA ) shall be allocated to such distribution and the distribution shall be chargeable to accumulated earnings and profits ( AEP ) in the same ratio as the AAA bears to the AEP. The post-termination transition period generally is the period beginning on the date after the corporations last taxable year as an S corporation and ending on the later of, (i) one year after such last day or, (ii) the due date for filing the final return as an S corporation (including extensions). During the post-termination transition period, distributions of cash by the C corporation to it s shareholders are tax free to the extent of AAA and reduce basis. 17

18 Full Expensing under Section 168(k) 100% for property acquired and placed in service after Sep. 27, 2017 and through the end of 2022 and additional five-year extension at reduced rates (with one year longer for long production period property (LPPP)): Special phase down rules apply for property acquired prior to and placed in service after Sep. 27, 2017 Special 50% bonus depreciation election for the first taxable year ending after September 27,

19 Full Expensing under Section 168(k) (cont'd) Expands bonus depreciation to include: Used property eligible for bonus depreciation (if new to taxpayer) Certain qualified films and theatrical productions Restricts bonus depreciation to exclude: Public utilities and businesses with floor plan financing indebtedness (because they are exempt from the interest limitation) QIP for an "electing real property trades or business" (election out of interest limitation) because must apply ADS 19

20 S Corporation Deferral Election under Section 965(i) Deferred foreign income is treated as subpart F income under Section 965(a) Subpart F income is increased by the greater of the accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or December 31, S corporation shareholders can defer tax until a triggering event occurs Shareholders of S corporations may elect to defer payment of tax liability under Section 965 until the shareholder's taxable year which includes a triggering event with respect to such liability. 20

21 Section 461(l) Limit on Excess Business Losses Applies to business losses of taxpayers other than C corporations. Excess business loss of the taxpayer is not permitted An excess business loss is generally an overall loss in excess of $500,000 (joint) or $250,000 (single/other) The excess amount over the threshold becomes a net operating loss (NOL) carryforward to next tax year If S corporation or Partnership, the limit applies at the shareholder or partner level Applies to Non-passive losses (i.e., more expansive than historical section 469 limits) And, applies after the application of passive loss rules of section

22 Changes to S Corporation, Partnership and LLC Taxation under the Tax Cuts and Jobs Act January 24, 2018 Sponsored by the ABA Section of Taxation Mike Hauswirth, PwC Morgan Klinzing, Pepper Hamilton LLP Ryan Dobens, PwC 22

23 Agenda Introductions Interest Limitations under Section 163(j) Carried Interest and the Application of Section 1061 Codification of Rev. Rul Other Miscellaneous Partnership Changes Repeal of Technical Terminations Substantial Built-in Loss Rules Charitable Contribution Limitations Partnership International Provisions 23

24 Interest Limitations under Section 163(j) 24

25 Interest Limitations under Section 163(j) Interest deduction limitation -- What s the new law? Limits deduction for business interest expense to sum of business interest income plus 30% of the adjusted taxable income (ATI) of a taxpayer for the taxable year. ATI is defined similarly to EBITDA for tax years beginning after 2017 and before 2022, and similarly to EBIT (computed without regard to any deduction for depreciation, amortization, or depletion, and without regard to Section 199A) for tax years beginning after Allows disallowed interest deductions to be carried forward indefinitely. Exempts taxpayers with average gross receipts for the three-year period ending with the prior taxable year that do not exceed $25 million. Provides that limitation applies to both related party and third party debt. Section 163(j) does not apply to investment interest expense. Excludes certain trades and businesses. 25

26 Interest Limitations under Section 163(j) Application to a partnership: In the case of a partnership, the section 163(j) limitation is applied at the partnership level. Any deduction for business interest is taken into account by the partnership in determining the non-separately stated income or loss of the partnership. The partnership: Determines its ATI under general rules of section 163(j); Deducts business interest expense up to the sum of its business interest income and 30% of its ATI; and Allocates disallowed business interest expense ( excess business interest ) to its partners. Each partner, for purposes of calculating its ATI, disregards partnership items and takes into account only its share of the partnership s excess taxable income. Excess taxable income of the partnership is the partnership s ATI x (unused limitation/total limitation). 26

27 Interest Limitations under Section 163(j) Basis adjustment and carryforward by partner: To the extent interest is not deductible at the partnership level, the carryforward ( excess business interest ) is at the partner level. The interest expense carryforward may only be offset by the partner s share of excess taxable income of the partnership in the next taxable year (not business income from other sources). Each partner s outside basis is reduced by its share of excess business interest (i.e., basis is not available to support distributions), but basis is restored upon transfer of the interest in a taxable or non-taxable transaction. 27

28 Interest Limitations under Section 163(j) ABC $200 adjusted taxable income (EBITDA) $-60 business interest expense $140 non-separately stated income ETI = $200 x ($0/$60) XYZ Corporation $0 ETI from partnership $70 Taxable income from partnership $0 business income from other sources Any business interest expense at XYZ is nondeductible. XYZ Corporation 50% ABC Individual 50% 28

29 Interest Limitations under Section 163(j) ABC $200 adjusted taxable income (EBITDA) $-40 business interest expense $160 non-separately stated income ETI = $200 x ($20/$60) XYZ Corporation $33 ETI from partnership $80 Taxable income from partnership $0 business income from other sources Business interest expense at XYZ is deductible to the extent of 30% of ETI (i.e., $10). XYZ Corporation 50% ABC Individual 50% 29

30 Carried Interest and the Application of Section

31 Carried Interest and the Application of Section 1061 Long-term capital gains (LTCGs) with respect to certain applicable partnership interests get benefit of preferential 20% rate only if the relevant capital asset was held for at least three years. Applicable partnership interest: a partnership interest that is transferred to a taxpayer in connection with the performance of substantial services by the taxpayer or a related person in any applicable trade or business. Applicable trade or business: raising and returning of capital in connection with either (i) investing in specified assets or (ii) developing specified assets. Specified assets: securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership s proportionate interest in any of the foregoing. Regulations may exclude from the definition of specified asset any asset not held for portfolio investment on behalf of third party investors. 31

32 Basic Questions Regarding the Application of Section 1061 What is the relevant capital asset? Is it the applicable partnership interest? Is it a capital asset held by the partnership in which the partner holds an applicable partnership interest? Both? Which holding period is relevant? On sale of an asset by the partnership, then the partnership s holding period (Rev. Rul ) On the sale of the partnership interest, then either (i) the partner s holding period in the interest or (ii) a look-through rule (as applies on disposition to a related person). 32

33 Interests that are not Applicable Partnership Interests Some interests in partnerships conducting applicable trades or businesses held by service provider are not applicable partnership interests: An interest held by a person who is employed by another entity that is conducting a trade or business (other than an applicable trade or business) and only provides services to such other entity; An interest held directly or indirectly by a corporation; and Any capital interest which provides the taxpayer with a right to share in partnership capital commensurate with (i) the amount of capital contributed (determined at the time of receipt of the partnership interest), or (ii) the value of such interest subject to tax under section 83 upon the receipt or vesting of such interest. Does corporation mean just C corporations? What about mixed profits and capital interests? Purchased interests? 33

34 Codification of Rev. Rul

35 Codification of Rev. Rul The IRS s position has long been that gain or loss on the sale or exchange of a partnership interest is treated as income that is effectively connected with a US trade or business (ECI) to the extent that the transferor would have had ECI if the partnership sold all of its assets at fair market value on the date of the sale. Last summer, the Tax Court took the position that a non-us partner s gain on the disposition of a partnership interest that is engaged in a US trade or business is not ECI, so long as the gain is not attributable to a US office. The new tax legislation codifies the IRS position and is applicable for sales or exchanges on or after November 27,

36 Codification of Rev. Rul This rule is enforced through withholding of 10% of the amount realized on the sale or exchange of the partnership interest. Withholding requirement is effective for tax years beginning after December 31, Notice suspends withholding for publicly traded partnerships until further guidance is issued. Substantive tax still in effect. Additional relief is needed with respect to the withholding requirements on non-publicly traded partnership interests that are sold. Partnership required to withhold from distribution if amounts not withheld by transferee. 36

37 Codification of Rev. Rul Foreign Partnership Investment in US US Partnership Investment in US Foreign Partnership Investment in US - Blocked Non-US Partner Foreign Pship Non-US Partner US Pship Non-US Partner Foreign Pship ECI LLC Non-ECI Investment ECI LLC Non-ECI Investment US Blocker (non- USRPHC) Non-ECI Investment ECI LLC 37

38 Other Miscellaneous Partnership Changes 38

39 Repeal of Technical Terminations Under former section 708(b)(1)(B), a partnership was treated as terminating if, within any 12-month period, there was a sale or exchange of 50 percent or more of the total interest in partnership capital and profits. Section 708(b)(1)(B) eliminated entirely for tax years beginning after December 31,

40 Modifications to the Substantial Built-in Loss With respect to a transfer of a partnership interest or certain distributions when a partnership has a substantial built-in loss, the property of the partnership must be adjusted as if a Section 754 election was in effect, whether or not such an election is made (this is a nonissue if the partnership in question actually has a Section 754 election in effect). The definition of substantial built-in loss under Section 743(d) is modified 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. 40

41 Charitable Contribution Limitations Modifies Section 704(d) to apply the outside basis limitation to a partner s distributive share of charitable contributions and foreign tax credits. 41

42 Partnership International Provisions Toll Charge Global Intangible Low-Taxed Income (GILTI) Foreign-Derived Intangible Income (FDII) Section 250 Deduction (for Corporations) Base Erosion and Anti-abuse Tax (BEAT) 42