November 6, 2017 Passthrough and partnership-specific considerations of recently released House tax reform bill The November 2, 2017, release of a comprehensive tax reform bill, called the Tax Cuts and Jobs Act (the House Bill) will have immense consequences for almost all partnerships, S corporations and their owners if enacted. The House Bill would establish a special 25% income tax rate for individuals that would not apply equally to all individuals or industries, would lower the C corporation tax rate to 20% (below the 25% special individual income tax rate), would expand the type of labor-related income attributable to partnerships and S corporations that is treated as net earnings from self-employment and would repeal the rule that provides for a "technical termination" of a partnership. While tax reform may still evolve with provisions being added, removed or altered, the House Bill contains significant items that taxpayers should begin considering now. The House Ways and Means Committee is expected to begin its deliberation on the bill on November 6 and, separately, a Senate Republican version of a tax reform bill is expected to be released shortly. General overview The House Bill includes provisions to lower individual tax rates and lower the corporate tax rate to 20%, while eliminating many current tax benefits. Further, the US tax system would move to a territorial system of taxing foreign earnings with an anti-base erosion provision and a one-time transitional tax on accumulated foreign earnings. For an overview of the House Bill, and its potential application to individuals, accounting methods, and various other sector implications, please see Tax Alert 2017-1831. Passthrough provisions The proposal would add of a new maximum income tax rate of 25% for individuals on certain net income from passthrough entities, which include partnerships and S corporations. The proposal generally would provide a 25% tax rate for an individual who has passthrough taxable income otherwise subject to a rate higher than 25%. The 25% tax rate would apply to qualified business income (QBI), after the exclusion of net capital gain. QBI generally is 100% of "net business income" derived from a "passive business activity" and 30% of any "net business income" derived from an "active business activity." Identifying business activities. In the case of a passthrough, QBI is determined by first identifying each particular business activity of the passthrough. The House Bill would define a "business activity" as any activity (within the meaning of Section 469) that involves the conduct of a trade or business. Under Section 469 and its regulations, trade or business activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss. Whether an appropriate economic unit exists depends upon all the relevant facts and circumstances using any reasonable method. This generally takes into account similarities and differences in types of trades or businesses, the extent of common control, the extent of common ownership, geographical location, and interdependencies between or among the activities. Determining income or loss. After each business activity of a passthrough is identified, an individual owner's income, gain, deduction, and loss from the activity are netted, taking into account only items includible or allowable in determining taxable income. The House Bill would exclude certain items from being allocated to the business activity, including: capital gains and losses, dividends and dividend equivalents, interest income unless properly allocable to a trade or business, certain foreign currency and commodity hedging gains and losses, annuities not connected with the trade or business, as well as any deduction or loss on these items. Separating passive and active activities. Because eligibility for the QBI rate will vary, each business activity must also be identified as active or passive for the individual owner. The House Bill would define a "passive business activity" by cross-reference to Section 469(c), which treats as passive any trade or business activity in which the individual taxpayer does not materially participate. The House Bill would disregard Section 469(c)(3), which would exclude from the passive category any working interest in any oil or gas property which the taxpayer holds through an entity that does not limit the taxpayer's liability. Similarly, the House Bill would disregard Section 469(c)(6), which would have included expenses for the production of income, such as investment expenses in the concept of "a trade or business." The House Bill would define an "active business activity" as any business activity that is not passive. Identifying specified service activities. Subject to an exception for capital-intensive activities (further discussed later), active business income from specified service activities is generally ineligible for the QBI rate. Activities treated as specified service activities are determined by cross-reference to Section 1202(e)(3)(A), which include 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 one or more of its employees or owners. In addition to the Section 1202(e)(3)(A) list, the House Bill also would treat investing, trading, or dealing in securities, partnership interests, or commodities as a specified service activity. Determining the capital percentage. Although 100% of net business income derived from a passive business activity would generally be eligible for the new 25% rate, because only a portion of the net business income from an active business activity would be eligible for the new lower rate, a capital percentage would need to be determined for each active business activity. For the specified service activities already described, the capital percentage is zero unless an individual partner can establish an "applicable percentage" (further discussed later) that is at least 10%. In effect, active QBI attributable to a specified service activity can be eligible for the 25% rate only if the individual can establish an applicable percentage of at least 10% for such activity. For all business activities other than those involving specified service activities, the capital percentage is 30% unless an individual taxpayer elects to use the applicable percentage. Once an individual taxpayer makes the election to apply the applicable percentage, the taxpayer must use the applicable percentage (as calculated each year) for the current tax year and the four succeeding tax years and the election may not be revoked during such period. For any business activity (whether or not a specified service activity), the net business income or loss is calculated by including the following items: wages, Section 707(a) and (c) payments and director's fees properly attributable to the business activity. However, those specific items might reduce the capital percentage. Specifically, the capital percentage is limited to the portion of the net business income not comprised of those items. That is, for example, if wages constitute 80% of the net business income from the activity, the capital percentage is limited to 20%. Determining the applicable percentage. The applicable percentage is equal to an individual partner's "specified return on capital" from the activity for the tax year divided by the partner's net business income from the activity for that tax year. An individual partner's specified return on capital is the taxpayer's share of the active business activity's "asset balance" multiplied by a deemed rate of return (the Federal short-term rate plus 7%) reduced by deductible interest attributable to the activity. The asset balance is the owner's distributive or pro rata share of the partnership's or S corporation's adjusted basis of any property described in Section 1221(a)(2) that is used in connection with the active business activity as of the end of the tax year (money is not included in the asset balance). For this purpose, Sections 168(k) (concerning bonus depreciation) and 179 (concerning accelerated depreciation) are disregarded. Determining the amount eligible for the QBI rate. For those activities with a net income, 100% of passive net business income is combined with the capital percentage of active net business income. From that total, loss activities are subtracted. All passive net business loss is combined with 30% of active net business loss and, if a prior year had negative QBI, that negative QBI is included with the loss activities. If the remaining amount is a positive number, that dollar amount is eligible for the QBI rate. If the remaining amount is a negative number, it is taken into account in determining QBI in a later year. Revenue estimate. According to the JCT, the provision would reduce revenues by $448 billion from 2018 through 2027. S corporation income subject to SECA. Changes to Section 1402(a) would treat an S corporation shareholder's distributive share of income attributable to "labor" as "net earnings from self-employment," after taking into account wages paid to the shareholder. The House Bill does not change the treatment of wages under FICA. For example, assume a shareholder is paid $20 in wages and is allocated $100 of net income from the S corporation. Under the House Bill, $64 is treated as net-earnings from self-employment. The $64 is computed as follows: The $20 of wages is added to the $100 distributive share to arrive at a tentative amount treated as self-employment income. The $120 is multiplied by 70% (defined as the labor percentage) and then the $84 (70% of $120) is reduced by the $20 of wages. Deductibility of interest expense Current law allows business interest as a deduction in the tax year in which the interest is paid or accrued, subject to limitation rules, as applicable. Section 163(j) limits a corporation's ability to deduct disqualified interest (i.e., interest paid or accrued to a related party when no federal income tax is imposed on the interest) paid or accrued in a tax year if: (1) the payor's debt-to-equity ratio exceeds 1.5 to 1.0 (safe harbor ratio); and (2) the payor's net interest expense exceeds 50% of its adjusted taxable income. In general, adjusted taxable income is the corporation's taxable income calculated without taking into account deductions for net interest expense, NOLs, domestic production activities under Section 199, depreciation, amortization and depletion. Disallowed interest amounts may be carried forward indefinitely and any excess limitation may be carried forward for three years. Effective for tax years beginning after December 31, 2017, the House Bill would limit the net interest expense deduction for every business, regardless of form, to 30% of adjusted taxable income. The provision would require the interest expense disallowance to be determined at the tax filer level. Adjustable taxable income for purposes of this provision would be a business's taxable income calculated without taking into account business interest expense, business interest income and NOLs, as well as depreciation, amortization and depletion. The provision would allow businesses to carry forward interest amounts disallowed under the provision to the succeeding five tax years and those interest amounts would be attributable to the business. The provision would include special rules to allow a pass-through entity's owners to use the unused interest limitation for the tax year and to ensure that net income from pass-through entities would not be double-counted at the partner level. The provision would exempt businesses with average gross receipts of $25 million or less from these rules. The provision also would not apply to certain regulated public utilities and real property trades or businesses; these businesses would be ineligible for full expensing. Additionally, the provision would repeal Section 163(j). If enacted, this provision would significantly affect highly leveraged taxpayers, as well as industries that traditionally consider the deduction of interest expense to be an important factor in their operating business decisions. Partnership-specific provisions Repeal of partnership technical terminations caused by the sale or exchange of a 50% or more interest in the capital and profits of a partnership. Under Section 708(b)(1)(B) of current law, a sale or exchange of 50% or more of interests in partnership capital and profits within a 12-month period causes a "technical termination" of the partnership. The House Bill would repeal Section 708(b)(1)(B) for partnership tax years beginning after December 31, 2017. Repeal of exclusion from self-employment tax for limited partners. Section 1402(a), which defines "net earnings from self-employment," is modified to conform to the new passthrough rate regime and the determination of QBI. Sections 1402(a)(1) and (13) would be repealed such that individuals would have net earnings from self-employment as a result of rental income and any partner would have net earnings from self-employment regardless of the individual's status as a limited partner. Implications of passthrough provisions Administrative complications and uncertainties. If enacted, implementation of the 25% tax rate for individuals who are owners of interests in passthrough entities would cause widespread changes for any individual who could benefit from the preferential rate. Determining the rate at which different types of passthrough income are taxed will cause significant administrative complexity for taxpayers and the IRS. Taxpayers will need to determine the extent to which they are active or passive in a trade or business using the rules under Section 469. The regulations and other guidance under Section 469 are complicated and were developed with the purpose of limiting the ability of taxpayers to use losses from passive activities to reduce active income. In contrast, passive net business income is treated more favorably than active net business income under the House Bill as 100% of passive net business income is eligible for the 25% rate while only 30% of active net business income would typically be eligible for the 25% rate. Where passthrough owners believe they may benefit from an applicable percentage that exceeds the default 30% capital percentage, they will need to (i) analyze their activities to determine which are active or passive under Section 469; (ii) determine whether availing themselves of the election to use the "applicable percentage" with respect to certain business activities will yield additional income qualifying for the 25% rate; and (iii) track the results of such determinations annually and carry forward any business loss to offset QBI in future years. These computations could be complex for passthrough owners that operate or own an interest in more than one trade or business and the determinations must be made annually and will likely vary from year to year. The applicable percentage election is also complicated by the fact that its computation is based in large part on the computation of a "specified return on capital," which computes a return on the taxpayer's adjusted tax basis in property described in Section 1221(a)(2) used in connection with an active business activity, which will likely vary from year to year. Additionally, taxpayers will need to calculate and track the adjusted basis of their assets without regard to the basis recovery rules of Sections 168(k) and 179. In the case of partnerships, it is not clear whether or how positive or negative basis adjustments under Section 743 would affect adjusted tax basis for this purpose or how Section 704(c) would affect the "allocation" of basis to the partners. It would appear that a Section 734(b) common basis adjustment (whether positive or negative) would be counted in determining the adjusted tax basis of property for this purpose. In addition, uncertainty exists because the new 25% rate provision incorporates by reference the Section 1202(e)(3)(A) notion that 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 is a specified service activity with a presumed 0% capital percentage. A related uncertainty is whether a distributive share of income allocated to a specified service activity partnership from a partnership that does not conduct a specified service activity is tainted as specified service activity income when allocated to its partners merely because the income passes through the specified service activity partnership. Finally, the new provision may have the effect of causing individual passthrough owners who are currently considered active in a trade or business under Section 469, and thus generally unable to include 70% of their active net business income as eligible for the new 25% rate to consider reducing their participation in a trade or business to be able to treat their income as passive net business income eligible for the 25% rate. Under current law, "active" status under Section 469 is typically desired because of the disallowance of "passive" losses. As a result, regulations under Section 469 tend to put the burden of proof of active status on the taxpayer. In contrast, the favorable rate applicable to passive investors under the proposed changes may incentivize taxpayers to fail to "prove" their active status, should the formula for evidencing active status remain unchanged. Corporate tax rate and individual tax rate disparity. The reduction in the C corporation tax rate to 20% and the repeal of the limited partner exception for self-employment tax purposes would change the calculus as to whether doing business in corporate form is preferable to the passthrough form. In particular, the corporate form might be preferable to the passthrough form even after considering double taxation on its earnings given the disparity between (i) the 20% corporate income tax rate and (ii) the highest marginal individual income tax rate plus the self-employment tax rate and taking into account that, under the default rule, only 30% of active net business income is eligible for the 25% rate. This effect is magnified to the extent that corporations are still entitled to deduct all state and local income and property taxes, but individuals are not. In this regard, the rules related to the accumulation of corporate earnings might become more relevant than they have been at any time since the enactment of the Tax Reform Act of 1986. Implications of partnership-specific provisions Repeal of partnership technical terminations caused by the sale or exchange of a 50% or more interest in the capital and profits of a partnership. The most consequential results of partnership technical terminations are generally that the partnership must file two short-period returns, restart depreciation on its assets, make certain new elections, and accelerate many deferred income items such as deferred revenue. In that regard, the repeal of the technical termination rule might be favorable for most taxpayers; however, the repeal of the technical termination rule could limit the ability of partnerships to terminate unfavorable elections or to make a favorable election. Repeal of exclusion from self-employment tax for limited partners. The repeal of the limited partner exclusion in Section 1402(a)(13) could be expected to increase the number of partners treated as having net earnings from self-employment. As presently drafted, the House Bill appears to subject a passive partner's distributive share of partnership income to the self-employment regime. Perhaps when the Senate develops its bill, it will exclude a passive partner's distributive share of partnership income from the self-employment regime. ———————————————
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