December 20, 2017 Senate and House pass Conference Agreement on tax reform containing provisions affecting S corporations and their shareholders On December 20, 2017, the House approved the "Tax Cuts and Jobs Act" (H.R. 1) Conference Agreement, following passage by the Senate on December 19. The Conference Agreement now goes to the President for his signature. The Conference Agreement contains proposed statutory text, which provides major changes to the taxation of corporations, individuals, and pass-thru entities (S corporations, partnerships, and sole-proprietorships). Key provisions affecting S corporations and their shareholders are discussed below. Lower tax rates Current Law Under current law, the highest marginal individual income tax rate is 39.6 % and the highest marginal corporate rate is 35%. Provision The Conference Agreement would reduce the highest marginal individual income tax rate to 37% and corporations would be subject to a flat tax rate of 21%. Effective date The changes to individual and corporate tax rates would be effective for tax years beginning after December 31, 2017. A "blended" tax rate will apply to fiscal year corporations for their fiscal year that includes January 1, 2018. The reduction in the corporate income tax rate to 21% is permanent, while the changes to the individual income tax rates only apply to tax years before January 1, 2026. Implications The corporate tax rate of 21% in the Conference Agreement represents a significant reduction from the highest marginal US federal income tax rate on C corporation income currently in effect of 35%. In contrast, the Conference Agreement would only reduce the highest marginal US federal income tax rate on individuals from 39.6% to 37%. While the deduction for qualified business income (QBI) (discussed below) may help mitigate this rate differential, even with the QBI deduction, the rate differential between undistributed C corporation earnings and undistributed S corporation earnings increases meaningfully under the Conference Agreement. Because of the meaningful increase in the rate differential on undistributed earnings, S corporations and their shareholders should consider whether they should take action to cause some or all of the corporation's earnings to be subject to C corporation tax. Deduction for QBI1 Current law No provision. Provision The Conference Agreement includes new Section 199A, which would allow taxpayers other than corporations a deduction for QBI. In general, the deduction is the sum of: 1. The lesser of (A) the combined QBI amount, or (B) 20% of the excess of taxable income over any net capital gain and qualified cooperative dividends; and 2. The lesser of (A) 20% of qualified cooperative dividends, or (B) taxable income (reduced by net capital gain) The combined QBI amount is defined as the sum of deductible QBI determined for each trade or business, plus 20% of qualified REIT dividends and qualified publicly traded partnership income of the taxpayer for the tax year. Deductible QBI with respect to any qualified trade or business is the lesser of: 1. 20% of QBI with respect to the qualified trade or business, or 2. The greater of (A) 50% of the W-2 wages with respect to the qualified trade or business, or (B) the sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after the acquisition of all qualified property QBI is generally defined as items of income, gain, deduction and loss included or allowed as a deduction during the tax year to the extent such items are effectively connected with the conduct of a trade or business within the United States. In general, a qualified trade or business is any trade or business other than: (1) one involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners; (2) one that involves the performance of services that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities; or (3) the trade or business of performing services as an employee. In the case of an S corporation, Section 199A is applied at the shareholder level, with each shareholder taking into account the shareholder's allocable share of each qualified item of income, gain, deduction, and loss, and with each shareholder treated as having W-2 wages and unadjusted basis immediately after acquisition of qualified property for the tax year in an amount equal to the shareholder's pro rata share of the S corporation's W-2 wages and unadjusted basis of property. The deduction for QBI is not allowed in computing adjusted gross income, but rather is allowed as a deduction in computing taxable income that is available to both non-itemizers and itemizers. Effective date The provision would be effective for tax years beginning after December 31, 2017, and expires for tax years beginning after December 31, 2025. Implications The deduction for QBI represents Congress' attempt to help mitigate the difference between the tax rate applicable to earnings of pass-thru entities that are taxed to individuals and the tax rate that applies to C corporations. While the QBI deduction may somewhat mitigate the rate differential, the rate differential under the Conference Agreement is meaningfully higher than under current law. Taking into account only US federal income tax rates, and assuming that all income is QBI and the 20% deduction applies, the rate differential increases from approximately 5% under current law to approximately 9%. In certain cases, the rate differential may be exacerbated by other factors, including the self-employment tax, the net investment income tax (which applies to owners that do not materially participate in the business), the Conference Agreement's new limitation on an individual's deduction for state and local income taxes, and state and local income taxes. Of course, the pass-thru entity form has an advantage over C corporation form, in that the income of a pass-thru entity is generally only taxed once. In contrast, the income of a C corporation is generally taxed twice: first, at the corporate level when earned, and second, at the shareholder level when distributed or when the stock of the C corporation is sold.2 Thus, the question becomes when and how much benefit will be realized from operating in a single-layer of tax regime versus a two-layer of tax regime? Given the increased rate differential, S corporations and their shareholders should consider whether a complete or partial conversion to C corporation status could be beneficial. In performing this analysis, note that the Conference Agreement provides that the deduction for QBI is not allowed in computing adjusted gross income, but rather is allowed as a deduction in computing taxable income. This is significant in that most states tax individuals based on federal adjusted gross income. Accordingly, by providing that the deduction for QBI is not allowed in computing adjusted gross income, the deduction will not be allowed in many states. Limitation on excess business losses Current law Under current law, three limitations may apply to limit a shareholder's ability to claim flow-thru losses from an S corporation: (1) the basis limitation under Section 1366(d); (2) the at-risk limitation under Section 465; and (3) the passive activity loss limitation under Section 469. Provision Under the Conference Agreement, a taxpayer's "excess business loss" for the tax year would not be allowed. An excess business loss is the excess of: (1) the aggregate deductions attributable to trades or businesses of the taxpayer, over (2) the aggregate gross income or gain attributable to such trades or businesses, plus $250,000 ($500,000 in the case of a joint return).3 Any loss disallowed by reason of this provision is treated as a net operating loss carryover to the following tax year under Section 172. The provision applies after application of Section 469. In the case of an S corporation shareholder, the provision is applied at the shareholder level. Under the Conference Agreement, net operating loss carryovers are allowed for a tax year up to the lesser of the carryover amount of 90% (80% for tax years beginning after December 31, 2022) of taxable income determined without regard to the deduction for net operating losses. Effective date The provision would be effective for tax years beginning after December 31, 2017, and before January 1, 2026. Implications The addition of another limitation on business losses may make operating in pass-thru entity form less attractive than it is currently, given that the limitation prevents S corporation shareholders from utilizing business losses in excess of the limitation against other sources of income. Limitation on deduction for state and local taxes Current law Under current law, individuals may claim a deduction for: (1) state and local real and foreign property taxes; (2) state and local personal property taxes; and (3) state, local and foreign income, war profits, and excess profits taxes. At the election of the taxpayer, an itemized deduction may be claimed for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes. Provision Under the provision, in the case of an individual, generally state, local and foreign property taxes and state and local sales taxes are allowed as a deduction only when paid or accrued in carrying on a trade or business or an activity described in Section 212. Accordingly, the provision allows only those deductions for state and local and foreign property taxes and sales taxes that are currently deductible in arriving at adjusted gross income. In the case of an individual, generally state and local income, war profits, and excess profits taxes are not allowable as a deduction. However, taxpayers may claim an itemized deduction of up to $10,000 ($5,000 for married filing separate) for the aggregate of: (1) state and local property taxes not paid or accrued in carrying on a trade or business or an activity described in Section 212, and (2) state and local income, war profits, and excess profit taxes (or sales taxes in lieu thereof), paid or accrued in the tax year. Effective date The limitation on the deduction for state and local taxes would apply for tax years beginning after December 31, 2017, and before January 1, 2026. Implications The limitation on the deduction for state and local taxes will likely adversely affect S corporation shareholders, who often incur significant state and local income taxes on their S corporation flow-thru income. As under prior law, such state and local income taxes are not considered attributable to a trade or business of the taxpayer or an activity described in Section 212 and, therefore, the deduction for such state and local income taxes will be at most $10,000. The limitation on the deduction for state and local income taxes will likely increase the rate differential between undistributed C corporation income and undistributed S corporation income and should be taken into account in assessing whether a complete or partial conversion to C corporation status could be beneficial. Of course, this would also likely have the effect of increasing the effective tax rate on dividend income and capital gains recognized by a shareholder, which should also be taken into account when considering a conversion to C corporation status. Limitation on deduction for business interest Current law Under current law, generally trade or business interest expense is deductible. Provision The Conference Agreement would generally limit the deduction for business income to the sum of business interest income plus 30% of adjusted taxable income, plus floor plan financing interest. Any business interest not allowed as a deduction by reason of this limitation would be treated as interest paid or accrued in the succeeding tax year. Adjusted taxable income is the taxable income of the taxpayer computed without regard to: (1) any items of income, gain, deduction, or loss that is not properly allocable to a trade or business; (2) any business interest or business interest income; (3) any net operating loss deduction under Section 172; (4) the amount of any deduction allowed under Section 199A; and (5) in the case of tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion. In the case of an S corporation, the provision is applied at the S corporation level and the deduction for business interest is taken into account in computing nonseparately computed income or loss. In applying the business interest limitation to an S corporation shareholder, the shareholder's share of flow-thru items of the S corporation are disregarded and the shareholder takes into account the shareholder's share of the S corporation's excess taxable income. For this purpose, excess taxable income is the amount that bears the same ratio to the S corporation's adjusted taxable income as: (A) the excess (if any) of (1) 30% of the adjusted taxable income of the S corporation over (2) the amount (if any) by which the business interest of the S corporation, reduced by floor plan financing interest, exceeds the business interest income of the S corporation bears to (3) 30% of the adjusted taxable income of the S corporation, or (B) 30% of the adjusted taxable income of the S corporation for the tax year. This allows an S corporation shareholder to deduct additional business interest expense that the S corporation shareholder may have paid or accrued to the extent the S corporation could have deducted more business interest. The limitation on the deductibility of business interest does not apply to certain small businesses. Effective date The provision would apply to tax years beginning after December 31, 2017. Implications Under prior law, many of the rules limiting the deductibility of trade or business interest did not apply to S corporations. However, S corporations are included in the provision under the Conference Agreement limiting the deduction for trade or business income, which has the effect of increasing the cost of borrowing. Expansion of qualifying beneficiaries of an electing small business trust (ESBT) Current law Under current law, each potential current beneficiary of an ESBT is treated as a shareholder for purposes of the S corporation eligibility requirements that limit the number of permissible shareholders to 100 and the types of permissible shareholders to US citizens or resident aliens, and certain qualifying trusts, estates and tax-exempt organizations. Provision The provision would eliminate the rule that treats a potential current beneficiary of an ESBT as a shareholder for purposes of the S corporation eligibility requirement that precludes a nonresident alien from qualifying as a permissible S corporation shareholder. Effective date The provision would take effect on January 1, 2018. Implications The provision may expand the trusts that may qualify as ESBTs and may also help prevent the termination of a corporation's S election that could occur when a nonresident alien becomes a potential current beneficiary of an ESBT (e.g., when a trust's potential current beneficiaries are defined to include specific individuals and their spouses and a nonresident alien becomes a beneficiary as a result of marriage). Charitable contribution deduction for ESBTs Current law In the case of an ESBT, the deduction for charitable contributions applicable to trusts, rather than the deduction applicable to individuals, applies to the trust. Generally, a trust is allowed a charitable contribution deduction for amounts of gross income, without limitation, which pursuant to the terms of the governing instrument are paid for a charitable purpose. No carryover of excess contributions is allowed. An individual is allowed a charitable contribution deduction limited to certain percentages of adjusted gross income generally with a five-year carryforward of amounts in excess of this limitation. Provision Under the Conference Agreement, the charitable contribution deduction of an ESBT is not determined by the rules generally applicable to trusts but rather by the rules applicable to individuals. Thus, the percentage limitations and carryforward provisions applicable to individuals would apply to charitable contributions made by the portion of an ESBT holding S corporation stock. Effective Date The provision would apply to tax years beginning after December 31, 2017. Implications The provision will allow an ESBT to claim a deduction for charitable contributions made by an S corporation without the need to consider application of the special rules for charitable contributions applicable to trusts and, perhaps more importantly, would allow for the carryover of excess charitable contributions. Extended Section 481(a) adjustment period upon termination of S election Current law Under current law, a taxpayer may, with the consent of the Secretary, change its method of accounting. When a taxpayer changes its method of accounting, in computing taxable income for the year of change, the taxpayer must take into account those adjustments that are determined necessary solely by reason of such change in order to prevent items of income or expense from being duplicated or omitted. Net adjustments that decrease taxable income generally are taken into account entirely in the year of change, and net adjustments that increase taxable income are generally taken into account ratably during the four-tax-year period beginning with the year of change. Generally, S corporations are permitted to use the cash method of accounting. Generally, C corporations, other than small C corporations, are required to use an accrual method of accounting. Provision Any Section 481(a) adjustment of an eligible terminated S corporation attributable to the revocation of its S election (i.e., a change from the cash method to an accrual method) would be taken into account ratably during the six-tax-year period beginning with the year of change. An eligible terminated S corporation would be any C corporation that: (1) is an S corporation the day before the enactment of the Conference Agreement; (2) during the two-year period beginning on the date of such enactment revokes its S corporation election under Section 1362(a); and (3) all of the owners on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment. Effective date The provision would be effective upon enactment of the Conference Agreement. Implications An S election may terminate: (1) by revocation; (2) by the corporation ceasing to qualify as a small business corporation; or (3) as a result of the corporation having excess passive investment income and subchapter C earnings and profits at the close of the tax year, for three consecutive tax years. The provision applies only to the termination of S status resulting from the revocation of an S election. Accordingly, the general Section 481 rules would continue to apply to changes in methods of accounting required as a result of the termination of S status when the terminating event is other than a revocation of the election. However, given the requirement that the ownership of the S corporation be identical on the effective date of the termination and on the date of the enactment of the Conference Agreement for this provision to apply, the limitation to terminations resulting from the revocation of an S election is likely not meaningful. The provision does not distinguish between negative and positive Section 481(a) adjustments resulting from the change. This could mean that a negative Section 481(a) adjustment of an eligible terminated S corporation attributable to the revocation of its S election would also be required to be taken into account ratably during the six-tax-year period beginning with the year of change. S corporation distribution rules apply to certain cash distributions made after the post-termination transition period (PTTP) Current law Under the S corporation distribution rules, a distribution from an S corporation's accumulated adjustments account (AAA) is tax-free to a shareholder to the extent of the shareholder's basis in the S corporation's stock, and capital gain to the extent the distribution exceeds stock basis. The S corporation distribution rules generally cease to apply when a corporation's S election terminates. However, under a special rule, cash distributions with respect to stock during the PTTP that are not in excess of the corporation's AAA are-tax free to the extent of a shareholder's basis in the S corporation's stock. The PTTP includes the period beginning on the day after the last day of the corporation's last tax year as an S corporation and ending on the later of: (1) the day that is one year after such last day, or (2) the due date for filing the return for such last tax year as an S corporation. Provision Under the Conference Agreement, cash distributions by an eligible terminated S corporation after the PTTP would be allocated pro rata between the AAA and accumulated earnings and profits. The distribution from the AAA would be tax-free to the extent of shareholder stock basis, and the distribution from accumulated earnings and profits would be taxable as a dividend. An eligible terminated S corporation is any C corporation that: (1) is an S corporation the day before the enactment of the Conference Agreement; (2) during the two-year period beginning on the date of such enactment revokes its S corporation election under Section 1362(a); and (3) all of the owners on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment. Implications As with the provision for Section 481(a) adjustments upon termination of an S election, the special rule relating to distributions only applies when the S election is revoked, and not when the S election terminates as a result of the corporation ceasing to be a small business corporation or from excess passive investment income. Some key points to consider regarding this expanded PTTP: 1. The special rule only would apply to distributions of cash, so distributions of property would not qualify. 2. Distributions during this expanded PTTP would be allocated between AAA and accumulated earnings and profits. The corporation may have: (1) accumulated earnings and profits from when it was previously a C corporation; (2) acquired accumulated earnings and profits from engaging in a tax-free transaction with a C corporation (or an S corporation with earnings and profits); and (3) accumulated earnings and profits post-conversion. As a practical matter, it may be difficult to determine accumulated earnings and profits for purposes of the required allocation. 3. The provision would not limit distributions from the AAA to shareholders owning stock on the effective date of the corporation's revocation of its S election. However, it is possible that the IRS and Treasury will impose that limitation, consistent with the rule adopted for distributions during the PTTP. 4. For distributions made during the regular PTTP, an election can be made to not have the special distribution rules apply. There does not appear to be an election to not have the special distribution rules apply during the expanded PTTP. There may be planning available to extend the PTTP based on the timing of the revocation of a corporation's S election, as well as planning to distribute or preserve the AAA. Various international provisions The Conference Agreement includes various international provisions that are discussed in detail in Tax Alert 2017-2166. These provisions include: 1. Establishing a participation exemption system by allowing a 100% dividends received deduction on qualifying dividends paid by foreign corporations to 10% US corporate shareholders 2. Imposing a one-time transition tax on deferred foreign earnings of 15.5% for liquid assets and 8% for illiquid assets 3. Imposing new anti-deferral rules to ensure that the imputed intangible returns of controlled foreign corporations are subject to a minimum rate of US and/or foreign tax 4. Creating an incentive for US companies to sell goods and provide services abroad by effectively taxing income from those activities at a reduced rate 5. Imposing a new base erosion minimum tax that would be calculated by reference to all deductible payments made to a foreign affiliate for the year and would apply to certain US corporations with average annual gross receipts of $500 million or more over three years For S corporations and its shareholders: 1. The dividends received deduction would not apply to an S corporation because the dividends received deduction only applies to dividends received by a domestic corporation and for this purpose an S corporation is not treated as a foreign corporation by virtue of Section 1363 (which provides that the taxable income of an S corporation is computed in the same manner as an individual). 2. The transition tax would apply to an S corporation. However, special rules would apply. Under these rules, in the case of an S corporation that is a US shareholder of a deferred foreign income corporation, each shareholder of the S corporation may elect to defer payment of the shareholder's net transition tax liability until the shareholder's tax year that includes the triggering event with respect to such liability. A triggering event is whichever of the following occurs first: — The corporation ceases to be an S corporation. Under a special rule, the portion that is included in income by reason of Section 965(a) that is equal to the deduction allowed under Section 965(c) would increase shareholder basis and the S corporation's AAA. 3. An S corporation would be required to include global intangible low-tax income in gross income. However, the deduction for foreign-derived intangible income and global intangible low-taxed income would not be available to an S corporation or its shareholders. 4. The base erosion minimum tax does not apply to an S corporations or its shareholders. Effective dates See Tax Alert 2017-2166 for a more detailed description of the above proposals and their proposed effective dates. Implications The ability to defer payment of the transition tax is generally favorable for S corporations and their shareholders. However, other provisions may be favorable or unfavorable, depending on the facts. The international provisions should be carefully considered in evaluating whether a complete or partial conversion to C corporation status could be beneficial. For those taxpayers that do not intend to convert to C corporation status, a review of the taxpayer's international structure would likely still be warranted to assess the tax efficiency of the structure given the significant changes to the taxation of corporations, flow-thru entities, individuals and international operations under the Conference Agreement. ———————————————
——————————————— 1 See Tax Alert 2017-2141 for a more complete description of the QBI deduction. 2 But consider the availability of the gain exclusion under Section 1202. 3 For tax years beginning after December 31, 2018, these dollar amounts are indexed for inflation. | |||||
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