21 July 2025 Final budget reconciliation law makes several changes affecting pass-through entities
Final budget reconciliation legislation signed into law on July 4, 2025 (H.R. 1, the Act) makes several changes affecting pass-through entities, including clarifying disguised payments under IRC Section 707(a)(2) and reinstating and making permanent the EBITDA definition of business interest expense under IRC Section 163(j), among others. While the rules of Subchapter K allow for nonrecognition transactions between partners and the partnership, certain transactions, in substance, may more closely resemble a payment for services to a partner or a sale of property between the parties, which requires treatment outside of Subchapter K's rules. Adopted in the Tax Reform Act of 1984, IRC Section 707(a)(2) addresses the exchange of services by a partner for related allocations or distributions from a partnership (disguised payment for services) in IRC Section 707(a)(2)(A) or the related transfers of money or other property between a partnership and one or more of its partners (disguised sales) in IRC Section 707(a)(2)(B). If these exchanges or transfers between a partnership and its partner(s), when viewed together, are more properly characterized as a payment for services or as a sale or exchange outside of the partnership context rather than an allocation, distribution or contribution under the rules of Subchapter K, they will be treated as such. By its terms, IRC Section 707(a)(2)(B) can be read to encompass not only disguised sales of property contributed to (or distributed from) a partnership but also disguised sales of partnership interests. Under IRC Section 707(a)(2)(B), if a partner makes a contribution to a partnership and there is a related distribution to another partner, those transfers could be recharacterized as a sale of all or a part of the distributee partner's partnership interest to the contributing partner (disguised sale of partnership interests). Under the new modified IRC Section 707(a)(2), the phrase "Under regulations prescribed by the Secretary" was removed and replaced with "Except as provided by the Secretary." The rest of IRC Section 707(a)(2) is unchanged. This modification to IRC Section 707(a)(2) applies only to transactions occurring after the date of enactment (July 4, 2025). The modification to IRC Section 707(a)(2) clarifies that it is self-executing (i.e., operative without the issuance of regulations). Treasury previously issued final regulations on the disguised sale of property but reserved on the treatment of disguised payments for services and the disguised sale of partnership interests. Proposed regulations for the disguised payment for services under IRC Section 707(a)(2)(A) were issued in 2015 but have not been finalized. Additionally, no final regulations under IRC Section 707(a)(2)(B) addressing the disguised sale of partnership interests have been issued to date (proposed regulations issued in 2004 were later withdrawn). While the IRS's historic position has been that IRC Section 707(a)(2) was always self-executing, some tax practitioners had argued that the prior "Under regulations prescribed by the Secretary" language meant the statute was not operative without final regulations. The current change confirms that the statutory provision is self-executing, at least going forward. In addition, the modification applies to IRC Section 707(a)(2)(A). This section deals with, among other things, disguised payments by a partnership to a partner for services. The IRS and Treasury Department issued proposed regulations in 2015 to address this concept (sometimes referred to as the "management fee waiver" proposed regulations, although they were broad enough to apply to arrangements other than management fee waivers). See REG-115452-14. The current statutory change would eliminate any argument that the statutory provision is not effective in the absence of final regulations. At a very high level, the IRC Section 707(a)(2)(A) legislative history from the Tax Reform Act of 1984 indicates that Congress generally did not intend distributions by a partnership to a partner to be recast as disguised payments for services if the payments were subject to significant entrepreneurial risk. In light of the current legislative change, private equity funds with management fee waiver arrangements may wish to re-visit their arrangements to confirm that they have sufficient entrepreneurial risk. For tax years beginning after December 31, 2017, and before January 1, 2026, an individual taxpayer may deduct: (1) 20% of qualified business income from a partnership, S corporation or sole proprietorship; and (2) 20% of aggregate qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income. The deduction is not permitted for certain specified service trades or businesses (SSTBs) above certain income levels. The 20% deduction may not be used in computing adjusted gross income and may be utilized both by non-itemizers and itemizers. "Qualified business income" (QBI) is the net amount of domestic qualified items of income, gain, deduction and loss from the taxpayer's qualified business. QBI does not include:
The Act makes the qualified business deduction permanent at 20%. The Act also increases the deduction limit phase-in range from $50,000 to $75,000 (single filers) and $100,000 to $150,000 (married filing jointly filers). In addition, the Act establishes a new minimum deduction of $400 (adjusted for inflation) for taxpayers with at least $1,000 of QBI from one or more active trades or businesses. Making the QBI deduction permanent is a welcome provision for owners of eligible pass-through entities, and the adjustments to the phase-in ranges will prevent some taxpayers from losing the benefit over time. Current law allows taxpayers to claim additional depreciation (i.e., bonus depreciation) under IRC Section 168(k) in the year in which qualified property is placed in service through 2026 (with an additional year to place the property in service for qualified property with a longer production period, as well as certain aircraft). It also allowed taxpayers to claim 100% bonus depreciation for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for certain qualified property with a longer production period, as well as certain aircraft). Bonus depreciation phases down to 80% for qualified property placed in service before January 1, 2024; 60% for qualified property placed in service before January 1, 2025; 40% for qualified property placed in service before January 1, 2026; and 20% for qualified property placed in service before January 1, 2027. Qualified property is defined as tangible property with a recovery period of 20 years or less under the modified accelerated cost recovery system, certain off-the-shelf computer software, water utility property or certain qualified film and television productions, as well as certain qualified theatrical productions. Certain trees, vines and fruit-bearing plants are also eligible for bonus depreciation when planted or grafted. Property is generally eligible for bonus depreciation if the taxpayer has not used the property previously (i.e., it is the taxpayer's first use of the property), provided the taxpayer does not acquire the "used" property from a related party or in a carryover basis transaction. Nonresidential real property is generally recovered over a 39-year period utilizing a straight-line depreciation (or recovery) method. Under current law, nonresidential real property is defined as buildings or structures that are not used for residential purposes, including office buildings, retail stores, warehouses and other commercial properties. IRC Section 1245 subjects depreciable personal property and certain depreciable real property disposed of at a gain to depreciation recapture. A taxpayer must recapture the gain on disposition of the property as ordinary income to the extent of earlier depreciation or amortization deductions that the taxpayer claimed for the property. The taxpayer must treat any remaining gain recognized on the sale of the IRC Section 1245 property as IRC Section 1231 gain. The Act permanently extends bonus depreciation. It allows taxpayers to claim 100% bonus depreciation for qualified property acquired and placed in service after January 19, 2025, as well as specified plants planted or grafted after that date. In addition, the Act modifies IRC Section 168(k)(10) to give taxpayers the option to elect to claim 40% bonus depreciation (or 60% for longer production period property or certain aircraft) in lieu of 100% bonus depreciation for qualified property placed in service during the first tax year ending after January 19, 2025 (Transitional Election). The Act also establishes an elective 100% depreciation allowance for "qualified production property," which means the portion of any nonresidential real property that meets the following requirements:
Qualified production property does not include any portion of the nonresidential real property used for offices, lodging, administrative services, sales activities, software engineering activities, parking or other functions unrelated to manufacturing, production or refining of tangible personal property. The Act defines a qualified production activity as the manufacturing, production or refining of a qualified product. It similarly defines the term "production" as limited to agricultural and chemical production. However, the Act limits a "qualified product" to any tangible personal property that is not a food or beverage prepared in the same building as a retail establishment in which such property is sold. In addition, the Act clarifies that an election to apply the 100% depreciation allowance for qualified production property is irrevocable (except in "extraordinary circumstances"). The Act also clarifies that a lessor cannot qualify for the 100% depreciation allowance, even if the lessee uses the property in a qualified production activity. Finally, the Act treats qualified production property as IRC Section 1245 property and also provides certain recapture rules if the taxpayer stops using such property in a qualified production activity. The change generally applies to property acquired and placed in service after January 19, 2025, as well as to specified plants planted or grafted after that date. Property will not be treated as acquired after the date on which a written binding contract is entered for such acquisition. The Transitional Election applies to tax years ending after January 19, 2025. As stated previously, the qualified production property deduction only applies to certain nonresidential real property whose construction begins during an applicable window and is placed-in-service after July 4, 2025. Permanent 100% bonus depreciation is a welcome development, particularly for taxpayers contemplating large bonus-eligible asset acquisitions at the time of enactment. Because the acquisition of otherwise eligible property must occur after January 19, 2025, to qualify for 100% bonus depreciation, taxpayers will need to analyze whether assets placed in service after January 19, 2025, satisfy the acquisition date requirements, which will generally involve a review of the underlying purchase contracts. Property acquired on or before January 19, 2025, is subject to the bonus depreciation rules under current law. Taxpayers that do not want to immediately return to 100% expensing may elect a reduced bonus depreciation percentage (40% for most property) in the first tax year ending after January 19, 2025. The ability to apply 100% cost recovery to a portion of nonresidential real property used in the manufacturing process in the property's placed-in-service year substantially benefits certain taxpayers. Regulations and/or other guidance are needed to provide a more substantial framework for claiming the accelerated depreciation, tackling issues such as how to allocate/bifurcate a building into the part that is integral to the production activity and the extent to which a taxpayer's activity constitutes "production," among other items. IRC Section 163(j) limits the business interest expense that may be deducted in a tax year to the sum of (1) the taxpayer's business interest income, as defined in IRC Section 163(j)(6); (2) 30% of the taxpayer's adjusted taxable income (ATI), as defined in IRC Section 163(j)(8); and (3) the taxpayer's floor plan financing interest, as defined in IRC Section 163(j)(9). For tax years beginning before January 1, 2022, a taxpayer's ATI was based on EBITDA. Thereafter, a taxpayer's ATI is computed with regard to any deduction allowable for depreciation, amortization or depletion (i.e., the IRC Section 163(j) limitation is generally based on earnings before interest and taxes (EBIT)). While IRC Section 163(j)(8) does not address a US shareholder's treatment of controlled foreign corporation (CFC) income inclusions under IRC Sections 78, 951(a) (Subpart F income) or 951A(a) (GILTI), the final IRC Section 163(j) regulations provide that such amounts (referred to as "specified deemed inclusions") are not included in the determination of the US shareholder's ATI. However, under proposed IRC Section 163(j) regulations, which taxpayers may have been applying prior to finalization, a US shareholder may be able to effectively include in ATI a portion of the specified deemed inclusions to the extent there is CFC excess taxable income, as defined in the proposed regulations. In general, under the final IRC Section 163(j) regulations, IRC Section 163(j) applies after the application of provisions that subject business interest expense to disallowance, deferral, capitalization or other limitation. As a result, capitalized interest expense is not treated as business interest expense for purposes of IRC Section 163(j). The Act amends IRC Section 163(j)(8)(A)(v) so that ATI is once again computed without regard to any deduction allowable for depreciation, amortization or depletion (i.e., based on EBITDA), and this reversion is now permanent. The Act amends IRC Section 163(j)(8)(A) to adjust the ATI calculation of a US shareholder by fully excluding CFC income inclusions under IRC Sections 78, 951(a) and 951A, consistent with the final IRC Section 163(j) regulations but contrary to the proposed IRC Section 163(j) regulations. The Act establishes a new IRC Section 163(j) ordering rule to coordinate between the IRC Section 163(j) limitation and interest capitalization provisions. Specifically, the Act provides that the IRC Section 163(j) limitation applies before all interest capitalization provisions other than the mandatory interest capitalization provisions in IRC Sections 263(g) and 263A(f). As a result, business interest expense capitalized under elective capitalization provisions is subject to the IRC Section 163(j) limitation. The Act provides special ordering rules for determining the extent to which allowed interest (i.e., interest allowed after the application of the IRC Section 163(j) limitation) comes from the taxpayer's pool of electively capitalized interest vs. deductible interest and provides that allowed interest first comes from the taxpayer's pool of electively capitalized interest. The reversion to determining ATI based on EBITDA is effective for tax years beginning after December 31, 2024. The provisions relating to CFC income inclusions and the coordination with capitalization provisions are effective for tax years beginning after December 31, 2025. The permanent addback of depreciation and amortization to ATI (in conjunction with the return of 100% bonus depreciation) provides significant relief to certain taxpayers by reducing the amount of business interest expense limited under IRC Section 163(j). However, certain taxpayers with foreign operations may see this benefit eroded (starting in tax years beginning after December 31, 2025) by the exclusion of Subpart F income and GILTI inclusions (and any associated IRC Section 78 gross-up) from ATI. Due to the new IRC Section 163(j) ordering rule, taxpayers that remain IRC Section 163(j) limited (even after the reversion to EBITDA) in tax years beginning after 2025 will not be able to reduce the impact of the IRC Section 163(j) limitation through elective interest capitalization. Required interest capitalization under IRC Sections 263A(f) and 263(g) will still reduce business interest expense subject to the limitation. Given the ability to compute ATI based on EBITDA has now been made permanent for tax years beginning after December 31, 2024, there may be instances where taxpayers that made the real property trade or business election for tax years after 2022, which is irrevocable, might not have otherwise made such an election. It remains to be seen if the IRS will grant relief to such taxpayers. We note that in the context of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), the IRS did grant limited relief to revoke such elections. If the election was made for the 2024 tax year, the filing of a superseding return may be considered. IRC Section 856(c)(4) requires a REIT to satisfy certain asset tests at the close of each quarter of the tax year. Under IRC Section 856(c)(4)(B)(ii), TRS securities may represent no more than 20% of the value of a REIT's total assets. The Act increases the percentage of a REIT's gross assets that may be TRS securities from 20% to 25%. The Act restores the TRS asset test to the 25% threshold in place before the Protecting Americans from Tax Hikes Act of 2015. This favorable change will give REITs greater flexibility to use a TRS to hold certain investments and conduct activities that may not generate qualifying income for purposes of the REIT gross income tests. Opportunity Zones are designed to spur investment in distressed communities throughout the country by granting investors preferential tax treatment. These investments must be made through qualified Opportunity Funds, which are specially created investment vehicles that invest at least 90% of their assets in Opportunity Zone Property. Opportunity Zone Property includes Opportunity Zone Business Property, which is tangible property that is:
Tangible property used in a qualified Opportunity Fund's trade or business is considered substantially improved if investments are made in the property during the 30 months following the property's acquisition, and those investments exceed the property's adjusted basis at the beginning of the 30-month period (i.e., the investments equal at least 100% of the property's basis after 30 months). The preferential tax treatment offered under the Opportunity Zone program is threefold. First, investors can defer tax on capital gains invested into Opportunity Zones until no later than December 31, 2026. Second, investors that hold the Opportunity Fund investment for five or seven years as of December 31, 2026, receive a 10% or 15% reduction, respectively, on their deferred capital gains tax bill by increasing the basis of the original deferred gain. Finally, investors that hold the Opportunity Fund investment for at least 10 years can receive the added benefit of paying no tax on any realized appreciation in the Opportunity Fund investment. Investments in qualified Opportunity Funds may consist partially of deferred gains and partially of basis or ordinary income, but the tax benefits under the Opportunity Zone Program accrue only on the eligible capital gains. To date, the IRS has designated Opportunity Zones in all 50 states, the District of Columbia, American Samoa, Guam, Northern Marianas Islands, Puerto Rico and the Virgin Islands. (See Tax Alerts 2018-0806, 2018-0865, 2018-1050, 2018-1070 and 2018-1261). Those designations will expire after December 31, 2028. Opportunity Zone designations: The Act creates rolling, 10-year Opportunity Zone designations, with the first determination period beginning on July 1, 2026, and the new census tracts designations going into effect on January 1, 2027. The criteria for qualifying as a low-income community, and therefore an eligible census tract that can be designated as a qualified Opportunity Zone, is generally narrowed so that areas with a median income of 70% or less of statewide median income (rather than 80% or less under the Tax Cuts and Jobs Act (TCJA) Opportunity Zone program) are eligible for designation. Under the Act, communities that are contiguous to a qualified Opportunity Zone but themselves are not low-income communities are no longer eligible for designation. The Act also creates a new "qualified rural Opportunity Fund," with certain benefits unique to funds holding at least 90% of their assets in qualified Opportunity Zone property (directly or via other ownership interest) that is located in a rural area. Opportunity Zone benefits: Investors may defer tax on eligible capital gains from new investments made after December 31, 2026, for up to five years by investing in qualified Opportunity Funds. Upon reaching the five-year mark, investors investing in qualified Opportunity Funds receive a 10% step-up in basis on the capital gains deferred. Investors in a qualified rural Opportunity Fund may similarly defer eligible capital gains for five years and get a 30% step-up in basis on the capital gains deferred upon reaching the five-year mark. To demonstrate substantial improvement of property in a qualified Opportunity Zone comprised entirely of a rural area, the qualified rural Opportunity Fund only needs to make new substantial improvements up to 50% of the property's adjusted basis (rather than 100% for non-rural funds). The Act preserves the election allowing investors to elect to step-up the basis of investments held for at least 10 years to fair market value on the date that the investment is sold or exchanged. Additionally, the new law allows investors to elect to step-up the basis of investments held for 30 years or more to fair market value without disposing of the investment. Reporting requirements: The Act introduces statutory reporting requirements for qualified Opportunity Funds, qualified rural Opportunity Funds and qualified Opportunity Zone businesses. Opportunity Funds must file information returns containing information listed in the new law, including:
Failure to satisfy these requirements triggers penalties of $500 per day, up to a maximum of $10,000 per return for small qualified Opportunity Funds (i.e., funds with $10 million or less in gross assets) and $50,000 for large qualified Opportunity Funds (i.e., funds with more than $10 million in gross assets). For funds that intentionally disregard the reporting requirement, the penalty increases to $2,500 per day, up to a maximum of $50,000 for small funds and businesses, and $250,000 for large funds and businesses. Under the Act, qualified Opportunity Zone businesses and qualified rural Opportunity Zone businesses must furnish qualified Opportunity Funds with a written statement enabling the qualified Opportunity Fund to meet these information reporting requirements. Qualified Opportunity Zone businesses and qualified rural Opportunity Zone businesses are also subject to penalties for failing to provide these written statements. In conjunction with the new information reporting requirements, the Secretary of the Treasury or the Secretary's delegate must compile annual reports on qualified Opportunity Funds, which track the investments made in each census tract and the impact measured by economic indicators, such as job creation, poverty reduction, new business starts and other metrics as determined by the Secretary. The Act generally applies to investments made after December 31, 2026. The new reporting requirements apply to tax years beginning after July 4, 2025, while the first decennial determination process will begin on July 1, 2026, with new census tracts designations going into effect on January 1, 2027. The new Opportunity Zone program retains some of the key benefits of the prior program, including deferral of gains, an exclusion of gains and a step-up in basis to fair market value for investments held for 10 years or more. The ability to receive a 10% basis step-up after five years, regardless of when that investment was initially made, is a new feature, presumably designed to make the program more attractive. The program's permanency is also attractive, as it gives investors more certainty. These benefits, however, also come with new restrictions and requirements. Criticism of the TCJA Opportunity Zone program led to a tightening of eligibility for the program, such as stricter low-income-community qualifications and limiting the program to new investments only. Beginning with 2026 returns, new reporting requirements also apply, which will likely increase compliance requirements for businesses and funds. The introduction of rural Opportunity Zones expands the areas eligible for investment. The statute's definition of rural area, however, is a bit unclear. It excludes an "urbanized area" contiguous and adjacent to a city or town with a population of more than 50,000 but does not define what an "urbanized area" is. As such, it is unclear whether suburbs in the greater area of a major city could be considered rural areas if (1) their population is less than 50,000; and (2) they are adjacent and contiguous to another city or town that is in the greater area of the same city and also has a population of 50,000 or less. Guidance will likely be needed to resolve this issue. As the new program is effective for investments made after December 31, 2026, gains that are otherwise eligible for deferral and realized in 2026 may not be eligible for deferral under the new program unless they are invested within the 180-day investment period on or after January 1, 2027. The inability to defer capital gains generated in 2026 likely means investors will want to wait until 2027 to trigger gains. The July 1, 2026 new census tract determination date gives low-income communities time to review the new requirements and petition to become eligible through their state governor's office. As each state can only designate 25% of low-income communities, early action should be considered. We expect fierce lobbying for which low-income communities get designated. IRC Section 460 was first adopted in 1986 as a separate provision for reporting income from "long-term contracts." Under IRC Section 460, it appeared that residential pre-sale contracts had to be reported under the percentage-of-completion method. In 1988, an exception to IRC Section 460 was enacted for income from residential long-term contracts when a sale closes using the completed contract method of accounting. However, because this exception was narrowly drawn to exclude only residential buildings with four or fewer units, all other residential buildings by implication continued to be subject to the percentage-of-completion method of accounting. Under this method, developers that earned relatively small deposits upon signing a contract could be subjected to significantly accelerated income recognition. (See Treas. Reg. Section 1.460-4(h), example 5.) The Act extends the exception to apply to all residential buildings, including those with more than four units. Consequently, all residential buildings can use the completed contract method of accounting. This is a favorable change to eliminate the disparity in tax accounting for condominium developers with respect to the pre-sale of units. By permitting condominium developers to use the completed contract method of accounting for both regular and AMT tax purposes, it puts condominium developers on parity with developers of other residential housing (i.e., townhomes and single-family homes). IRC Section 461(l) temporarily disallows a deduction for "excess business losses" of noncorporate taxpayers for tax years 2021 to 2028. The excess business loss is calculated by determining the excess, if any, of the taxpayer's aggregate deductions for the tax year attributable to a trade or business over the sum of the aggregate gross income and gain for the tax year attributable to those trades or businesses, plus $250,000 (adjusted for inflation, $313,000 in 2025 for single filers, $626,000 for married filing jointly). Excess losses are treated as net operating loss carryovers. For partnerships and S corporations, the excess business loss limitation is taken into account at the partner or shareholder level. The Act permanently extends the excess business losses limitation. The Act also reinstates and re-indexes the $250,000 addition to a taxpayer's aggregate business income to inflation for tax years beginning after December 31, 2025. The loss limitation is effective for tax years beginning after December 31, 2026. For the tax year beginning after December 31, 2024 (i.e., calendar year 2025), the inflation-adjusted amount equals $313,000 for single filers ($626,000 for married filing jointly). However, in tax years beginning after December 31, 2025 (e.g., calendar year 2026) the cap decreases to $250,000 for single filers ($500,000 for married filing jointly). The decreased cap in calendar year 2026 will again begin to be inflation-adjusted in tax years that follow. The legislative history under IRC Section 461(l) explains the excess business losses will not "re-enter" the computation year-over-year. Instead, the historic treatment of IRC Section 461(l) has been made permanent, essentially requiring a one-year deferral on any loss for which there is no sufficient net business income to offset. While a complete repeal of IRC Section 461(l) would have been the most taxpayer-favorable outcome, allowing excess business losses to become net operating losses in the following year provides a somewhat welcome outcome. The Act includes a variety of provisions that will provide certainty to partnerships and the real estate industry going forward. The Act's expansion and permanent extension of certain provisions from the TCJA, such as the pass-through deduction and bonus depreciation, will provide welcome relief for owners of pass-through businesses and the real estate sector. Business owners and the real estate industry will also benefit from the Act's addition of the ability to elect to take 100% depreciation on qualified production property and the favorable tax accounting changes for certain condominium developers. The Act's expansion and extension of the Opportunity Zone program will provide certainty to investors and make the program more attractive with increased tax benefits. The introduction of rural Opportunity Zones expands the areas for eligible investment, although guidance will likely be needed to define key terms for the program. The Act also imposes new restrictions and reporting requirements that will likely increase compliance requirements for businesses and funds and should be closely reviewed. The permanent addback of depreciation and amortization to ATI will provide significant relief to taxpayers by reducing the amount of interest limited under IRC Section 163(j). However, certain taxpayers with foreign operations may see the benefit hindered by the exclusion of Subpart F income and GILTI inclusions (and any associated IRC Section 78 gross-up) from ATI. As with any major tax legislation, it is prudent to consider the tax changes in a holistic manner on a case-by-case basis.
Document ID: 2025-1548 | ||||||
