2017 Federal Tax Act - Pass-Through Entity Tax Provisions
The most salient provisions of the 2017 Federal Tax Act applicable to pass-through business entities, which include partnerships (and LLCs that are treated as partnerships for Federal income tax purposes), S corporations, and sole proprietorships, are as follows:
Deduction for Pass-Through Income
For tax years beginning after December 31, 2017, and before January 1, 2026, there is a new deduction for non-corporate taxpayers that have certain types of income from a partnership, S corporation, or sole proprietorship. The deduction is not allowed in computing adjusted gross income (AGI); instead, it reduces taxable income.
The starting point in calculating the deduction is the term “qualified business income,” or QBI, which is generally defined as domestic business income other than (1) investment-related income (such as most dividends, investment interest income, capital gains, etc.) and (2) income in the nature of compensation (including guaranteed payments). The deduction is determined under a complex set of rules but, as a general matter, the deduction for most taxpayers will equal the lesser of 20% of QBI or 20% of the excess of taxable income over net capital gain. Special rules apply to dividends from REITs and cooperatives and income from publicly traded partnerships.
The deduction is subject to two limitations:
- The deduction is limited to 50% of the taxpayer’s share of W-2 wages with respect to the business (or, if greater, 25% of such W-2 wages plus 2.5% of the basis of certain tangible depreciable property of the business). This limitation only kicks in for taxpayers with taxable income exceeding $315,000 (for married individuals filing jointly) or $157,500 (for other individuals), and there is a phase-in of the limitation above those thresholds.
- The deduction is also limited with respect to certain service business sectors including, among others, health, law, consulting, athletics, financial services, and brokerage services, but excluding engineering and architecture. A similar threshold and phase-in applies to this limitation as well.
Treatment of Profits/Carried Interests
With respect to certain partnership “profits interests” (sometimes called “carried interest”) received in exchange for services, the Act denies preferential long-term capital gain treatment unless the profits interest is held for 3 years. The 3-year holding period rule applies notwithstanding the rules of Code Section 83 and is unaffected by an election under Code Section 83(b). The rule does not apply to C corporations or capital interests.
This rule only applies to profits interests in partnerships engaged in raising or returning capital and investing in, disposing of or developing so-called “specified assets” (including securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or certain derivative contracts, as well as interests in partnerships to the extent of the partnership’s proportionate interest in the foregoing).
This rule does not apply to a profits interest held by a person who is employed by another entity that is conducting a trade or business (other than the types listed above) and who provides services only to the other entity. Further, to the extent the Secretary of the Treasury provides in Regulations or other guidance, this provision does not apply to income or gain attributable to any asset that is not held for portfolio investment on behalf of third party investors.
This provision applies to taxable years beginning after December 31, 2017.
Look-through Rule Applied to Sale of Partnership Interest by Foreign Persons
Gain or loss from the sale of a partnership interest by a foreign person is effectively connected with the conduct of a US trade or business (subjecting the selling partner to US tax) to the extent that the selling partner would have had effectively connected gain or loss had the partnership sold its assets at fair market value. Gain or loss from the hypothetical asset sale is allocated among the partners in the same matter as non-separately stated income and loss. Generally, the transferee of a partnership interest must withhold 10% of the amount realized unless the selling partner certifies non-foreign status. The provision is applicable for transfers on or after November 27, 2017, but the withholding feature takes effect for transfers until after December 31, 2017.
Repeal of Partnership Technical Termination
For tax years of a partnership beginning after December 31, 2017, the Act repeals the Code provision under which a partnership is treated as terminated (i.e., experiences a technical termination) upon a sale or exchange of 50% or more of the total interest in partnership capital and profits within a one-year period. Under current law, such a technical termination causes termination of certain tax attributes of the old partnership, close of the partnership’s tax year, termination of partnership-level elections, and a reset of depreciation recovery periods.
Definition of Partnership “Substantial Built-In Loss” Modified
Effective for transfers of partnership interests after December 31, 2017, the Act expands the definition of “substantial built-in loss” for purposes of determining when a partnership must adjust the basis of its property following the transfer of a partnership interest. A substantial built-in loss will exist if the transferee of a partnership interest would be allocated a net loss in excess of $250,000 upon a hypothetical disposition by the partnership of all of its assets in a fully taxable transaction for cash equal to the assets’ fair market value immediately after the transfer. The current definition also remains in effect (i.e., a substantial built-in loss exists if the partnership’s adjusted basis in its property exceeds the property’s fair market value by $250,000), meaning that, under the Act, the test for substantial built-in loss applies both at the partnership level and at the transferee partner level.
Modification to Basis Limitation on Partner Losses
Generally, a partner may only deduct distributive share of partnership loss to the extent of the partner’s basis in the partnership. For taxable years of a partnership beginning after December 31, 2017, a partner’s distributive share of partnership charitable contributions and foreign taxes will be included in determining partnership loss and therefore the deductibility of these items will be subject to the basis limitation (the items are not part of the basis limitation calculation under current law). The new provision does not apply, however, to the appreciation component in a charitable contribution of appreciated property.
Modification of Treatment of S Corporation Conversion to C Corporation
Effective upon enactment of the Act, for certain S corporations that convert to C corporation status, distributions are treated as paid from the entity’s accumulated adjustments account (AAA) by the terminated S corporation in the same ratio as the AAA bears to the amount of the accumulated earnings and profits (AE&P) on a pro rata basis. Also, such entities will recognize any adjustments required due to a change in accounting method over a six-taxable-year period (an increase from the four-taxable-year period prescribed under current law). These provisions apply to a C corporation that was an S corporation on the day before enactment of the Act, revoked the S election during the following two-year period, and had the same owners (in the same proportions) on the enactment date and termination date.
Expansion of Qualifying Beneficiaries of Electing Small Business Trust (ESBT)
Effective January 1, 2018, a non-resident alien individual may be a potential current beneficiary of an ESBT, which is a permissible shareholder of an S corporation. A non-resident alien individual still may not a direct owner of an S corporation.
Charitable Contribution Deduction for ESBTs
For tax years beginning after December 31, 2017, the charitable contribution deduction of an ESBT will be subject to the rules applicable to individuals, rather than the rules applicable to trusts that apply under current law. The individual rules include the percentage-of-AGI limitation on the deduction for charitable contributions and a 5-year carryforward for contributions in excess of the limitation, where trusts are not subject to a percentage-of-AGI limitation.
For questions, information, or guidance, please feel free to contact Bill Hussey (firstname.lastname@example.org; 215.864.6257), John Eagan (email@example.com; 212.868.4835), Kevin Koscil (firstname.lastname@example.org; 215.864.6827) or another member of our Tax and Estates Group.