The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part II
January 04, 2018
Yesterday’s post examined various changes to the taxation of S corporations, partnerships, and their owners.
Today, we will focus on a number of partnership-specific issues that were addressed by the Act.
A partnership may issue a profits (or “carried”) interest in the partnership to a service or management partner in exchange for their performance of services. The right of the profits interest partner to receive a share of the partnership’s future profits and appreciation does not include any right to receive money or other property upon the liquidation of the partnership immediately after the issuance of the profits interest. The right may be subject to various vesting limitations.
In general, the IRS has not treated the receipt of a partnership profits interest for services as a taxable event for the partnership or the partner. However, this favorable tax treatment did not apply if: (1) the profits interest related to a substantially certain and predictable stream of income from partnership assets (i.e., one that could be readily valued); or (2) within two years of receipt, the partner disposed of the profits interest. More recent guidance clarified that this treatment would apply with respect to a substantially unvested profits interest, provided the service partner took into income his share of partnership income (i.e., the service provider is treated as the owner of the interest from the date of its grant), and the partnership did not deduct any amount of the FMV of the interest as compensation, either on grant or on vesting of the profits interest.
By contrast, a partnership capital interest received for services has been includable in the partner’s income if the interest was transferable or was not subject to a substantial risk of forfeiture. A capital interest for this purpose is an interest that would entitle the receiving partner to a share of the proceeds if the partnership’s assets were sold at fair market value (“FMV”) immediately after the issuance of the interest and the proceeds were distributed in liquidation.
Under general partnership tax principles, notwithstanding that a partner’s holding period for his profits interest may not exceed one year, the character of any long-term capital gain recognized by the partnership on the sale or exchange of its assets has been treated as long-term capital gain in the hands of the profits partner to whom such gain was allocated and, thus, eligible for the lower applicable tax rate.
In order to make it more difficult for some profits interest partners to enjoy capital gain treatment for their share of partnership income, for taxable years beginning after December 31, 2017, the Act provides for a new three-year holding period for certain net long-term capital gain allocated to an applicable partnership interest.
Specifically, the partnership assets sold must have been held by the partnership for at least three years in order for a profits interest partner’s share of such gain to enjoy the lower tax rate applicable to long-term capital gains.
If the assets sold had not been held by the partnership for at least three years, the entire amount of any capital gain allocated to the profits interest would be treated as short-term capital gain, and would be taxed up to a maximum rate of 37% as ordinary income.
An “applicable partnership interest” is any interest in a partnership that is transferred to a partner in connection with the performance of “substantial” services in any applicable trade or business.
In general, an “applicable trade or business” means any activity conducted on a regular, continuous, and substantial basis that consists in whole or in part of: (1) raising or returning capital, and (2) investing in, or disposing of, or developing specified assets.
“Developing” specified assets takes place, for example, if it is represented to investors or lenders that the value, price, or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider or of others acting in concert with the service provider.
“Specified assets” means securities, commodities, real estate held for rental or investment, as well as other enumerated assets.
If a profits interest is not an applicable partnership interest, then its tax treatment should continue to be governed by the guidance previously issued by the IRS.
Adjusting Inside Basis
In general, a partnership does not adjust the basis of partnership property following the transfer of a partnership interest unless the partnership has made an election under Code Sec. 754 to make such basis adjustments, or the partnership has a substantial built-in loss immediately after the transfer.
If an election is in effect, or if the partnership has a substantial built-in loss immediately after the transfer, inside basis adjustments are made only with respect to the transferee partner. These adjustments account for the difference between the transferee partner’s proportionate share of the adjusted basis of the partnership property and the transferee’s basis in its partnership interest. The adjustments are intended to adjust the basis of partnership property to approximate the result of a direct purchase of the property by the transferee partner, and to thereby eliminate any unwarranted advantage (in the case of a downward adjustment) or disadvantage (in the case of an upward adjustment) for the transferee.
For example, without a mandatory reduction in a transferee partner’s share of a partnership’s inside basis for an asset, the transferee may be allocated a tax loss from the partnership without suffering a corresponding economic loss. Under such circumstances, if a Sec. 754 election were not in effect, it is unlikely that the partnership would make the election so as to wipe out the advantage enjoyed by the transferee partner.
In order to further reduce the potential for abuse, the Act expands the definition of a “substantial built-in loss” such that, in addition to the present-law definition, for transfers of partnership interests made after December 31, 2017, a substantial built-in loss also exists if the transferee would be allocated a 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’ FMV, immediately after the transfer of the partnership interest.
Limiting a Partner’s Share of Loss
A partner’s distributive share of partnership loss is allowed only to the extent of the adjusted basis (before reduction by current year’s losses) of the partner’s interest in the partnership at the end of the partnership taxable year in which the loss occurred.
Any disallowed loss is allowable as a deduction at the end of succeeding partnership taxable years, to the extent that the partner’s adjusted basis for its partnership interest at the end of any such year exceeds zero (before reduction by the loss for the year).
In general, a partner’s basis in its partnership interest is decreased (but not below zero) by distributions by the partnership and the partner’s distributive share of partnership losses and expenditures. In the case of a charitable contribution, a partner’s basis is reduced by the partner’s distributive share of the adjusted basis of the contributed property.
In computing its taxable income, no deductions for foreign taxes and charitable contributions are allowed to the partnership – instead, a partner takes into account his distributive share of the foreign taxes paid, and the charitable contributions made, by the partnership for the taxable year.
However, in applying the basis limitation on partner losses, the IRS has not taken into account the partner’s share of partnership charitable contributions and foreign taxes.
By contrast, under the S corporation basis limitation rules (see above), the shareholder’s pro rata share of charitable contributions and foreign taxes are taken into account.
In order to remedy this inconsistency in treatment between S corporations and partnerships, the Act modifies the basis limitation on partner losses to provide that the limitation takes into account a partner’s distributive share of partnership charitable contributions (to the extent of the partnership’s basis for the contributed property) and foreign taxes. Thus, effective for partnership taxable years beginning after December 31, 2017, the amount of the basis limitation on partner losses is decreased to reflect these items.
This marks the end of our three-post review of the more significant changes in the taxation of pass-through entities resulting from the Act.
In general, these changes appear to be favorable for the closely held business and its owners, though they do not deliver the promised-for simplification.
Indeed, the new statutory provisions raise a number of questions for which taxpayers and their advisers must await guidance from the IRS and, perhaps, from the Joint Committee (in the form of a “Blue Book”).
However, in light of the administration’s bias against the issuance of new regulations, and given its reduction of the resources available to the IRS, query when such guidance will be forthcoming, and in what form.
Until then, it will behoove practitioners to act cautiously, to keep options open, and to focus on the Act’s legislative history (including the examples contained therein) in ascertaining the intent of certain provisions and in determining an appropriate course of action for clients.
As they used to say on Hill Street Blues, “Let’s be careful out there.”
[Next week, we’ll take a look at the Act’s changes to the estate and gift tax, and how it may impact the owners of a closely held business, as well as the changes to the taxation of C corporations.]
It may be issued in lieu of a management fee that would be taxed as ordinary income.
See Sec. 83 of the Code.
Rev. Proc. 93-27, Rev. Proc. 2001-43.
In general, property is subject to a substantial risk of forfeiture if the recipient’s right to the property is conditioned on the future performance of substantial services, or if the right is subject to a condition other than the performance of services, provided that the condition relates to a purpose of the transfer and there is a substantial possibility that the property will be forfeited if the condition does not occur.
Notwithstanding Code Sec. 83 or any election made by the profits interest holder under Sec. 83(b); for example, even if the interest was vested when issued, or the service provider elected under Sec. 83(b) of the Code to include the FMV of the interest in his gross income upon receipt, thus beginning a holding period for the interest.
Query whether this will have any impact on profits interests that are issued in the context of a PE firm or a real estate venture, where the time frame for a sale of the underlying asset will likely exceed three years.The Act also provides a special rule for transfers by a taxpayer to related persons
A partnership interest will not fail to be treated as transferred in connection with the performance of services merely because the taxpayer also made a capital contribution to the partnership. An applicable partnership interest does not include an interest in a partnership held by a corporation.
Rev. Proc. 93-27, Rev. Proc. 2001-43, Prop. Reg. REG-105346-03.
Prior to the Act, a “substantial built-in loss” existed only if the partnership’s adjusted basis in its property exceeded by more than $250,000 the FMV of the partnership property.
The basis limitation does not apply to the excess of the contributed property’s FMV over its adjusted basis.