Category: Perspectives

This is a summary of some of the changes to federal tax law that have been made by the Tax Cuts and Jobs Act, passed in December of 2017. These changes are effective for tax years beginning in 2018 unless otherwise noted.

Corporate Tax Rates Have Been Reduced. The corporate income tax rate is now set at a flat 21%. Previously, rates were graduated across four income brackets.

Dividends Received Deduction Has Been Reduced. This deduction is available to corporations that receive dividends from other corporations. Corporations that own 20% or more of a company that pays them dividends may now deduct only 65% of those dividends, reduced from the previous 80%. Corporations that own less than 20% of the dividend payor will see their DRD shrink from 70% to 50%.

Corporate AMT Repealed. The Alternative Minimum Tax, as it applies to corporations, has been repealed.

Alternative Minimum Tax Credit. The elimination of the corporate AMT notwithstanding, the corporate AMT credit remains. For tax years beginning after 2017 and before 2022, the credit is refundable is an amount equal to 50% of the excess of the AMT credit for the year over the credit allowable for the year against regular tax liability. Hence, the full amount of the credit will be available in tax years beginning before 2022.

Modification of the NOL Deduction. Net Operating Losses arising in tax years ending after 2017 may only be carried forward, no longer back. Nonetheless, a two-year carryback for certain farming losses is allowed. NOLs may now be carried forward indefinitely, whereas they formerly expired after 20 years. This can be taken into account as a useful tax planning tool, especially in connection with indefinitely carried-forward deferred tax liabilities, such as amortization of goodwill. For losses incurred after 2017, the NOL deduction is limited to 80% of taxable income, determined without regard to the deduction. NOL carryovers are adjusted to take the 80% limitation into account.

New Limitation on Business Interest Deduction. Every business, regardless of its form (corporation, LLC, etc), is limited to a deduction for business interest equal to 30% of its adjusted taxable income. For pass-through entities, such as partnerships and S-corporations, the limit determination is made at the entity level. Adjusted taxable income is computed without regard to the repealed domestic production activities deduction and, for tax years beginning after 2017 and before 2022, without regard for deductions for depreciation, amortization, or depletion. Any business interest disallowed under this rule is carried into the following year, and, generally, may be carried forward indefinitely. The limitation does not apply to taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less for the three-year period ending with the prior tax year. Real property trades or businesses can opt out of the rule by electing to use the alternative depreciation system for real property used in their trades or businesses. Partnerships are affected by additional rules.

Domestic Production Activities Deduction is Repealed. The DPAD previously allowed taxpayers 9% (or, in the cases of certain oil and gas activities, 6%) of the lesser of the taxpayer’s (a) qualified production activities income (QPAI) or (b) taxable income for the year, limited to 50% of the W-2 wages paid by the taxpayer for the year. QPAI was, under the former rules, the taxpayer’s receipts, minus expenses allocable to the receipts, from: i) property manufactured, produced, grown, or extracted within the United States; ii) qualified film productions; iii) production of electricity, natural gas, or potable water; iv) construction activities performed in the U.S.; and  v) certain engineering or architectural services.

New Business Expense and Fringe Benefit Rules. The new law eliminates the 50% deduction for business entertainment expenses. The previous law’s 50% limit on deductible business meals is now expanded to include meals purchased from an in-house cafeteria or other food service establishment on the employer’s business premises. Also, the deduction for transportation fringe benefits (such as parking and public transportation subsidies) is now eliminated. Note, however, such subsides remain excluded from income for employees. On the other hand, reimbursements to employees for bicycle commuting are deductible by the employer but not excludible from income by the employee. No deduction is allowed for transportation expenses that are the equivalent of commuting for employees, except as may be provided for the safety of the affected employees.

Penalties and Fines. Under prior law, deductions were not allowed for fines and penalties paid to a government for the violation of any law. Now, the tax law provides that no deduction is allowed for any otherwise deductible amount paid or incurred by suit, agreement, or otherwise to, or at the direction of a government or specified nongovernmental entity in relation to the violation of any law or investigation or inquiry by the government or entity into potential violations of any law. There is an exception for any payment the taxpayer establishes as either restitution (including property remediation), or an amount required to establish compliance with any law that was violated or involved in the investigation or inquiry that is identified in the court order or settlement agreement as such a payment. There is also an exception for amounts paid or incurred as taxes due.

Sexual Harassment. The new law, effective for amounts paid or incurred after December 22, 2017 provides that no deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if the payments are subject to a nondisclosure agreement.

Lobbying Expenses. The law now disallows deductions for lobbying expenses paid or incurred after the date of enactment with respect to lobbying expenses related to legislation before local government bodies, including Indian tribal governments. Previously, such expenses were deductible.

Family and Medical Leave Credit. A new general business credit is available to eligible employers for tax years beginning in 2018 and 2019. The credit is equal to 12.5% of wages such employers pay to qualifying employees on family and medical leave if the rate of payment is 50% of wages normally paid to that employee. The credit increases by .25%, up to a maximum of 25% for each percentage point by which the payment rate exceeds 50% of regular wages. For this purpose, the maximum leave that may be taken into account for any employee for any year is 12 weeks. Eligible employers are those with with a written policy in place allowing a qualifying full-time employee at least two weeks of paid family and medical leave a year, and employees who are less than full time a prorated amount of leave. A qualifying employee is one that has been employed by the employer for one year or more and who, in the preceding year, had compensation not above 60% of the compensation threshold for highly compensated employees. Paid leave provided as vacation leave, personal leave, or other medical or sick leave is not considered family and medical leave.

Qualified Rehabilitation Credit. The TCJA repeals the 10% credit for qualified rehabilitation expenditures for a building that was first placed in service before 1936 and modifies the 20% credit for qualified rehabilitation expenditures for a certified historic structure. The 20% credit is available during the five-year period starting with the year the building was placed in service in an amount equal to the ratable share for that year. This is 20% of the qualified rehabilitation expenditures for the building, as allocated ratably to each year in the five-year period. It is intended that the sum of the ratable shares for the five years not exceed 100% of the credit for qualified rehabilitation expenditures for the building. The repeal of the 10% credit and modification of the 20% credit takes effect starting in 2018, subject to a transition rule for certain buildings owned or leased at all times after 2017.

Orphan Drug Credit Reduced and Modified. The tax law now reduces and modifies the business tax credit for qualified clinical testing expenses for certain drugs for rarer diseases or conditions, often known as “orphan” drugs.  The credit was equal to 50% of qualified clinical testing expenses, and is now equal to 25% of such expenses, beginning after 2017. Qualified Clinical Testing Expenses are costs incurred to test an orphan drug after it has been approved by the FDA for human testing but before it has been approved for sale. Amounts used in calculating this credit are excluded from the computation of the separate research credit. The law now modifies the credit by allowing a taxpayer to elect to take a reduced orphan drug credit in lieu of reducing otherwise allowable deductions.

Increased Code Section 179 Expensing. The new tax law increases the maximum amount that may be expensed under Code Section 179 to $1 million. If the taxpayer places more than $2.5 million of Section 179 property into service during the year, the $1 million limitation is reduced by the excess over $2.5 million. Both the $1 million and the $2.5 million amounts are indexed for inflation after 2018. The expense election has also been expanded to cover (a) certain depreciable, tangible personal property used mostly to furnish lodging or in connection with furnishing lodging, and (b) listed improvements to nonresidential real property made after it was first placed in service: roofs; heating, ventilation and air conditioning equipment; fire protection an alarm systems; security systems; and any other building improvements that are not elevators or escalators, do not enlarge the building, and are not attributable to the building’s internal structural framework.

Bonus Depreciation. The law now provides for a 100% first year deduction for qualified new and used property acquired and placed in service after September 27, 2017 and before 2023. Prior law allowed a 50% deduction, phased out for property placed in service after 2017. The new 100% deduction begins to phase out after 2023.

Depreciation of Qualified Improvement Property. Qualified improvement property is now depreciable using a 15-year recovery period and the straight-line method. Qualified improvement property is any is any improvement to an interior portion of a building that is nonresidential real property placed in service after the building was placed in service. It does not include expenses related to the enlargement of the building, any elevator or escalator, or the internal structural framework. There are no longer separate requirements for leasehold improvement property or restaurant property.

Depreciation of Farming Equipment and Machinery. The tax law now provides, subject to certain exceptions, the cost-recovery period for farming equipment and machinery the original use of which begins with the taxpayer is reduced from 7 to 5 years. Now, in general, the 200% declining balance method may be used in place of the 150% declining balance method that had previously been required.

Luxury Automobile Depreciation Limits. The tax law now provides that, for an automobile for which bonus depreciation is not claimed (see above), the maximum depreciation allowance is now as follows:

These amounts are indexed for inflation after 2018. For passenger automobiles eligible for bonus first year depreciation, the maximum additional first year depreciation allowance remains at $8,000, as provided by prior law.

Computers and Peripheral Equipment. The new law removes computers and peripheral equipment from the definition of listed property. This means that the heightened substantial requirements and often slower cost recovery for listed property no longer apply.

New Rules for Post-2021 Research and Experimentation Expenses. Specified R&E expenses paid or incurred after 2021 in connection with a trade or business will have to be capitalized and amortized ratably over a 5-year period, or 15 years if the business is conducted outside the U.S. The affected expenses include expenses for software development, but do not include expenses for land or depreciable or depletable property used in connection with R&E activities. Note, however, that affected R&E expenses do include the depreciation and depletion allowance for such property. Prior law had provided that, for R&E expenses paid or incurred before 2022, such expenses were, at the taxpayer’s election, currently deductible, capitalized and recovered over the shorter of the useful life of the research or 60 months, or ten years.

Like-Kind Exchange Treatment Limited. Now, the deferral of gain on like-kind exchanges of property held for productive use of property held for productive use in a taxpayer’s trade or business or for investment purposes is limited to like-kind exchanges of real property not held primarily for sale. A transition rule provides that prior law applies to like-kind exchanges of personal property if the taxpayer has either disposed of the property given up or obtained the replacement property before 2018.

Excessive Employee Compensation. Prior law allowed a deduction for compensation paid or accrued with respect to a covered employee of a publicly traded corporation up to $1 million per year. The law provided exceptions for commissions, performance-based pay, stock options, payments to a qualified retirement plan, and amounts excludable from the employee’s gross income. The new law repeals the exceptions for commissions and performance-based pay. It also revises the definition of “covered employee” to include the principal executive officer, principal financial officer, and the three highest paid officers. An individual who is a covered employee for a tax year beginning after 2016 remains a covered employee for all future years.

Clarification of Employee Achievement Awards. An employee achievement award is tax free to the extent the employer can deduct its cost, generally limited to $400 per employee or $1600 for a qualified plan award. An employee achievement award is an item of tangible personal property given to an employee in recognition of length of service or a safety achievement and presented as part of a meaningful presentation. The new law amends the definition of “tangible personal property” to exclude cash, cash equivalents, gift cards, gift coupons, gift certificates (other than from an employer pre-selected limited list), vacations, meals, lodging, theater or sports tickets, stocks, bonds, or similar items, and other non-tangible personal property.

New Deduction for Pass-Through Income. Tax law now provides a 20% deduction for “qualified business income,” defined as income from a trade or business conducted within the U.S. by a partnership, S corporation, or sole proprietorship. Recall that limited liability companies being treated, for tax purposes, as partnerships, fall within this category. Investment items, reasonable compensation paid by an S corporation, and guaranteed payments from a partnership, are excluded. The deduction reduces capital income but not adjusted gross income. For taxpayers with taxable incomes above $157,500 ($315,000 for joint filers), (a) a limitation based on W-2 wages paid by the business and the basis of acquired depreciable tangible property used in the business is phased in, and (b) the deduction is phased out for income from certain service-related trades or businesses, such as health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.

Partnership Technical Termination Rule Repealed. Under prior law, a partnership faced a technical termination, for tax purposes, if, within any 12-month period, there was a sale or exchange of at least 50% of the total interest of partnership capital and profits. This resulted in a deemed contribution of all partnership assets and liabilities to a new partnership in exchange for an interest in it, followed by a deemed distribution of interests in the new partnership from the purchasing partners and continuing partners from the terminated partnership. Some of the tax attributes of the old partnership terminated, its tax year closed, partnership-level elections ceased to apply, and depreciation recovery periods restarted. This often imposed unintended burdens and costs on the parties. The new law repeals this rule.  A partnership termination is no longer triggered if, within a 12-month period, there is a sale of 50% or more of total capital and profits interests. A partnership termination will still occur only if no part or any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.

Partnership Loss Limitation Rule. A partner can only deduct his share of partnership loss to the extent of his basis in his partnership interest as of the end of the partnership tax year in which the loss was incurred. IRS has ruled, however, that this loss limitation rule should not apply to limit a partner’s deduction for his share of partnership charitable contributions and foreign taxes paid. However, in the case of partnership charitable contributions of property with a fair market value that exceeds its adjusted basis, the partner’s basis reduction is limited to his share of the basis of the contributed property.

Look-Through Rule on Sale of Partnership Interest. The new tax law provides that gain or loss on the sale of a partnership interest is effectively connected with a U.S. business to the extent the selling partner would have had effectively connected gain or loss had the partnership sold all of its assets on the date of the sale. Such hypothetical gain or loss must be allocated in the same way as is non-separately stated partnership income or loss. Unless the selling partner certifies that he is not a nonresident alien or foreign corporation, the buying partner must withhold 10% of the amount realized on the sale. This rule applies to transfers on or after November 22, 2017 and will cause gain or loss on the sale of an interest in a partnership engaged in a U.S. trade or business by a foreign person to be foreign source.

Change in Tax Treatment of a Profits Interest in a Partnership. Taxation of carried interest held in connection with the performance of services is now calculated on the excess of:

The taxpayer’s net long-term capital gain with respect to those interests for that tax year over

The taxpayer’s net long-term capita gain with respect to those interests for that tax year computed by applying Code section 1222(3) and Code Section 1222(4) by substituting “3 years” for “1 year.”

This amount will be treated as short term capital gain and will apply notwithstanding Code Section 83 or any election in effect under Code section 83(b). Observe also that this calculation applies to  an “applicable partnership interest.” This is defined as any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business. An interest held by an individual employed by another entity that is conducting a trade or business (which is not an applicable trade or business) and who provides services only to that other entity is not an applicable partnership interest. Code Section 1061(c)(1). Also, expressly excluded from the definition of “applicable partnership interest” is any interest in a partnership held by a corporation. Code Section 1061(c)(4)(A). This language does not limit the exclusion to any type of corporation, so it arguably could be interpreted to allow for an S-corporation to serve as a carried interest partner and thereby avoid the 3-year holding period. While Treasury has stated it will narrow this apparent loophole by regulation, it is not at all clear that it has the authority to do so.

Deduction for Foreign-Source Portion of Dividends. The tax law now provides a 100% deduction for the foreign-source portion of dividends received from specified 10%-owned foreign corporations by domestic corporations that are 10% shareholders of those foreign corporations.  No foreign tax credit is allowed for any taxes paid and accrued as to any dividend for which the deduction is allowed, and those amounts are not treated as foreign source income for purposes of the foreign tax limitation. In addition, if there is a loss on any disposition of stock of the specified 10%-owned foreign corporation, the basis of the domestic corporation in that stock is reduced (but not below zero) by the amount of the allowable deduction.

Sales or Exchanges of Stock in Foreign Corporations. Now, if a domestic corporation sells or exchanges stock in a foreign corporation held for over a year, any amount it receives which is treated as a dividend for Code Section 1248 purposes, will be treated as a dividend for purposes of the deduction for dividends received, discussed above. In the same way, any gain received by a CFC from the sale or exchange of stock in a foreign corporation that is treated as a dividend under Code Section 964 to the same extent that it would have been so treated had the CFC been a U.S. person is also treated as a dividend for purposes of the deduction for dividends received.

Incorporation of Foreign Branches. The new tax law now provides that, if a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign subsidiary, the transferred loss amount must be recognized in the U.S. corporation’s gross income.

Deemed Repatriation. The tax law now requires U.S. shareholders owning at least 10% of a foreign subsidiary to include in income, for the subsidiary’s last tax year before beginning before 2018, the shareholder’s pro-rata share of the undistributed, non-previously taxed post-1986 foreign earnings of the corporation. The inclusion amount is reduced by any aggregate foreign earning and profits deficits, and a partial deduction is allowed such that a shareholder’s effective tax rate is 15.5% on his aggregate foreign cash positions and 8% otherwise. The net tax liability can be spread over a period of up to 8 years, Special rules apply for S corporation shareholders and for RICs and REITs.

Global Intangible Low-Taxed Income. GILTI must now be included in gross income by taxpayers who are shareholders of controlled foreign corporations (CFCs). This is the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return (10% of the aggregate of the shareholder’s pro rata share of the qualified business asset investment of each CFC with respect to which it is a U.S. shareholder). The GILTI is treated as an inclusion of Subpart F income for the shareholder. Only an 80% foreign tax credit is available for amounts included in income as GILTI.

Deduction for Foreign-Derived Intangible Income and GILTI. Under the new law, in the case of a domestic corporation, a deduction is allowed equal to the sum of (a) 37.5% of its foreign-derived intangible income (FDII) for the year, plus (b) 50% of the GILTI amount include in gross income (see above for this calculation). Generally, FDII is the amount of a corporation’s deemed intangible income that is attributable to sales of property to foreign persons for use outside the U.S. or the performance of services for foreign persons or with respect to property outside the U.S. or the performance of services for foreign persons or with respect to property outside the U.S.  Coupled with the 21% tax rate, for domestic corporations, these deductions result in effective tax rates of 13.125% on FDII and of 10% on GILTI. The deductions are reduced for tax years after 2025.

Subpart F Changes. The new tax law made several changes to the taxation of Subpart F income of U.S. shareholders of CFCs. Among other things, the new law expands the definition of U.S. shareholders to include U.S. persons who own 10% or more of the total value, and not merely the total vote, of shares of all classes of stock of the foreign corporation. In addition, the requirement that a corporation must be controlled for 30 days before Subpart F inclusions apply has been eliminated.

Base Erosion Prevention. To prevent companies from stripping earnings out of the U.S. through payments to foreign affiliates that are deductible for U.S. tax purposes, a base erosion minimum tax applies to corporations other than RICs, REITs, and S corporations, with average annual gross receipts of $500 million or more that made deductible payments to foreign affiliates that are at least 3% (2% in the case of banks and certain securities dealers) of the corporation’s total deductions for the year. The tax is structured as an alternative minimum tax and applies to domestic corporations, as well as to foreign corporations engaged in a U.S. trade or business in computing the tax on their effectively connected income.

Tax exempt organizations are also affected by the new tax law. Here is a summary of some of the new provisions.

Excise Tax on Exempt Organizations’ Excessive Compensation. Under prior law, executive compensation paid by tax-exempt entities was subject to reasonableness requirements and a prohibition against private inurement. The new tax law adds an excise tax that is imposed on compensation in excess of $1 million paid by an exempt organization to a “covered” employee. The tax rate is set at 21%, equal to the new corporate tax rate. For these purposes, compensation is the sum of: (a) remuneration (other than an excess parachute payment) over $1 million paid to a covered employee by a tax-exempt organization for a tax year; plus (b) any excess parachute payment paid by the organization to a covered employee. A covered employee is an employee or former employee of the organization who is one of its five highest compensated employees for the tax year, or its predecessor for any preceding tax year beginning after 2016. Remuneration is treated as paid when there is no substantial risk of forfeiture of the rights to the remuneration.

Excise Tax on Private College Investment Income. Previously, the law allowed private colleges and university to be treated as public charities, rather than private foundations, and were therefor not subject to the private foundation excise tax on the net investment income of colleges and universities meeting specified size and asset requirements. The excise tax rate is 1.4% of the institution’s net investment income and applies only to private colleges and universities with at least 500 students, more than half of whom are in the U.S., and with assets of at least $500,000 per student. For this purpose, assets used directly in carrying out the institution’s exempt purposes are not counted. The number of student is based on a daily average of “full time equivalent” students. So, for example, two students carrying half-loads of credits would count as a single, full-time equivalent student. For purposes of the excise tax, net investment income is the institution’s gross investment income minus expenses incurred to produce it, but without the use of accelerated depreciation or percentage depletion.

Exempt Organization’s UBTI Computed Separately for Specific Businesses. Previously, a tax-exempt organization computed its unrelated business taxable income (UBTI) by subtracting deductions directly connected with the unrelated trade or business. If the organization had more than one unrelated trade or business, the organization combined its income and deduction from all of the trades of businesses. Under that approach, a loss from one trade or business could offset income from another unrelated trade or business, thereby reducing overall UBTI. Now, the law provides that an exempt organization cannot use losses from one unrelated trade or business to offset income from another such business. Gains and losses are calculated and applied to each unrelated trade or business separately. This differs from the consolidated treatment available to for-profit corporations which are members of affiliated groups. The new tax law provides an exception to this separate allocation rule for net operating losses from pre-2018 tax years that are carried forward.

Exempt Organization’s UBTI to Include Disallowed Fringe Benefits Costs. The new tax law provides that an exempt organization’s unrelated business taxable income (UBTI) must include any nondeductible entertainment expenses and costs incurred for any qualified transportation fringe benefit, parking facility used in qualified parking, or any on-premises athletic facility. However, UBTI does not include any such amount to the extent it is directly connected with an unrelated trade or business regularly carried on by the organization.

This new tax law includes many other changes which can affect you and your business in substantial ways. We are happy to discuss with you how you might plan for the effects of these changes. Please do not hesitate to contact us.

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[1] This note illustrates general principles only and is not intended as tax or legal advice. You should discuss your circumstances with a qualified professional before taking any action. In some jurisdictions, this may be interpreted as attorney advertising.

As part of a budget compromise, the Bipartisan Budget Act was enacted on November 2, 2015, and became effective on January 1, 2018. Title XI of the BBA is a revenue device and works to raise tax revenue without raising taxes by substantially streamlining IRS partnership audit procedures, including audit procedures for LLCs which are treated as partnerships for tax purposes.

Opt-Out for Small Partnerships

Small partnership can elect out of the new rules if:

• The partnership is required to issue no more than 100 Schedules K-1
• Each partner is an individual an estate of a deceased partner, and S corporation, a C corporation, or a foreign entity that would be treated as a C corporation if it were domestic
• An election is timely filed with a timely filed return providing the names and identification numbers of the partners and
• The partnership notifies each partner of the election

Hence, a partnership that includes among its partners another partnership or trust, including a grantor trust, may not opt out. Also, a partnership with a tax-exempt entity as a partner will need to determine if the entity is a C corporation. When an S corporation is a partner, the names and taxpayer identification numbers of the S corporation’s shareholders, together with the S corporation itself, must be included in the election statement, and the Schedules K-1 of the S corporation count toward the 100 shareholder limit for the opt-out qualification. Observe that IRS is authorized to issue rules allowing partnership to elect to opt-out regardless of the type of entities owning a partnership interest, so long as the total number of Schedules K-1 required to be issued by the partnership and its partners do not exceed 100 and the partnership discloses the identities of indirect partners.

The apparent counting problem created by issuance of multiple Forms K-1 to the same partner who holds different classes of interests in the partnership will likely need to be addressed by regulation.

In the same way, regulations will be needed to clarify whether a disregarded entity or nominee holding an interest will be disregarded in determining who owns the interest. Related to this issue will be the need for regulations for guidance as to whether a partnership interest held by an IRA, SEP, or other closely held retirement entity will be treated as owned by the individual beneficiary.

New Partnership Representative

The old rules called for appointment of a tax maters partner in many cases involving partnerships. Beginning with 2018, any audits will be managed at the partnership level by a Partnership Representative (PR). We are seeing many LLCs and other partnership entities attempting to comply with this change by merely changing nomenclature within their operating agreements. This, however, disregards the dramatically different authority the PR has from the old TMP.

Under the BBA, unless a partnership can and does opt-out (recall the opt-out election must be made annually) the IRS will deal only with the PR. The partners have no rights to appeal a tax assessment. The PR also has the authority to:

• Waive the statute of limitations and other defenses
• Communicate with the IRS and agree to settle the total tax liability of all the partners
• After the total tax assessment is agreed, the PR can elect either to
  • Allocate the total amount among the partners enabling IRS to collect a specific amount from each partner or
  • Pay, at the partnership lever, the tax on behalf of each partner

The BBA eliminates the notion of Notice Partners who were formerly entitled to receive notice directly from the IRS. Under the new regime, an audit might commence and be completed, and the partners might never hear about it until they receive a non-appealable tax bill from the IRS.

So, in addition to accommodating the tax liability allocation scheme the BBA now imposes on partnerships,* partnership agreements should be amended to include:

A dispute resolution mechanism (e.g. mediation, arbitration) to manage disputes by partners who don’t agree with the acts of the PR

• A collection mechanism for circumstances in which the partnership pays a tax assessment at the entity level but one or more partners does not voluntarily pay his share of the assessment
• A reconciliation mechanism for cases where the PR makes a good faith error
• Notice obligations as between the PR and the partners
• Liquidity provisions, such as insurance, for the PR’s acts and omissions
• Selection of the PR and successor PR

Operating agreements should also address the following issues:

• Does a decision to extend the statute of limitations or a decision to settle an audit case require a simple majority vote of the partners, a majority of each class or a unanimous vote?
• How should the PR settle the case if there is no agreement among the partners?
• How and when should the PR notify the partners of correspondence and other communications with the IRS?
• How should the partnership’s tax liability be allocated among the partners and the classes of partners? How should exiting and entering partners be obliged to manage tax liability of which they are nit yet aware?
• Should any additional tax simply be paid by the partnership and charged against each partner’s account as a distribution? Or should the tax-payment responsibility be “pushed-out” to each partner so the IRS handles the collection? This election must be made within a very short 45 day window.
• The new law presumes that all partners are taxed at the highest possible bracket, unless the PR proves otherwise within 270 days of making a settlement. How and when should the partners supply information to the PR that will enable him to protect their right to use the lower tax brackets?

This note does not include review of the entire effect on the BBA on partnerships. It is intended only as an illustration of selected general principles.

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* The BBA now imposes imputed tax underpayments and all related penalties and interest directly on the partnership at the highest individual marginal tax rate. One of the several effects of this approach is that even partners who were not members of the partnership at the time the tax liability was incurred will be charged with the associated tax liability.

Pursuant to Executive Order 13789,  IRS and Treasury have been reviewing tax regulations issued since  January 1, 2016 with an eye toward regulations that:

• Impose an undue financial burden on US taxpayers
• Add undue complexity to the US tax laws; or
• Exceed the statutory authority of the IRS

In a Notice released July 7, 2017, Treasury issued its first conclusions identifying eight regulations that they felt met the announced criteria. Now, in a second report, this one dated October 2, 2017, Treasury has announced its recommended actions on those regulations.

This note offers a brief roadmap of the October 2 report.

Of the 105 temporary, proposed, and final regulations issued between January 1, 2016 and April 21, 2017, Treasury identified eight which they believe meet at least one of the first two criteria of the Executive Order. Treasury also notes in its October report that they are also considering unstated reforms to regulations under Section 871(m) (related to payments treated as U.S. Source dividends) and under the Foreign Account Tax Compliance Act.

Treasury has identified two proposed regulations to be withdrawn, three temporary or final regulations to be revoked in substantial part, and three regulations to be substantially revised. I will summarize these proposed changes in order.

1.   There are two proposed regulations proposed to be withdrawn entirely. These include:
2. Proposed Regulations under Section 2704 concerning restrictions on liquidation of an interest for Estate, Gift, and Generation-Skipping Transfer Taxes. Section 2704 addresses the valuation of interests in family controlled entities, for purposes of wealth transfer tax. In some cases, Section 2704 treats lapses of voting or liquidations rights as if they were transfers for gift and estate tax purposes.

The goal of the proposed regulations was to respond to developments in state statutes and case law which had reduced the applicability of Section 2704 and enabled certain family entities to generate artificially high valuation discounts for such characteristics as lack of control and marketability.  By depressing the values of assets this way, taxpayers can depress the value of property for gift and estate tax purposes. Some comments on the regulations indicated that it is not practicable to value an interest in a closely held entity as if there were no restrictions on withdrawal or liquidation in the organization’s governing documents or state law simply because such a hypothetic environment does not exist.

Treasury now concludes that the approach of the proposed regulations to the issue of artificial valuation discounts is “unworkable” and plans to publish a withdrawal of the associated regulations in their entirety.

2. Prosed Regulations under Section 103 concerning the definition of a Political Subdivision. Section 103 of the Code excludes from a taxpayer’s gross income the interest on state or local bonds, including obligations of political subdivisions. The proposed regulations called for such a political subdivision, for this purpose, to possess not only sovereign power, but also to meet certain tests to demonstrate a governmental purpose and governmental control.

While Treasury continues to express the belief that some enhanced standards for qualifying as a governmental entity are needed to suit the purposes of Code Section 103, it expresses the conclusion that, in the context of the extensive impact on existing legal structures of Section 103, the proposed regulations are not justified.

1.   Regulations Treasury may consider revoking in part. These include the following three final, proposed, and temporary regulations:
2. Final Regulations under Section 7602 on the Participation of a Person Described in Section 6103(n) in a Summons Interview. The final regulations allow the IRS to use private contractors to assist the IRS in auditing taxpayers. This participation includes the authority of the Service to allow the private contractor to “participate fully” in IRS interviews of taxpayers and other witnesses, including witnesses under oath. The regulation also allows private contractors to review records received in response to a summons. These regulation were first promulgated as temporary regulation in 2014, then finalized in 2016.

Only two comments were received on these regulations. However, the regulations were not well-received by the public. One federal court observed that such a practice “may lead to further scrutiny by Congress” (U.S. v. Microsoft Corp. 154 F. Supp. 3d 1134, 1143 (W.D. Washington 2015). Thereafter, the Senate Finance Committee approved legislation that would prohibit IRS from using private contractors in a summons proceeding for any purpose.

Treasury now takes the position that it may consider amending these regulations with only prospective effect. Such an amendment would serve to prohibit the IRS from using outside legal counsel in an examination or a summons interview. Outside attorneys would not be permitted question witnesses or be involved in a back office capacity such as reviewing summoned records or consulting on IRS legal strategy. IRS will continue to use outside subject matter experts such as economists, engineers, and authorities on foreign legal matters.

2. Regulations under Sections 707 and 752 on Treatment of Partnership Liabilities. These regulations include:

• Proposed and Temporary Regulations addressing allocation of liabilities for purposes of the disguised sale rules; and
• Proposed and Temporary Regulations treating so-called “bottom dollar” guarantees and generally disallowing such guarantees for purposes of calculating a partner’s liability in the context of liability allocation

The first set of rules, dealing with liability allocation in evaluating a disguised sale, effectively renders all liabilities for these purposes as nonrecourse liabilities. Treasury acknowledges that this characterization technique is “novel” and allows that it is “considering whether the proposed and temporary regulations relating to disguised sales should be revoked and the prior regulations reinstated.”

The prior, proposed regulations were largely a codification of the IRS arguments in Canal Corporation v. Comm’r, 135 T.C. 199 (2010) where the Tax Court held that a partner’s guarantee in the context of a so-called “leveraged partnership” transaction should not be respected where the partner-guarantor was undercapitalized vis-a-vis the liability and had no contractual requirement to maintain a minimum net worth. The 2014 regulations had their own cumbersome qualities, many of which were intended to be resolved by the 2016 regulations.

Treasury indicates even less willingness to change the proposed and temporary bottom dollar regulations. After an extended recitation of the perceived problems arising from non-commercial guarantees, Treasury concludes that “the temporary regulations are needed to prevent abuses and do not meaningfully increase regulatory burdens of the taxpayers affected.”  Accordingly, Treasury does not plan to review the bottom dollar guarantee regulations.

3. Final and Temporary Regulations under Section 385 on the Treatment of Certain Interests in Corporations as Stock or Indebtedness.

These regulations generally include two categories of rules:

• Rules establishing minimum documentation requirements that must usually be satisfied before claimed debt obligations between related parties can be treated as debt for federal tax purposes (known as the “Documentation Regulations”); and
• Rules that treat as stock debt that is issued by a corporation to a controlling shareholder in a distribution or in another related party transaction that achieves an economically similar result (known as the “Distribution Regulations”).

The Documentation Regulations apply principally to domestic issuers and establish minimum characteristics of a transaction whereby its tax posture can be evaluated.

The Distribution Regulations generally affect interests issued to related parties who are non-U.S. holders and serve to limit earnings-stripping, whether by way of inversions or foreign takeovers.

Treasury now proposes to:

1. Revoke the Documentation Regulations in their entirety, followed by introduction of new regulations at a later date; and
2. Retain the Distribution Regulations in anticipation of reforms to the Internal Revenue Code.

III.   Regulations Treasury May Consider Substantially Revising

Treasury has identified two Final Regulations and a Temporary Regulation for consideration for revision:

1. Final Regulations under Code Section 367 on the Treatment of Certain Transfers of Property to Foreign Corporations.

Section 367 of the Code imposes a tax on transfers of property to foreign corporations, subject to certain exceptions, including an exception for property transferred for use in the active conduct of a trade or business outside of the United States.

These regulations eliminate the ability of taxpayers to transfer foreign goodwill and going concern value to a foreign corporation without incurring tax. The rules provide no exception for an active trade or business.

Treasury now argues that “an exception to the current regulations may be justified by both the structure of the statute and its legislative history.” Treasury, through the Office of Tax Policy, is proposing to expand the active trade or business exception to include relief for outbound transfers of foreign goodwill and going concern value attributable to a foreign branch under circumstances with limited potential for abuse and, curiously, administrative difficulties. The notion that making regulations controlling outbound transfers of foreign goodwill which simultaneously maximize simplicity and minimize risk of abuse, while noble in the articulation, has historically proven more aspirational than practical.

2. Temporary Regulations under Section 337(d) on Certain Transfers of Property to Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs)

The Temporary Regulations amend existing rules on transfers of property by C corporations to RICs and REITs. The regulations also govern application of the PATH Act to spinoff transactions involving disqualification of nonrecognition treatment for C corporation property transferred to REITs. Treasury now believes that the REIT spinoff rules could result in over-inclusion of gain in some circumstances. This might be particularly problematic, Treasury says, when a large corporation acquires a small corporation that had engaged in a Section 355 spin-off and the large corporation then makes a REIT election.

Treasury now concludes that the temporary regulations may produce too much taxable gain in some cases. Hence, Treasury is considering proposing caps in situations where, because of the predecessor and successor rule in Reg. Section 1.337(d)-7T(f)(2), gain recognition is required in excess of the amount that would have been recognized if a party to a spin off had directly transferred assets to a REIT.

3. Final Regulations under Section 987 on Income and Currency Gain or Loss with Respect to a Section 987 Qualified Business Unit

These final regulations govern:

• Translation protocols forincome from branch operations conducted in a currency that differs from the owner’s functional currency;
• Calculating foreign currency gain or loss with respect to the branch’s financial assets and liabilities; and
• Recognizing foreign currency gain or loss when the branch makes certain transfers of property to its owner

The Treasury report states that these regulations “have proved difficult to apply for many taxpayers.” While this explanation meets none of the criteria advanced by the Executive Order, Treasury proposes as a solution to “defer application of Regulations Sections 1.987-1 through 1.987-10 until at least 2019.” It is unclear how delay of application of the regulations will respond either to the problem identified by Treasury or to the Executive Order.

Treasury takes its response to the subject regulations a couple of steps further. Treasury declares its intent to propose modifications to the final regulations to adopt a simplified method of translating and calculating Section 987 gains and losses, subject to unspecified timing limitations.  By way of example, the Report suggests rules that would treat all assets and liabilities of a Section 987 qualified business unit (QBU) as marked items and translate all items of income and expense at the average exchange rate for the year. Section 989 of the Code defines a QBU as “any separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records.” The goal identified for this change is rendering Section 987 gain and loss consistent with currency translation gain and loss under applicable financial accounting rules and well as under the proposed Section 987 regulations proposed in 1991.

Treasury further proposes to limit a taxpayer’s Section 987 losses to the extent of its net Section 987 gains recognized in prior or subsequent years. The Report makes no reference to any proposed time limitation for this carryback and carryforward device.

1.   Conclusion

The October 2, 2017 Treasury Report further identifying the regulations whore removal or revision answer Executive Order 13789 appears to apply uneven and incomplete standards for those choices, and promulgate a strategy for revision and removal that may not yield, in the final analysis, a reduction in the number or complexity of  the tax regulations.

Counsel should, in any event, be aware of the changes proposed in the Report to appropriately anticipate the substantial revision in the legal landscape proposed by Treasury.