By Aman Badyal
The enactment of the Tax Cuts and Jobs Act in December 2017 (the “Tax Reform Act”) and the promulgation of regulations implementing the Bipartisan Budget Act of 2015 represent significant changes that must be accounted for when structuring a tax partnership. Tax partnerships include limited liability companies, limited partnerships, limited liability partnerships and general partnerships. In this article, the terms LLC and partnership, as well as LLC member and partner, are used interchangeably. This article discusses a small subset of recent tax changes applicable to partnerships.
The recent tax reform act added a new tax benefit to the Internal Revenue Code in the form of the Qualified Business Income Deduction (the “QBI Deduction”). The QBI Deduction is available to individuals, trusts and estates with income earned through tax partnerships, S corporations, and sole proprietorships. The QBI Deduction purports to be equal to 20% of the taxpayers qualified business income from a qualified trade or business; however, various limitations apply that may reduce or eliminate the QBI Deduction. The limitations phase in for single taxpayers with taxable income exceeding $157,500 and for married taxpayers filing jointly who have taxable income exceeding $315,000. When the limitations are fully phased in, (i) taxpayers with income from certain service businesses will not receive a QBI deduction, and (ii) other taxpayers will see their QBI Deduction limited to the greater of (X) 50% of the qualified wages paid by the partnership or (Y) 25% of the qualified wages paid plus 2.5% of the unadjusted basis of the partnership’s qualified property. The application of these limitations is quite complex and we are still awaiting Treasury Regulations which will inform taxpayers as to the details of this new deduction. However, partners will require significant information from entities in which they have invested in order to determine the amount of their deduction.
For high income taxpayers, the limitation on qualified wages may cause partnerships to be at a disadvantage to S corporations. The compensation paid to a partner in a partnership must be treated as “guaranteed payments” rather than “wages,” and such compensation will not be included in the “50% of qualified wages” calculation. In contrast, compensation paid as salaries to S corporation shareholders will be so included. Conversely, if a taxpayer has taxable income of less than $157,500 ($315,000 for a joint return), an S corporation structure will be disadvantageous, as an S corporation is required to pay salaries to its workers, and these salaries will not qualify as Qualified Business Income.
Clients should consider updating their LLC agreements to (i) require that the LLC provide its members all the information necessary to compute the QBI Deduction, and (ii) update tax distribution provisions to account for the QBI Deduction in order to avoid excessive tax distributions.
Treasury Regulations regarding the QBI Deduction are expected this summer. Following the promulgation of such regulations, CKR Law will issue an in-depth client alert on the topic.
The Tax Reform Act limits the amount of interest expense a business with gross receipts of greater than $25 million can deduct. Multiple entities under common control may be aggregated to determine whether the $25 million gross receipts threshold has been exceeded. The maximum interest expense deduction under the new law is 30% of the taxpayer’s adjusted taxable income. Until January 1, 2022, “adjusted taxable income” will essentially mean EBITDA (and EBIT thereafter). In the case of partnerships, the 30% cap is applied at the partnership level (i.e., a partnership’s adjusted taxable income determines the maximum amount of partnership interest expense that its partners may deduct). Real estate partnerships may elect out of this limitation; the cost of doing so is a relatively small extension of the depreciable life of the partnership’s real estate assets (i.e., electing partnership must depreciate commercial real estate over 40 years rather than 39 years and residential real estate over 30 years instead of 27.5 years).
Partnerships that face the prospect of an interest expense limitation may want to consider recapitalizing debt into preferred equity (i.e., a class of equity that is repaid in preference to common equity). For example, assume partnership AB has two partners, A and B. The partnership is currently capitalized with a $1,000 loan from partner A and it earns $70 EBITDA. It pays $30 interest expense to partner A. Only $21 of the interest is currently deductible (30% x $70 = $21); therefore, the partners would collectively have current year taxable income of $79 ($30 interest income to partner A plus $49 partnership business income ($70-$21=$49) earned by A and B collectively). The remaining $9 of interest expense would be carried forward until the partnership produces excess adjusted taxable income. On the other hand, if partner A’s $30 loan were recapitalized as preferred equity; the partners, collectively, would be allocated $70 of income. Creditor-partners of partnerships that earn qualified business income may see an increased tax benefit by recapitalizing into preferred equity.
The Bipartisan Budget Act of 2015 overhauled the manner in which the IRS can collect underpayments of tax resulting from an audit of a partnership. Previously, the IRS could audit a partnership’s return, but was required to collect any unpaid taxes from each partner. The new centralized partnership audit rules permit the IRS to collect tax from partnerships directly in certain circumstances. The new audit regime includes various changes that require immediate attention. For example, the role of “Tax Matters Partner” is eliminated and the role of “Partnership Representative” is substituted in place thereof. The law gives the Partnership Representative vast powers to handle tax audit matters on behalf of the partnership, including the power to concede tax liabilities and bind the partnership; therefore, it is imperative that operating agreements be drafted to include parameters and restrictions around the Partnership Representative’s powers. Additionally, Partnership Representatives should insist that they be indemnified against any liability arising from all appropriate actions taken as a Partnership Representative.
If the IRS makes an adjustment to partnership income or loss, they will have the power to impose any resulting tax directly upon the partnership rather than the partners. When the IRS imposes such tax, the general rule is that the additional tax will be imposed at the highest rate of income tax applicable under the Internal Revenue Code for the tax year under audit. However, there are methods by which the partnership can reduce the rate of taxation or transfer the tax liability to its partners. Operating agreements must be drafted properly to ensure the ability to take these actions. Furthermore, in the event that the partnership is required to pay additional tax, there must be a methodology for allocating the tax cost to the respective partners. Finally, one or more partners who were partners in the year under audit may no longer be partners at the time of the audit. Therefore, it is important that partnership agreements include a mechanism to recoup tax underpayments from a former partner.
Certain eligible partnerships have the ability to elect out of the new rules. If a partnership elects out of the new rules, the IRS is required to audit each partner individually. It is widely believed that partnerships electing out of the new rules will be less likely to be drawn into federal income tax audits. Eligible partnerships are those partnerships that have 100 or fewer direct or indirect eligible partners. Generally speaking, each of the partners must be either an individual or a corporation; oddly, disregarded entities, other partnerships, and even garden-variety revocable living trusts are not eligible partners, even if they are owned by otherwise eligible partners. If an S Corporation is a partner, then the shareholders of the S Corporation are also counted towards the 100-partner limit. Given the benefits of electing out of these new rules, eligible partnerships may want to ensure that they remain eligible for this election.
Partnerships and partners must consult with their tax and legal advisors to ensure that their affairs are properly structured and their organizational agreements are properly drafted to ensure an optimal tax result.
Should you have any questions or desire further insight, feel free to contact one of the members of our Tax Department:
Mayer Nazarian, Chair of the Tax Department - email@example.com
Eli Akhavan, Chair of the Private Clients and Wealth Preservation Practice Group - firstname.lastname@example.org
Aman Badyal - email@example.com
Elizabeth Larrauri Chamulak - firstname.lastname@example.org
Elizabeth Nelson - email@example.com
Farzaneh Savoji - firstname.lastname@example.org
Gary Edelstone - email@example.com
Michael Shaff - firstname.lastname@example.org
Jon Hughes - email@example.com
Gordon Einstein - firstname.lastname@example.org
DISCLAIMER: This article is not intended to provide legal advice, and no legal or business decision should be made based on its contents.