The revised limitation on interest expense brought about by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, may affect a broader base of businesses than originally anticipated by many. The newly minted Sec. 163(j) limits the deduction for business interest to the sum of business interest income and 30% of adjusted taxable income, which is taxable income allocable to a trade or business without regard to business interest or business interest income; net-operating-loss deductions; Sec. 199A deductions; and for tax years beginning before Jan. 1, 2022, any deduction for depreciation, amortization, or depletion.
An entity (other than a tax shelter that cannot use the cash method of accounting under Sec. 448(a)(3)) that meets the gross-receipts test of Sec. 448(c) is exempt from the Sec. 163(j) interest limitation. An entity meets the gross-receipts test if its average annual gross receipts for the previous three tax years does not exceed $25 million. In the reporting to date on the small business exemption to the Sec. 163(j) limitation, the impact of the tax shelter exception to the exemption and the application of the aggregation rules under Sec. 448(c)(2) in determining an entity’s average annual gross receipts have been largely overlooked.
Certain aggregation rules apply when determining an entity’s average annual gross receipts for the three previous tax years for purposes of Sec. 448(c). Entities controlled by common ownership under Sec. 52 or entities treated as part of an affiliated service group under Sec. 414 may be subject to aggregation of revenues, which could cause average gross receipts to exceed the $25 million ceiling for an exemption from the limitation under Sec. 163(j). Further exploration of Secs. 52 and 414 is beyond the scope of this discussion, but the aggregation rules would certainly merit further attention if a taxpayer is seeking an exemption from the limitation.
Further guidance on the application of the aggregation rules to Sec. 163(j) may be forthcoming. The AICPA requested immediate guidance to clarify the requirement to aggregate the revenues of certain entities in a Jan. 29, 2018, letter (available at http://www.aicpa.org to the IRS and Treasury.
Exemption not available for tax shelters
It is important to note that the exemption to the limitation on business interest under Sec. 163(j) does not apply to a tax shelter prohibited from using the cash-receipts-and-disbursements method of accounting under Sec. 448(a)(3). A tax shelter is defined differently under various Code sections, with one of the broadest definitions used in this case. The Sec. 448(a)(3) prohibition defines “tax shelter” at Sec. 448(d)(3), which states that “[t]he term ‘tax shelter’ has the meaning given such term by section 461(i)(3).” Sec. 461(i)(3) provides that the term “tax shelter” means:
any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or State agency having the authority to regulate the offering of securities for sale,
any syndicate (within the meaning of section 1256(e)(3)(B)), and
any tax shelter (as defined in section 6662(d)(2)(C)(ii)).
Sec. 448(d)(3) in addition states:
An S corporation shall not be treated as a tax shelter for purposes of this section merely by reason of being required to file a notice of exemption from registration with a State agency described in section 461(i)(3)(A), but only if there is a requirement applicable to all corporations offering securities for sale in the State that to be exempt from such registration the corporation must file such a notice.
Any governmental regulation over the sale or offering of interests should be noted, as should the slightly more notorious definition of a tax shelter under Sec. 6662, relating to entities formed with a significant purpose of avoiding or evading federal income tax. Far more commonly, however, a business unwittingly stumbles into the definition of a syndicate.
A syndicate is defined by Sec. 1256(e)(3)(B) as any partnership or other entity (other than a corporation that is not an S corporation) if more than 35% of the losses of the entity during the tax year are allocable to limited partners or limited entrepreneurs.
The meaning of “limited entrepreneur” is provided in Sec. 461(k)(4) as a person who has an interest in an enterprise other than as a limited partner and who does not actively participate in the management of that enterprise. Sec. 461 and the related regulations, however, do not provide factors that would indicate someone is actively participating in management. This determination is based on facts and circumstances, with much of the available insight coming from private letter rulings.
Example 1: A and B form AB Co. and make an election to be taxed as an S corporation, with each contributing $50 for 50% of the stock. A operates the business and is paid a salary of $30; B does not participate in the operations or management of the company. AB Co. takes out a loan of $100, incurring $10 of interest expense in year 1. Operating revenues total $50, and expenses other than interest and A’s salary total $40, resulting in a $30 loss for the year before the new Sec. 163(j) limitation is applied. AB Co. is considered a syndicate, and thus a tax shelter, in year 1 for purposes of Sec. 461 because more than 35% of the loss will be allocated to B, who is considered a limited entrepreneur. As such, AB Co. does not receive a deduction in year 1 for its $10 of interest expense, resulting in a tax loss of only $20.
Sec. 1256(e)(3)(C) provides some further guidance by attributing a holding to one held as an active participant in management if:
(i) for any period if during such period such interest is held by an individual who actively participates at all times during such period in the management of such entity,
(ii) for any period if during such period such interest is held by the spouse, children, grandchildren, and parents of an individual who actively participates at all times during such period in the management of such entity,
(iii) if such interest is held by an individual who actively participated in the management of such entity for a period of not less than 5 years,
(iv) if such interest is held by the estate of an individual who actively participated in the management of such entity or is held by the estate of an individual if with respect to such individual such interest was at any time described in clause (ii), or
(v) if the Secretary determines (by regulations or otherwise) that such interest should be treated as held by an individual who actively participates in the management of such entity, and that such entity and such interest are not used (or to be used) for tax-avoidance purposes.
Losses allocable or allocated? What losses are included?
While Sec. 1256(e)(3)(B)’s definition of a syndicate refers to losses that are “allocable to limited partners or limited entrepreneurs,” Temp. Regs. Sec. 1.448-1T(b)(3) mirrors that definition, but it replaces losses “allocable” with losses “allocated.” This would indicate that if there were no losses allocated to limited partners or limited entrepreneurs in any given year, an entity would not be considered a syndicate for that year.
Example 2: Referring back to Example 1, assume instead that AB Co. breaks even in year 1 by generating operating revenues of $80 while paying A’s salary of $30, incurring other operating expenses of $40 and interest expense of $10. Although 50% of the losses would have been allocable to B if AB Co. had generated a loss in year 1, AB Co. is not treated as a syndicate under Sec. 461 in year 1, as no losses were allocated. Assuming AB Co. does not meet another definition of a tax shelter under Sec. 461, its interest deduction of $10 will not be limited under Sec. 163(j) because its average annual gross receipts do not exceed $25 million.
Example 3: Assume instead that in Example 1, AB Co. elects to be treated as a partnership for income tax purposes, and the operating agreement allocates all losses in year 1 to A. AB Co. would not be considered a syndicate under Sec. 461 because more than 35% of the losses will not be allocated to B, the only limited partner or entrepreneur. Assuming AB Co. does not meet another definition of a tax shelter under Sec. 461, its interest deduction of $10 will not be limited under Sec. 163(j) because its average annual gross receipts do not exceed $25 million. A would be allocated the partnership’s $30 loss.
Temp. Regs. Sec. 1.448-1T(b)(3) provides that for purposes of defining the term “syndicate,” the losses of a partnership, entity, or other enterprise means the excess of the deductions allowable to the enterprise over the amount of income recognized by the enterprise under its method of accounting used for federal income tax purposes (determined without regard to this section). For this purpose, gains or losses from the sale of capital assets or Sec. 1221(a)(2) assets are not taken into account.
Other limitations affected by the definition of a tax shelter
Some businesses may qualify to elect to be treated as an electing real property trade or business under Sec. 163(j), in which case they would not be subject to the limitation on business interest deductions. Further details about electing real property trades or businesses is beyond the scope of this discussion; however, it should be noted that making this election may have undesired effects. Additionally, the election does not avoid the impact of tax shelter status on other sections of the Code.
Sec. 163(j) makes a direct reference to tax shelters prohibited from using the cash-receipts-and-disbursements method of accounting; however, it is important to note that additional provisions beneficial to small businesses are also unavailable to tax shelters under the same definition. These include exceptions to the uniform capitalization rules of accounting for inventories and the required use of the percentage-of-completion method for small construction contracts, as well as the ability to use the recurring-item exception.
Evaluation of tax shelter status more relevant than ever
In addition to the exemption from the new Sec. 163(j) limitation on business interest, the TCJA has raised the gross-receipts ceiling from $5 million to $25 million to qualify for several provisions that provide relief to small businesses. Many businesses that have not previously qualified for some of these provisions based on a $5 million average-gross-receipts ceiling may now qualify. Ownership structures should be examined carefully to determine if an entity would be considered a tax shelter under Sec. 448 and if measures can be taken to avoid being tainted by that status.