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2019 year-end tax letter: developing rules under the Tax Cuts and Jobs Act and technical corrections

Authored by Paul Dillon

The Tax Cuts and Jobs Act (TCJA) was signed into law nearly two years ago. While the Treasury Department and the IRS have published thousands of pages of guidance in the past 24 months, taxpayers could still use assistance in some critical areas.

In addition to awaiting guidance from the Treasury, taxpayers are encountering numerous problems within the context of the TCJA that may require “technical corrections” legislation to resolve. By some congressional estimates, the TCJA needs more than 70 technical corrections, many of which involve international issues. Perhaps the most known technical correction involves the depreciation life for qualified improvement property. The TCJA intended to reduce the depreciation life for such property to 15 years, but because of a drafting error, it remains at 39 years and also not eligible for bonus depreciation.

Due to the political divide in Congress, any technical correction relief does not appear to be on the horizon. There has been some speculation that a few bipartisan provisions, such as a fix for the 15-year qualified improvement property issue, may occur at year-end. Rather than stand-alone legislation, a limited number of technical correction provisions could be attached to other year-end legislation, such as a government spending bill. At this time, we are pessimistic of any tax legislation passing by the end of 2019.

Even in topics where guidance has been issued (such as business interest expense deductions), questions remain. Consequently, as the 2019 tax year comes to a close, we provide the following discussion of certain areas that remain open for clarification.

Key takeaway: Taxpayers still await TCJA-related guidance on excess business losses, business interest expense deduction limitations through tiered structures and carried interests.

Excess business losses

Perhaps the most significant TCJA-related change where no guidance has been issued is the excess business loss limitation rules for noncorporate taxpayers, which remain a mystery. On the surface, the law places limits on the use of business losses on noncorporate taxpayers. Basically, individuals conducting business via S corporations, partnerships or as sole proprietors will have their business losses limited. These same restrictions also apply to trusts.

An “excess business loss” (EBL) (for taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026) is calculated by comparing the aggregate deductions to the sum of aggregate gross income or gain of the taxpayer’s trade or business. A threshold amount of $250,000 (single taxpayer) or $500,000 (married filing joint return) is also included in the computation. Any excess amounts are suspended to a future tax year, becoming part of the taxpayer’s net operating loss carryforward and subject to the 80% NOL limitation.

While the EBL formula appears straightforward, there are questions about the components that comprise “aggregate deductions.” For example, if a taxpayer has NOL carryforwards from a prior year, it is unclear whether these would be included as part of aggregate deductions. Also, it is not clear if wages are used in the computation of aggregate gross income. Wages are considered business income for certain areas of tax law such as computing NOL usage; however, wages are not considered business income when calculating the qualified business income deduction or the business interest expense limitation. As a result, calculating aggregate deductions and gross income attributable to a taxpayer’s trade or business remains fraught with uncertainty.

While we await additional guidance, we offer the following tips when assessing how these new rules affect your business activity.

  • Consider carefully when to use bonus depreciation and IRC section 179 expensing. Since NOLs are now limited in their carryforward amount, it may be prudent for loss companies to preserve depreciation deductions for future years.
  • The new 80% limitation on carryforwards on top of the historic loss limitations may make the acquisition of NOL companies less valuable. Acquisition pricing may need reassessing in certain deals. You should also keep in mind that historic rules that can also limit the use of “purchased” NOLs remain unchanged by the TCJA.
  • As individual taxpayers are now limited in how much nonbusiness income can be sheltered with business losses, careful planning should take place before year-end to project the amount of any 2019 tax liability.
  • While the passive loss limitations apply before the excess business loss rules, it remains unclear whether passive activity income and losses are included in the determination of the excess business loss.
  • Taxpayers generating business losses via multiple pass-through entities may have to apportion or allocate a piece of each entity’s loss up to the threshold. Guidance is needed in order to determine how these amounts should be allocated and tracked.
  • If a married couple has separate trades or businesses reported on a joint return, the presumption is the EBL limitation applies to the combined income and deductions from all of the trades or businesses.

Business interest expense limitation

One of the primary revenue raisers in the TCJA is the limitation on the deduction of business interest expense. In an effort to balance debt versus equity infusions into American businesses, the TCJA limits the deduction for business interest expense to 30% of adjusted taxable income (ATI). ATI is essentially taxable income plus certain adjustments including NOLs and the qualified business income deduction. For tax years beginning before Jan. 1, 2022, depreciation, depletion and amortization are also excluded from ATI. ATI is then increased by adding business interest income plus floor plan financing income to determine the limitation. Generally, any business interest expense not deductible in the current year is carried forward and treated as business interest expense in a subsequent year, again subject to this formula.

Last year, more than 400 pages of regulations were released defining the computation of the business interest expense limitation. While providing taxpayers with much-needed guidance on applying and computing this limitation, several areas still lack guidance. For example, partnerships are generally required to compute the limitation at the entity level with certain excess amounts allocated to the partners. According to the statute, in a tiered structure, the upper-tier entity does not use its share of pass-through activity from a lower-tier entity in computing its limitation. This is to avoid double counting of ATI between entities. However, there are no rules yet addressing whether excess items from a lower-tier entity should be suspended at the upper-tier entity level or if the upper-tier entity should in turn pass on the those allocations to its partners. The IRS has also not defined how the limitation is to be addressed in a partnership merger or division.

The bottom line is taxpayers should include a careful review of the interest limitation deduction as part of their year-end tax projection and tax planning.

Carried interest

In general, the receipt of a capital interest for services provided to a partnership results in taxable compensation to the recipient. However, a safe harbor rule allows that the receipt of a profits interest in exchange for services is not a taxable event if the holder is entitled to share only in gains and profits generated after the date of issuance (and certain other requirements are met).

Fund managers are often the recipients of a type of profits interest known as a carried interest. The carried interest is typically offered as compensation in exchange for managing the fund’s assets. Prior to the TCJA, capital gains attributable to carried interests were taxed at long-term capital gains rates provided they were held for at least one year. In contrast, the TCJA’s carried interest provision provides that long-term capital gains from carried interests held less than three years will be treated as short-term capital gain (i.e., taxed at ordinary rates). The law was enacted to address the concern among policymakers that compensation for services (the carry) was being taxed as capital gain rather than ordinary income.

The new rules apply to applicable partnership interests that are held or received in connection with the performance of services in any “applicable trade or business.” An applicable trade or business means any activity that consists in whole or in part of the following:

  1. raising or returning capital, and either
  2. (a) investing in (or disposing of) “specified assets” (or identifying specified assets for investing or disposition), or (b) developing specified assets.

    Specified assets means securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to such securities, commodities, real estate, cash or cash equivalents, as well as an interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing.

Numerous issues remain unresolved at this time, including whether the three-year holding period applies to the partnership interest, the assets or both, and whether section 1231 gains will be subject to the carried interest provision.

This is a developing issue that will be the subject of much speculation and discussion until the IRS issues guidance. Furthermore, the prospect of additional legislation in this area could increase depending upon the results of the 2020 elections.

View more insights in the 2019 year-end tax planning letter >

Download the 2019 year-end tax planning letter >

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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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