Pass-through businesses, and the real estate industry in particular, were generally pleased with the results of the 2017 Tax Cuts and Jobs Act (TCJA), as well as the upbeat economic atmosphere that continued after its enactment. However, a number of important areas of the new law continue to be unclear, as the IRS has been slow to issue guidance. Here are our latest observations on major areas of tax uncertainty.
Carried interest and section 1231 gains
There continues to be uncertainty as to whether gains on real estate used in a trade or business are covered by the new rules limiting the availability of capital gains treatment for carried interests. Taxpayers facing this issue should consult with their tax advisors to determine what level of certainty can be accorded to any opinions or other conclusions at this time.
Some observers believe that the technical provisions, read literally, apply only to gains from the sale of “capital assets” – such as shares of stock or partnership interests – and do not apply to “property used in a trade or business” also known as “section 1231 property.” Such a reading would exclude from the provisions any gains from the sale of most real estate assets, as well as the sale of the business assets of a portfolio company structured as a partnership (but not a sale of the partnership interests). Many have asked whether this is intentional, or whether it might be a drafting error that could be modified by future legislation or regulations.
Our latest thinking is that the technical reading – excluding section 1231 property – may well be the correct one. This is based on a review of the larger statutory context and background, as well as a review of cases interpreting similar provisions. In effect, there appears to be both a textual and a policy basis for distinguishing section 1231 property from capital assets in the context of the carried interest legislation. Indeed, absent a statutory change, even a regulatory rule purporting to change that result might encounter difficulties.
Taxpayers who want to have a better sense of the degree of certainty that can be attached to conclusions of this nature should consult with their tax advisors, with due focus on the facts and circumstances of any particular arrangement.
Business interest limitation and the tax shelter rules
Many real estate transactions will be subject to the election to avoid the new interest limitations that is available to real estate trades or businesses. In other cases, real estate or non-real estate businesses or endeavors may seek to rely on the “small business” exception under section 163(j)(3) to avoid the general limitation on the deductibility of business interest under section 163(j). However, to enjoy that benefit, taxpayers must consider some of the arcane rules governing “tax shelters.”
The “good news” is that there is an exception to the interest limitation rules for “any taxpayer (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3)) which meets the gross receipts test of section 448(c) for any taxable year…”. While the gross receipts test is pretty clear – average gross receipts must not exceed $25 million for the previous three-taxable-year period – the “bad news” is that the taxpayer must also fall outside the technical definition of a tax shelter – which may be quite broad unless it is somehow limited by IRS guidance.
For the purposes of section 163(j)(3), a tax shelter includes (by cross reference to section 448(d)(3) and section 461(i)(3)), any syndicate, which is defined by section 1256(e)(3)(B) to include:
…any partnership or other entity (other than a corporation which is not an S corporation) if more than 35 percent of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs…
For the purposes of section 1256(e)(3)(B), a limited entrepreneur is defined 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 the enterprise.
With most small enterprises structured as pass-throughs, and most pass-through investors (other than in S corporations) holding as limited partners, LLP partners, or LLC members, this could make the provision largely unavailable, other than for S corporation shareholders.
The definition of tax shelter also includes any enterprise (other than a C corporation) that has, at any time, held its interest out for sale in an offering required to be registered with a federal or state agency with authority to regulation the offering, as well as a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement whose significant purpose is the avoidance or evasion of federal income tax.
Given the scope of the types of enterprises that could fall within the definition of a tax shelter – particularly within the definition of a “syndicate” – many smaller real estate and other enterprises may find themselves ineligible for exemption from the general limitation on the deductibility of business interest. Accordingly, any enterprise looking to rely on the small business exemption under section 163(j)(3) must consider the tax shelter rules when making this determination.
It is hoped that the IRS may issue clarifying guidance that would help ensure that the small business exception fulfills the intent of Congress in enacting it.
199A W-2 wage guidance
As we await guidance under the new 20 percent deduction for pass-through businesses, many taxpayers are struggling with the question of whether they are paying their “wages” properly to qualify for the deduction. Clients relying on W-2 wages to provide their owners with the potential benefit of the section 199A deduction, need to be cognizant of the current uncertainties in this area. Specifically, the question for many real estate clients will be whether the common law definition of employee applies with respect to W-2 wages of the business – without regard to the rules regarding professional employer organization or employee leasing firms.
Guidance from the IRS and The Department of the Treasury (Treasury) will ultimately be necessary to resolve many of the uncertainties. By its terms, however, the language suggests that if the economic cost of a 'wage' is incurred, directly or indirectly, by a proprietor, partner, or S corporation shareholder, and it is incurred in the same ‘trade or business’ generating income inuring to that individual, that should be sufficient to qualify the trade or business income as being from a trade or business paying the ‘wages.’
It is unclear, however, whether it will be possible for more than one trade or business to be aggregated, similar to the way multiple “activities” can be “grouped” for purposes of the passive active loss rules and the net investment income tax.
If guidance is issued (as is anticipated to be the case), some expect that – other than in abusive cases – it will be issued in the form of a proposed regulation that will not be effective until it is issued in final form. Again, however, no assurances can be provided. Accordingly, clients should be aware of the uncertainties surrounding this issue, as well as the anticipation of guidance from the IRS and Treasury.
