The U.S. House of Representatives’ Ways and Means Committee recently released proposed revisions to the Internal Revenue Code that will dramatically affect the taxation of pass-through entities and their investors.
There are some important questions that the proposal does not answer, and it almost certainly will go through some changes before it ever comes to a vote in the House or Senate. But there are some points worth considering, because this proposal sets the stage for broader tax reform efforts.
Key Provision of Proposed Tax Reforms
Here is a rundown of some key points:
Tax accounting methods – The cash method of accounting would not be available to pass-through entities with more than $10 million of annual gross receipts (average of three prior years). Even pass-through entities that don’t hold inventories will be required to convert to the accrual method of accounting. Professional service corporations (law, health, etc.) also would be required to adopt the accrual method of accounting, unless they fall below the average annual gross receipts test.
Due dates for tax returns – Partnership and LLC returns will be due within 2 ½ months of the close of the tax year (March 15 for companies with a calendar year-end). S Corporation returns will be due within three months (March 31 for calendar year-end), and C Corporation returns will be due within 3 ½ months (April 15). All are eligible for a six-month extension. This is generally a favorable provision.
S Corporations – The built-in gains tax recognition period for C Corporations now taxed as S Corporations will be permanently set at five years. The threshold for applying the “sting tax” moves from 25 percent net passive investment income to 60 percent, and it will no longer result in the revocation of S status. ESBT shareholders will include non-resident alien beneficiaries. For donations of appreciated property to charity, the basis of a shareholder’s stock is reduced only by the amount of the adjusted cost basis of the appreciated asset. S elections can be made on or before the due date of the return, including extensions, which allows for more hindsight. In general, these are all favorable provisions.
Guaranteed payments – In general, the treatment of guaranteed payments under current law will be repealed. These payments are common in partnerships and LLCs that have owners who are also service providers. In essence, these are salary payments to the owners – deductible by the payer and includable in the income of the recipient owner. Such payments under the proposal would be treated as distributions.
This would not be a favorable change for many of our clients. It would necessitate revisions to the partnership and operating agreements of any companies that are affected.
Payments to retiring and deceased partners – The tax treatment would resemble the purchase of assets used in a trade or business typically encountered today in asset purchase and sale agreements. Payments for goodwill would be mandatorily amortizable and result in ordinary income to the recipient. Payments of deferred compensation would be deductible when includable in the income of the recipient. This is generally a simplification of current tax law. It is not clear if open transactions at end of 2013 will be “grandfathered.”
Partnerships/LLCs – Transferring interest would require an adjustment to the basis of the company’s assets; current law requires a step-down in basis only in certain instances and a step-up only when elected. When a member redeems interest, it would require a mandatory adjustment to the basis of undistributed property. Generally, both provisions will add complexity.
Treating partnerships/LLCs and S Corporations the same – Partnerships/LLCs and S Corporations would be governed by the same tax provisions – provisions that vary widely under current law. Transition rules will be complicated.
A withholding tax at the entity level is provided for on the owner’s distributive share of taxable income. The tax rate has not been specified, but separate rates will be applied to different character of taxable income in the distributive share. The withheld tax is considered an item passed through to the owner for use on its tax return. It isn’t clear if this withholding occurs annually or throughout the year.
The withholding provision is a trap for the unwary and is designed to better ensure that the government is paid taxes on distributive shares of taxable income in a timely manner. It resembles the system currently in place by states for the taxation of non-resident owners. This tax will not replace the withholding requirements currently in place for non-U.S. resident owners of U.S. property.
Distributive share is determined as it is under current law. Distributions follow the owner’s economic interest in the entity. The effect of this is to move away from the single class of stock in an S Corporation to a broader and more flexible capital structure found today in LLCs and partnerships.
Contributions of appreciated property by an owner to an S Corporation will follow today’s partnership tax rules; they are generally deferrable. Distributions of appreciated property will follow today’s S Corporation rules; they are generally taxable. Sales of ownership interests and the character of that gain on sale will follow today’s partnership tax law; this is generally unfavorable to current S Corporations. An owner’s basis will include a share of the entity’s liabilities, as is the case under today’s partnership tax law; the “at risk” rules are not modified.