Many of the favorable attributes of the new tax law apply to businesses with less than $25M of gross receipts. In addition, these entities avoid the 30% of taxable income interest limitations under §163(j). Unfortunately, there is a significant exception to the $25M test.
Businesses that are deemed tax shelters are not eligible for the benefit of the following:
- cash method of accounting
- exemption from §263A
- exemption from maintaining inventories,
- exemption from using the Percentage-of-completion Method (PCM) to account for long-term contracts
- the small business exception to the §163(j) interest expense limit (30% limit).
What is a tax shelter?
Per the cash method of accounting rules of §448(d)(3) and §461(i)(3), a tax shelter means:
- a registered security
- an entity formed to avoid or evade federal income tax or,
- a syndicate
Most businesses will have no issues with the registered securities or entity formed to avoid or evade tax but the syndicate definition has a definite impact.
An entity (other than a C corporation) that allocates more than 35% of its losses during the tax year to limited partners or limited entrepreneur per § 1256(e)(3)(B)
A limited entrepreneur is one who has an interest in an enterprise other than as a limited partner and doesn’t actively participate in the management of the enterprise per §461(k)(4). A facts and circumstances test are used to determine if an owner actively participates in the management of the business.
An S corporation, LLC or Partnership is a syndicate if more than 35% of the loss is allocated to unrelated owners who aren’t involved in the day-to-day operations of the business. If the company generates a tax loss, it will be considered a tax shelter because more than 35% of ownership are limited entrepreneurs. Note that IRC Sec. 1256(e)(3)(C)(ii) says that entities can include ownership of the spouse, children, grandchildren, and parents of an individual who actively participated in the entity for a period of not less than 5 years as active.
A limited partnership that traditionally allocates 99% of its losses to limited partners (1% to a general partner) will be subject to IRC Sec. 163(j) even if it meets the $25 million gross receipts test. However, real property trades or businesses can elect out of the interest limitation rules if they use the Alternative Depreciation System (ADS) to depreciate nonresidential real property, residential rental property, and qualified improvement property.
Real property trades or businesses include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trades or businesses. Real estate companies with significant mortgages will need to analyze whether to accelerate interest or depreciation expense to maximize deductions. If you have any questions, please contact John Csargo, CPA, MBT, CFP at firstname.lastname@example.org.