CMPR Review of Year-End Tax Law Changes
On December 18, 2015, President Obama signed into law the Consolidated Appropriations Act, 2016 (the “Appropriations Act”) and the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act” and together with the Appropriations Act, the “Tax Acts”). Notably, the Tax Acts made significant changes to the U.S. federal income tax treatment of various entities and also extended or made permanent certain provisions of the Internal Revenue Code which had expired or were otherwise set to expire, including the following:
- Extension of reduction in S corporation recognition period for built-in gains tax
- Extension and modification of bonus depreciation
- Extension and modification of increased expensing limitations and treatment of certain real property as Section 179 property
- Extension of temporary minimum low-income housing tax credit rate for non-Federally subsidized buildings
- 100 percent exclusion for Qualified Small Business stock made permanent
Separately, the Bipartisan Budget Act of 2015, signed by President Obama on November 2, 2015 (the “Budget Act”) introduced sweeping changes to partnership audit proceedings.
Extension of Reduction in S Corporation Recognition Period for Built-in Gains Tax
When a C corporation converts to an S corporation or an S corporation acquires assets from a C corporation in a tax-free transaction (e.g., a tax-free reorganization), the S corporation may eventually find itself subject to a corporate-level “built-in gains” tax in addition to the tax imposed on its shareholders upon disposition of its assets. This rule supersedes the traditional pass-through tax treatment afforded to S corporations, otherwise, a C corporation could make an election to be taxed as an S corporation and then proceed to sell all or part of its assets with only a single level of tax applied.
The time period during which an S corporation is required to track dispositions of assets subject to the built-in gains tax was originally ten years from conversion to an S corporation (or asset acquisition), but was then reduced to seven years for taxable years beginning in 2009-2011, and then to five years for taxable years beginning in 2012 to 2014. Absent legislation, this time period was slated to return to the original ten-year time period in 2015.
In a very favorable provision for small businesses, the built-in gain recognition period has been permanently reduced to a five-year period, with retroactive effect to the 2015 tax year.
Extension and Modification of Bonus Depreciation
The PATH Act extends and phases out the Section 168(k) bonus depreciation for qualified property placed in service over the next five years as follows: from 2015 to 2017, bonus depreciation will remain at 50 percent, in 2018 it will be 40 percent and in 2019, 30 percent.
Additionally, the PATH Act provides for a very beneficial election for certain plants which bear nuts and fruits (including grapes). Under the prior law, bonus depreciation was only available in the year in which the property is placed in service, which typically means when the plant becomes income producing (in most cases, several years after planting). If the election is made, the plants are considered to be placed in service when planted, and thus eligible for bonus depreciation in the first year (at the then current percentage).
These provisions apply to property placed in service after December 31, 2015.
Extension and Modification of Increased Expensing Limitations and Treatment of Certain Real Property as Section 179 Property
A taxpayer may elect under Section 179 to deduct (or “expense”) the cost of qualifying property rather than depreciate the property. From 2015 forward, such expensing will be allowed up to $500,000, assuming that less than $2 million worth of equipment is placed in service during the year. Absent legislation, the $500,000 and $2 million thresholds would return to prior levels, $25,000 and $200,000, respectively.
The Tax Acts also removed the limitation on Section 179 deductions for qualified real property (e.g., retail, restaurant, and other leasehold improvements) and made permanent the permission granted to a taxpayer to revoke without the consent of the Commissioner any election made under Section 179.
Extension of Temporary Minimum Low-income Housing Tax Credit Rate for Non-Federally Subsidized Buildings
In the case of newly constructed or substantially rehabilitated housing that are not federally subsidized, the calculation of the “applicable percentage” was originally designed to produce a ten-year credit equal to 70 percent of the present value of the building’s qualified basis. However, prior legislation extending as far back as the Housing and Economic Recovery Act of 2008, had mandated, on a temporary basis only, that the applicable percentage for newly constructed or substantially rehabilitated housing which is not federally subsidized could be not less than nine percent.
The PATH Act makes permanent the minimum applicable percentage of 9 percent and is effective January 1, 2015.
100 Percent Exclusion for Qualified Small Business Stock Made Permanent
The Section 1202 exclusion from gross income of gain from the sale of Qualified Small Business stock held for more than five years has been permanently extended to 100%.
The provision is effective for stock acquired after December 31, 2014.
Changes to Partnership Entity Audit Rules
The Budget Act effectively repeals and replaces the current TEFRA partnership audit procedures with a significantly different procedural regime, effective for tax years beginning after December 31, 2017. All partnerships (and LLC’s taxable as partnerships), whether or not formed prior to the effective date are impacted. Prior to these changes, an Internal Revenue Service (“IRS”) audit would occur at the partnership level and the IRS would cause adjustments to be made to the partners directly. Under the new audit regime, and unless otherwise elected, the IRS will assess and collect tax, penalties, and interest attributable to audit adjustments at the partnership level, leaving it up to the partnership as an entity to pay (and then pass any liability on to its partners). Depending upon which procedure the partnership elects, and the audit year in question, it is possible that current partners could find themselves on the hook for a deficiency attributable to years in which such partner did not hold a partnership interest.
Some partnerships (and LLC’s taxable as partnerships) may elect out of these new procedures altogether. The ability to elect out is limited to partnerships with 100 partners or less and various ownership and look-through rules apply; most notably, tiered partnerships (i.e., partnerships with other partnerships as partners) are not eligible to elect out of the new regime.
The new rules also substitute the concept of a “Partnership Representative” for the TEFRA-era Tax Matters Partner. The Partnership Representative is to serve as the sole liaison between the partnership and the IRS and shall have the authority to bind the partnership in such dealings.
In its current form, the new audit rules leave many issues and questions unanswered. Given the delayed effective date, the IRS is entertaining comments and the expectation is that additional guidance will be provided. In the interim, partnerships (and LLC’s taxable as partnerships) should consider the impact of these new rules on their existing and future agreements.