(Editor’s note: This is part 1 of a two-part column on new tax regulations for pass-through entities. See part 2 here.)
As a result of the federal tax reform passed in 2017, pass-through entities such as S corporations, partnerships and LLCs face several new tax compliance requirements. Four of the provisions impact pass-through entities significantly and require immediate attention. Although these changes may not affect it directly, the entity must collect and report certain information to help its owners comply with IRS regulations.
- Business interest expense limitation: Section 163(j) severely limits taxpayers’ ability to deduct business interest expenses. Under prior law, business interest was disallowed only in specific circumstances, such as when interest was paid to a related party and no federal income tax was imposed. Under the new law, however, almost all business interest is capped at 30%. Other than small businesses, who are not bound by this limitation, businesses can deduct interest expense only up to the sum of: business interest income; 30% of the taxpayer’s adjusted taxable income; and the taxpayer’s floor plan financing interest for the taxable year, which only applies to dealers of certain motor vehicles.
Any excess interest can be carried forward indefinitely, but it must be done so at the owner level. When this happens in a partnership, the carried-over interest reduces the partner’s outside basis in the business. Partners can deduct this expense in future years only when the business entity reports excess interest income over interest expense that year, or when the entity reports excess taxable income. Determining ETI is a complex, multistep calculation that is based off the partnership’s taxable income and the amount of business interest it can deduct under Section 163(j).
For a partner to calculate how much of a business interest expense deduction he or she can take in a given year, the partnership must disclose additional information on Form K-1.
- Box 20, Codes AE & AF: Excess Taxable Income & Excess Business Interest Income: Both ETI and excess business interest income dictate the amount of carried-over interest expense that can be utilized, so these amounts must be reported to the partners.
- Box 13, Code K: Excess Business Interest Expense: Excess business interest expense must be reported on Schedule K-1 so the taxpayer knows how much to carry forward until they have ETI or excess business interest income to offset it.
- New holding period for carried interest: Taxpayers with applicable partnership interests received in connection with the performance of services may need to reclassify the gains they recognize on the carried interest they report. Carried interest is a form of profit-sharing compensation paid to general partners of investment or private equity funds, paid out when the fund sells one or more of its investments.
Carried interest has historically been taxed as a capital gain rather than ordinary income. Long-term capital gains are taxed at preferential rates kept at a maximum of 20%, while ordinary income – wages and salaries – is taxed at the taxpayer’s marginal tax rate, which can creep as high as 37%. The reform legislation upheld this preferential tax treatment for carried interest but limited it to gains that have at least a three-year holding period.
This new limitation will require partnerships to report additional information about their capital gains.
The partnership must specify the amount of the long-term capital gain reported on the partner’s Schedule K-1, Line 9A, that results from property held for more than three years, and the amount attributable to property held for three years or less. n
Tracy Dalpe and Kristen Terceira are tax directors and members of the Private Equity & Venture Capital Practice in the New England office of CBIZ & MHM.
