Changes to Pass-Through Entities

​The Tax Cuts and Jobs Act of 2017 made sweeping changes to U.S. tax law. Given the magnitude of some of the changes, there are a number of changes relating to pass-through entities that may be overlooked. These changes are discussed below.

Elimination of Technical Termination of Partnership

Under prior law, a partnership was terminated if no part of the business of the partnership continued to be carried on by any of its partners in a partnership. In addition, a “technical termination” of the partnership was deemed to occur if, within any 12-month period, there was a sale or exchange of 50% or more of the total interest in partnership capital and profits. 

The new law, effective for partnership tax years beginning after December 31, 2017, eliminates the “technical termination” provision. Therefore, a partnership is only terminated when its partners no longer carry on any business in the partnership. This change is welcome relief for taxpayers who previously would have had to file a final and initial tax return and re-start asset depreciation periods, among other extremely inconvenient consequences of a technical termination.

Sale of a Partnership Interest by a Non-Resident Alien Is Taxable

The IRS previously took the position that the gain or loss of a foreign partner from a disposition of an interest in a partnership that conducts a trade or business through a fixed place of business or has a permanent establishment in the U.S. is taxable in the U.S. (Revenue Ruling 91-32). However, in Grecian Magnesite Mining, Industrial & Shipping Co., (2017) 149 TC No 3, the Tax Court rejected the IRS position and held that a foreign corporation's gain on the sale of an interest in a partnership that is engaged in a U.S. trade or business is not U.S. source income and is not effectively connected with a U.S. trade or business. In other words, the Tax Court held that the gain on sale of such partnership interest was not subject to U.S. tax.

Under the new tax reform law, however, for sales and exchanges occurring on or after November 27, 2017, gain or loss from the sale or exchange of a partnership interest by a non-resident alien is subject to income tax in the U.S. The gain or loss is equal to the hypothetical effectively connected gain or loss the partnership would report if it sold all of its assets at fair market value as of the date of the sale or exchange. Any gain or loss from the hypothetical asset sale by the partnership must be allocated to interests in the partnership in the same manner as non-separately stated income and loss.

Withholding Requirements on Sales, Exchanges and Dispositions of a Partnership Interest 

For sales, exchanges, and dispositions after December 31, 2017, the transferee (buyer) of a partnership interest must withhold 10% of the amount realized on the sale or exchange of a partnership interest unless the transferor (seller) certifies that the transferor is not a non-resident alien individual or foreign corporation.  

This is a new requirement that must be satisfied in the case of any sale or exchange of a partnership interest. Therefore, sellers should be prepared to certify that they are not a non-resident alien individual or foreign corporation. Buyers should request such certification or withhold 10% at closing. Attorneys will presumably add these certification statements to their legal process for drafting documents to close such sales; however, buyers and sellers of partnership interests should be on notice regarding these new requirements.

Partnership “Substantial Built-In Loss” Update

Under prior law, the tax basis of partnership property was not adjusted as a result of a transfer of a partnership interest unless the partnership had made a step-up election under IRC §754, or the partnership had a substantial built-in loss at the time of the transfer. A “substantial built-in loss” exists if the partnership’s tax basis in partnership assets exceeds the fair market value of the assets by more than $250,000 (“overall built-in loss”). In such cases, a mandatory step-down in the tax basis of the assets to fair market value is required.

The new law expands the mandatory step-down provision to include situations where a transferee partner would be allocated a loss of more than $250,000 if the partnership were to sell all of its assets at fair market value on the date the transferee partner is admitted, even if there is no overall built-in loss.

Basis Reduction for Partnership Charitable Contributions Amended

The Tax Cuts and Jobs Act provides that, in determining the amount of a partner's allowable loss, the partner's distributive share of partnership charitable contributions and taxes paid or accrued to foreign countries or U.S. possessions is taken into account. 

S-Corporation to C Corporation Conversion Rules

With lower corporate tax rates, some profitable S-Corporations may wish to revisit the benefits of income deferral available through a C-Corporation structure. However, revocation of an S-Corporation election can have negative implications. The new law includes two important temporary changes related to such conversions.

Extended IRC §481(a) Pay-Back Period on S-Corporation to C-Corporation Conversions

Converting from an S-Corporation to a C-Corporation may result in a required change of accounting method (i.e. cash to accrual method), which could result in tax due. This tax due amount is referred to as a Section 481(a) adjustment and may typically be paid to the IRS over a 4 year period. Under the new law, the payback period is extended to 6 years and is available for existing S-Corporations that convert to a C-Corporation between December 22, 2017 and December 21, 2019 and maintain the same ownership as on December 22, 2017.

Pro-Rata Treatment of Distributions as Tax-Free (AAA) and Taxable Dividends After Post-Termination Transition Period (“PTTP”)

Under existing law, there is a one year period (the “PTTP”) after converting from an S-Corporation to a C-Corporation whereby distributions of S-Corporation earnings which were already taxed at the shareholder level but not distributed by the time of a conversion to a C-Corporation are tax free. The amount of income eligible for tax-free treatment is tracked under the Accumulated Adjustment Account (“AAA”) during the life as an S Corporation. The new law effectively allows for tax-free distributions of previously earned AAA beyond the PTTP time limit by allowing a pro-rata allocation of distributions between the previously earned AAA and the new C-Corporation’s earnings and profits.

It should be noted that the benefit of either of these changes appears to apply only if the S-Corporation election is terminated and not revoked. 

This information is based on the statutes and guidance available as of the date of publication (January 2018) and is subject to change.