Tax Reform’s Likely Impact On Domestic M&A

January 24, 2018Articles Law360

The Tax Cuts and Jobs Act, enacted on Dec. 22, 2017, contains several provisions that significantly affect the federal income tax consequences of structures often used in domestic mergers and acquisitions. These are the pass-through provisions of Section 199A, provisions relating to treatment of carried interests, changes related to treatment of certain intellectual property, and imposition of tax (and withholding obligations) in connection with a foreign person’s sale of interests in a partnership that has effectively connected income.[1] The act contains a number of ambiguities, which makes application uncertain, and we expect and hope for clarifying regulations to be issued and technical corrections to be enacted. Until then, taxpayers and their advisers must tread carefully, relying on legislative history and, in certain cases, pre-act authorities to determine the scope and application of these provisions.

Pass-Through Deduction

The act adopts a new Section 199A providing noncorporate taxpayers with a deduction associated with qualified business income (QBI). The deduction applies to tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, and reduces taxable income, and is available to taxpayers regardless of whether they itemize deductions. Subject to an overall limitation that the deduction cannot exceed taxable income reduced by net capital gain, the deduction is calculated based on a series of if/then analyses. First, taxpayers determine (A) the combined qualified business income amount (CQBI, see below) or (B) an amount equal to 20 percent of the taxpayer’s taxable income for the taxable year reduced by net capital gains and further reduced by qualified cooperative dividends of the taxpayer for the taxable year.[2] Then, the lesser of 20 percent of aggregate qualified cooperative dividends of the taxpayer or taxable income reduced by net capital gain is added to the lower of A or B to obtain the taxpayer’s deduction.[3] This deduction is calculated based on income separately derived from each of a taxpayer’s qualified trade or business (QTB).

CQBI is essentially 20 percent of QBI with respect to each QTB subject to a wage-based cap discussed below.[4] QBI is included in CQBI if it is equal to or lower than the greater of a wage-based test (the wage limit). The wage limit is (i) 50 percent of the QTB’s W-2 wages or (ii) 25 percent of the QTB’s W-2 wages plus 2.5 percent of the unadjusted basis of its qualified property determined immediately after acquisition.[5] Generally, taxpayers with a QTB that has low wages or levels of capital investment in qualified property will be limited by the wage limit rather than 20 percent of QBI.

The wage limit does not apply if the taxpayer’s taxable income does not exceed a threshold amount of $157,500 ($315,000 in case of a joint return), subject to adjustment for inflation.[6] If the taxpayer’s taxable income exceeds the threshold amount by an amount equal to or less than $50,000 ($100,000 in case of a joint return), then instead of using the wage limit, the amount used to calculate CQBI is the QBI for such QTB reduced by an amount called the excess amount, which is phased out.

In general, qualified property is, with respect to any QTB, depreciable tangible property that has not been fully depreciated using a hybrid depreciation schedule.

Qualified business income, or QBI, means for any taxable year, the net amount of qualified items of income gain and loss of deductions with respect to the QTB, excluding qualified real estate investment trust dividends, qualified cooperative dividends or qualified publicly traded partnership income. Any QBI that results in a loss is treated as a loss from the QTB in the succeeding taxable year.[7] Qualified items are those that are effectively connected with the conduct of a U.S. trade or business using concepts under Section 864(c). See Section 199A(c)(3) for exclusions of certain investment income. QBI also will not include amounts paid by the QTB to the taxpayer that are reasonable compensation, Section 707(c) guaranteed payments and certain Section 707(a) payments.[8]

There has been quite a bit of hullabaloo over what constitutes a qualified business, and its definition is quite broad. A qualified business includes any trade or business other than a specified service trade or business (a tainted service business) or the trade or business of performing services as an employee. The tainted service business generally includes any trade or business involving the performance of various investment services, and services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees.[9] The act’s legislative history references Treasury Regulations Section 1.448-1T(e)(4(ii), suggesting that a tainted service business in the health field is not intended to apply to the provision of services not directly related to a medical field, such as health clubs and health spas. Moreover, the final version of the act eliminated references to engineering and architecture, but included a reference to the reputation and skill of both owners and employees. It is unclear how this will ultimately be applied.

The taint of tainted service business for taxpayers with taxable income less than the threshold amount plus $50,000 (or $100,000 in the case of a joint return) is removed, but the deduction is phased out with respect to taxable income between the threshold amount and the threshold amount plus $50,000 ($100,000 for joint returns).

The deduction for S corporations and partnerships is applied at the partner or shareholder level. Section 199A(f)(1)(A). Moreover, while the calculation of QBI is made for each QTB, Congress did not address its application to tiered entities and instead authorized the U.S. Department of the Treasury to issue regulations for reporting and allocating items.[10]

Partnership Interests Held in Connection with the Performance of Services

The act adds new Section 1061, which provides that, subject to certain exceptions discussed below, net long-term capital gain with respect to an “applicable partnership interest” is recharacterized as short-term capital gain (taxable at ordinary income tax rates) if the asset that gave rise to such gain was held for not more than three years.

An “applicable partnership interest” is generally a profits interest (also known as a carried interest in the private equity context). Specifically, an “applicable partnership interest” means any interest in a partnership that, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any “applicable trade or business.” Whether a taxpayer included an amount in income upon receipt of the interest, or made a Section 83(b) election with respect to such an interest, does not change the more than three-year holding period requirement. An applicable partnership interest does not, however, include: (1) any partnership interest held directly or indirectly by a corporation; or (2) any capital interest in the partnership that provides the taxpayer with a right to share in partnership capital commensurate with: (i) the amount of capital contributed (determined at the time of receipt of such partnership interest); or (ii) the value of such interest subject to tax under Section 83 upon the receipt or vesting of such interest. An interest held by an individual employed by another entity that is conducting a trade or business (which is not an applicable trade or business) and who provides services only to that other entity is not an applicable partnership interest.

An “applicable trade or business” generally means any activity conducted on a regular, continuous and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists (in whole or in part) of: (1) raising or returning capital, and (2) either (a) investing in (or disposing of) “specified assets” (or identifying “specified assets” for such investing or disposition) or (b) developing “specified assets.”

Specified assets are generally investment-type assets, including securities (e.g., stocks and bonds), commodities, cash and cash equivalents, real estate held for rental or investment, and partnership interests, to the extent of the partnership’s proportionate interest in any of the foregoing.

If the taxpayer transfers an applicable partnership interest to a related person the taxpayer is required to include in income, as short-term capital gain, the amount of gain with respect to such interest attributable to the sale or exchange of any asset held for not more than three years as is allocable to the interest.

Interpretative uncertainties regarding the application of the provision abound. The Internal Revenue Service is authorized to issue regulations and guidance to carry out the intent of the provision, including excepting income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors.

The provision is effective for tax years beginning after Dec. 31, 2017.

Ordinary Income on Disposition of Patents and Similar Assets

The act provides that gain on the sale of certain self-created patents, inventions, models or designs (regardless of whether patented), and secret formulas and processes (collectively, patents and similar assets) may not qualify for the preferential long-term capital gain rate, effective for dispositions after Dec. 31, 2017. Specifically, the act amends Section 1221(a)(3) to provide that the term “capital asset” does not include patents and similar assets held by a taxpayer “whose personal efforts created such property” or by a taxpayer whose tax basis in the patents and similar assets is determined in whole or part by reference to the tax basis of such property in the hands of a person whose personal efforts created such property. The act also prevents patents and similar assets described in Section 1221(a)(3) from being included in the calculation of Section 1231 gains or Section 1231 losses.

The act does not repeal Section 1235, which generally provides for the sale or exchange of all substantial right to a patent (or patentable items) by an individual whose efforts created such property, or by an individual who acquired their interest in such property in exchange for consideration in money or money's worth paid to the individual creator prior to actual reduction to practice of the invention covered by such property (if such individual is not the creator’s employer, and is not related to the creator).

An individual inventor can qualify for long-term capital gain with respect to the sale of a patent (or patentable items) subject to the rules and limitations of Section 1235, including with respect to certain patents contributed to a partnership by such individual, or created by such individual using partnership property with the understanding that the patent, when issued, would become partnership property.[11] However, it appears that long-term capital gain treatment should not apply to an S corporation, or to a partnership with respect to patents not created by individual partners.[12]

Treatment of Gains and Losses by Foreign Persons From the Sale of an Interest in a Partnership That is Engaged in a U.S. Trade or Business

The act provides that gain or loss from the sale or exchange of a partnership interest by a nonresident alien or a foreign corporation is subject to federal income tax at graduated income tax rates to the extent that the seller of the interest would have had income that is effectively connected with a U.S. trade or business had the partnership sold its assets.[13] The act is generally consistent with Revenue Ruling 91-32, 1991-1 C.B. 107, and overturns Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (2017), which held that a foreign person’s gain or loss from the sale of an interest in a partnership that is engaged in a U.S. trade or business is foreign-source income and not subject to U.S. tax.

The act also adds a new Section 1446(f), effective Jan. 1, 2018, which requires the transferee to withhold 10 percent of the amount realized on the disposition, and requires the partnership to withhold such amount from distributions to the transferee if the transferee fails to withhold. Notably, the amount realized presumably would include the amount of partnership liabilities from which the transferor is relieved, under Section 752. Thus, the amount of withholding could be significantly greater than 10 percent of amounts actually paid by the transferee. In addition, Section 1446(f) permits the transferor and the transferee to request that the IRS agree to a lower amount to be withheld, if this would not jeopardize the collection of federal income tax.

The act expressly authorizes the Treasury Department to issue guidance addressing the treatment of exchanges under Sections 332, 351, 345, 355, 356 and 361. Additional guidance would also be useful to determine how the provisions would apply to persons who qualify for treaty benefits, whether debt relief under Section 752 would be taken into account for the purposes of Section 1446(f), and whether Section 1446(f) will incorporate procedures similar to the ones issued under Section 1445(c) that apply for purposes of reducing withholding under the Foreign Investment in Real Property Tax Act of 1990.

Reprinted with permission from the January 24 issue of Law360. (c) 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.