Despite all the press coverage and sound bites from presidential candidates, comprehensive tax reform is not likely, at least not during the final years of President Obama’s administration.
One reason is because one entity’s "loophole" is another's economic incentive, which is in direct conflict with the overall goal of tax reform being to simplify the code and reduce overall tax rates. Each benefit in the tax code has political champions who prefer to pay for lower rates by eliminating someone else's benefit. Any actual overhaul would require picking winners and losers among those groups, all of whom have allies in Congress. This is why tax reform is so hard. Even within political parties, there is no consensus as to which benefits to eliminate since each region of the country has different economic interests.
While some have suggested pursuing corporate tax reform first, individual provisions of the code must also be addressed since most small businesses are conducted via pass-through entities (i.e., partnerships and S corporations). Once the individual provisions of the code are on the table, we believe the process becomes too complex and political to be accomplished in the short time before the 2016 presidential campaign hits full stride.
This is not to say we won’t have significant changes in the federal tax law during 2015. We expect that the proposed regulations on partnership liability allocations will be finalized this year. Also, the tax extenders legislation passed in December only addressed various provisions for 2014. We expect those that expired to be addressed for 2015, and possibly 2016, sometime this year.
IRS proposed changes to liability allocation rules
The IRS has issued long anticipated changes to the section 752 regulations. These proposed regulations would significantly impact how partnerships allocate their liabilities to their owners for at-risk and basis purposes. The intent of the proposed regulations is to end so-called “paper guarantees” and to ensure that guarantees are commercially reasonable in order to be respected for at-risk purposes.
If adopted, these changes would curtail the use of bottom guarantees, impose net worth requirements on guarantors, and potentially impact how nonrecourse liabilities are allocated. While we cannot be sure of the final language, we do expect the proposed regulations to be adopted in some form during the current year.
Bottom guarantees are sometimes used to defer the recognition of negative tax capital accounts, thereby delaying the recognition of “phantom income” (i.e., taxable income without the corresponding cash).
To accomplish the IRS’s objectives, the proposed regulation:
- require that the guarantee meet six factors in order to be recognized for purposes of section 752; and
- state that the guarantee is only recognized to the extent of the net value of the partner or related guarantor.
The following is a brief synopsis of the major provisions contain in the proposed regulations.
Under the proposed regulations a guarantee must meet all of the following requirements to be recognized for purposes of section 752.
- The partner or related person must maintain a commercially reasonable net worth through the term of the debt, or be subject to commercially reasonable restrictions on transfers of assets for inadequate consideration. See additional discussion below for application of this provision to individuals and estates.
- The guarantor must periodically provide reasonable documentation to the partnership regarding their financial condition.
- The term of the obligation does not end prior to the term of the liability.
- The guarantee does not require the primary obligator (the partnership) or any other obligator, to hold money or other liquid assets that exceed the reasonable needs of the obligator.
- The guarantor receives arm’s-length consideration for entering into the guarantee.
- No indemnity or reimbursement arrangement exists with another party.
Commentary: Several of these factors do not appear to be how taxpayers regularly structure their transactions and may be difficult to implement if adopted as final. For example, the rules require a fee to be paid for credit support in order for the resulting guarantee to work. However, it is standard commercial practice for an owner to guarantee entity-level debt without receiving a fee for doing so. In addition, many times guarantors are unwilling to provide their net worth financial information to the partnership. Yet, the IRS is requiring such data but does not provide any guidance as to what constitutes “reasonable documentation.”
Net value requirement
Currently, guarantees made by disregarded tax entities are respected only to the extent of the disregarded entity’s net worth. Guarantees made by any other taxpayer are assumed to be valid. The proposed regulations extend the net value requirement to all partners or related entities, other than individuals and decedent’s estates. While individuals and estates are not currently included in this net value requirement, the IRS has requested comments on whether or how to extend this requirement in the final regulations. We are of the opinion that the net value requirement will be extended to individuals in the final regulations.
The proposed regulations would end so-called bottom guarantee arrangements where partners guarantee the least risky portion of the debt. Such transactions are typically entered into in order to defer recognition of a negative capital account.
Example: Guarantee of first and last dollars. A, B, and C are equal members of limited liability company, ABC, that is treated as a partnership for federal tax purposes. ABC borrows $1,000 from Bank. Partner A guarantees payment of up to $300 if any amount of the full $1,000 liability is not recovered by the Bank. Partner B guarantees payment of up to $200, but only if the Bank otherwise recovers less than $200.
- A is obligated to pay up to $300 if, and to the extent that, any amount of the $1,000 partnership liability is not recovered by Bank. Since A's guarantee covers the riskiest portion of the debt, it would be respected under the proposed regulations and the $300 liability would be allocated to A for basis purposes.
- However, because B is obligated to pay up to $200 only if and to the extent that the Bank otherwise recovers less than $200 of the $1,000 partnership liability (a bottom dollar guarantee), B's guarantee does not satisfy the requirements under the proposed regulations and B’s guarantee is not recognized. As a result B does not receive a special allocation of the $200 for basis purposes; rather that debt is allocable to all partners as nonrecourse debt.
Tax extender provisions
Numerous tax provisions commonly known as “extenders” expired at the end of 2014. At this time, the House Ways and Means Committee Chairman Paul Ryan has indicated he intends to advance extenders legislation this summer. As we go to press, there is no indication as to if or when the full House or Senate would extend any specific provision. However, as previously discussed, major tax reform in the current year is highly unlikely so we expect that extenders will be addressed during the fall. The following is a list of some of the major extenders:
- 50 percent bonus depreciation
- Fifteen-year straight-line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements
- Treatment of certain real property as section 179 property
- Research tax credit
- New Markets Tax Credit
- Employer wage credit for employees who are active duty members of the uniformed services
- Work Opportunity Tax Credit
- Enhanced charitable deduction for contributions of food inventory
- Basis adjustment to stock of S corporations making charitable contributions of property
- Reduction in S-corporation recognition period for built-in gains tax
- Empowerment zone tax incentives
- Treatment of certain dividends of regulated investment companies
- Regulated investment company qualified investment entity treatment under the Foreign Investment in Real Property Tax Act (FIRPTA)
- Subpart F exception for active financing income
- Look-through treatment of payments between related controlled foreign corporations under foreign personal holding company rules
- Temporary exclusion of 100 percent of gain on certain small business stock
- Special rule for contributions of capital gain real property made for conservation purposes
- Tax-free distributions from individual retirement plans for charitable purposes
- Deduction for certain expenses of elementary and secondary school teachers
- Exclusion from gross income of discharge of qualified principal residence indebtedness
- Parity for employer-provided mass transit and parking benefits
- Mortgage insurance premiums treated as qualified residence interest
- Deduction of state and local general sales taxes
- Above-the-line deduction for qualified tuition and related expenses
- Credit for nonbusiness energy property
- Second-generation biofuel producer credit
- Incentives for biodiesel and renewable diesel
- Credit for energy-efficient new homes
- Energy-efficient commercial buildings deduction
- Excise tax credits relating to certain fuels
Fee waiver guidance
The IRS is looking to issue regulations in the coming months in the area of fee waivers. This is an area of particular concern to fund managers, particularly in the private equity area. Broadly stated, fee waivers are often used to shift earnings for managing funds from service fees taxed at ordinary rates to carried interests eligible for capital gain treatment. Fund managers frequently waive the right to receive such fees, typically priced at two percent, in exchange for a higher carried interest.
A senior IRS attorney recently told tax practitioners that the project is largely complete and will be released in a matter of months. The regulations are expected to contain provisions that will require any fee waiver have a significant entrepreneurial risk of payment. Numerous factors to define significant risk can be expected.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.