2018 was a very active year for tax developments. The big story was the application of the substantial reforms of the Tax Cuts and Jobs Act of 2017, which took initial effect in 2018. But there were several other developments in the 2018 tax world as well. It is hard to come up with just five areas to discuss, but here are the ones that lit up my desk. Obviously, these highlights provide only a very high-level view. If you would like additional information or have questions, we'll be happy to assist you.
1. New IRS Partnership Audit Rules. New rules that change the way that partnership entities are audited took effect on January 1, 2018 (they were enacted by the Bipartisan Budget Act of 2015, but implementation was delayed). Partnership entities include all entities that are taxed as partnerships under federal tax law, including traditional partnerships (limited and general partnerships) and modern entities that are taxed as partnerships (LLCs, PLLCs, LLPs, and PLLPs). The rules depart fundamentally from prior rules, by focusing audit adjustments at the partnership level so that the assessment and collection of underpaid tax, penalties, and other additions to tax will now be imposed as a matter of default at the partnership level, rather than at the partner level. This was done in part because of the difficulty the IRS was having auditing large partnerships, which were growing in number, and applying adjustments to the myriad of partners. Thus, the new rules potentially impose partnership-level tax and give rise to considerable complexity when considering how to ensure that the correct partners ultimately bear the economic burden of adjustments. Issues can arise in this regard particularly where there has been a change in partnership membership between the year in which the adjustment is determined and the tax year to which it relates because the adjustment liability attaches to the year in which it is made.
The new rules are expected to substantially increase the number of partnership audits and the amount of tax generated by partnership audits. Partnerships subject to the rules must designate a "Partnership Representative," who has the sole authority to deal directly with the IRS during a partnership audit. Certain partnerships with 100 partners or less and where each partner is an individual, C corporation, S corporation, foreign entity treated as a C corporation or an estate of a deceased partner may elect out of the rules. The rules also provide mechanisms to push the relevant audit adjustment to the correct partners. Most partnerships will have to amend their operating agreements to take account of these new rules. For more information, read our legal update: "New IRS Partnership/LLC Rules Require Your Immediate Action."
2. 20 Percent Pass Through Deduction. The Tax Cuts and Jobs Act of 2017 (“TCJA”) enacted Section 199A of the Internal Revenue Code, which allows for owners of sole proprietorships, S corporations, or entities taxed as partnerships to deduct up to 20 percent of their "qualified business income" from the business (which basically is the net income of the business subject to some adjustments). This helps to level the playing field with C corporations, given that the corporate tax rate was lowered by the TCJA to 21 percent. The new deduction is subject to many restrictions and limitations, however, especially where "specified service businesses" are concerned. In general, a taxpayer may qualify for the full deduction no matter what business he/she is in, if the taxable amount is below $157,500 (single) or $315,000 (married filing jointly). Above these income thresholds, there is a phase out of the deduction for specified service business income, with the phase out complete at taxable income of $207,500 (single) or $415,000 (married filing jointly).
Specified service businesses include trades or businesses involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners. Engineering and architecture services are specifically excluded from the definition (those professions presumably had good lobbyists!). An additional set of limitations apply to taxpayers having taxable incomes above the limited threshold ($157,500/$315,000) that are not specified service businesses that limit the deduction to an amount based on W2 wages paid by the business or W2 wages and qualified property used in the business.
3. Qualified Opportunity Zone Funds. Another TCJA creation, the idea here is to incentivize investment in low income communities – specifically those designated and approved as “qualified opportunity zones.” If a taxpayer has generated a capital gain, the taxation of such gain can be deferred by investing a similar amount of cash in a Qualified Opportunity Fund (“QOF”). The reinvestment of the gain proceeds must be made within 180 days of the date the original gain was recognized. The provisions allow deferral of the original gain until the earlier of a disposition of the QOF interest or the end of 2026. The provisions also allow a small increase in the basis of the investor's QOF interest after five and seven years, respectively (that basis starts at zero). Interrelating these basis adjustment benefits with the 2026 drop dead date for QOF benefits, in practice means that the QOF investment would have to be made by December 31, 2019 for full benefits to be available.
There are many other complex rules relating to what property a QOF may hold and other matters, as well as how it must be constituted. While some Treasury Regulations have been issued, more are anticipated, as there are many areas of remaining uncertainty in interpreting the statutory provisions. Nonetheless, the rules have received a lot of interest, both from small investors interested in making a single investment to hold long term (such as rental property), as well as larger fund groups looking to establish more complex QOFs holding multiple assets. For more information, refer to our article in EDGE Magazine "Opportunity Zones offer incentive to investors and developers" or contact a member of our Real Estate team.
4. Corporate International Provisions. The TCJA effected major international tax reform focused mainly on US multinational groups, but the reform can also apply elsewhere. US multinational groups have long been at a tax competitive disadvantage relative to many Canadian and European competitors. This is mainly because the competitor home countries typically have rules allowing a home country parent to repatriate dividends from a foreign subsidiary free of home country tax, provided the subsidiary paid a minimum level of tax in its operating jurisdiction. The US, on the other hand, subjected the repatriation to US tax, subject to a foreign tax credit. Simply put, the result was that the US group paid the higher of the US rate or the subsidiary country rates on the dividends received (and US rates, before TCJA, were among the highest in the world). Arguably in part as a result, many US multinationals kept foreign earnings offshore.
The TCJA now makes available to US controlled multinational groups a “participation exemption” whereby, in essence, foreign subsidiary profits may be repatriated without US tax (but no foreign tax credit is allowed for the repatriation). It's not that simple, though, and other related provisions ensure that at least a certain level of tax is paid in the subsidiary's operating jurisdiction. Furthermore, a one-time US tax (at a reduced rate of 8 percent or 15.5 percent, depending on how those earnings are held, and with the opportunity to pay over an 8-year period) is imposed on post-1986 earnings and profits of the foreign subsidiaries, to make sure that at least some US tax is imposed on those earnings.
Related provisions include the so-called “Global Intangible Low Taxed Income” (“GILTI") rules. These rules assume that other than a certain deemed return on a foreign subsidiary's fixed assets (essentially 10 percent), the rest of its income is intangible income. The GILTI rules then include the intangible income in the US parent's income, subject to a 50 percent deduction and 80 percent foreign tax credit. The end result is that GILTI is subject to some US tax unless it has been taxed to the subsidiary in its home country at a rate of at least 13.125 percent. The GILTI rules thus work with the participation exemption to ensure that a US group's foreign subsidiary income is subject to a minimum threshold of tax. However, the GILTI rules also are part of a set of rules to encourage US multinationals to own intangible assets in the United States, not overseas. GILTI is often described as a “stick” to punish foreign intangible ownership by US groups with at least a minimum level of tax. The “carrot” is found in rules relating to “foreign derived intangible income" (“FDII”). These rules basically mirror the GILTI rules, allowing foreign source income from deemed intangible income of US corporations (computed similarly to GILTI) also to be taxed at a rate of 13.125 percent. The idea is that the tax incentives for US multinational groups to move intangibles (and their associated income) offshore is eliminated.
5. South Dakota v. Wayfair. The US Supreme Court, in a 5-4 opinion penned by Justice Kennedy prior to his recent retirement, overturned over 50 years of precedent regarding sales taxes. Until Wayfair, retailers engaging in interstate sales had been able to rely on a bright-line standard that meant they did not have to collect destination state sales taxes unless they had nexus based on having a physical presence in that state. The standard was founded in US Supreme Court constitutional cases, most prominently, National Bellas Hess, decided back in 1967, and Quill, decided 25 years later in 1992. That physical presence standard for nexus was eliminated in Wayfair in favor of an economic presence standard for nexus. Rather than affirming the rigid physical presence standard previously adopted by the Court in National Bellas Hess and Quill, the Wayfair Court's new economic presence standard permits states to require out-of-state businesses to register for and collect sales taxes based on activities such as the number of transactions occurring in the state or having certain sales volume derived from the state. The Wayfair case can be seen as part of an onslaught over the years by states challenging the physical presence standard, and businesses and trade association groups pushing back, resulting in significant litigation at the state level. In recent years, several states had enacted laws or passed regulations attempting to skirt the physical presence standard, arguing that times had changed, and that the old standard was devised before the internet changed the world of sales and distribution. They also argued, as did South Dakota in Wayfair, that the status quo was causing large revenue losses because of the difficulty in collecting use taxes from purchasers of products and services (South Dakota argued it was losing up to $58 million annually). Many states had joined in an amicus brief in support of South Dakota in Wayfair. Justice Kennedy in Wayfair cited evidence that states could be losing up to $33 billion of sales taxes annually. Since the Wayfair decision was issued, many states have now passed laws introducing standards similar to those enacted by South Dakota, which were based on the number of transactions a retailer had in the state, and/or total sales volume in the state.
Most every business will need to evaluate whether its tax compliance function adequately addresses the input of Wayfair and the laws of the states in which they might have an economic preserve. For more information, read Substantial Sales Tax Implications for Vendors Selling Product Across State Lines.