How the Broad Definition of Tax Shelter Affects Business Interest Deductions and Cash Method Accounting under New Tax Law (article)
Update: Shortly after publication of this article, new legislation was enacted that corrects the definition of a “limited entrepreneur” with respect to a tax shelter, now referring to the same definition used for a farming syndicate (we observed in our original article that this likely was the correct definition). Following is the original version of our article.
The new tax law expands the availability of the cash method of accounting, as well as a new restriction on business interest expense deductions. Both of these provisions are subject to a “small business” threshold, where the cash method is available to a qualifying business, and where the business interest expense limitation does not apply to a qualifying business. Both of these provisions, however, are unavailable to any business defined as a “tax shelter,” regardless of the business size. The dramatic implications of the tax shelter designation cannot be overstated. Because the definition of a tax shelter is much broader than is generally understood, many businesses may be caught off-guard by the unfortunate consequences.
Cash Method and Business Interest Expense Limitation
First, the good news about these two provisions. Businesses that meet the definition of a small business, other than tax shelters, generally may use the cash method of accounting, and are exempt from the new business interest expense limitation. A small business for these purposes is one that meets a $25 million average annual gross receipts threshold. In the case of the cash method of accounting, this threshold is substantially higher than the previous $1 million, $5 million, and $10 million thresholds that applied under former law. And better yet, a small business now can use the cash method of accounting even if it maintains inventory as an income-producing factor.
The change under the new tax law (informally the Tax Cuts and Jobs Act or TCJA) to the business interest expense deduction rules limits the deduction to the sum of business interest income, “floor plan financing interest,” and 30 percent of a taxpayer’s “adjusted taxable income.” For tax years beginning before Jan. 1, 2022, adjusted taxable income means taxable income, excluding the following items:
- Business interest expense and business interest income;
- Any net operating loss deduction;
- Any deduction for qualified business income under Section 199A;
- Any item not properly allocable to a trade or business; and notably,
- Depreciation, amortization, or depletion.
Hence, adjusted taxable income essentially is earnings before interest, taxes, depreciation, and amortization (EBITDA) for tax years beginning before Jan. 1, 2022. For tax years beginning after Dec. 31, 2021, the final exclusion item for depreciation, amortization, or depletion is removed, generally making a taxpayer’s EBIT the reference. For limitation purposes, a higher adjusted taxable income is desirable, as that will yield a higher 30 percent limitation amount. As stated previously, the new business interest expense limitation does not apply to a “small business” that is not a tax shelter.
The $25 million threshold of a small business is applied in the same manner with respect to the cash method of accounting and the business interest expense limitation. For these purposes, average gross receipts are the average of the gross receipts for the three tax years prior to the current tax year. Special rules apply for businesses that have not been in existence for the entirety of this three-year period.
Additionally, for these purposes, businesses are subject to aggregation rules to determine the $25 million amount for a given year. These rules are extremely complex and have been in the Internal Revenue Code for other purposes for decades.
Under the aggregation rules, the gross receipts from multiple businesses must be aggregated where they meet either a “controlled group” ownership test or an affiliated service group (ASG) test. A controlled group generally exists when there is greater than 50 percent common control (based upon identical ownership of five or fewer individuals, estates, or trusts) among each business.
The ASG test is not based on a percentage of ownership test. Instead, members of an ASG are part of a controlled group generally when a first service organization (FSO) has a relationship with another service organization that is a shareholder or partner in the FSO, and the other service organization regularly performs services for the FSO or is regularly associated with the FSO in performing services for a third person, or generally when the FSO utilizes any other organization held by highly compensated employees of the FSO where the other organization performs services for the FSO.
If multiple businesses meet either the controlled group or ASG tests, then the gross receipts of the multiple businesses must be aggregated when determining the $25 million small business threshold. Nevertheless, a tax shelter may not use the cash method of accounting, and a tax shelter may not use the business interest expense limitation, regardless of the tax shelter’s average annual gross receipts. The definition of a tax shelter therefore becomes a critical factor in determining tax consequences for a business that otherwise could be a small business.
What is the Definition of a Tax Shelter?
A tax shelter includes any entity, plan, or arrangement where a significant purpose of the entity, plan, or arrangement is the avoidance or evasion of federal income tax. A tax shelter also includes any enterprise (other than a C corporation) that has had interests offered for sale in an offering required to be registered with any federal or state regulatory agency. These first two definitions are not surprising, and they conform to traditional concepts of what constitutes a tax shelter. What is surprising, however, is the third definition. A tax shelter also includes a “syndicate.” A syndicate is defined as a partnership or other entity (excluding C corporations) where more than 35 percent of the entity’s losses are allocable to “limited partners or limited entrepreneurs.”
Unfortunately, due to previous drafting errors, the definition of limited partners or limited entrepreneurs for this purpose was repealed, leaving no official definition. Businesses are now presented with a level of uncertainty regarding this definition. However, a separate (and unrelated) section of the law pertaining to farming syndicates reveals the potential answer.
Using nearly identical language as provided for a “syndicate” above, a farming syndicate includes a partnership of other entity (excluding C corporations) where more than 35 percent of the entity’s losses are allocable to limited partners or limited entrepreneurs. But the law for farming syndicates then goes on to define limited partners or limited entrepreneurs by looking generally at the amount of participation one has in the management of the entity. Incidentally, the language used for this definition is identical (word-for-word) to the prior definition applicable to a “syndicate” that was repealed under previous drafting errors.
A limited entrepreneur under the farming syndicate definition is a taxpayer who is not a limited partner, and who does not actively participate in the management of the enterprise. No regulations currently exist to expand on the meaning of active participation for this purpose (note that other sections pertaining to material participation or active participation for passive loss limitation purposes are limited to that purpose, and do not apply here). Withdrawn proposed regulations for farming syndicates once indicated that active participation entails either participation in the decisions regarding operation and management of the entity or participation in actual operations. The regulation included the following factors to consider.
Factors that tend to indicate active participation (i.e., not a limited entrepreneur) include:
- Participating in the decisions involving the operation or management of the business;
- Actually working in the business; or
- Hiring and discharging employees (as compared to only the business manager)
Factors that tend to indicate a lack of participation (i.e., a limited entrepreneur) include:
- Lack of control of the management and operation of the business;
- Having authority only to discharge the business manager;
- Having a business manager who is an independent contractor rather than an employee, and
- Having limited liability for business losses
So, if someone participates in either the operation or management of the business, he/she may still be considered active and therefore not a limited entrepreneur. The absence of management authority alone may not be the last word for taxpayers who are active in the operations of the business. For example, the fact that a law firm has a management committee would not prevent law partners who are not on the committee from being “active participants” if they participate in the firm's operations. If a person lacks control of both management and operations, however, he/she may be considered to lack active participation, and will therefore be a limited entrepreneur.
Using the “elementary principle of statutory construction that similar language in similar statutes should be interpreted similarly” [United States v. Sioux, 362 F.3d 1241, 1246 (9th Cir. 2004) fn 100 (citing Northcross v. Bd. of Educ. Memphis City Schools, 412 U.S. 427, 428 (1973))], the best indicator of the appropriate definition of limited entrepreneurs for purposes of a “syndicate,” is to use the definition and guidance provided for a “farming syndicate.”
Electing a Real Property Trade or Business
An important exception to the negative aspects of being categorized as a tax shelter applies in the real property area. A real property trade or business (RPTB) can elect out of the provision (Section 164(j)) that limits the business interest deduction described above. Because an electing RPTB is no longer a "trade or business" to which Section 163(j) applies, the "small business" exception is inapplicable, and as a result, whether the electing RPTB meets the definition of a tax shelter does not restrict its ability to deduct business interest.
What the Definition of Tax Shelter Means for Small Businesses
This strongly suggests that the definition of limited entrepreneur focuses on whether the limited partner, S corporation shareholder, or LLC member “actively participate[s] in the management [or operations] of such enterprise.” Thus, an allocation of more than 35 percent of an entity’s losses to such taxpayers will cause it to be a tax shelter. An enterprise that is consistently profitable and that experiences one loss year would be a tax shelter for that loss year, if more than 35 percent of that loss is allocated to a limited entrepreneur or limited partner.
Under this broad definition of tax shelter, many small businesses that would qualify otherwise will not be eligible for the cash method of accounting and will be subject to the business interest expense limitation (other than an electing RPTB). This could have a substantial impact on the taxable income of your business. For more information about tax shelters and the role they play on the cash method and on the business interest expense limitation, please consult your local CBIZ MHM tax professional.
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