Prepare for New K-1 Reporting Burdens Thanks to the Tax Cuts and Jobs Act (article)
The Tax Cuts and Jobs Act (TCJA), passed more than a year ago, continues to demand our attention – and for good reason. Not only was this tax act far-reaching, affecting almost all taxpayers in all industries, it was also so complex that the IRS still has yet to clarify how it will interpret all aspects of the law.
Pass-through entity taxpayers will have many changes to consider. Four of the tax act’s provisions in particular—each highlighted below—will impact pass-through entities significantly and should be considered now. Although these modifications may not affect a particular pass-through entity directly, there is information it must collect and report to help its owners comply with IRS regulations.
Qualified Business Income Deduction
The Section 199A Deduction, commonly known as the Qualified Business Income (QBI) deduction, provides a 20 percent deduction to owners of pass-through entities whose taxable incomes are below certain dollar thresholds. For 2018, the thresholds are $315,000 for married taxpayers, and $157,500 for non-married taxpayers. As their taxable incomes creep over that threshold, they may be subject to certain limitations based on their business’s wages and the basis of property the business holds. Owners of specified services businesses will fare even worse because they will lose their deductions all together if their taxable income gets too high.
Interestingly, the Section 199A Deduction is not a business-level deduction; it is a deduction for individuals. However, in order for individuals to calculate their own deductions, the business entities must report additional items on Schedules K-1. Box 20 on Schedule K-1 includes new codes where entities can report Section 199A-specific information to their owners.
- Box 20, Code Z: Qualified Business Income
The 20 percent deduction is based on the taxpayer’s portion of the business’s “qualified business income.”
- Box 20, Codes AA & AB: W-2 Wages & Unadjusted Basis of Business Assets
Taxpayers whose taxable incomes exceed the thresholds must calculate whether or not their deductions will be limited based on the business’s W-2 wages or the unadjusted basis of the business assets just after acquisition.
- Box 20, Codes AC & AD: REIT Dividends and Qualified Publicly Traded Partnership Income
Dividends from Real Estate Investment Trusts and income from publicly traded partnerships may be eligible for 199A treatment, so these amounts must be reported to the business owners.
Business Interest Expense Limitation
Section 163(j) severely limits taxpayers’ ability to deduct business interest expenses. Under prior law, business interest was disallowed only in specific circumstances, like when interest was paid to a related party and no federal income tax was imposed. Under the new law, however, almost all business interest is capped at 30 percent. Other than small businesses, who are not bound by this limitation, businesses can deduct interest expense only up to the sum of:
- Business interest income,
- 30 percent of the taxpayer’s adjusted taxable income, and
- The taxpayer’s floor plan financing interest for the taxable year, which only applies to dealers of certain motor vehicles.
Any excess interest can be carried forward indefinitely, but it must be done so at the owner level. When this happens in a partnership, the carried-over interest reduces the partner’s outside basis in the business. Partners can deduct this expense in future years only when the business entity reports excess interest income over interest expense that year, or when the entity reports Excess Taxable Income (ETI). Determining ETI is a complex, multi-step calculation that is based off of the partnership’s taxable income and the amount of business interest it is able to deduct under Section 163(j).
In order for a partner to calculate how much of a business interest expense deduction he or she can take in a given year, the partnership must disclose additional information on Form K-1.
- Box 20, Codes AE & AF: Excess Taxable Income & Excess Business Interest Income
Both ETI and excess business interest income dictate the amount of carried-over interest expense that can be utilized, so these amounts must be reported to the partners.
- Box 13, Code K: Excess Business Interest Expense
Excess business interest expense must be reported on Schedule K-1 so that the taxpayer knows how much to carry forward until they have ETI or excess business interest income to offset it.
The Global Intangible Low-Taxed Income (GILTI) provision in the TCJA was created to deter taxpayers from moving income-generating activities to low-taxed jurisdictions. The law essentially imposes a minimum tax on all earnings of controlled foreign corporations (CFCs). Under these provisions, any 10 percent or greater U.S. shareholder of a CFC must include in its gross income foreign earnings from the CFC that are in excess of a fixed return on the CFC’s assets. To help soften this imposition, the provision allows a deduction of up to 50 percent of the inclusion—through 2025—to corporate shareholders.
All U.S. persons who are shareholders of a CFC, including shareholders who own a CFC indirectly through a partnership, S corporation, or trust, must worry about GILTI. The entity that is the direct owner of the CFC will need to report certain information to its shareholders or partners, including the following:
- Footnote Disclosure on Schedule K-1: GILTI Inclusion Amount
Taxpayers must pay tax on the GILTI that is allocated to them as the end shareholder, and they are responsible for paying the resulting tax.
New Holding Period for Carried Interest
Taxpayers with applicable partnership interests received in connection with the performance of services may need to reclassify the gains they recognize on the carried interest they report. Carried interest is a form of profit-sharing compensation paid to general partners of investment or private equity funds, paid out when the fund sells one or more of its investments.
Carried interest has historically been taxed as a capital gain rather than ordinary income. Long-term capital gains (LTCG) are taxed at preferential rates kept at a maximum of 20 percent, while ordinary income (like wages and salaries) is taxed at the taxpayer’s marginal tax rate, which can creep as high as 37 percent. The TCJA upheld this preferential tax treatment for carried interest, but limited it to gains that have at least a three-year holding period.
This new limitation will require partnerships to report additional information about their capital gains.
- Footnote Disclosure on Schedule K-1: LTCG Detail
The partnership must specify the amount of the LTCG reported on the partner’s Schedule K-1, Line 9A, that results from property held for more than three years, and the amount attributable to property held for three years or less.
K-1 Reporting is Arduous but Attainable
Collecting this information, maintaining records, and reporting the correct amounts to each owner will be a time-consuming process for pass-through entities and their tax practitioners. It will be important to get started today and analyze the effect of each change on your reporting process.