The House Ways and Means Committee on September 15 approved tax increase and tax relief proposals that are to be acted on by the House of Representatives as part of “Build Back Better” reconciliation legislation (the bill). The legislation was approved by a largely party-line vote of 24 to 19.
Outlined below are key tax provisions of the bill that affect partners, partnerships, and other passthrough entities by:
Differences between the House version of reconciliation legislation and forthcoming Senate tax proposals that are expected to be considered in coming weeks will have to be resolved before final legislation can be put to a vote in both chambers. Congressional Democratic leaders are seeking to complete action on the legislation so it can be signed into law by President Biden before the end of this year.
Observation: Reconciliation legislation can be approved with only Democratic votes over the expected objections of Congressional Republicans, but moderate Democrats in both the House and Senate have indicated that they will not support a package with a price tag of $3.5 trillion over 10 years. While the cost of any final package remains uncertain, the Ways and Means Committee-approved bill features significant business and individual tax increases. Moderate House and Senate Democrats are expected to insist on scaling back the scope of both the spending proposals and certain tax increase proposals.
Action item: Taxpayers should continue to monitor the status of reconciliation legislation and analyze how particular provisions could affect their investment and business activities. Taxpayers also should consult with advisors on which provisions are most likely to be enacted as part of any final legislation. On Tuesday, September, 21, PwC will host a webcast on which we will cover some of the key provisions in the reconciliation legislation. Please register in order to participate.
The bill would subject individuals with taxable income in excess of $400,000 ($500,000 in the case of a joint return) to the 3.8% NIIT on all net income or net gain from a trade or business, regardless of whether the person participates in the trade or business that generated the income, unless the income is subject to employment taxes (FICA) or self-employment taxes (SECA). Distributions from a qualified retirement plan would continue to be exempt from NIIT. The provision would be effective for tax years beginning after December 31, 2021.
Observation: Under current law, an individual who is a limited partner in a limited partnership is not subject to SECA on his or her distributive share of partnership income. Provided the partnership’s trade or business is not a passive activity with respect to such person, the partner’s distributive share also is not subject to NIIT. In the case of a limited partner in a limited partnership with income in excess of the applicable threshold, the bill generally would subject the partner’s distributive share of the limited partnership income to NIIT.
Observation: Under current law, passthrough income from an S corporation is not subject to self-employment taxes, and also is not subject to NIIT provided the shareholder is not passive with respect to the business. Treasury has expressed concerns about some S corporation shareholders seeking to avoid payroll taxes by not paying appropriate salaries and taking out large distributions. The bill could partially alleviate such concerns as it would subject S corporation passthrough income to NIIT regardless of the extent a shareholder is active in the business.
The bill would limit the Section 199A deduction for qualified business income by setting the maximum allowable deduction at $500,000 in the case of a joint return ($250,000 in the case of a married individual filing a separate return); $400,000 in the case of an individual return; or $10,000 in the case of an estate or trust, effective for tax years beginning after December 31, 2021.
Observation: The bill does not modify the existing limitations on the deduction but would add an additional dollar limitation on the deduction.
Observation: The limit of the Section 199A deduction in the bill is not as restrictive as that proposed by Senate Finance Committee Chairman Ron Wyden (D-OR) in the Small Business Tax Fairness Act introduced in July 2021. Senator Wyden’s proposal removes the specified service trade or business and W-2-wage/capital investment limitations, but phases out the deduction for taxpayers with taxable income in excess of $400,000. The maximum deduction under the Wyden proposal would be 20% of $400,000 or $80,000.
Current Section 1061, enacted as part of the 2017 tax reform legislation, extends the long-term capital gains holding period with respect to applicable partnership interests (API) from a greater than one-year holding period to a greater than three-year holding period. An API is a partnership interest that is transferred to a taxpayer in connection with the performance of substantial services by the taxpayer or a related person in an applicable trade or business (ATB). An ATB is any activity conducted on a regular, continuous, and substantial basis which consists of (A) raising or returning capital and (B) either (i) investing in or disposing of specified assets or (ii) developing specified assets. Specified assets are securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing.
The bill generally would extend the long-term capital gains holding period with respect to an API from three years to five years. A three-year holding period would continue to apply to taxpayers (other than a trust or estate) with adjusted gross income of less than $400,000 and to any income with respect to an API that is attributable to a real property trade or business within the meaning of Section 469(c)(7).
The bill would expand the scope of Section 1061 by introducing the term ‘net applicable partnership gain.’ Net applicable partnership gain generally would be defined as all amounts included in the gross income of the taxpayer with respect to an API that are treated as capital gain or subject to tax at the rate applicable to capital gain. All net applicable partnership gain is subject to recharacterization under Section 1061. Additionally, the bill adds rules for measuring the holding period of both APIs and of assets that give rise to net applicable partnership gain. The holding period would be measured from the later of the date on which the taxpayer acquired substantially all of the API with respect to the amount realized or the date on which the partnership in which the API is held acquired substantially all of the assets held by the partnership. Similar rules apply if the API is held in a tiered structure.
Observation: These changes would significantly expand the application and scope of Section 1061. Contrary to the current final regulations under Section 1061, gain determined under Sections 1231 and 1256 and qualified dividend income (QDI) would be subject to recharacterization under Section 1061. Additionally, the clock on the five-year holding period with respect to an API would not begin to run until the holder of the API acquired substantially all of its interest and the partnership acquired substantially all of its assets. A newly admitted partner would not be able to benefit from the long-term holding period of the assets held by the partnership. In addition, gain from the sale of an asset held for the required period would not be eligible for long-term capital gain unless substantially all of the assets of the partnership were held for the required period.
The bill would make additional changes related to the definition of an API. First, the bill clarifies that an API does not include any interest in a partnership directly or indirectly held by a C corporation; this would codify the position taken in the final regulations that a partnership interest held by an S corporation is not excluded from the term API. In addition, the bill modifies an exception for employees who provide services. Section 1061(c)(1) currently provides that an API does not include an interest held by a person who is employed by another entity that is conducting a trade or business (other than an ATB) and only provides services to such other entity (the portfolio company exception). The bill expands the portfolio company exception and applies it to a person who only provides services with respect to a trade or business that is not an ATB.
Observation: The change to the portfolio company exception would clarify that an employee of a portfolio company who receives a profits interest and provides services to more than one entity will not be considered to have received an API so long as the services are not provided with respect to an ATB.
The bill also would rewrite the rules related to transfers of APIs. Currently, the Code provides for the recharacterization of gain on the transfer of an API to a related person, but the intent and scope of the provision are not clear. Proposed regulations under Section 1061 interpreted the provision as an acceleration provision and provided that the term transfer includes contributions, distributions, sales and exchanges, and gifts. In response to comments, the final regulations limited the application of Section 1061(d) to transfers in which long-term capital gain is recognized under chapter 1 of the Internal Revenue Code. In contrast, the bill would provide that if a taxpayer transfers an API, gain shall be recognized notwithstanding any other provision of Subtitle A. The bill does not define “transfer.”
Observation: The bill would be a significant expansion of the application of Section 1061 in connection with transfers of APIs. Under the bill, the provision would apply to all transfers, whether or not the transfer is to a related person and whether or not gain is recognized in the transaction.
Finally, the bill would provide additional regulatory authority to Treasury. The Secretary is directed to provide regulations or other guidance to prevent abuse of Section 1061, including through distributions of property by a partnership and through carry waivers. The Secretary also can issue guidance to provide for the application of Section 1061 to financial instruments, contracts, or interests in entities other than partnerships to the extent necessary to carry out the purposes of Section 1061.
The carried interest changes would apply to tax years beginning after December 31, 2021.
The bill would amend Section 163(j) to apply the interest limitation at the partner level, instead of at the partnership level as under current law, effective for tax years beginning after December 31, 2021. Under a transition rule, excess business interest expense allocated to a partner by a partnership under current law that is carried over to a tax year beginning after December 31, 2021 would be treated as business interest paid by the partner. New rules in Section 163(o) would address the carryforward of disallowed interest expense.
Observation: While applying the Section 163(j) limitation at the partner level potentially could simplify the complex rules that currently apply to Section 163(j) in the partnership context, the change also could result in a reduced overall borrowing capacity for some partnership structures as compared to current law.
Observation: A discussion draft addressing partnership tax rules, recently introduced by Senate Finance Committee Chairman Wyden, takes the opposite approach to applying Section 163(j) to partnerships, applying the limitation at the partnership level and preventing partners from using a partnership’s excess capacity to support the deduction of partner-level business interest expense.
Under current law, a taxpayer may, under certain circumstances, recognize an ordinary loss if a partnership interest the taxpayer owns becomes worthless. The bill would provide that if a partnership interest becomes worthless, the resulting loss is treated as a loss from the sale or exchange of a capital asset at the time of the identifiable event establishing the worthlessness of the interest. As a result, a taxpayer that owns a worthless interest recognizes a capital loss except to the extent that the “hot asset” rules of Section 751(a) apply to recharacterize gain or loss attributable to the partner’s share of the partnership’s inventory or unrealized receivables as gain or loss from the sale of property other than a capital asset. The bill also would expand the definition of securities for purposes of defining a worthless security to include a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a partnership. These changes would be effective for tax years beginning after December 31, 2021.
Observation: The bill generally eliminates the possibility that a taxpayer could claim an ordinary loss for a worthless partnership interest. In the case of individuals, the deductibility of ordinary losses from worthless partnership interests already was significantly limited in many cases, because such losses (except when incurred in a trade or business) are miscellaneous itemized deductions, which the 2017 tax reform act made nondeductible through 2025.
Under current law, the conversion of an S corporation to an entity taxed as a partnership is a taxable event requiring gain recognition on the appreciation of any assets inside the S corporation and gain recognition with respect to the stock surrendered. The bill would allow an “eligible S corporation” to convert to a partnership tax-free. An eligible S corporation is a corporation (including any predecessor corporation) that has been an S corporation at all times since May 13, 1996. The conversion would take place via a “qualified liquidation,” which is the transfer in a two-year period beginning on December 31, 2021, of substantially all the assets and liabilities of the S corporation to a domestic partnership in transactions that result in the complete liquidation of an eligible S corporation. The tax-free nature of the transaction is only applicable if the eligible S corporation elects to have the provision apply in a manner as the Treasury may require.
Observation: While the bill would allow for greater flexibility with respect to ownership and operations post conversion, there are many open items. The bill requires the S corporation to transfer its assets to a partnership. From a policy standpoint, there is no reason that the provision could not also apply to a transfer of substantially all the assets to a disregarded entity owned by the S corporation shareholder. The bill would be limited to S corporations that have been S corporations continuously since May 1996. The bill does not indicate how qualified subchapter S subsidiaries (QSub) would be treated for purposes of determining continuous existence. Could an S corporation fail to be an "eligible S corporation" because it made a QSub election for one of its C corporation subsidiaries after May 1996, which may make the S corporation a successor to the C corporation under the tax fiction of that election?
Observation: While the S corporation conversion would be tax-free for federal income tax purposes under these proposals, it will be important to examine the state and local tax jurisdictions in which the S corporation operates. The deemed gains may be triggered for state and local tax purposes due to nonconformity to the current Internal Revenue Code as revised if this provision is enacted. State and local adoption of the Internal Revenue Code varies widely, but generally is on a rolling basis, a fixed-date basis, or select provision conformity. To the extent a jurisdiction does not adopt the Internal Revenue Code on a rolling basis, there could be unintended state and local tax consequences of an S corporation conversion.
Under current law, taxpayers other than corporations generally may exclude between 50% and 100% of gain recognized on the sale of qualified small business stock acquired at original issue so long as it has been held for at least five years (the ‘50% exclusion rule’). The 50% exclusion rule applies to a taxpayer regardless of its gross income and also may apply to gain recognized by certain passthrough entities to the extent allocated to taxpayers other than corporations. However, the 50% exclusion rule is substituted when taxpayers acquire otherwise eligible qualified small business stock during certain time periods. After February 17, 2009 but before September 28, 2010 the relevant exclusion percentage is increased to 75% (the ‘75% exclusion rule’) and in the case of stock acquired after September 27, 2010 the relevant exclusion percentage is increased to 100% (the ‘100% exclusion rule’).
The bill would only allow the benefit of the 75% and 100% exclusion rules to those taxpayers with adjusted gross income less than $400,000. Furthermore, trusts and estates would not be eligible for the enhanced exclusion percentages (at any income level). Taxpayers not eligible for the enhanced exclusion percentages still would be permitted to benefit from the qualified small business stock exclusion but would be limited to the 50% exclusion rule. The changes made by this provision would apply to sales and exchanges on or after September 13, 2021, subject to a binding contract.
Observation: Although the bill would substantially curtail the benefit of the qualified small business stock exclusion to those affected, the 50% exclusion rule still appears to provide meaningful tax savings assuming the other proposed tax rate increases affecting high-income households are adopted.