You might be a tax shelter if …
The Tax Cuts and Jobs Act, P.L. 115-97, made tax accounting easier for many businesses with average annual gross receipts of $25 million or less (inflation-adjusted to $26 million for 2019) under Sec. 448. The benefits include the cash method of accounting, exemption from UNICAP rules, exemption from some inventory accounting requirements, and more.
But an “exception to the exceptions” denies these advantages to tax shelters, including “syndicates.” Chris Hesse, chair of the AICPA’s Tax Executive Committee, reveals where the traps lie for business taxpayers and their CPA advisers in this podcast recorded at the AICPA National Tax Conference in Washington, D.C.
What you’ll learn from this episode:
The questions businesses need to ask themselves to determine whether they fall under the definition of a syndicate.
Possible measures to make sure that the business does not allocate more than 35% of its losses in a tax year to limited partners or limited entrepreneurs and so avoid syndicate status.
How limited liability companies fit into these rules.
How active participation in management could help avoid limited entrepreneur status.
Paul Bonner: I am Paul Bonner. I’m a senior editor at the Journal of Accountancy, and I’m welcoming today at the National Tax Conference in Washington, D.C., Chris Hesse, CPA. Chris is chair of the AICPA’s Tax Executive Committee. He’s a tax principal in the National Tax Office of CliftonLarsonAllen in Kennewick, Wash. Chris has more than 40 years of experience with regional and national CPA firms and more than 30 years of speaking and training experience before tax professionals on a variety of topics. He’s testified at many legislative committees on tax policy matters and has been instrumental in federal and state tax law changes. Thank you, Chris, and welcome to the podcast.
Chris Hesse: Oh, thank you Paul. I’m enjoying being here.
Bonner: This podcast, I think, will have the title “You Might Be a Tax Shelter If …” certain, unexpected or maybe surprising things are true of your trade or business. It’s inspired by your article, Chris, in the December 2019 issue of The Tax Adviser titled “A Quirk in the TCJA’s Small Business Exceptions,” the TCJA being, of course, the Tax Cuts and Jobs Act, the transformative big bundle of changes to the tax Code enacted in late 2017. And I think the quirk that you allude to in that title could be described as certain small businesses’ being shut out from taking advantage of a TCJA change that was favorable for most small businesses, right?
Hesse: Well, if we think about the small businesses, yes, the Tax Cuts and Jobs Act exempted the smallish businesses, if you will, from some of the more onerous tax accounting methods. I’m thinking specifically about, let’s say, [Sec.] 263A, the UNICAP rules, where we have to capitalize into inventory some of our general and administrative expenses. Since 1986, it’s been a very onerous calculation for all of the manufacturers of the country — it didn’t matter what size you were — and then, for the larger resellers in the country, with more than $10 million of sales, they had to go through these calculations. And then the IRS would come in and say, “Oh, well, you didn’t capitalize enough. Here’s your adjustment,” and the taxpayer’s realizing, “Oh, this is only a one-year deal; I’m not going to spend a lot of money arguing with the IRS for a mere one-year deferral in these expenses.”
So it was an easy audit for the IRS but yet a complex calculation for the taxpayers. And we have the Tax Cuts and Jobs Act now that says, average annual gross receipts no more than $25 million — now $26 million — we don’t care, you don’t have to comply with the UNICAP rules, and you don’t have to be accrual method, and you aren’t subject to the business interest expense limitations of Sec. 163(j), to throw out a Code section number for you. But then we have this “gotcha” provision where these exceptions from the more onerous accounting methods don’t apply to tax shelters. And that’s where we need to drive down into the definition, well, just what is a tax shelter?
Bonner: Right, and I believe one of these tax shelters is a syndicate, is it not? Which when I first heard about it, I thought of, you know, Al Capone or, you know, the syndicates that syndicate newspaper cartoons, and this is neither of those, at least not necessarily, right?
Hesse: No, no, and you’re absolutely right, Paul. I used that same example in many of the seminars I present in talking about syndicates, always thinking of something that’s evil, and we can’t have a syndicate. And we look at our clientele, and we don’t have any evil clients. Syndicate rules don’t apply to me.
But, well, yes, the syndicate rules might apply to you, and they’ve been out there since the mid-1970s. We really haven’t paid much attention to them because our smallish clients — at this time, we were really only concerned perhaps with clients with less than $1 million of gross receipts, or less than $10 million of gross receipts under some older revenue procedures. But now, with $25 million, $26 million, there’s more at stake, and we are also exempted from some additional rules as a result of the Tax Cuts and Jobs Act.
So it’s more important that we revisit what these old rules are, and we find, “Oh, we may have clients that are syndicates” — a syndicate not being an evil term. We merely look at “Does my client have limited liability?” and owners that are not actively participating in the management of the business. And that brings up a whole nother set of questions as to active participation.
Bonner: Now more specifically, this has to do with allocation of a certain amount of losses to limited partners or limited entrepreneurs. Is that right?
Hesse: Yes. When this Code section was written, limited partners were very strictly prohibited from participating in management, so the Internal Revenue Code relied on state law to say, “If you’re a limited partner, you’re not going to be actively participating in management.” It was a self-policing provision. Over the years, the states have loosened up their limited partnership laws to allow limited partners to make some decisions or be involved in management without violating their limited partner status, and then, 1977, we have Wyoming creating this limited liability company [LLC], and by 1994 all of the states have limited liability companies. And that brings in — if we look at, “Well, what does a “limited entrepreneur” mean?” Well, we didn’t really know what “limited entrepreneur” might mean prior to 1977; perhaps an S corporation shareholder. But all LLC members have limited liability, and they can certainly participate or not participate in management. And how does this provision now apply for LLCs?
And we have no guidance, really, from the IRS as to what “active participation” in management means. And you did mention allocation of losses, and a couple of points that we did see from the IRS, dealing with mostly professional services firms, is that if you didn’t have a loss in that year — most professional service firms don’t have a net loss — then you are not a syndicate in a year in which you have income. Even though the Code section says “allocable,” more than 35% of your losses allocable, and I’m thinking, “Well, if I had a loss, it would be allocable to —”
Hesse: “— to these limited members, and therefore I should be concerned.” And the IRS says, “No. Don’t worry about that in years that you have income. Only worry about it in the year that you have a loss.” Well, we still really don’t know. There’s no regulations; there’s no guidance out there with respect to what is active participation in management. That’s still an unknown.
Bonner: Well, let’s try to get a handle on what kind of limited partnership might fall prey to this provision. Can you give me an example of an enterprise that might not be thinking they’re a syndicate and maybe they are?
Hesse: I think in today’s world, where now we have a $26 million average annual gross receipt limit, so we can have, let’s say, a business that’s $20 million. Clearly underneath the gross receipts limit. But we are a large enough entity that we’ve raised some money from pure investors. These people, the investors, are not participating in the management. They have put their money forth to the LLC. Maybe they have a preferred return from the LLC, and they’re satisfied with that. They are comfortable with the management by their co-owners. But these pure investors, maybe they make up 40% of the LLC ownership. Forty percent is more than 35%, and if I have a loss in that particular year, allocated — allocable — to these LLC members that are pure investors, I’m a syndicate.
Now, there are some planning opportunities, I think, around that, depending on, perhaps, how you word your LLC agreement, to say “We won’t allocate losses to the pure investors,” the people who are only putting their money forth, and they’re not working in the LLC, they’re not providing management services or other services to the LLC. I think that’s a way that we can get around — we can avoid — I shouldn’t use the word “get around,” but we can avoid being a syndicate, is making sure that our LLC agreements don’t allocate losses to this particular class of owners that are just investors and not working for the LLC.
Bonner: Do you suppose there’s a risk that if you don’t follow the partnership agreement in every respect the IRS will come back and say “Well, you weren’t following your partnership agreement, and, therefore, this allocation of losses is purely artificial and it doesn’t appear you followed it anyway”?
Hesse: Certainly, that’s a concern, but I think from a state legal standpoint, if you didn’t follow your agreement — let’s say that the preparer of the return forgets to, or doesn’t read, doesn’t follow the LLC agreement and just allocates losses across the board. That would be a problem, without knowing that, “Oh, there’s a syndicate issue here, and I’ve just fallen into the syndicate rule.” Now you have to work your way out of it. But let’s say, on the flip side, that the preparer of the LLC return chooses to, “Oh, I just won’t allocate losses over there this year,” but the LLC agreement says you will allocate losses straight across the board to ownership. And the preparer knows, “Well, no, if I allocate the losses to these people, I’m going to end up being subject to the syndicate rule, so I just won’t.” Well, you haven’t followed your own agreement.
Bonner: And the partners might want their losses.
Hesse: Well, they might want their losses, but if they understand that, “No, if I allocate losses in this direction, I’m also now prohibited from the cash method,” maybe they’ll understand and appreciate though, too.
That really points up, Paul, the reason why CPAs need to understand what some of these rules are and not be caught unawares, so that prior to the end of the year, for example, or prior to the original due date of this LLC’s tax return, that either they change the LLC agreement — because you have until the original due date of the tax return to change your LLC agreement — so that you don’t fall into these rules.
Bonner: I see.
Hesse: That’s — that’s really the important part is to — you don’t have to know all of the rules, but you do have to know enough to recognize when you may have a problem. And now’s the time to seek additional counsel and perhaps bring in somebody that has some more experience, or raise the issue with other counsel, for the client, to keep out of the status, if the status is important.
Bonner: Now, you mentioned cash method of accounting, which is one of the big TCJA small business exceptions, and now this exception to the exception that would knock you out of being able to use the cash method of accounting — it could have serious repercussions, couldn’t it?
Hesse: It certainly could. I might not have understood that I’m subject to accrual method of accounting, or I’m subject to full uniform capitalization rules, and I’m surprised. And the IRS comes in and says, “Well, sorry, you should have been following accrual method of accounting. You should have been capitalizing. Here’s your large adjustment.”
And, of course, you thought you had done all of this careful tax planning — cash method of accounting, got the LLC right to the point that you wanted it, as far as the optimal taxable income. And the IRS comes in and says “Nope, sorry. You need to add X number of hundreds of thousands of dollars of income allocated to all of these members of the LLC.” And the LLC wonders, “Why did we pay you for all of that tax planning that we did before the end of the year? I thought you knew these rules.”
Well, of course, that’s why we hold National Tax Conferences, and that’s why we go to continuing professional education, so that we can be aware of what some of these, not only exceptions to the rule, but as you noted, the exceptions to the exception — stay out of putting ourselves at risk for some form of malpractice or client claim for not following all of the rules. And clients don’t like accuracy-related penalties, for example.
Bonner: No, I’m sure they don’t. One more thing, and it suggests to me that there’s another planning point, perhaps. Let’s see if this is a possible one. That is that the members of the LLC participate actively in management, right?
Bonner: That could be a planning point as well, couldn’t it?
Hesse: It certainly could, that perhaps that if the investor — we talked about the pure investor, but perhaps that investor is on the board of managers for the LLC, that they have authority to make decisions on behalf of the LLC. That might be enough. We don’t really have guidance from the IRS as to what active participation in management is. We don’t look, for example, to the passive activity rules, just to count hours. It’s a qualitative measure rather than a quantitative measure.
Bonner: I see.
Hesse: But having some say in the management of the LLC; maybe that’s enough, and that would keep the LLC from falling into a syndicate status.
Bonner: That would be a good area for some regulations from the IRS, wouldn’t it?
Hesse: It would be nice to have some guidance, and I think the IRS recognizes the issues here. And, certainly, the IRS has litigated syndicate status. It was a farm syndicate status, but nonetheless litigated as syndicate status, And we have some concerns with respect to what that really means, too, because it would appear from the argument that the IRS made, that if you had an LLC that is only made up of entities, a partnership of partnerships, that you would automatically be a syndicate, because the IRS argues only individual owners can be actively participating in management, and if you don’t have individual owners, or more than 35% of your owners are entities that can’t be actively participating in management, maybe you’re automatically a syndicate.
That seems to be the IRS’s argument, and if the IRS litigates that and wins — they litigated it and lost in the Fifth Circuit, but if they litigate it and win, this will be a much bigger issue.
Bonner: Well, seems like to me it’s already a big issue, but perhaps one that practitioners and their clients aren’t duly aware of as we go into this next tax filing season for 2020.
Hesse: I’m sure that’s the case, yes.
Bonner: Thank you, Chris, so much for these insights, both in your article and in your presentation here at the AICPA National Tax Conference, calling attention to these rules and putting a spotlight on them.
Hesse: Thank you, Paul.