A quirk in the TCJA’s small business exceptions

Sometimes the legislation that emerges from a tax reform process is not fully aligned with the intended objective. Consider certain changes to the rules of the game for small businesses enacted in the law known as the Tax Cuts and Jobs Act (TCJA).¹ While most businesses are now permitted to use the cash receipts and disbursements method of accounting and are spared from having to comply with a variety of burdensome requirements if they have average annual gross receipts of $25 million or less, "tax shelters" are expressly excluded. However, the definition of a tax shelter sweeps more broadly than many people realize, and some small businesses that are not used for tax-avoidance purposes are denied the benefit of these tax simplifications.

From a policy standpoint, a broad tax shelter disqualification is unnecessary because passive activity rules are already effective at stymying the abusive use of entities to generate tax losses for nonparticipating owners. As discussed below, the AICPA urges Treasury and the IRS to provide certain small businesses relief from the definition of a tax shelter to ensure that they will qualify for the small business exceptions.

The TCJA's small business exceptions

One of the TCJA's aims was to reduce complexity for small businesses. The legislation allows most businesses with average annual gross receipts, or AAGR, no greater than $25 million to use the cash method of accounting.² It also exempts these businesses from some of the more onerous recordkeeping requirements, including:

• The uniform capitalization rules of Sec. 263A;³
• Specific inventory accounting rules;⁴
• The business interest expense limitation rules of Sec. 163(j);⁵ and
• Certain long-term contracting requirements under Sec. 460.⁶

However, these valuable exemptions are unavailable to a business that meets the relevant definition of a tax shelter, regardless of whether it satisfies the $25 million gross receipts test. Before exploring the meaning of a tax shelter in detail, some background information may be helpful.

Prior to the TCJA, the rules governing the use of the cash method were significantly tighter and less uniform. Businesses with AAGR less than $1 million were exempt from the requirement to use the accrual method.⁷ Specific industries were allowed to use the cash method if the business's AAGR was less than $10 million.⁸ Most C corporations were required to use the accrual method if their AAGR exceeded $5 million.⁹ Aggregation with related-party rules applied, of course, in determining the corporation's AAGR. Defined family farm corporations and farm partnerships with C corporation partners¹⁰ were allowed to use the cash method of accounting if gross receipts for all prior years did not exceed $25 million.¹¹ Non-family farm corporations and farm partnerships with a C corporation partner were restricted to the accrual method if total gross receipts in any prior year exceeded $1 million.¹² The TCJA effectively eliminated these separate rules to provide a uniform $25 million AAGR test, increasing dramatically the number of businesses exempt from some of the more onerous provisions of tax accounting. The $25 million limitation is indexed for inflation in $1 million increments.¹³

How many businesses benefit from the AAGR exception? The Joint Committee on Taxation published a report in 2017 that compares the annual gross receipts of businesses of various types (C corporation, S corporation, partnership, and sole proprietorship).¹⁴ Although 4.36% of C corporations reported gross receipts on their 2014 tax returns in excess of $10 million, the numbers for S corporations and partnerships were substantially fewer at 2.35% and 1.20%, respectively.¹⁵ The number of sole proprietorships reporting gross receipts in excess of $10 million was negligible. (There are a huge number of sole proprietorships — over 24.6 million — of which nearly 25% reported gross receipts less than $2,500.) From these statistics, we can infer fewer than 2% of the businesses in the United States report AAGR greater than $25 million. One reason the threshold is important is because businesses that exceed it face the dramatically increased complexity of the business interest expense limitation of Sec. 163(j).

As under the previous framework, a tax adviser must test for aggregation of related taxpayer gross receipts to determine if the $25 million threshold is exceeded.¹⁶ Taxpayers treated as a single employer under Sec. 52(a) or (b) or Sec. 414(m) or (o) must aggregate gross receipts for each of the prior three years. However, our discussion today is not about aggregation, which was the subject of a previous article.¹⁷ The present topic concerns small businesses that fall within the definition of a tax shelter and thus are ineligible for the TCJA's small business tax simplifications.

The definition of 'tax shelter'

If a taxpayer is found to be a tax shelter, it is not allowed to compute taxable income under the cash receipts and disbursements method of accounting.¹⁸ Nor may it rely on the other tax simplifications for small businesses mentioned above. Because of this, the tax shelter definition is important.

"Tax shelter" has the meaning provided by Sec. 461(i)(3), including a specific rule for farming activities.¹⁹ As one might expect, the term includes a partnership or other entity if a significant purpose is the avoidance or evasion of federal income tax.²⁰ In addition, a tax shelter is any enterprise if interests have been offered for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale (excluding C corporations).²¹ Less obviously, and most importantly here, the term tax shelter also includes any "syndicate."²²

Syndicates come in two flavors: a farm syndicate²³ and a syndicate that is not a farm syndicate²⁴ (call this a nonfarm syndicate). They are very similar, but there are nuanced differences. In both cases the definitions are complex.

Nonfarm syndicates

A nonfarm syndicate is any entity (other than a C corporation) if more than 35% of the losses of the entity during the tax year are allocable to limited partners or limited entrepreneurs. For purposes of the allocation calculation, limited partners or entrepreneurs do not include:

1. An individual who actively participates in management;
2. The spouse, children, grandchildren, and parents of the individual who actively participates in management;
3. An individual who actively participated in the management for a period of not less than five years;
4. An estate of an individual who actively participated in the management, or the estate of an individual described in number 2 above; or
5. Anyone else for whom Treasury determines that the interest should be treated as held by an individual who actively participates in the management, and the interest is not used for tax-avoidance purposes.²⁵

It is instructive to look at several past private letter rulings that the IRS issued addressing the tax shelter status of professional firms. These rulings found that the professional service firms in question were not tax shelters, in that all the professionals were or could be active in the management of the business, and the business was not operated with a motive to avoid federal income tax.²⁶ In these rulings (which concerned the partnership status of LLCs prior to the check-the-box regime), the delegation of management to an executive committee did not preclude a conclusion that the members actively participate in management. In one ruling, which noted that the professional firm had been in business for over 100 years and had consistently reported taxable income (rather than a loss), the IRS stated that the taxpayer "is not a syndicate for any year in which it does not incur losses."²⁷

This last statement appears to interpret the word "allocable" as "allocated." The mere possibility of the entity's reporting a loss that is more than 35% allocable to limited partners or limited entrepreneurs should taint the entity as a syndicate, but that is not how the IRS has privately ruled.

It also matters to whom losses are allocated. According to Letter Ruling 9321047, the "classification as a syndicate and its prohibition from using the cash method of accounting depends on how its members are classified and how its losses are allocated." This implies that agreements to allocate losses away from members who do not actively participate in management may be a strategy to avoid syndicate status. If losses are allocated to actively participating members for a year, a future year's first-tier allocation of profits to members previously allocated losses would place the members back into their relative economic positions.

Farm syndicates

So far, this article has focused on nonfarm businesses, where syndicate status is a year-by-year determination and an entity can be a syndicate only in a year that it has a loss.²⁸ This is the beginning point at which the definitions of farm and nonfarm syndicates diverge. A farm syndicate includes any entity engaged in the trade or business of farming (other than a C corporation), if more than 35% of the losses of the entity are allocable to limited partners or limited entrepreneurs during any period.²⁹ Note the temporal difference. If more than 35% of losses are allocable, during any period, to limited partners or limited entrepreneurs, the farming entity is a farm syndicate. The mere potential for losses to be allocated, even though the entity reports income, should be sufficient to taint the entity as a farm syndicate. However, if the IRS reads the word "allocable" as "allocated," the taint as a farm syndicate would only occur upon the entity's reporting a loss that is allocated more than 35% to the limited partners or limited entrepreneurs. Once tainted, the entity will always be a farm syndicate, due to the "during any period" verbiage.

A farm syndicate also differs from a nonfarm one in the holdings of persons deemed to be active in management. Paraphrasing the requirements, the following are treated as active management:

• In the case of a person who has actively participated in management of any trade or business of farming for at least five years, any interest in an entity that is attributable to such active participation;
• In the case of an individual whose principal residence is on a farm, the trade or business of farming such farm (no five-year test and no active participation in management required);
• Certain participation in the processing of livestock;
• Certain interests held in any other farming trade or business; or
• Any interest held by a member of the family (or a spouse of any such member) of a grandparent of any of the above individuals, if the interest in the entity is attributable to the active participation of that other individual.³⁰

The last exception to limited partner or limited entrepreneur status is especially taxpayer-favorable. If the ownership interests of individuals excepted from limited treatment total at least 65%, the entity is not a farm syndicate.

The IRS has not had cause to issue a private letter ruling on the temporal aspects of determining whether an entity is a farm syndicate. We do not know whether "once a farm syndicate, always a farm syndicate," is an appropriate aphorism. Nonetheless, the difference in definitions between a farm syndicate and a nonfarm syndicate should be read as having significance.

Active participation in the farming context

Active participation in farm management is not defined in current guidance. Former proposed guidance, withdrawn in 1998, provided factors that indicated active participation.³¹ They included participating in the decisions involving the operation or management of the farm, actually working on the farm, living on the farm, or hiring and discharging employees.

Factors indicating a lack of active participation included the lack of control of the management and operation of the farm, having authority only to discharge the farm manager, having a farm manager who is an independent contractor rather than an employee, and having limited liability for farm losses.

One more word on active participation: The IRS asserts that the active participation test is available only for individual owners and that if entities own more than 35% of the entity in question, it is not possible to meet the active participation test. In Burnett Ranches, Ltd.,³² the IRS took this position in finding that a taxpayer was not allowed to use the cash method of accounting. Burnett Ranches was 99% owned by an S corporation, which in turn was 100% owned by Anne Marion, who ran the operation for a period of not less than five years. According to the IRS, these facts mandated a syndicate designation. Disagreeing, a federal appellate court upheld the lower court's determination that Marion's years of active participation in farm management qualified for an exception. It was not necessary for her to hold a legal or titled (direct) interest in the limited partnership. Unconvinced, the IRS announced its nonacquiescence to the decision for cases appealable outside the Fifth Circuit.³³ As this case highlights, there are pitfalls in the definition of a syndicate.

AICPA advocates for extended simplicity

The AICPA urges Treasury and the IRS to provide relief to certain small businesses from the definition of a syndicate. Small businesses should be allowed to use the simplifying provisions under the TCJA, regardless of the participation of the owners. The abusive use of entities to generate tax losses for nonparticipating owners was effectively stymied by the Tax Reform Act of 1986, when the passive activity rules were implemented.³⁴ Congress has effectively stated that small businesses should not be saddled with complex accounting method rules. The AICPA believes the status of owner participation should not matter. The AICPA requests that Treasury determine, by regulations or otherwise, that all interests in an entity that meets the gross receipts test should be treated as held by an individual who actively participates in the management of the entity, provided that the entity and the interests were not used for tax-avoidance purposes.³⁵ This regulatory authority is available to Treasury.³⁶

In the absence of such regulatory relief, it will be important to be able to identify syndicates (both farm and nonfarm). Planning opportunities will exist to help affected clients avoid a tax shelter designation, such as by recommending changes to an entity's agreement. Careful forethought may enable such clients to use the cash method of accounting and avail themselves of the TCJA's other small business exceptions.

Footnotes

¹P.L. 115-97.

²Sec. 448(c).

³Sec. 263A(i).

⁴Sec. 471(c).

⁵Sec. 163(j)(3).

⁶Sec. 460(e).

⁷Rev. Proc. 2001-10.

⁸Rev. Proc. 2002-28.

⁹Prior Sec. 448(c).

¹⁰C corporations are not considered C corporations for this purpose if the farm C corporation meets the gross receipts test. See Sec. 447(c)(2), prior and current.

¹¹Prior Sec. 447(d)(2).

¹²Prior Sec. 447(d)(1).

¹³Sec. 448(c)(4).

¹⁴Joint Committee on Taxation, Present Law and Data Related to the Taxation of Business Income (JCX-42-17), pp. 48-52 (Sept. 15, 2017).

¹⁵The report disclosed the number of returns with gross receipts between $10 million and $50 million, and total gross receipts in excess of $50 million.

¹⁶Sec. 448(c)(2).

¹⁷John Werlhof, "Small Business Taxpayer Exceptions Under Tax Reform — Gross Receipt Aggregation Rules," AICPA Tax Section News (Jan. 25, 2019).

¹⁸Sec. 448(a)(3); Sec. 448(b)(3), providing that meeting the gross receipts test allows C corporations and partnerships with C corporation partners (Secs. 448(a)(1) and (2)) to use the cash method. However, this does not apply to tax shelters, which are referred to in Sec. 448(a)(3).

¹⁹Sec. 448(d)(3).

²⁰Sec. 6662(d)(2)(C)(ii), via Sec. 461(i)(3)(C).

²¹Sec. 461(i)(3)(A).

²²Sec. 461(i)(3)(B).

²³Sec. 461(i)(4).

²⁴Sec. 1256(e)(3)(B).

²⁵Sec. 1256(e)(3)(C).

²⁶See, e.g., IRS Letter Rulings 9407030, 9412030, and 9328005.

²⁷IRS Letter Ruling 9415005.

²⁸Sec. 1256(e)(3)(B).

²⁹Sec. 461(k)(1)(B).

³⁰Sec. 461(k)(2).

³¹Prop. Regs. Sec. 1.464-2(a)(3), announced in 48 Fed. Reg. 51936 (Nov. 15, 1983), withdrawn by 63 Fed. Reg. 71047 (Dec. 23, 1998). Sec. 464(c) was moved to Sec. 461 in 2014.

³²Burnett Ranches, Ltd., 753 F.3d 143 (5th Cir. 2014), aff'g No. 4:11-CV-562-Y (N.D. Tex. 10/24/12).

³³Action on Decision 2017-01.

³⁴Sec. 469, added by the Tax Reform Act of 1986, P.L. 99-514.

³⁵AICPA letter to William M. Paul, IRS acting chief counsel, dated Feb. 13, 2019, regarding small business relief from the definition of tax shelter, available at www.aicpa.org.

³⁶Sec. 1256(e)(3)(C)(v).