Are you doing all you can to keep the cash method for your clients?

For decades, the government has placed restrictions on the use of the cash method of accounting. One of the reasons was that the cash method was used by some “tax shelters” to provide investors with losses they could use to offset income or gains from other sources. The entity providing “shelter” typically used the cash method to make large deductible expenditures close to year end. The congressional response to this tactic was to amend Sec. 448 to prohibit the use of the cash method by so–called tax shelters.

The definition used for “tax shelter” was trifold. It included (1) any entity that failed the registered securities test of Sec. 461(i)(3)(A); (2) an entity formed as part of a plan where tax avoidance or evasion is a significant purpose, as described in Sec. 6662(d)(2)(C)(ii); or, most importantly here, (3) a syndicate, as defined in Sec. 1256(e)(3)(B):¹ a partnership or other entity (other than a C corporation) if more than 35% of its losses during a tax year are allocable to limited partners or limited entrepreneurs (within the meaning of Sec. 461(k)(4)). The rule limiting access to the cash method is sometimes referred to as the “syndicate rule.”

Congress changed its attitude toward the cash method in the Tax Cuts and Jobs Act (TCJA), P.L. 115–97, making it available, via Sec. 448(c)(1), to almost any entity with annual gross revenue under $25 million. This was a permanent provision of the TCJA and not subject to a sunset date. With the TCJA’s addition of cost–of–living adjustment provisions, this limit is $31 million for 2025.² But Congress left in place the rule denying syndicates the ability to use the cash method.

An entity classified as a syndicate loses more than just the ability to use the cash method. Classification as a syndicate also limits the ability of the entity to use the small business exception (available to businesses under the $31 million ceiling) for several other Code provisions including the business interest deduction,³ the percentage–of–completion method for construction contracts,⁴ the exception from the uniform–capitalization (UNICAP) rules,⁵ the recurring–item exception,⁶ and the exception from the inventory rules.⁷

This article explores the syndicate rule. First, it describes a helpful elective rule. Then it discusses certain useful exceptions that prevent an owner from being considered a limited partner or limited entrepreneur. Finally, it delves into how losses are calculated for the purpose of determining whether more than 35% of a business’s losses during a tax year are allocable to limited partners or limited entrepreneurs. By understanding the intricacies of the syndicate rule, practitioners can help protect businesses from being classified as syndicates and losing the use of the cash method.

A helpful elective rule

Under a regulation finalized in 2021 (new regulations), the government has provided a mechanism that will allow businesses, in certain circumstances, to avoid classification as a syndicate. The regulation contains a very taxpayer–favorable elective rule that can allow a business otherwise failing the syndicate rule — and thereby losing use of the cash method and/or other methods mentioned above — to retain the use of the methods. Here is what the regulation says:⁸

(B) Irrevocable annual election to test the allocation of losses from prior taxable year. (1) In general. For purposes of paragraph (b)(2)(iii)(A) of this section, to determine if more than 35 percent of the losses of a venture are allocated to limited partners or limited entrepreneurs, entities may elect to use the allocations made in the immediately preceding taxable year instead of using the current taxable year’s allocation. An election under this paragraph (b)(2)(iii)(B) applies only to the taxable year for which the election is made. Except as otherwise provided in guidance published in the Internal Revenue Bulletin (see §601.601(d)(2) of this chapter), a taxpayer that makes an election under this paragraph (b)(2)(iii)(B) must apply this election for other provisions of the Code that specifically apply the definition of tax shelter in section 448(a)(3).

Some illustrations

The elective rule can be illustrated as follows:

Example 1: A partnership or S corporation using the cash method is profitable in 2020. In 2021, the entity has a loss, and more than 35% of that loss will be allocable to limited partners or limited entrepreneurs. The entity would, under the rules in place prior to this change, be required to change from the cash method for 2021. Under the new rule, the entity can elect to use the 2020 allocations instead of the 2021 allocations. Syndicate status is avoided for 2021, and the cash method can continue to be used.

There may be some ability to use the prior–year rule for passthrough entities in other situations if the mix of active to passive members has changed between the current and preceding year. Assume that in 2020 an S corporation had a loss, but only 30% of the loss was allocated to a passive owner. By “passive owner” this article means an individual not able to be considered active under any of the exceptions to Sec. 1256(e)(3)(B) discussed later. In 2021 the S corporation again has a loss, but due to a change in shareholder status (redemption of one of the active owners), 40% of the loss is allocable to the same passive owner. Can the S corporation elect the prior–year rule and maintain the use of the cash method even though it has a loss in both 2020 and 2021? It appears the answer is “yes.”

The use of the phrase “allocations made in the immediately preceding taxable year” does not appear to refer to the actual dollar amount or percentage of profit or loss allocated to any given partner or shareholder. Rather, it appears to be referring to the aggregate result of loss allocated to limited partners or limited entrepreneurs in the preceding year. If 35% or less of the prior–year loss was allocated to passive owners, then the cash method will be allowed for the next subsequent year if the election under this rule is made.

Assume a partnership had losses in the preceding year where no more than 35% were allocated to limited partners or limited entrepreneurs. In the current year, that partnership has the same partners, but more than 35% of losses are allocated to limited partners or limited entrepreneurs. The change in allocations complies with the partnership rules governing allocations. Using the new prior–year allocation election would preserve use of the cash method for another year.

While partnerships can alter allocations between owners for a given year, S corporations are bound by the rule that all shares are treated equally. For S corporations, the ability to use the prior–year elective rule will generally be affected more by control over the profit and loss of the entity. But in some instances, a change in the status of existing shareholders could make the new elective option attractive.

Assume an S corporation has a 36% shareholder who was active in management in the preceding year, but the individual is not active in management at all in the current year. All other shareholders are active in both years. The S corporation has losses in both the preceding year and the current year. Can the elective rule be used? In the preceding year there were no allocations of loss to limited entrepreneurs, as all shareholders were active. Electing to use the new rule could rescue the use of the cash method for the current year if the active status of an owner in a year determines whether a loss is made to a limited entrepreneur. If the current–year status is used to describe the prior–year allocation regardless of management status in the prior year, then the use of the cash method may be lost. An exception to this would be if one of the exceptions described below applied.

The ‘active management’ exceptions

Having sampled the opportunities allowed under the elective rule to preserve use of the cash method, we now dive deeper into the issues, challenges, and opportunities provided by a more thorough review of “active management” exceptions. These exceptions define certain situations in which an interest in an entity will not be treated as held by a “limited partner or a limited entrepreneur” — which is important because the syndicate rule applies only if more than 35% of losses are allocable to limited partners or limited entrepreneurs. A deeper knowledge of this provision and a client’s history can protect use of the cash method even in years where the elective rule would seem to be unavailable.

Before delving into the active–management exceptions, some broad points are helpful to keep in mind. First, limited partners, under the state law allowing limited partnerships, generally can have no active role in management. Since the advent of the limited liability company (LLC), limited partnerships are rarely encountered by the modern tax practitioner. Consequently, this article focuses on the term “limited entrepreneur,” as it can refer to either an LLC member or a shareholder in an S corporation.

Second, the syndicate rule is an anti–abuse provision, designed to prevent “tax shelters” from using a legitimate hedge transaction used in the ordinary course of a business as a vehicle for directing losses to taxpayers not involved in the business. In the conference report to the Tax Reform Act of 1981, Congress made it clear that it wished to provide taxpayer–friendly exemptions from the syndicate rule to ensure that legitimate businesses were not inadvertently snared by the new limitation: “It is intended that authority granted the Secretary to treat an interest in an entity as if it were held by an active participant be used to insure that for legitimate and demonstrated business reasons, an entity may take advantage of this exemption.”⁹

Understanding the purpose for which Congress provided the active–management exceptions, we now review the exceptions to better understand how we can make sure that all taxpayers qualifying for an exception enjoy the intended benefits.

Sec. 1256(e)(3)(C) sets forth the active–management exceptions. It provides that an interest in an entity shall not be treated as held by a limited partner or a limited entrepreneur if any of the following apply:

i. for any period if during such period such interest is held by an individual who actively participates at all times during such period in the management of such entity,

ii. for any period if during such period such interest is held by the spouse, children, grandchildren, and parents of an individual who actively participates at all times during such period in the management of such entity,

iii. if such interest is held by an individual who actively participated in the management of such entity for a period of not less than 5 years,

iv. if such interest is held by the estate of an individual who actively participated in the management of such entity or is held by the estate of an individual if with respect to such individual such interest was at any time described in clause (ii), or

v. if [Treasury] determines (by regulations or otherwise) that such interest should be treated as held by an individual who actively participates in the management of such entity, and that such entity and such interest are not used (or to be used) for tax-avoidance purposes.

For purposes of this subparagraph, a legally adopted child of an individual shall be treated as a child of such individual by blood.

Some interpretive issues

A variety of issues can arise in applying the active–management exceptions. First, the “period” referred to in Sec. 1256(e)(3)(C)(i) is presumed to be the tax year in question, and one may wonder: Are short tax years treated the same as full tax years? Logically, short periods should be considered a period. The statute does not exempt short years. Interpreting the term “period” as anything but a tax year, regardless of length, produces results clearly outside the intent of the statute. Yet, in Sec. 1256(e)(3)(C)(iii), the statute refers to a five–year time span as a period. Perhaps short periods created by a closing–of–the–books election under Sec. 1377(a)(2) would count, but logically, they should count only for those shareholders affected by the “short year.” Varying interest periods for partners raise similar issues.

If an individual dies during the year, it seems logical that the period referred to in Sec. 1256(e)(3)(C)(i) should be the period in which the individual was alive, even if less than 12 months. If the deceased was active in management prior to death, then the combination of clauses (i) and (iv) would treat that interest as an active interest for the full year. This result seems consistent with congressional intent.

The phrase “held by an individual” presumably includes interests owned directly by an individual as well as interests held by a grantor trust or a single–member LLC that is treated as a disregarded entity. Under the only court case in this area, the Fifth Circuit held that an individual did not have to hold the interest directly but could also hold it indirectly through the ownership of a wholly owned S corporation.¹⁰

Note that participation in the entity in a nonmanagerial capacity does not count for purposes of this rule. Contrast this with the material–participation standard for passive loss limitation purposes, where participation is measured in hours regardless of whether those hours are spent on managerial activities or more mundane matters. Instead, there is no requirement here, in the statute or relevant regulations, as to the minimum number of hours needed to qualify.

Note, too, that participation is required “at all times” during the period. Being active in management for only a portion of the period is not sufficient. Is it sufficient if one is active during the entire period the business is active? A seasonal business may not have year–round work, but it would seem reasonable to allow an individual to qualify if they are active in management for the entire season the business operates. To hold otherwise would be to narrow the exception to only those businesses requiring 12 months of active management.

While the statute states “at all times,” it does not state whether this phrase means “at all times when management was needed” or at all times the taxpayer was participating in the activity. If 100 hours is all the time needed to manage an activity, and the taxpayer, perhaps a practicing attorney, does all the law firm management work (100 hours) and spends the rest of the time working on billable client work (1,500 hours), it seems logical that the taxpayer would qualify under the first requirement of Sec. 1256(e)(3)(C)(i). This interpretation is, in the author’s opinion, supported by the guidance available as detailed in the IRS letter rulings discussed next and the representations these rulings required of the taxpayers. Note that letter rulings apply only to the taxpayer receiving them. They cannot be cited as precedent by others. However, with limited specific guidance to the contrary, letter rulings provide insight into the IRS’s thinking.

There is no guidance in regulations as to what constitutes management activities. The only government guidance in this area comes from IRS letter rulings issued to the first professional service firms attempting to convert their legal entities from partnerships to LLCs. The Service permitted the owners of these firms to be considered active in management. A professional adviser attempting to determine how Sec. 1256(e)(3) applies to a client would be well served to be aware of the details of these rulings.

IRS letter rulings on what constitutes management activities

In one of the earliest rulings addressing what constitutes management activities for purposes of applying the active–management exceptions, the IRS concluded that the delegation of numerous responsibilities to an executive committee did not preclude a conclusion that LLC members actively participated in management. The taxpayer described the management responsibilities of each partner/owner as follows:¹¹

The taxpayer represents that each member of the LLC will actively participate in the day–to–day responsibilities of recruiting, staffing, business development, selection of future members of the LLC, employee management, training and evaluation, and billing and collections. The members will conduct and manage their respective practices, which collectively will account for substantially all the revenue of the LLC. The LLC Agreement vests management of the LLC in the members. However, the members will delegate management responsibilities to an Executive Committee comprised of the members. The Executive Committee is accountable to all the members; the Executive Committee is required to keep the members advised of all important committee actions; and the Executive Committee will serve at the will of the members. The taxpayer represents that the members as a whole are responsible for the management of the LLC’s affairs notwithstanding the existence of the Executive Committee.

Under the applicable provisions of the LLC Agreement, prior approval of the members is required for admission of new members; for the expulsion of a member; for the amendment of the LLC Agreement; and before the LLC becomes bound under any obligation which involves a potential liability in excess of the net fair market value of the LLC’s assets.

The foregoing allowed the Service to conclude:

The taxpayer’s representations regarding the involvement of the members of the LLC in the management of the company and the responsibilities of the members indicate that the members will actively participate at all times in the management of the LLC. The fact that many of the responsibilities will be delegated to the Executive Committee does not preclude a conclusion that the members actively participate in management. Therefore, the LLC will not be treated as a syndicate under section 1.448–1T(b)(1)(ii) of the temporary regulations for any period during which the members of the LLC are not treated as limited partners under section 1258(e)(3)(C)(i) because of their active participation in management.¹² 

The next ruling, issued six months later on the same subject, allowed the firm to remain on the cash method based on very general representations of the taxpayer. This taxpayer–favorable ruling was based on the representation of all the lawyer–partners that they would be active in management. No definitions or details of what was required to be considered active in management were required or provided.¹³

Another, later ruling allowed a law firm to remain on the cash method even though the entity was run by an executive committee and not by all the partners. In reasoning like that in the first ruling in this area, the IRS found the individual lawyers were “the ultimate policymakers of the company, although an executive committee will be responsible for management and for the implementation of the plans adopted by the LLC.”¹⁴

Review of the cited portions of these private letter rulings may help the practitioner who is trying to apply the statute to a client’s facts for the next tax return being prepared. The rulings ranged from a very limited fact set to providing much more substantial detail, and yet the results were the same. As is typical of the ruling process, the IRS accepted, without audit but subject to verification upon audit, the representations of the taxpayer applying for the ruling. In one ruling the taxpayer represented, without additional detail, that all partners were active in management. Note that the rulings allow participation to be considered managerial even though the business owner may not sit on the management committee.

The executive committee referred to in the rulings is analogous to the board of directors of an S corporation. A shareholder should not be required to be on the board of directors or be an officer in the corporation to be considered an active participant in management, although it is helpful. Being on the board or being a corporate officer should allow a shareholder to be considered an active participant if the role is true in name and in fact. In a similar fashion, holding an LLC interest in a member–managed LLC could be sufficient. Being a manager of an LLC should provide a sufficient basis for concluding that an individual is active in management. Assuming a client represents that all partners or shareholders are active in management, and absent any knowledge to the contrary, is the tax preparer allowed to conclude that the syndicate rule does not apply? Regs. Sec. 1.6694–1(e) would appear to answer in the affirmative when it states that “the tax return preparer generally may rely in good faith without verification upon information furnished by the taxpayer.” The question for the tax preparer is, “Where in your workpapers have you documented the taxpayer’s representation?”

Other aspects of the active-management exceptions

Certain aspects of these exceptions are important to emphasize. The active participation of one individual in management is sufficient to bestow active–participation status, through attribution, on the individual’s spouse, parents, children, and grandchildren. Note the attribution rule goes up by one generation but down two generations; grandparents do not qualify, but grandchildren do qualify. The statute states that adopted children are treated the same as biological children.

Active participation for five years gives an individual the equivalent of tenure for purposes of this test. Note that this test does not require the five years to be consecutive or the five most recent years. Contrast this with the five–year rule in the passive loss regime where the five years must be within the most recent 10 years.¹⁵ For purposes of the syndicate rule, individuals who actively participated at one time for a total of five years will be permanently considered active. This would allow grandparents who were once active to retain that status without needing the attribution rule. Similarly, retired management owners could qualify under this rule even if they are not related to any other owner.

If an entity only has members or shareholders, each of whom has been active in management for five years, then this entity is protected against loss of the use of the cash method due to the syndicate rule until there has been a change of ownership. Likewise, if members or shareholders entitled to 65% of loss allocations are members of the five–year club, then the entity is free of the syndicate rule until there is a change in ownership for S corporations or in ownership or loss allocation for partnerships.

The rule for estates is even more generous with respect to determination of active–participation status. The estate of an individual who actively participated is considered to be an active participant. Note this rule applies regardless of how long the decedent participated; there is no five–year minimum. It seems logical that such prior active participation would be a minimum of one year, but that year could be any prior year.

Building on this generous interpretation, the statute goes on to permit an estate of an individual who never was an active participant to acquire active–participation status through the attribution rules above regardless of when the decedent’s qualifying relative had active–participation status. The use of the phrase “at any time” in the statute would seem to qualify the estates of family members permanently, even if the qualifying relative held active status for a single year.

It should be clear that a tax practitioner could easily maintain an ownership list for small businesses that, in addition to the normal information, provides the category of an applicable syndicate exemption: currently active, active through attribution, five–year tenure rule, or qualified estate. The planning profile maintained for the client could show the vulnerability, or lack thereof, to loss of the use of the cash method and/or other accounting methods mentioned above.

Calculating losses for the 35% threshold

For those clients who are not able to avoid the syndicate rule through the use of the elective prior–year rule or the active–management exceptions, it is important to understand the nuances, traps for the unwary, and planning opportunities that are involved in the calculation of losses for purposes of the syndicate rule. We now dig deeper into this area.

New Regs. Sec. 1.448–2(b)(2)(iii)(A) defines losses for this purpose, stating:

[T]he losses of a partnership, entity, or enterprise (entities) means the excess of the deductions allowable to the entities over the amount of income recognized by such entities under the entities’ method of accounting used for Federal income tax purposes (determined without regard to this section). For this purpose, gains or losses from the sale of capital assets or assets described in section 1221(a)(2) are not taken into account. 

The regulation thus excludes from the syndicate rule’s profit computation the gain or loss from capital assets as well as the gain or loss from assets described in Sec. 1221(a)(2). Students of the Code will recall that the definition of a capital asset under Sec. 1221 is exclusionary. That is to say, the statute states that any asset “held by the taxpayer (whether or not connected with his trade or business)” is a capital asset unless it is described in one of eight categories of assets listed in that subsection.¹⁶ The second class of assets excluded from capital asset status — but expressly included here under the regulation — are those that are “property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business.”¹⁷ Therefore, when computing profit or loss for purposes of the syndicate rule, the regulation excludes gains or losses from depreciable property and business real estate, as well as all other capital gains or losses.

Note that the regulation states gains or losses from the sale of capital assets are not considered, but it does not state that only capital, as opposed to ordinary, gain or losses are excluded from the computation. The ordinary–income component related to depreciation recapture would not be considered for purposes of the syndicate rule, as it is a gain from the disposition of a Sec. 1221(a)(2) asset. The ordinary loss from sale of a Sec. 1231 asset and the ordinary income stemming from recaptured Sec. 1231 losses both occur at the taxpayer level and not at the level of the passthrough entity. Thus, at the passthrough–entity level, all Sec. 1231 gains or losses are to be excluded from the computation under Sec. 1256(e)(3)(A).

One should note that, although Sec. 167 only covers depreciation of tangible assets, intangible assets eligible for amortization under Sec. 197 are treated as being of a character subject to depreciation under Sec. 167 for all purposes of Code Chapter 1 (of Subtitle A).¹⁸ To the extent the sale of an intangible asset is treated as a capital asset, the gain or loss, including an amortization recapture, would be excluded from the syndicate loss computation. Sales of self–created intangible assets are generally not considered capital assets¹⁹ but may qualify as capital under Sec. 1235.

The regulation states that the deductions considered in this computation are those “allowable to the entities.” This obviously means that nondeductible expenses such as fines and penalties would not be considered. Note it does not say “allowable to the entities or entity owners.” Does it also mean that deductions not considered at all by the entity, such as charitable contributions or investment interest expense, do not enter the computation? How are items that can be either capitalized or deducted but only at the partner or S corporation shareholder level considered? These would include circulation expenses, research–and–experimental expense, intangible drilling costs, and costs related to mining.²⁰ Note that such expenses are not considered in computing entity–level income for purposes of the net income limitation of Sec. 179 discussed next. Drawing on the treatment of these expenses for purposes of the Sec. 179 deduction, it seems to this author that it is defensible to exclude these expenses, as they are not “allowable to the entities.”

The expensing election in Sec. 179 has a net income limitation, which should not result in problems with using the cash method, as the deduction cannot cause a loss.²¹ However, there is a trap for the unwary S corporation or partnership here. This is because for S corporations, the shareholder wages are added back to income solely for purposes of the Sec. 179 net income limit.²² Guaranteed payments for partners are treated in a similar manner.²³

Example 2: A partnership and an S corporation each have net income, before any limitations, of $500,000. The partnership has paid $400,000 in guaranteed payments, and the S corporation has paid $400,000 in wages to its shareholders. Each entity has purchased $1 million in Sec. 179–eligible properties. After adding back the partner and shareholder compensation, each entity will be able to deduct $900,000 of Sec. 179 property. However, for purposes of the syndicate rule, each entity will have a loss of $400,000. If more than 35% of this loss is allocated to “limited entrepreneurs” and the entities are not able to finesse their way out of the syndicate rule using the tools described earlier, use of the cash method could be lost. Unless workpapers or software track this potential problem, there is risk of an unpleasant surprise.

Deductions without specific economic outlay, such as those provided by Sec. 179D, would be considered in the special computation of loss under the syndicate rule, as the deduction is “allowable to the entities.”

The computation for this purpose is always at the entity level first. The computation stops if the partnership has a profit, even if the partnership agreement allows a loss to be reported for one partner while a profit is reported for another. If, in the aggregate, the partnership has a profit, the syndicate rule will not apply to that year. If, on the other hand, the partnership has a loss, no matter how small, then the second test does apply, and one must analyze whether greater than 35% of the loss is allocated to a limited partner or limited entrepreneur. If the partnership agreement allows for special allocations, then the test would apply to the entity–level loss. Assume a circumstance where the partnership has a loss of $10,000. The partnership agreement has allocation provisions that result in $30,000 of loss being allocated to some partners and $20,000 of profit being allocated to other partners. It appears the test would be failed if more than 35%, or $3,500, of loss were allocated to a limited partner or limited entrepreneur who is not active in management. If so, the use of the cash method is potentially lost. If $28,000 of loss is allocated to partners active in management, with the remaining $2,000 of loss going to a passive partner, the syndicate rule test is passed, and the use of the cash method is preserved.

Depreciation specially allocated to a partner under a Sec. 754 election does not impact this computation, as the depreciation is not a deduction “allowable to the entity.”

Credits would not have an impact, as they are neither “income” nor “deductions,” these two being the only tax elements described in the regulation.

Limits on losses that relate to basis limitations, at–risk rules, passive loss limits, and excess business losses would not be considered to the extent that the limitation would apply at the partner or shareholder level. Thus, an entity with a loss that may not be currently deductible to any partner or shareholder due to one or more of these limits would still be in danger of losing the use of the cash method. Keeping the tradition alive that all statements in taxation are likely to have an exception, one should note that a basis limitation can apply if a lower–tier partnership passes through a loss that the upper–tier partnership or corporate owner does not have sufficient basis to claim. Since basis limitations only limit recognized losses, this can be a silver lining; if the loss recognized by the upper–tier partnership is reduced by a basis limitation, this lowers the probability of the syndicate rule applying to the upper–tier partnership.

Sec. 163(j) provides a limit on the amount of interest expense that can be deducted. However, Regs. Sec. 1.1256(e)-2(b) provides that “[f]or purposes of section 1256(e)(3), the amount of losses to be allocated under paragraph (a) of this section is calculated without regard to section 163(j).” Sec. 163(j) acts as a limit on interest deductions. Computing profit or loss for purposes of the syndicate rule without regard to this limit would mean that all interest expense for the year would be considered, even if the interest deduction is ultimately curtailed by Sec. 163(j). As a practical matter, the small business exception to the Sec. 163(j) rules provides that the limitation does not apply if the entity is not a syndicate. This small business exception generally applies to businesses with average gross receipts of less than $31 million (for tax years beginning in 2025). However, this small business exception does not apply if the entity is a syndicate, regardless of the level of gross receipts.

Additional illustrations

The following examples may help in understanding the loss calculation rules.

Example 3: An S corporation or partnership using the cash method has a profit for the year shown on page 1 of the Form 1120–S, U.S. Income Tax Return for an S Corporation, or Form 1065, U.S. Return of Partnership Income, in the amount of $100. The entity has no other income or expense, so only the ordinary–income box on Schedule K has an entry. One might think that the syndicate rule could not operate to force the entity off the cash method for the year. However, a closer review of page 1 of the return shows that gross income includes $150 of Sec. 1245 depreciation recapture. Removing the gain from the Sec. 1221(a)(2) asset from the calculation of profit for the year for purposes of the new regulation results in the entity having a loss of $50. If more than 35% of this loss is allocable to a limited partner or limited entrepreneur, then the entity will potentially lose the ability to file this return on the cash method.

Example 4: Assume the same as Example 3, where the entity has page 1 profit of $100 that includes $150 of ordinary income from depreciation recapture. However, in this situation, the taxpayer also shows, on Schedule K, $40 of profit from real estate rental activities, along with $5 of interest income and $7 of dividend income. Adding all Schedule K items, the taxpayer has a taxable profit of $152. Now, when the $150 of depreciation recapture is removed from the computation required by this new regulation, the entity has a profit of $2. The entity is allowed to retain the cash method.

Example 5: Assume the entity has Schedule K, box 1, income of $100, a Sec. 1231 gain of $10, and Sec. 179 expense of $110. The entity–level taxable income limit for Sec. 179 includes items such as Sec. 1231 gains that are excluded from the syndicate rule computation.²⁴ Because the Sec. 1231 gain allows a Sec. 179 deduction greater than the box 1 income while that same gain is excluded from the syndicate rule computation, the entity would have a loss of $10 for the year for purposes of the syndicate rule. The cash method would be lost if the entity loss allocable to limited partners or limited entrepreneurs exceeded 35%.

Example 6: However, the entity upgraded its equipment during the year, trading in its old equipment for new equipment. The company received a $50,000 trade–in credit for its old, fully depreciated equipment on its purchase of $75,000 of new equipment. Assume the entity has a taxable profit of $10,000 after including the depreciation recapture and deducting the maximum depreciation, including bonus depreciation, on the new equipment. Removing the $50,000 of depreciation recapture from the computation of profit under the syndicate rule changes the $10,000 profit to a $40,000 loss, bringing use of the cash method into jeopardy.

Planning opportunities

Turning now to planning considerations, tax preparers should note that changing a small loss, computed under the syndicate rules, to a small profit guarantees the continued use of the cash method for the current year and the subsequent year. A profit, no matter how small, obviates the risk of losing the use of the cash method because of the syndicate rule for the current and the following year. If the subsequent year should show a loss, the taxpayer can elect the prior–year rule (referring back to the current year) and continue using the cash method. Similarly, a loss, no matter how small, can trigger the loss of the use of the cash method if more than 35% is allocable to passive owners. There is no minimum amount of loss that allows one to ignore this rule.

This opens planning opportunities that tax preparers should consider for protecting the use of the cash method. Some deductions such as depreciation on property otherwise qualified for bonus depreciation can be electively reduced from the default rule percentage of deductibility in the current year.

Another alternative would be to use Sec. 179 instead of bonus depreciation. However, one should note that although Sec. 179, with its entity–level net income limitation, would seem to be ideal for lowering income without taking the entity to a loss for the year, the way in which net income is computed is different. As mentioned previously, gains from the sale of business assets are included in the computation of income for Sec. 179 purposes. As previously mentioned, the syndicate rule calculation specifically excludes such gains. The important distinction is that one may select, subject to the limitations of Sec. 179, any or all the cost of a depreciable asset, on an asset–by–asset basis. Bonus depreciation is an all–or–nothing default proposition, deducting the full cost of all eligible assets unless an election to the contrary is filed under Sec. 168(k)(7). The election out of bonus depreciation then applies to all assets of that class for a year.

Example 7: An S corporation has $900 of income and a gain from sale of a business asset of $100. The corporation also purchased an asset for $1,000, which is eligible for Sec. 179 expensing. Using the maximum Sec. 179 deduction, income is reduced to zero in compliance with the Sec. 179 net income limitation.²⁵ However, when the income for the year is computed for purposes of the syndicate rule, the $100 asset gain is removed, leaving the entity with income of $900 and a Sec. 179 deduction allowable to the entity of $1,000. If more than 35% of the resulting loss is allocable to shareholders not active in management, the use of the cash method will be lost unless the elective prior–year rule can save it. If the prior–year election cannot be used, the corporation could elect to take depreciation and a Sec. 179 deduction totaling, between the two, $900 and then be eligible to continue to use the cash method.

The example above provides a simple illustration of how the computations can be different. Fortunately, modern tax preparation software makes it much easier to compute and compare the different limitations. However, the author is not aware of any commercial software that automatically produces entity income or loss under the syndicate rule. Until this computation becomes routinely produced by commercial software, tax practitioners would be well served to have a workpaper that computes profit or loss under the syndicate rules. Earlier in this article, it was recommended that the master tax planning memo or document for the client establish whether the client can be exempted from the syndicate rule under one or more of the active–participation–in–management exceptions. If an exemption is currently available, one can skip the preparation of the separate computation of syndicate income or loss.

Note that while the new regulation applies to years beginning on or after March 22, 2021, the regulation allows taxpayers to apply the regulation to earlier periods after 2017 if it is applied consistently to all years after adoption.²⁶

Thus, tax returns being filed for the 2021 calendar year can apply the taxpayer–favorable rules of this regulation. Additionally, prior years, such as calendar years 2018, 2019, and 2020, could benefit from the interpretations provided by this regulation. It appears, but is not completely clear, that if a taxpayer adopts earlier application of this rule, the related parties described in the cited regulation may have to adopt earlier application of this rule as well. Related parties are those “within the meaning of sections 267(b) (determined without regard to section 267(c)(3)) and 707(b)(1).”²⁷

Finally, since 2021, the Form 1065 instructions mention the new election to use the prior–year allocations to avoid syndicate status. Oddly, the Form 1120–S instructions have never mentioned it.

Practitioners who educate themselves on how the syndicate rule works can help protect clients from having their business classified as a syndicate and losing the right to use the cash method.

Footnotes

¹Sec. 448(d)(3), through cross-reference to Sec. 461(i)(3).

²Sec. 448(c)(4); Rev. Proc. 2024-40.

³Sec. 163(j)(3).

⁴Sec. 460(e)(1)(B).

⁵Sec. 263A(i).

⁶Sec. 461(i)(1).

⁷Sec. 471(c).

⁸Regs. Sec. 1.448-2(b)(2)(iii)(B).

⁹Conf. Rep’t No. 97-215, 97th Cong., 1st Sess. (1981).

¹⁰Burnett Ranches, Ltd., 753 F.3d 143 (5th Cir. 2014). The IRS nonacquiesced to this decision in Action on Decision 2017-1.

¹¹IRS Letter Ruling 9407030, issued Nov. 24, 1993.

¹²Id.

¹³IRS Letter Ruling 9432018, issued May 16, 1994.

¹⁴IRS Letter Ruling 9501033, issued Jan. 1, 1995.

¹⁵Temp. Regs. Sec. 1.469-5T(a)(5).

¹⁶Sec. 1221(a).

¹⁷Sec. 1221(a)(2).

¹⁸Sec. 197(f)(7). Chapter 1 includes Secs. 1 through 1400Z-2.

¹⁹Sec. 1221(a)(3).

²⁰Sec. 59(e).

²¹Sec. 179(b)(3)(A).

²²Regs. Sec. 1.179-2(c)(3)(ii).

²³Regs. Sec. 1.179-2(c)(2)(iv).

²⁴Regs. Sec. 1.179-2(c).

²⁵Sec. 179(b)(3).

²⁶Regs. Sec. 1.1256(e)-2(d).

²⁷Id.

Contributor

Kevin J. Walsh, CPA, CGMA, is a partner of WKS, A Professional Corporation, in Fairbanks, Alaska, and an associate member of the AICPA S Corporation Taxation Technical Resource Panel. The author thanks Kenneth Orbach, Ph.D., CPA, and Matthew Curley, CPA, for their review, comments, and support. For more information about this article, contact thetaxadviser@aicpa.org.

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