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Effect of the Build Back Better Act on Corporate and Partnership Taxation

On September 15, the House Ways and Means Committee voted to approve sweeping changes to the Internal Revenue Code through the Build Back Better Act, which proposals, if ultimately passed, will have a significant effect on the taxation of corporations and partnerships. We discussed the changes proposed to affect estate and gift taxation in an earlier article. In this article we explore the effect of the Build Back Better Act on corporate and partnership taxation.

The most widely talked about proposal is the increase to the corporate tax rate, but the proposed legislation contains a number of other equally important changes, including a number of international corporate tax issues. However, this article will not touch on the international issues; instead, we’ll focus on the effect that the proposed changes will have on domestic corporations and partnerships.

New Corporate Provisions

Increase in Corporate Tax Rate

Effect of the Build Back Better Act on Corporate and Partnership TaxationThe Ways and Means Committee proposed a graduated rate structure for most corporations.[1] A corporation’s taxable income that does not exceed $400,000 would be subject to an 18% tax rate. If the corporation’s income exceeds $400,000 but does not exceed $5 million, it would be subject to a 21% tax rate, and if the corporate income exceeds $5 million, it would be subject to a 26.5% tax rate.

But wait, there’s more for larger corporations and personal service corporations…

Taxes owed by corporations with income in excess of $10 million also would be increased by the lesser of (1) 3% of the excess or (2) $287,000 – meaning the effective tax rate of a large corporation will be a bit higher. Further, the graduated rate structure would not apply to qualified personal service corporations (as defined in IRC § 448(d)(2)).[2]

Instead, these corporations would be subject to a flat US federal income tax rate of 26.5%. Deductions on dividends received from a domestic corporation under IRC § 243 would be increased from 65% to 72.5% for dividends received from 20%-owned corporations and from 50% to 60% for other dividends that are not qualifying dividends.  These changes to the corporate income tax rate and domestic dividends-received deduction would be effective for tax years beginning after December 31, 2021.

Expansion of the Net Investment Income Tax

BBBA Rich2The proposal would amend IRC § 1411 (Imposition of Net Investment Income Tax) by adding a new subsection entitled “Application to Certain High-Income Individuals.”[3]  Specifically, in the case of any individual, whose modified AGI exceeds the “high income threshold amount,” the net income investment tax (“NIIT”) will be applied to the individual taxpayer’s net investment income.

The term “high income threshold amount” means $400,000, except in the case of a taxpayer making a joint return or a surviving spouse ($500,000) and a married taxpayer filing separately, $250,000.  Wages subject to FICA are not taken into account, nor are net operating losses.  However, certain foreign income is included.

Limitation on Deduction of Qualified Business Income for Certain High-income individuals

BBBA LimitUnder IRC § 199A, as it is currently written, in the case of a taxpayer other than a corporation, there a deduction is allowed for any taxable year in an amount equal to the lesser of the (1) combined qualified business income amount of the taxpayer, or (2) an amount equal to 20 percent of the excess (if any) of (a) the taxable income of the taxpayer for the taxable year, over the net capital gain of the taxpayer for such taxable year.[4]

The proposal would add a third category of income: $500,000 in the case of a joint return or a surviving spouse; $250,000 in the case of a married individual filing a separate return; $10,000 in the case of an estate or trust; or $400,000 in the case of any other taxpayer.

Extension of Expensing of Research and Experimental Costs under IRC § 174

BBBA Experiment

The proposal would extend the expensing of research and experimental costs under IRC § 174 for expenses paid or incurred in tax years beginning before 2026.[5] IRC § 174 expensing currently is scheduled to expire for tax years beginning after 2021. The effective date of the amendment would be the date of enactment.

Modifications to Treatment of Certain Corporate Losses

BBBA WorthlessThe proposal amends IRC § 165(g)(1) (Worthless Securities), which currently provides that if “any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall, for purposes of this subtitle, be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset.” The proposal strikes the bolded language and replaces it with “at the time of the identifiable event establishing worthlessness.”[6] These provisions would apply to losses arising in taxable years beginning after December 31, 2021.

Deferral of Losses in Certain Controlled Group Liquidations

The proposal would add new IRC § 267(h), which would defer the recognition of certain losses realized on the stock or securities of a liquidating corporation in a complete liquidation to which IRC § 331 applies.[7] Specifically, in the case of two related corporations within the meaning of IRC § 267(b)(3), no loss is recognized on the stock or securities of a liquidating corporation in a complete liquidation to which IRC § 331 applies until the corporation receiving property in such liquidation disposes of substantially all of the property it received in such liquidation to one or more persons who are not related to such corporation (within the meaning of IRC § 267(b)(3) or IRC § 707(b)(1)). These provisions would apply to liquidations happening on or after the date of the enactment of the BBBA.

Additional Limitation on Divisive Reorganizations in the Context of Leveraged Spinoffs

BBBA SpinoffThe proposal would add new IRC § 361(d), which would limit the tax-free transfer of boot and controlled corporation debt securities by a distributing corporation to its creditors.[8] Under new IRC § 361(d), a distributing corporation in a divisive reorganization would recognize gain on the boot received to the extent of the excess of (a) the sum of 1) boot issued, 2) controlled securities issued, and 3) liabilities assumed by the controlled corporation, over (b) the basis in the assets transferred by the distributing corporation to the controlled corporation in the reorganization. The provision would apply to reorganizations occurring on or after the date enacted.

Expansion of Constructive Sales rules to “Digital Assets” (Cryptocurrency)

The proposal would expand the definition of “appreciated financial position” in the IRC § 1259 constructive sale rules to include positions with respect to “digital assets.”[9] It’s important to note that the term “digital asset” has never been used in the Code or the Treasury Regulations. The term “digital asset” means “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology,” which is just fancy talk for cryptocurrency.

BBBA CryptoFurthermore, the types of transactions that may result in a constructive sale of certain appreciated economic short positions with respect to property would be amended to include entering into a contract to acquire the same or substantially identical property. These changes would be effective for constructive sales that occur, or for contracts entered into, after the date of enactment of the BBBA.

The constructive sale rules, which generally prevent taxpayers from deferring gain recognition on appreciated assets by entering into an offsetting position to effectively lock in a gain without actually selling the asset, previously applied only to positions in stock, certain debt, partnership interests, and certain trust interests.

Rules Relating to Common Control

The proposal would amend IRC § 52(b) to add that the term “trade or business” includes any activity treated as a trade or business under IRC §469(c)(5) (any activity involving research or experimentation (within the meaning of IRC § 174)) or IRC §469(c)(6) (any activity in connection with a trade or business, or any activity with respect to which expenses are allowable as a deduction under IRC § 212).  The effect of this change would be that non-corporate taxpayers engaged in activities treated as a trade or business for purposes of the passive activity loss rules, which includes any for-profit activity, would be treated as a “trade or business” subject to the aggregation rules.

Expansion of Wash Sale Rules

The proposal would amend the wash sale rules of IRC § 1091(a).[10] Currently, IRC § 1091(a) provides that in the case of any loss claimed to have been sustained from any sale or other disposition of shares of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired (by purchase or by an exchange on which the entire amount of gain or loss was recognized by law), or has entered into a contract or option so to acquire, substantially identical stock or securities, then no deduction shall be allowed under IRC § 165 unless the taxpayer is a dealer in stock or securities and the loss is sustained in a transaction made in the ordinary course of such business.

The proposal would amend the bolded language to include sales in which both taxpayers and a related party have acquired substantially similar assets. Related parties include an individual, the taxpayer’s spouse, any dependent of the taxpayer, as well as a corporation, partnership, trust, or estate that controls or is controlled by (within the meaning of IRC § 954(d)(3)) the taxpayer, among others.[11] This inclusion of related parties will likely significantly increase the volume of transactions for which the wash sale rules are relevant.

BBBA Wash
Indeed it is.

Further, the proposal would expand the types of assets subject to the wash sale rules to include commodities, foreign currencies, and digital assets (including contracts or options to acquire or sell these assets).[12] The definition of digital assets is consistent with the proposed amendment to IRC § 1259, discussed above. An exception is provided for any sale or disposition of a foreign currency or commodity that is directly related to the business needs of a trade or business of the taxpayer — other than the trade or business of trading foreign currencies or commodities — or is part of a hedging transaction under IRC § 1221(b)(2).

The proposal also provides that if the taxpayer (or the taxpayer’s spouse) acquires substantially identical assets during the period which begins 30 days before the disposition at a loss (that was disallowed under the wash sale rules) and ends with the close of the taxpayer’s first tax year which begins after such disposition, the basis of such assets is generally increased by the amount of the loss disallowed.[13]

The proposal does not provide for such a basis adjustment to the extent a related party (other than the taxpayer’s spouse) acquires substantially identical assets. The amended basis adjustment rules generally prevent a loss that is disallowed under the wash sale rules because of a related party acquisition from being added to the basis of substantially identical assets acquired by such related-party (unless the related party is the taxpayer’s spouse), which may result in a permanent disallowance (rather than a deferral) of such loss. These wash sale provisions would apply to sales and other dispositions made after December 31, 2021.

Limitation on Qualified Small Business Stock Gain Exclusion

Under current law, individual, trust and estate taxpayers generally may exclude 100% of their gain realized on the sale of “qualified small business stock” acquired after September 27, 2010 (or 75% of gain with respect to stock acquired before such date and after February 17, 2009) to the extent such gain exceeds the greater of $10 million or 10 times the taxpayer’s basis in the stock.[14] Under the proposal, taxpayers with adjusted gross income of $400,000 or more would be eligible to exclude only 50% of any such gain.[15] This limitation would apply to all sales or exchanges occurring after September 13, 2021 (the date the proposal was introduced), except for sales or exchanges entered into pursuant to a binding contract in place on or before such date.

Modifications to Limitation on Deduction of Excessive Employee Remuneration

The American Rescue Plan Act of 2021,[16] passed in March, enacted amendments to the existing rules that prevent certain publicly traded corporations from deducting compensation in excess of $1 million paid to certain officers. Those amendments would increase the number of employees whose compensation is subject to this limitation from five to 10 for any taxable year.

BBBA Rich

The amendments as enacted are set to take effect for taxable years beginning after December 31, 2026, but the proposal would change the effective date to taxable years beginning after December 31, 2021.[17] Additionally, the proposal would cause additional types of compensation, including performance-based compensation and post-termination compensation, to be subject to the deduction limitation and would add a new aggregation rule for purposes of determining the “employer” that is subject to the limitation of IRC § 162(m).[18]

New Partnership Provisions

Modifications to Treatment of Certain Partnership Losses

BBBA Worthless2The proposal amends IRC § 165(g)(2)(C) (Definition of Securities with Regard to Worthless Securities) to include partnerships to the list of issuers of bonds, debentures, notes, certificates, or other evidence of indebtedness, which list previously only included corporations and governments (or political subdivisions thereof).[19] The proposal further adds a new subsection to IRC § 165, which new subsection would be found in IRC § 165(m).[20]

The new subsection, entitled Worthless Partnership Interest, provides that if “any interest in a partnership becomes worthless during the taxable year, the loss resulting therefrom shall…be treated as a loss from the sale or exchange of the interest in the partnership, as provided in IRC § 741, at the time of the identifiable event establishing worthlessness.” These provisions would apply to losses arising in taxable years beginning after December 31, 2021.

Partnership Interests Held in Connection with the Performance of Services (Carried Interests)

BBBA Dear GodThe proposal would amend IRC § 1061 by generally extending the current three-year holding period requirement that must be satisfied in order for long-term capital gains rates to apply to a holder of an “applicable partnership interest” (which generally includes carried interest received in exchange for services provided to certain investment businesses) to five years, except in the case of certain real estate businesses and for taxpayers with adjusted gross income below $400,000.[21]

Long-term capital gains treatment would be available only with respect to gains realized five years later than the later of (i) the date on which the taxpayer acquired substantially all of its applicable partnership interest and (ii) the date on which the applicable partnership acquired substantially all of its assets, with a requirement similar to (i) and (ii) applied in the case of tiered partnerships. The proposal further amends IRC § 1061(d) to provide that if a taxpayer transfers any applicable partnership interest, gain will be recognized notwithstanding any other provision in the Code.[22]

Changes to Definition of Applicable Partnership Interest and Specified Asset

BBBA Changes

Further, the proposal would amend the very definition of “Applicable Partnership Interest.”[23] Currently, the definition provides that the term “applicable partnership interest” means any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.[24]

The previous sentence does not, currently, apply to an interest held by a person who is employed by another entity that is conducting a trade or business (other than an applicable trade or business) and only provides services to such other entity. The exclusion would be amended by striking “to such other entity” and replacing it with “with respect to a trade or business that is not an applicable trade or business.”

The definition of “specified asset” would likewise be amended from including commodities, investment or rental real estate, cash or cash equivalents, options or derivative contracts or an interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing, to include an interest in a partnership if such partnership has a direct or indirect interest in any of the foregoing.[25]

Temporary Rule to Allow Certain S Corporations to Reorganize as Partnerships.

Under the proposal, a “qualified liquidation” of an “eligible S corporation” will be treated in the same manner as if such liquidation or complete liquidation described in IRC § 332(b), and the domestic partnership—to which substantially all of the assets and liabilities of the eligible S corporation are, as a result of such transactions—were a corporation which is an 80% distributee (within the meaning of IRC § 337(c)).[26]

An “eligible S corporation” means an S corporation that was an S corporation on May 13, 1996, and at all times thereafter would be permitted to elect to reorganize as a partnership for tax purposes during the two-year period beginning on December 31, 2021 without triggering gain recognition.[27]  a “qualified liquidation” means one or more transactions occurring during the two-year period beginning on December 31, 2021, if the transactions constitute the complete liquidation of an eligible S corporation, and substantially all of the assets and liabilities of the eligible S corporation are, as a result, transferred to a domestic partnership.[28]

The eligible S corporation must make an affirmative election that this section apply not later than the due date for filing the new partnership’s income tax return.[29]  in the case of a qualified liquidation, the transferee domestic partnership will not fail to be treated as a successor corporation of the eligible S corporation for purposes of IRC § 1362 (Election, Revocation, and Termination of S Corporation Status).[30]

BBBA Sums it Up
In a nutshell.

 

BBBA Legislative Text

 


Footnotes:

[1] BBBA, § 138101.

[2] A “qualified personal service corporation” means any corporation, substantially all of the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and substantially all of the stock of which is held by employees performing services for the corporation, retired employees who had performed such services, the estate of either of the foregoing, or anyone who acquired stock by reason of the death of the foregoing. See IRC § 448(d)(2)(A)-(B).

[3] BBBA, § 138103(a).

[4] IRC § 199A(a).

[5] BBBA, § 138516.

[6] BBBA, § 138142(a)(1).

[7] BBBA, § 138142(b).

[8] BBBA, § 138143(a).

[9] BBBA, § 138151(a).

[10] BBBA, § 138153(a).

[11] BBBA, § 138153(c).

[12] BBBA, § 138153(d).

[13] BBBA, § 138153(b).

[14] IRC § 1202.

[15] BBBA, § 138150(a).

[16] Pub L. No. 117-2.

[17] BBBA, § 138501(b).

[18] BBBA, § 138501(c).

[19] BBBA, § 138142(a)(2).

[20] BBBA, § 138142(a)(2).

[21] BBBA, § 138149(a).

[22] BBBA, § 138149(c).

[23] BBBA, § 138149(b).

[24] IRC § 1061(c)(1).

[25] BBBA, § 138149(b).

[26] BBBA, § 138509(a).

[27] BBBA, § 138509(b).

[28] BBBA, § 138509(c).

[29] BBBA, § 138509(d).

[30] BBBA, § 138509(e).

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