Introduction

Many taxpayers will need to consider the recent small business taxpayer regulations. On January 5, 2021, the IRS released final regulations[1] that provide guidance on the implementation of several provisions of the Tax Cuts and Jobs Act (TCJA).[2] The final regulations address several important tax provisions including the following: limitation on use of the cash method of accounting, exemption from inventory methods required under IRC § 471, uniform capitalization requirements under § 263A, and the percentage of completion method for certain long-term construction contracts under § 460A. Also of importance is the application for qualified small business taxpayers that provides an exemption from the complex interest expense limitations under § 163(j). The TCJA provided simplified tax accounting rules, including permitted use of the cash method of accounting, that apply to small business taxpayers having average annual gross receipts of $25 million or less (adjusted for inflation). The computation is generally made for the three–tax year period ending before the current year.[3] The inflation threshold is increased to $26 million for tax years 2019, 2020 and 2021.[4] Taxpayers treated as tax shelters or syndicates are prohibited from utilizing these small taxpayer simplifications[5]; for example, such entities are prohibited from using the cash method of accounting and are required to utilize the complex interest limitations under § 163(j). Prior to the final regulations, many taxpayers might have fallen into the tax shelter trap; the final regulations provide some helpful elections.

Tax Shelter – Syndicate

A tax shelter is defined under § 448(d)(3) and § 461(j)(3) and under Treas. Reg. § 1.448-2(b)(2). The first test is any enterprise, other than a C corporation, if the interests offered are required to be registered. The second test is any syndicate described under § 1256(e)(3)(B) and the third is any tax shelter defined in IRC § 6662(d)(2)(C)(ii). Although it is easy to see that a registered offering, partnership or arrangement having a significant purpose to avoid or evade federal income taxes is a tax shelter, it is less intuitive to immediately recognize a syndicate as a tax shelter. 

A syndicate is a partnership or other flow-through entity if more than 35% of the losses of the entity during the tax year are allocated to limited partners or limited entrepreneurs.[6] A limited entrepreneur is a person not active in the management of the entity. The determination is made on an annual basis. In an attempt to address COVID-19-related losses, the final regulations addressed the situation where historically profitable taxpayers experienced an unforeseen tax loss for 2020 and return to profitability in 2021. As we will address in the examples later in this article, the simplification and helpful guidance and elections may not be available for those taxpayers who experienced losses in both 2020 and 2021; other planning options must be considered, or the taxpayer will lose status as a small business taxpayer. For example, if the taxpayer meets the definition of a syndicate, the taxpayer is precluded from using the cash method of accounting is required to compute inventories under § 471, including the Uniform Capitalization (UNICAP) rules. Interest expense will also be limited under the complex § 163(j) computations.

The final regulations provide relief to some taxpayers and permit an annual election to use allocated taxable income or loss for the immediately preceding tax year in order to determine whether syndicate status has been triggered. Many families have expedited their estate planning and business succession programs in order to take advantage of the high gift exemptions provided by the TCJA.[7] This brief example will help illustrate the syndicate trap. Entity X is a cash method limited liability company (LLC) that is owned 51% by Mother, and the remainder is divided equally among her four children. Child 1 is active in the business and the other three are inactive. For 2020, the LLC incurred a loss from its rental operations but historically, the entity had reported profits. Assuming the loss is allocated proportionately, the entity will trigger syndicate status in 2020 and, absent the election (which will be described immediately below), will not be allowed to use the cash method of accounting and will likely have suspended mortgage interest expense to future years. Syndicate status was triggered because three of the children holding a combined 36.75% interest in the entity will receive an allocated loss exceeding 35%. A similar result would apply if the entity were an S corporation. As described below, planning techniques that may be available to a partnership will not be available to an S corporation.

The Election

The final regulations provide relief by establishing an annual irrevocable election to test the allocation of losses based upon the prior taxable year. In the prior example, LLC may elect to utilize 2019 as the test year; because 2019 reported income, syndicate status is avoided, and the cash method may be retained. As helpful as the election is for 2020, if a loss also occurs for the year 2021, other planning must be considered.

The regulations provide rules for the time and manner of making the election. The taxpayer makes the election for each taxable year by attaching a statement to its timely filed original federal income tax return, including extensions. The statement must say that the taxpayer is making the election under § 1.448-2(b)(2)(iii)(B). The election is made by the entity (S corporation or the partnership) and not by the individual member. Once the election is made it may not be revoked but it will not apply automatically to the next year.[8]

2021

If LLC X in the prior example also had a loss in 2021, utilization of the election would not avoid syndicate status because more than 35% of the losses were allocated to the inactive children in the tax year 2020. Many of the larger and more complicated loss returns for 2020 have been placed on extension and several planning ideas must be considered depending on the individual facts and circumstances; for example, perhaps it is possible to have another child become active in the management of the real estate business. In that event, less than 35% of losses will be allocated to the inactive children and syndicate status will be avoided. Alternatively, for entities that are partnerships for tax purposes, perhaps a special allocation of the loss under § 704(b) to the active owners may be possible so that losses passing to the inactive partners would not exceed 35%, thereby avoiding syndicate status. It might also be possible to defer certain expenses until 2022 and elect different depreciation methods for improvements to property placed in service in 2021, thereby creating a profit instead of a loss. Syndicate status is not applicable if the entity has income for the tax year.

It is important to remember that S corporations may have only a single class of stock, and special allocations are not permitted.[9]

Conclusion

Tax preparers need to be aware of the syndicate tax trap and alert to the possibility that flow-through entities will be considered tax shelters or syndicates. Perhaps the most unexpected result of triggering the syndicate trap is that the taxpayer will not be able to use the cash method of accounting. A change from the cash to the accrual method may be required if the taxpayer fails to meet the gross receipts test in a given year or is unable to utilize the gross receipts test because they are a syndicate. The proposed regulations issued in August 2020 included a five-year prohibition on reelecting the cash method. The final regulations removed that five-year eligibility requirement and future procedural guidance will be issued for taxpayers that wish to reemploy the cash method after they had been forced to utilize the accrual method under these rules.

With respect to inventories under § 471, small taxpayers were able to utilize several alternative methods that are not available to tax shelters or syndicates. A detailed discussion of inventory treatment is beyond the scope of this article, but dramatic changes in the utilization of different inventory methods will have a large impact on taxpayers required to use the inventory method and UNICAP rules. Similarly, many taxpayers were able to avoid the complex interest expense limitation rules under § 163(j).[10] Tax advisers need to be very focused on these rules as they prepare 2020 returns reporting tax losses. These rules add to the already complex landscape of the loss carryback rules and computational changes ushered in by the TCJA and Coronavirus Aid, Relief and Economic Security (CARES) Act.

Robert S. Barnett, JD, MS (Taxation), CPA, is a founding partner at Capell Barnett Matalon & Schoenfeld, LLP, attorneys at law in Jericho, N.Y. His practice areas include business tax planning, estate planning, tax dispute resolution, and Tax Court representation. He can be reached at rbarnett@cbmslaw.com.

[1] T.D 9942, 1/5/2021.