Revisiting Eligibility for Small Business Taxpayer Exemptions

“An exemption from UNICAP? And no limitation on the amount of business interest expense I can deduct? Sign me up!”

Many taxpayers (and their tax return preparers) have eagerly embraced the small business exemptions provided under the Tax Cuts and Jobs Act (TCJA) as a helpful planning tool to streamline compliance processes and reduce taxable income. Although the rules under the TCJA allow a considerable number of taxpayers to use the simplifying exemptions, determining eligibility for the exemptions can be a challenging process requiring taxpayers to overcome multiple hurdles. For instance, while most taxpayers and tax professionals are familiar with the existence of a gross receipts test for purposes of qualifying as a small business taxpayer, many may not be aware that entities considered to be tax shelters are never allowed to use any of the simplifying exemptions, regardless of the amount of gross receipts. Further, the types of fact patterns that can result in a taxpayer being considered a tax shelter are far more common than many expect. Accordingly, taxpayers currently utilizing one or more of the small business taxpayer exemptions (or are interested in utilizing these exemptions in future tax years) should familiarize themselves with the tax shelter definition and evaluate the applicability of the definition to their facts on an ongoing basis.

The small business taxpayer rules allow a qualifying taxpayer to apply any or all of the following exemptions:

• Exemption from the requirement to use the accrual method under IRC Section 448.
• Exemption from UNICAP under Section 263A.
• Exemption from maintaining inventories under Section 471.
• Exemption from the percentage-of-completion method under Section 460 for certain long-term construction contracts.
• Exemption from the business expense limitation under Section 163(j).

To use one of the small business taxpayer exemptions, Section 448(c) sets forth a gross receipts test that is met if a taxpayer has average annual gross receipts of $25 million or less, as adjusted for inflation, for its three prior tax years. For a tax year beginning in 2023, a taxpayer meets the gross receipts test if it has average annual gross receipts for the three prior tax years of $29 million or less. However, as noted above, this gross receipts test is irrelevant for “tax shelters,” as such entities are precluded from using any of the listed exemptions (that is, tax shelters are never considered small businesses for purposes of the streamlined accounting methods and the exemption from Section 163(j)).

What is a tax shelter for purposes of the small business taxpayer exemptions?

For purposes of Section 448, a tax shelter includes a syndicate as defined under Treasury regulations. The regulations define a syndicate to mean a partnership or other entity (other than a C corporation) if more than 35% of the losses of such entity (i.e., the excess of deductions allowable over the amount of income recognized by the entity under the entity’s method of accounting) during the taxable year are allocated to limited partners or limited entrepreneurs.

Section 1256 lists several examples of interests in an entity that shall not be treated as held by a limited partner or a limited entrepreneur, therefore excluding the entity from the definition of a syndicate. For example, if an individual with an ownership interest in a partnership actively participates at all times in the management of the partnership, then that individual would not be treated as a limited partner for purposes of determining syndicate status for the partnership. Notably, the scenarios described in Section 1256 all refer to interests held by individuals, rather than taxpayers. The IRS has indicated in guidance that based on the plain language of the statute, any limited interests held by non-individuals (e.g., another partnership or an S corporation) would be treated as held by a limited partner or limited entrepreneur.

Because the definition of a syndicate is tied to the allocation of losses during a taxable year, a passthrough entity generating taxable income for a given tax year will not be considered a syndicate for that specific year, regardless of the percentage being allocated to limited partners or limited entrepreneurs. Importantly, passthrough entities that generate taxable income in some years and taxable losses in other years may find themselves alternating between tax shelter and non-tax shelter status from year to year, thereby underscoring the necessity of evaluating the applicability of the tax shelter definition on an annual basis.

Below are the key questions to ask to assess whether a taxpayer is considered a syndicate for a given tax year:

• Is the taxpayer an entity other than a C corporation (e.g., a partnership or an S corporation)?
• Is the taxpayer generating losses for the tax year?
• Are more than 35% of the losses being allocated to limited partners or limited entrepreneurs?

If the answer to all three questions is “yes,” and none of the exceptions listed under Section 1256 apply, then the taxpayer is likely considered a syndicate for the taxable year. As a result, it may have to change its method of accounting (to the extent it has historically used one or more of the simplifying exemptions) and begin considering the application of the Section 163(j) limitation.

Limited relief available to avoid syndicate status

In response to taxpayers’ and practitioners’ concerns regarding the broad definition of a syndicate, the IRS and Treasury introduced an annual election allowing a taxpayer to determine its syndicate status for a given tax year by using the allocations made in the immediately preceding taxable year. As the election is made on a year-by-year basis, passthrough entities that typically generate taxable income but occasionally experience losses for one-off tax years may reap significant benefits from making the election for the loss years. For example, if a partnership with a limited partner owning more than 35% of the partnership is taxable in 2022 but generates a loss in 2023, it can make the election for the 2023 tax year to use its 2022 allocations of taxable income and avoid triggering syndicate status in 2023. If the partnership is taxable once again in 2024, then it would simply forgo making the election for that year and use its 2024 allocations of income to avoid syndicate status.

To make the election for a given taxable year, a taxpayer must attach a statement to the timely filed original federal income tax return (including extensions) for such taxable year. Once made, the election is irrevocable.

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