Internal Revenue Code section 199A attracted immediate attention when it was enacted last December, since it created a new tax benefit.
Section 199A allows individuals to deduct up to 20% of the “qualified business income” from certain types of businesses operated in “pass-through” form. Partnerships, limited liability companies, S corporations and sole proprietorships meet this definition because there is no corporate level tax and the earnings from the business pass through to the owners for tax purposes.
While the intent of Section 199A was to generally put business owners operating in pass-through form on the same footing as businesses who received a reduced 21% federal corporate tax rate, the complexity of the rules left many questions in need of clarification.
On August 8, 2018, the Treasury Department issued proposed regulations addressing some of these questions. One such clarification is the extent to which a buyer of a pass-through entity can avail themselves of the 20% deduction.
Purchases of a pass-through entity are often structured in a way so as to maximize the “step-up” in basis in the business assets and to create additional tax depreciation and amortization. These tax benefits can be of tremendous value because they reduce future taxes and impact the projected profitability of a business. Depending on the amount of tax benefits at stake, parties can spend a significant amount of time modeling and negotiating over these tax benefits.
The proposed regulations clarify that special basis adjustments are disregarded for purposes of Section 199A, meaning that any Section 743(b) basis step-up (generally, basis allocated to tax goodwill and specifically enjoyed by the buyer) may be negated or diminished by having to pay a higher tax rate on those earnings. If buyers of a pass-through entity anticipate the 20% 199A deduction and are modeling and negotiating based on this assumption, they are likely to be in for quite a surprise to the extent that their earnings are in part attributable to Section 743(b) special basis adjustments. A bifurcated interest in a business that is partially eligible for the Section 199A deduction and partially ineligible also creates complex accounting and compliance issues.
The optimal way to structure the purchase of a pass-through entity will depend on the particular facts. Because this analysis is largely quantitative in nature, it is imperative that buyers are modeling their effective tax rate appropriately.
The Section 199A deduction will also have an interesting impact on the negotiation of tax distributions. Where a qualified business is involved, it is likely that the tax rates amongst the members will vary more significantly because some members may be able to avail themselves of the Section 199A deduction while others will not. This may make tax distributions less accurate going forward and there could be certain members receiving tax distributions well in excess of their actual tax liability.
Please contact the MSK tax team if you have any questions with respect to the Section 199A deduction and how the proposed regulations may impact your anticipated purchase or sale of a pass-through entity.