An exception to the general rule that small businesses are exempt from the §163(j) limits on the deduction for business interest applies to any entity that is a “tax shelter.”  The most likely problem to arise that many may not initially notice is that the organization might meet the definition of a syndicate.

On January 11, 2019, Tax Notes Today published a story that featured comments from Tony Nitti, CPA that discussed the potential issues that may arise with the interest deduction limitation under §163(j) and the syndicate rules.[1]

Getting to what is a syndicate involves bouncing through various cross-references in the tax law—and even then finding out what Congress did with a provision they cross-referenced but later moved without updating the cross-reference.

The issue of an otherwise “small” taxpayer being subject to the interest limits arises because §163(j) uses a cross-reference to the §448(a)(3) to define organizations exempt from the application of the limit.  IRC §163(j)(3) provides:

(3) Exemption for certain small businesses

In the case of any taxpayer (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3)) which meets the gross receipts test of section 448(c) for any taxable year, paragraph (1) shall not apply to such taxpayer for such taxable year. In the case of any taxpayer which is not a corporation or a partnership, the gross receipts test of section 448(c) shall be applied in the same manner as if such taxpayer were a corporation or partnership.

IRC §448(a)(3) itself merely says a tax shelter cannot use the cash method of accounting.  However, further down in §448 a definition of a tax shelter is found at IRC §448(d)(3)

(3) Tax shelter defined

The term “tax shelter” has the meaning given such term by section 461(i)(3) (determined after application of paragraph (4) thereof). An S corporation shall not be treated as a tax shelter for purposes of this section merely by reason of being required to file a notice of exemption from registration with a State agency described in section 461(i)(3)(A), but only if there is a requirement applicable to all corporations offering securities for sale in the State that to be exempt from such registration the corporation must file such a notice.

Again the IRC does not provide a definition, but rather provides a cross-reference, this time to IRC §461(i)(3).  When we follow that cross-reference, we end up with the following list of tax shelters which, not surprisingly, contains additional cross-references:

(3) Tax shelter defined

For purposes of this subsection, the term “tax shelter” means—

(A) any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or State agency having the authority to regulate the offering of securities for sale,

(B) any syndicate (within the meaning of section 1256(e)(3)(B)), and

(C) any tax shelter (as defined in section 6662(d)(2)(C)(ii)).

Our primary interest is in the second set of definitions.  Ignoring the fact that IRC §461(i)(3)(C) literally defines a tax shelter as a tax shelter, that cross-reference does provide an endpoint.  For these purposes, a tax shelter which, even with revenue of less than $25 million, that will be subject to the §163(j) business interest limits would include:

(ii) Tax shelter

For purposes of clause (i), the term “tax shelter” means—

(I) a partnership or other entity,

(II) any investment plan or arrangement, or

(III) any other plan or arrangement,

if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax.

In “IRC-speak” tax avoidance is what we’d normally call tax planning while “tax evasion” is what lands the taxpayer in prison.  However, the key term is “significant purpose” under this test.  Generally, that means a tax benefit that is a major reason for the arrangement.  Most simple partnerships that own real estate are not likely to run afoul of this test.

However, there is still the issue of a syndicate referenced at IRC §461(i)(3)(B).  Again, the IRC uses a cross-reference for this definition, this time sending the reader to IRC §1256(e)(3)(B).  That section reads as follows:

(B) Syndicate defined

For purposes of subparagraph (A), the term “syndicate” means any partnership or other entity (other than a corporation which is not an S corporation) if more than 35 percent of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs (within the meaning of section 464(e)(2)).

We generally know what a limited partner is, but what is a limited entrepreneur?  You’d think that the answer would be found by following the cross-reference.  But here the reader hits a problem—there no longer is an IRC §464(e)(2).

In 2014 Congress repealed IRC §464(e)(2).  Or, actually, moved the material to IRC §461(k)(4).  In reality, initially a second IRC §461(j) was added in the Act, with no §461(k).  Eventually, in the 2018 Consolidated Appropriations Act, the provision we are concerned with moved to the empty slot at §461(k)(4).

So we finally arrive at what probably (assuming the IRS and Courts agree that the reference has moved) is the definition of a limited entrepreneur at IRC §461(k)(4):

(4) Limited entrepreneur

For purposes of this subsection, the term "limited entrepreneur" means a person who --

(A) has an interest in an enterprise other than as a limited partner, and

(B) does not actively participate in the management of such enterprise.

While this provision has been in Code for quite a while, even if not always in the same location, there is not much guidance outside of private letter rulings on what constitutes such a “limited entrepreneur” under the law.  As well, most of those letter rulings date from the 1990s.

IRC §1256(e)(3)(C) provides some “safe harbors” that exclude certain interests as being treated as held by a limited partner or limited entrepreneur:

(C) Holdings attributable to active management

For purposes of subparagraph (B), an interest in an entity shall not be treated as held by a limited partner or a limited entrepreneur (within the meaning of section 464(e)(2))— 

(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 the Secretary 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.

In PPC’s Limited Liability Companies volume of its Tax and Financial Planning Library, the authors reference a series of letter rulings where various entities have been held not to be tax shelters under the limited entrepreneur provision.  These cases include rulings where:

• All members of the LLC were engaged in the profession of the LLC (referencing PLRs 9432018, 9422034, 9350013, and 9602018);

• Management was vested in an executive or management committee or the like (PLRs 9501033, 9321047, and 9328005);

• The LLC always reports income and is not expected to report losses (PLRs 9452024 and 9415005; and

• The LLC had non-equity members where less than 35% of the losses would be allocated to such non-equity members (PLR 9426030).[2]

The dearth of guidance on the topic is becoming especially trouble now that the provision takes on a special significance for §163(j)’s limitations.

The Tax Adviser published an article in September of 2018 that looked at this in a bit more detail, authored by Bruce Redmond, CPA of Denver.[3] As that article points out, Reg. §1.448-1T(b)(3) follows the definition found at IRC §1256(e)(3)(B) except the regulation changes “losses allocable” to “losses allocated.”  As the article notes “[t]his would indicate that if there were no losses allocated to limited partners or limited entrepreneurs in any given year, an entity would not be considered a syndicate for that year.” [4]

Advisers this year will need to remember that, before deciding the interest rules don’t apply to the taxpayer due to the gross income limits, that the adviser must also be able to defend why the entity is not a tax shelter under these rules. Because if the entity is a tax shelter, regardless of how little revenue it may have, the §163(j) business interest deduction limitations would apply to the entity.

[1] Eric Yauch, “Tax Shelter Rules Tee Up Tough Decisions for Smaller Businesses,” Tax Notes Today, 2019 TNT 8-1, January 11, 2019

[2] PPC Tax and Financial Planning Library, Limited Liability Companies, 2019, ¶805.24

[3] Bruce Redmond, “Sec. 163(j) places renewed importance on tax shelter status”, The Tax Adviser, September 2018, https://www.thetaxadviser.com/issues/2018/sep/sec-163j-renewed-importance-tax-shelter-status.html

[4] Bruce Redmond, “Sec. 163(j) places renewed importance on tax shelter status”, The Tax Adviser, September 2018, https://www.thetaxadviser.com/issues/2018/sep/sec-163j-renewed-importance-tax-shelter-status.html