Tax Deferral Opportunities for Small Businesses
Small business taxpayers benefit from several tax reform provisions that may simplify reporting and defer taxes. However, many of these tax savings opportunities depend on whether you are considered a “small business,” which typically hinges on your total gross receipts.
Prior to tax reform, that ceiling was $5 million, but after tax reform legislation passed in 2017, the ceiling was raised to $25 million. The higher threshold may qualify more businesses for those small business tax exceptions.
If you are not currently eligible for small business rules, proactive planning may permit you to qualify for the benefits in the future. So how do you determine if you qualify? Let’s start with the gross receipts test.
Gross receipts test
To apply the $25 million test, the gross receipts of certain related entities must be combined. This includes gross receipts of a “parent-subsidiary group,” a “brother-sister group,” or a combined group under common control. These groups are defined as follows:
Parent-subsidiary — A parent-subsidiary group includes a parent business (e.g., a partnership or corporation) and a subsidiary business in which the parent owns more than 50 percent, and any other business that is more than 50 percent owned by other members of the parent-subsidiary group.
Brother-sister group — Entities that are part of a brother-sister group include all business organizations where the same five or fewer persons own at least 80 percent of each business and more than 50 percent of each business, taking into account each owner’s lowest ownership percentage in each business.
A person’s ownership counts for purposes of the 80 percent test only if the person owns an interest in each of the organizations. For example, the 80 percent test would not be satisfied in the following situation: neither Partner 2’s nor Partner 3’s ownership would be counted because the partners do not own an interest in each of Partnership A and B.
|Partnership A||Partnership B|
Here is another example that illustrates the application of the aggregation rules and shows two partnerships that satisfy both the 50 percent and 80 percent tests:
|Partnership A||Partnership Y||Ownership to extent identical|
|Partner 1||10%||35%||10% (lesser of 10% and 35%)|
|Partner 2||30%||20%||20% (lesser of 20% and 30%)|
|Partner 3||40%||25%||25% (lesser of 25% and 40%)|
Combined groups — Where the parent organization in a parent-subsidiary group is also a member of a brother-sister group, the parent-subsidiary group and brother-sister group must be combined.
Family attribution — For purposes of applying the ownership tests, parents are treated as owning stock held by their children, and vice versa, if the children are younger than 21 years old. An individual who owns more than 50 percent of the vote or value of a corporation is treated as owning stock held by parents, grandparents, grandchildren, or children who are 21 years of age or older.
If your gross receipts exceeds the $25 million dollar threshold, you may still be able to modify the ownership to avoid common control and qualify for the small business benefits. Here’s one way it could play out:
Aaron and Bob are unrelated individuals and each owns 50 percent of two corporations, Alpha Corporation and Beta, Inc. Each corporation has $15 million of gross receipts. Neither corporation is eligible for the small taxpayer exceptions because both are part of a brother-sister group whose combined gross receipts exceed $25 million.
Aaron and Bob decide to transfer 21 percent of Beta, Inc. to key members of the Beta management team. The transfer terminates the brother-sister group — the same five or fewer individuals no longer own at least 80 percent of each business because Aaron and Bob own only 79 percent of Beta and the management team doesn’t own any stock in Alpha. Following the transfer, both Alpha and Beta qualify for the various small taxpayer exceptions.
Now imagine that Aaron transfers 21 percent of the stock of Beta to his adult child instead of transferring it to management. Since Aaron does not own more than 50 percent of the corporation, his stock is not considered to be owned by his adult child. Thus, the transfer terminates the brother-sister group.
The tax shelter variable
Even if your business passes the $25 million gross receipts test, it may be ineligible for small business status if it is considered a “tax shelter.” We typically think of a tax shelter as an entity formed to avoid taxes but the definition is much broader than that; a tax shelter includes an entity where more than 35 percent of the losses are allocated to certain partners not actively involved in management, regardless of the motivation behind forming the entity.
For example, a partnership formed to invest in rental real estate, which generates losses allocated to investors not involved in the day-to-day management of the partnership, could be considered a tax shelter under these rules even though the investment was made for non-tax business reasons.
If you are not eligible for the small business exceptions due to tax shelter status, you may be able to change that status by:
- Increasing owner involvement in management of the business.
- Changing partnership allocations so that no more than 35 percent of losses are allocated to limited partners.
- Considering whether there is an argument that a business entity partner is not a limited partner.
- Considering whether there is an argument that the tax shelter rules do not apply as long as the business is profitable.
The upside of being ineligible for small taxpayer exceptions
In some cases, it may be desirable for a pass-through entity, such as a partnership or S corporation, to be ineligible for the small taxpayer exceptions. The business interest limitation may restrict the amount of interest a business can deduct. If the limitation does not apply at the entity level because the entity qualifies as a small business, the limitation may apply at the owner level unless the owner also qualifies as a small business.
Real estate and farming businesses can elect not to apply the business interest limitation, but that election is not available if the business is exempt from the limitation as a small business. For example:
Pete, Vikki, and Carl each own one-third of PVC LLC, an entity treated as a partnership for tax purposes. The owners are each actively involved in the management of PVC. PVC owns rental real estate that is treated as a business for tax purposes, which has historically generated a loss due to significant interest expense and depreciation, and has average annual gross receipts of $10 million. Each of the partners has more than $25 million in average annual gross receipts from other sources and is thus subject to the business interest limitation.
PVC is a small business taxpayer because its average annual gross receipts do not exceed $25 million and it is not a tax shelter. As a small business taxpayer, PVC is exempt from the interest limitation and is ineligible to elect out of it. The three partners’ ability to deduct their share of PVC’s interest expense is subject to the business interest limitation at the owner level.
Alternatively, planning may subject PVC to the business interest limitation, which allows the company to elect out of it. For example, two of the partners could reduce their involvement in the business, causing more than 35 percent of PVC’s losses to be allocated to partners not actively involved in management of the business and opening the option for PVC to elect out of the business interest limitation.
How we can help
CLA’s business tax professionals can help you apply the complex tax shelter and gross receipt aggregation rules to your businesses to determine whether they are eligible for the small business exceptions as currently structured. If an exception is not available, we can work with you to identify changes to your business that may allow you to take advantage of the exceptions, while minimizing any adverse effects on your business operations.