The new tax law has two provisions which are subject to a “small business” threshold. Many business owners have heard that this threshold has increased substantially to an aggregated $25 million average annual gross receipts, and they stop there, thinking they qualify as a small business. They aren’t paying attention to the fact that “Tax Shelters” are specifically excluded from the definition of a small business.
Under the new law, the first provision expands the availability of the cash method of accounting to the new threshold and includes small businesses that maintain inventory as an income-producing factor. The second provision is an exemption provided to small business from the new business interest expense limitation which limits the deduction to the sum of business interest income, “floor plan financing interest,” and 30 percent of a taxpayer’s “adjusted taxable income”.
The availability of the cash method of accounting applies and the new business interest expense limitation does not apply to a “small business” that is not a tax shelter. Therein, lies the rub.
Regardless of the tax shelter’s average annual gross receipts, a tax shelter may not use the cash method of accounting, nor may a tax shelter use the exemption for the business interest expense limitation. The definition of a tax shelter therefore becomes a critical factor in determining tax consequences for a business that otherwise could be a small business.
Most business owner’s depth of understanding of a tax shelter is that it has something to do with the avoidance or evasion of tax, which makes sense. However, the broader definition of small business, is a surprise to many. It introduces the concept of a “syndicate” as a tax shelter. A syndicate is defined as a partnership or other entity (excluding C corporations) where more than 35 percent of the entity’s losses are allocable to “limited partners or limited entrepreneurs. If any partnership or S Corporation that allocates more than 35% of its losses for the year to limited partners or limited entrepreneurs is considered a tax shelter, then the definition of limited partner & limited entrepreneur becomes a critical factor and the test really has to do with when operating losses from an entity are allocated to partners or shareholders that are not active in the business.
No specific guidance exists on how “active participation” is defined. As such, the degree of involvement required by each member or shareholder to avoid syndicate classification is an open question and being member-managed as opposed to manager-managed becomes an important distinction. If an entity is organized by a group of professionals all of whom participate in the management of the company (e.g., an accounting firm), it should not be difficult to avoid being classified as a syndicate. However, if the entity is organized as an investment vehicle and the owners choose to have the organization run by a manager, it is unlikely the entity will be able to escape the 30 percent deduction limitation via the small business exception unless the managers own more than 65 percent of the company.
An important exception in the law allows real property and farming trades or businesses to make an irrevocable election out of the business interest deduction limitation. These businesses must then use the alternative depreciation system (ADS) to depreciate property. This election is irrevocable, and you won’t be able to opt back into the interest limitation in later years when the interest deduction is not limited under the 30% rule.
If your enterprise has limited partners that don’t actively participate in management or operations and it allocates more than 35% of losses to them, your small business is likely considered a tax shelter. Even if consistently profitable, one loss year, will cause it to be a tax shelter for that year. Which means it would not be eligible to use the cash method of accounting for that year and it would also be subject to the business interest expense limitation. This could have a material impact on the taxable income of your business. Please contact RINA accountancy for further guidance on your specific situation.