Tax Law Changes Affecting Partnerships, LLCs and Their Owners
The Tax Cuts and Jobs Act (TCJA) brought many modifications to the tax laws that affect partnerships, limited liability companies (LLCs), and their owners. Here’s a look at the key changes.
Technical Termination Rule Repealed
Under prior law, a partnership (or LLC treated as a partnership for tax purposes) was considered to terminate for federal income tax purposes if, within a 12-month period, there was a sale or exchange of 50% or more of the partnership’s (LLC’s) capital and profits interests. This “technical termination rule” was generally unfavorable because:
- It could require you to file two short-period partnership tax returns for the year in which the technical termination occurred.
- It restarted the depreciation periods for the partnership’s (LLC’s) depreciable assets.
- It terminated favorable tax elections that were made by the partnership (LLC).
Thankfully, the TCJA repeals the technical termination rule, effective for partnership (LLC) tax years beginning in 2018 and beyond. This is a permanent change.
Lower Tax Rates for Individual Partners and LLC Members
For 2018 through 2025, the TCJA retains seven tax rate brackets for ordinary income and net short-term capital gains recognized by individual taxpayers, including income and gains passed through to individual partners and LLC members. Six of the rates are lower than before. In 2026, the rates and brackets that were in place for 2017 are scheduled to return.
Meanwhile, the rate brackets for 2018 are as follows:
|Bracket||Single||Joint||Head of Household|
|10% tax bracket||0$ - $9,525||$0 - $19,050||$0 - $13,600|
|Beginning of 12% bracket||$9,526||$19,051||$13,601|
|Beginning of 22% bracket||$38,701||$77,401||$51,801|
|Beginning of 24% bracket||$82,501||$165,001||$82,501|
|Beginning of 32% bracket||$157,501||$315,001||$157,501|
|Beginning of 35% bracket||$200,001||$400,001||$200,001|
|Beginning of 37% bracket||$500,001||$600,001||$500,001|
After 2018, these brackets will be indexed for inflation.
Unchanged Long-Term Gain and Qualified Dividend Rates
The TCJA retains the 0%, 15%, and 20% tax rates on long-term capital gains and qualified dividends recognized by individual taxpayers, including gains and dividends passed through to individual partners and LLC members.
For 2018, the rate brackets are as follows:
|Bracket||Single||Joint||Head of Household|
|0% tax bracket||0$ - $38,000||$0 - $77,200||$0 - $51,700|
|Beginning of 15% bracket||$38,601||$77,201||$51,701|
|Beginning of 20% bracket||$425,801||$479,001||$452,401|
After 2018, these brackets will also be indexed for inflation.
New Pass-Through Deduction
Under prior law, net taxable income that was passed through to you from a partnership or LLC was simply taxed on your return at the standard rates for individual taxpayers.
For tax years beginning in 2018 until 2025, the TCJA establishes a new deduction based on your share of qualified business income (QBI) passed through from the partnership or LLC. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels and another restriction based on your taxable income. This new deduction is scheduled to disappear after 2025. Consult your tax advisor for details on how to cash in on this potentially lucrative break.
Unfavorable Restrictions on Deducting Losses
Before the TCJA, an individual taxpayer’s business losses — including those passed through from partnerships and LLCs — could generally be deducted in full in the tax year when they arose. That was the result unless:
- Some tax-law provision such as the passive loss rules prevented that favorable outcome or
- The loss exceeded your taxable income from other sources, in which case it created a net operating loss (NOL).
For 2018 to 2025, the TCJA makes two unfavorable changes to the rules for deducting an individual taxpayer’s business losses.
1. Excess Business Loss Disallowance Rule
If your business activity throws off a tax loss — and many do during the early years — things get complicated. First, the passive activity loss (PAL) rules may apply if you have limited involvement in the business activity or if it’s a rental operation. In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources — like positive income from other business or rental activities or gains from selling them. Passive losses in excess of passive income are suspended and carried forward to future years until you either have sufficient passive income or you sell the activity that produced the losses.
It gets worse. After you’ve successfully cleared the hurdles imposed by the PAL rules, the TCJA establishes a new hurdle. For tax years 2018 to 2025, you cannot deduct an excess business loss in the current year.
An excess business loss means the amount of a business loss that exceeds $250,000 or $500,000 if you are a married joint-filer. The excess loss is carried over to the following tax year, and you can then deduct it under the rules for handling net operating loss (NOL) carryforwards (explained later).
The idea behind this new loss disallowance rule is to further restrict the ability of individual taxpayers to use current-year business losses (including losses passed through from a partnership or LLC) to offset income from other sources — such as salary, self-employment income, interest, dividends, and capital gains. The practical impact is that your allowable current-year business losses (after considering the PAL rules) cannot offset more than $250,000 of income from such other sources or more than $500,000 for married joint-filers.
The requirement that an excess business loss must be carried forward as an NOL forces you to wait at least one year to get any tax-saving benefit from the excess loss.
You and a partner are 50/50 owners of a commercial real estate rental venture that you operate as an LLC treated as a 50/50 partnership for tax purposes. You are single. Your partner is a married joint-filer.
For 2018, you and your partner each have a $300,000 loss from the LLC after applying the passive loss rules. Neither you nor your partner have any income or loss from any other business activities, but you have $400,000 of income from a trust, and your partner’s spouse has $200,000 of salary income.
The new excess business loss disallowance rule is applied at the owner level. So, for 2018 you have an excess business loss of $50,000 from the LLC ($300,000 loss minus $250,000 excess loss disallowance threshold for a single taxpayer). For 2018, you can deduct $250,000 of the LLC loss (the amount up to the threshold) against your trust income. The $50,000 excess business loss is carried forward to your 2019 tax year as part of an NOL carryover to that year.
Your partner has no excess business loss from the LLC, because her $300,000 loss is less than the $500,000 excess loss disallowance threshold for a married joint-filing taxpayer. For 2018, your partner can deduct the first $200,000 of the LLC loss against her husband’s salary income. The remaining $100,000 loss from the LLC creates an NOL carryover to your partner’s 2019 tax year (assuming she and her husband have no other income to report on their 2018 joint return).
2. Stricter Rules for Deducting Net Operating Losses
For net operating losses (NOLs) arising in tax years beginning in 2018 and beyond, the TCJA stipulates that you generally cannot use the NOL carryover to shelter more than 80% of taxable income in the carryover year. Under prior law, you could generally use an NOL carryover to shelter up to 100% of your taxable income in the carryover year.
Another TCJA change stipulates that NOLs arising in tax years ending after 2017 generally cannot be carried back to an earlier tax year. They can only be carried forward. However, they can be carried forward indefinitely. Under prior law, NOLs could be carried forward for up to 20 years.
Legislative glitch: The statutory language says the elimination of NOL carrybacks applies to NOLs arising in tax years ending after 2017, while the Congressional Conference Committee explanation of the new law says this change is supposed to be for NOLs arising in tax years beginning after 2017 (meaning years beginning in 2018 and beyond). The Conference Committee explanation indicates Congressional intent, so we hope and trust that future technical corrections legislation will fix this drafting error.
Unfavorable Rule for Charitable Donations and Foreign Taxes
Under a longstanding rule, you as a partner or LLC member cannot deduct losses that exceed your tax basis in a partnership or LLC ownership interest. For partnership (LLC) tax years beginning in 2018 and beyond, the TCJA stipulates that your share of the partnership’s (LLC’s) deductions for charitable donations and foreign taxes must decrease your basis in the partnership (LLC) interest for purposes of applying the loss limitation rule. This change can reduce the amount of partnership (LLC) losses from other sources that you can currently deduct. However, for charitable donations of appreciated property (where the fair market value is higher than the tax basis), the excess of the fair market value over the basis doesn’t reduce your basis in the partnership (LLC) interest for purposes of applying the loss limitation rule. In other words, when applying the loss limitation rules, only your share of the basis of the donated appreciated property reduces your basis in the partnership (LLC) interest.
Key point: While this is an unfavorable change, it rarely has a significant impact on partners or LLC members.
For partnerships, LLCs, and their owners, the TCJA includes some very beneficial changes and some unfavorable ones. When all is said and done, most individual partners and LLC members will come out well ahead under the TCJA compared to prior law. If you want additional details or have questions, consult your Brady Ware tax advisor.