Recent Changes to Regulations may affect Small Businesses
The IRS recently republished a regulation under IRC section 52, which can have a significant impact on a number of provisions enacted under the Tax Cuts and Jobs Act (TCJA).
A number of TCJA rules apply only to small businesses (i.e., where average gross receipts for the prior three years do not exceed $25 million). These include:
- The use of the cash method of accounting by a C corporation.
- The treatment of inventory as non-incidental materials and supplies.
- The ability to avoid the uniform cost capitalization rules.
- The exception from the new section 163(j) business interest limitation rules.
- The avoidance of the percentage of completion method for small contractors with respect to certain long-term contracts.
In determining whether a business meets the gross receipt limits, related companies must be viewed together. These include commonly controlled businesses. A commonly controlled business includes a “brother-sister” group of entities where:
- Five or fewer persons who own an interest in each of the tested businesses hold 80% of the voting power or value of the businesses.
- The “identical ownership” by these persons in the tested businesses must total more than 50% of their voting power or value.
In determining the amount of equity owned, certain constructive ownership rules are used in order to include equity by certain related parties. The intention of these rules is to prevent the avoidance of the brother-sister rules by structuring ownership of different companies through ownership by certain related parties.
The rules are intended to rectify a problem in the text of the constructive ownership rules under IRS regulations. Old printed copies of the regulations reference section 1.414(c)-4, which includes a range of constructive ownership rules governing matters such as:
- Interest subject to an option to purchase being treated as owned by the option-holder.
- Attribution of interests held by an entity (e.g., partnership, estate/trust, corporation) to a 5% owner (partner, beneficiary, shareholder) on a pro rata basis.
- Attribution of interests held by a spouse and certain family members.
However, the online version of the regulation references only 1.414(c)-4(b)(1) – which involves the situation where one holds an option to acquire an interest in a business. This version would suggest that the other attribution rules (and particularly family attribution) do not apply.
Prior discussion with Treasury indicated that the reference to regulation section 1.414(c)-4 (the full attribution rules) was correct and that a “clarification” would be made.
IRS recently republished this regulation, explaining that there was a typographical error in the regulations as originally issued in March of 1988. A subsequent correction was made in May of that year but was not incorporated into the Code of Federal Regulations.
The preamble to the newly republished regulation provides that “generally, the amendments to the regulations under section 52 of the Code (relating to tax credits for employees) apply to taxable years beginning after December 31, 1976. However, because the May 9, 1988 correction was not properly incorporated into the Code of Federal Regulations at the time of publication, with respect to taxable years that began prior to the Effective date, the Internal Revenue Service will not challenge the application of either published version of the regulations.” The effective date is July 11, 2019.
This permits constructive ownership based solely on using the option rule for the 2018 and 2019 tax years, beginning before July 11, 2019. Consequently, businesses owned by family members or other related parties may not need to be aggregated. Taxpayers will be better able to qualify under the small business exception for these tax years and delay the harmful impact of not qualifying as a small business.
Previous analysis should be reconsidered in light of this new IRS position.
If you have any questions on this matter, please consult your Marcum tax professional.