Inside the proposed regs on acct'g method changes and carried interest
On July 30 and July 31, 2020, the IRS published proposed regulations addressing small-business accounting method changes, and carried interest, respectively.
Certain aspects of the two sets of regs are troubling, according to Tom Wheelwright, CPA, founder and CEO of the WealthAbility Accounting Network.
“Both sets have provisions that run contrary to the clear intent of the law,” he said. “What the IRS is doing is legislating — they did it with the Paycheck Protection Program loans when they disallowed the deductions related to PPP forgiveness, effectively legislating contrary to the obvious intent of the law.”
The proposed regulations on carried interest under Code Section 1061 generally confirm that carried interest on investments held for less than three years will be taxed at ordinary rates, and carried interest on investments held for more than three years will benefit from long-term capital gain rates. However, under the proposed rules, Section 1061 does not apply to a number of types of income that qualify for long-term capital gain rates without reference to holding period rules, including Section 1231 gains.
“This means that it doesn’t apply to most real estate developers, since their gains tend to be Section 1231 gains based on the sale of income-producing assets,” said Wheelwright. “The second thing that is notable is that they said that S corporations are subject to the carried interest rule even though the language of the Tax Cuts and Jobs Act said corporations are not subject to the rule. Of course, what happened is that there was a mistake in the law, just like the qualified improvement property was a mistake. It was initially left out of the bonus depreciation rules, until it was ‘fixed’ under the CARES Act.”
Due to a drafting error in the TCJA and a failure of both parties to agree on a remedy, QIP was deprived of bonus depreciation treatment — the “retail glitch” — until an agreement was reached as part of the CARES Act negotiations. QIP is now treated as 15-year property and is therefore eligible for 100 percent bonus depreciation.
“The IRS is not wrong to say that the intent is that C corporations are not qualified, but the legislation didn’t say that,” he said. “Effectively the IRS is legislating by correcting the mistake.”
The other set of proposed regulations — the accounting method changes — are the more troubling, according to Wheelwright.
“The Bluebook [explanation of tax legislation released by the Joint Committee on Taxation] specifically said that the $2,500 de minimus exception would apply to inventory, and gave an explanation of how to do it. The IRS, in the proposed regs, said ‘No’ — the business owner does not qualify for the de minimis exception with respect to inventory,” he said.
“If you previously took the inventory deduction using the de minimis rule, the proposed regs would require you to file Form 3115 to change your accounting method, and when you do, you’ll pick up inventory you deducted into income over four years. It’s still not a bad result, even if someone made a change in 2019 on a return filed this year. They get the deduction now and pick up income over four years after the regs are finalized. While the result is not the way intended by Congress, it’s better than if you didn’t take the deduction in the first place,” he continued.
In another change, the IRS proposes a definition for “syndication” that requires the business to use the accrual method of accounting for any partnership or S corporation with 35 percent or more of losses if net loss is allocated to limited partners, or what they call limited entrepreneurs — people without management authority. According to Wheelright, “The challenge is, if you have a loss in any year regardless of your gross receipts, and it’s allocated 35 percent to investors, you’ll be on the accrual basis forever.”
“The whole point of the legislation was to increase the number of businesses that can use the cash method, but this is going in the opposite direction,” Wheelwright indicated. “If you’re a syndication, and under $26 million in revenue, you start on the accrual method. This means that you’re picking up revenue you won’t receive until later.”