The TCJA added a new 30% limitation on the deduction of business interest. You are probably aware — and thankful — that this new limitation does not apply to a business with average annual gross receipts of $25 million or less. However, did you know that this small-taxpayer exception does not apply if the business is a tax shelter?
Some taxpayers may be surprised to learn that their business is a tax shelter, preventing them from taking advantage of this $25 million exemption. The determination is based on whether operating losses from the business are allocated to partners or S-corporation shareholders who are not active in the business. Specifically, any partnership or S corporation that allocates more than 35 percent of its losses for the year to limited partners or limited entrepreneurs is considered a tax shelter.
For purposes of this section, an interest in an entity is not treated as held by a limited partner or a limited entrepreneur (and therefore does not count toward the 35% test) if the owner of the interest satisfies any one of the following tests:
- They actively participate in the management of the entity.
- They are a spouse, child, grandchild or parent of an individual who actively participates in the management of the entity.
- They actively participated in the management of the entity for a minimum of five years.
- It is an estate of an individual who actively participated in the management of the entity for a minimum of five years.
If an entity is organized by a group of professionals, all of whom participate in the management of the company (e.g., a law firm), it should not be difficult to avoid being classified as a tax shelter. 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 utilize the $25 million exception unless the manager owns more than 65 percent of the company. Each taxpayer will need to analyze whether they are a tax shelter under these rules before they know whether the $25 million exception to the 30% interest limitation is available to them.