The Not-So-Simple Aggregation Rules for Tax Reform’s Simplifying Conventions
The Not-So-Simple Aggregation Rules for Tax Reform’s Simplifying Conventions
By Connie Cheng Cunningham and Pam Morrow
This article originally appeared in The Tax Advisor on May 1, 2019.
Tax reform promised overall simplification for small business taxpayers, including streamlined accounting method provisions as well as an exemption from the interest expense limitation under Sec. 163(j). While many of these simplifying exceptions existed in some fashion prior to tax reform, the enactment of the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, significantly expanded the universe of taxpayers that qualify for the provisions. In particular, the new exceptions now apply to taxpayers with average annual gross receipts of $25 million or less, more than doubling or quadrupling prior thresholds provided in pre-TCJA simplifying conventions. While the $25 million gross receipts test seems straightforward upon first impression, the nuances related to the application of the threshold are anything but simple.
This discussion reviews the mechanics of the gross receipts test, highlights several potential traps for the unwary, and raises several common but still unanswered questions that will hopefully be addressed by the IRS and Treasury in future guidance.
For tax years beginning after Dec. 31, 2017, an entity other than a tax shelter, as defined under Sec. 448(d)(3), the average annual gross receipts of which over the three immediately preceding tax years do not exceed $25 million (indexed for inflation), is eligible for the overall cash method of accounting, exemption from the requirement to account for inventories under Sec. 471, exemption from the UNICAP rules under Sec. 263A, exemption from the use of the percentage-of-completion method under Sec. 460 for long-term contracts, and exemption from the interest expense limitation under Sec. 163(j).
Although the $25 million threshold may appear generous for many small to midsize entities, taxpayers should carefully examine the aggregation rules under Sec. 448(c)(2), as they could result in multiple entities' gross receipts being combined for purposes of applying the test. Specifically, Sec. 448(c)(2) requires the aggregation of gross receipts for entities treated as a single employer for purposes of the work opportunity tax credit in Secs. 52(a) and 52(b) or under the qualified plan rules relating to affiliated service groups (or would be so treated if they had employees) in Secs. 414(m) and 414(o). Taken together, these references to multiple Code sections send taxpayers through a labyrinth of complex rules involving a combination of controlled group definitions and employment tax principles.
Aggregation rules in general
Before delving into the aggregation rules, it is important first to define the types of gross receipts that must be included for purposes of applying the $25 million gross receipts test. Temp. Regs. Sec. 1.448-1T(f)(2)(iv)(A) broadly defines gross receipts as receipts that are properly recognized under the taxpayer's accounting method used in that tax year for federal income tax purposes. Gross receipts include total sales (net of returns and allowances) and all amounts received for services, as well as any income from investments and from incidental or outside sources. For example, gross receipts include interest (including original issue discount and tax-exempt interest within the meaning of Sec. 103), dividends, rents, royalties, and annuities, regardless of whether these amounts are derived in the ordinary course of the taxpayer's trade or business.
Generally, taxpayers are not allowed to reduce gross receipts by cost of goods sold or by the cost of property sold (e.g., in the case of inventory). However, with respect to sales of capital assets or sales of property used in a trade or business, taxpayers can reduce gross receipts by the adjusted basis in that property. Additionally, the Sec. 448 regulations provide specific rules addressing how to compute gross receipts for taxpayers with newly formed entities, short tax years, transactions between aggregated group members, and predecessor entities.
Once an entity determines the types of gross receipts it must consider for purposes of Sec. 448, the next step is assessing whether it must aggregate its gross receipts with amounts from other entities. The purpose of the aggregation rules under Sec. 448(c)(2) is to eliminate spinoffs of larger businesses into separate entities to meet the gross receipts test. As previously stated, entities must therefore aggregate their gross receipts to the extent they are treated as a single employer under subsection (a) or (b) of Sec. 52 or subsection (m) or (o) of Sec. 414. Sec. 414(o) states that Treasury has broad authority to issue regulations necessary to prevent avoidance of employee benefit requirements, including Sec. 457, through the use of separate organizations, employee leasing, or other arrangements. Although the IRS and Treasury did issue Sec. 414(o) proposed regulations, this guidance has largely been superseded by other regulations. As such, this discussion focuses solely on Secs. 52(a), 52(b), and 414(m). Each subsection is discussed separately below.
Under Sec. 52(a), entities making up the same controlled group of corporations (defined by reference to Sec. 1563(a)) are treated as a single employer. Sec. 1563(a) defines a controlled group of corporations as a parent-subsidiary controlled group, a brother-sister controlled group, or a combined group. For purposes of applying Sec. 52(a), a parent-subsidiary controlled group is one or more chains of corporations that are connected through stock ownership with a common parent corporation if members of the group, in the aggregate, own (directly or constructively under Secs. 1563(d) and (e), without regard to Sec. 1563(e)(C)(3)), stock possessing more than 50% of the total combined voting power or more than 50% of the total value of each of the corporations. A brother-sister group under common control is defined as (1) two or more corporations, if the same five or fewer persons who are individuals, estates, or trusts own (directly and with the application of the rules in Regs. Sec. 1.1563-3(b)) at least 80% of the voting power or value of each corporation; and (2) the same five or fewer persons also own more than 50% of the voting power or value of each corporation after considering the ownership interest of each person only to the extent that the interests are identical with respect to each corporation. Thus, for a person's ownership to be considered for purposes of the 80% test, that person must also have an interest that is taken into account for purposes of the 50% test. Lastly, as the name suggests, a combined group is three or more corporations, each of which is a member of a parent-subsidiary group or brother-sister group, and one of which is a common parent corporation of the parent-subsidiary group and is included in a brother-sister group.
One common misconception in applying the rules of Sec. 52(a) relates to the inclusion of foreign corporations in the gross receipts test. Under Sec. 1563(b), a foreign corporation subject to Sec. 881 is excluded from the definition of a "component member" of a controlled group of corporations. While Sec. 448 and its regulations are silent as to whether the exclusion of foreign corporations under Sec. 1563(b) should apply in the context of the aggregation rules, another definition of gross receipts provided under former Sec. 263A(b)(2)(C) specifically referred to Sec. 448 and Regs. Sec. 1.263A-3(b)(3)(ii) to clarify that the component member rules of Sec. 1563(b) should be disregarded. Similarly, Regs. Sec. 1.414(b)-1(a) also provides that the component member rules of Sec. 1563(b) are disregarded when determining whether a controlled group relationship exists. Accordingly, a foreign corporation does not appear to be excluded from a controlled group of corporations for purposes of applying the $25 million gross receipts test.
Under the principles of Sec. 52(b), gross receipts of entities that are deemed to be "under common control" must be aggregated for purposes of applying the $25 million gross receipts test. Unlike Sec. 52(a), trades or businesses that are under common control under Sec. 52(b) can include noncorporate entities, such as a sole proprietorship, a partnership, a trust, or an estate. Under Regs. Sec. 1.52-1(b), the types of controlled groups are labeled in a manner identical to Sec. 1563(a), in that the groups include parent-subsidiary, brother-sister, and combined groups but with slight variations in how the definitions are applied.
One issue involving the application under Sec. 52(b) (and Sec. 52(a), although perhaps to a lesser extent) relates to obtaining the necessary information to determine whether common control exists.
Example: Partnership Z is owned equally by four individuals. For Partnership Z to properly apply the gross receipts test, it must first determine whether any of the individuals have ownership interests in other entities besides Partnership Z. If so, Partnership Z must then assess whether any combination of the four individuals meets the 50% test and the 80% test with respect to Partnership Z and the other entities.
This determination can be challenging for the tax return preparer of Partnership Z if it has limited insight into the other activities of the four individual owners. This may result in significant uncertainties as to whether Partnership Z may use the cash method of accounting, for example, or whether it is subject to the interest expense limitation under Sec. 163(j).
Entities that are considered to be in an affiliated service group under Sec. 414(m) must also aggregate their gross receipts for the $25 million test. While the nuances of the affiliated service group rules are complex and beyond the scope of this discussion, a brief description of the three types of affiliated service group compositions follows:
- A-Organization (A-Org) group: This consists of an organization designated as a first service organization (FSO) and at least one A-Org. An FSO is a corporation, partnership, or other organization engaged in the performance of services (e.g., accounting, consulting, health, or law) as its principal business. An A-Org is an organization that is a partner or shareholder in the FSO (regardless of the ownership percentage) and regularly performs services for the FSO or is regularly associated with the FSO in performing services for third parties.
- B-Organization (B-Org) group: This consists of an FSO and at least one B-Org, which is an organization that spends a significant portion of its business performing services for an FSO or one or more A-Orgs with respect to the FSO, or both.
- Management group: This consists of an organization that performs management functions and whose principal business is performing management functions on a regular and continuing basis for a recipient organization. Note that there is no requirement for common ownership between the management organization and the recipient organization; thus, aggregation rules can apply for two unrelated parties to the extent they are in the same management group.
Many of the determinations above, such as whether an entity's principal business of providing management services is performed on a regular and continuing basis, require a facts-and-circumstances type of analysis. Given the subjective nature of this assessment, taxpayers are encouraged to begin their fact-gathering process as soon as possible to ensure that proper time is allocated to the analysis.
While tax reform provides small business taxpayers with streamlined accounting method procedures, the aggregation rules under Sec. 448(c)(2) grant these taxpayers (and their tax return preparers) an additional "gift" that keeps on giving: extra work in analyzing and fully understanding taxpayers' businesses and organizational structures. Keep in mind that as taxpayers' operations and/or organizational structures change over time, the analysis described above must be applied on an ongoing basis to determine whether those changes result in the taxpayer's disqualification under the $25 million gross receipts test. As such, taxpayers must ensure that they set aside adequate time in performing the necessary analysis for not only their first tax year affected by tax reform but for future years as well.