Public Law 115-97, colloquially known as the Tax Cuts and Jobs Act (the 2017 Act), has introduced several new provisions to the Internal Revenue Code. Unsurprisingly, these new provisions rely on longstanding concepts in the tax law, including the concept that related-party transactions will be subject to extra scrutiny. This short article discusses two provisions within the 2017 Act—a modification to section 168(k) and new section 199A—and describes how the related-party rules apply to these provisions.
Related Party Expensing and Loss Disallowance Provisions
Both section 168(k) and section 199A incorporate related-party limitations by reference to section 179(d)(2). Section 179 generally allows an election for the expensing of “section 179 property” in the year that such property is placed into service. Section 179 property, as defined in section 179(d), is limited to certain types of property acquired by purchase for use in an active trade or business. Section 179(d)(2) defines “purchase” by exclusion, specifically excluding property acquired from related parties. Section 179(d)(2)(A) defines a related party of the acquiring taxpayer as a person whose relationship to the acquiring taxpayer would trigger the loss disallowance provisions of sections 267 and 707(b).
Section 267(a) provides both a rule disallowing loss deductions resulting from sales or exchanges of property, directly or indirectly, between related parties and a matching rule for interest and expense deductions and the associated income. Section 267(b) provides a list of covered relationships, including (i) siblings, spouses, ancestors, and lineal descendants and (ii) certain relationships involving trusts, partnerships, corporations, and charitable organizations. This definition of relationship applies not only for purposes of the loss disallowance and matching rules found in section 267, but also for several other provisions scattered throughout the Code. Section 707(b) provides similar loss disallowance and matching rules for transactions between certain partners and a partnership or two partnerships if requisite common ownership thresholds are met.
Section 179(d)(2)(A) excludes siblings from its application of the related party definition in section 267.
The 2017 Act
Two provisions of the 2017 Act include limitations for transactions between parties with section 267 or section 707(b) relationships. First, the 2017 Act made several changes to section 168(k). Prior to the 2017 Act, section 168(k) allowed for “bonus depreciation” in an amount equal to 50% of the adjusted basis of qualified property, which included certain types of depreciable property placed in service by the taxpayer before January 1, 2020. Also, under the prior version of section 168(k), a taxpayer could claim bonus depreciation only for property whose original use commenced with the taxpayer (i.e., not “used” property). The 2017 Act revised section 168(k) to provide for 100% bonus depreciation for property placed in service after September 27, 2017 and before January 1, 2023 (with a 20% sliding scale reduction for property placed in service over the following four years). It also expanded is the definition of “qualified property” to include property the use of which did not commence with the taxpayer—i.e., used property. However, this liberalization of section 168(k) has a limitation: the acquisition of the used property must meet the requirements of section 179(d)(2)(A). This reference to section 179(d)(2)(A) incorporates the related-party definitions of sections 267 and 707(b) outlined above. Accordingly, section 168(k) bonus depreciation is not permitted if the taxpayer acquires otherwise qualifying used property from a party treated as “related” under those provisions.
The 2017 Act also introduces new section 199A, which generally provides a 20% deduction for qualifying business income that a taxpayer receives through a sole proprietorship, partnership, or S corporation. In order to claim the deduction, a taxpayer needs to have qualifying business income, which is generally non-portfolio and non-compensation income. The taxpayer must also receive such qualifying business income from a qualified trade or business, a term which excludes the performance of services as an employee. For taxpayers above certain income thresholds, additional limitations apply. Certain services businesses are excluded from the definition of qualified trade or business, and the taxpayer’s qualified trade or business must engage in certain types of activity in order for the taxpayer to be able to claim the deduction. In regard to this latter limitation, the section 199A deduction with respect to each qualified trade or business is limited to the greater of (i) 50% of the W-2 wages paid by the qualified trade or business or (ii) 25% of the W-2 wages paid by the qualified trade or business plus 2.5% of the unadjusted bases immediately after acquisition of all qualified property of the qualified trade or business (the Wages Plus Property Test).
For purposes of the Wages Plus Property Test, qualified property is defined as certain tangible property held and used by the qualified trade or business. Only property whose depreciable period has not ended counts as qualified property. For this purpose, however, the applicable depreciation period is the greater of (i) ten years or (ii) the applicable recovery period under section 168. In enacting the statute, Congress ordered Treasury to apply rules to prevent the use of related-party transactions to manipulate the depreciable period of otherwise fully depreciated property, and stated that the rules should be similar to those in section 179(d)(2). It is therefore likely that a taxpayer cannot count used property acquired from a related taxpayer for purposes of the Wages Plus Property Test.
Like section 168(k), the 20% qualifying business income deduction under section 199A is temporary and will expire for taxable years beginning after January 1, 2025. While they last, both provisions will provide significant benefits to qualifying taxpayers. However, taxpayers who regularly buy property from related parties, or who are contemplating such transactions, must recognize that these benefits may not be available for them. ■