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By Edward R. Jenkins, CPA, CGMA

It’s been awhile since tax shelters were a hot topic. In fact, practice in tax shelters has been a bit sleepy. If “tax shelters” haven’t been on your radar screen for a while, this blog is a wake-up call. What is vital, really, is the definition of tax shelter because if your entity falls within the definition of a tax shelter, you cannot use the small business exceptions of the Internal Revenue Code (IRC) Section 163(j) interest limitation rule or a number of important accounting methods available to small businesses.

The Tax Cuts and Jobs Act (TCJA) expanded the definition of what constitutes a small business in IRC Section 448(c)(1) to a business that has average annual gross receipts of $25 million ($26 million adjusted for inflation for 2019) or less. But you need to go back to IRC Section 448(a)(3) to note that tax shelters are not permitted to use the cash method of accounting.

You may say, “My business isn’t a tax shelter. This doesn’t affect me.” Are you sure? This is where the definition becomes important. A tax shelter is defined in IRC Section 461(i)(3) as one of three entities:

• An entity, other than a C or regular corporation, that is offering interests for sale to the public that requires registration with any federal or state agency that has authority to regulate the offering of securities for sale
• A syndicate as defined in IRC Section 1256(e)(3)(B)
• A tax shelter created for the avoidance or evasion of tax as defined in IRC Section 6662(d)(2)(C)(ii)

This blog does not address the publicly offered shelter or the shelter intended to avoid or evade taxes. While those definitions are important, we probably all understand what those entities are doing. So that leaves us with the “syndicate.”

A syndicate is defined as any partnership or other entity, other than a C corporation, if more than 35% of losses of the entity during the taxable year are allocable to limited partners or limited entrepreneurs. A limited entrepreneur is defined in IRC Section 461(k)(4) as “a person who has an interest in an enterprise other than as a limited partner or does not actively participate in the management of the enterprise.”

So, who might that include?

• Limited partners in a limited partnership, obviously
• S corporation shareholders who are not actively participating in management
• LLC members (taxed as partners or as S corporation shareholders) who are not actively participating in management
• Trust/estate beneficiaries who are not actively participating in management (unless the trustee is active)

If your entity has those individuals owning interests and, together, they are entitled to more than a 35% allocation of losses, the entity is a syndicate. Therefore, the entity is a tax shelter. As a tax shelter, you do not get to use the small business exception for the following tax benefits:

• Cash method of accounting under IRC Section 448
• Exemption from inventory accounting under IRC Section 471
• Exemption from uniform capitalization under IRC Section 263A
• Exemption from percentage completion contract accounting under IRC Section 460
• Most surprisingly, the exemption from the interest deduction limitation of IRC Section 163(j)

Congress intentionally included this definitional construct of a tax shelter in crafting the small business exceptions. In a letter dated Feb. 19, 2019, the AICPA asked for relief from this definition, but the IRS may not have the latitude to grant relief due to the intentional statutory construct. To date, no relief has been issued.

If you are responsible for one of these surprise tax shelters, make sure you are not using any of the small-business exceptions mentioned.

Edward R. Jenkins Jr., CPA, CGMA, is professor of practice in accounting for Pennsylvania State University in University Park, managing member of Jenkins & Co. LLC in Lemont, and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at erj2@psu.edu.

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