On December 18, 2015, President Barack Obama signed the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”). The PATH Act made permanent a variety of provisions of the Internal Revenue Code of 1986, as amended (the “Code”), relating to mergers and acquisitions. Such changes include, among other things, the exclusion of gain on qualified small business stock and the reduction in the recognition period for built-in gains tax for S corporations. The PATH Act also made significant changes with respect to real estate investment trusts (“REITs”) and the provisions incorporated in connection with the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”).
Exclusion of 100% of Gain on Qualified Small Business Stock
The PATH Act made permanent the Code section 1202 qualified small business (“QSB”) stock gain exclusion for noncorporate investors for stock acquired any time after September 27, 2010 and held for more than five years. Prior to the effective date of the PATH Act, QSB stock acquired after 2014 would have received only a 50% gain exclusion upon a sale after five years. The PATH Act extends and makes permanent the full 100% tax exemption for QSB stock acquired at any time after September 27, 2010. The exclusion is available to noncorporate taxpayers who hold eligible QSB stock for more than five years. In general, stock of a domestic “C corporation” (other than stock in certain entities subject to special tax treatment, such as REITs) may qualify as QSB stock if it meets the following requirements:
- the stock was acquired by the taxpayer at original issue (after August 10, 1993) for money, stock itself that was QSB stock, property other than stock, or as compensation for services;
- the stock is issued by a corporation whose aggregate gross assets at any time on or after August 10, 1993, through and immediately following the issuance do not exceed $50 million (taking into account the amounts received for the stock on its issuance);
- during substantially all of the taxpayer’s holding period at least 80% (by value) of the issuing corporation’s assets are used in the active conduct of one or more qualified trades or businesses, which generally includes any trade or business other than certain service businesses, and businesses engaged in financial, farming, public accommodation, and certain natural resource activities; and
- the issuing corporation has not made any specified disqualifying redemptions of its stock or violated certain other requirements.
The amount of gain eligible for exclusion is generally limited to the greater of (i) $10 million (reduced by the amount of gain eligible for exclusion in prior taxable years) or (ii) ten times the taxpayer’s tax basis in the QSB stock, but is subject to limits computed on a per-issuer basis. The remainder of the gain above the applicable threshold amounts is usually capital gain, taxable at a maximum rate of 28 percent. In addition, the PATH Act provides that, for dispositions of QSB stock that are eligible for the 100% capital gain exclusion, no portion of the excluded gain is treated as a preference item for purposes of the alternative minimum tax (“AMT”).
Reduction in S Corporation Recognition Period for Built-in Gains Tax
The PATH Act permanently reduced the period for which S corporations could be subject to the built-in gain tax under Code section 1374. Unlike C corporations, S corporations generally pay no corporate-level tax; instead, items of income and loss of an S corporation pass through to its shareholders. However, if an S corporation that was previously taxed as a C corporation has built-in gains attributable to the period during which it was a C corporation, it is subject to a corporate-level tax (generally at a rate of 35%) when it recognizes the built-in gains within a certain period of time following its conversion to an S corporation.
From 1986, when the built-in gains tax was first enacted, until 2009, the built-in gains tax applied to gains recognized during the first 10 years following an entity’s conversion to an S corporation. Since 2009, different pieces of tax legislation shortened the ten-year period. However, each one was temporary and was generally done retroactively, which limited the opportunities for practical tax planning.
The PATH Act permanently changed the recognition period from ten years to five years. By making the change to the recognition period permanent, in contrast with the temporary changes that were made starting in 2009, the PATH Act will help reduce the uncertainty involved in tax planning for S corporations.
FIRPTA and REITs
The PATH Act made a number of changes that affect FIRPTA and REITs. Under FIRPTA, non-U.S. persons are generally subject to U.S. federal income tax with respect to gain from the disposition of certain United States real property interests (“USRPIs,” including stock in a domestic corporation for which the fair market value of its United States real property interests equals or exceeds 50% of the fair market value of its United States real property interests, its interests in real property located outside the United States, and any other of its assets which are used or held for use in a trade or business). If a non-U.S. person owns stock of a REIT, FIRPTA also generally applies to the investor’s receipt of certain distributions attributable to gain from the sales of U.S. real property interests by the REIT. To help enforce the collection of such taxes, FIRPTA imposes withholding taxes on the payer of such sale proceeds or distributions.
Before the PATH Act, a foreign person owning 5% or less, actually or constructively, of a publicly traded REIT, was not subject to FIRPTA on the sale of the REIT stock or upon the receipt of a REIT capital gain dividend. The PATH Act increases the maximum ownership from 5% to 10% that a shareholder may hold in a publicly traded REIT without causing such stock to be subject to FIRPTA.
Gain on the sale of the stock of a “domestically-controlled” REIT is not subject to FIRPTA. For this purpose, a REIT is a “domestically-controlled” REIT if less than 50% of its stock is held directly or indirectly by foreign persons at all times during an applicable testing period. The PATH Act provides greater certainty in determining whether a publicly traded REIT is domestically controlled by providing that a REIT shareholder that owns less than 5% of stock in a REIT that is regularly traded on an established securities market in the United States will be presumed to be a U.S. person unless the REIT has actual knowledge that such person is not a U.S. person.
Before the PATH Act, foreign pension funds were subject to FIRPTA, but U.S. pension funds were generally exempt from U.S. federal income tax on capital gains. The PATH Act exempts certain qualified foreign pension funds from FIRPTA withholding; thus, qualified foreign pension funds will no longer be subject to FIRPTA on gain from the sale or disposition of USRPIs held directly, or indirectly through a partnership, or on capital gains distributions attributable to sales of USRPIS by the REIT. Importantly, this exemption from FIRPTA is not limited to foreign governmental pension plans but also applies more broadly to private pension plans, so long as they satisfy the requirements of being a “qualified foreign pension fund.”
A “qualified foreign pension fund” includes a (i) non-U.S. created pension fund, (ii) that is established to provide retirement or pension benefits to current or former employees, (iii) does not have a single beneficiary with a right to more than 5% of its assets or income, (iv) is subject to government regulation and provides annual reports about its beneficiaries to the local government, and (v) with respect to which, under the laws of the country in which it is established or operates (A) contributions to such trust, corporation, organization, or arrangement which would otherwise be subject to tax under such laws are deductible or excluded from gross income of such entity or taxed at a reduced rate, or (B) taxation of any investment income of such trust, corporation, organization, or arrangement is deferred or such income is taxed at a reduced rate.
Foreign pension plans qualifying under the new exception will be able to invest in private U.S. REITs even if such REITs are not “domestically-controlled” REITs. Moreover, foreign pension plans that are investing in real estate funds via blocker corporations (to block taxable real estate gain) may want to consider restructuring; it should be noted, however, that the PATH Act does not alter the rules that can impose U.S. federal income tax on rent, interest, and other income.
Finally, the PATH Act increased the rate of withholding on dispositions of USRPIs from 10% to 15% for dispositions occurring on or after February 17, 2016.