District of Columbia’s Historic Terminating Business Exclusion from its Unincorporated Business Franchise Tax About to End
The current rate of tax on net income is 8.25%. Unincorporated businesses include businesses conducted in the District by partnerships, limited liability companies taxed as partnerships, and sole proprietorships. For federal income tax purposes, the income of such entities flows through to its owner or owners, but the District imposes an entity-level franchise tax. A significant portion of the District’s unincorporated business franchise tax is borne by entities that own and operate commercial real property located in the District.
Section 117.13 of the D.C. Municipal Regulations currently provides that gain (other than ordinary gain resulting from the recapture of depreciation) from the sale or other disposition of property that results in the termination of an unincorporated business is to be recognized and reported by the owners of the business rather than by the business entity. To the extent the owners of the business are not District residents or entities that carry on a business in the District, gain from a sale that terminates the business is not subject to the District’s unincorporated business franchise tax. The District generally cannot impose income tax directly on nonresident individuals. Nonresident real estate owners, in particular, have benefitted from this terminating business exclusion.
The terminating business exclusion is set to end on January 1, 2021. In the summer of 2020, the District of Columbia Council enacted, and Mayor Muriel Bowser signed, the Fiscal Year 2021 Budget Support Emergency Act of 2020 (the BSA), which amends the definition of taxable income of an unincorporated business in DC Code Section 47-1808.02(1) by adding the following:
Taxable income shall include gain from the sale or other disposition of any assets, including tangible assets and intangible assets, including real property and interests in real property, in the District, even when such a sale or other disposition results in the termination of an unincorporated business.
The above language would override the current business termination exclusion. The BSA is currently subject to the usual 60-day period of Congressional review, but Congress is not expected to take any action. The D.C. Council projects that the BSA will become law on December 1, 2020, with an effective date of January 1, 2021.
There is no provision for grandfathering an existing businesses. Accordingly, this rule will apply to any sales by an unincorporated business in the District on or after January 1, 2021.
District nonresidents who hold District real property through an unincorporated business should consider the following tax planning ideas:
- If a sale is currently being contemplated, accelerate the closing date to occur prior to year-end. It is not clear if the new provision would result in gain being taxed to the extent the seller receives an installment sale note payable after 2020.
- Consider restructuring the ownership of the District real property so that it is held by a real estate investment trust (a REIT). For federal income tax purposes, a REIT may eliminate its entity taxable income by making distributions to its shareholders and claiming a dividends-received deduction. This exclusion applies both to operating income and gain on sale. The District of Columbia conforms to the federal income tax treatment of REITs. REITs are not, however, a solution for every type of real property business. They also involve a significant amount of tax accounting and administrative compliance costs. But in many situations, REITs may significantly reduce overall taxation.
- Under the District’s unincorporated business tax regime, losses do not pass through to the owners; instead, they remain with the unincorporated business and if unused, become a net operating loss carryover. Such losses can be applied to offset gain on sale. Unincorporated businesses should make sure that their losses are properly being accounted for, even if they would not offset all of the gain on sale.
It is worth noting that the unincorporated business franchise tax would apply even though the gain would be excluded for federal income tax purposes under the Opportunity Zone investment rules of Section 1400Z of the Internal Revenue Code of 1986, as amended. Unless changed in the future, the District would become one of the few state or local jurisdictions that do not follow this federal exclusion, and Opportunity Zone investors and sponsors may want to look elsewhere.
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