Authored by Jean Paul Schwarz
The hedge fund, private equity and alternative asset industries will be impacted by a number of tax provisions from the final tax reform bill called the “Tax Cuts and Job Act” that was signed into law by the president on Dec. 22, 2017. Provisions will affect carried interest, general tax rates, compensation, like-kind exchanges and more. This article is intended to provide a high-level summary of some of the key provisions of the act.
Key provisions: management companies
Deduction for qualified business income of pass-through entities
For taxable years beginning after Dec. 31, 2017, the act generally provides a taxpayer (other than a corporation) with a deduction equal to the lesser of:
- the combined qualified business income (QBI) of the taxpayer from a partnership, S corporation or sole proprietorship; or
- 20 percent of the excess of
- the taxpayer’s taxable income, over
- the sum of any net capital gains.
The deduction reduces taxable income, but not adjusted gross income, and is limited to the taxpayer’s taxable income (reduced by net capital gains) for the year. Hence, eligible taxpayers are entitled to the deduction regardless of whether they elect to itemize their personal deductions.
QBI means income or loss from any qualified trade or business of the taxpayer during the year. QBI does not include nonbusiness interest, dividends, capital gains or losses, or §1231 gains. It is unclear if §1231 losses are excluded from the computation, but since they receive ordinary loss treatment, presumably they are included and reduce QBI. A taxpayer’s qualified business income does not include reasonable compensation paid to the taxpayer from a qualified business, guaranteed payments under §707(c), or any payment under §707(a) to a partner for services rendered to the partnership. QBI must also be effectively connected with the conduct of a trade or business within the United States (within the meaning of § 864(c)). Foreign-source income generally will not qualify for the deduction.
The amount deductible for each qualified trade or business is then limited to the lesser of:
- 20 percent of such QBI, or
- The greater of:
- 50 percent of the W-2 wages with respect to the qualified business, or
- 25 percent of the W-2 wages with respect to the qualified business, plus 2.5 percent of the unadjusted basis immediately after the acquisition of qualified property.
The term “qualified trade or business” does not include specified trade or business activities which entails the performance of (i) certain professional services, (ii) investing and investment management, or (iii) trading or dealing in securities, partnership interests or commodities. Notwithstanding the foregoing, if the taxpayer’s taxable income is less than the sum of $157,500 ($315,000 for those filing a joint return) plus $50,000 ($100,000 for those filing a joint return), then the foregoing specified trade or business exclusion shall not apply. However, only a portion of such trade or business income shall be taken into account for purposes of computing the deduction.
Carried interest/incentive allocation/carve-out/profit reallocation
For taxable years beginning after Dec. 31, 2017, the act imposes a three year holding period to be eligible for long term capital gain tax rates when in connection with the performance of substantial services by the taxpayer in a trade or business consisting of raising or returning capital and either investing in or developing securities, commodities, real estate held for rental or investment, cash, options or derivative contracts. Internal Revenue Code (IRC) §83(b) elections specifically cannot be used to circumvent the three-year holding period requirement.
Many other ambiguities exist as the act is currently written and will hopefully be addressed by regulations written hereafter. For example:
- Does the exception provided for a corporation apply to an S corporation? Presumably not, since S corporation income passes through to individuals, qualifying trusts and certain qualified employee benefit plans.
- Does the three-year holding period apply to both sale of the partnership interest and also to passed-through capital gains? Although not entirely clear, it appears that the three-year holding period described in the bill is required for sales of assets held (directly or indirectly) by the applicable partnership or, in the case of the sale of an applicable partnership interest, the applicable partnership interest itself. Rather than treating amounts failing the three-year test as ordinary income (as has been the typical recharacterization under prior versions of proposed carried interest legislation), new §1061 treats such gain as short-term capital gain.
- Does it not affect the pass through of qualified dividends, IRC §1231 gains and/or IRC §1256 gains? As for other types of pass-through income, pending the issuance of IRS guidance, it is still unclear how such items should be handled.
- Must partnerships now provide three-year holding period disclosures so that fund of funds may calculate the correct holding period? Yes, pursuant to IRS regulations or other IRS guidance when issued.
- What happens to the accrued but still unrealized gains at Dec. 31, 2017? Hopefully, future IRS guidance will clarify the treatment of such items.
Other open questions that require IRS guidance:
- Does the three-year holding period rule apply to a member of the general partner’s own limited partnership interest in the same entity?
- Do the new related person rules now effectively end the practice of general partner entities distributing out fund partnership interests with unrealized gains to the owners of the general partner and then those interests being recontributed to the fund?
Sale of partnership interests which conduct U.S. trade or business activities by foreign persons
Effective for sales, exchanges and dispositions after Nov. 27, 2017, IRC section 864(c)(8) is amended to provide that gains or losses from the sale or exchange of a partnership interest engaged in a U.S. trade or business is treated as U.S. effectively connected income (U.S. ECI) to the extent that the transferor would have realized U.S. ECI if the partnership sold all of its assets at fair market value as of the date of the sale or exchange. IRC section 864(c)(8) effectively codifies Rev. Rul. 91-32 and reverses the Tax Court’s decision in Grecian Magnesite Mining v. Commissioner, 149 T.C. No, 3 (July 13, 2017). For sales starting in 2018, pursuant to IRC section 1446(f)(1), the transferee of the partnership interest will be required to withhold 10 percent of the amount realized on the disposition. If the transferee fails to withhold as required, the partnership shall be required to deduct and withhold from distributions to the transferee/distributee an amount equal to the amount that should have been withheld by the transferee in connection with the original sale.
On Jan., 2, 2018, the IRS issued Notice 2018-8, in which the IRS determined that withholding under new IRC section 1446(f) should not be required with respect to any disposition of an interest in a publicly traded partnership (within the meaning of IRC section 7704(b)) until regulations or other guidance have been issued. This temporary suspension is limited to dispositions of interests that are publicly traded and does not extend to non-publicly traded interests. The Treasury Department and the IRS intend to issue future prospective regulations or other guidance on how to withhold, deposit and report the tax withheld under new IRC section 1446(f) with respect to a disposition of an interest in a publicly traded partnership. It should be noted that while the Notice is suspending withholding under new IRC section 1446(f) with respect to publicly traded partnerships, it does not suspend the application of new IRC section 864(c)(8), which remains in full force and effect.
For more information on this and depreciation changes, please see Baker Tilly’s article Tax Reform: The Tax Cuts and Jobs Act passes published on Dec. 19, 2017.
Effective for dispositions after 2017, self-created property such as patents, inventions, models or designs, secret formulas or process no longer qualify as capital assets. Presumably, trading algorithms may be treated as a “design, secret formula or process” for this purpose.
Prior to amendment by the act, IRC section 274(a) disallowed certain entertainment, amusement or recreational related expenses unless certain conditions were met. As amended, IRC section 274(a) now eliminates the deductibility of such expenses. The changes made by the act are effective for amounts paid or incurred after Dec. 31, 2017.
Substantial built-in losses
Under prior law, IRC section 743(d)(1) provided that a partnership does not adjust the basis of its property as a result of a transfer of an interest in the partnership unless (i) the partnership has made an IRC section 754 election or (ii) the partnership has a substantial built-in loss of $250,000 or more with respect to its property immediately after the transfer. A partnership has a substantial built-in loss with respect to its property if the adjusted basis of the partnership’s property exceeds its fair market value by more than $250,000.
Effective for transfers of partnership interests occurring after Dec. 31, 2017, the substantial built-in loss rules have been expanded to also apply where the transferee partner would be allocated a loss of more than $250,000 if the partnership hypothetically sold its assets for cash equal to their fair market value immediately after the transfer. Presumably, the new rule might be implicated if in the hypothetical sale, a legacy partner would be allocated a built-in gain of $400,000, while the transferee partner would be allocated a built-in loss of $300,000, even though there is net built-in gain of $100,000.
Effective for exchanges completed after Dec. 31, 2017, the IRC section 1031 like-kind exchange rule will only apply to exchanges of real property. The act also amended IRC section 1031(h) to provide that exchanges of real property located in the United State and real property located outside the United States are not considered of a like kind. Obviously, exchanges involved aircraft and art work will no longer be eligible for deferred tax treatment under IRC section 1031, as amended.
Effective for partnership taxable years beginning after Dec. 31, 2017, the IRC section 708(b)(1)(B) technical termination rule is eliminated.
Additional key provisions: Hedge funds
For information on deduction for qualified business income of pass-thru entities, carried interest/incentive allocation/carve-out/profit reallocation see information included under in key provisions: management companies.
Interest expense deduction
IRC section 163(j) Modifications: Effective for tax years beginning after 2017, the amount allowed as a deduction for business interest shall not exceed the sum of: (a) the business interest income for the taxable year; (b) 30 percent of the adjusted taxable income for the taxable year; plus (c) floor plan financing interest for the taxable year. Business interest expense must be incurred on indebtedness that is related to the taxpayer’s trade or business. Disallowed interest can be carried forward indefinitely.
Small businesses with less than $25 million of gross receipts are exempt from the new rules.
IRC section 163(j), as amended, contain numerous rules which implement the new regime, particularly in the case of partnerships and S corporations. A complete discussion of these rules is beyond the scope of this article.
Effective for tax years beginning after Dec. 31, 2017, the act imposes a 1.4 percent excise tax on the net investment income of certain private colleges and universities that: (i) have more than 500 students; (ii) have at least half of their students located in the United States; and (iii) have assets of least $500,000 per full-time student. See our article on impacts to tax exempt entities for more information.
Passive foreign investment company (PFIC)
Effective for tax years beginning after Dec. 31, 2017, the act revises the insurance exception for PFICs to add the concept of a “qualifying insurance corporation.” The term “qualifying insurance corporation” is defined as a corporation that would qualify to be taxed as an insurance company if it were a domestic corporation and that has applicable insurance liabilities greater than 25 percent of its total assets. Qualifying insurance corporation status may also be available to a company that does not meet this threshold under certain circumstances. Under the act the term “applicable insurance liabilities” include unpaid losses and loss adjustment expenses and certain reserves for life and health insurance risks. The Conference Report indicates that annuity reserves are intended to be applicable insurance liabilities. Unearned premium reserves are not applicable insurance liabilities.
Although the act should provide somewhat greater certainty than current law, some uncertainty remains. The revised PFIC exception still requires that the corporation in question still be involved in “the active conduct of an insurance business.”
Additional key provisions: Private equity funds
For information on deduction for qualified business income of pass-thru entities, and carried interest/incentive allocation/carve-out/profit reallocation, see information included under in Key provisions: management companies.
For information on interest expense deduction, university endowments and passive foreign investment company (PFIC) impacts, see information included under Additional key provisions: Hedge funds.
Corporate tax rates are reduced to a flat 21 percent starting beginning after 2017. Corporations treated as personal service corporations (PSCs) will be subject to a flat 21 percent rate. Effective for tax years beginning after Dec. 31, 2017:
- The corporate Alternative minimum tax (AMT) is repealed. For tax years beginning after 2017 and before 2022, a prior AMT credit is refundable in an amount equal to 50 percent and AMT credit carryforward becomes a refundable credit.
- Net operating losses arising in tax years beginning after Dec. 31, 2017, will be limited to 80 percent of taxable income. Carrybacks of NOLs arising in tax years beginning after Dec. 31, 2017will be eliminated. Unused amounts will be able to be carried forward indefinitely.
- Many tax credits, including the work opportunity tax credit, are eliminated. The research and development credit and low-income housing credit remain.
The act contains significant international tax provisions that will drastically change the way U.S. multinationals are taxed and conduct business abroad, as well as change how foreign multinationals will conduct business in the United States. Qualifying U.S. corporations will benefit from a 100 percent dividends received deduction (DRD) with respect to dividends paid from certain foreign subsidiaries (i.e., the participation exemption system). Consequently, the foreign earnings of foreign subsidiaries owned by such U.S. corporations will generally not be subject to U.S. federal income tax at the corporate shareholder level assuming it’s an actual dividend distribution, not a deemed inclusion.
This fundamental change to a hybrid territorial system via a participation DRD comes with a one-time “repatriation tax.” The bifurcated effective tax rates for this repatriation of foreign earnings are 15.5 percent (for cash and cash equivalents) and 8 percent (for other earnings). The repatriation tax is assessed on the undistributed, non-previously taxed post-1986 foreign earnings and profits (E&P), based on the higher of E&P as of Nov. 9, 2017, or Dec. 31, 2017 (the use of fixed measurement dates is intended to prevent the reductions of E&P prior to enactment).
This hybrid territorial system also does away with the indirect foreign tax credits (FTC) under section 902 which are no longer allowable on future foreign earnings, with some exceptions. The act expands the scope of the current subpart F anti-deferral regime by implementing the following base erosion measures: 1) a minimum tax on global intangible low-taxed income (GILTI), 2) a limitation of interest expense to 30 percent of adjusted taxable income and 3) a base erosion and anti-abuse tax (BEAT). The act includes several other provisions targeted at cross-border transactions, including a deduction, in part, for foreign-derived intangibles income (FDII), revised treatment of certain payments in hybrid transactions or with hybrid entities, rules for outbound transfers of intangibles, new U.S. sourcing rules related to inventory, changes to gain recognition and reductions in tax basis on certain transfers related to foreign branches. For more information, please see Baker Tilly’s tax reform resource center.
Key provisions: Fund managers and individual investors
Individual income tax rates
The new bill will change the current seven tax brackets to 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent and 37 percent. The 37 percent bracket starts at $600,000 for married filing joint returns and $500,000 for single individuals.
- Standard deductions would be increased to the following:
- $24,000 for married filing jointly filers
- $12,000 for single filers
- Personal exemptions are repealed
- Alternative minimum tax is not repealed, but exemptions and exemption thresholds have been increased
- The cap on deductible home (qualified residence) mortgage interest for new mortgages (for debt incurred after Dec. 15, 2017) is reduced from $1,000,000 to $750,000. Home equity loans would no longer receive any benefit for interest paid.
- Deductions for state and local income and property taxes are capped at $10,000.
- The deduction limitation for charitable contributions expands to 60 percent of an individual’s contribution base (generally, adjusted gross income (AGI), but without including any NOL carrybacks to the year) from the previous 50 percent of AGI limitation.
- Deductions for medical expenses have been modified.
- Deductions for casualty losses (but not federally declared disasters), tax preparation expenses, alimony payments, moving expenses and miscellaneous itemized deductions (professional fees, management fees, etc. of an investor fund as opposed to a trader fund), are eliminated.
- Alimony deduction by payor/inclusion by payee is suspended. For any divorce or separation agreement executed after Dec. 31, 2018, or modified after it (if the modification expressly provides that the new amendments apply), alimony and separate maintenance payments are not deductible by the payor spouse and are not included in the income of the payee spouse.
Net investment income tax (NII)
The 3.8 percent NII tax remains intact.
Estate and gift tax
The act increases the federal estate and gift tax unified credit base exclusion amount to $10 million ($11.2 million, indexed for inflation), effective for decedents dying and gifts made after 2017 and before 2026. The GST base exemption amount also increased to $10 million ($11.2 million, indexed for inflation) for GST transfers made after 2017 and before 2026. The former $5 million base exemption amount (as indexed for inflation) will be reinstated as of Jan. 1, 2026 for estate, gift and GST purposes. The step up rule is unchanged. See our article on the final tax bill for more information on the estate and gift tax.
Note that Treasury regulations will probably be written on many of the new provisions that will help further explain ambiguities in the law and will, no doubt, raise further questions. As practitioners weigh in on how to interpret all of these new provisions, a consensus will hopefully be formed as to the practical implementation. We recommend speaking with your Baker Tilly tax advisor to understand how the changes may impact your organization.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.