The Tax Cuts and Jobs Act 2 Months Later - Considerations for Hedge Funds, Private Equity Funds and Their Fund Managers
Key provisions of the Tax Cuts and Jobs Act (the “Tax Act”), signed into law on December 22, 2017, will have a major impact on the investment funds industry. This note provides a brief overview of the significant provisions of the Tax Act that will likely impact many hedge and/or private equity funds, both at the fund and the portfolio company levels, and their managers, as well as the discussions that we have been having with our clients over the course of the two months since its enactment regarding possible tax structuring options going forward.
The Tax Act significantly modifies the taxation of the carried interest earned by fund managers and other partnership interests held in connection with the performance of substantial services by the taxpayer (a so called “applicable partnership interest”). Under the Tax Act, gain allocated by a partnership in respect to carried interest and other applicable partnership interests will qualify as long-term capital gain only to the extent that the partnership has held the relevant assets giving rise to the gain for more than three years as of the time of disposition (rather than the one-year holding period generally required for long-term capital gain treatment). Gains that do not meet the three-year holding period are reclassified as short-term capital gain (taxable at ordinary income rates), rather than as ordinary income. In addition, the three-year holding period requirement also applies to gain derived from the sale of an applicable partnership interest itself (i.e., the general partner will be required to hold the partnership interest attributable to its carried interest in a fund for more than three years in order for the gain on the sale of such interest to qualify as long-term capital gain).
This new provision does not modify the tax treatment of carried interest allocations of qualified dividend income (generally taxable at the preferential 20% rate, plus the 3.8% tax on net investment income) or of gains on sales of futures contracts (taxable under Section 1256 of the Code as 60% long-term capital gain and 40% short-term capital gain). It also will not impact any portion of the partnership interest held by a general partner which is attributable to capital contributed to the partnership by the general partner. Also, foreign managers will not be required to treat carried interest allocations as U.S. effectively connected income (ECI) as the new rules do not treat carried interests as fees being received for services.
The modification to the carried interest rules will clearly impact hedge fund managers more than managers of private equity and real estate funds, as these funds generally hold assets for more than the requisite three-year holding period. Hedge fund managers of funds that hold positions for greater than one-year but less than the newly required three-year period will be most affected by the new rules.
It has been suggested that managers of funds which do not hold assets for more than three years consider restructuring their incentive allocations to incentive fees. However, the incentive allocation structure still retains the benefits of exemption from New York City unincorporated business income tax (for NY City based managers), allocations of qualified dividend income and futures gains at preferential tax rates, and avoiding the investment fee deductibility restrictions for individual limited partners in certain funds, as discussed further below in Elimination of Miscellaneous Itemized Deductions Subject to the 2% Floor. However, this strategy may be helpful for non-NY City based managers of funds with high frequency trading (so called “trader” funds) where there is very little unrealized income and mostly short-term capital gains.
It should also be noted that the statutory language under the Tax Act provides that the new changes do not apply to carried interests held by corporations (which, for this purposes, would include C corporations as well as S corporations). This has led to discussions with clients about electing to treat their existing general partner entities as S corporations to take advantage of this carve-out. However, the Treasury and IRS announced on March 1 that they intend to issue regulations providing that the term “corporation” for these purposes does not include an S corporation.
While an earlier version of the House bill contained a repeal of the exemption in the Internal Revenue Code of 1986, as amended (the “Code”), from self-employment tax for income received by limited partners in a partnership, the final Tax Act maintains this exemption. As the Code does not specifically allow for this exemption to apply to members of a limited liability company (LLC), hedge fund managers structured as LLCs should consider restructuring to limited partnerships in order to claim this exemption from self-employment tax on their allocations of the management company’s management fee and other fee income.
Corporate vs. Pass-through Structure
The Tax Act permanently reduces the corporate tax rate from 35% to 21% and repeals the corporate alternative minimum tax entirely. In contrast, the highest federal income tax rate for individuals is reduced from 39.6% to 37%. In addition, the 3.8% Medicare tax on an individual’s net investment income remains in effect.
The Tax Act adds a new deduction for non-corporate taxpayers based on a non-corporate owner’s qualified business income (QBI), which expires after the year 2025 year. The deduction generally equals 20% of a taxpayer’s share of QBI from pass-through entities (e.g., partnerships, S corporations, sole proprietorships, etc.), up to the greater of (i) 50% of W-2 wages of the business or (ii) 25% of W-2 wages of the business plus 2.5% of the initial cost of the tangible assets of the business. The deduction results in an effective federal income tax rate of 29.6% on QBI for an individual in the highest tax bracket.
QBI is generally defined as the net amount of qualified items of income, gain, deduction and loss from any qualified business of the non-corporate owner. QBI does not include investment income, and, as such, will generally not be applicable to investors in hedge funds organized as partnerships. The 20% deduction is generally not available for income realized from certain businesses, including consulting and financial services, and, as such, will not be applicable to owners of hedge fund managers organized as pass-through entities.
As the deduction is limited to a percentage of wages and/or asset cost, the benefit of the deduction will primarily benefit businesses with large payrolls relative to profits and businesses that make large investments in depreciable property. To the extent that a private equity fund invests in these types of businesses, it would be beneficial to make these investments through pass-through entities, rather than through corporate entities, so investors can receive the benefit of the deduction.
Since the new 21% corporate tax rate is now significantly lower than the highest applicable individual rate applicable to owners of pass-through entities, some fund managers are beginning to analyze whether it makes sense to convert their management companies from partnerships to corporate structures, especially given that investment managers cannot take advantage of the QBI deduction. The Tax Act may make it more advantageous to structure an investment management company as a corporation for certain taxpayers, even taking into account the second level of tax on dividend distributions of corporate earnings, given the potential for a corporation to retain and reinvest its earnings prior to making dividend distributions to shareholders. However, any such analysis will need to factor in the state and local tax implications at the corporation and shareholder levels, the potential impact of the 20% additional accumulated earnings tax on undistributed corporate earnings, the 20% tax on “personally holding company income” (i.e., passive investment income) of certain closely held C corporations and other benefits and detriments of the use of corporate versus pass-through structures.
New Limitation on Deduction of Business Interest
Under prior law, business interest paid or accrued by a business was generally fully deductible (subject to some limitations and restrictions). The Tax Act generally limits the deduction for “net business interest” for every type of business, regardless of structure, to 30% of “adjusted taxable income” or “ATI”. ATI is determined at the entity level for entities treated as partnerships and S corporations and generally is earnings before interest, depreciation, amortization or depletion (EBITDA) for tax years beginning before 2022. For 2022 and later years, a more restrictive limitation applies with 20% of net earnings before deducting interest expense and taxes (EBIT).
Certain taxpayers are exempted from the interest deductibility limitation, including small businesses averaging annual gross receipts of $25 million or less for the three prior taxable years, as well as real property businesses that elect out of the limitation. The term business interest does not include investment interest described under Section 163(d) of the Code, and, thus, does not generally impact interest expense incurred by hedge funds.
For entities treated as partnerships and S corporations, the interest deductibility limit is applied at the entity level rather than at the partner/shareholder level by reference to the entity’s ATI and business interest. Interest deductions that are allowed by the entity decrease the net income or increase the net loss allocated by the entity to its owners. For purposes of calculating the deductibility of business interest paid directly by a partner in a partnership, the partner’s ATI is determined without regard to the partner’s share of income, gain, deduction or loss of the partnership. If an entity has excess capacity for business interest deductions (i.e., its business interest expense is less than 30% of its ATI), each owner’s ATI will be increased by its share of the entity’s excess ATI, solely for purposes of determining the amount of business interest which such owner can deduct. Any business interest disallowed at the entity level in a taxable year is allocated to the owners and may only be deducted by them against excess ATI allocated to them from such entity in a future year. Unused deductions can generally be carried forward indefinitely.
The business interest deductibility limitation will significantly reduce the impact on debt incurred by a blocker corporate entity used by funds to invest in US businesses structured as partnerships. A blocker generally does not have income other than its share of the income of the operating partnership in which it invests, and, due to the partnership-level calculations, the blocker will have no ATI other than its share of any excess ATI of the operating partnership. Accordingly, unless the blocker is allocated excess ATI from the operating partnership, the blocker will not receive any current tax benefit for any interest paid or accrued on any debt incurred at the blocker level. While it is unclear under the current Tax Act, it is possible that a blocker can carry forward its unused business interest deduction and use it against its share of gain on a future sale of its interest in the underlying operating partnership.
Elimination of Miscellaneous Itemized Deductions Subject to the 2% Floor
For the 2018 through the 2025 tax years, the Tax Act completely repeals miscellaneous itemized deductions previously allowed to individual investors, subject to the 2% of adjusted gross income floor and phase-out rule under prior law. Such deductions generally included an investor’s share of the investment expenses, including management fees, incurred by a fund that is not engaged in the active trade or business of trading securities (i.e., a fund that is considered to be an “investor” rather than a “trader” of securities). If a fund is classified as a trader rather than an investor, the fund’s investment expenses are fully deductible as trade or business expenses. The determination of whether a fund is classified as a trader is based on facts and circumstances and is generally determined by the level of active trading of securities conducted by the fund. Currently, there is not clear guidance from the IRS as to what level of trading is sufficient to make a fund a trader, but this determination will be more significant given the change in tax law.
For funds that do not qualify for trader status, individual investors may now prefer to invest in the offshore corporate feeder fund instead of the onshore partnership fund, provided that ownership in the offshore fund by U.S. investors is not so concentrated and significant to cause the fund to be treated as a controlled foreign corporation (see Certain International Provisions below). As the offshore corporate fund is classified for U.S. tax purposes as a passive foreign investment company (PFIC), a U.S. investor can elect for the fund to be treated as a “qualified electing fund” (a “QEF Election”). If a QEF Election is made by a U.S. investor, the fund reports to the investor each year its share of the fund’s net long-term and short-term capital gain and net ordinary income after the deduction of all of the fund’s expenses (including expenses that would otherwise be classified as miscellaneous itemized deductions), and the investor’s reports this net income and gain on its tax return (i.e., investment expenses are deducted off the top and the investor is not subject to any limitations on the amount or types of expenses deducted).
Disallowance of Deduction for Excess Business Loses
For 2018 through 2025, the Tax Act imposes a new imitation on deductions for “excess business losses” incurred by non-corporate taxpayers. Generally, an “excess business loss” is the amount by which (i) a taxpayer’s aggregate deductions from trades or businesses exceed (ii) the sum of (1) the taxpayer’s aggregate business income and gains and (2) an amount equal in 2018 to $500,000 for taxpayers filing joint returns and $250,000 for other taxpayers, indexed for inflation for future years. Losses that are disallowed under this rule are carried forward to later tax years and can then be deducted under the rules that apply to net operating losses (NOLs), subject to the limitations discussed below. In the case of a partnership or S corporation, this limitation applies at the partner or shareholder level, and not the entity level. The limitation applies after the application of the currently applicable passive activity rules which generally limit the ability of investors in private funds to deduct their share of losses and deductions of operating partnerships in which the funds invest.
This new limitation on excess business losses will apply to investors in actively traded “trader” funds, and not to investors in funds classified as investors.
Changes to NOL Deductions
Under prior law, NOLs could be carried back two years and carried forward for twenty years. Under the Tax Act, starting in 2018, NOLs cannot be carried back, can be carried forward indefinitely, and are deductible only to the extent of 80% of a taxpayer’s taxable income. Existing NOLs arising in taxable years beginning prior to December 31, 2017 will continue to be carried back for two years and forward for twenty years and offset against 100% of income.
Effectively Connect Income on Sale of Partnership Interest
The Tax Act effectively codifies the position set forth in Revenue Ruling 91-32 and thereby overrides the recent Grecian Magnesite decision. Under the Tax Act, gain or loss realized on the sale of a partnership interest by a foreign partner on or after November 27, 2017 is treated as U.S. effectively connected income (ECI) and subject to U.S. tax if the gain or loss from the sale of the underlying assets held by the partnership would be treated as ECI for the foreign partner. Transferees of partnership interests are required to withhold 10% of the amount realized on the sale or exchange of such an interest unless the transferor certifies it is not a foreign person. Further, if the purchaser does not withhold, the partnership is required to withhold on distributions to such purchaser to cover the withholding.
This new rule has potential implications for a fund with a non-U.S. partner that wishes to transfer its partnership interest. As the fund will have ultimate responsibility for the withholding obligation, funds will want to ensure that they are indemnified by the transferor and transferee for any withholding taxes. In addition, private equity funds with pass-through investments at the operating company level may want to consider structuring such investments on behalf of their non-U.S. investors through corporate blockers to protect against ECI generation for such investors upon a sale by the investors of their interests in the fund.
Certain International Provisions
The Tax Act introduces a “modified” territorial system of corporate income taxation under which certain income earned by certain foreign subsidiaries of U.S. corporations is not subject to U.S. tax when it is repatriated back to the U.S. Beginning in 2018, U.S. corporations are entitled to a 100% dividend received deduction (DRD) on foreign source dividends received from a foreign corporation in which it is a 10% shareholder (other than a PFIC that is also not a controlled foreign corporation (CFC)). The Tax Act is not a full territorial system, however, because this DRD does not apply to a 10% shareholder’s inclusions of Subpart F income of a CFC or inclusions of earnings that a CFC invests in U.S. property, even if the CFC distributes the amounts back to its shareholders.
The switch to the territorial system came with a one-time mandatory repatriation tax for tax year 2017 on foreign earnings of “U.S. Shareholders” of “specified foreign corporations”. A foreign corporation is a specified foreign corporation if either (i) it is a CFC or (ii) it has at least one domestic corporation that is a U.S. Shareholder (i.e., a shareholder that owns 10% or more of stock directly, indirectly or constructively). Specified foreign corporations do not include PFICs as long as they are not also CFCs.
The tax is imposed on the greater of a specified foreign corporation’s accumulated earnings and profits determined as of November 2, 2017 or December 31, 2017, after the offset of earnings deficits. The tax is applied at effective rates for C corporation shareholders of 15.5% on cash or cash equivalent E&P and 8% on all other E&P. For non-corporate shareholders, the effective rates are 17.54% on cash and 9.05% rate on non-cash. This tax may be paid immediately or an election may be made to pay the tax in installments over eight years. If the installment election is made, the first installment must be paid by the original due date of the taxpayer’s 2017 tax return (determined without regard to any extensions, which for individuals is April 15, 2018), and each succeeding installment must be paid by the corresponding due dates for the following years’ tax returns.
The Tax Act has made a number of changes that will increase the situations in which a foreign corporation is treated as a CFC and expands the types of shareholders treated as U.S. Shareholders and subject to the CFC regime. A CFC is a foreign corporation more than 50% of the vote or value of stock of which is owned or deemed owned (through attribution rules) by U.S. Shareholders. Under prior law, a U.S. Shareholder was a U.S. person who owns or is deemed to own 10% or more of the vote of all classes of shares of voting stock of a foreign corporation. The Tax Act expanded this rule for 2018 and going forward (i.e., the change does not apply for determinations as to whether the repatriation tax is applicable) to provide that U.S. Shareholders include U.S. persons who own 10% or more of the voting power or the value of shares of a foreign corporation. In addition, the Tax Act modified the attribution rules applied in determining CFC status by removing a provision in the Code which prohibited “downward attribution” of stock ownership from foreign persons to U.S. persons. This modification is effective as of January 1, 2017 and, therefore, is applicable in determining whether a foreign corporation qualifies as a CFC and thereby subjecting its U.S. Shareholders to the repatriation tax.
U.S. Shareholders of a CFC are generally taxed currently at ordinary income rates on the CFC’s “Subpart F” income, which generally includes passive type income of the CFC, whether or not distributed. The Tax Act expands the categories of Subpart F income of a CFC beginning in 2018 to include “global intangible low-taxed income” (“GILTI”) which is intended to capture a portion of a CFC’s active earnings derived from low-tax jurisdictions where the CFC does not retain substantial tangible property. GILTI is generally the portion of a CFC’s net income (excluding U.S. effectively connected income and other taxable Subpart F income) that exceeds an amount equal to an implied 10% rate of return on the CFC’s tangible depreciable business assets. Corporate U.S. Shareholders are permitted to deduct a portion of the GILTI inclusion so that they are taxed on this income at a reduced effective rate of 10.5% (13.125% beginning in 2026). All other U.S. Shareholders include all GILTI in ordinary income each year.
It should be noted that the above international provisions of the Tax Act will create material new due diligence items for any transactions involving the purchase of stock in a foreign corporation as there are potential liabilities for the repatriation tax as well as GILTI exposure. Also, the Tax Act’s reduced rates on GILTI of U.S. corporate investors, combined with the fact that the DRD described above is only available to U.S. corporate shareholders, should be considered in structuring the purchasing entity of certain foreign portfolio companies through U.S. corporate blockers.
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