Tax Cuts and Jobs Act Issues Impacting the Asset Management Industry
Tax Cuts and Jobs Act Issues Impacting the Asset Management Industry O n December 22, 2017, the Tax Cuts and Jobs Act (the Act ) was signed into law by President Trump. The last time such sweeping tax legislation was enacted was the Tax Reform Act of 1986, more than 31 years ago. That act took more than four years to implement and required the issuance of thousands of pages of regulations. The provisions of the Act raise a number of issues that impact the asset management industry. Outlined below are some of these considerations and observations: I. Fund Level Considerations In general, the taxation of most financial instruments, capital gains and losses, interest and qualified dividends have not changed as a result of the Act. However, the treatment of pass-through investments, such as in publicly traded partnerships ( PTPs ) and private equity ( PE )-backed portfolio companies has been meaningfully impacted. Deduction for Investment in Pass-Through Entities PE Alternative Investment Vehicles and PTPs The Act allows some owners of pass-through businesses to deduct 20% of certain types of income earned by those businesses. 1
For taxable years beginning after December 31, 2017, and before January 1, 2026, the Act allows a deduction of 20% of a taxpayer s domestic qualified business income ( QBI ) from a partnership, S corporation or sole proprietorship. The 20% deduction is also allowed for a taxpayer s qualified REIT dividends, qualified cooperative dividends and qualified PTP income. Specified agricultural and horticultural cooperatives also qualify for the 20% deduction. QBI is defined as all domestic business income other than investment income (e.g., dividends other than qualified REIT dividends and cooperative dividends), investment interest income, short-term capital gains, long-term capital gains, commodities gains and foreign currency gains. QBI does not include reasonable compensation or guaranteed payments made to the taxpayer. For taxpayers whose taxable income is above the limits mentioned below, the 20% deduction is not allowed if the QBI is earned from a specified service trade or business. A specified service trade or business is defined as any trade or business (other than architecture or engineering) involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. In addition, the Act expands the definition to specifically include activities which involve the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in Internal Revenue Code 2
( IRC ) Sec. 475(c)(2)), partnership interests or commodities (as defined in IRC Sec. 475(e)(2)). For specified service businesses, noted above, the deduction phases out for joint filers with taxable income between $315,000 and $415,000, and for individual filers earning between $157,500 and $207,500. Taxpayers below this income threshold that are invested in non-specified service businesses may deduct the 20%. Taxpayers above this income threshold that are invested in non-specified service businesses may still deduct the 20% but subject to a cap (the wage limitation test ). The 20% deduction is limited to the greater of (a) 50% of the W-2 wages paid with respect to the qualified trade or business or (b) the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property. For this purpose, qualified property is generally defined as tangible property subject to depreciation under IRC Sec. 167, held by a qualified trade or business and used in the production of qualified business income the depreciable period for which has not ended before the close of the taxable year. The depreciable period with respect to qualified property is the period beginning on the date the property is first placed in service and ending on the later of (1) the date ten years after that date or (2) the last day of the last full year in the applicable recovery period that would apply to the property under IRC Sec. 168 without regard to IRC Sec. 168(g) (which lists applicable recovery periods under the alternative depreciation system ( ADS )). A qualified trade or business is any business other than a specified 3
service trade or business (defined above) or the trade or business of performing services as an employee. The 20% deduction is not allowed in computing adjusted gross income ( AGI ) but instead is allowed as a deduction to taxable income. The deduction is available to taxpayers who itemize as well as taxpayers using the standard deduction. Observation: An investor in a PE fund is qualified to receive the 20% deduction, subject to the limitations mentioned above, from an underlying non-specified flowthrough business investment regardless of the passive nature of that investment. Additional reporting will be necessary to allow the investor to know what share of the W-2 wages or basis in qualified property from the underlying fund investment is allocable to the share of the business income allocated to the investor. A partnership that only generates investment income (as described above) does not qualify for this provision. Business losses from pass-through investments. For taxable years beginning after December 31, 2017, the law disallows an excess business loss of a taxpayer other than a C corporation. However, an excess business loss can be treated as part of the taxpayer s net operating loss carryover to the following year. The excess business loss for the taxable year is calculated as the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount ($500,000 for married taxpayers filing jointly; $250,000 for all other taxpayers (indexed for inflation)). The limitation applies at the partner or S 4
corporation shareholder level and expires after December 31, 2025. This provision applies after applying the passive loss limitation rules (IRC Sec. 469). Observation: The term trade or business under this provision is not clearly defined. Until further regulations are written, losses from trader funds and IRC Sec. 475 mark-to-market funds that, for federal tax purposes, have been treated as trades or businesses may be subject to this provision. It is important to note that a taxpayer owning multiple businesses may first net the business income and losses of the various business entities without limitation. Once there is an overall net business loss, the amount allowed to offset other types of gross income (wage or investment income) is limited as above. Portfolio Deductions Effective for taxable years beginning after December 31, 2017 and before January 1, 2026, the Act suspends all miscellaneous itemized deductions that are subject to the 2% floor under pre-act law. Observation: Fees such as management fees, incentive fees, professional fees and accounting fees paid by investors in an investor fund are nondeductible under the Act. Similar fees paid by a trader fund that historically were not subject to the 2% floor under pre-act law are still deductible under the Act. In light of the elimination of the 2% portfolio expense deductions, investors in an investor fund may look to 5
investing through passive foreign investment company ( PFIC ) structures so that they do not lose the deductions. Such a strategy needs to be vetted as there are other less beneficial consequences to investing through PFICs. First-in first-out ( FIFO ). The original Senate bill had a provision to limit the allowable tax lot relief methodology to FIFO only. However, this provision was not included in the Act as adopted. Effectively Connected Income In 1991, the Internal Revenue Service released Revenue Ruling 91-32, which concluded without much analysis that under the pre-act IRC, the sale of a partnership engaged in a U.S. trade or business gives rise to income effectively connected with a U.S. trade or business ( ECI ). Many practitioners argued that the conclusion of the revenue ruling was incorrect. In 2017, the Tax Court in the Grecian Magnesite Mining case declined to follow the holding of the Revenue Ruling. Under the Act, partially in response to the Grecian case, the gain or loss from the sale or exchange of a partnership interest is treated as effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. Any gain or loss from this hypothetical asset sale will be allocated to interests in the partnership in the same manner as non-separately stated income and loss. The transferee of a partnership interest will be required to withhold 10% of the amount realized on the sale or 6
exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation. Observation: This effectively negates the ruling in Grecian Magnesite Mining and follows the conclusion of Revenue Ruling 91-32. As such, gains on the sale of partnership interests that are engaged in a U.S. trade or business will be considered ECI. Please note that the Grecian case is currently under appeal. Unrelated Business Taxable Income ( UBTI ) The Act requires that organizations which carry on more than one unrelated trade or business separately calculate UBTI for each trade or business, effectively prohibiting using deductions relating to one trade or business to offset income from a separate trade or business. This change applies to taxable years beginning after December 31, 2017. Under a special transition rule, net operating losses arising in a taxable year beginning before January 1, 2018, that are carried forward to a taxable year beginning on or after such date are not subject to this rule. Certain private colleges and universities ( applicable educational institutions ) are now subject to a 1.4% tax on their net investment income. The term applicable educational institution means an eligible educational institution as defined in IRC Sec. 25A(f)(2) (A) more than 50% of the tuition-paying students of which are located in the United States and (B) the aggregate fair 7
market value of assets of which at the end of the preceding taxable year is at least $500,000 per student. Observation: Tax-exempt entities should consider investing through blocker corporations and other investment vehicles. Partnership Transfers Built-in Losses Generally, a partnership does not adjust the basis of partnership property following the transfer of a partnership interest unless either the partnership has made an optional election to make basis adjustments under IRC Sec. 754 or the partnership has a substantial built-in loss immediately after the transfer. The Act modifies the definition of substantial built-in loss for purposes of IRC Sec. 743(d) by adding to the definition a situation where a transferee would be allocated a net loss in excess of $250,000 in a hypothetical liquidation of all of the partnership s assets immediately following the transfer. This addition is effective for transfers that take place after December 31, 2017. Under the new provision, the test for a substantial built-in loss applies at the partnership level and the transferee level. Observation: This provision prevents a seller from circumventing the built-in-loss rules by selling a partnership interest at a loss and the transferee getting the allocation of the loss inside the partnership. 8
Technical Terminations Under pre-act law (IRC Sec. 708(b)(1)(B)), a partnership that had a sale or exchange of 50% or more of the partnership interests within a 12-month period was considered terminated (a technical termination ). The Act repeals IRC Sec. 708(b)(1)(B). The provision does not change the present law rule of Section 708(b)(1)(A) that a partnership is considered terminated if no part of any business, financial operation or venture of the partnership continues to be carried on by any of its partners in a partnership. Observation: The Act reduces the need for additional compliance due to the sale or exchange of a 50% or greater partnership interest. II. Portfolio Company Considerations Reduction in Corporate Rates The Act institutes a corporate tax rate of 21%, effective for tax years beginning after December 31, 2017. In addition, the dividends received deduction ( DRD ) allowed to corporations receiving dividends from taxable domestic corporations other than a member of the same affiliated group is reduced as follows: The general 70% DRD is reduced to 50% and the 80% DRD (in the case of 20% or more owned corporations by vote and value) is reduced to 65%. Finally, the corporate alternative minimum tax ( AMT ) is eliminated (with limited minimum tax credits allowed from prior years). 9
Observation: For most corporate entities, the new rates are a significant reduction from the pre-act 35% top rate. While the Act itself does not address fiscal year taxpayers, in general, pre-act law would prorate on a daily basis the new rate (for that part of the fiscal year after December 31, 2017). Pass-Through Rates and Limitations on Business Losses See discussion under Fund Level Considerations, describing the deduction of 20% of business income. Observation: While there has been public commentary as to whether some entities might convert to C corporation status, that would not appear to be beneficial in general. Limitation on the Deductibility of Net Interest Expense The Act contains a limitation on net interest expense deductions of corporations and partnerships that more closely follows the Senate version of the limitation, but ultimately it included certain key points from the House version of the bill as well. The Act contains only one revamped limitation on the deduction for business interest expense (see the Observation below). Both the House and Senate bills included an additional limitation for international financial reporting groups, but this provision was dropped in the final bill. In addition, the net investment interest expense limitation under IRC Sec. 163(d) has not been altered. 10
The new rules apply to all business interest. The rules apply to related and non-related party interest; they apply to both partnership and corporations, and they apply regardless of the debt-to-equity ratio of the entity. This a rather significant change from the previous IRC Sec. 163(j). The new limitation does not apply to any business with average annual gross receipts for the threetaxable-year period ending with the prior taxable year that do not exceed $25 million (aggregation rules apply as they do in IRC Sec. 448(c)). Business interest is defined as any interest paid or accrued on indebtedness properly allocable to a trade or business and does not include investment interest as defined in IRC Sec. 163(d). Limitation. In general, the amount allowed as a deduction will not exceed the sum of: (1) The business interest income of such taxpayer for such taxable year; (2) 30% of the adjusted taxable income ( ATI ) of such taxpayer for such taxable year; PLUS (3) The floor plan financing interest of such taxpayer. Generally, in the financial services area, it is points (1) and (2) that will have the greatest impact unless the underlying portfolio company is an auto dealership. What is still unclear is whether payment of interest on shareholder loans to a blocker corporation the proceeds of which are used to invest in an underlying operating partnership is really considered business interest expense. Business interest income is defined as the amount of interest includible in the gross income of the taxpayers 11
for the taxable year, which is properly allocable to a trade or business. Such term does not include investment income (investment income is defined by reference to subsection (d) of IRC Sec. 163, which would include interest income from a trader fund although perhaps not the GP portion of such interest income). There are specific carve-outs from the definition of trade or business for certain real estate and energy related businesses. ATI is defined as the taxable income of the taxpayer computed without regard to: (i) any item of income, gain, deduction or loss which is not properly allocated to a trade or business; (ii) any business interest or business interest income; (iii) the amount of any net operating loss deduction; (iv) the amount of any deduction allowed under IRC Sec. 199A (which is the new 20% deduction for pass-through entities discussed above); and (v) in the case of taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion. The allowance of the addback of deprecation in the Act represents a nod to the House version of the bill. The original Senate version of the bill did not allow for a deprecation addback when determining ATI. For asset classes with large amounts of depreciation, this addback could be extremely beneficial. The Act also allows for any disallowed business interest expense to be carried forward indefinitely. Finally, the application to partnerships is new. The same limitation applies to partnerships. The business interest deduction is taken into account in determining the nonseparately stated taxable income or loss of the partnership. The Act puts into place rules to assure that a 12
partner in a partnership does not include the flowthrough income of the partnership to be able to take additional interest expense at the partner level using the same income initially utilized at the partnership level. Without this provision, the partnership would deduct interest and the partner would be able to deduct even more interest expense if the partner had the ability to increase his ATI with the items from the flow-through partnership. The Act does allow for a partner to increase his ATI from the underlying partnership by including the partnership s excess taxable income. This provision allows a partner to take advantage of any sort of excess limitation that the partnership was not able to utilize because of the lack of additional interest expense. For example, if a partnership has $200 of ATI, this would allow the partnership a $60 deduction for interest expense. If the partnership has only $40 of interest expense to deduct, the extra $20 (assuming the partner has partner level interest expense) will be allowed at the partner level by taking into account the partner s share of partnership excess taxable income in computing ATI. Observation:To provide a bit more context, the new rules are meant to replace IRC Sec. 163(j) which applied only to corporations and which placed certain limitations on related-party interest. Under pre-act law, only relatedparty interest was limited and the limitation only applied if the debt-to-equity ratio of the corporation was greater than 1.5:1. In that situation, interest was limited to 50% of ATI. This rule could significantly increase the after-tax cost of LBO financing and may make preferred equity financing or 13
other interest equivalents more attractive than debt financing. While this new limitation will affect the portfolio companies of PE funds, it will also have an effect on certain fund level structures, such as the use of levered blockers (i.e., corporations used to block trade or business income earned from a portfolio company set up as a flowthrough). While not clear yet, the application of these rules to blockers may be limited, and, at the same time, some of the pre-act limitations have been repealed. Expensing of Assets Bonus depreciation is extended through 2026 the current 50% bonus depreciation allowance is increased to 100% for property acquired and placed in service after September 27, 2017 and before January 1, 2023. In addition, the property does not have to be first use property in order for the bonus depreciation to be allowed. After 2022, there is a phase down of the bonus depreciation through 2027. There is a transition rule in place that allows a taxpayer for its first taxable year ending after September 27, 2017 to elect to apply the 50% allowance as opposed to the 100% allowance. Net Operating Loss ( NOL ) The Act limits NOL carryforwards to 80% of taxable income and does not allow most carrybacks. The Act applies to losses arising in taxable years beginning after December 31, 2017. Observation: NOLs incurred prior to January 1, 2018 will not be subject to the 80% limitation, nor will the AMT be 14
applicable. Therefore, in the case of a calendar year taxpayer, if a taxpayer s pre-2018 NOLs exceed the taxpayer s income in a year after 2017, no tax will be due. However, where the taxpayer is utilizing losses incurred after December 31, 2017, even where the NOLs exceed the taxable income for the current year, the minimum tax payable would be 4.2%. Meals and Entertainment Effective January 1, 2018, the Act eliminates the current deduction for entertainment associated with the active conduct of a trade or business. Businesses are still allowed to deduct 50% of meals related to a trade or business, but the Act now requires the same 50% disallowance for expenses for food and beverages (and facilities used in connection therewith) furnished on the business premises of the taxpayer primarily for his employees (employee cafeterias). The Act also disallows deductions for any employer expenses for providing the qualified transportation fringe (IRC Sec. 132(f)). However, most employees are still eligible for the exclusion from income for qualified transportation expenses. Effective January 1, 2026, the Act disallows expenses for meals provided for the employer s convenience. Contributions to Capital Pre-Act law allowed certain payments by nonshareholders, such as governmental units, to be excluded from income. The Act repeals that exclusion, effective for contributions after December 22, 2017 (the date of enactment), but a transition rule allows the exclusion for 15
contributions made after that date pursuant to a master development plan that was approved prior to that date by a governmental entity. Observation: Many state and local governments have provided grants which have not been considered taxable income in the past; this will need to be revisited. Other Accounting Methods Taxpayers will be required to use their financial statements in applying the all-events test. The objective rules, including economic performance, remain in effect, but in addition, taxpayers will not be able to deduct amounts until they are expensed for financial statement purposes. As a practical matter, generally, amounts are expensed for book purposes before tax. Other Provisions The Act includes numerous other provisions, many of which have threshold levels that have been increased (e.g., Unicap, accounting for inventories, accounting for long-term contracts, cash method of accounting). III. Management Company/General Partner Considerations Carried Interest (Incentive Allocation) For taxable years beginning after December 31, 2017 and subject to certain qualifications and exceptions, a taxable carried interest earned by the GP (an applicable 16
partnership interest, defined below) is subject to a threeyear holding period to qualify for long-term capital gain rates. That is, if the holding period of the underlying realized fund assets is less than three years, the gain will be recharacterized as short-term capital gain to the GP. There are some exceptions to this rule. To the extent provided by regulations, this provision does not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors. Second, it does not apply to any interest in a partnership held directly or indirectly by a corporation. Finally, it does not apply to any capital interest in a partnership giving the taxpayer a right to share in partnership capital commensurate with the amount of capital contributed (as of the time the partnership interest is received), or commensurate with the value of the partnership interest that is taxed under IRC Sec. 83 on receipt or vesting of the partnership interest. An applicable partnership interest is an interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer or any other related person in any applicable trade or business. An applicable trade or business is any activity conducted on a regular, continuous and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists in whole or part of raising or returning capital and either (1) investing in (or disposing of) specified assets or (2) developing specified assets. 17
Transfer of applicable partnership interest to a related person. If a taxpayer transfers any applicable partnership interest, directly or indirectly, to a person related to the taxpayer, then the taxpayer includes in gross income as short-term capital gain so much of the taxpayer s net long-term capital gain attributable to the sale or exchange of an asset held for not more than three years as is allocable to the interest. The amount included as short-term capital gain on the transfer is reduced by the amount treated as short-term capital gain on the transfer for the taxable year under the general rule of the provision (that is, amounts are not double counted). A related person for this purpose is a family member (within the meaning of the attribution rules) or colleague who performed a service within the current calendar year or the preceding three calendar years in any applicable trade or business in which or for which the taxpayer performed a service. Observations: The carried interest provision may apply to management fee waiver interests. Due to the more-than-three year holding period for GPs to achieve long-term treatment, consider incentive fees vs. incentive allocations. Allocations may now be less advantageous to the GP. Please note that fee income does not give the benefit of the deferral of unrealized gains and is subject to state sourcing and New York City UBT if applicable. 18
The provision does not appear to affect the 20% preferential rate for qualified dividends allocated to the GP as part of an incentive allocation. The law is unclear as to how these rules apply in tiered partnership structures (such as funds of funds) ( FOFs )). If a new fund of hedge funds GP is entitled to an incentive allocation in the first year of the FOF and some of the underlying hedge funds allocate three year long-term property to the FOF, does that character remain for the GP s incentive allocation which is allocated at the FOF level? The effect of the new law on the admission of new partners to the GP that fail the more-than-three year holding period requirement is unclear at this time. If the net long-term gain from capital assets held more than three years is greater than the long-term gain, all the gain is treated as long-term. If the net long-term gain from capital assets held more than three years is less than the total long-term gain, then the difference is short-term. Pass-Through Implications for Management Company Please see the discussion above under Fund Level Considerations. 19
Observations: GPs that will be allocated short-term gains should consider paying out bonuses to employees as an incentive allocation through a special limited partnership interest. Management companies should monitor their P&L throughout the year to consider any potential excess non-deductible losses. Expensing of Assets Please see discussion above. Meals and Entertainment Please see discussion above. Choice of Entity With the federal corporate income tax rate lowered to 21% beginning in 2018, many wonder if changing the structure of their management company might make sense. However, there are considerations beyond just a federal rate cut that need to be carefully examined. The effective federal/state/local tax rates for C corporations vs. pass-through entities should be considered as well the implications of paying out reasonable compensation from a C corporation. In addition, the tax effect of dividend 20
payments, the accumulated earnings tax and the personal holding company tax must also be considered. In the original House bill, there was a provision that would have eliminated the limited partnership exception from the self-employment tax (IRC Sec. 1402(a)(13)). This provision was not included in the Act. Consideration should be given to structuring management companies as limited partnerships. Contributors Michael Laveman Simcha David Murray Alter Jeff Chazen David Helprin Richard Shapiro Mark Stahl Karen Kelly Katie Brandtjen About EisnerAmper LLP EisnerAmper LLP is one of the premier full-service accounting and advisory firms in the United States and serves clients worldwide. We provide audit, accounting, and tax services as well as corporate finance, internal audit and risk management, litigation consulting, and other services to clients across a broad range of industries. EisnerAmper works with middle-market and Fortune 1000 companies, as well as high net worth individuals, family offices, closely held businesses, not-for-profits, and early stage companies. Our range of expertise and standing in the profession allows us to leverage our insight and relationships on behalf of our clients. Copyright 2018 by EisnerAmper LLP. All rights reserved. This book, or portions thereof, may not be reproduced in any form without permission of EisnerAmper LLP. This publication is intended to provide general information to our clients and friends and is based on authorities that are subject to change. It does not constitute accounting, tax or legal advice; nor is it intended to convey a thorough treatment of the subject matter. Before engaging in any specific course of action, you should consult your tax advisor. 21