Tax Reform and Financial Services Entities
By Gregory Kastner
Provisions in the new tax reform bill signed into law on Dec. 22, 2017 have affected a number of areas that impact financial services entities.
These include limitations on the deductibility of interest expense, the carried interest, and the new Internal Revenue Code (IRC) §199A 20% deduction. While there are still some ambiguities in the law to be worked out as the IRS releases more guidance (which they are slated to do over the next few years), many answers have been provided in recent months.
The new business interest expense limitation
For tax years beginning after 2017, under the new IRC section 163(j), the business interest deduction for the taxable year may not exceed the sum of:
(a) Business interest income
(b) 30% of the adjusted taxable income
(c) Floor plan financing interest
This expense must be incurred on indebtedness related to the taxpayer’s trade or business, as opposed to that related to investment activities. Any disallowed amount can be carried forward without limitation.
If the disallowed interest is incurred by a partnership, the amount will result in a basis adjustment to the partner’s partnership interest and the partner will get the deduction upon exiting the partnership
Small businesses with less than $25 million of gross receipts are excepted from the new rules. Also, certain electing real property businesses can be exempt as well if they opt into using the longer Alternative Depreciation System for their fixed assets.
If the entity falls under the definition of a syndicate under IRC §1256(e)(3)(B), then it will be considered a tax shelter for purposes of IRC §163(j) and will not be eligible for the small business exception.
If more than 35% of the entity’s losses are allocable to limited partners, it is considered a syndicate. Limited partners are those not involved in managing the portfolio or doing any other business of the partnership.
Most investors in alternative investment funds are likely to fall under this definition and make the fund a syndicate. In an income year, the syndicate rule may not apply, since there is no loss allocable to limited partners.
Common ownership across entities also applies for purposes of the small business $25 million exception – as such, if in the aggregate, the gross receipts are greater than the threshold, the 30% limitation may still apply.
Allocation of interest expense across excepted businesses (like electing real property businesses) and non-excepted businesses is generally done based on a proportionate adjusted basis.
The new proposed Treasury regulations indicate that this new limitation will affect trader partnerships. Trader partnerships generally turn their portfolio over on a regular and continuous basis. The partners themselves deduct their share of the expenses “above the line” if they are individuals, meaning those expenses directly reduce an individual’s Adjusted Gross Income.
Before the change in the law, the general partner of a trader partnership was able to deduct its full share of any interest expense as an ordinary deduction, and the limited partners were able to deduct any interest expense if they had sufficient investment income.
Now the partnership must test if the IRC §163(j) 30% limitation applies (for both general partners and limited partners) and the limited partners must still apply the IRC §163(d) limitation as well, to see if they have sufficient investment income to take the deduction. How the calculation of gross receipts is to be made for a trader fund for it to fall under the small business exception has not yet been clarified; i.e., whether gross proceeds from all security sales or only sales are included.
The carried interest under new IRC §1061
Entities or individuals receiving capital gain after Dec. 31, 2017 in connection with the performance of substantial services 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, and cash, options or derivative contracts must have a holding period in excess of three years for those taxpayers to receive the beneficial lower tax rate afforded to long term holdings.
This rule does not apply to C corporations, but it does to S corporations. Because the distinction for S corporations was not part of the original law, but in Tax Notice 2018-18, some taxpayers have been arguing that is only one interpretation and does not necessarily need to be followed. This approach seems fraught with risk and should be considered carefully before being applied.
Structuring the carry vehicle as a Passive Foreign Investment Company (PFIC) is also being considered by funds as a way to take advantage of getting pass-through long-term capital gains with a more than one year holding period if the corporation makes a Qualifying Electing Fund (QEF) election (as opposed to the more than three year holding period standard if the entity was structured as a partnership, S corporation or sole proprietorship). In such a case, income is limited in any year to earnings and profits, meaning losses are not allowed.
The beneficial individual income tax rates afforded by IRC §1256 for qualifying dividends and for IRC §1231 gain do not appear to have been removed by this rule, nor has the required holding period for their beneficial tax rate been extended to over three years. They appear to be taxed the same way in either case.
Unrealized gains built up as of December 31, 2017 do not appear to be grandfathered in under the rule, so that a holding period in excess of three years will apply to all gains going forward. However, if the gains were earned on actual cash invested in the fund, satisfaction of the 3-year holding period for long term capital gain treatment would not be required.
Most practitioners are recommending bifurcating limited partner or general partner interests into those held on invested capital and those receiving the carried interest
One ambiguity still not addressed by the IRS is whether a new partner receiving a carried interest can get long term capital gain treatment when the new partner has not been in the partnership for longer than three years.
Many practitioners are taking the position that if the entity receiving the carry interest itself met the holding period requirement, the partner in that entity would not necessarily have to as well to receive long term capital gain treatment.
This is similar to the way that fund of funds are treated in that the character of income is not changed at the lower tier partnership level. Sale of an interest in the carry vehicle would, however, have to meet the three-year holding period in order to receive the beneficial rate.
Excess Business Loss Under IRC §461(l) Affects Investor Partnerships
Investor funds do not turn their portfolios over regularly, instead looking to make most of their profit through long term appreciation, dividends and/or interest. If structured as partnerships, the recent elimination of the itemized deduction for miscellaneous expenses have effectively eliminated the deduction for management fees and other professional fees on the tax returns of any individual investors.
For those investor funds that run their management company at a loss to pay for bonuses and the like, while the carry vehicle makes income, the new IRC §461(l) excess business loss rules might be problematic.
Calculated at the partner level, if the net loss from all trades or businesses exceeds $250,000 ($500,000 for a married couple filing joint – this amount is indexed to inflation each year and only applies from 2018 to 2025), the excess is currently disallowed and will be rolled forward as a net operating loss carryforward. The crux of the problem is that the management fee loss would probably be treated as trade or business income/(loss), while the carried interest income would not.
Qualified Business Income of Pass-Through Entities – IRC §199A and the 20% Deduction
The new tax bill generally provides a taxpayer (other than a corporation) with a deduction for the tax year beginning after December 31, 2017 equal to the lesser of:
- the combined qualified business income (QBI) of the taxpayer from a partnership, S corporation or sole proprietorship; or
- 20% of the excess of
- The taxpayer’s taxable income, over
- The sum of any net capital gains
Whether or not an individual itemizes deductions on their Schedule A is irrelevant to being able to take the deduction.
QBI doesn’t include nonbusiness interest, dividends, capital gains or losses, or IRC §1231 gains. IRC §1231 losses appear to reduce QBI. QBI does not include reasonable compensation paid to the taxpayer from a qualified business, guaranteed payments under IRC §707(c), or any payment under IRC §707(a) to a partner for services rendered to the partnership. QBI must also be US sourced as defined by IRC §864(c)), so foreign-source income generally won’t qualify for the deduction.
The amount deductible for each qualified trade or business is then limited to the lesser of:
- 20% of such QBI, or
- The greater of:
- 50% of the W-2 wages with respect to the qualified business, or
- 25% of the W-2 wages with respect to the qualified business, plus 2.5% of the unadjusted basis immediately after the acquisition of qualified property.
Specified trades or businesses are ineligible for the deduction: these entail the performance of:
(i) certain professional services,
(ii) investing and investment management, or
(iii) trading or dealing in securities, partnership interests or commodities.
Consequently, most alternative investment firms will not be qualifying businesses. However, 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 this exclusion will not apply.
Affiliated groups are treated as one entity for the purpose of this deduction calculation. A group is affiliated if entities share more than 50% ownership. When first announced, some alternative investment firms had considered spinning off intellectual property into its own entity to qualify for the deduction – however, both the affiliation rule and the requirement that the entity be actually conducting a trade or business may be problematic to such a practice.