Unless you have been visiting an exotic island without any access to the news coming out of Washington, you’re well aware by now that a new tax act has been passed and signed. With any substantive change comes innumerable questions about what it means to each taxpayer and what strategies are available to minimize any tax exposure.
We have been reviewing the provisions that will directly affect alternative investment strategies and have some early thoughts to share on how we see this unfolding. Below are some of the key provisions that will affect strategies in the alternative investment space.
After extensive gnashing of teeth and politicians lining up to decry the “abuse” of the carry, the teeth were removed and the provisions related to the carry were substantially toned down.
The GP typically receives a reallocation of the earnings of the LP’s in the same nature and form. The perceived abuse was the allocation of long-term gains taxed at preferential rates.
A greater than three year holding period has been imposed associated with the reallocation of capital gains. Gains derived from holdings of less than three years but greater than 1 year will be recharacterized as short term. In addition, this provision applies regardless of existing 83(b) elections that may be in place.
The change will require the Fund to essentially cull out in a separate holding period, those realized gains in excess of three years. Private Equity and Venture Capital should see little impact as the holding period is typically longer than three years. That said, timing of transactions close to the three-year threshold will require scrutiny.
Taxpayers (LPs) could deduct investment expenses passed through to them from an investment partnership. The deduction is limited to a 2% of adjusted gross income floor, and is an addback for the Alternative Minimum Tax computations.
The deduction for investment expenses has been eliminated through 2025.
The deduction always had limited utility due to the nature of the phase-out and AMT implications. Nonetheless, this will have an impact on LPs. A review of the costs that might be reallocated to the management company should be undertaken where the costs would be deductible. Trading specific costs should be looked at for inclusion in basis of the underlying security. Management fees which are typically the biggest component may result in a reexamination of the economic deal shifting some of the cost to the Carry.
A provision that will have an effect on portfolio companies is the limitation of the deduction for net interest expense.
A deduction was permitted against income for interest paid or accrued.
Net interest expense will now be limited for any operating business. Note: This does not apply to investment interest expense. The limitation will impose a maximum deduction of 30% of adjusted taxable income. Adjusted taxable income is taxable income before interest, taxes, depreciation and amortization through 2021 and earnings before interest and taxes after that.
The limitation does not apply to real estate trades or businesses if so elected, nor businesses with gross receipts under $25 million.
As it relates to partnerships and S corporations the limitation is determined at the entity level.
Unused interest deductions are carried forward indefinitely for corporate entities. Partnerships will pass through the excess interest as a separately stated item for potential use by the partner in future years.
Some much for simplification. Fortunately, this will only affect the larger entities. That said, Private Equity and Venture Capital may need to look at deal structures to manage the interest expense borne by the portfolio company.
We will also be on the lookout for the regulations as it relates to funds that have elected to be treated as Traders. Traders typically view their interest as from a trade or business. The law as written would appear to exclude these funds from the limitations, as the nature of the interest remains investment interest expense. We do believe it bears monitoring regardless.
Business losses incurred could be carried back two years and forward 20 years.
For losses incurred post-December 31, 2017, the carryback opportunity is gone and such losses can only be carried forward indefinitely. In addition, such losses can only offset 80% of taxable income. NOLs incurred before January 1, 2018, are not subject to the 80% limitation and can continue to be carried back two years and forward 20 years.
Again, primarily an issue for portfolio companies. It will take some additional modeling to understand how to maximize the use of loss carryforwards. Further, the 80% limitation may result in unexpected surprises, by way of taxable income.
Outside of the State and Local Tax deduction no provision of the new law received more attention that the treatment of pass-through income.
General rule: Non-Corporate owners of an interest in Pass-through trades and businesses will receive a 20% deduction from taxable income.
This was such a simple idea; leave it to the politicians to turn it into a Rubik’s cube.
First, the “deduction” only applies to Trades and Business. It does not apply to most service businesses. Which means specifically excluded are entities associated with 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 1 or more of its employees. In other words, as it relates to alternatives, the deduction is generally not available to its owners.
There is a carve-out for certain taxpayers who have taxable income below $415,000 on a married joint-filing basis. In this case, the deduction will phase out beginning at $315,000 of taxable income and be completely phased out at $415,000. Single taxpayers are subject to half of those amounts.
Interestingly enough this should provide a bit of a windfall to certain of the States since the deduction is from taxable income.
One of Withum’s tax partners, Tony Nitti, recently wrote an article extensively examining the provisions related to the 20% pass-through deduction. If you’re interested in understanding this in detail I recommend that you read his post.
A partnership who has had an ownership change by more than 50% in a 12 month period was required to “terminate” and file a final return, then spring back to life and file a second “initial” return once the ownership interests were reconstituted.
Old law is repealed. Partnerships with years beginning after December 31, 2017, will no longer need to be concerned with this issue.
This is a welcome change. Mark this one as a win!
Disposition of partnership interests associated with a US trade or business were typically treated as effectively connected income, at least that’s what the IRS wanted to happen.
For sales and exchanges on or after November 27, 2017, by a nonresident alien individual or foreign corporation, any gain or loss from the sale or exchange is treated as effectively connected income to the extent the gain or loss does not exceed certain limitations.
In addition, the transferee of a partnership interest must withhold 10% of the gross amount realized on the sale or exchange of a partnership interest.
This is designed to specifically address a situation where the IRS lost in tax court regarding its position that the gain constituted ECI.
Basis of partnership property was not adjusted as a result of a transfer of an interest unless the partnership made a section 754 election. Only in instances where the loss recognized by the transferor exceeded $250,000 was the partnership required to make such an election.
The election of section 754 basis adjustment remains optional. However, the definition of a substantial built-in loss is modified affecting transfers of partnership interests. In addition to the present-law definition, a substantial built-in loss also exists if the transferee would be allocated a net loss in excess of $250,000 upon a hypothetical disposition by the partnership of all partnership’s assets immediately after the transfer of the partnership interest.
This will have limited application, however, requires monitoring as most alternatives did not utilize the 754 provisions. Now, if the portfolio has substantial unrealized losses a transfer could force an election.
Should I convert to a corporate entity?
Possibly the most asked question since enactment, ok should I prepay my 2018 taxes is the most often asked, but I digress.
The 21% tax rate is appealing, but don’t be drawn in by the allure of a 21% tax rate. While it will make sense in some situations, it is not a panacea. You need to consider that the income will be taxed in the corporate shell (at 21%), it still needs to find its way to its principles and investors. In this instance, the rules of double taxation have not disappeared. A dividend, likely a qualified dividend will be taxed to the individual at a 20% rate. Wages paid to principles will be taxed at a maximum 37% rate. All this before you factor in State and local taxes. We will be happy to assist with the analysis.
I heard that the law was going to require securities to be accounted for on a FIFO basis?
You heard correctly, fortunately, the provision was stripped out in the conference.
What about self-employment taxes, the original provisions were going to draw in virtually all pass-through entities.
That is true, fortunately, that provision never made it to the final bill.
I have seen a suggestion to have my employees form LLCs or corporations and pay them as contractors so they can get the 20% deduction.
Several things here, first, the IRS is already on the employee versus contractor issue and have been for some time. Second, the provision specifically excludes the business of being an employee. Third, they are still in one of the excluded businesses regardless of the window dressing. Fourth, you put your firm at risk as the IRS will assess the employment tax deficiency against the firm, not the employee/contractor. Fifth the “employee” would lose access to the existing benefit plans, which may also pose complications for existing plans. Sixth the “employee” now needs to cover the employee as well as the employer share of the payroll tax liabilities. In other words, not a great idea.
Short answer is do nothing, let’s see how this all unfolds in the coming months. There will be time to take appropriate action. Contact your Withum Tax Advisor or fill out the form below, and we’ll be happy to evaluate your unique situation relating to alternative investment strategies.
The thing you do need to do now has nothing to do with the tax law change, but rather the IRS partnership audit rules which are effective January 1, 2018. These rule changes will require you to update your partnership documents, and name a partnership representative amongst other things. For more details, watch Withum’s recent webinar, How to Prepare for the New Partnership Audit Rules.
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.