As a business owner or managing member, navigating the complexities of tax obligations is inevitable. Questions such as “How much tax do I have to pay?” and “Are there ways to reduce tax liability?” are common. Here, we explore some effective strategies to reduce taxable income.
Management Fee Waivers
Management companies typically earn a percentage (e.g., 2%) of capital commitments from the funds they service. These management fees are usually treated as ordinary income for fund managers but are not deductible for fund investors following the Tax Cuts and Jobs Act (TCJA). A “management fee waiver” strategy can mitigate this issue. Instead of receiving management fees in cash, the management company can enter into a waiver agreement to contribute cash as GP commit into the partnership to receive a profit interest or carried interest. This approach may help defer income and benefit from a preferential tax rate by converting ordinary income into long-term capital gain.
In recent years, the IRS has proposed regulations that treat certain arrangements, especially those lacking “significant entrepreneurial risk,” as disguised payments for services. Therefore, it is advisable for fund managers to consult their tax advisors before implementing a management fee waiver agreement.
State Passthrough-Tax Entity Taxes
An increasing number of states now allow passthrough entities to elect to be taxed at the entity level. This election helps partners, members, or shareholders deduct more state taxes beyond the $10,000 limitation on their federal returns. States offering this option include California, Connecticut, Illinois, New Jersey, and New York. Taxes paid at the entity level are treated as a business deduction on the entity’s tax returns and as a credit on the personal state tax returns of partners, members, or shareholders.
New York State permits eligible passthrough entities to make an irrevocable election annually. For PTET taxable years 2022 and later, the eligible entity may opt in between January 1 and March 15, and must pay quarterly estimated taxes during the year. NYS PTE taxable income is defined as:
- For partnerships, all income from New York sources included in the taxable income of a non-resident partner and all income included in the taxable income of a resident partner.
- For S corporations, all income derived from New York sources for both resident and non-resident shareholders.
Retirement Plans
Establishing a retirement plan is another effective way to reduce taxes. Business owners can choose from various retirement plans, such as IRA plans, 401(k) plans, defined contribution plans, and defined pension plans. Each plan has its pros and cons, so it is essential to select the one that best fits your situation. Our next Venture to Know article will delve into the details of different retirement plans.
We highly recommend that fund managers engage in year-end planning to minimize unnecessary tax burdens and identify potential tax savings.
Authors: Sally Sun, CPA | [email protected] and Amanda McKenna, CPA, Partner and Team Leader, Financial Services Tax | [email protected]
Contact Us
For more information on this topic, please contact a member of Withum’s Financial Services Team.
