On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (the Act) enacting the most comprehensive tax reform legislation since 1986. While the Act includes sweeping changes affecting all taxpayers, to follow is a brief summary of the more significant provisions impacting the investment management industry, including investment advisers, private funds, and investors in such funds.
Reduction in Tax Rates
The centerpiece of the Act is a reduction in tax rates for corporations, individuals, trusts, and estates. As enacted, the reduction in the corporate tax rate is permanent; however, the lower rates for individuals, trusts, and estates are temporary and set to expire at the end of 2025.
Effective for tax years beginning on or after January 1, 2018, the graduated corporate tax rates with a maximum rate of 35% are replaced by a flat rate of 21%.
The Act retained graduated tax rates for individuals, trusts, and estates (see these brackets). In addition to a broadening of the brackets, the top marginal rate is reduced from 39.6% to 37% effective January 1, 2018, through December 31, 2025. Preferential rates on net long-term capital gains and qualified dividend income remain unchanged with the maximum rate of 20%. Self-employment tax as well as the 3.8% Net Investment Income Tax also remain unchanged under the Act.
With the corporate tax rate less than the highest marginal rate for individuals, converting an existing pass-through entity, such as a partnership or S corporation, to a C corporation could potentially reduce income tax on business profits. However, the lower corporate tax rate is not the sole determinant factor in evaluating the benefits of this conversion. A proper assessment entails a review of the underlying economics and goals of the business as well as a thorough analysis of the impact of other provisions of the tax code on the distribution or accumulation of earnings.
Distributions of corporate earnings as well as proceeds from the sale of corporate assets or liquidation of a corporation continue to be taxed as dividends at the shareholder level, while distributions of earnings from pass-through entities remain tax-free in most circumstances. The continued divergence in treatment of distributions reduces the impact of the reduced corporate tax rate. For businesses that typically retain and reinvest profits, the potential tax benefits of the lower corporate rate could also be minimized by the accumulated earnings tax as well as the personal holding company tax, which restrict the ability to accumulate earnings within a C corporation to avoid tax at the shareholder level.
Qualified Business Income Deduction
In conjunction with the reduction of the corporate tax rate from 35% to 21%, the Act also provides an income tax deduction for individuals owning businesses organized as pass-through entities, such as S corporations, partnerships, and sole proprietorships. For tax years beginning after December 31, 2017, and before January 1, 2026, individuals as well as trusts and estates may be eligible to deduct up to 20% of “qualified business income” derived from an ownership interest in a pass-through entity. As a result of the deduction, the highest effective federal income tax rate for individuals, trusts, and estates earning qualified business income from a pass-through entity will be 29.6%.
Reasonable compensation received from a pass-through entity as wages or guaranteed payments is excluded from qualified business income as well as investment income including interest, dividends, and capital gains. Furthermore, all income derived from a trade or business involving the performance of services including investment management as well as trading or dealing in securities is also ineligible for the deduction unless the shareholder’s or partner’s taxable income is less than $157,500 for individuals and $315,000 for married couples filing jointly. For taxpayers with taxable income in excess of those amounts, the deduction will be phased out ratably until taxable income exceeds $207,500 for individuals and $415,000 for married couples filing jointly. For individuals with taxable income in excess of $207,500 and couples with taxable income in excess of $415,000, no deduction will be allowed for any amounts derived from a trade or business involving the performance of services.
For individuals with taxable income in excess of $157,500 and couples with taxable income in excess of $315,000, the deduction is also subject to a limitation based on the individual’s proportionate share of wages paid by the pass-through entity as well as the pass-through entity’s capital investment in fixed assets used in the trade or business.
Interest, dividends, capital gains, and other investment-type income attributable to a general partner or limited partner interest in a hedge fund or private equity fund will be ineligible for the deduction. Ordinary business income attributable to a portfolio investment in a lower-tier partnership would be eligible for the deduction provided the portfolio company is not engaged in the performance of non-qualifying services.
The benefits of the deduction for shareholders and partners of management companies are likely to be restricted due to the taxable income limitation imposed on amounts derived from the performance of investment services.
New Holding Period Requirement for Carried Interest
Despite discussions regarding elimination of the perceived tax loophole for carried interest, income attributable to a profits interest remains eligible for preferential long-term capital gain treatment. However, effective for tax years beginning after December 31, 2017, the Act imposes a three-year holding period requirement in order for capital gains derived from “applicable partnership interests” to be taxed at the preferential long-term capital gain rate (maximum rate = 20%). Gains failing to meet the new holding period test will be treated as short-term capital gains subject to federal income tax at ordinary income tax rates (maximum rate = 37%).
The new holding period requirement applies to a partner’s distributive share of long-term capital gains that are reported on Schedule K-1 and associated with an “applicable partnership interest”, gain realized on the sale or redemption of an “applicable partnership interest”, and the transfer of an “applicable partnership interest” to a partner’s spouse, child, grandchild, or parent. An “applicable partnership interest” is any interest entitling the recipient to future profits received in exchange for the performance of substantial services on behalf of a partnership engaged an “applicable trade or business.” An “applicable trade or business” is any activity involving raising or returning capital for the purposes of investing in “specified assets,” as well as enhancing or increasing the value, price or yield of a portfolio business. “Specified assets” consists of cash or cash equivalents, securities, commodities, real estate held for rental or investment, options, derivative contracts, and any partnership holding such assets.
The new three-year holding period requirement does not apply to partnership interests held by a corporation. It also does not apply to gains that are attributable to any partnership interest received in exchange for a capital contribution or a taxable capital interest received in exchange for services. Furthermore, gain attributable to any asset not held for portfolio investment on behalf of third party investors, such as gains realized on the disposition of fixed assets used by a management company, are not subject to the new holding period requirements.
The new holding period requirements will likely have little impact on managers of private equity funds that typically hold portfolio investments for more than three years. However, managers and general partners of hedge funds holding investments for shorter durations are likely to lose preferential long-term capital gain treatment on the distributive share of income attributable to their carried interest.
Under Massachusetts law, gross income is generally determined based on the Internal Revenue Code in effect on January 1, 2005. Accordingly, the new holding period requirements applicable to an investment manager’s carried interest in a hedge fund or private equity fund do not apply when determining Massachusetts personal income tax. Amounts characterized as short-term capital gains for federal purposes would continue to be treated as long-term capital gains for Massachusetts purposes (tax rate = 5.1%), rather than short-term capital gains (tax rate = 12%).
Deductibility of Management Fees & Portfolio Deductions
For 2018 through 2025, individuals, trusts, and estates will no longer be allowed to deduct miscellaneous itemized deductions that were formerly deductible to the extent they exceeded 2% of adjusted gross income (AGI). Miscellaneous itemized deductions include expenses incurred with the production or collection of income, and the management, conservation, or maintenance of property held for the production of income. Investment management fees as well as other expense incurred with the production of investment income (portfolio deductions) are considered miscellaneous itemized deductions.
Accordingly, individuals, trusts, and estates investing in a private equity fund or hedge fund classified as an “investor” will no longer be allowed to deduct their distributive shares of a fund’s management fees and administrative expenses such as brokerage fees, administration fees, legal fees, audit fees, and tax preparation fees. However, individuals, trusts, and estates investing in a hedge fund classified as a “trader” will still be allowed a deduction for their distributive shares of the fund’s management fees and administrative expenses. This is because the amounts are treated as business expenses rather than portfolio deductions.
Given the temporary suspension of portfolio deductions, the distinction between trader and investor status will take on increasing significance for non-corporate investors in hedge funds. Since the distinction is undefined within the Internal Revenue Code or regulations, the relevant factors cited in case law including investment objective, character of income, and frequency, extent, and regularity of transactions, should be reviewed to ensure the appropriate classification.
Business Interest Expense Limitation
Effective for tax years beginning after December 31, 2017, the Act limits the amount of deductible interest expense for businesses with average gross receipts in excess of $25,000,000. For businesses subject to the limitation, the deduction will be limited to 30% of “adjusted taxable income.” Amounts in excess of the limitation will be carried forward indefinitely to subsequent tax years.
For purposes of calculating the limitation for tax years beginning in 2018 through 2021, taxable income is adjusted to exclude investment income and deductions, qualified business income deduction, interest expense, depreciation, and amortization. For subsequent years, the limitation is more restrictive since taxable income is adjusted to exclude only investment income and deductions, qualified business income deduction, and interest expense.
Under existing law, interest paid or accrued on debt that is used to acquire property held for investment is not considered business interest expense. Accordingly, investment interest expense is not subject to the limitation.
Interest expense attributable to a general partner or limited partner interest in a private equity fund or hedge fund classified as an investor is considered investment interest expense and will not be subject to the new limitation. Interest expense attributable to a limited partner interest in a securities trading partnership is also treated as investment interest expense and is not subject to the limitation. However, interest expense attributable to a general partner interest in a securities trading partnership is subject to the limitation since it is treated as a business expense of the general partner under existing regulations and administrative guidance from the Internal Revenue Service.
For 2018 through 2025, the itemized deduction for state and local income and property taxes is limited to $10,000. Amounts subject to the limitation include state and local income taxes assessed on an individual’s distributive share of taxable income from a limited partner interest in a hedge fund or private equity fund. Income tax assessed on an individual’s distributive share of income from a management company or general partner entity organized as a pass-through entity is also subject to the limitation. State or local income tax imposed at the pass-through entity level as well as property taxes assessed on assets used in a pass-through entity’s business will continue to be fully deductible in determining a shareholder’s or partner’s distributive share of taxable income.
The Act permits full expensing of capital expenditures (bonus depreciation) by allowing a first-year deduction of 100% of the cost of qualifying new and used business property. This deduction is applicable for property placed in service between September 27, 2017, and December 31, 2022, with reduced write-offs for calendar years 2023 through 2026. In addition to the enhanced write-offs permitted under the bonus depreciation provisions, the Act also increased the annual limit on expensing under Section 179 to $1,000,000, subject to an increased phase-out threshold of $2,500,000.
For amounts incurred or paid after December 31, 2017, deductions for entertainment expenses, such as tickets to sporting or entertainment events, are disallowed in full even if the expenses are directly related to or associated with business activities. However, 50% of the cost of meals and beverages directly related to or associated with business activities will continue to be deductible assuming the requisite substantiation is maintained. In light of the changes, employee expense reimbursement and accounting procedures should be modified to properly account for deductible and nondeductible amounts.
The cost of meals provided to employees for the employer’s convenience on or near the employer’s business premises are no longer fully deductible. Effective January 1, 2018, such costs will be subject to the general 50% disallowance on the deductibility of business meals. For amounts incurred after December 31, 2025, no deduction will be allowed.
Effective January 1, 2018, employers will no longer be allowed to deduct the cost of qualified transportation fringe benefits (e.g., parking and transit passes) provided to employees. While the Act disallows a deduction for the cost of employer-sponsored transportation benefit programs, the value of the benefits continue to be excluded from an employee’s taxable wages.