How Hedge Funds Choice of Entity Remains After Trump’s Tax Reform

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A Pass-Through Entity: To be or Not To Be?

The tax rate changes implemented as a part of the TCJA generally result in an increase in the rate differential on undistributed entity earnings to 8.6% from approximately 5.78%. As a result, pass-through entities should consider whether to convert to C corporation status:

  • If it is anticipated that no earnings will be distributed and there will be no sale for the indefinite future C status
  • If significant earnings are distributed and/or sale is anticipated pass-through entity status may be preferred
  • Many taxpayers will fall somewhere in between distributing no earnings and distributing all earnings
    1. The net investment income tax, self-employment tax, and state and local taxes may increase the rate differential on undistributed entity earnings. QBI deductions are only allowed for income tax purposes
    2. Pass-through entities that have earnings that are not QBI will find that the rate differential will find that the rate differential will also increase
    3. Many pass-through entities make distributions to cover owner tax liabilities on pass-through income based on the owner with the highest tax rate. This might exacerbate the effect of the rate differential from an entity perspective
  • The unfavorable aspects of certain of the international tax changes may favor conversion to C or the use of a C corporation as a blocker).

Modeling to Assess Pass-Through Versus C Corporation Form

  1. Modeling should be performed to understand the effect of the higher rate of tax on undistributed entity earnings and the double taxation of distributed earnings of a C corporation
  2. The modeling should consider the effect of a sale transaction on a choice of tax classification
    • When evaluating a sale transaction the value of a basis step-up that can generally be provided tax-efficiently by a pass-through entity but not by a C corporation should be considered.
  • Careful consideration of local and tax implications should also be carefully considered

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Partnership Vs C Modeling          

  1. Concepts are similar to S versus C comparison
    • Effective tax rate based on after-tax cash from earnings
    • Five to ten-year after-tax cash projections with application of NPV concepts
    • Consider exit in a future year


  1. Differences in value in the year of exit depending on form chosen
  2. Earnings taxed at preferential vs. ordinary rates
  • Section 199A deductions:
    • Aggregation of activities
    • Share of wage expense/basis

Terminating S Corporation Status


  1. How can an S election be terminated?
    • Revocation
    • Intentional violation of an S corporation eligibility requirement
  2. Effect
    • General tax-free with no deemed change in taxpayer
    • Special S corporation distribution rules will generally stop applying. Some special rules, however, will apply during the post-termination transaction period and more special rules that apply during the expanded post-termination transition period

Planning For The Termination

Accumulated adjustment account (AAA) must be preserved of accumulated:

  1. Distribute the AAA in cash, property or notes prior to the termination of S status. It might be advisable to use an LLC to maintain control over the assets
  2. Distribute cash during the post-termination transition period. By creating an S termination year to lengthen the post-termination transition period
  • Distribute the cash during the expanded post-termination transition period. The accumulated earnings and profits must be known to properly apply this rule. This creates a service opportunity.
  1. Consideration in terminating an S corporation status, it is advisable to use the hybrid structure (parent S corporation with C corporation subsidiaries)
  2. Benefits of a hybrid structure:
    • Preserves the AAA
      • It should be considered to retain the assets at the S-corporation level with a tax basis equal to AAA to fund future distributions
    • Provides a mechanism to fund future shareholder distributions without incurring a second layer of tax
    • Provides ability to readily convert back to pass-through entity taxation

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More Conversion Considerations

  1. Return filing requirements
    • Does an S termination year result?
    • Short S and short C year returns
    • Allocation of items between years
  2. Estimated tax payment requirements
  • Ability to file consolidated returns
  1. Waiting period on re-electing S status
  2. Accumulated earnings tax and personal holding company tax
  3. Structuring of international operations


  • Termination of S election will terminate QSub election
    • Results in deemed formation of a new corporation
      • Generally governed by section 351 which is generally tax-free, but consider:
        • Springing liabilities
        • Section 357 (c)
        • Section 304
  • Attributes don’t carry over in Section 351 transactions so consider the need for new elections:
    • LIPO inventory
    • Recurring item exception
  • Will termination of QSub elections result in the deemed formation of partnerships?
  • Consider converting QSubs to LLCs prior to termination of S

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Incorporating a Partnership

  1. Revenue ruling 84-111
    • There are three forms of incorporating a partnership:
      1. Assets over
      2. Assets up
      3. Interest over
    • When a formless incorporation takes place it is considered as a assets-over incorporation
    • Form matters: can effect tax consequences, including basis and holding period
    • Government generally respects the taxpayer’s use of one of the three forms above
  2. Revenue Ruling 99-6
    • Conversion of a partnership into a disregarded entity


  1. Partnership terminates for the U.S. federal income tax purposes
    • Potential triggering of deferred income items
    • Termination of liabilities and contracts
    • New elections
  2. Subchapter C
    • Section 351, Section 357(c) and Section 304
    • Holding period in the stock
  3. Subchapter K
    • Disguised sale, mixing bowl rules, hot asset shifting
  4. International
  5. Interests-over partnership incorporation
  6. From interest-over transferee corporation’s view:
    • Single partner approach
      • Transferee corporation is treated as a single partner for a moment in time before liquidation of partnership
  1. Rul. 84-111 (Situation 3) appears to follow single-partner approach
  • Rul. 99-6 approach:
    • Partnership liquidates after which the partners transfer the assets and liabilities to the transferee corporation
  • In PLR 201505001 the IRS cited rev. Rul. 84-111 (Situation 3) as supporting the same treatment as Rev. Rul. 99-6
  • When a parent contributes $100 cash and the Sub contributed asset with AB=$0/FMV=$100, then the parent’s outside basis is $100 and Sub’s outside basis is $0
  • Under Single-Partner approach, Sub has a $100 basis in Partnership (PS). The PS is treated as having a single partner (Sub) for a moment in time and the PS is treated as liquidating into the sub
    • The Sub will not recognize gain under Section 731(a)(1)
  1. Under the 99-6 approach, PS is treated as distributing all of its assets to POarent and Sub in complete liquidation, following which Parent will contribute to Sub the assets deemed distributed to the Parent
    • Sub could recognize $50 gain under Section 731(a)(1)
    • When the movement is reversed and the Sub transfers its interest to Parent, $50 of free basis arises
  2. Interests over partnership incorporation
  3. Further considerations in addition to 731(a), from the view of the transferee:
    • Disguised sale (mixing bowl and hot asset rules)
    • Subchapter C and international tax considerations
  • Rev. Rul. 99-6 does not address proportion of assets and liabilities distributed
    •  Does the partnership allocation of debt under Section 752 govern how debt is distributed on partnership’s liquidation
      Partial Incorporation/Hybrid
  1. Retaining partnership provides flexibility on
    • Incorporation
    • Sharing of items
    • Current distributions
    • Monetization
    • Addressing possible future tax rate charges
  2. Also having a C corporation underneath the partnership


Now you are able to:

  • Recognize the impact that tax reform has on a taxpayer’s decision to operate as a pass-through entity vs. a C corporation
  • Compare the advantages and disadvantages of being taxed as a pass-through entity and as a C corporation
  • Determine key issues to address when converting a pass-through entity to a C corporation
  • Identify planning opportunities to consider when implanting a conversion from a pass-through entity to a C corporation. Click to mail us and create the best tax plan for you hedge and private equity funds


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Fulton Abraham Sanchez, CPA

Fulton Abraham Sánchez, CPA I am Certified Public Accountant, specialized in Tax Planning & Offshore Strategies for Real Estate, Hedge/Equity Funds, Fintech, Crypto, Expats, IRS Debt Resolution. You can email me fa@fascpaconsultants.com and follow us on Facebook : FAS CPA & Consultants.

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