fbpx

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


 

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 a 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

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

CONSIDER

  1. Differences in value in 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

TO BE CONSIDERED:

  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 a LLC to maintain control over the assets
  2. Distribute cash during the post-termination transition period. By creating a 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 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

Download Now

 

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

SPECIAL CONSIDERATIONS FOR QUALIFIED SUBCHAPTER S SUBSIDIARIES (QSUBs)

  1. 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
  1. Attributes don’t carryover in Section 351 transactions so consider the need for new elections:
    • LIPO inventory
    • Recurring item exception
  2. Will termination of QSub elections result in deemed formation of partnerships?
  • Consider converting QSubs to LLCs prior to termination of S

Tax Planning For U.S. Hedge and Private Equity Funds

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

CONSIDERATIONS

  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
  • Subchapter K
    • Disguised sale, mixing bowl rules, hot asset shifting
  1. International
  2. Interests-over partnership incorporation
  3. 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

Funding for Real Estate Projects

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

Summary

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

Contact us for more info about tax strategies for Hedge Funds and Private Equity. 

Request a Confidential Consultation

FAS CPA & Consultants

9000 SW 137 AV Suite 224 Miami, FL 33186 T: 786-462-7899 E: support@fascpaconsultants.com

Fulton Abraham Sanchez, CPA

Fulton Abraham Sánchez, CPA is a Certified Public Accountant, specialized In Tax Planning, International Business, Wealth Management and Offshore Banking. You can email him to fa@fascpaconsultants.com or follow us on Facebook : FAS CPA & Consultants.

You may also like...

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.

error: Content is protected !!