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Summary Of Changes for Hedge Funds and Private Equity After Trump’s Tax Reform

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Self-employment Tax

  1. In terms of the Self-Employment Contributions Act (SECA) individuals are subject to self-employment tax on their net earnings from self-employment derived from conducting a trade or business directly or indirectly through a partnership.
  2. In terms of Section 1402 (a)(13) a limited partner’s distributive income share from a limited partnership (interest, dividends and capital gains) are not subject to self-employment tax.
  3. In order to minimize self-employment taxes asset management professionals utilize limited partnerships to serve as the investment manager and receive management fees.
  4. The asset management professionals hold direct limited partnership interests in the investment manager and will form an LLC to serve as the GP of this limited partnership.
  5. These individuals will also hold management interests in the LLC. The limited liability company (GP) will typically be entitled to 1% of the net income of the limited partnership. The limited partners in the investment manager are collectively entitled to the remaining 99% of the net income of the investment manager limited partnership.
  6. The individual’s position is that they are subject to self-employment tax on the fee income allocated to the GP (1%) but they are exempt from self-employment tax on the 99% under Section 1402(a) (13).

Renkemeyer Vs. Commissioner

  1. In this case (2011) the tax court held that individual law firm partners in a limited liability partnership did not qualify for the limited partner exclusion form self-employment tax
  2. The court concluded that none of the individual partners were limited partners in terms of Section 1402(a)(13) since they actively participated in the partnership’s business of providing legal services.
  3. Asset management professionals often distinguish their situation from the facts of the Renkemeyer case because they are 99% limited partners in a limited partnership that has a general partner and it would be the general partner that actively participates.

Sands Vs. Commissioner

  1. In this case (2015) relief was sought on self-employment taxes asserted by the IRS on income earned as a limited partner in a limited partnership due to the exemption in Section 1402(a)(13)
  2. Frank Sands was the CEO & CIO for an investment management firm. The operating business was owned (99.32%) by a limited partnership and 0.68% by a limited company as GP.
  3. Sands paid self-employment tax (SET) on the $25,000 earned through the GP, but not on the $18 million through the limited partnership. The IRS asserted SET on the partnership share.
  4. The IRS admitted that it erred in its determination of SET on the taxpayer, but disagreed it had asserted the SET.

Tax Cuts And Jobs Act

  1. An early version of the proposed TCJA repealed the limited partnership exemption from SET.
  2. The suggestion as made that Section 1402(a)(13) was to be repealed in order to make any partner liable for SET regardless of their status as limited partners.
  3. The final version of the TCJA did not contain the suggested repeal.

Audits on Horizon?

  1. The IRS Large Business & International (LB&I) division announced on March 13th 2018 that it is focused on limited partner exemptions from SET as one of its compliance campaigns.
  2. “Partners report income passed through from their partnerships. Unless an individual partner qualifies as a “limited partner” for self-employment tax purposes, the partner’s distributive share is subject to self-employment tax under the Self-Employment Contributions Act (SECA). Some individual partners, including service partners in service partnerships organized as state-law limited liability partnerships, limited partnerships, and limited liability companies, have inappropriately claimed to qualify as “limited partners” not subject to SECA tax.”

Erisa Hard Wiring: Erisa Vs. TCJA

Miscellaneous Itemized Deduction Now Disallowed

  1. IRC § 67(g):TCJA repeals miscellaneous itemized deductions under Section 212 for tax years 2018-2025
  2. However, Section 162 trade or business expenses are still deductible (subject to “silo” limitations under the new Section 461(I) for “excess business losses.”
  3. Under TCJA it becomes very important whether a fund is considered a trader or investor when it comes to deductibility of manager’s fees

Erisa “Hard Wired”

  1. ERISA “hard wired” structure allows for 25% ERISA money to be measured at Master level if Feeders are so called _|”hard wired.”
  2. Hence, if no investments are made or management performed at the Feeder level and the Feeders are mere conduits where the asset manager’s only role at Feeder level is to transfer money from Feeder to Master per direction of the investors.
  3. A foreign feeder may be a Benefit Plan Investor, but an Asset Manager may not be viewed as a Fiduciary with respect to Foreign Feeder.

Erisa Vs. TCJA

  1. It is the ERISA position that Feeders are not making investments but that they are mere conduits; however, this undermines the U.S. federal income tax position that U.S. Feeders are traders and not investors.
  2. Before TCJA, certain miscellaneous itemized deductions were allowed if their aggregate value exceeded 2% of the taxpayer’s adjusted gross income.
  3. Under TCJA this is no longer allowed
  4. The question is, does TCJA force fees and allocations to the Master level and does this bolster the hard wired solution for ERISA?

Section 67/212 Limitation On portfolio Expenses

Section 67(A) Repeal Of Section 212 Deductions

  1. Previously these amounts were subject to a 2% AGI floor (expires 2025)
  2. Now it is fully non-allowable. The question has to be asked: is there a difference between non-deductible and non-allowable?
  3. The above impacts the individual tax owners of:
    • Investor Hedge Funds.
    • Private Equity Funds (without investments in passtroughs).
    • Separately managed accounts.
  4. Planning points:
    • PFIC
    • Capitalization
    • Management Fee Waiver.

Carried Interest/Section 1061

Select Open Issues

1061(c) Indirect Partner Issue

  1. Section 1061(c) defines an Applicable Partnership Interest with a two-prong test:
    • Any interest in a partnership which is directly or indirectly transferred or held by the taxpayer in connection with the performance of substantial services by the taxpayer.
    • Any other related person in any applicable trade for business.
  2. So what about an interest held by someone “unrelated” who provides no services with respect to such interest in any entity that itself holds an API?

1061(c) Employee Issue

  1. Section 1061(c) provides an exclusion : API does not include an interest held by any person who is employed by another entity that is conducting a trade or business (other than applicable trade or business) and only provides services to such other entity.
  2. So what is this provision intended to cover? Would it apply to employees of portfolio companies held by the fund?

1061(b) Third Party Investor Rule

  1. Some exceptions are specifically enumerated in Section 1061(c)(4)
    • Notice 2018-18
    • PFICs
  2. A capital interest that provides the taxpayer with a right to share in partnership capital commensurate with:
    • The amount of capital contributed (determined at the time the interest is received).
    • The value of the interest subject to tax under IRC 83 upon its receipt or vesting.

Reinvestment of previously allocated amounts (earned, taxable, impact of 1.704-1(b)(2)(iv)(f)

Limitations on the rights associated with “capital” interest received in exchange for capital contributed

 1061(c) (3) Specified Assets and Their Holding Periods

  1. Section 1061(c)(3) lists specified assets:
    • Securities
    • Commodities
    • Real Estate held for rental or investment
    • Cash or cash equivalents
    • Options or derivative contracts regarding any of the previously listed assets or an interest in a partnership to the extent of the partnership’s interest in the listed assets

Does 1061 extend the holding period for Section 1231 property (i.e. are real estate funds excepted?

Does 1061 call into question the holding period for Section 1256 contracts?

Are REIT shares affected by 1061?

Partnership Interests?

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1061(d) Related Party Transfers

  1. Section 1061(d) seems to be an anti-abuse provision borrowed from earlier versions of carried interest legislation:
    • If a taxpayer transfers an API to a related person, the taxpayer recognizes STCG equal to the excess of the taxpayer’s LTCG regarding the interest for the tax year attributable to the sale or exchange of any assets held for less than three years as is allocable to interest over any amount treated as STCG under 1061(a) regarding the transfer of the interest.
    • Related persons are family members (318(a)(1)) OR anyone who performed services in the current year or any preceding 3 calendar years for the same applicable trade or business as the taxpayer.

What if the transferor has held its API for four years?

Does the reference in the House Report to anti-abuse (abuse of the purposes of the provision including through the allocation of income tax-indifferent parties) cover this provision?

Grandfatering Issue

  1. Section 1061(b) provides an exception to the general rule of section 1061(a):
    • Subsection A shall not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third party investors.
    • Question 1: In the absence of guidance from the Secretary, is this provision self-executing?
    • Question 2: Are the other provisions which may be relied upon to provide relief for the general partner’s capital as of December 31st 2017?
  2. Contributed Capital Exception 
    • The term ‘applicable partnership interest’ shall not include any capital interest in the partnership which provides the taxpayer with the right to share in partnership capital commensurate with:
      1. The amount of capital contributed (determined at the time of receipt of the partnership interest)
      2. The value such interest being subject to tax under section 83 upon receipt vesting of such interest.
    • Question 3: Can a taxpayer rely on this exception with respect to previously earned carry which could have been withdrawn but was reinvested? What about previously taxed amounts?

Entity Choice/Conversion/Construction

Should HFs Be Charged a carry or Fee?

  1. What is the character of income at fund level?
    • An actively managed fund with high percentage of ST gains is generally taxed at highest marginal rate
    • The new 3-year rule in section 1061 will make it harder for the GP to benefit from a carried interest allocation
  1. What is the nature of the fund’s activities?
    • A trader fund’s are deductible but an investor fund’s are not
    • Offshore investors in a mini-master are not subject to the limitation
  1. What is the structure of the GP?
    • Many are structured as LLCs which most likely do not qualify for the SE tax exemption applicable to LPs
  1. The GP of an actively managed fund may be better off changing the incentive from a “carry” to a “fee.”
    • A fee earned by the GP is not subject to the NII tax
    • If an GP is an LP (or converts to an LP) then fee is also exempt from SE apart from guaranteed payment amount.
    • Fee taxed at same rate as carry for actively traded funds
    • State and local implications should be considered for GP and investors as well.

Comparative Tax Liabilities

 GP LLC EARNS FEEGP LP EARNS FEEDIFFERENCE
GROSS CARRY(1)100,000,000100,000,00
FEDERAL TAX @ 2018 RATES37,000,00037,000,000
SE TAX (2)
NII TAX (3)3,800,0003,800,000
NYC UBT (4) 2,530,000(2,530,000)
NYS INDIVIDUAL INCOME TAX (RESIDENT) (5)8,820,0008,596,854223,146
TOTAL TAX LIABILITY49,620,00048,126,8541,493,146
  1. Assumes carry all taxed at highest rate; ignores AMT
  2. Assumes guaranteed payment is funded through management fee
  3. Assumes gross and net carry are equal (ignores netting of losses)
  4. NYC UBT is 100% allocated to NYC; assumes UBT is federal deductions
  5. NYS rate is 8.82%; also assumes NYC UBT is deduction in computing NYS tax

Chaging The GP Management Fees

  1. Most funds do not charge management fees to the GP Capital Account
  2. IF the GP is charged a management fee AND:
    • The fund is a trader (hence the management fee is a 162 expense AND
    • The same individuals own the GP and management company, THEN
    • A favorable rate arbitrage can be achieved sharing a management fee to the GP – assuming the Sec. 1402(a)(13) exclusion from SET for limited partners continues to apply.

Once The GP Earns a Fee Deferral is possible

  1. Section 409A short deferral election
  2. Section 457A compliant deferral plan
  3. Option/FARS/SARS strategy

Section 163(J) Net Interest Expense Limitation

Business Interest Expense limitation

163(j)

Since the limitation applies to ‘business’ interest expense and not ‘investment’ interest expense, its impact will be specific and perhaps not limited for investment funds

  1. Portfolio Companies
  2. Loan Origination Funds
  3. Leveraged Blocker Entities
  4. General Partners of Trading Fund

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

 

Section 461(I) Excess Business Losses

  1. Under this section excess business losses are not allowed for the current tax year. They are treated as part of the taxpayer’s NOL and are carried forward.
  2. NOL carryforwards are allowed for a tax year up to an amount equal to 80% of the taxpayer’s taxable income determined without regard to the NOL deduction.
  3. This applies to the partner level after the application of Section 469 passive loss rules.

Issues

  1. Partners or owners are now limited to their ability to offset other income with pass-through losses
    • How do excess business loss limitations affect an asset manager’s split of fee and allocation?
    • How do excess business loss limitations affect an investor’s investments in multiple funds some of which may be traders and some investors?
  2. 1-year deferral as well as NOL haircut on using excess losses in future years.

UBI Considerations – Netting

Unrelated Business Income

Aggregation Of Unrelated Business Income

  1. After tax years beginning after December 31st 2017 a tax-exempt entity can no longer net losses and income of different trades or businesses
  2. When determining taxable income tax-exempt entities must net income on a trade-or-business by trade-or-business basis.
  3. Unrelated business taxable income equals the sum of all trades or businesses with positive income
  4. Notice 2018-67 provides guidance for the calculation of unrelated business taxable income under section 512(a)(6)
  5. To identify unrelated trades or businesses:
    • Proposed NAICS to identify unrelated trades or business. Until final regulations are issued the use of NAICS codes will be reasonable and good-faith interpretation
  6. To identify net operating losses (NOL) :
    • NOLs should be maintained on an activity-by-activity basis – the 80% limitation and indefinite carryforward rules under section 172 apply.
  7. PARTNERSHIPS: The notice addresses the treatment of income derived from activities in the nature of an investment through partnerships with an interim rule and a transition rules.
    • Interim Rule: Taxpayer may aggregate qualifying partnership interest that satisfy either of the following tests:
      1. De minimis test: Directly owns no more than 2% of profits and 2% of capital interest
      2. Control test: Directly holds no more than 20% of capital interest and does not have control or influence over partnership.
      3. Transition rule: If any partnership interest acquired before August 21st 2018, do not meet the interim rule described above, the organization may treat  each partnership as a single trade or business even if the partnership conducts multiple trades or businesses directly or through lower-tier partnerships

Unrelated Business Income Reporting

  1. Notice 2018-67 does not address the reporting requirements for partnerships to tax-exempt organizations
  2. It also does not address the reporting requirements from a lower-tier partnership without tax-exempt entities to an upper-tier partnership with tax-exempt entities.

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.

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