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From: Richard Kahn
Sent: 1/23/2018 6:23:09 PM
To: jeffrey E. [jeeyacation@gmail.com]
Subject: Fwd: Alert: The 2017 Tax Reform Act
Importance: High
Richard Kahn
HBRK Associates Inc.
575 Lexington Avenue 4th Floor
New York, NY 10022
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TAX ALER JANUARY 23, 2018
The 2017 Tax Reform Act - Key
Provisions Impacting Fund Managers
and Their Funds
For further information about this Alert,
please contact:
Alex Gelinas
Partner
212.573.815g
agelinas@sglawyers.com
Steven Etkind
Partner
212.573.8412
setkind@sglawyers.com
Please feel free to discuss any aspect of
this Alert with your regular Sadis &
Goldberg contact or with any of the
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partners whose names and contact
information can be found at the end of
the Alert.
The Tax Cuts and Jobs Act (the "Tax Act"), which was signed into law by President Trump on December
22, 2017, contains the most sweeping federal tax law changes since 1986. Most provisions of the Tax
Act take effect for taxable years beginning on or after January 1, 2018. This Client Alert is not intended
to be a comprehensive review of this massive legislation. The Alert focuses on certain provisions of
the Tax Act that may have the most significant impact on asset management firms, their owners, their
investment vehicles, and the investors in such funds. Certain changes made by the Tax Act are
permanent but many others are scheduled to expire after 2025 unless extended by further
Congressional legislation.
I. Carried Interest Survives in Modified Form
The Tax Act contains changes to the treatment of "carried interests", but such changes are not as
negative as the prior legislative changes that had been proposed but never adopted. The granting of a
"future profits only" interest in a partnership in connection with the performances of services to the
partnership continues to be eligible for tax-free treatment under the new law. For certain owners of
"Applicable Partnership Interests" (of the sort that would generally be issued by an investment
partnership to the general partner), the Act applies a three-year holding period requirement for capital
gains derived by the partnership (or from the disposition of the profits interest) to be eligible for the
long-term capital gains tax rate (instead of the generally applicable one-year holding threshold).
The change in carried interest taxation clearly impacts managers of hedge funds more than managers
of private equity funds or real estate funds, which typically have a longer than three-year holding period
for investments in their portfolio companies or real estate assets. The new tax treatment applies to
income realized in tax years beginning on or after January 1, 2018 and existing carried interests are not
grandfathered. Thus, it appears that any unrealized capital gains which have already been allocated to
a general partner on the books of the partnership would be subject to the new tax treatment at the time
the partnership realizes such gains in 2018 or subsequent years.
Note, however, that the Tax Act does not change the current federal income tax treatment of carried
interest allocations of "qualified dividends" to individuals, which are also taxed at long-term capital gains
rates. The capital gains from the carried interest that fail to satisfy the new three-year holding period
requirement are treated as "short-term capital gains" which are taxable at ordinary income rates.
The "Applicable Partnership Interest" held by the general partner or an affiliate should not include any
portion of the partnership interest that is attributable to capital contributed to the partnership by the
general partner. The exact manner on how such exception will apply will need to be addressed in future
IRS notices or regulations to be issued. Limited partners holding capital interests in private investment
funds are also not affected and therefore retain the one-year holding period requirement for long-term
capital gain treatment.
Note also that the term "Applicable Partnership Interest" does not include an interest held directly or
indirectly by a corporation and it currently appears that such exception includes holdings by both C
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corporations and S corporations. It is likely that further guidance will be issued on this question, as it
may be advantageous for certain general partners to convert their existing entities that hold the carried
interest to S corporations, and such general partners may have until March 15, 2018 to accomplish such
conversion.
Managers of hedge funds and other partnerships that do not hold capital assets for more than three
years before their sale may consider whether the carried interest incentive allocation should be replaced
with an incentive fee structure. Also, the reduced after-tax value of a carried interest partnership
allocation may impact the management company's executive compensation arrangements.
Although an earlier version of the tax legislation would have repealed the exemption in the Code which
provides that a limited partner's income is exempt from self-employment tax, the final version of the
Tax Act does not contain such change in law.
II. New 21% Corporate Income Tax Rate and Reduction of the Maximum Rates Applicable to
Individuals
The Tax Act reduces the 35 percent corporate rate to a flat 21 percent corporate rate. There is no special
higher rate for personal service corporations (as existed under prior law). The new 21 percent rate is
effective for taxable years beginning on or after January 1, 2018. The corporate alternative tax (AMT)
has also been repealed. Such corporate tax changes are permanent. In contrast, the highest applicable
federal income tax rate for individuals and other non-corporate taxpayers is reduced from 39.6% to
37%. In addition, the 3.8% "add-on" Medicare contributions tax on an individual's net investment
income remains in effect.
1. Possible Use of a "C" Corporation as a Tax Shelter
Since the new 21% corporate tax rate is now well below the highest rate applicable to high income
individuals, some investment managers may conclude that some or all of their management entities
that are pass through partnerships should convert to corporate form. In addition, certain partnership
funds that are engaged in trade or business, such as active loan origination or real estate activities may
find it advantageous to convert to corporate form.
The advantage to the corporate form of organization is that the C corporation's net income after taxes
is not taxable to its shareholders until it is distributed (e.g., either as a dividend or as a redemption of
stock (i.e., as a capital gain)). Corporations that are engaged in active businesses are able to retain and
reinvest their earnings. Also relevant to choice of entity decisions is the fact that the Tax Act restricts
the ability of individuals to deduct more than $10,000 in state and local taxes, but corporations can
continue to deduct such taxes as under prior law.
However, there are certain anti-abuse provisions that remain in the Internal Revenue Code that limit
the use of a C corporation as a tax shelter. Lurking in the Code is a provision which allows the Internal
Revenue Service to impose a 20 percent additional "accumulated earnings" income tax on the
"accumulated taxable income" of a corporation if such taxable income is allowed to accumulate "beyond
the "reasonable needs of the business". There is a $250,000 safe harbor for most corporations, while
personal service corporations are allowed a safe harbor of only $150,000. There is also a 20 percent tax
on the "personal holding company income" (i.e., passive investment income) of certain closely held C
corporations (i.e., when five or fewer individuals own, in the aggregate, more than fifty percent of the
corporation's stock and at least 60 percent of the corporation's adjusted ordinary income is personal
holding company income (e.g., passive investment income)). These penalty taxes on corporations have
received little attention in recent decades. However, with the enactment of the sharply lower corporate
tax rate, these anti-abuse rules are likely to become a significant focus of the IRS in its audits of tax
returns of privately held corporations.
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2. The New Deduction for Qualified Business Income of Pass Through Entities
Congress also wanted to provide an income tax rate reduction for those businesses that are organized
as partnerships or S corporations or which are owned by sole proprietors. In order to meet this goal, the
Tax Act provides an income tax deduction for individuals and other non-corporate taxpayers equal to (i)
20 percent of their domestic "qualified business income"; plus (ii) 20 percent of any qualifying dividends
from real estate investment trusts, qualifying income from publicly traded partnerships, and gain
derived from sale of such publicly traded partnerships that would be treated as ordinary
income. Therefore, such deduction results in an effective federal income tax rate of 29.6% on such
qualifying income for a top bracket individual. The deduction does not apply to investment income (i.e.,
capital gains, dividends (other than certain ordinary income dividends paid by REITs), and most interest
income). In addition, it does not apply to reasonable compensation income and guaranteed payments
paid to the taxpayer from the business.
The 20 percent of "qualified business income" deduction described in (i) above is also generally limited
to the greater of either (a) 50% of the W-2 wages paid with respect to the qualified trade or business,
or (b) the sum of 25% of the W-2 wages paid with respect to such business plus 2.5% of the unadjusted
tax basis of all qualified business property of such business. Thus, if the partnership, S corporation or
sole proprietorship does not pay "W-2 wages" and the second limitation is a minor amount or not
applicable, the owner or pass through taxpayer's tax deduction would be a minor amount or zero.
Unfortunately, partners or owners of certain types of professional service businesses, including
financial services providers, investment managers, brokers, consultants, lawyers and accountants (and
others), are not permitted to claim the "qualified business income" deduction unless the taxpayer's
adjusted gross income is below certain levels ($207,500 for individuals and $365,000 for married couples
filing jointly). Even in such case, the benefit of the available deduction is phased out ratably as the
taxpayer's income exceeds $157,500 if single, or $315,000 if filing a joint tax return. Therefore, fund
managers organized as pass through entities are not likely to, and investment funds organized as
partnerships will not, derive a significant benefit from this deduction.
ISSUES FOR PARTNERSHIP FUNDS
1. Repeal of Itemized Deductions Previously Available to Non-Corporate Taxpayers for Non-Business
Investment Expenses
For 2018 through 2025, the Tax Act completely repeals the deductions previously allowed to individuals
and other non-corporate taxpayers for "miscellaneous itemized deductions" (which were subject to a
2% floor and a phase-out rule under prior law). It is important to note that for individual investors in
partnership funds that are not treated as engaged in a trade or business, the investor's share of the
fund's investment expenses, including management fees, would now pass through as non-deductible
miscellaneous itemized deductions. If the fund is properly classified as an active "trader" rather than a
mere investor, then such expenses would be completely deductible as trade or business expenses. This
Tax Act change obviously puts considerable strain on the fund manager and its tax advisors with respect
to the trader vs. investor issue. At this time, there is a lack of clear guidance from the Internal Revenue
Service on what level of trading activity is sufficient for a professionally managed fund to qualify as a
"trader fund".
In cases where a partnership fund's expected activities are not likely to qualify for trader status or
another trade or business, the fund's sponsor may find that US high net worth individuals may now
prefer to invest in the offshore corporate feeder fund instead of the onshore partnership fund. The US
income tax reason for this would be that since the offshore feeder is classified as a corporation for US
tax purposes, its net income would be calculated under the rules applicable to corporations, for which
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there are no miscellaneous itemized deductions. Thus, assuming that the foreign feeder is a passive
foreign investment company (PFIC), if the US high net worth shareholder is able to make the "qualified
electing fund" election, the net income the investor would be required to report on his federal income
tax return would be calculated after deducting all of the corporation's expenses, including management
fees and investment expenses.
2. Non-US Partner's Gain on Sale of Partnership Interest may be Taxable as US Trade or Business
Income; New Withholding Requirements apply to the Purchaser or the Fund
The Tax Act specifically provides that gains realized by a non-US partner on a sale or exchange of a
partnership interest will be treated as effectively connected US trade or business income ("Ed") to the
extent that such partner would have been allocated [Cl had the partnership sold all of its assets. This
provision is consistent with the IRS position in Revenue Ruling 91-32, and overrules a recent Tax Court
case which had rejected the position taken in such IRS Ruling and instead held that since a partnership
interest is treated as a capital asset, the foreign person's gain on its sale could escape US income taxation
as a non-business capital gain.
To the extent that a partnership has any [Cl-generating assets (including US real property interests), a
seller of a partnership interest will have to provide a certificate that it is not a foreign person, and in the
absence of such a certificate a purchaser (which could include the fund) will be required to withhold
10% of the gross purchase price. Further, the Tax Act provides that if the purchaser does not withhold,
the partnership is required to withhold on distributions to such purchaser to cover the withholding. The
Tax Act provides that the new withholding obligation for purchasers is effective for sales or other
dispositions of partnership interests after December 31, 2017.
3. New Limitation on Deduction of Net Interest Expense
Under prior law, subject to some restrictions and limitations, business interest paid or accrued by a
business was fully deductible. For taxable years beginning after December 31, 2017, the Tax Act limits
the deduction for "net business interest" expense for every type of business, regardless of entity form,
to 30 percent of adjusted taxable income. Business interest paid or accrued after the effective date on
indebtedness, including debt that was incurred prior to the effective date of the Tax Act, is subject to
this limitation.
The term business interest does not include investment interest described in Code section
163(d). Operating companies, such as management entities, and investment funds that are engaged in
a business and have outstanding indebtedness could be subject to such deduction limitation. For this
purpose, "adjusted taxable income" is determined at the entity level for partnerships, and is similar to
EBITDA (i.e., net earnings before deducting interest expense, taxes, depreciation and amortization) for
taxable years 2018 through 2021. A more restrictive 20% of [BIT limitation (net earnings before
deducting interest expense and taxes) applies for 2022 and later years.
Certain taxpayers are exempted for the new interest deductibility limitation, including small businesses
with average annual gross receipts of $25 million or less for the three prior taxable years, as well as real
estate businesses that elect out of such limitation. The Conference Committee Report on the Tax Act
clarified that interest paid on shareholder loans by a blocker corporation is "business interest" that is
subject to this new limitation. Blocker corporations for a lending business would have business interest
income, which reduces the effect of this new limitation on net business interest expense (i.e., deductible
business interest expense in excess of business interest income).
4. Deemed Repatriation Tax
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One of the major tax raising provisions in the Tax Act is a one-time tax imposed on the accumulated
earnings held in foreign subsidiaries of US companies. This provision is broader that it may first
appear. Under the Tax Act, any 10% US shareholder of a foreign corporation (determined on December
31, 2017) will be required to include in income, for the taxable year 2017, its proportionate share of the
foreign corporation's undistributed earnings, if the foreign corporation is either a controlled foreign
corporation (CFC) or has at least one 10% US shareholder that is a corporation.
This law change could generate significant phantom income with respect to 10%-or-greater owned
foreign portfolio companies both (i) for US taxable investors (including the general partner and its
owners) in partnership funds organized in the United States and/or for US sponsors of non-US
funds. The Tax Act provides for reduced tax rates on such income for corporate investors of 8% (for
earnings invested in tangible business assets) and 15.5% (for cash and cash equivalents), and 9.05% and
17.54% for investors taxed as individuals.
5. Tax-Free Section 1031 Like Kind Exchanges Eliminated Except for Real Property Transactions
The Tax Act eliminates the ability to qualify for tax-free exchange treatment under Code section 1031 if
the property being exchanged is personal property. Consequently, for transactions occurring after
December 31, 2017, exchanges of artwork, equipment, vehicles or other personal property held for
investment or for use in a business, including Bitcoin or other cryptocurrencies, for like kind property
will not eligible for Section 1031 tax treatment. Exchanges of real property continue to be eligible for
Section 1031 exchange treatment.
6. Certain Tax Accounting Rules Have Been Revised
Under prior law, net operating losses (NOLs) could be carried back two years and carried forward for
twenty years. Under the Tax Act, NOLs arising in tax years ending after December 31, 2017 generally
cannot be carried back, but can be carried forward indefinitely. However, only 80% of a company's
taxable income is permitted to be offset by NOLs. The remainder of the unused NOLs will carry forward.
The Tax Act also expands the category of corporations and partnerships that are eligible to use the cash
method of accounting. Certain businesses may derive a tax benefit by switching from the accrual
method to the cash method of accounting.
7. Deferred Compensation
The Tax Act generally leaves the current tax rules for deferred compensation intact. However, the Act
also includes a new deferral provision for certain types of broad-based employee equity, which may
apply to certain private companies.
8. Estate and Gift Tax Changes
In 2017, an individual could give or transfer at death up to $5,490,000 without paying gift or estate taxes.
The Tax Act doubles the federal estate and gift tax unified exemption amount for estates of decedents
dying and gifts made after December 31, 2017, and inflation adjustments will continue to
apply. Therefore, in 2018, an individual has approximately an $11.2 million exemption, and a married
couple has approximately $22.4 million of available shelter from federal gift and estate taxation. Note
that the large exemption which applies to gifts may be useful in federal income tax planning. For
example, large lifetime gifts of appreciated securities, artwork and other personal property (including
possibly, a carried interest) to relatives who are in lower income tax brackets, or who reside in states
with lower, or no state income taxes could save the family substantial federal income and/or state
income taxes when such property is sold by the recipient of the gift.
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Sadis & Goldberg LLP
Please feel free to discuss any aspect of this Alert with your regular Sadis & Goldberg contact
whose names and contact information are provided below.
Alex Gelinas, 212.573.8159, agelinas@sglawyers.com
Daniel G. Viola, 212.573.8038, dviola@sglawyers.com
Danielle Epstein-Day, 212.573.8416, depstein@sglawyers.com
Douglas Hirsch, 212.573.6670, dhirsch@sglawyers.com
Erika Winkler, 212.573.8022, ewinkler@sglawyers.com
Greg Hartmann, 212.573.8030, ghartmann@sglawyers.com
Jeffrey Goldberg, 212.573.6666, igoldberg@sglawyers.com
Jennifer Rossan, 212.573.8783, kossan@sglawyers.com
Mitchell Taras, 212.5738417, mtaras@sglawyers.com
Paul Fasciano, 212.573.8025, pfasciano@sglawyers.com
Paul Marino, 212.573.8158, pmarino@sglawyers.com
Richard L. Shamos, 212.573.8027, rshamos@sglawyers.com
Robert Cromwell, 212.573.8034,  rcromwell@sglawyers.com
Ron S. Geffner, 212.573.6660, rgeffner@sglawyers.com
Sam Lieberman, 212.573.8164, slieberman@sglawyers.com
Steven Etkind, 212.573.8412, setkind@sglawyers.com
Steven Nuttier, 212.573.8424, shuttler@sglawyers.com
Yehuda Braunstein, 212.573.8029, ybraunstein@sglawyers.com
Yelena Maltser, 212.573.8429, ymaltser@sglawyers.com
If you would like copies of our other Alerts, please visit our website at www.sglawyers.com and
choose "Library."
The information contained herein was prepared by Sadis & Goldberg LLP for general
informational purposes for clients and friends of Sadis & Goldberg LLP. Its contents should not
be construed as legal advice, and readers should not act upon the information in this Alert
without consulting counsel. This information is presented without any representation or warranty
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