Treasury Giveth and Treasury Taketh Away – The Business Interest Expense Limitation and Trader Funds
March 08, 2021
By Simcha David
Following a previously published EisnerAmper article I wrote which explained the new position that Treasury had taken with regard to the applicability of the business interest expense limitation of IRC Sec. 163(j) to trader funds, deemed a positive game changer to the funds industry, in January 2021, Treasury issued final regulations (“Final Regulations”) finalizing part of the Proposed Regulations. While the language of the Final Regulations did not change much from the Proposed Regulation with regard to the non-materially participating partners of a trader fund, Treasury once again in the preamble to the Final Regulations has taken a position that limits the non-materially participating partner exception to IRC Sec. 163(j).
In the proposed regulations that were published on July 27, 2020 (“Proposed Regulations”), Treasury had reversed a prior interpretation of IRC Sec. 163(j). It concluded that to the extent interest expense of a trader fund was allocated to a non-materially participating partner, the interest expense would not first be subject to the business interest expense limitation at the partnership level but rather would only be subject to the investment interest expense limitation of IRC Sec. 163(d) as had been the case prior to the 2017 Tax Cuts and Jobs Act (“TCJA”). It reversed an initial interpretation that had allowed the business interest expense limitation of IRC Sec. 163(j) to apply first, and only upon passing that test would the investment interest expense limitation of IRC Sec. 163(d) apply.
Under IRC Sec. 163(j), business interest expense is limited to the sum of business interest income and 30% (for 2020 only, the CARES Act changed this to 50%) of adjusted taxable income. Under IRC Sec. 163(d), a taxpayer can only deduct investment interest expense to the extent that the taxpayer has investment income. Although the interest expense of a trader fund should technically be business interest as all of a trader fund’s expenses are deductible as business expenses (as opposed to an investor funds expenses that are non-deductible investment expenses), IRC Sec. 163(d) specifically recasts trader interest expense into investment interest expense for non-materially participating partners. Initially, Treasury took the position that the interest expense of a trader fund (set up as a partnership) was business interest expense at the entity level and investment interest expense at the partner level once the interest expense was allowed at the entity level. They reversed this position in the Proposed Regulations. Treasury giveth.
As with all things “Treasury,” however, the devil is in the details. Treasury regulation preambles are the forum in which Treasury responds to comments that are submitted after proposed regulations are issued. In responding to one particular comment, the preamble states as follows:
“One commenter observed that the proposed regulations do not discuss a tiered partnership structure with respect to the material participation rules. The Treasury Department and the IRS determined that such a rule is not needed. The bifurcation approach in proposed §1.163(j)-1(c)(1) and (2) applies where interest income or expense is allocable to one or more partners that do not materially participate (within the meaning of section 469), as described in section 163(d)(5)(A)(ii). Thus, in a tiered structure where interest is not allocable to one or more partners that do not materially participate, the rules in §1.163(j)-6(c)(1) and (2) do not apply and the interest expense is subject to the rules under section 163(j)(4) (ed. note: our bold).”
As mentioned above, the new rule is that for non-materially participating partners in a trader fund, only the investment interest expense limitation (IRC Sec. 163(d)) will apply and not the business interest expense limitation of IRC Sec. 163(j). The response to the commenter above clearly states that in Treasury’s view, a partnership cannot be deemed to be non-materially participating even though all of its partners are non-material participants. Therefore, in most hedge funds that are set up in a master/feeder structure, the business interest expense limitation will apply to all of the partners as all of the partners of the master fund (the trader fund) are partnerships or corporations (the onshore feeder and GP entity are generally partnerships and the offshore feeder is generally a corporation). In Treasury’s view, only when an individual or trust is a direct investor in a trader fund can the trader fund bifurcate the interest expense for the non-materially participating partners. Treasury taketh away.
Thankfully, however, there is a silver lining in this interpretation. In a number of places in the preamble, Treasury also makes clear that once interest expense is subjected to scrutiny under the business interest expense limitation, it can no longer be subject to scrutiny under the investment interest expense limitation. This means that in a master/feeder structure, if the interest expense is allowed as a deduction because it is less than the limit or even if the trader fund is eligible for the “small business exception” (IRC Sec. 163(j)(3)) so that the limit does not apply, that interest expense will no longer be subject to the investment interest expense limitation of IRC Sec. 163(d).
Interestingly, this creates additional confusion. There are certain types of interest expense that while they will not be considered business interest expense under IRC Sec. 163(j), they will be considered interest expense under IRC Sec. 163(d). Short dividend expense is an example of this. While it will be included as investment interest expense under IRC Sec. 163(d), it will not be included in the definition of interest for the business interest expense limitation of IRC Sec. 163(j). What this means is that a typical trader hedge fund may now allocate short dividend expense on Schedule K-1 line 13h, which is investment interest expense (for the short dividend expense) and other interest expense on line 13w (this would be deductible business interest expense). As mentioned previously, investment interest expense can only be deducted by a taxpayer to the extent that such taxpayer has investment income. Previously, certain income items of a hedge fund were deemed to be investment income reported on line 20A of Schedule K-1. However, these same line items will be part of adjusted taxable income, as for IRC Sec. 163(j) these items are viewed as business and not investment items.
While the rest of the world seeks to perfect quantum computing, where bits of information can be two different things simultaneously, Treasury has already managed to do this by treating the same items as both business and investment at the same time.
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