Proposed Tax Reform Legislation: What Managers, Investors and Advisors Are Discussing

As of the date of this article, both the House and Senate have voted on and approved separate versions of tax reform legislation.  The process of reconciliation is now underway.  Although tax planning decisions, both long term and short term, cannot be finalized until a bill is signed into law, many fund managers, their investors and their advisors are discussing various aspects of the proposals and the effect on the financial services industry.  This article addresses some of the issues being addressed in the financial services fund world. It is meant to be a springboard for discussion between the fund managers and their advisors and not meant to be advisory.   

1. Converting management companies currently organized as partnerships, limited liability companies and S corporations to a C corporation

One of the major components of both the House and Senate bills is the reduction of the corporate income tax rates to a flat 20% (possibly 22%).  In the House bill, this would take effect after 2017 and in the Senate bill after 2018.  The House bill provides that personal service corporations (“PSCs”) would be subject to a flat 25% rate for the first two years and 20% thereafter.  The Senate bill would eliminate the special tax rate of a PSC.  A PSC is a corporate entity formed by individuals who provide personal services for their clients. Examples of this type of business include doctors’ offices, law firms and accounting firms.  The House bill would also provide a maximum 25% tax rate on a portion of net income distributed by a pass-through entity (i.e., sole proprietorship, partnership, limited liability company taxed as a partnership or S corporation) to an owner or shareholder effective for taxable years beginning after December 31, 2017.  The remaining portion of net business income would be treated as compensation and continue to be subject to ordinary income tax rates.  Rules are provided to determine the proportion of business income and to prevent the re-characterization of actual wages paid as business income.

The Senate bill would also reduce the tax on a portion of net income distributed by a pass-through entity to an owner or shareholder but it would do so via a deduction from income as opposed to a reduced rate of tax. The effective rate after deduction would be approximately 29%.

Both bills would preclude certain personal services businesses from eligibility for the lower tax.  However the Senate version would allow the deduction for a service business where the taxpayers’ taxable income does not exceed $500,000 (married filing jointly; $250,000 for other taxpayers)

Accordingly there would be very little change in the taxation of a fund manager’s ordinary income if the management company remains a flow-through entity other than through a reduction in individual tax rates.  Note only the Senate version reduces the top individual rate from 39.6% to 38.5%

Some fund managers are exploring a conversion of their flow-through management company entities to C corporations to avail themselves of the lower corporate income tax rate. 

Example: Assume a management company has $10 million in pretax net income after paying a reasonable compensation to its manager/owners and the earnings are subject to the self-employment tax in the hands of the owners of the management company.  As the management company is a flow-through entity, its owners would be subject to tax on its income.  Assuming a top rate of 41.74% (38.5% as per the Senate proposal and 3.24% self-employment tax net of the benefit for partial deduction of the self-employment tax), the tax would be $4,174,000 plus social security tax.  If the same $10 million of pretax net income was earned in a C corporation, the corporation would have a 20% tax (Senate version and House version after two years) or $2 million.  The C corporation would have $8 million remaining to distribute as a dividend, which would be taxable at 23.8% (inclusive of the net investment income tax (“NII”)) or an additional $1,904,000 for a grand total of $3,904,000 of tax.  This translates to a 39.04% tax rate and a savings of $270,000.

However if the management company were structured so as to minimize the self-employment tax, the tax on the individual owners of the management company would have been $3,850,000.  No need for a conversion

In addition, a fund located in a jurisdiction where state and local corporate income tax rates are higher than the individual rates (Florida and New York City come to mind), the disparity favors the flow-through structure. 

Some fund managers are thinking of accumulating the earnings inside the corporation and not paying dividends thereby deferring the shareholder level tax on the dividends.  The Internal Revenue Service has at its disposal a rarely imposed penalty on corporations that accumulate earnings to avoid shareholder level taxes on dividends.  The accumulated earnings tax is a 20% surcharge imposed on corporations with retained earnings deemed to be beyond the reasonable needs of the corporation.  Reasonable needs includes reasonably anticipated needs of the business.  A lengthy discussion of reasonable needs is beyond the scope of this article.

Converting a flow-through entity to a corporation can result in some very unfavorable tax consequences, long-term, if the business appreciates. The double-level tax cost is exacerbated by future appreciation of corporate assets, which could cost the owners in a future exit transaction. 

Generally buyers want to buy assets and not stock so they can get a step-up in basis of the business’ underlying assets (tangible and intangible) and depreciate their investment over time.  A new investor purchasing part or all of the shares of a C corporation cannot depreciate his/her invest in the C corporation.  If they purchased the assets of the C corporation, there would be a corporate-level tax on the gain from the sale of the assets and an additional tax on the dividend paid out to the selling shareholders.  If the owners of the management company were to sell the assets in a flow-through entity, a good portion of the gain would likely be attributable to goodwill and be taxed at a 20% tax rate (plus state and local taxes).  Note the 3.8% NII would not apply to the sale of assets from an active trade or business.

2. Converting incentive allocation to a fee

Fund managers generally receive two streams of income for managing the activities of a fund: (1) a management fee equal to 1-2.5% of the assets under management and (2) a share of the profits, generally from 5-25% of the net profits after taking into consideration expenses of the fund, including the management fee.  This share of the profits is known as the “carried interest”.

Standard practice for fund managers located in the United States is to structure the carried interest as an allocation of partnership profits.  In that way, the income for the fund manager retains the character of the income of the fund.  For example, if the investment income of the fund consists solely of long-term capital gains, the carried interest is taxed only when those gains are realized and at the lower capital gains rate. Structuring the carried interest as a fee would subject the carried interest to ordinary income tax rates and immediate taxation.  

When allocating the partnership profits to the fund manager, each item of income, gain, expense, loss and credit is allocated.  Since management fees are part of the fund’s profits, the fund manager is allocated a portion of the management fees as well. 

In the Senate bill, all miscellaneous itemized deductions subject to the 2% floor under current law would generally be repealed.  This provision would apply to taxable years beginning after December 31, 2017 and before January 1, 2026.  It would then revert to its form as existed prior to January 1, 2018.

Management fees paid by investors in private equity funds and hedge funds classified as investor funds are considered miscellaneous itemized deductions subject to the 2% floor and would no longer be deductible.  Under current law, these deductions are not allowed under the alternative minimum tax (“AMT”) regime. 

Based on the above, an argument can be made that certain fund managers could benefit from structuring their carried interest as an incentive fee as opposed to an allocation of profits. 

Example: Assume a fund has $2 million of short-term capital gains and $500,000 of management fees paid for a net profit of $1.5 million, and the fund manager is allocated 20% of the net profits of the fund.   Accordingly the carried interest is $300,000 ($1,500,000 * 20%). Where the carried interest is structured as an allocation of profits, the fund allocates $300,000 to the fund manager, which consists of $400,000 of gains and $100,000 of management fees. Since the management fees are not deductible, the fund manager will pay $154,000 of tax ($400,000 at 38.5% marginal tax rate as proposed in the Senate bill).  Where the carried interest is structured as a fee, the manager will receive $300,000 of ordinary income and pay tax of $115,500 ($300,000 at 38.5% marginal tax rate as proposed in the Senate bill). This is a net savings of $38,500 or 9.63%.

This raises several issues:

1. Taxable limited partners (“LPs”) would be hurt.  In an allocation of profits, the LPs’ income and deductions are reduced by 20%.  In other words, they would have 20% less capital gains and 20% less management fees.  An incentive fee, on the other hand, would be treated as a miscellaneous itemized deduction subject to the 2% floor, similar to management fees. Therefore the LPs would have more nondeductible items.
   
   Example:   Assume the same facts as above.  The LPs have $1,200,000 of net profits ($1,500,000 less the carried interest of $300,000).  Where the carried interest is structured as an allocation of profits, the LPs will have $1,600,000 of short-term capital gains and $400,000 of management fees.  Since the management fees are not deductible the LPs will pay $616,000 of tax ($1,600,000 at 38.5% marginal tax rate as proposed in the Senate bill).  Where the carried interest is structured as a fee the LPs will have $2 million of capital gains and itemized deductions of $800,000 ($500,000 management fees and $300,000 incentive fee).  They will have an income tax of $770,000 ($2 million at 38.5% marginal tax rate as proposed in the Senate bill) -- a net increase in tax in the amount of $154,000. 
   
   Nontaxable LPs, such as endowments and pension funds, won’t care about the character of the income as they are not paying tax in either scenario.  Accordingly a manager of a fund with all tax-exempt partners may find this attractive.
   
   
2. Unrealized gains will not benefit the fund manager where the carry is structured as a  fee.  Where the carried interest is structured as an allocation of profits, the fund manager generally benefits from the deferral of tax on unrealized gains.  Where the carry is structured as a fee, the fund manager is taxed immediately on the payment of the fee. 
   
   Example:  Assume a fund has $2 million of unrealized gains in the current year.   Where the carried interest is structured as an allocation of profits, the fund manager will be allocated $400,000 of unrealized gains and will not be taxed until the fund realizes those gains.  Where the carry is structured as a fee the fund manager is taxed immediately upon payment of the $400,000.
   
   This may not have a material effect on a fund with all short term gains.
   
   
3. New York City Unincorporated Income Tax (“NYC UBT”).  In New York City a fee is subject to the 4% NYC UBT.  An allocation of profit is not. 

Note that many variables must be considered.  Funds can have any combination of gains and losses, realized and unrealized and all the facts and circumstances must be examined when contemplating such a change. 

3. Leveraged Recaps

Applicable to tax years beginning after December 31, 2017, and subject to certain qualifications and exceptions, transfers of “applicable partnership interests” held for three years or less would be treated as short-term capital gain.  An applicable partnership interest is an interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer or any other related person in any “applicable trade or business.”  An applicable trade or business is any activity conducted on a regular, continuous and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists in whole or in part of raising or returning capital, and either (i) investing in or disposing specified assets (or identifying such assets for investing or disposition) or (ii) developing specified assets.  Certain equity interests and interests held by corporations would be exempt.  To the extent provided in Income Tax Regulations, this provision would not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors. 

Accordingly, fund managers who receive a carried interest would have to hold those assets for three years in order to qualify for the long term gain tax rates.

A leveraged recapitalization is executed by the corporation borrowing money and using the proceeds to buy back the company's stock or to pay dividends. Leveraged recapitalizations are used by privately held companies as a means of refinancing, generally to provide cash to the shareholders while not requiring a total sale of the company. Debt generally has some advantages over equity as a way of raising money, since it can have also have some tax benefits.  A resulting reduction in equity also makes the firm less vulnerable to a hostile takeover.

Dividends are not subject to the new three-year rule and qualifying dividends are eligible for the long-term capital gains tax rates.  The fund manager may consider a leveraged recap of a portfolio company in order to generate qualifying dividends thus ensuring the manager of the preferential tax rates and at the same time giving the LPs a return on cash. 

When contemplating this transaction, one needs to be aware of another provision in the proposed tax legislation.  For taxable years beginning after December 31, 2017, the deduction for business interest would be limited to the sum of business interest income, floor plan financing interest, and 30% of the “adjusted taxable income” of the taxpayer for the taxable year.  The adjusted taxable income is the taxable income of the taxpayer computed without regard to (i) any item of income, gain, deduction or loss which is not properly allocable to a trade or business; (ii) any business interest or business interest income; (iii) the 23% deduction for certain pass-through income (under the Senate proposal); and (iv) the amount of any net operating loss deduction.  The amount of disallowed interest would be carried forward indefinitely.  Exempt from these would be businesses with average gross receipts $15 million or less, regulated public utility companies, electing real property trades or businesses, and electing farming businesses.  The trade or business of performing services as an employee would not be treated as a trade or business; as a result, the wages of an employee would not be counted in adjusted taxable income for purposes of determining the limitation.  The rules would apply at the entity level for pass-through entities and special rules would apply to the pass-through entities’ unused interest limitation for the year.  

Conclusion

As stated above, this article is for the purpose of generating conversation between the fund managers and their advisors.  The law is not yet finalized and many of the details of the law have not been written.  As the saying goes, the devil is in the details.  The details are not out yet and in fact they may not come out until regulations are written.   What, did you say there is a moratorium on regulations?  Then how are we to implement the new law?