Q1 2019 - The Impact of the New Interest Expense Limitation Rules on Trader Funds
February 18, 2019
By Simcha David
The business interest expense limitation, new Internal Revenue Code (IRC) Sec. 163(j), is among the many new provisions of the IRC that was added by the Tax Cuts and Jobs Act of 2017 (TCJA). The limitation on its face seems to be rather simple. Interest expense is limited to 30% of the adjusted taxable income (ATI) of a trade or business. However, the practical application of this provision is anything but simple. Part of the reason is because the limitation applies to partnerships, corporations and individuals that are in a trade or business. Treasury recently issued proposed regulations to explain the nuances. Buried in the preamble is a troubling application of the new rules as it applies to trader hedge funds. In general, treasury regulations cannot be used to promulgate new laws. That is for Congress to do. However, the practical application and interpretation of the law and intent of Congress is very much in the purview of the authors of the treasury regulations.
Hedge funds fall into two categories, investor funds and trader funds. In the simplest form, investor funds invest in the markets for longer-term appreciation while trader funds invest for short-term gains or swings in the market. In general, trader funds will have a much higher trading volume than investor funds. Trader funds may still have some long-term capital gains, but those are the exception rather than the norm. Because of this, many trader funds make an IRC Sec. 475(f) mark-to-market election which removes the necessity to perform securities analysis on the portfolio as it is marked to market on an annual basis and all gains and losses are ordinary rather than capital in character. In addition, the expenses related to a trader fund are considered to be trade or business expenses, deductible against the income generated by the trader funds, while most expenses relating to investor funds are investment expenses that are no longer deductible.
Under pre-TCJA law and still under current law, interest expense that is utilized to create investment (non-trade or business) income is subject to the investment interest expense limitation of IRC Sec. 163(d). This limits the amount of interest expense that a partner in an investment partnership can deduct on his personal income tax return to the amount of investment income earned. For example, if an investor fund utilizes a margin account and pays interest on it, the fund will separately report this interest expense to its investors on the schedule K-1. The partners are then required to calculate how much investment income they have earned that year to determine if they can deduct the interest expense allocated to them. If a taxpayer is invested in multiple funds, they aggregate all of the investment income to determine if they can utilize the interest expense to offset their income. Although trader funds are considered to be in a trade or business, the income they generate is primarily investment type income. However, if the law did not specifically include the trader income in the definition of investment income, the interest expense utilized to generate trader fund income would be deductible without limitation. In order to bring parity in the investment world, Congress included in the definition of investment income, a limited partner’s share of a trader fund’s income, which then makes the interest expense allocated to a limited partner in a trader fund subject to the investment interest expense limitation. The interest expense allocated to the general partner of a trader fund is generally not subject to the investment interest expense limitation. This is because of the language in IRC Sec. 163(d).
Under the TCJA, which added new IRC Sec. 163(j), we now have an interest expense limitation that applies to trade or business interest. A trader fund is a trade or business. As noted above, the expenses of a trader fund, other than interest expense, which may be limited under the investment interest expense limitation of IRC Sec. 163(d), are fully deductible. So, one could conclude that the interest expense of a trader fund is now subject to the Sec. 163(j) trade or business limitation. However, under IRC Sec. 163(d), the interest expense of a trader fund is investment interest subject to the investment interest expense limitation. The business interest expense limitation is an entity level limitation (fund level) while, as explained above, the investment interest expense limitation is a partner level limitation (individual return). So which provision should apply?
IRC Sec. 163(j)(5) defines “business interest” for purposes of the new trade or business limitation as follows: “For purposes of this subsection, the term ‘business interest’ means any interest paid or accrued on indebtedness properly allocable to a trade or business. Such term shall not include investment interest (within the meaning of subsection (d)).” Based on this definition it would seem clear that, in a trader fund scenario where IRC Sec. 163(d) (investment interest expense limitation) applies, neither the interest income generated nor the interest expense generated should be deemed to be business interest. While this may seem clear to us, the opposite was clear to Treasury in the preamble to the new proposed regulations. Treasury specifically applied the new rules under IRC Sec. 163(j) to trader partnerships. As mentioned above, in the trader fund context, the business interest expense limitation will first be applied at the partnership level1. They further concluded that once the interest is an allowable expense at the partnership level, the partner would still have to have enough investment income in order to actually deduct the interest (the investment interest expense limitation of IRC Sec. 163(d)). In addition, if interest expense is limited in the current year at the partnership level (excess business interest expense) once the excess business interest expense is allowed in a future year at the partner level2, the partner would still have to have enough investment income in that year in order to actually deduct the interest (the investment interest expense limitation of IRC Sec. 163(d)).
Clearly, Treasury seems to be ok with the notion of applying both IRC Sec. 163(j) at the partnership level and IRC Sec. 163(d) at the partner level , even though it is clear from the statute that the intent of Congress was that IRC Sec. 163(j) should not apply if IRC Sec. 163(d) is applicable. To add insult to injury, treasury is not even asking for comments on this. Instead this paragraph concludes that:
“The Treasury Department and the IRS have concluded that this is the result of the statutory rules contained in section 163(d)(4)(B) and (d)(5)(A)(ii) and, therefore, no additional rules are needed in regulations to reach this result.”
To further illustrate how these new rules burden a limited partner in a trader fund, consider this scenario: An investor owns an interest in two different trader funds. Fund 1 utilizes margin but has losses for the year and Fund 2 does not utilize margin and has income for the year. In the past, as long as Fund 2 generated enough investment income to shelter the interest expense generated by Fund 1, the interest expense of Fund 1 could offset as a deduction the investment income generated by Fund 2. If we followed the above preamble, in this scenario, the interest expense generated by Fund 1 would not be deductible in the current year regardless of the amount of investment income at the partner level because it is limited under IRC Sec. 163(j) to 30% of ATI. Fund 1 has zero ATI in the current year and so the interest expense is no longer deductible. In order for the interest expense of Fund 1 to be deductible in a future year, Fund 1 will have to generate “excess taxable income” and allocate such income to the limited partner. If in that future year the “interest expense” becomes allowable, the limited partner must then determine if it has earned enough investment income to deduct that interest expense under the IRC Sec. 163(d) limitation.
Thankfully, there is a separate exception under Section 163(j) called the “small business exception.”3 Congress did not want to burden a growing business with a limitation on the deductibility of its interest expense. The small business exception states that if an entity passes the “gross receipts” test of IRC Sec. 448(c), such business will be considered a small business and will not be subject to the business interest expense limitation. IRC Sec. 448(c) states that an entity that does not have aggregate gross receipts for the prior three years in excess of $25 million passes the gross receipts test. How a fund calculates gross receipts for this test is itself unclear, and one should contact his/her tax advisor to help with that determination.
As can be imagined, this seemingly innocuous piece of the preamble has caused an outcry in the financial services community, as it seems to be contrary to Congressional intent and to the four corners of the statute itself. Many letters have been and are being written to Treasury asking that the position be reconsidered. If that effort is successful, it will hopefully be “status quo” when it comes to the limited partners’ share of trader fund interest expense, such that the investment interest expense limitation will apply at the partner level and no business interest expense limitation will apply.
1 For federal tax purposes, a partnership does not pay tax. Instead, the income earned and expenses allowed at the partnership level flow up to the partner in a K-1 (partner level). Although a partnership seems to be the aggregate of its partners, there are some limitations that apply at the partnership level that treat the partnership as an entity on its own.
2 Section 163(j) has a mechanism in place that requires the partners in a partnership to track the excess business interest expense and to determine when that interest expense may be deductible for Sec. 163(j) purposes in a future year.
Asset Management Intelligence – Q1 2019
- What Are the Top Three Things U.S. Asset Managers Should Be Doing to Prepare for Brexit?
- Are You Ready for Your Annual Audit?
- Should I Market My Fund in Europe?
- The Impact of the New Interest Expense Limitation Rules on Trader Funds
- Alternative Investment Outlook for Q1 and Beyond
- Secondary Private Equity Market: Offering Flexibility Amid Brexit