New Proposed Regulations on the Treatment of Trader Fund Interest Expense Under IRC Section 163(j) -- A Personal Perspective
August 14, 2020
By Simcha David
In an article I wrote that was published in the Q1 2019 edition of EisnerAmper’s Engaging Alternatives, I wrote about the application of the IRC Sec. 163(j) business interest expense limitation rules to trader hedge funds. At the time, Treasury had taken a position that IRC Sec. 163(j) would apply to such funds even though this seemed contrary to the definition of business interest in IRC Sec. 163(j)(5). IRC Sec. 163(j)(5) defines business interest for purposes of IRC Sec. 163(j) 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))” (author’s bold). I explained that interest expense generated at a trader fund was already subject to the investment interest expense limitation of IRC Sec. 163(d) when allocated to a non-materially participating partner and, as such, it would seem contrary to the actual law to apply the IRC Sec. 163(j) limitation to trader funds. Treasury, in the preamble to the 2018 proposed regulations (which were finalized simultaneously with these current proposed regulations on July 27, 2020), argued that IRC Sec. 163(j) would first apply at the trader fund partnership level and, if the interest was not limited at the trader fund partnership level, it would be subject to the investment interest expense limitation of IRC Sec. 163(d) at the partner level. Treasury wrote: “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.”
I argued that this result seemed to be contrary to the actual wording of the law and contrary to the purpose of the bolded language above. It seemed clear to me that Congress did not want both IRC Secs. 163(j) and 163(d) to apply to the same interest expense. While I held strong belief that I was correct, it was clear that Treasury disagreed and so every trader fund tax return with interest expense was subjected to an IRC Sec 163(j) analysis. Two tax return filing seasons later, we may have finally been vindicated. In the preamble to the new proposed regulations addressing the comments of practitioners that Treasury’s initial application was inconsistent with the wording above, Treasury agreed: “After considering the comments, Treasury Department and the IRS have concluded that the approach described in the preamble to the 2018 Proposed Regulations is inconsistent with the statutory language and intent of section 163(j)(5) because the second sentence of section 163(j)(5) specifically states that BIE [business interest expense] shall not include investment interest expense.” One simple beautiful sentence and I actually feel vindicated. As I argued in the earlier article, it is not the place of Treasury to write new law but rather to explain and interpret the law through regulations.
The preamble continues with three possible ways to treat trader fund interest expense in the future. The proposed regulations settle on the following methodology: To the extent that interest expense of a trader fund is allocated to a non-materially participating partner (in the hedge fund context that would usually be everyone except for the general partner (GP), such interest expense would be excluded from the IRC Sec. 163(j) calculation and not be subject at all to the IRC Sec. 163(j) limitation, but would instead be subject to the IRC Sec. 163(d) investment interest expense limitation as was the case prior to the enactment of IRC Sec. 163(j). To the extent such interest expense is allocated to a materially participating partner, such as the GP, the interest expense would be subject to the IRC Sec. 163(j) limitation. The reason a GP is different is because the investment interest expense limitation of IRC Sec. 163(d) does not apply to the GP as the GP materially participates in the trading of the fund. Further, in determining the “adjusted taxable income” of the trader fund for purposes of calculating the GP’s IRC Sec. 163(j) limitation, only the amounts of income and expense allocated to the GP would be included in the calculation. Presumably the small business exception limitation (IRC Sec. 163(j)(3)) would still need to be taken into account by looking at the gross receipts of the entire trader partnership. If the members of the GP who materially participate in the trade or business of the trading fund also have limited partner accounts in the trading fund, is the interest expense allocated to those limited partner accounts subject to IRC Sec. 163(j)? I believe the answer is yes. IRC Sec. 163(d)(5)(A)(ii), in defining “property held for investment,” does not distinguish between a limited partner and a general partner but rather distinguishes between a materially participating partner and non-materially participating partner.
Thankfully, taxpayers may already rely on these new proposed regulations if they choose to do so, which will bring relief to what has become an extremely burdensome calculation for tax practitioners and a difficult double limitation for many investors. In actuality, a taxpayer may apply these proposed regulations for any tax year beginning after December 31, 2017. Under the new BBA partnership audit rules, partnerships are technically not allowed to file amended returns. Instead they would have to file an administrative adjustment request (“AAR”), which gives the benefit of a prior year change only prospectively.
However, due to the coronavirus pandemic, the IRS in Revenue Procedure 2020-23 has actually allowed partnerships to file amended returns for tax years beginning in 2018 and 2019. While the purpose of the revenue procedure was to give partnerships the opportunity to take advantage of the CARES Act provisions that were retroactive to the 2018 tax year, the revenue procedure allows a partnership to file an amended return to take advantage of any change allowed under the IRC. This is great news for trader funds that may have been severely limited in their interest expense deduction in a prior year due to the application of IRC Sec. 163(j). Funds may want to amend prior-year returns to take advantage of the new proposed regulations. While not clear in the proposed regulations, if a trader fund applies the new rules prospectively, the prior excess business interest expense that had not yet been eligible for deduction should probably be deemed paid in the tax year within which the taxpayer begins to apply these new proposed regulations.