Financial Services Insights – August 2014 – Impact of the Camp Tax Proposal (Tax Reform Act of 2014) on the Asset Management Industry
"In this world nothing can be said to be certain, except death and taxes."1 No question, taxes are a certainty. However, the computation and share of taxes that a person or entity needs to pay is another thing.
On February 26, Ways and Means Committee Chairman Dave Camp (R-MI) released his long-awaited plan to overhaul the tax code. Following are proposals of particular interest to the asset management community:
1. Ordinary income treatment in the case of partnership interests held in connection with performance of services (“carried interest” reform)
Certain partnership interests held in connection with the performance of services would be subject to a rule that characterizes a portion of any capital gains as ordinary income. An applicable partnership interest would include any interest transferred to a partner in connection with the performance of services by the partner, provided that the partnership is engaged in a trade or business conducted on a regular, continuous and substantial basis consisting of: (1) raising or returning capital, (2) identifying, investing in, or disposing of other trades or businesses, and (3) developing such trades or businesses.
Under the Proposal, a “recharacterization account balance” is established and partnership income is allocated to the general partner (“GP”) as ordinary income to the extent of that balance. The purpose of this is designed to approximate the compensation that the GP earns for services performed in managing the capital of the partnership.
As an example, if the GP has a 20% carried interest, then an amount equal to 20% of the contributed capital would go into the "recharacterization account balance." A stated interest rate (long-term “applicable federal rate” (“AFR”)2 + 10%) would be imputed based on this balance and would establish the amount of partnership income allocated to the GP that may be treated as ordinary. The remaining amount not treated as ordinary would get capital treatment.
2. Repeal of rules relating to guaranteed payments and liquidating distributions
The rules relating to guaranteed payments to partners would be repealed. Thus, payments received by partners would constitute either payments in their capacity as partners (i.e., part of their distributive shares of partnership income or loss) or in their capacity as non-partners (i.e., as an independent third party).
Observation:When a fund generates a loss but is still allocated a carry, the fund would still get an allocation and not be treated as a guaranteed payment.3
3. Mandatory adjustments to basis of partnership property in case of transfer of partnership interests
Mandatory adjustment of a partnership’s basis in partnership property would be required when a partner transfers his interest in a partnership or a partnership distributes property to a partner.
4. Treatment of certain derivatives (proposal to mark derivatives to market at ordinary income rates)
Derivative financial transactions generally would be marked to market at the end of each tax year, and any gains or losses from marking a derivative to market would be treated as ordinary income or loss. The provision would not apply to transactions that are properly identified as hedging transactions for tax purposes. For offsetting financial positions that include at least one derivative position, all positions in the straddle would be marked to market.
Observation: The Proposal retains the rule that the term “derivative” includes a contract with an embedded derivative component with an expansion related to certain debt instruments. Any substantial diminution of the risk of loss or opportunity for gain (i.e., straddle) would trigger the recognition of any built-in gain immediately and would defer the recognition of loss until the position is disposed of. There would also be a repeal of 60/40 treatment for IRC Section 1256 contracts4,5.
5. Current inclusion in income of market discount
Purchasers of bonds at a discount on the secondary market would be required to include the discount in taxable income over the post-purchase life of the bond, rather than only upon retirement of the bond or resale of the bond by the purchaser. Any loss that results from the retirement or resale of such a bond would be treated as an ordinary (rather than capital) loss to the extent of previously accrued market discount.
The Proposal would also limit taxable secondary market discount to an amount that approximates increases in interest rates since the loan was originally made. Specifically, the provision would limit this amount to the greater of (1) the original yield on the bond plus 5 percentage points, or (2) the long-term AFR plus 10 percentage points.
6. Use of FIFO for basis calculation on sale of securities
A taxpayer would no longer be able to specifically identify the securities that he/she sells for purposes of determining its cost basis. Instead, cost basis of any security sold after December 31, 2014, would be computed under a ‘first-in/first-out’ methodology.
7. Determination of net earnings from self-employment
The Self Employed Contributions Act (“SECA”) tax would be clarified to apply to general and limited partners of a partnership (including limited liability companies) as well as to shareholders of an S corporation to the extent of their distributive share of the entity’s income or loss (subject to certain exclusions under current law).
The Proposal would conform the treatment of earnings passed through to materially participating general partners, limited partners, limited liability company members, and S corporation shareholders for purposes of imposition of SECA taxes. In general, the Proposal would require partners and S corporation shareholders who materially participate in the activities of their “flow through” entity to treat 70% of their share of income and compensation as net earnings from self-employment. Non-materially participating partners or S corporation shareholders would not be subject to SECA on their share of earnings. The definition of material participation is the same as that for the passive activity rules found in IRC Section 469(h).
8. Application of Unincorporated Business Tax (“UBTI”) to state pension plans
All entities exempt from tax under IRC Section 501(a), notwithstanding the entity’s exemption under any other provision of the code, would be subject to the UBTI rules.
As noted above, the intent of the Proposal is to simplify the tax code and more fairly apportion the tax burden. The last major overhaul of the tax code occurred in 1986. “A tax that places significantly different burdens on taxpayers in similar economic circumstances is not fair. For example, if two similar families have the same income, they should ordinarily pay roughly the same amount of income tax, regardless of the sources or uses of that income.”6 While the likelihood of the enactment of the current Proposal is remote, it makes a substantial stride in framing possible future changes in the code and furthering the objective to simplify it.
Questions? You can contact David Helprin, a director at EisnerAmper, at 212.891.6852.
1 Benjamin Franklin in a letter to Jean-Baptiste Leroy, 1789, which was re-printed in The Works of Benjamin Franklin, 1817
2 AFR is defined as: rates published monthly by the IRS for various federal income tax purposes. Every month, the IRS publishes these rates in accordance with IRC Section 1274(d)
3 Under current IRC Section 707(c), an allocation to a partner not "out of income" is treated as a guaranteed payment
4 IRC Section 1256 contracts are defined as: any regulated futures contract, any foreign currency contract, any nonequity option, any dealer equity option and any dealer securities futures contract.
5 IRC Section 1256(a)(3) - any gain or loss with respect to a section 1256 contract shall be treated as–
- 1256(a)(3)(A) - short-term capital gain or loss, to the extent of 40 percent of such gain or loss, and
- 1256(a)(3)(B) - long-term capital gain or loss, to the extent of 60 percent of such gain or loss
6 Tax Reform report of the Treasury Department to President Ronald Reagan, November 1984
Financial Services Insights – August 2014