Spicer Jeffries wants our clients to be aware of the following legislation that has direct effects on Fund Managers:
1. CARRIED INTEREST – Incentive Allocation
New Holding Period Requirement
In general, the receipt of a capital interest for services provided to a partnership results in taxable compensation for the recipient. However, under a safe harbor rule, the receipt of a profits interest in exchange for services provided is not a taxable event to the recipient if the profits interest entitles the holder to share only in gains and profits generated after the date of issuance (and certain other requirements are met).
Typically, hedge fund managers guide the investment strategy and act as general partners to an investment partnership, while outside investors act as limited partners. Fund managers are compensated in two ways. First, to the extent that they invest their own capital in the funds, they share in the appreciation of fund assets. Second, they charge the outside investors two kinds of annual “performance” fees: a percentage of total fund assets, typically 2%, and a percentage of the fund’s earnings, typically 20%, respectively. The 20% profits interest is often carried over from year to year until a cash payment is made, usually following the closing out of an investment. This is called a “carried interest.”
Under pre-Act law, carried interests were taxed in the hands of the taxpayer (i.e., the fund manager) at favorable capital gain rates instead of as ordinary income.
New law.Effective for tax years beginning after Dec. 31, 2017, the Act effectively imposes a 3-year holding period requirement in order for certain partnership interests received in connection with the performance of services to be taxed as long-term capital gain. (Code Sec. 1061, “Partnership Interests Held in Connection with Performance of Services,” added by Act Sec. 13309(a)) If the 3-year holding period is not met with respect to an applicable partnership interest held by the taxpayer, the taxpayer’s gain will be treated as short-term gain taxed at ordinary income rates. (Code Sec. 1061(a))
Fund managers should consider, depending on their specific facts and circumstances, converting part of the GP interest to an LP interest. The new law potentially may cause the GP’s capital account balance to also be subject to the same 3-year limitation as applies to the carried interest itself. There is risk under the new rules that this would not work and the new LP interest would be traced back to the carried interest and still be subject to the new rules.
New Deduction for Pass-Through Income – Net Management Fees
Under pre-Act law, the net income of these pass-through businesses— sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations—was not subject to an entity-level tax and was instead reported by the owners or shareholders on their individual income tax returns. Thus, the income was effectively subject to individual income tax rates.
New law. Generally for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, the Act adds a new section, Code Sec. 199A, “Qualified Business Income,” under which a non-corporate taxpayer, including a trust or estate, who has qualified business income (QBI) from a partnership, S corporation, or sole proprietorship is allowed to deduct:
(1) the lesser of: (a) the “combined qualified business income amount” of the taxpayer, or (b) 20% of the excess, if any, of the taxable income of the taxpayer for the tax year over the sum of net capital gain and the aggregate amount of the qualified cooperative dividends of the taxpayer for the tax year; plus
(2) the lesser of: (i) 20% of the aggregate amount of the qualified cooperative dividends of the taxpayer for the tax year, or (ii) taxable income (reduced by the net capital gain) of the taxpayer for the tax year. (Code Sec. 199A(a), as added by Act Sec. 11011)
The “combined qualified business income amount” means, for any tax year, an amount equal to: (i) the deductible amount for each qualified trade or business of the taxpayer (defined as 20% of the taxpayer’s QBI subject to the W-2 wage limitation; see below); plus (ii) 20% of the aggregate amount of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income of the taxpayer for the tax year. (Code Sec. 199A(b))
QBI is generally defined as the net amount of “qualified items of income, gain, deduction, and loss” relating to any qualified trade or business of the taxpayer. (Code Sec. 199A(c)(1), as added by Act Sec. 11011) For this purpose, qualified items of income, gain, deduction, and loss are items of income, gain, deduction, and loss to the extent these items are effectively connected with the conduct of a trade or business within the U.S. under Code Sec. 864(c) and included or allowed in determining taxable income for the year. If the net amount of qualified income, gain, deduction, and loss relating to qualified trade or businesses of the taxpayer for any tax year is less than zero, the amount is treated as a loss from a qualified trade or business in the succeeding tax year. (Code Sec. 199A(c)(2), as added by Act Sec. 11011) QBI does not include: certain investment items; reasonable compensation paid to the taxpayer by any qualified trade or business for services rendered with respect to the trade or business; any guaranteed payment to a partner for services to the business under Code Sec. 707(c); or a payment under Code Sec. 707(a) to a partner for services rendered with respect to the trade or business.
The 20% deduction is not allowed in computing adjusted gross income (AGI), but rather is allowed as a deduction reducing taxable income. (Code Sec. 62(a), as added by Act Sec. 11011(b))
Limitations. For pass-through entities, other than sole proprietorships, the deduction cannot exceed the greater of:
(1) 50% of the W-2 wages with respect to the qualified trade or business (“W-2 wage limit”), or
(2) the sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property.” Qualified property is defined in Code Sec. 199A(b)(6) as meaning tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year, which is used at any point during the tax year in the production of qualified business income, and the depreciable period for which has not ended before the close of the tax year.
The second limitation, which was newly added to the bill during Conference, apparently allows pass-through businesses to be eligible for the deduction on the basis of owning property that qualifies under the provision (e.g., real estate).
For a partnership or S corporation, each partner or shareholder is treated as having W-2 wages for the tax year in an amount equal to his or her allocable share of the W-2 wages of the entity for the tax year. A partner’s or shareholder’s allocable share of W-2 wages is determined in the same way as the partner’s or shareholder’s allocable share of wage expenses. For an S corporation, an allocable share is the shareholder’s pro rata share of an item. However, the W-2 wage limit begins phasing out in the case of a taxpayer with taxable income exceeding $315,000 for married individuals filing jointly ($157,500 for other individuals). The application of the W-2 wage limit is phased in for individuals with taxable income exceeding these thresholds, over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals). (Code Sec. 199A(b)(3), as added by Act Sec. 1101)
Thresholds and exclusions. The deduction does not apply to specified service businesses (i.e., trades or businesses described in Code Sec. 1202(e)(3)(A), but excluding engineering and architecture; and trades or businesses that involve the performance of services that consist of investment-type activities). However the service business limitation begins phasing out in the case of a taxpayer whose taxable income exceeds $315,000 for married individuals filing jointly ($157,500 for other individuals), both indexed for inflation after 2018. The benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for joint filers ($50,000 for other individuals). (Code Sec. 199A(d)) The deduction also does not apply to the trade or business of being an employee.
The new deduction for pass-through income is also available to specified agricultural or horticultural cooperatives, in an amount equal to the lesser of (i) 20% of the co-op’s taxable income for the tax year, or (ii) the greater of (a) 50% of the W-2 wages of the co-op with respect to its trade or business, or (b) or the sum of 25% of the W-2 wages of the cooperative with respect to its trade or business plus 2.5% of the unadjusted basis immediately after acquisition of qualified property of the cooperative. (Code Sec. 199A(g), as added by Act Sec. 11012)
3. Miscellaneous Itemized Deductions Suspended – Investor Expenses
Under pre-Act law, taxpayers were allowed to deduct certain miscellaneous itemized deductions to the extent they exceeded, in the aggregate, 2% of the taxpayer’s adjusted gross income.
New law. For tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, the deduction for miscellaneous itemized deductions that are subject to the 2% floor is suspended. (Code Sec. 67(g), as added by Act Sec. 11045)