Posted by & filed under Baker Tilly Tax Tips, Hedge Fund Assets.

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Hedge Connection is pleased to bring our readers Tax Tips, a series of articles by the full service accounting and advisory firm, Baker Tilly. Authored by Jean Paul Schwarz.

The hedge fund, private equity and alternative asset industries could be impacted by a number of tax provisions proposed in the House Ways and Means Committee’s comprehensive tax reform bill called the “Tax Cuts and Job Act” released on Nov. 2, 2017. The act as it stands currently, however, does not include any changes to the taxation of financial products.

Key provisions: Management companies

Tax rates

  • A reduced rate of 25 percent will apply to pass-through business entities including partnerships and S corporations with restrictions. The 25 percent rate applies only to income included in the “capital percentage” of business income. The 25 percent rate would apply to all business income for passive investors in the management company.
  • The default capital rate for professional service entities such as lawyers and accountants is zero and, as such, they will not be entitled to reduced rates. Although financial service entities are also included in the definition of professional service entities, it is not fully clear if management companies will fall under this definition and not be entitled to the reduced rates. 
  • Under the proposal, non-professional service entities will treat 30 percent of their income as from “capital” and the remaining 70 percent of income as from “labor.” 

Carried interest / incentive allocation / carve-out / profit reallocation

  • The original bill was silent as to carried interests. An amendment proposed on Nov. 6 includes a change to the taxation of carried interests. This amendment imposes a three year holding period to be eligible for long term capital gain tax rates. Neither the original bill nor the amendment touch on the benefits of receiving a share of qualified dividends or unrealized gains.
  • The recharacterization rule applies to the performance of substantial services related to securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivatives, and partnership interests. The proposal includes an exception for capital interests.

Self-employment tax

  • The proposal repeals the exclusion from self-employment tax for limited partners in a limited partnership. Additionally, S-Corporation shareholders will be subject to self-employment on their income earned. Rental real estate income would also become subject to self-employment tax.

Deferred compensation

  • Employees will now be taxed on compensation as soon as there is no substantial risk of forfeiture with regard to compensation. A covenant not to compete will not be treated as not creating substantial risk of forfeiture.

Capital expensing

  • Qualified property acquired and placed in service after Sept. 27, 2017 and before Jan. 1, 2023 will be able to be expensed in full. Qualified property used in real estate trades or businesses, and certain public utilities, is not eligible for 100 percent expensing. 

Self-created property

  • Self-created property such as patents, inventions and trading algorithms will no longer qualify as capital assets.

Entertainment

  • Deductibility of entertainment expenses will be eliminated.

Like-kind exchanges

  • Like-kind exchanges for all types of property excluding real property are disallowed. Aircraft and art work will no longer be eligible for like-kind exchanges.

Technical terminations

  • The rules for technical terminations are eliminated.

Key provisions: Hedge funds

Rate reductions

  • A reduced rates of 25 percent will apply to business income from pass-through business entities including partnerships and S corporations with restrictions. Generally, hedge funds are not engaged in a trade or business and will likely not be subject to the reduced 25 percent rate.

Carried interest / incentive allocation / carve-out / profit reallocation

  • As noted in the section above for management companies, the original bill was silent as to carried interests, however, an amendment proposed on Nov. 6 includes a change to the taxation of carried interests. This amendment imposes a three year holding period to be eligible for long term capital gain tax rates. Neither the original bill nor the amendment touch on the benefits of receiving a share of qualified dividends or unrealized gains.
  • The recharacterization rule applies to the performance of substantial services related to securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivatives, and partnership interests. The proposal includes an exception for capital interests.

Interest expense deduction

  • Section 163 (j) Modifications: Effective for tax years beginning after 2017, net interest expense will be limited to 30 percent of the business’s adjusted taxable income. Interest expense will need to be related to a business’s active trade or business. Disallowed interest can be carried forward 5 years. This provision will not alter the treatment of interest treated as investment interest expense.
  • Small businesses with less than $25 million of gross receipts are exempt from the new rules.

Unrelated business income tax (UBIT)

  • The new proposal clarifies that all entities exempt from tax under section 501(a) would be subject to the UBIT rules including public pension plans. 

University endowments

  • There is a 1.4 percent excise tax on private universities with assets exceeding $100,000 per student. Amendments have been proposed to increase the threshold to $250,000 per student.

Passive foreign investment company (PFIC)

  • Foreign insurance companies can now be classified as a PFIC. The exclusion is repealed.

Key provisions: Private equity funds

Rate reductions

  • Reduced rates of 25 percent will apply to business income from pass-through business entities including partnerships and S corporations with restrictions. Generally, private equity funds are not engaged in a trade or business and will likely not be subject to the reduced 25 percent rate.

Carried interest / incentive allocation / carve-out / profit reallocation

  • As noted above, the original bill was silent as to carried interests. An amendment proposed on Nov. 6 includes a change to the taxation of carried interests imposing a three year holding period to be eligible for long term capital gain tax rates. Neither the original bill nor the amendment touch on the benefits of receiving a share of qualified dividends or unrealized gains.
  • The recharacterization rule applies to the performance of substantial services related to securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivatives, partnership interests. The proposal includes an exception for capital interests.

Interest expense deduction

  • Section 163 (j) Modifications: Effective for tax years beginning after 2017, net interest expense will be limited to 30 percent of the business’s adjusted taxable income. Interest expense will need to be related to a business’s active trade or business. Disallowed interest can be carried forward 5 years. This provision will not alter the treatment of interest treated as investment interest expense.
  • Small businesses with less than $25 million of gross receipts are exempt from the new rules.

Unrelated business income tax (UBIT)

  • The new proposal clarifies that all entities exempt from tax under section 501(a) would be subject to the UBIT rules including public pension plans. 

University endowments

  • There is a 1.4 percent excise tax on private universities with assets exceeding $100,000 per student. Amendments have been proposed to increase the threshold to $250,000 per student.

Passive foreign investment company (PFIC)

  • Foreign insurance companies can now be classified as a PFIC. The exclusion is repealed.

Corporations

  • Corporate tax rates are reduced to a flat 20 percent starting in 2018. Corporations treated as personal service corporations (PSCs) will be subject to a flat 25 percent rate.
  • Corporate Alternative Minimum Tax (AMT) is repealed. There is some ability to take unused AMT credits in the future. 
  • Net operating losses will be limited to 90 percent of taxable income. Carryback of NOL will be eliminated except for a one-time one year in which small businesses and farms will be able to utilize it to the extent of certain casualty and disaster losses. Unused amounts will be able to be carried forward indefinitely.
  • Many tax credits, including the work opportunity tax credit, the employer-provided child-care credit, and certain energy-related credits, are eliminated. The research and development credit and low-income housing credit remain.

International

  • The U.S. would change to a territorial system with a participation exemption regime. Foreign-sourced dividends received by a U.S corporation which owns more than a 10 percent interest in a foreign corporation would not be taxable.
  • A flat, one-time transitional tax of 12 percent will be imposed on a 10 percent or greater U.S. shareholder. It will be charged on the pro rata share of the foreign corporation’s accumulated earnings and profits held in cash and cash equivalents. This tax will be 5 percent for illiquid assets such as property, plant and equipment. This tax can be paid over 8 years if so elected.
  • U.S. shareholders of Controlled Foreign Corporations (CFC) are subjected to current US tax on 50 percent of aggregate net CFC income (excluding income from commodities, subpart F income, certain related-party payments, insurance income, etc.) in excess of extraordinary returns from tangible assets. Only 80 percent of the foreign taxes paid on the income are allowed be claimed as foreign tax credits. Meeting the ownership threshold for at least 30 days to be considered a CFC is now eliminated.  
  • All deductible payments (except for interest) paid to a foreign corporation will be subject to a 20 percent excise tax unless the foreign corporation receiving the payments elects to treat the payments as effectively connected income (ECI) and subjects the payments to U.S. taxation.

Key provisions: Fund managers and individual investors

Individual income tax rates

  • The new bill will compress the current seven tax brackets to four brackets: 12 percent, 25 percent, 25 percent, and 39.6 percent. However, the 12 percent rate is phased out for AGI over $1 million (single filers) / $1.2 million (joint filers)
  • Standard deductions would be increased to the following:
    • $24,400 for married filing jointly filers
    • $12,200 for single filers
  • Personal exemptions would be repealed
  • Alternative Minimum Tax would be repealed

Deductions

  • The cap on deductible home mortgage interest for new mortgages (after Nov. 2, 2017) would be reduced from $1,000,000 to $500,000. Second home mortgages would no longer receive any benefit for mortgage interest paid.
  • Deductions for state and local taxes will be eliminated.
  • Deductions for property taxes are capped at $10,000 and this amount is not indexed for future inflation.
  • The deduction limitation for charitable contributions will expand to 60 percent of adjusted gross income (AGI) from the previous 50 percent.
  • Deductions for medical expenses, casualty losses, tax preparation expenses, alimony payments and moving expenses, are eliminated.

Exclusion for gain on sale of principal residence

  • The $500,000 exclusion for a couple is retained. However, it is phased out dollar for dollar on the excess of the taxpayer’s average modified AGI over a three year period by which it exceeds $500,000. The holding period required is increased from 2 out of the last 5 years to 5 out of the last 8 years.

Net investment income tax (NII)

  • The 3.8 percent NII tax remains intact.

Estate and gift tax

  • The estate tax will be phased out in six years while the gift tax remains.
  • Starting in 2018, the estate/GST exemption doubles from $5.6 million to $11.2 million per person.
  • Estate/GST tax fully repealed after 2023; beneficiaries retain stepped-up basis.

Note that there are likely to be changes to the tax reform provisions in the coming weeks. We recommend speaking with your Baker Tilly tax advisor to understand how the changes may impact your organization. Our team will continue to follow the changes to the tax reform package and keep our clients updated.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.

 


Disclaimer

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

 

 

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