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Memorandum

House and Senate Tax Reform Bills

November 27, 2017

On November 16, 2017, the House of Representatives passed its final version of tax reform (the "House Bill"), and the Senate Finance Committee advanced its version of tax reform (the "Senate Bill") to the full chamber for consideration.  We previously published a Client Alert on tax reform that addressed a draft version of the House Bill; our previous Client Alert is available here. Below we revisit our previous analysis (noting changes between the draft and voted-on House Bills), and we compare the House Bill, as passed, with the Senate Bill.

Topic

House Bill

Senate Bill

Income Tax Brackets

Individual

  • Four brackets
  • The top marginal tax rate is 39.6% on income in excess of $1 million for married-filing-joint taxpayers (or $500,000 for single and married-filing separate taxpayers). 1
  • No reduction in number of brackets.
  • Top marginal tax rate is 38.5% on income in excess of $1 million for married-filing-joint taxpayers (or $500,000 for single and married-filing separate taxpayers).
  • These tax rates will expire after 2025 and will revert back to pre-2018 tax rates.

Corporate

  • Corporate tax rate reduced to 20% for tax years beginning in 2018 and later.
  • 25% tax rate applicable to personal service corporations.
  • Corporate tax rate reduced to 20% for tax years beginning in 2019 and later.
  • No separate rate for personal service corporations.

Proposals Affecting Investment Managers and Management Companies

Treatment of Carried Interest

  • Managers receiving an incentive allocation can treat underlying capital gains from the partnership as long-term capital gains, if the partnership held the asset for more than three years.
  • Carried interest from investments held for less than three years would be taxed at short-term capital gains rates (i.e., ordinary income rates).
  • It is unclear how this provision would apply to Section 1256 contracts (which are currently eligible for 60 percent long-term capital gains treatment on a mark-to-market basis irrespective of holding period) and qualified dividend income.
  • Substantially similar treatment under the Senate Bill.

Taxation of Pass-Through Entities

  • A portion (generally 30%) of net income allocated by a pass-through entity to an individual owner or shareholder would be treated as "business income" and therefore subject to a maximum 25% rate. The remaining amount of income would be taxed at ordinary individual income tax rates.
  • Investment managers, however, would likely not be eligible for the 25% rate. Taxpayers actively participating in a 'specified service activity,' which includes investing, trading, or dealing in securities, partnership interests, or commodities, may not directly benefit from this provision.
  • While not every pass-through entity (and its owners) will directly benefit from this provision, there may be opportunities available if this provision is enacted.
  • After 2017, individual taxpayers may deduct 17.4% of "qualified business income" from a pass-through entity. For this purpose, qualified business income may include REIT dividends that are not attributable to capital gains.
  • Investment managers, however, would likely not be eligible for the 17.4% deduction under the Senate Bill.
  • This deduction will expire after 2025.

Repeal of LP Exception to Self-Employment Tax

  • Since our previous Client Alert, the House Bill was amended and no longer repeals the exception to self-employment tax for limited partners.
  • Not addressed.

Entertainment Expense Deductions

  • No deduction would be allowed for entertainment, amusement or recreation activities, even if directly related to the active conduct of the taxpayer's trade or business.
  • Food and beverage expenses will continue to be deductible, subject to the existing 50-percent limitation.
  • Substantially similar treatment under the Senate Bill.

State and Local Taxes

  • State and local income or sales taxes would generally not be deductible under the House Bill.
  • However, state and local property taxes would continue to be deductible up to $10,000.
  • In addition, state and local taxes incurred in connection with a trade or business or certain investment activities will continue to be deductible.
  • State and local real estate taxes would not be deductible.
  • State and local property taxes on business assets would be deductible.
  • State and local income or sales taxes would not generally be deductible.
  • This provision is scheduled to sunset after 2025.

Proposals Affecting Fund Structures

Cost Basis Rules

  • Not addressed.
  • The tax basis of certain securities that are sold after 12/31/2017 will be determined on a "first-in, first-out" basis.
  • This rule would not apply to RICs and would not apply where the "average basis method" is available.

Sale of Partnership Interests

  • Not addressed.
  • Sales or exchanges of partnership interests by non-U.S. partners will be treated as ECI to the extent such partner would be allocated ECI on the hypothetical sale of all assets by the partnership.
  • This change would codify a 1991 IRS ruling that was recently overturned by the Tax Court.

Interest Deductibility

  • Business interest expense will be deductible only to the extent of business interest income plus 30% of adjusted taxable income.2
  • If the taxpayer claiming interest expense deductions is a pass-through entity, the determination of disallowed excess interest expense is made at the entity level (not at the level of the owner).
  • Businesses (and not owners in the case of pass-through entities) can carry forward interest for five taxable years.
  • This provision may increase the overall effective tax rate applicable to certain "leveraged blocker" structures used by private equity funds.
  • Substantially similar treatment under the Senate Bill.

Public Pension Plans Subject to UBTI

  • State and local government entities (such as state pension plans) would become subject to tax on their unrelated business taxable income ("UBTI"), imposing income tax liability on otherwise tax-exempt organizations that earn certain types of income or utilize borrowed funds to acquire assets.
  • If this provision were enacted, state and local governmental entities that invest in private funds or joint ventures would need to consider whether to structure (or restructure) their investments to avoid UBTI (e.g., by investing in an offshore feeder fund or a UBTI sensitive vehicle).
  • Not addressed.

Foreign Insurance Company PFIC Changes

  • Tightens requirements for foreign insurance companies to avoid being treated as passive foreign investment companies ("PFICs"), which could subject U.S. shareholders to unfavorable tax treatment.
  • The House Bill could treat certain offshore reinsurance companies as PFICs, which would reduce the attractiveness of such investments to U.S. taxable investors.
  • Substantially similar treatment under the Senate Bill.

Proposals Affecting Estate Planning

Increase in Credit against Estate, Gift and Generation-Skipping Transfer Taxes

  • As of January 1, 2018, the lifetime credit against gift, estate and generation-skipping transfer tax would double, to $11.2 million for individuals and $22.4 million for married couples.
  • These amounts are indexed for inflation in future years.
  • Same increase in credit as is included in House Bill.
  • The increase is only temporary, however, and ends as of January 1, 2026, when the credit returns to its current amount ($5,600,000 for individuals and $11,200,000 for married couples in 2018 under current law).

Repeal of Estate and Generation-Skipping Transfer Taxes

  • As of January 1, 2025, the estate and generation-skipping transfer taxes are repealed.3
  • Not addressed. 

Decrease in Maximum Gift Tax Rate

  • As of January 1, 2025, the maximum gift tax rate is reduced to 35 percent for gifts in excess of the cumulative lifetime gift tax exemption.
  • Not addressed.

Changes in Estate Tax Rules Regarding Non-Citizen Spouses

  • For individuals dying on or before December 31, 2024, qualified domestic trust ("QDOT") distributions made after December 31, 2034 are not subject to estate tax, and the value of the property remaining in a QDOT on the date of death of the surviving spouse is not subject to estate tax if the surviving spouse dies after December 31, 2024.
  • For individuals dying on or after January 1, 2025, the QDOT rules would no longer be relevant, due to the estate tax repeal.
  • Not addressed. 

Changes to Education Savings Rules

  • Taxpayers may make tax-free withdrawals of up to $10,000 per year from §529 plans to pay elementary or secondary school tuition expenses, and may make unlimited tax-free withdrawals to pay for books, supplies, and equipment in connection with an apprenticeship program registered and certified with the Secretary of Labor under the National Apprenticeship Act.
  • Taxpayers may not make new contributions (other than rollover contributions) to Coverdell Education Savings Accounts ("Coverdell accounts"), but may elect to make tax-free rollovers of their Coverdell accounts into §529 plans.
  • These changes would take effect as of January 1, 2018.
  • Not addressed.

 

Final Remarks

The proposals discussed herein may not be included in the bill that is ultimately enacted into law. We expect debate and a vote on the Senate Bill after Thanksgiving.  If the Senate Bill passes, members of each of the House of Representatives and the Senate will convene to resolve the differences between the House Bill and the Senate Bill.  If a single legislative proposal emerges from this conference committee, both chambers of Congress must pass that bill before it can be signed into law by the President. Therefore, any proposals discussed herein may not be reflected in any legislation enacted into law.

Seward & Kissel LLP actively monitors any changes to the legislative landscape and how such changes may impact the investment management industry and our clients' personal assets.  If you would like additional information about how the proposed tax reforms may affect your business or your personal wealth, please reach out to your Seward & Kissel contact or to anyone listed below.

For additional information on recent income tax proposals, please contact Ronald P. Cima (212-574-1471), Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Peter E. Pront (212-574-1221), Daniel C. Murphy (212-574-1210) or Brett R. Cotler (212-574-1269).

For additional information on recent tax developments with respect to private wealth planning, please contact Hume R. Steyer (212-574-1555), Scott M. Sambur (212-574-1445), David E. Stutzman (212-574-1219), Lori A. Sullivan (212-574-1406), Stacia C. Kroetz (212-574-1352), or Samuel F. Thomas (212-574-1609).

 

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1   The 39.6% rate applies to unmarried taxpayers and married-filing-separate taxpayers for income in excess of $500,000.  The House Bill also phases-out the 12% tax rate for incomes in excess of $1.2 million for married-filing-joint or $1 million for unmarried and married-filing-separate taxpayers.

2   Business interest expense and business interest income means interest that is properly allocable to a trade or business and does not include investment interest. Adjusted taxable income means the taxable income of a business calculated without regard to business interest income and expense, net operating losses, depreciation, amortization and depletion.

3   Since our previous Client Alert, an amendment to the House Bill was approved and the repeal of the estate and generation-skipping transfer taxes were pushed back one year, from 2024 to 2025.

 

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About Seward & Kissel LLP

 

Seward & Kissel LLP, founded in 1890, is a leading U.S. law firm with an international reputation for excellence. We have offices in New York City and Washington, D.C.

Our practice primarily focuses on corporate, litigation and restructuring/bankruptcy work for clients seeking legal expertise in the financial services, corporate finance and capital markets areas.  The Firm is particularly well known for its representation of major commercial banks, investment banking firms, investment advisers and related investment funds (including mutual funds and hedge funds), master servicers, servicers, investors, distressed trade brokers, liquidity providers, hedge fund administrators,  broker-dealers, institutional investors and transportation companies (particularly in the shipping area).
 

 

Notices

 

This memo may be considered attorney marketing and/or advertising. Prior results do not guarantee a similar outcome.  The information contained in this memo is for informational purposes only and is not intended and should not be considered to be legal advice on any subject matter.  As such, recipients of this memo, whether clients or otherwise, should not act or refrain from acting on the basis of any information included in this memo without seeking appropriate legal or other professional advice.  This information is presented without any warranty or representation as to its accuracy or completeness, or whether it reflects the most current legal developments.