On November 2, 2017, Republicans in the House of Representatives introduced the Tax Cuts and Jobs Act of 20171 (the “House Bill”). The Ways and Means Committee has reviewed the House Bill and offered several amendments. The House of Representatives may vote on the House Bill as early as the week of November 13, 2017. Additionally, Senate Republicans released a separate tax reform proposal on November 9, 2017; a client alert regarding that proposal is forthcoming.
Most notably, the House Bill consolidates the existing seven income tax brackets for individuals into four brackets, increases the income threshold for the 39.6% marginal tax rate to $1 million for married-filing-joint taxpayers,2 and also eliminates the alternative minimum tax. The House Bill reduces the corporate tax rate from 35% to 20% (25% in the case of personal service corporations).
This Memorandum highlights aspects of the House Bill that are of particular salience to our Investment Management, Trusts & Estates and Family Office clients. Section I of this Memorandum describes certain proposals in the House Bill that affect investment managers. Section II of this Memorandum describes certain proposals that affect investment funds. Section III describes changes to the estate and gift tax.
I. Proposals Affecting Investment Managers and Management Companies
Three-Year Holding Period for Carried Interest
- Under current law, investors must hold capital assets for more than 12 months to obtain long-term capital gains tax treatment.
- Under the House Bill, taxpayers who received partnership interests in connection with the performance of substantial services can treat 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) and qualified dividend income (which is taxed at long-term capital gains rates regardless of holding period).
Taxation of Pass-Through Entities
- Partnerships, limited liability companies, and S corporations are not subject to Federal income taxation on their income, but the owners of such entities include their allocable share of income from these types of entities on their Federal income tax return.
- Under the proposed bill, 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.
Repeal of LP Exception to Self-Employment Tax
- The bill repeals the exception to self-employment tax for limited partners.
- This provision targets partnership structures that mitigate self-employment tax exposure of the partners.
Disallowance of Deductions for Entertainment Expenses
- Currently, taxpayers may deduct up to 50 percent of expenses related to entertainment, amusement or recreation activities if the taxpayer establishes that the expense was directly related to the active conduct of the taxpayer’s trade or business.
- Under the proposed bill, 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.
Disallowance of Deduction for State and Local Taxes
- Under the House Bill, state and local real estate taxes would continue to be deductible up to $10,000.
- State and local income or sales taxes would generally not be deductible under the House Bill.
II. Proposals Affecting Fund Structures
Interest Deduction Limitations
- Under the proposed bill, “business interest expense” will be deductible only to the extent of “business interest income” plus 30% of adjusted taxable income.3
- If the taxpayer claiming interest expense deductions is a pass-through entity, the determination of disallowing 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.
Public Pension Plans Subject to UBTI
- Under the House Bill, 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).
Foreign Insurance Company PFIC Changes
- The House Bill 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 offshore reinsurance companies as PFICs, which would reduce the attractiveness of such investments to U.S. taxable investors.
III. Estate and Gift Tax Changes
Increase in Credit against Estate, Gift and Generation-Skipping Transfer Taxes
- The House Bill proposes that, effective January 1, 2018, individual estates valued at less than $10,000,000 in 2011 dollars (and $20,000,000 for the estates of married couples), and cumulative lifetime gifts of less than $10,000,000 in 2011 dollars (and $20,000,000 for married couples), will not be subject to estate, gift, or generation-skipping transfer tax.
- These amounts would be indexed for inflation; under the proposed Bill, the 2018 exclusion amount for gift and estate taxes is expected to be $11.2 million for individuals and $22.4 million for married couples.
Repeal of Estate and Generation-Skipping Transfer Taxes
- Under the proposed bill, as of January 1, 2024, the estate and generation-skipping transfer taxes would be repealed.
Decrease in Maximum Gift Tax Rate
- Currently, the maximum gift tax rate is 40 percent.
- Under the proposed bill, as of January 1, 2024, the maximum gift tax rate would be decreased to 35 percent for gifts in excess of the cumulative lifetime gift tax exemption.
Changes in Estate Tax Rules Regarding Non-Citizen Spouses
- Under current law, transfers at death to a surviving spouse who is not a U.S. citizen are not eligible for the estate tax unlimited marital deduction, unless such transfers are made to qualified domestic trusts (“QDOTs”) for the benefit of the surviving spouse.
- Distributions from the QDOT during the lifetime of the surviving spouse, and the value of the property remaining in the QDOT on the date of death of the surviving spouse, are subject to estate tax.
- Under the proposed bill, for individuals dying on or before December 31, 2023, QDOT distributions made after December 31, 2033 would not be subject to estate tax, and the value of the property remaining in a QDOT on the date of death of the surviving spouse would not be subject to estate tax if the surviving spouse dies after December 31, 2023.
- For individuals dying on or after January 1, 2024, the QDOT rules would no longer be relevant, due to the estate tax repeal.
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.
1 H.R. 1.
2 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.
3 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.