Both the House of Representatives and the Senate have proposed their own versions of tax reform (the “House Proposal” and “Senate Proposal”, respectively, and together, the “Proposals”) which will drastically change the current U.S. federal income tax structure and the Internal Revenue Code of 1986, as amended (the “Code”). Both Proposals will be effective for tax years beginning after December 31, 2017, though certain provisions have a later effective date. This Alert highlights the impact the Proposals will have on private equity and discuss the following topics:
- Corporate and Individual Tax Rates
- Tax Rates on Pass-Through Income
- Interest Deductibility
- State and Local Income Taxes
- Carried Interest
- Source of Gains Upon Transfer of Partnership Interest
- State Pension Plans
- Self-Employment Tax
Corporate and Individual Tax Rates
The current corporate tax rate is graduated, with a maximum marginal rate of 35 percent. The House Proposal eliminates the graduated tax rate structure and will apply a flat 20 percent rate, except in the case of personal service corporations, which would be subject to a 25 percent rate. The Senate Proposal also eliminates the graduated tax rate structure, and will apply a flat 20 percent rate for all corporations. The corporate tax rate of the Senate Proposal will be effective for tax years beginning after December 31, 2018.
Under current law, there are seven ordinary income tax brackets at 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent and 39.6 percent. The Senate Proposal changes these rates to 10 percent, 12 percent, 22.5 percent, 25 percent, 32.5 percent, 35 percent and 38.5 percent.
The House Proposal collapses the tax rate structure into four brackets at 12 percent, 25 percent, 35 percent and 39.6 percent. The House Proposal also creates a new tax bracket for owners of pass-through entities. A 9 percent tax rate would apply to the first $37,500 of an individual’s share ($75,000 if filing jointly) of active business income from a pass-through entity. This rate would gradually phase out for individuals who have greater than $75,000 in taxable income ($150,000 if filing jointly), and is fully phased out at $112,500 ($250,000 if filing jointly). The 9 percent rate will be gradually phased in over the next five years.
Tax Rates on Pass-Through Income
Under current law, owners of a pass-through entity report net income on their individual tax returns, which is subject to ordinary tax rates (as discussed above under “Corporate and Individual Tax Rates”). Under the House Proposal, a portion of net income that is distributed by the pass-through entity to the partners may be treated as “qualified business income,” and is subject to a maximum tax rate of 25 percent rather than ordinary income tax rates. For tax years that straddle December 31, 2017, the reduced rate will apply proportionately for the period after December 31, 2017.
“Qualified business income” under the House Proposal is meant to include all passive business activity and certain active business activity, reduced by carryover business losses and certain current year net business losses. It does not include income subject to preferential rates (e.g., capital gains or losses, dividends, interest and other generally passive types of income). The remaining portion of net business income that is not qualified business income will be taxed as ordinary income.
Under the Senate Proposal, an individual may generally deduct 17.4 percent of domestic qualified business income received from a pass-through entity. The amount of the deduction for qualified business income received from a partnership is limited to 50 percent of the W-2 wages of the individual. If the amount of qualified business income is less than zero, the amount of the loss will be deducted from the individual’s qualified business income in the following tax year. The deduction is phased out for certain income thresholds ($500,000 for married couples under the bill that passed the Senate Finance Committee).
“Qualified business income” under the Senate Proposal generally means the net amount of domestic income generated from the taxpayer’s business. It does not include amounts distributed to a partner who is acting outside of his or her capacity as a partner, or amounts that are guaranteed payments for services actually rendered to a partnership to the extent that the payment is in the nature of compensation for those services.
Individual investors in private equity funds that invest in portfolio companies organized as pass-through entities are generally eligible for the 25 percent tax rate under the House Proposal and the 17.4 percent deduction on qualified business income with respect to such investments. However, income received by individuals for their involvement in the management of the fund will not be eligible for the preferential rates.
Under current law, a business is generally allowed to deduct all interest paid or accrued in the taxable year, subject to limitations. Under the House Proposal, “business interest” deductions are limited to the sum of “business interest income” plus 30 percent of the “adjusted taxable income” of the business. The amount of interest expense in excess of 30 percent of the business’s adjusted taxable income may be carried forward up to five years after the interest was paid or accrued, and will be deducted on a first-in, first-out basis.
“Adjusted taxable income” under the House Proposal means the taxable income of the taxpayer without regard to: (i) any item of income or loss not properly allocable to a trade or business; (ii) any business interest or business interest income; (iii) any net operating loss deduction; and (iv) any deduction for depreciation or amortization.
Although the business interest deduction limitation is determined at the entity level, special rules allow for the partners of a partnership to use any unused interest expense deductions. If the amount of business interest deductions is below the 30 percent cap, the limit on the amount allowed as a business interest deduction is increased by a partner’s distributive share of the partnership’s unused interest expense deductions. There are corresponding rules to prevent double counting of such unused interest expense deductions.
The Senate Proposal is generally the same as the House Proposal, except that “adjusted taxable income” includes the 17.4 percent pass-through deduction (as discussed under “Tax Rates on Pass-Through Income”), and does not include depreciation and amortization. The Senate Proposal also allows for interest expense deductions to be carried forward indefinitely.
The limitation on interest expense deductions will increase the cost of capital, particularly in the private equity context, where a significant amount of debt is often used to acquire a target company. This may cause private equity funds to reconsider how they finance acquisitions to avoid the payment of interest.
State and Local Taxes
Under current law, amounts paid for state and local income taxes and property taxes are fully deductible for both individuals and corporations on their U.S. federal taxes. The House Proposal repeals the state and local income tax deduction for individual taxpayers, and limits the deductibility for state and local property taxes to $10,000 ($5,000 for a married individual filing separately). Corporations will be able to continue to take these deductions.
Initially, the House Proposal was interpreted as allowing individual owners of pass-through entities to take such deductions. However, the House Ways and Means Committee Chairman later clarified that state and local income taxes paid by individual owners of pass-through entities would not be eligible for such deductions.
The Senate Proposal also repeals the state and local income tax deduction for individual taxpayers, but not for corporations. Unlike the House Proposal, the Senate Proposal eliminates the state and local property tax deduction entirely. There is still uncertainty at this time whether this provision applies to owners of pass-through entities.
This remains a controversial issue in both Proposals, and is likely to change before any tax bill is enacted.
Under current law, profits paid to private equity fund managers that are generated from investments (commonly referred to as “carried interest”) held for more than one year are taxed at capital gains rates. Under the House Proposal, an investment must be held for more than three years to receive capital gains treatment. Such profits attributable to gains on investments held for three years or less will be taxed as short-term capital gains (which is taxed as ordinary income).
Moreover, to receive capital gains treatment, the gain must be derived from an “applicable partnership interest,” which is generally intended to account for a profits interest of a partnership. An applicable partnership interest includes any interest held in connection with the taxpayer’s substantial services in a trade or business that involves raising and returning capital and investing or trading in securities, commodities and/or certain other assets (which is generally intended to include a portfolio management business).
The Senate Proposal has no proposed change to carried interest.
The House Proposal will likely not affect private equity funds that typically invest in assets long term. However, this may disproportionately affect activist funds, which generally hold assets for one or two years. Asset managers that have investment horizons of less than three years should consider how the House Proposal will apply to their individual circumstances.
Source of Gain Upon Transfer of Partnership Interest
As held by the recent U.S. Tax Court case Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3 from July 2017, the sale of a non-“FIRPTA” partnership interest generally will not be taxable to a foreign holder, even if the partnership engages in a U.S. trade or business. We have previously written about this case, which you can read more about here.
Under the Senate Proposal, gain or loss upon such a sale generally would be treated as effectively connected with a U.S. trade or business. This provision effectively overrules Grecian Magnesite. As a result, foreign investors will likely continue to use “blocker” entities to avoid effectively connected income in the private equity context.
The House Proposal does not have any provision similar to the Senate Proposal described above.
State Pension Plans
Under current law, certain organizations are exempt from U.S. federal income tax. However, even if an organization is otherwise deemed to be exempt from U.S. federal income tax, it may still be required to pay tax on unrelated business income that is not substantially related to the performance of the organization’s tax-exempt status (commonly known as unrelated business taxable income, or “UBTI”). State and local entities (including state pension plans) that are exempt from U.S. federal income tax are not usually subject to the UBTI rules.
Under the House Proposal, all entities exempt from U.S. federal tax under Code Section 501(a), regardless of the entity’s exemption under any other provision of the Code, will be subject to the UBTI rules. This means that state and local entities that are tax exempt under both Section 501(a) and 115(1) as a government-sponsored entity will be subject to the UBTI rules. The Senate Proposal does not change current law.
Under current law, a limited partner’s share of income received from a partnership is excepted from self-employment tax. The initial House Proposal repealed this exception, and instead provided that a limited partner’s “labor percentage” of trade or business income is subject to self-employment tax. However, the second amendment to the House Proposal on November 9 returns to the current law. The Senate Proposal does not change current law.
Below is a summary of the Proposals and how they differ from current law:
|Current Law||House Proposal||Senate Proposal|
|Corporate Tax Rate||35%||20%, 25% for personal service corporations.||20%, effective for tax years beginning after December 31, 2018.|
|Individual Tax Rate||Brackets at: 10%, 15%, 25%, 28%, 33%, 35% and 39.6%||Brackets at: 12%, 25%, 35% and 39.6%An additional bracket at 9% for pass-through income, phased out at certain income thresholds; phased in over five years.||Brackets at: 10%, 12%, 22.5%, 25%, 32.5%, 35% and 38.5%.|
|Pass-Through Tax Rate||Owners of pass-through entities are taxed on income at individual rates.||Certain "qualified business income" is taxed at 25%. Remaining net business income is taxed as ordinary income.||Certain "qualified business income" is allowed a 17.4% deduction. The deduction is limited to 50% of W-2 wages.|
|Interest Deductibility||Businesses are allowed a full deduction for interest paid.||Interest expense deduction is limited to business interest income plus 30% of adjusted taxable income before net operating loss deductions and depreciation and amortization.||Interest expense deduction is limited to business interest income plus adjusted taxable income before net operating loss deductions (excluding depreciation and amortization) and 17.4% pass-through deduction.|
|SALT||Amounts paid SALT are fully deductible.||For individuals (including owners of pass-through entity), state and local income taxes are not deductible. Certain amounts of state and local property taxes are deductible.No change for corporate deductions.||For individuals, state and local income taxes are not deductible. Certain amounts of state and local property taxes are deductible. It is unclear if this applies to the owners of a pass-through entity. No change for corporate deductions.|
|Carried Interest||Profits interest paid to fund managers is taxed as capital gain if investment is held for more than one year.||Investments must be held for more than three years to receive capital gains treatment.||No proposed change from current law.|
|Source of Gains||The sale of a non-"FIRPTA" partnership interest generally will not be taxable to a foreign holder, even if the partnership engages in a U.S. trade or business (Grecia Magnesite).||Gain or loss on the sale of a partnership interest by a foreign person will not be subject to U.S. tax.||Gain or loss on the sale of a partnership interest by a foreign person will be ECI to the extent that the foreign person would have had effectively connected gain or loss had the partnership sold all of its assets.|
|State Pension Plans||State pensions do not pay UBTI.||All entities from U.S. federal tax under Section 501(a) are subject to the UBTI rules.||No proposed change from current law.|