On December 20, 2017, Congress passed tax reform legislation (the “Tax Act”). President Trump signed the Tax Act into law today. Most provisions take effect for tax years beginning after December 31, 2017.
This Memorandum updates our previous analysis of the House and Senate Tax Acts, and focuses particularly on the issues that are most relevant to our Investment Management, Trusts & Estates and Family Office clients. Seward and Kissel’s Trusts and Estates group has also reviewed the Tax Act and offered guidance on year-end planning. Section I of this Memorandum describes notable individual and corporate income tax changes. Section II describes certain provisions that affect investment managers. Section III describes certain provisions that affect investment funds.
I. General Individual and Corporate Income Tax Changes
Notable Individual Income Tax Changes
- For tax years beginning after December 31, 2017 and before January 1, 2026 the top marginal individual income tax rate is reduced to 37%. This rate applies to married taxpayer filing jointly on income in excess of $600,000 and to single taxpayers on income in excess of $500,000.
- Miscellaneous itemized deductions (including for investment expenses and tax preparer fees) will not be allowed for tax years 2018 through 2025.
- Taxpayers may deduct up to $10,000 for amounts paid to state and local governments for: (i) income or sales taxes; and (ii) property taxes. Taxpayers may be able to prepay a reasonable estimation of 2018 property taxes (but not income taxes) this year and claim a 2017 deduction.
- The exemption amounts for the individual alternative minimum tax (“AMT”) are increased to $70,300 for single filers and $109,400 for joint filers and will begin to phase out for those taxpayers at $500,000 and $1 million, respectively. This should result in far fewer taxpayers being subject to the AMT.
Notable Corporate Income Tax Changes
- The corporate income tax rate is reduced to 21%, and the corporate AMT is repealed.
- Interest expense deductibility is discussed below.
- New provisions provide for a modified territorial system of international taxation. This new regime repeals indirect foreign tax credits and allows U.S. corporations to claim a 100% dividends received deduction on the foreign source portion of dividends from 10%-owned foreign subsidiaries that are not PFICs.
- Foreign earnings of controlled foreign corporations (“CFCs”)1 accumulated after 1986 will be deemed to be repatriated to 10% U.S. shareholders of CFCs and will be subject to a 15.5% tax rate to the extent accumulated foreign earnings are held in cash or cash equivalents and an 8% rate to the extent held in illiquid assets as of December 31, 2017.
Deductions for dividends received are reduced to 50% in the case of less than 20%-owned subsidiaries and 65% in the case of at least 20%-owned subsidiaries.
- NOLs generated in tax years beginning after 2017 are limited to 80% of taxable income. Unused NOLs generated in tax years beginning after 2017 may be carried forward indefinitely and cannot be carried back. NOLs are not indexed for inflation.
- Various provisions of the Tax Act may allow for greater expensing or accelerated depreciation or amortization of certain capital expenditures than is permitted under current law.
II. Provisions Affecting Investment Managers and Management Companies
Three-Year Holding Period for Carried Interest
- Under the Tax Act, taxpayers who received partnership interests in connection with the performance of substantial services can treat capital gains from the sale of assets by the partnership as long-term capital gains only if the partnership held such assets for more than three years.
- Carried interest from investments held for three years or less would be taxed at short-term capital gains rates (i.e., ordinary income rates).
- For more information regarding changes to the tax treatment of carried interest, see our Memorandum on the subject.2
Taxation of Qualified Business Income
- For tax years beginning after December 31, 2017 and before January 1, 2026, non-corporate taxpayers may deduct up to 20% of “qualified business income” (“QBI”), subject to certain limitations.
- QBI generally includes all domestic business income from a “qualified trade or business.”
- However, certain services businesses, including most investment managers, are excluded from the definition of a qualified trade or business. Therefore, investment managers are not likely to be eligible to claim this deduction.
Disallowance of Deductions for Entertainment Expenses
- The Tax Act disallows deductions for entertainment, amusement or recreation activities, even if such activities are directly related to the active conduct of the taxpayer’s trade or business.
- Taxpayers may still deduct 50 percent of food and beverage expenses associated with operating their trade or business.
III. Provisions Affecting Fund Structures
Interest Deduction Limitations
- Business interest will be deductible only to the extent of business interest income plus 30% of adjusted taxable income.3
- Whether business interest paid by a partnership (or other pass-through entity) is subject to this limitation will be determined at the partnership level (not at the level of the individual partners).
- The business interest limitation may increase the overall effective tax rate applicable to certain “leveraged blocker” structures used by private equity funds, which will also benefit from the corporate rate reduction.
- Use of financial products that are economically equivalent to debt but give rise to deductible non-interest expense may also increase.
Expanded Definition of U.S. Shareholder of CFCs
- The Tax Act expands the definition of a “United States shareholder” to include U.S. persons that hold 10% of the vote or value of a non-U.S. corporation.
- This change may impact certain ownership structures where voting shares of a foreign corporation are held by an entity that may or may not participate in the economics of the corporation and other shareholders hold non-voting shares that confer only economic rights.
Sales of Partnership Interests
- A sale, exchange or disposition of a partnership interest by a non-U.S. partner will be treated as “effectively connected income” (“ECI”) to the extent such partners would be allocated ECI on the hypothetical sale of all assets by the partnership. This will affect treatment of publicly traded partnerships held by offshore funds.
- Transferees of partnership interests will be required to withhold 10% of the gross sales proceeds where the transferor would be subject to ECI under this new rule, unless the IRS permits a reduced amount of withholding. This new withholding tax may have a significant impact on the PTP market as there is no withholding mechanism currently in place in the market.
- This provision is effective for sales, exchanges, and dispositions occurring on or after November 27, 2017, but withholding provisions are not effective until January 1, 2018.
Foreign Insurance Company PFIC Changes
- The Tax Act 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 Tax Act could treat offshore reinsurance companies as PFICs, which would reduce the attractiveness of such investments to U.S. taxable investors.
Seward & Kissel LLP actively monitors changes to the legislative landscape and how any 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 any of the members of our Tax Department listed below.
For additional information on recent income tax changes, 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).
1 Under pre-Tax Act law, a CFC is a foreign corporation, more than fifty percent of the vote or value of the stock of which is owned in the aggregate by U.S. persons who each own 10% or more of the voting stock of the foreign corporation. See below for changes to certain CFC provisions in the Tax Act.
2 Our prior Memorandum discussed proposed changes to the tax treatment of carried interest. The proposals were enacted by the Tax Act.
3 “Business interest” means any interest paid or accrued on indebtedness properly allocable to a trade or business and does not include investment interest; “business interest income” means the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business and does not include investment income. “Adjusted taxable income” means the taxable income of a business calculated without regard to: (i) items of income, gain, deduction or loss not properly allocable to a trade or business; (ii) business interest or business interest income; (iii) net operating losses; (iv) the amount of any deduction allowed for “qualified business income” of a pass-through entity (see the bullet on “Taxation of Pass-Through Entities, above); and (v) in the case of taxable years beginning after December 31, 2017 and before January 1, 2022, any deduction allowable for depreciation, amortization or depletion.