It seemed from the moment the presidential election was decided this past November, taxpayers across the country were inundated with reports and analysis on the fast approaching “Fiscal Cliff” that would occur as the Bush-era tax cuts expired on December 31st, 2012. With implications of these expiring tax cuts nearly coming to fruition, Congress was able to throw a hypothetical “trampoline” in to catch anyone deemed to have fallen off the “Fiscal Cliff" and prop them back up on the ledge. For hedge fund and private equity managers, trying to position themselves in light of these changes can be a challenging task.
American Taxpayer Relief Act
On January 2nd, 2013, President Obama signed and enacted into law the American Taxpayer Relief Act (the “Act”). Amongst the various changes the Act will make to the Internal Revenue Code are increases in the tax rates for the highest earners as well as increases to taxes imposed on certain income types.
- Taxpayers earning $400,000 or more (single) and $450,000 or more (married persons filing jointly) will see an increase in the top tax rate on ordinary income, which includes short-term capital gains, to 39.6% from 35% during the Bush-era;
- Taxpayers earning $400,000 or more (single) and $450,000 or more (married persons filing jointly) will now be taxed at 20% on long-term capital gains and qualified dividend income; rather than the 15% tax rate that taxpayers enjoyed during the last decade plus. The increase to a 20% tax rate on the preferential tax treatment for “qualified dividend income” has been permanently extended;
- Placed extensions on estate and gift tax provisions as well as providing a patch to the Alternative Minimum Tax exemption amount so that it would be adjusted for inflation going forward.
Patient Protection and Affordable Care Act
In March of 2010 President Obama also signed into law the Patient Protection and Affordable Care Act (“PPACA”) which intended to give citizens access to health insurance coverage, with most of the coverage provisions to become effective in 2014. However, in order to make coverage available in 2014, the revenues needed to pay for such coverage would be raised through taxes on high-income taxpayers that become effective in 2013. The PPACA will impose an additional payroll tax of 0.9% on high-income taxpayers with over $200,000 (single) and $250,000 (married persons filing jointly) effective in taxable years after December 31st, 2012. To be clear, the additional 0.9% tax will apply to wages and self employment income above the threshold hold amounts mentioned above.
Another tax to be imposed in order to raise revenues for health care reform will be a 3.8% tax on the lower of net investment income or modified adjusted gross income above a threshold amount of $200,000 (single) and $250,000 (married persons filing jointly). Generally, net investment income is non-business gross income from interest, dividends, annuities, royalties, rents, and capital gains. Taxpayers will be able to deduct allocable deductions in arriving at net investment income. For an investor fund, such expenses would only become allocable after being subject to the various limitations, such as the 2% portfolio deduction limitation. However, all deductions from a trader fund should be allocable deductions. Prop. Reg §1.1411-1 summarizes how a taxpayer would determine their amount of allocable deductions. The IRS has expressly warned not to make an attempt to take advantage of unintentional loopholes in the language of the Proposed Regulations.
For a brief summary of some of the rate changes discussed above please refer to the chart below:
Top Tax Rates
|Type of Income||Law through 2012||Effective in 2013||Increase (+)/ Decrease (-)|
|Interest and Short-term Capital Gains||35%||39.6%||+4.6%|
|Long-term Capital Gains||15%||20%||+5%|
|*Health Care Reform||N/A||0.9% - On Wages and Self Employment Income Above
3.9% - On Net Investment Income
Threshold amounts $200,000 (single) and $250,000 (married persons filing jointly).
The new tax rates can cause some peculiar results. Even though the highest ordinary tax rates have increased by 4.6%, the overall tax increase on long-term capital gains is even higher at 5%. Thus, Congress has penalized investors for committing their capital to business for the long haul rather than the short haul. Furthermore the decision to stay invested in America will cause taxpayers to incur 3.8% (the net investment income tax) on gains that may be attributable to prior years.
Fund managers have an opportunity to potentially escape both the 3.8% net investment income tax and the Medicare tax on management company income provided that they receive their share of profits as a limited partner. To take advantage of this opportunity, fund managers may have to restructure their management company by converting from a limited liability company to a limited partnership. Now that the 3.8% net investment income tax is now effective, the Internal Revenue Service will have an ever greater incentive to make sure limited liability company members do not escape the Medicare tax on their share of profits. Of course, guaranteed payments will continue to be subject to the full 3.8% Medicare tax. Fund managers who have structured their management company’s as limited liability companies should consult their tax advisors as soon as possible.