President Trump Keeps his Promise! Tax Reform is here, and it’s Impacting Fund Managers
Throughout his presidential campaign and during his first year in office, President Trump promised tax reform. He often stated that “we will enact the biggest tax cuts and reforms in American history.” On December 22, 2017, he kept his promise by signing into law the Tax Cuts and Jobs Act (“Act”). The Act makes significant and sweeping changes to the tax code. As the scope of the Act is comprehensive, it is not surprising that sections of the Act will have a serious impact on investment fund managers.
Perhaps the most important change is the treatment of gains received by a fund manager for its profits interest in the fund. Profits interest is income received in connection with the performance of services, sometimes referred to as carried interest. Prior to the Act, carried interest earned by a fund manager was taxed at the same rate at which other investors in the fund were taxed. If the fund generated short-term gains, the fund manager’s carried interest included its share of short-term capital gains, and the gains were subject to tax at ordinary rates. Similarly, if the fund earned long-term capital gains, the fund manager was allocated long-term capital gains and benefited from the lower long-term capital gain rate.
Beginning in 2018, the Act imposes a more onerous holding period for a fund manager. In order to benefit from the preferential long-term capital gains rate of 20%, the required holding period was changed from one year to three. Assets which are sold less than three years after purchase will be taxed at ordinary rates to the fund manager. Additionally, it appears that no grandfather rule will apply; thus any sale of securities that were purchased in 2016, and subsequently sold in 2018 at a gain, will be treated as a long-term gain by limited partners. However, the gain attributable to the fund manager’s carried interest will be taxed as a short-term capital gain. It should be noted that the new rule introduced in the Act does not include an interest that is held by a C or S Corporation. Additionally, with the general reduction of corporate tax rates, to a low rate of 21%, fund managers, especially those focusing on a shorter term strategy, may want to reconsider their choice of entity used for carried interest.
A less evident impact the Act may have on fund managers is the location of their physical operations. The Act limits the amount of state income tax deductions that can be used to reduce an individual owner’s taxable income reported on Form 1040. Prior to enactment, as long as an individual owner was not subject to the Alternative Minimum Tax or certain income threshold limitations, an individual taxpayer could generally report all the state income taxes paid on their Schedule A and reduce their federal taxable income. For tax years beginning in 2018, the federal deduction for state income taxes is limited to $10,000. Thus, fund managers located in states that impose a higher income tax rate may want to consider relocating to a jurisdiction where the tax bite isn’t as great, allowing them to keep more of their earnings.
Surprisingly, the Act did not include any changes with respect to Code Sec. 1402(a)(13). Under this code section, income received by a limited partner in a limited partnership, other than guaranteed payments, is not subject to self-employment tax. In past years, the IRS targeted members of Limited Liability Companies who relied on this code section to limit their exposure to self-employment tax. Additionally, in a 2011 decision (Renkemeyer, Campbell & Weaver, LLP et.al. v Commissioner, 136 T.C. 137 (2011)), the United States Tax Court took the position that a limited partner’s share of profits in an LLP, other than profit on a capital investment, is subject to self-employment tax. Notwithstanding, a limited partner’s earnings in an LP, even under the new Act, is not taxed as self-employment income. However, now that the Act has caused carried interest to be subject to higher income tax rates, it may not be too long before lawmakers target this code section viewed as overly beneficial to fund managers.
Although the Act has been signed into law, tax reform is far from over. It is anticipated, through the issuance of regulations and technical corrections, that the IRS will clarify portions of the new Act. Accordingly, it is important for fund managers to stay in contact with their tax advisers so they can structure themselves in the most tax-efficient manner.