Tax Reform Bills Seek Largest Restructuring of Tax Code in More Than a Generation

On Nov. 16, 2017, the House of Representatives passed its version of the tax reform bill, the Tax Cuts and Jobs Act.  The Senate Budget Committee voted on Nov. 28, 2017, to send the Senate version of the bill to the floor, after two Republican holdouts dropped their objections.  A Senate vote on that bill, which differs in several respects from the bill passed by the House, could take place shortly.

The tax reform bills represent the largest proposed overhaul of the tax code in more than 30 years.  Should tax reform successfully navigate a course through Congress and to the Oval Office for signature into law, it would have a significant effect on the investment management industry.

Notable Changes

At this time, the exact provisions of any tax reform that may ultimately be enacted are uncertain, and it is not clear how differences between the House and Senate tax reform bills will be reconciled.  However, the following notable changes (among others) that would affect the investment management industry are under consideration:

A.  Tax Rates

1.  Corporations. The corporate tax rate would be reduced to 20 percent.

2.  Individuals. The tax rates on individual taxpayers would be reduced, though the reduction for the highest bracket ($500,000 for individuals and $1 million for couples) would be relatively small.

3.  Income from pass-through entities. Under the House bill, the tax rate on income from pass-through entities engaged in a trade or business would be reduced to 25 percent (for “passive” investors).  The Senate bill would generally permit a partner in a partnership to deduct 17.4 percent of the partner's share of the partnership’s U.S. trade or business income, but limited to 50 percent of the partner's share of the wages paid by the partnership. 

4.  Foreign earnings.  The tax on dividends from foreign subsidiaries would be eliminated.  There would be a one-time tax (payable with interest over eight years) on unrepatriated earnings of foreign subsidiaries. Illiquid assets would be taxed at 5 percent (7 percent in the House bill); liquid assets, such as cash, would be taxed at 14 percent (10 percent in the House bill).  Certain anti-base erosion measures would be added to discourage shifting profits overseas.

5.  Alternative Minimum Tax.  Both the corporate and the individual AMT would be repealed.

B.  Carried interest.  Under the House bill, a partner’s share of long-term capital gains would be treated as short-term capital gain (taxed at ordinary income rates) to the extent the gain is attributable to the sale of assets held for three years or less, if the partnership interest is transferred to, or held by, the partner in connection with the performance of substantial services in an investment management business.  This should not have an effect on managers of funds that trade frequently, and therefore generate short-term capital gains in any event, or on managers of funds (such as private equity or venture capital funds) that hold interests in their portfolio companies for more than three years.

C.  Deductions

1.  Business interest.  Deductions for interest expense incurred in most trades or businesses would be limited to business interest income plus 30 percent of adjusted taxable income (computed without taking into account business interest income or expense).  This limitation would generally be determined at the partnership (or S corporation) level.  Disallowed deductions could be carried forward to later years.

2.  NOLs.  The use of NOLs would be limited to 90 percent of taxable income (possibly dropping to 80 percent after 2022 in the Senate bill), and provisions relating to carrybacks and carryovers would be modified.

3.  Expensing and depreciation.  100 percent expensing would generally be extended through 2022, and the Senate bill would shorten the recovery period for certain real property to 25 years.

4.  State and local tax deductions. Deductions for state and local income and sales taxes not paid or accrued in carrying on a trade or business are eliminated.  Most other deductions are also eliminated, except for deductions for charitable donations, property taxes up to $10,000 a year (retained only in the House bill) and mortgage interest deductions, which would be capped at debt of  $500,000 in the House bill; the Senate bill would retain the $1 million limit.

D.  Other

1.  Sale of partnership interests by foreign partners.  The IRS position in Revenue Ruling 91-32 — that foreign partners are subject to U.S. income tax on the sale of a partnership interest to the extent the gain is attributable to assets used in the partnership’s U.S. trade or business — would be codified into law under the Senate bill.  The purchaser of the partnership interest would be required to withhold 10 percent of the purchase price of the partnership interest.

2.  Timing of income recognition.  Under the Senate bill, income would need to be recognized no later than the year in which it is included for financial reporting purposes.