By Michael Oates, CPA
Team Leader, Financial Services Tax
The 2016 campaign trail introduced the nation to then-candidate Donald Trump’s promised tax cuts, which gave way in 2017 to sweeping reality in the form of the Tax Cuts and Jobs Act (TCJA). In the almost two years since, the extensive repercussions of the TCJA have become increasingly apparent within the private equity, hedge fund and venture capital space. While IRS clarifications are typically intended to clear up ambiguity, on the TCJA front they also have created muddied waters for individual, fiduciary and business taxation.
Regardless of industry or fund type, TCJA created a wave of uncertainties and challenges related to the execution of these new provisions. Expansions of certain deductions, new limitations of others and changes in various tax rates have significantly altered the taxation landscape in the immediate future – and until at least 2025.
Most prominently, the TJCA has boosted the limits of standard deductions to nearly twice their previous amount while severely curbing itemized deductions. According to The Tax Foundation, this apparent motivation was to simplify tax returns by discouraging the headache-inducing technicalities of itemized calculations.
So, how has the TCJA altered the alternative investment fund landscape?
Trader Fund vs. Investor Fund
It is absolutely crucial to understand and differentiate between these two types of funds. Quite simply, the distinction significantly influences the tax treatment of the partnership and its investors. As a result, it is essential to determine the fund’s classification each year.
On one side of the ring is the trader fund – typically high-risk, high-reward endeavors designed to capitalize on micro-market trends and short-term swings with a high level of portfolio turnover. And in the other corner is the investor fund: notable for the buying and holding of assets over the long term to generate income from interest, dividends and capital appreciation.
Despite the differences, the proverbial fence between the status of trader and investor funds is not as rigid as one might imagine. In fact, the area between the two is quite grey and has been developed by case law over the years. Hence, the deep nuances and occasional loopholes the TCJA presents.
Since the impact of the trader v. investor debate has longevity on its side, funds need to carefully evaluate their investment strategies in order to achieve intended returns. This is due to the TCJA’s shift of the trader/investor fund landscape with profound effects on both investors and managers. Some highlights of importance include:
- Suspension of itemized deductions for miscellaneous expenses (inclusive of management fees and other investment expenses)
- New limit on business interest deductions
- Limitation of excess business loss from a partnership
Non-deductible Section 212 Expenses
The trend from itemized to standardized deductions is a step in favor of trader funds – primarily because funds with the “trader” designation are categorized under the umbrella of business expenses, according to IRC Section 162. Thus, business expenses can be deducted as standard expenses.
The same, however, cannot be said for investor funds. Under the TJCA, itemized expenses under Section 212 are no longer deductible by investors (with the exception of C-Corps, which will be addressed later). This greatly reduces the extent to which investor fund expenses can benefit taxpayers. In fact, the new Section 11045 stipulates that tax-related expenses – such as investment advisory fees – are no longer deductible.
But (there’s always a but): If these fees are tagged as business expenses and fall into the same category as trader funds, there is a possibility they can be deducted. This minor wrinkle in the system is a perfect representation of the complex and often-convoluted implications of applying the TJCA’s effects on funds’ above-the-line/below-the-line expenses.
Business Interest Expense Limitations
But, when are they limited? It should be noted that new article 163(j) has introduced a limitation on deductions to business interest expenses. According to the IRS, relevant taxpayers must ensure the total of such deductions comes in lower than three different criteria. These include business interest income for that year; 30% of adjusted taxable income; and floorplan financing interest expense. Any excess is carried over to future tax years.
Even though 163(j) does not apply to investor funds – since these funds do not qualify as business expenses – they are restricted by other limits tied to annual investment income. As a result, TCJA has two limitations for investors in trader funds. first the limitation under 163(j) and then annual investment income.
Excess Business Losses in Trader Funds
Perhaps one of the most puzzling components of TJCA is Section 461, the Excess Business Losses provision. Under the guidelines, there is a cap of $250,000 on non-corporate business losses. Any amount beyond this limit is subject to a net operating loss (NOI) that passes over to the next tax year.
What makes this a head scratcher is its undermining potential with taxation at a higher rate. However, regardless of fairness or utility, trader funds could benefit from or be limited in calculating in business losses under the $250K ceiling ($500K for married filing jointly).
QBI’s Minimal Impact on Funds
While QBI was heralded as providing substantial tax savings for eligible pass-through entities, these benefits have not yet materialized on the trading fund front. Under Section 199(A), a deduction claim can be made if there is income from a trade or business operated as a pass-through other than a specified service trade or business, which includes the activity of trading securities in a partnership. There are, however, limited benefits for the deduction for fund investors for the following types of income:
- 20% of ordinary dividends from a REIT
- 20% of ordinary income from an MLP with QBI
The Pass-Through to C-Corp Reality
Despite the prediction that a tidal wave of pass-through entities would soon be converting their status to C-Corps, such has not been the case. In reality, few have made the jump in the face of decreased tax rates favoring the latter. The original logic was this: the TCJA’s new corporate income tax rate of 21% had great allure. However, C Corps still retain the double layer of taxation – the first associated with the corporate tax rate on profits and the second at the shareholder level on dividends. Rather than being an incentive, this has been a deterrent as pass-throughs have taken a “wait and see” approach that appears to be working in their favor. And why not? Pass-throughs are taxed on the individual rate, not the corporate rate.
While the TJCA – at its initial roll out – was comprised of 400+ pages of twisting tax reform, its volume has since expanded with the ensuing clarifications, regulations and final rules. While the TJCA is neither heads nor tails, black nor white, one thing is certain: it is a complex, turbulent ocean best navigated with experienced financial services industry tax advisors at the helm.