Client Alerts

So You Manage a Fund? Watch Out for the Excess Business Loss Rules!

Client Alerts | October 18, 2018 | Hedge Funds

Following tax reform, there is a restriction on the deductibility of business expenses. Under the new “excess business loss” rules, trade or business expenses are not deductible to the extent they exceed trade or business income. (Provided that taxpayers filing joint returns are allowed to deduct up to $500,000 of such excess expenses, and other taxpayers are allowed to deduct up to $250,000.) These restrictions apply on a look-through basis to owners of partnerships and S corporations, but do not apply to C corporations. Disallowed losses are carried forward as net operating losses. The IRS has issued a draft form to report excess business losses, but there has been no other regulatory guidance regarding the application of these rules. Consequently there remains considerable uncertainty regarding their application to real world situations.

So what does this mean for funds and their stakeholders?

The answer may turn on whether the fund is a trader or investor, and the results may be surprising (in a bad way).

Consider Hector, the unmarried principal of Buy & Hold LP, an investor fund. During 2018, Hector earns $2 million of management fees and $2 million of incentive allocation, and pays $2 million of overhead and $1 million of performance bonuses. Prior to tax reform, Hector would have $1 million of taxable income ($4 million of income less $3 million of expenses). Following tax reform, with no changes to his economic income, Hector may have an additional $750,000 of taxable income, or $1.75 million. That is, his carried interest income may not be considered “business income”, and thus he may have a nondeductible “excess business loss” of $750,000 (i.e. the excess of $3 million expenses over $2 million management fees, less the $250,000 allowance for a single filer). This result does not appear to be influenced by whether Hector has one entity that earns both the management fee and incentive allocation, or (as is typical for New York City based managers) different entities that earn the management fees and incentive allocation.

Fund investors may also be harmed by these rules, although it appears that they do not affect the application of capital losses against capital gains.

In some cases, there may be a solution to the excess business loss problem.

Returning to Hector: if he restructures the $1 million of performance bonuses as employee equity in his management company (i.e., as “profits interests”) he should not be subject to any excess business loss limitation. That is, he will have replaced a $1 million trade or business deduction (bonuses paid), with an allocation of $1 million of taxable income to the other members of the management company. And, depending on the facts, there may be other solutions to this issue.

So what should you do?

You should speak with your tax advisor, and soon: action may be required before year-end to mitigate the effects of these rules.