–Year-end planning should be Considered–
The tax legislation, which passed Congress and is expected to be signed by the President shortly, includes a new section of the Internal Revenue Code which is entitled “Partnership Interests Held in Connection with Performance of Services.” This section (Section 1061) changes the taxation of “carried interests” in certain circumstances, particularly for hedge fund managers. The changes to the taxation of carried interests is a huge development for the taxation of hedge fund managers. (The changes to the taxation of carried interests are generally of less importance to other fund managers such as private equity managers and real estate fund managers since the new law does not change the taxation of carried interests to the extent the assets are held for more than 3 years.)
The legislation will be effective for taxable years beginning after December 31, 2017.
This newsletter briefly summarizes what managers should consider doing now because of the proposed changes to the taxation of carried interests. This newsletter does not otherwise discuss the details of the new changes to the taxation of carried interests or any other changes in the new legislation.
Should the manager reduce the GP’s capital account in the fund, how and by when?
Yes, managers should take action. Hedge fund general partners (GPs) should take certain actions, depending on their facts and their desired tax consequences, as discussed below. This is because the new law may cause the investment return on the GP’s capital account balance to also be subject to the same 3 year limitation as applies to the carried interest itself.
By When. Because the new law is effective January 1, 2018, some believe that actions should be taken before January 1, 2018. There is no guidance on the new law other than the specific statutory language and brief accompanying explanations. It would be safer to take any actions by December 31, 2017, but it is not clear that actions need to be taken by then.
1. Convert. Convert part of the GP interest in the fund to an LP interest. This would seem to be a minimum action to take before January 1, 2018, if possible. There is a risk under the new rules that this would not work and the new LP interest would be traced back to the carried interest and still be subject to the new carried interest rules.
2. Distribute cash. Have the GP withdraw cash from the fund and then distribute the cash to the owners of the GP. The owners of the GP can contribute the cash back to the fund after a period of time. Factors to consider are how much cash the fund has, how much taxable basis the GP has in its account (which will affect whether the withdrawal is taxable) and whether the principals desire to recognize gain in 2017 (in order to pay more state and local taxes this year while they are deductible).
3. Distribute securities in-kind. Have the GP withdraw securities in-kind and either sell the
securities or distribute the securities to the owners of the GP and they can potentially sell the securities
4. Contribute the cash or securities. Whether the cash or securities in 2 or 3 should be contributed to the fund or another fund managed by the investment manager
5. Recognize unrealized gains in the GP. There are potentially other ways to realize gains at the GP level, in addition to 2 and 3 above, in order to recognize the built-in unrealized gain that the GP has in its fund interests in 2017 at long-term capital gains rates. Avoiding double taxation of the gains needs to be considered, however.
6. S or C corporation technique. The statutory language provides that the new changes do not apply to carried interests held by corporations. Corporations for this purpose would include C corporations (both domestic and foreign) and S corporations. Some are considering checking the box to have their existing GP taxed as an S corporation or C corporation effective January 1, 2018. The rationale for the statutory language is not clear and this would seem to be subject to change. Some are considering having the owners set up limited liability companies to own the interests in the GP. In either of these scenarios, there is some degree of retroactivity since a check the box election to tax the LLC as a C corporation or S corporation can be made retroactively to January 1, 2018, by on or before March 15, 2018.
7. Change carried allocation to a fee. It might make sense for some funds to change the incentive allocation to a fee. Whether this is beneficial for managers (and/or investors) will depend upon the particular circumstances of the fund, in particular its trading strategy and the physical location of the manager. It may be helpful to managers where there is very little unrealized income and mostly short-term capital gains.
Factors to consider in deciding how to proceed.
It is always helpful to minimize what is in the GP for asset protection purposes.
What is the GP’s capital account in the fund versus its taxable basis in the fund (that is, what is the unrealized amount in the GP’s interest in the fund).
Do the principals of the GP want to realize taxable income in 2017 in order to pay more state and local taxes in 2017 and potentially convert unrealized gains to tax favored long-term capital gains (click here to see our 2017 year-end newsletter).
Are there any restrictions or limitations on the GP withdrawing cash or securities from the fund or any other non-tax considerations.
What types of income does the fund generate. Any long-term capital gains for property held for more than 3 years. When would any distributed securities otherwise have been sold. What is the potential for remaining appreciation. The new rules do not appear to change the taxation of qualified dividend income and do not cause unrealized gains to be realized. It does not appear to be clear whether the new rules would affect gains under Section 1256 or Section 1231.