Effect TCJA Private Investment Funds

Effect TCJA Private Investment Funds

Effect of the TCJA on Private Investment Fund – The TCJA is likely to have a significant effect on private funds, with consequences for portfolio companies, investors and investment professionals. This memorandum discusses the treatment of “carried interest” under the TCJA and provides a brief overview of a number of other provisions of the TCJA that may affect private funds, including changes in tax rates, the repeal  of the allowance of “miscellaneous itemized deductions” and the deduction for state and local income taxes, new rules affecting the taxation of pass-through business income, new rules affecting U.S. tax-exempt and non-U.S. investors, and the TCJA’s overhaul of the international tax regime.

Carried Interest

Typically, the general partner of a private fund or a separate entity owned by the fund’s investment professionals (such entity, the “Carry Entity”) holds an equity interest in the fund that entitles the Carry Entity to a share of the fund’s profits that is larger than the Carry Entity’s percentage interest in the capital invested in the fund.

This “carried interest” gives the Carry Entity a percentage (e.g., 20%) of the profits that would have been allocated to the fund’s other investors if all fund profits had been allocated pro rata according to capital contributions.The fund vehicle that issues the carried interest is an entity treated as a partnership for U.S. federal income tax purposes. A partnership is not subject to entity-level tax, but instead allocates its items of income, gain, loss and deduction to  its partners, who include their shares of those items in determining their own tax liability.

Under current law, a carried interest is treated in the same manner as any other partnership interest, with the result that the character of the income and gains recognized by the issuing fund vehicle (e.g., as long-term capital gain, short-term capital gain or ordinary income) flows through to the Carry Entity. The Carry Entity, in turn, is typically itself a partnership for tax purposes, so that the character of the underlying fund income flows through to the individuals who hold interests in the Carry Entity.

Over the last several years, various bills have been introduced in Congress that, if enacted, would have treated all carried interest allocated by an investment partnership as ordinary income derived from the provision of services by the Carry Entity and its members. While the TCJA contains a provision that modifies the treatment of carried interest, it does not take this approach.

 

Instead, it retains the general treatment of carried interest under current law, but imposes a three-year holding period for the determination of whether capital gain derived by the fund is long-term or short-term. The principal features of the carried interest provision are outlined below.

 

Three-year Holding Period

 

Individuals are subject to U.S. federal income tax on net capital gain (that is, the excess of net long-term capital gain over net short-term capital loss) at rates that are substantially lower than the rates applicable to ordinary income and short-term capital gains (under the TCJA, a maximum rate of 20% vs. a maximum rate of 37%).

 

Unless otherwise noted, this memorandum assumes that the private fund investment vehicles described herein are entities that are treated as partnerships for U.S. federal income tax purposes. In hedge funds, this profits interest is generally called an “incentive allocation” or “performance allocation,” rather than a “carried interest.” In general, gain from the sale or other disposition of a capital asset is treated as long-term capital gain if the owner has held the asset for more than one year as of the date of disposition and as short-term capital gain if the owner has held the asset for a shorter period.

 

The TCJA changes this rule for carried interest allocations. Under the TCJA, gain allocated in respect of carried interest will qualify as long-term capital gain only if the fund has held the relevant investment for more than three years at the time of the disposition. If the fund has held the investment for a shorter period of time, the gain will be treated as short-term capital gain.

 

Sale of Carried Interest

 

The three-year holding period requirement also apparently applies to gain derived from the sale or other disposition of a partnership interest attributable to carried interest (called an “applicable partnership interest”). The taxpayer will be required to have held the “applicable partnership interest” for more than three years in order for gain on the disposition to qualify as long-term capital gain.

 

Qualified Dividend Income Unaffected

 

“Qualified dividend income” (generally, dividends from U.S. corporations and certain non-U.S. corporations) is subject to U.S. federal income tax at the rates applicable to net capital gain (i.e., 20%, plus the 3.8% tax on net investment income, in the case of an individual). The TCJA does not modify the treatment of carried interest allocations of qualified dividend income, and therefore these allocations will continue to qualify for the 23.8% rate.

 

Limited to “Applicable Partnership Interests”

 

For purposes of imposing the special three-year holding period requirement, the TCJA defines a carried interest as an “applicable partnership interest” – specifically, the three-year holding period requirement applies only to capital gain derived with respect to an “applicable partnership interest.”

 

An “applicable partnership interest” is a partnership interest that is transferred to, or held by, a taxpayer in connection with the performance of substantial services by the taxpayer (or by a person related to the taxpayer) in an “applicable trade or business.” The TCJA provides no guidance as to what will constitute “substantial services.”

 

An “applicable trade or business” is generally defined to mean

 

  • raising and returning capital and

 

  • either investment or development activities with respect to “specified ” “Specified assets” are
  • securities, commodities, real estate held for rental or investment and cash or cash equivalents and

 

  • options or derivative contracts with respect to, and interests in partnerships relating to, any of these

 

 

No Effect on Capital Interests.

 

An “applicable partnership interest” does not include a partnership interest that provides the taxpayer with a right to share in partnership capital commensurate with either

 

  • capital contributions made by the taxpayer or

 

  • amounts that were included as compensation income by the taxpayer at the time of grant or vesting of the relevant partnership interest (in either case, a “capital interest”).

 

As a result, the new three-year holding period rule will not apply to any capital interest. These are the U.S. federal income tax rates. Net capital gain is generally also subject to the 3.8% tax on net investment income. Any ordinary income that constitutes net earnings from self-employment will be subject to the hospital insurance tax (that is, the Medicare tax),  generally at the rate of 3.8%.

 

An “applicable partnership interest” does not include any partnership interest directly or  indirectly held by a corporation.

 

For this purpose, the amount of capital contributed by a taxpayer in respect of a partnership interest is determined at the time of the taxpayer’s receipt of the partnership interest. In private funds other than hedge funds, it is typical for investors to make capital commitments that are drawn down as capital contributions over a number of years. While it is not entirely clear how

 

the TCJA’s definition of a capital interest would apply in this situation, it seems likely that the requirement was not intended to preclude capital interest treatment, but instead that the Carry Entity (and each of its members) will be treated as receiving a separate capital interest each  time the Carry Entity (and the relevant member) makes a capital contribution.

 

The timing requirement may be aimed at arrangements in which a portion of the management fee otherwise payable by the fund is replaced with a special profits interest held by the Carry Entity, providing for a targeted amount of allocations equal to the management fee reduction, and the capital contributions that the Carry Entity would otherwise have made to the fund are reduced by the amount of allocations to be made in respect of this special profits interest. Under the TCJA, any such special profits interest would be treated as an “applicable partnership interest,” rather than as a capital interest.

 

IRC Sec. 83(b) Elections

 

In general, a person who receives property in connection with the performance of services must include in income, as compensation income, an amount equal to the excess of the fair market value of the property over the amount, if any, that the person paid for the property, with the inclusion occurring on the date of grant if the person’s rights to the property are fully vested on grant or on the vesting date if the person’s rights to the property are subject to vesting conditions. I

 

IRC Sec. 83(b), as amended allows a person who receives unvested property in connection with the performance of services to elect to ignore the vesting conditions and to recognize the compensation income, if any, as of the grant date.

 

Under guidance issued by the IRS (the “Profits Interest Guidance”), these rules do not apply to  a partnership profits interest that is issued to a person in respect of services the person provides to or for the benefit of the partnership in a partner capacity (as opposed to another capacity, such as an employee of a related entity).

 

The IRS has explicitly stated that IRC Sec. 83(b) elections are not required in the case of the issuance of a partnership profits interest that is subject to the Profits Interest Guidance. It is typical, however, for individuals who hold interests in a Carry Entity also to be employees of a related entity (generally, a management company that provides services to the fund), and as a result, there may be some uncertainty as to whether the IRS would view the individuals’ services are being provided in their capacities as partners of the Carry Entity, rather than in their capacities as employees. It is therefore common for an individual to make a “protective” IRC Sec. 83(b) election in connection with the receipt of an interest in a Carry Entity.

 

While an earlier version of the tax bill provided that IRC Sec. 83 (and thus a IRC Sec. 83(b) election) would not apply to a grant of an “applicable partnership interest,” the TCJA contains no such provision. Indeed, the TCJA specifically contemplates the possibility that a taxpayer will

 

make a IRC Sec. 83(b) election in respect of an “applicable partnership interest” by stating that the three-year holding period rule applies notwithstanding any IRC Sec. 83(b) election.

 

The TCJA does not limit the definition of “applicable partnership interest” to the provision of substantial services “in a partner capacity.” Thus, if an individual receives an interest in a Carry Entity in connection with services that he or she performs as an employee of another entity, the three-year holding period requirement will apply except in respect of the portion of the interest that is treated as a capital interest, as described above.

 

Exclusions for Certain Service Providers.

 

The three-year holding period requirement will not apply to a partnership interest held by a person who is employed by an entity other than the issuing partnership if

 

  • such other entity conducts a trade or business other than an “applicable trade or business,” as defined above, and

 

  • the person to whom the partnership interest is issued provides services only to that other

 

Although not entirely clear, this provision may be intended to clarify that the three-year holding period requirement does not apply to executives of a portfolio company who hold  profits interests in a holding vehicle for the portfolio company (sometimes referred to as a “top hat” vehicle).

 

Related Party Transfers

 

Although not entirely clear, a special rule appears to treat a direct or indirect transfer of a carried interest to certain specified persons as a taxable sale of the carried interest, even if the transfer would otherwise be entitled to non-recognition under another provision of the Code. The specified persons are

 

  • any family member or

 

  • any person who performed services in the current year or the preceding three years in any “applicable trade or business” in or for which the taxpayer performed a

 

 

Changes in Tax Rates

 

The TCJA revises the tax rates for both corporations and individuals.

 

 

Corporate Tax

 

The TCJA dramatically reduces the highest corporate rate from 35% to 21%. This rate reduction has no “sunset” provision and is effective for taxable years beginning after December 31, 2017. The TCJA also repeals the corporate alternative minimum tax (the “AMT”), unlike a version of the Senate tax bill, which would have retained the corporate AMT. Given the lower corporate tax rate, the amount of the dividends-received deduction (which a corporation may claim in respect of dividends received from U.S. corporations and the “U.S.-source portion” of dividends received from certain foreign corporations) has been reduced.

 

Individual Tax

 

The tax brackets for individuals have been modified, with the highest marginal individual rate reduced from 39.6% to 37%. The reduced rates are temporary – they will be effective for 2018 through 2025. Although the corporate AMT has been repealed, the TCJA retains the individual AMT, but increases the relevant exemption amount and the threshold amount of “alternative minimum taxable income” after which the exemption is phased out.

 

The TCJA also significantly increases the standard deduction available to individuals.

 

Restrictions on Deductions for Individuals

 

For 2018 through 2025, the years in which the reduced marginal tax rates apply to individuals and other non-corporate taxpayers, the TCJA imposes certain significant restrictions on the deductions that an individual or other non-corporate taxpayer may claim, thereby increasing the base on which the income tax will be imposed.

 

Disallowance of “Miscellaneous Itemized Deductions”

 

The TCJA disallows all miscellaneous itemized deductions for 2018 through 2025. For non-corporate taxpayers,

 

investment-related expenses (called “IRC Sec. 212 expenses”) are miscellaneous itemized deductions. These expenses generally include an investor’s share of the expenses of a private equity fund or other private fund that is not an active trader in securities or other assets, including the investor’s share of the management fee paid by the fund.

 

If such a private fund enters into a swap (i.e., an interest rate swap), a non-corporate investor’s share of payments made on the swap will be disallowed miscellaneous itemized deductions and will therefore not be netted against the investor’s share of the payments made on the swap. Disallowed miscellaneous itemized deductions may not be capitalized, with the result that the investor will not receive any tax benefit in respect of such expenses.

 

Under current law, a non-corporate taxpayer’s ability to deduct miscellaneous itemized deductions is subject to significant limitations. In particular, miscellaneous itemized deductions are allowable for any taxable year only to the extent that they exceed 2% of the taxpayer’s adjusted gross income for that year (a limitation known as the “2% floor”). After 2026, these limitations will again be applicable.

 

Expenses incurred in connection with trading activities by funds that are active traders in securities or other assets are treated as business expenses, rather than miscellaneous itemized deductions, and as a consequence the new disallowance will not apply to these expenses. In addition, an investor’s share of the expenses of a portfolio company that is engaged in a trade  or business and is treated as a partnership for U.S. federal income tax purposes (an “operating partnership”) will generally constitute business expenses, rather than miscellaneous itemized deductions.

 

An investor’s share of interest paid or accrued by a private fund will not constitute a miscellaneous itemized deduction, but is subject to separate limitations on deductibility, including primarily the pre-existing limitation on the deductibility of “investment interest,” under which a non-corporate taxpayer’s deduction for “investment interest” is limited to the amount of the taxpayer’s “net investment income.

 

Disallowance of Deduction for Excess Business Losses

 

For 2018 through 2025, a non-corporate taxpayer will not be entitled to deduct an “excess business loss.” An “excess business loss” is the amount, if any, by which

 

  • the taxpayer’s aggregate deductions attributable to trades or businesses exceed

 

  • the taxpayer’s aggregate gross income or gain attributable to trades or businesses plus an amount equal, in 2018, to $250,000 (or $500,000 in the case of a joint return) and indexed for inflation in subsequent taxable

 

Any disallowed excess business loss will be treated as a net operating loss carryover. In the case of a partnership, this limitation applies at the partner level by taking into account each partner’s share of the partnership’s items of income, gain, loss and deduction.

 

The same approach applies to shareholders of S corporations.

 

The “passive activity rules,” which pre-date the TCJA, limit the ability of taxpayers other than widely held corporations to deduct losses from a “passive activity,” generally defined as an activity that involves the conduct of a trade or business in which the taxpayer does  not materially participate. The passive activity rules limit the ability of investors in private funds, as well as members of a Carry Entity, to deduct their shares of the losses and deductions of operating

 

 

For this purpose, “net investment income” does not include long-term capital gains or qualified dividend income unless the taxpayer elects to be subject to tax on such income at the rates applicable to ordinary income.

 

The TCJA has also revised the rules applicable to net operating losses: it eliminates the two-year carryback, provides an indefinite (as opposed to a 20-year) carryover and limits the amount of a net operating loss carryover that may be used in any taxable year to 80% of taxable income, as computed without regard to the net operating loss deduction partnerships in which the fund invests.

 

The new excess business loss limitation will apply after application of the passive activity rules.

 

This limitation will also apply in situations in which the passive activity loss rules do not apply. In particular, trading in actively traded personal property is not treated as a “passive activity,” and therefore an investor’s share of the income, gains, losses and deductions derived by a fund  from trading in actively traded securities or other assets is not subject to the passive activity rules.

 

The new limitation on excess business losses will apply to investors in active trading funds. In addition, this limitation will apply in situations in which the taxpayer materially participates in the relevant business and in which the passive activity rules therefore do not apply. For example, it will apply to fund managers who hold interests in a management company that is treated as a partnership for tax purposes and to managers of an operating partnership who hold equity interests in the operating partnership.

 

Limitation on Deduction for State and Local Taxes

 

For an individual taxpayer, the TCJA limits to $10,000 (or $5,000 in the case of a married individual filing a separate return) in any taxable year the deduction for the aggregate amount  of:

 

  • state and local income taxes; and

 

  • state and local property taxes, other than taxes paid or accrued in carrying on a trade or business or an investment

 

These rules will apply for 2018 through 2025.

 

Corporations, unlike individuals, have retained the deduction for state and local income taxes.

 

The rules will apply not only to state and local income taxes paid directly by an individual, including in respect of the individual’s share of the income of a partnership, but also to an

 

individual’s share of any state and local taxes paid by a partnership. As a consequence, individual investors in private equity funds and individual members of any Carry Entity will not be able to deduct state and local income taxes imposed with respect to their shares of income derived from an operating partnership, regardless of whether those taxes are payable by the individuals or by the relevant portfolio company. In addition, individuals who are members of “management company” partnerships operating in New York City will not be able to deduct state and local income taxes imposed with respect to the management company’s income, including their shares of any New York City unincorporated business tax paid by the management company.

 

Special Deduction for Pass-Through Business Income

 

The TCJA establishes a new deduction for business income derived by individuals from partnerships and other pass-through arrangements (a “pass-through deduction”). For this purpose, pass-through arrangements include sole proprietorships, S corporations and entities that are treated as partnerships for U.S. federal income tax purposes, including limited liability companies that are treated as partnerships.

 

This deduction will be available for 2018 through 2025.

 

In general, U.S. persons other than widely held corporations may deduct their losses from “passive activities” only to the extent of their income from “passive activities.”  Disallowed passive activity loss deductions in respect of any passive activity may be carried forward to future years as passive activity losses and, subject to the new limitation on excess business losses, are allowed in full when the taxpayer disposes of its entire interest in the relevant passive activity, provided that the acquirer is unrelated to the taxpayer.

 

Deduction for “Qualified Business Income”

 

An individual may deduct an amount equal to 20% of the “qualified business income” he or she derives from each “qualified trade or business” in which he or she is engaged, either directly or through ownership of an interest in an entity that is treated as a partnership, subject to the wage cap and the taxable income cap described below.

 

In general, a “qualified trade or business” means any trade or business other than

 

  • a specified service trade or business, as discussed below, or

 

  • the performance of services as an

 

“Qualified business income” generally includes the net income derived from the relevant trade or business, but does not include (i) capital gain or loss, dividends, investment interest and certain other types of investment income, (ii) any compensation paid to the individual for services

 

rendered with respect to the “qualified trade or business,” whether paid as salary, as a “guaranteed payment” by a partnership or otherwise or (iii) any qualified REIT dividends or qualified publicly traded partnership (“PTP”) income, which give rise to a separate pass-through deduction, as described below. Net loss of a trade or business is carried over for purposes of determining the amount of an individual’s “qualified business income” for subsequent taxable years.

 

Deduction for REIT Dividends and PTP Income

 

Subject to the taxable income cap described below, an individual may also deduct 20% of

 

  • any dividends he or she receives from real estate investment trusts (“REITs”), other than any portion of any REIT dividend that constitutes a capital gain dividend or qualified dividend income (“qualified REIT dividends”) and

 

  • his or her share of the “qualified business income” of any PTPs, as well as the ordinary income that he or she recognizes on a disposition of an interest in a PTP in respect of certain non-capital assets of the PTP. (“qualified PTP income”).

 

The pass-through deduction will generally be available for income derived from a PTP that is engaged in a natural resources business, such as an oil and gas business, but generally will not be available for income derived from an investment management PTP because the income derived directly by such a PTP will generally constitute investment income, rather than “qualified business income.”

 

Taxable Income Cap

 

The amount deductible by an individual in respect of qualified business income, qualified REIT income and qualified PTP income for any taxable year may not exceed 20% of the individual’s taxable income, reduced by his or her net capital gain, for such taxable year.

 

Wage Cap

 

In general, an individual’s deductible amount in respect of any “qualified trade or business” is capped at the greater of

 

  • 50% of the individual’s share of the W-2 wages paid to employees in connection with the qualified trade or business and

 

  • the sum of 25% of such W-2 wages and 2.5% of the individual’s share of the tax basis, dividends” and

 

  • his or her taxable income, reduced by net capital gain. This memorandum does not address qualified cooperative

 

An individual is subject to U.S. federal income tax at a maximum marginal rate of 20% in respect of both REIT capital gain dividends and qualified dividend income.

 

Under IRC Sec. 751 of the Code, a person who disposes of an interest in a partnership may recognize ordinary income or loss to the extent that the sale proceeds are treated as attributable to certain unrealized receivables and inventory held by the partnership.

 

This cap does not apply to an individual whose taxable income is no more than a certain threshold amount ($157,500 or, in the case of a joint return, $315,000) and is phased in on a sliding scale for individuals whose taxable income is between this threshold amount and a higher specified amount ($207,500 or, in the case of a joint return, $415,000). The wage cap also does not apply to qualified REIT income or qualified PTP income.

 

Service Businesses Excluded

 

The pass-through deduction will not be available in respect of income derived from a “specified service trade or business,” generally defined as a trade or business involving the performance  of services in which the reputation or skill of one or more individuals is the principal asset. These categories of business include investment management and investing, trading or dealing in securities, partnership interests or commodities.

 

As a consequence, the special 20% deduction generally will not be available with respect to an individual’s share of income derived from a partnership that sponsors and manages investment funds, regardless of whether the individual is actively engaged in the fund management business or is a passive investor.

 

Similar to the wage cap, however, this exclusion does not apply to an individual whose taxable income is less than a certain threshold amount ($157,500 or, in the case of a joint return,

$315,000) and is phased in on a sliding scale for individuals whose taxable income is between the threshold amount and a higher specified amount ($207,500 or, in the case   of a joint return,

$415,000).

 

Fund investors who are individuals will generally be entitled to claim the pass-through deduction in respect of their shares of any “qualified business income” generated by an operating partnership in which the fund invests, as well as their shares of any qualified REIT dividends and qualified PTP income derived by the fund.

 

Although it is not entirely clear how the pass-through deduction rules will apply to individuals who are members of a Carry Entity, it would appear that these individuals may claim deductions for their shares of such “qualified business income,” qualified REIT dividends and qualified PTP

 

income, including the portion of any such income that is allocated to the Carry Entity as carried interest.

 

Tax-Exempt Investors in Funds

 

Certain provisions of the TCJA will affect investors that are organizations generally exempt from

  • federal income tax, including the provisions described

 

Excise Tax on Net Investment Income

 

The TCJA imposes a 1.4% excise tax on the “net investment income” of a private institution of higher education if

 

  • the institution has at least 500 tuition-paying students more than 50% of whom are located in the United States and

 

  • the aggregate value of its assets (other than assets used directly in carrying out its educational purpose) is at least $500,000 per

 

“Net investment income” is defined by reference to rules similar to those applicable to private foundations, which are subject to an excise tax on net investment income under current law, and would generally include income (net of certain expenses) from interest, dividends, rent, payments with respect to securities loans, royalties and capital gains. This tax would generally apply to such an institution’s share of the income of an investment fund.

 

UBTI Separately Computed for Each Trade or Business

 

In general, tax-exempt organizations are subject to U.S. federal income taxation with respect to any unrelated business taxable income. However, engineering and architecture are exempted from the “specified service trade or business” category of (“UBTI”) they derive.

 

UBTI is generally defined as income derived from any trade or business that is not substantially related to the purpose constituting the basis for the organization’s exemption from tax. Most types of investment income are excluded from UBTI, but investment income that would otherwise be excluded will constitute UBTI to the extent it constitutes “debt-financed income” (that is, to the extent that it is derived from property in respect of which “acquisition indebtedness” is outstanding).

 

A tax-exempt investor’s share of all or most of the income of an operating partnership will constitute UBTI. While some tax-exempt organizations elect to participate in operating partnership investments through investment vehicles that are treated as corporations for U.S. federal income tax purposes (“blockers”), other tax-exempt entities do not elect to participate  in

 

these investments through blockers, in large part because, under current law, they can offset net UBTI with net losses derived from UBTI-generating investments.

 

Under the TCJA, a tax-exempt organization will be required to calculate UBTI separately with respect to each trade or business in which it has an interest. Thus, a tax-exempt organization will not be entitled to use a net operating loss from one trade or business to offset UBTI from another trade or business: the net operating loss will be available only to offset net income generated by the same trade or business in subsequent years. However, the use of a net operating loss arising in a taxable year beginning before January 1, 2018 will be grandfathered.

 

Any such loss may be carried over to subsequent years and used to offset UBTI from a different trade or business. It is not entirely clear how the new limitation applies to debt-financed income, but presumably, a tax-exempt organization would compute its UBTI separately in respect of all of its debt-financed income that consists of income that would otherwise have been excluded from UBTI.

 

As a result of this “no netting” provision, an increased number of tax-exempt investors may elect to invest in operating partnerships through blockers. Tax-exempt investors may also be less likely to invest in funds that are likely to make a significant number of investments in operating partnerships and more likely to request contractual limitations on the portion of the investors’ commitments that a fund may invest in operating partnerships. In situations in which tax-exempt investors have unblocked interests in a fund with operating partnership investments, the investors will need the fund to provide information that separates the net income or net loss generated by each such operating partnership.

 

State and Local Governments

 

State and local governments, including pension plans for state and local employees, do not pay

U.S. federal income tax on UBTI. An early version of the tax legislation that was introduced in the House would have subjected state and local governments to tax on UBTI. The TCJA contains no such provision.

 

Non-U.S. Investors in Funds

 

Effectively Connected Income on Sale of Partnership Interest

 

In general, under pre-TCJA law, the sale by a non-U.S. individual or corporation of an interest in an    entity that is treated as a partnership for U.S. federal income tax purposes is not subject to

U.S. federal income or withholding tax. However, the Code provides that if a partnership holds one or more “U.S. real property interests” (“USRPI’s”) and a non-U.S. person disposes of an interest in the partnership, the portion of the sales proceeds attributable to the USRPI’s will be treated as a disposition of the USRPI’s, and any gain from this deemed disposition will  constitute “effectively connected income” (“ECI”).

 

 

The non-U.S. person is required to file a U.S. federal income tax return reporting any ECI and is required to pay U.S. federal income tax on a net income basis, at the rates applicable to U.S. persons (either the individual or the corporate rates, as the case may be), in respect of the ECI. In addition, if the non-U.S. person is a corporation, it will be subject to a U.S. branch profits tax at a flat rate of 30% on its “dividend equivalent amount” attributable to certain ECI (very generally, the after-tax amount of certain ECI that is not treated as reinvested in a U.S. trade or business).

 

In a 1991 ruling, the IRS extended this rule to cover other ECI-generating assets. The ruling adopted the position that gain derived by a non-U.S. person from the sale or other disposition of an interest in a partnership constitutes ECI to the extent that the gain is attributable to partnership assets, other than USRPI’s, the sale of which by the partnership would have given rise to gain that is treated as ECI (i.e., assets used in a U.S. trade or business conducted by the partnership).

 

In 2017, the U.S. Tax Court rejected the IRS’s position, holding that such gain   is not subject to

  • The TCJA codifies the 1991 IRS ruling, effective for dispositions of partnership interests on or after November 27, 2017. The new rule applies to dispositions of interests in PTPs (sometimes referred to as “master limited partnerships” or “MLPs”), as well as to dispositions of interests in private partnership.

 

The TCJA also provides that a non-U.S. person will recognize gain on the disposition of an interest in a partnership even if the disposition is within the ambit of a non-recognition provision of the Code (e.g., a contribution of a partnership interest to another partnership that would not otherwise be a recognition event). The TCJA gives Treasury regulatory authority to prescribe circumstances in which certain non-recognition provisions will apply to defer the recognition of gain under the new provision.

 

Withholding Tax on Sale of Partnership Interests

 

The TCJA generally requires a buyer of a partnership interest to withhold 10% of the gross purchase price on the sale of the interest unless the seller can establish that it is a U.S. person or that no portion of the seller’s gain is attributable to ECI-generating assets. While not explicitly provided in the legislation, the withholding tax would likely also apply to a redemption of a partnership interest.

 

If the buyer fails to withhold, the partnership is liable for the withholding tax, plus interest. Although the substantive tax is applicable to gain realized on dispositions of partnership interests on or after November 27, 2017, as described above, the withholding tax requirement is effective only for dispositions after December 31, 2017.

 

As a consequence of these new rules, a private fund with a non-U.S. partner that wishes to transfer its interest will need to provide the non-U.S. partner with information regarding the non-U.S. partner’s share of the partnership’s ECI-generating assets. In general, it would be prudent for the fund to require the transferor and transferee to inform the fund of the sale price and to provide the fund with a copy of the relevant withholding certificate and proof of payment of the withholding tax, if applicable.

 

Because the fund will have ultimate liability for the withholding taxes, private investment funds should consider amending their organizational  documents and transfer documents to ensure that the fund is indemnified by the transferor and transferee for any withholding tax imposed under this new provision.

 

Limitations on Deduction for Business Interest

 

The TCJA limits the deductibility of “business interest,” defined as any interest expense properly allocable to a trade or business. Business interest includes any interest paid or accrued by a Treasury has exceptions for non-recognition events in the case of certain transfers of USRPI’s by non-U.S. persons. Although these rules would not apply to the portion of any gain that is not attributable to USRPI’s, they may serve as a template for eventual exceptions in the case of such non-USRPI gain.

 

The legislative history states that Treasury may provide guidance permitting a broker to withhold 10% of the sale proceeds as an agent of the transferee (for example, on the sale by a non-U.S. person of units in a PTP) corporation. This limitation may affect portfolio companies in which funds invest, blocker entities formed by funds and investors in funds.

 

The deduction for business interest for any taxable year is limited to the sum of

 

  • the taxpayer’s “business interest income,”

 

  • the taxpayer’s “floor plan financing interest”and

 

  • 30% of the taxpayer’s “adjusted taxable income” (“ATI”) for the taxable

 

In general, a taxpayer’s ATI is its taxable income computed without regard to

 

  • items not properly allocable to a trade or business,

 

  • business interest income or business interest expenses,

 

  • any net operating loss deduction,

 

  • any pass-through deduction, as discussed above and

 

 

  • for taxable years beginning before January 1, 2022, any deduction for depreciation, amortization or

 

“Business interest income” is any interest income properly allocable to a trade or business. Any business interest that is not deductible as a consequence of this limitation may be carried forward indefinitely. Following a change of control of a corporation, the corporation’s carryforward of unused business interest expenses would be subject to limitation under IRC Sec. 382 of the Code, which limits the use of a corporation’s net operating losses and other tax assets following a change of control.

 

Existing debt Will Not Be Grandfathered

 

The limitation on the deductibility of business interest will not apply, however, to interest attributable to an electing real property trade or business or to certain other narrowly defined businesses.

 

In the case of a partnership, the limitation on the deductibility of business interest will apply at the partnership level, by reference to the partnership’s ATI and business interest income. After application of the limitation, any partnership deduction for business interest will decrease the net income, or increase the net loss, allocated by the partnership to its partners.

 

For purposes of determining the deductibility of business interest paid or accrued directly by a partner, the partner’s ATI will be determined without regard to the partner’s share of any items  of income, gain, deduction or loss of the partnership.

 

If a partnership has excess capacity for business interest deductions, each partner’s ATI will be increased by its share of the partnership’s “excess ATI” (that is, its share of the partnership’s ATI that corresponds to such excess capacity).

 

A partnership may not carry forward any of its business interest that it is not permitted to deduct. Instead, the excess business interest will be allocated to the partners and may be deducted by the partners to the extent, and only to the extent, of their shares of excess ATI, if any. The allocation of excess business interest to a partner results in certain adjustments to the basis of the partner’s interest in the relevant partnership.

 

If a taxpayer holds an interest in more than one partnership, the limitation is calculated separately for each partnership. As a result of the application of the limitation at the partnership level, a partner’s overall deduction for business interest, including the partner’s share of the partnership’s business interest expenses, may be less than the overall deduction would have been if the

 

“Floor plan financing interest” means interest paid or accrued on indebtedness used to finance the acquisition of certain motor vehicles held for sale or lease and secured by the inventory so acquired.

 

Specifically, it will not apply to any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business that elects not to have the limitation apply. A real property trade or business that makes such an election will be required to recover the cost of certain of its property over a longer period of time (and thus will have lower annual cost recovery deductions) than a real property trade or business that does not make such an election.

 

 

Limitation Applied At The Partner Level

 

Rules similar to the rules for partnerships will apply with respect to S corporations and their shareholders.

 

The limitation on the deductibility of business interest will affect portfolio companies that are treated as corporations for tax purposes and investors in operating partnerships. Moreover, it will significantly reduce the impact of debt incurred by a blocker entity. A blocker generally has no income other than its share of the income of the operating partnership(s) for which it serves as an investment vehicle.

 

As a result of the partner-level calculation described above, the blocker will have no ATI other than ATI that is attributable to its share of any excess ATI of the operating partnership. In the absence of any excess ATI, a leveraged blocker would not receive a current tax benefit for any interest paid or accrued on its debt. However, if gain from the sale of an interest in an operating partnership is treated as ATI (a point that is not clear), the blocker could use its carryforward of business interest expense to offset its share of any gain from the sale of the blocker.

 

In general, this limitation will not affect a non-corporate partner’s share of interest paid or accrued on fund-level indebtedness because that interest would generally be considered investment interest, rather than business interest. Instead, the non-corporate partner’s share of this interest would be subject to the pre-existing limitations on the deductibility of investment interest. It is not clear whether the interest in any fund-level borrowing that is incurred to finance the fund’s investment in an operating partnership would be treated as business interest.

 

Certain Provisions Affecting Portfolio Companies

 

Some of the provisions of the TCJA that may have a significant effect on portfolio companies  are described below.

 

Full Expensing for Certain Business Assets

 

 

Under current law, a taxpayer is allowed a first-year depreciation deduction equal to 50% of the adjusted basis (generally, the cost) of certain depreciable property it acquired and placed in service before January 1, 2021 (“bonus depreciation”). This deduction is allowed only if the taxpayer was the first user of the property.

 

The TCJA extends the application of the first-year deduction to property placed in service before January 1, 2027. Moreover, for property placed in service after September 27, 2017 and before January 1, 2023, the deduction will be equal to 100% of the adjusted basis of the relevant property. The percentage ratchets down for property placed in service during subsequent years: 80% for 2023; 60% for 2024; 40% for 2025; and 20% for 2026. Each of these dates is extended one year in the case of certain property with a longer production period.

 

The TCJA also removed the requirement that the taxpayer be the first user of the property, thus permitting a taxpayer to claim the deduction for used property that it acquires. Certain restrictions on the deduction in respect of used property, including the requirement that the property be acquired from an unrelated party, are intended to prevent abuse of this provision.

 

Net Operating Loss Deduction

 

Under current law, a taxpayer is permitted to carry a net operating loss back for two years and forward for twenty (20) years and could use a net operating loss carryback or carryover to offset all of its taxable income (determined without regard to the net operating loss deduction) for a taxable year. The TCJA eliminates the two-year carryback and provides that a net operating  loss may be carried forward indefinitely. In addition, it limits the amount of a net operating loss carryover that may be used in any taxable year to 80% of the taxpayer’s taxable income, determined without regard to the net operating loss deduction.

 

Special rules apply to property acquired before, and placed in service on or after, September  28, 2017. However, these changes in the rules relating to net operating losses do not apply to insurance companies.

The TCJA is likely to have a significant effect on private funds, with consequences for portfolio companies, investors and investment professionals. This memorandum discusses the treatment of “carried interest” under the TCJA and provides a brief overview of a number of other provisions of the TCJA that may affect private funds, including changes in tax rates, the repeal  of the allowance of “miscellaneous itemized deductions” and the deduction for state and local income taxes, new rules affecting the taxation of pass-through business income, new rules affecting U.S. tax-exempt and non-U.S. investors, and the TCJA’s overhaul of the international tax regime.

 

Carried Interest

 

Typically, the general partner of a private fund or a separate entity owned by the fund’s investment professionals (such entity, the “Carry Entity”) holds an equity interest in the fund that entitles the Carry Entity to a share of the fund’s profits that is larger than the Carry Entity’s percentage interest in the capital invested in the fund.

 

This “carried interest” gives the Carry Entity a percentage (e.g., 20%) of the profits that would have been allocated to the fund’s other investors if all fund profits had been allocated pro rata according to capital contributions.The fund vehicle that issues the carried interest is an entity treated as a partnership for U.S. federal income tax purposes. A partnership is not subject to entity-level tax, but instead allocates its items of income, gain, loss and deduction to  its partners, who include their shares of those items in determining their own tax liability.

 

Under current law, a carried interest is treated in the same manner as any other partnership interest, with the result that the character of the income and gains recognized by the issuing fund vehicle (e.g., as long-term capital gain, short-term capital gain or ordinary income) flows through to the Carry Entity. The Carry Entity, in turn, is typically itself a partnership for tax purposes, so that the character of the underlying fund income flows through to the individuals who hold interests in the Carry Entity.

 

Over the last several years, various bills have been introduced in Congress that, if enacted, would have treated all carried interest allocated by an investment partnership as ordinary income derived from the provision of services by the Carry Entity and its members. While the TCJA contains a provision that modifies the treatment of carried interest, it does not take this approach.

 

Instead, it retains the general treatment of carried interest under current law, but imposes a three-year holding period for the determination of whether capital gain derived by the fund is long-term or short-term. The principal features of the carried interest provision are outlined below.

Three-year Holding Period

 

Individuals are subject to U.S. federal income tax on net capital gain (that is, the excess of net long-term capital gain over net short-term capital loss) at rates that are substantially lower than the rates applicable to ordinary income and short-term capital gains (under the TCJA, a maximum rate of 20% vs. a maximum rate of 37%).

 

Unless otherwise noted, this memorandum assumes that the private fund investment vehicles described herein are entities that are treated as partnerships for U.S. federal income tax purposes. In hedge funds, this profits interest is generally called an “incentive allocation” or “performance allocation,” rather than a “carried interest.” In general, gain from the sale or other disposition of a capital asset is treated as long-term capital gain if the owner has held the asset for more than one year as of the date of disposition and as short-term capital gain if the owner has held the asset for a shorter period.

 

The TCJA changes this rule for carried interest allocations. Under the TCJA, gain allocated in respect of carried interest will qualify as long-term capital gain only if the fund has held the relevant investment for more than three years at the time of the disposition. If the fund has held the investment for a shorter period of time, the gain will be treated as short-term capital gain.

 

Sale of Carried Interest

 

The three-year holding period requirement also apparently applies to gain derived from the sale or other disposition of a partnership interest attributable to carried interest (called an “applicable partnership interest”). The taxpayer will be required to have held the “applicable partnership interest” for more than three years in order for gain on the disposition to qualify as long-term capital gain.

 

Qualified Dividend Income Unaffected

 

“Qualified dividend income” (generally, dividends from U.S. corporations and certain non-U.S. corporations) is subject to U.S. federal income tax at the rates applicable to net capital gain (i.e., 20%, plus the 3.8% tax on net investment income, in the case of an individual). The TCJA does not modify the treatment of carried interest allocations of qualified dividend income, and therefore these allocations will continue to qualify for the 23.8% rate.

 

Limited to “Applicable Partnership Interests”

 

For purposes of imposing the special three-year holding period requirement, the TCJA defines a carried interest as an “applicable partnership interest” – specifically, the three-year holding period requirement applies only to capital gain derived with respect to an “applicable partnership interest.”

An “applicable partnership interest” is a partnership interest that is transferred to, or held by, a taxpayer in connection with the performance of substantial services by the taxpayer (or by a person related to the taxpayer) in an “applicable trade or business.” The TCJA provides no guidance as to what will constitute “substantial services.”

 

An “applicable trade or business” is generally defined to mean

 

  • raising and returning capital and

 

  • either investment or development activities with respect to “specified ” “Specified assets” are
  • securities, commodities, real estate held for rental or investment and cash or cash equivalents and

 

  • options or derivative contracts with respect to, and interests in partnerships relating to, any of these

 

 

No Effect on Capital Interests.

 

An “applicable partnership interest” does not include a partnership interest that provides the taxpayer with a right to share in partnership capital commensurate with either

 

  • capital contributions made by the taxpayer or

 

  • amounts that were included as compensation income by the taxpayer at the time of grant or vesting of the relevant partnership interest (in either case, a “capital interest”).

 

As a result, the new three-year holding period rule will not apply to any capital interest. These are the U.S. federal income tax rates. Net capital gain is generally also subject to the 3.8% tax on net investment income. Any ordinary income that constitutes net earnings from self-employment will be subject to the hospital insurance tax (that is, the Medicare tax),  generally at the rate of 3.8%.

 

An “applicable partnership interest” does not include any partnership interest directly or  indirectly held by a corporation.

 

For this purpose, the amount of capital contributed by a taxpayer in respect of a partnership interest is determined at the time of the taxpayer’s receipt of the partnership interest. In private funds other than hedge funds, it is typical for investors to make capital commitments that are drawn down as capital contributions over a number of years. While it is not entirely clear how

the TCJA’s definition of a capital interest would apply in this situation, it seems likely that the requirement was not intended to preclude capital interest treatment, but instead that the Carry Entity (and each of its members) will be treated as receiving a separate capital interest each  time the Carry Entity (and the relevant member) makes a capital contribution.

 

The timing requirement may be aimed at arrangements in which a portion of the management fee otherwise payable by the fund is replaced with a special profits interest held by the Carry Entity, providing for a targeted amount of allocations equal to the management fee reduction, and the capital contributions that the Carry Entity would otherwise have made to the fund are reduced by the amount of allocations to be made in respect of this special profits interest. Under the TCJA, any such special profits interest would be treated as an “applicable partnership interest,” rather than as a capital interest.

 

IRC Sec. 83(b) Elections

 

In general, a person who receives property in connection with the performance of services must include in income, as compensation income, an amount equal to the excess of the fair market value of the property over the amount, if any, that the person paid for the property, with the inclusion occurring on the date of grant if the person’s rights to the property are fully vested on grant or on the vesting date if the person’s rights to the property are subject to vesting conditions. I

 

IRC Sec. 83(b), as amended allows a person who receives unvested property in connection with the performance of services to elect to ignore the vesting conditions and to recognize the compensation income, if any, as of the grant date.

 

Under guidance issued by the IRS (the “Profits Interest Guidance”), these rules do not apply to  a partnership profits interest that is issued to a person in respect of services the person provides to or for the benefit of the partnership in a partner capacity (as opposed to another capacity, such as an employee of a related entity).

 

The IRS has explicitly stated that IRC Sec. 83(b) elections are not required in the case of the issuance of a partnership profits interest that is subject to the Profits Interest Guidance. It is typical, however, for individuals who hold interests in a Carry Entity also to be employees of a related entity (generally, a management company that provides services to the fund), and as a result, there may be some uncertainty as to whether the IRS would view the individuals’ services are being provided in their capacities as partners of the Carry Entity, rather than in their capacities as employees. It is therefore common for an individual to make a “protective” IRC Sec. 83(b) election in connection with the receipt of an interest in a Carry Entity.

 

While an earlier version of the tax bill provided that IRC Sec. 83 (and thus a IRC Sec. 83(b) election) would not apply to a grant of an “applicable partnership interest,” the TCJA contains no such provision. Indeed, the TCJA specifically contemplates the possibility that a taxpayer will

make a IRC Sec. 83(b) election in respect of an “applicable partnership interest” by stating that the three-year holding period rule applies notwithstanding any IRC Sec. 83(b) election.

 

The TCJA does not limit the definition of “applicable partnership interest” to the provision of substantial services “in a partner capacity.” Thus, if an individual receives an interest in a Carry Entity in connection with services that he or she performs as an employee of another entity, the three-year holding period requirement will apply except in respect of the portion of the interest that is treated as a capital interest, as described above.

 

Exclusions for Certain Service Providers.

 

The three-year holding period requirement will not apply to a partnership interest held by a person who is employed by an entity other than the issuing partnership if

 

  • such other entity conducts a trade or business other than an “applicable trade or business,” as defined above, and

 

  • the person to whom the partnership interest is issued provides services only to that other

 

Although not entirely clear, this provision may be intended to clarify that the three-year holding period requirement does not apply to executives of a portfolio company who hold  profits interests in a holding vehicle for the portfolio company (sometimes referred to as a “top hat” vehicle).

 

Related Party Transfers

 

Although not entirely clear, a special rule appears to treat a direct or indirect transfer of a carried interest to certain specified persons as a taxable sale of the carried interest, even if the transfer would otherwise be entitled to non-recognition under another provision of the Code. The specified persons are

 

  • any family member or

 

  • any person who performed services in the current year or the preceding three years in any “applicable trade or business” in or for which the taxpayer performed a

 

 

Changes in Tax Rates

 

The TCJA revises the tax rates for both corporations and individuals.

 

Corporate Tax

 

The TCJA dramatically reduces the highest corporate rate from 35% to 21%. This rate reduction has no “sunset” provision and is effective for taxable years beginning after December 31, 2017. The TCJA also repeals the corporate alternative minimum tax (the “AMT”), unlike a version of the Senate tax bill, which would have retained the corporate AMT. Given the lower corporate tax rate, the amount of the dividends-received deduction (which a corporation may claim in respect of dividends received from U.S. corporations and the “U.S.-source portion” of dividends received from certain foreign corporations) has been reduced.

 

Individual Tax

 

The tax brackets for individuals have been modified, with the highest marginal individual rate reduced from 39.6% to 37%. The reduced rates are temporary – they will be effective for 2018 through 2025. Although the corporate AMT has been repealed, the TCJA retains the individual AMT, but increases the relevant exemption amount and the threshold amount of “alternative minimum taxable income” after which the exemption is phased out.

 

The TCJA also significantly increases the standard deduction available to individuals.

 

Restrictions on Deductions for Individuals

 

For 2018 through 2025, the years in which the reduced marginal tax rates apply to individuals and other non-corporate taxpayers, the TCJA imposes certain significant restrictions on the deductions that an individual or other non-corporate taxpayer may claim, thereby increasing the base on which the income tax will be imposed.

 

Disallowance of “Miscellaneous Itemized Deductions”

 

The TCJA disallows all miscellaneous itemized deductions for 2018 through 2025. For non-corporate taxpayers,

 

investment-related expenses (called “IRC Sec. 212 expenses”) are miscellaneous itemized deductions. These expenses generally include an investor’s share of the expenses of a private equity fund or other private fund that is not an active trader in securities or other assets, including the investor’s share of the management fee paid by the fund.

 

If such a private fund enters into a swap (i.e., an interest rate swap), a non-corporate investor’s share of payments made on the swap will be disallowed miscellaneous itemized deductions and will therefore not be netted against the investor’s share of the payments made on the swap. Disallowed miscellaneous itemized deductions may not be capitalized, with the result that the investor will not receive any tax benefit in respect of such expenses.

Under current law, a non-corporate taxpayer’s ability to deduct miscellaneous itemized deductions is subject to significant limitations. In particular, miscellaneous itemized deductions are allowable for any taxable year only to the extent that they exceed 2% of the taxpayer’s adjusted gross income for that year (a limitation known as the “2% floor”). After 2026, these limitations will again be applicable.

 

Expenses incurred in connection with trading activities by funds that are active traders in securities or other assets are treated as business expenses, rather than miscellaneous itemized deductions, and as a consequence the new disallowance will not apply to these expenses. In addition, an investor’s share of the expenses of a portfolio company that is engaged in a trade  or business and is treated as a partnership for U.S. federal income tax purposes (an “operating partnership”) will generally constitute business expenses, rather than miscellaneous itemized deductions.

 

An investor’s share of interest paid or accrued by a private fund will not constitute a miscellaneous itemized deduction, but is subject to separate limitations on deductibility, including primarily the pre-existing limitation on the deductibility of “investment interest,” under which a non-corporate taxpayer’s deduction for “investment interest” is limited to the amount of the taxpayer’s “net investment income.

 

Disallowance of Deduction for Excess Business Losses

 

For 2018 through 2025, a non-corporate taxpayer will not be entitled to deduct an “excess business loss.” An “excess business loss” is the amount, if any, by which

 

  • the taxpayer’s aggregate deductions attributable to trades or businesses exceed

 

  • the taxpayer’s aggregate gross income or gain attributable to trades or businesses plus an amount equal, in 2018, to $250,000 (or $500,000 in the case of a joint return) and indexed for inflation in subsequent taxable

 

Any disallowed excess business loss will be treated as a net operating loss carryover. In the case of a partnership, this limitation applies at the partner level by taking into account each partner’s share of the partnership’s items of income, gain, loss and deduction.

 

The same approach applies to shareholders of S corporations.

 

The “passive activity rules,” which pre-date the TCJA, limit the ability of taxpayers other than widely held corporations to deduct losses from a “passive activity,” generally defined as an activity that involves the conduct of a trade or business in which the taxpayer does  not materially participate. The passive activity rules limit the ability of investors in private funds, as well as members of a Carry Entity, to deduct their shares of the losses and deductions of operating

 

For this purpose, “net investment income” does not include long-term capital gains or qualified dividend income unless the taxpayer elects to be subject to tax on such income at the rates applicable to ordinary income.

 

The TCJA has also revised the rules applicable to net operating losses: it eliminates the two-year carryback, provides an indefinite (as opposed to a 20-year) carryover and limits the amount of a net operating loss carryover that may be used in any taxable year to 80% of taxable income, as computed without regard to the net operating loss deduction partnerships in which the fund invests.

 

The new excess business loss limitation will apply after application of the passive activity rules.

 

This limitation will also apply in situations in which the passive activity loss rules do not apply. In particular, trading in actively traded personal property is not treated as a “passive activity,” and therefore an investor’s share of the income, gains, losses and deductions derived by a fund  from trading in actively traded securities or other assets is not subject to the passive activity rules.

 

The new limitation on excess business losses will apply to investors in active trading funds. In addition, this limitation will apply in situations in which the taxpayer materially participates in the relevant business and in which the passive activity rules therefore do not apply. For example, it will apply to fund managers who hold interests in a management company that is treated as a partnership for tax purposes and to managers of an operating partnership who hold equity interests in the operating partnership.

 

Limitation on Deduction for State and Local Taxes

 

For an individual taxpayer, the TCJA limits to $10,000 (or $5,000 in the case of a married individual filing a separate return) in any taxable year the deduction for the aggregate amount  of:

 

  • state and local income taxes; and

 

  • state and local property taxes, other than taxes paid or accrued in carrying on a trade or business or an investment

 

These rules will apply for 2018 through 2025.

 

Corporations, unlike individuals, have retained the deduction for state and local income taxes.

 

The rules will apply not only to state and local income taxes paid directly by an individual, including in respect of the individual’s share of the income of a partnership, but also to an

individual’s share of any state and local taxes paid by a partnership. As a consequence, individual investors in private equity funds and individual members of any Carry Entity will not be able to deduct state and local income taxes imposed with respect to their shares of income derived from an operating partnership, regardless of whether those taxes are payable by the individuals or by the relevant portfolio company. In addition, individuals who are members of “management company” partnerships operating in New York City will not be able to deduct state and local income taxes imposed with respect to the management company’s income, including their shares of any New York City unincorporated business tax paid by the management company.

 

Special Deduction for Pass-Through Business Income

 

The TCJA establishes a new deduction for business income derived by individuals from partnerships and other pass-through arrangements (a “pass-through deduction”). For this purpose, pass-through arrangements include sole proprietorships, S corporations and entities that are treated as partnerships for U.S. federal income tax purposes, including limited liability companies that are treated as partnerships.

 

This deduction will be available for 2018 through 2025.

 

In general, U.S. persons other than widely held corporations may deduct their losses from “passive activities” only to the extent of their income from “passive activities.”  Disallowed passive activity loss deductions in respect of any passive activity may be carried forward to future years as passive activity losses and, subject to the new limitation on excess business losses, are allowed in full when the taxpayer disposes of its entire interest in the relevant passive activity, provided that the acquirer is unrelated to the taxpayer.

 

Deduction for “Qualified Business Income”

 

An individual may deduct an amount equal to 20% of the “qualified business income” he or she derives from each “qualified trade or business” in which he or she is engaged, either directly or through ownership of an interest in an entity that is treated as a partnership, subject to the wage cap and the taxable income cap described below.

 

In general, a “qualified trade or business” means any trade or business other than

 

  • a specified service trade or business, as discussed below, or

 

  • the performance of services as an

 

“Qualified business income” generally includes the net income derived from the relevant trade or business, but does not include (i) capital gain or loss, dividends, investment interest and certain other types of investment income, (ii) any compensation paid to the individual for services

rendered with respect to the “qualified trade or business,” whether paid as salary, as a “guaranteed payment” by a partnership or otherwise or (iii) any qualified REIT dividends or qualified publicly traded partnership (“PTP”) income, which give rise to a separate pass-through deduction, as described below. Net loss of a trade or business is carried over for purposes of determining the amount of an individual’s “qualified business income” for subsequent taxable years.

 

Deduction for REIT Dividends and PTP Income

 

Subject to the taxable income cap described below, an individual may also deduct 20% of

 

  • any dividends he or she receives from real estate investment trusts (“REITs”), other than any portion of any REIT dividend that constitutes a capital gain dividend or qualified dividend income (“qualified REIT dividends”) and

 

  • his or her share of the “qualified business income” of any PTPs, as well as the ordinary income that he or she recognizes on a disposition of an interest in a PTP in respect of certain non-capital assets of the PTP. (“qualified PTP income”).

 

The pass-through deduction will generally be available for income derived from a PTP that is engaged in a natural resources business, such as an oil and gas business, but generally will not be available for income derived from an investment management PTP because the income derived directly by such a PTP will generally constitute investment income, rather than “qualified business income.”

 

Taxable Income Cap

 

The amount deductible by an individual in respect of qualified business income, qualified REIT income and qualified PTP income for any taxable year may not exceed 20% of the individual’s taxable income, reduced by his or her net capital gain, for such taxable year.

 

Wage Cap

 

In general, an individual’s deductible amount in respect of any “qualified trade or business” is capped at the greater of

 

  • 50% of the individual’s share of the W-2 wages paid to employees in connection with the qualified trade or business and

 

  • the sum of 25% of such W-2 wages and 2.5% of the individual’s share of the tax basis, dividends” and

  • his or her taxable income, reduced by net capital gain. This memorandum does not address qualified cooperative

 

An individual is subject to U.S. federal income tax at a maximum marginal rate of 20% in respect of both REIT capital gain dividends and qualified dividend income.

 

Under IRC Sec. 751 of the Code, a person who disposes of an interest in a partnership may recognize ordinary income or loss to the extent that the sale proceeds are treated as attributable to certain unrealized receivables and inventory held by the partnership.

 

This cap does not apply to an individual whose taxable income is no more than a certain threshold amount ($157,500 or, in the case of a joint return, $315,000) and is phased in on a sliding scale for individuals whose taxable income is between this threshold amount and a higher specified amount ($207,500 or, in the case of a joint return, $415,000). The wage cap also does not apply to qualified REIT income or qualified PTP income.

 

Service Businesses Excluded

 

The pass-through deduction will not be available in respect of income derived from a “specified service trade or business,” generally defined as a trade or business involving the performance  of services in which the reputation or skill of one or more individuals is the principal asset. These categories of business include investment management and investing, trading or dealing in securities, partnership interests or commodities.

 

As a consequence, the special 20% deduction generally will not be available with respect to an individual’s share of income derived from a partnership that sponsors and manages investment funds, regardless of whether the individual is actively engaged in the fund management business or is a passive investor.

 

Similar to the wage cap, however, this exclusion does not apply to an individual whose taxable income is less than a certain threshold amount ($157,500 or, in the case of a joint return,

$315,000) and is phased in on a sliding scale for individuals whose taxable income is between the threshold amount and a higher specified amount ($207,500 or, in the case   of a joint return,

$415,000).

 

Fund investors who are individuals will generally be entitled to claim the pass-through deduction in respect of their shares of any “qualified business income” generated by an operating partnership in which the fund invests, as well as their shares of any qualified REIT dividends and qualified PTP income derived by the fund.

 

Although it is not entirely clear how the pass-through deduction rules will apply to individuals who are members of a Carry Entity, it would appear that these individuals may claim deductions for their shares of such “qualified business income,” qualified REIT dividends and qualified PTP

income, including the portion of any such income that is allocated to the Carry Entity as carried interest.

 

Tax-Exempt Investors in Funds

 

Certain provisions of the TCJA will affect investors that are organizations generally exempt from

  • federal income tax, including the provisions described

 

Excise Tax on Net Investment Income

 

The TCJA imposes a 1.4% excise tax on the “net investment income” of a private institution of higher education if

 

  • the institution has at least 500 tuition-paying students more than 50% of whom are located in the United States and

 

  • the aggregate value of its assets (other than assets used directly in carrying out its educational purpose) is at least $500,000 per

 

“Net investment income” is defined by reference to rules similar to those applicable to private foundations, which are subject to an excise tax on net investment income under current law, and would generally include income (net of certain expenses) from interest, dividends, rent, payments with respect to securities loans, royalties and capital gains. This tax would generally apply to such an institution’s share of the income of an investment fund.

 

UBTI Separately Computed for Each Trade or Business

 

In general, tax-exempt organizations are subject to U.S. federal income taxation with respect to any unrelated business taxable income. However, engineering and architecture are exempted from the “specified service trade or business” category of (“UBTI”) they derive.

 

UBTI is generally defined as income derived from any trade or business that is not substantially related to the purpose constituting the basis for the organization’s exemption from tax. Most types of investment income are excluded from UBTI, but investment income that would otherwise be excluded will constitute UBTI to the extent it constitutes “debt-financed income” (that is, to the extent that it is derived from property in respect of which “acquisition indebtedness” is outstanding).

 

A tax-exempt investor’s share of all or most of the income of an operating partnership will constitute UBTI. While some tax-exempt organizations elect to participate in operating partnership investments through investment vehicles that are treated as corporations for U.S. federal income tax purposes (“blockers”), other tax-exempt entities do not elect to participate  in

these investments through blockers, in large part because, under current law, they can offset net UBTI with net losses derived from UBTI-generating investments.

 

Under the TCJA, a tax-exempt organization will be required to calculate UBTI separately with respect to each trade or business in which it has an interest. Thus, a tax-exempt organization will not be entitled to use a net operating loss from one trade or business to offset UBTI from another trade or business: the net operating loss will be available only to offset net income generated by the same trade or business in subsequent years. However, the use of a net operating loss arising in a taxable year beginning before January 1, 2018 will be grandfathered.

 

Any such loss may be carried over to subsequent years and used to offset UBTI from a different trade or business. It is not entirely clear how the new limitation applies to debt-financed income, but presumably, a tax-exempt organization would compute its UBTI separately in respect of all of its debt-financed income that consists of income that would otherwise have been excluded from UBTI.

 

As a result of this “no netting” provision, an increased number of tax-exempt investors may elect to invest in operating partnerships through blockers. Tax-exempt investors may also be less likely to invest in funds that are likely to make a significant number of investments in operating partnerships and more likely to request contractual limitations on the portion of the investors’ commitments that a fund may invest in operating partnerships. In situations in which tax-exempt investors have unblocked interests in a fund with operating partnership investments, the investors will need the fund to provide information that separates the net income or net loss generated by each such operating partnership.

 

State and Local Governments

 

State and local governments, including pension plans for state and local employees, do not pay

U.S. federal income tax on UBTI. An early version of the tax legislation that was introduced in the House would have subjected state and local governments to tax on UBTI. The TCJA contains no such provision.

 

Non-U.S. Investors in Funds

 

Effectively Connected Income on Sale of Partnership Interest

 

In general, under pre-TCJA law, the sale by a non-U.S. individual or corporation of an interest in an    entity that is treated as a partnership for U.S. federal income tax purposes is not subject to

U.S. federal income or withholding tax. However, the Code provides that if a partnership holds one or more “U.S. real property interests” (“USRPI’s”) and a non-U.S. person disposes of an interest in the partnership, the portion of the sales proceeds attributable to the USRPI’s will be treated as a disposition of the USRPI’s, and any gain from this deemed disposition will  constitute “effectively connected income” (“ECI”).

 

The non-U.S. person is required to file a U.S. federal income tax return reporting any ECI and is required to pay U.S. federal income tax on a net income basis, at the rates applicable to U.S. persons (either the individual or the corporate rates, as the case may be), in respect of the ECI. In addition, if the non-U.S. person is a corporation, it will be subject to a U.S. branch profits tax at a flat rate of 30% on its “dividend equivalent amount” attributable to certain ECI (very generally, the after-tax amount of certain ECI that is not treated as reinvested in a U.S. trade or business).

 

In a 1991 ruling, the IRS extended this rule to cover other ECI-generating assets. The ruling adopted the position that gain derived by a non-U.S. person from the sale or other disposition of an interest in a partnership constitutes ECI to the extent that the gain is attributable to partnership assets, other than USRPI’s, the sale of which by the partnership would have given rise to gain that is treated as ECI (i.e., assets used in a U.S. trade or business conducted by the partnership).

 

In 2017, the U.S. Tax Court rejected the IRS’s position, holding that such gain   is not subject to

  • The TCJA codifies the 1991 IRS ruling, effective for dispositions of partnership interests on or after November 27, 2017. The new rule applies to dispositions of interests in PTPs (sometimes referred to as “master limited partnerships” or “MLPs”), as well as to dispositions of interests in private partnership.

 

The TCJA also provides that a non-U.S. person will recognize gain on the disposition of an interest in a partnership even if the disposition is within the ambit of a non-recognition provision of the Code (e.g., a contribution of a partnership interest to another partnership that would not otherwise be a recognition event). The TCJA gives Treasury regulatory authority to prescribe circumstances in which certain non-recognition provisions will apply to defer the recognition of gain under the new provision.

 

Withholding Tax on Sale of Partnership Interests

 

The TCJA generally requires a buyer of a partnership interest to withhold 10% of the gross purchase price on the sale of the interest unless the seller can establish that it is a U.S. person or that no portion of the seller’s gain is attributable to ECI-generating assets. While not explicitly provided in the legislation, the withholding tax would likely also apply to a redemption of a partnership interest.

 

If the buyer fails to withhold, the partnership is liable for the withholding tax, plus interest. Although the substantive tax is applicable to gain realized on dispositions of partnership interests on or after November 27, 2017, as described above, the withholding tax requirement is effective only for dispositions after December 31, 2017.

As a consequence of these new rules, a private fund with a non-U.S. partner that wishes to transfer its interest will need to provide the non-U.S. partner with information regarding the non-U.S. partner’s share of the partnership’s ECI-generating assets. In general, it would be prudent for the fund to require the transferor and transferee to inform the fund of the sale price and to provide the fund with a copy of the relevant withholding certificate and proof of payment of the withholding tax, if applicable.

 

Because the fund will have ultimate liability for the withholding taxes, private investment funds should consider amending their organizational  documents and transfer documents to ensure that the fund is indemnified by the transferor and transferee for any withholding tax imposed under this new provision.

 

Limitations on Deduction for Business Interest

 

The TCJA limits the deductibility of “business interest,” defined as any interest expense properly allocable to a trade or business. Business interest includes any interest paid or accrued by a Treasury has exceptions for non-recognition events in the case of certain transfers of USRPI’s by non-U.S. persons. Although these rules would not apply to the portion of any gain that is not attributable to USRPI’s, they may serve as a template for eventual exceptions in the case of such non-USRPI gain.

 

The legislative history states that Treasury may provide guidance permitting a broker to withhold 10% of the sale proceeds as an agent of the transferee (for example, on the sale by a non-U.S. person of units in a PTP) corporation. This limitation may affect portfolio companies in which funds invest, blocker entities formed by funds and investors in funds.

 

The deduction for business interest for any taxable year is limited to the sum of

 

  • the taxpayer’s “business interest income,”

 

  • the taxpayer’s “floor plan financing interest”and

 

  • 30% of the taxpayer’s “adjusted taxable income” (“ATI”) for the taxable

 

In general, a taxpayer’s ATI is its taxable income computed without regard to

 

  • items not properly allocable to a trade or business,

 

  • business interest income or business interest expenses,

 

  • any net operating loss deduction,

 

  • any pass-through deduction, as discussed above and

 

  • for taxable years beginning before January 1, 2022, any deduction for depreciation, amortization or

 

“Business interest income” is any interest income properly allocable to a trade or business. Any business interest that is not deductible as a consequence of this limitation may be carried forward indefinitely. Following a change of control of a corporation, the corporation’s carryforward of unused business interest expenses would be subject to limitation under IRC Sec. 382 of the Code, which limits the use of a corporation’s net operating losses and other tax assets following a change of control.

 

Existing debt Will Not Be Grandfathered

 

The limitation on the deductibility of business interest will not apply, however, to interest attributable to an electing real property trade or business or to certain other narrowly defined businesses.

 

In the case of a partnership, the limitation on the deductibility of business interest will apply at the partnership level, by reference to the partnership’s ATI and business interest income. After application of the limitation, any partnership deduction for business interest will decrease the net income, or increase the net loss, allocated by the partnership to its partners.

 

For purposes of determining the deductibility of business interest paid or accrued directly by a partner, the partner’s ATI will be determined without regard to the partner’s share of any items  of income, gain, deduction or loss of the partnership.

 

If a partnership has excess capacity for business interest deductions, each partner’s ATI will be increased by its share of the partnership’s “excess ATI” (that is, its share of the partnership’s ATI that corresponds to such excess capacity).

 

A partnership may not carry forward any of its business interest that it is not permitted to deduct. Instead, the excess business interest will be allocated to the partners and may be deducted by the partners to the extent, and only to the extent, of their shares of excess ATI, if any. The allocation of excess business interest to a partner results in certain adjustments to the basis of the partner’s interest in the relevant partnership.

 

If a taxpayer holds an interest in more than one partnership, the limitation is calculated separately for each partnership. As a result of the application of the limitation at the partnership level, a partner’s overall deduction for business interest, including the partner’s share of the partnership’s business interest expenses, may be less than the overall deduction would have been if the

“Floor plan financing interest” means interest paid or accrued on indebtedness used to finance the acquisition of certain motor vehicles held for sale or lease and secured by the inventory so acquired.

 

Specifically, it will not apply to any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business that elects not to have the limitation apply. A real property trade or business that makes such an election will be required to recover the cost of certain of its property over a longer period of time (and thus will have lower annual cost recovery deductions) than a real property trade or business that does not make such an election.

 

 

Limitation Applied At The Partner Level

 

Rules similar to the rules for partnerships will apply with respect to S corporations and their shareholders.

 

The limitation on the deductibility of business interest will affect portfolio companies that are treated as corporations for tax purposes and investors in operating partnerships. Moreover, it will significantly reduce the impact of debt incurred by a blocker entity. A blocker generally has no income other than its share of the income of the operating partnership(s) for which it serves as an investment vehicle.

 

As a result of the partner-level calculation described above, the blocker will have no ATI other than ATI that is attributable to its share of any excess ATI of the operating partnership. In the absence of any excess ATI, a leveraged blocker would not receive a current tax benefit for any interest paid or accrued on its debt. However, if gain from the sale of an interest in an operating partnership is treated as ATI (a point that is not clear), the blocker could use its carryforward of business interest expense to offset its share of any gain from the sale of the blocker.

 

In general, this limitation will not affect a non-corporate partner’s share of interest paid or accrued on fund-level indebtedness because that interest would generally be considered investment interest, rather than business interest. Instead, the non-corporate partner’s share of this interest would be subject to the pre-existing limitations on the deductibility of investment interest. It is not clear whether the interest in any fund-level borrowing that is incurred to finance the fund’s investment in an operating partnership would be treated as business interest.

 

Certain Provisions Affecting Portfolio Companies

 

Some of the provisions of the TCJA that may have a significant effect on portfolio companies  are described below.

 

Full Expensing for Certain Business Assets

 

Under current law, a taxpayer is allowed a first-year depreciation deduction equal to 50% of the adjusted basis (generally, the cost) of certain depreciable property it acquired and placed in service before January 1, 2021 (“bonus depreciation”). This deduction is allowed only if the taxpayer was the first user of the property.

 

The TCJA extends the application of the first-year deduction to property placed in service before January 1, 2027. Moreover, for property placed in service after September 27, 2017 and before January 1, 2023, the deduction will be equal to 100% of the adjusted basis of the relevant property. The percentage ratchets down for property placed in service during subsequent years: 80% for 2023; 60% for 2024; 40% for 2025; and 20% for 2026. Each of these dates is extended one year in the case of certain property with a longer production period.

 

The TCJA also removed the requirement that the taxpayer be the first user of the property, thus permitting a taxpayer to claim the deduction for used property that it acquires. Certain restrictions on the deduction in respect of used property, including the requirement that the property be acquired from an unrelated party, are intended to prevent abuse of this provision.

 

Net Operating Loss Deduction

 

Under current law, a taxpayer is permitted to carry a net operating loss back for two years and forward for twenty (20) years and could use a net operating loss carryback or carryover to offset all of its taxable income (determined without regard to the net operating loss deduction) for a taxable year. The TCJA eliminates the two-year carryback and provides that a net operating  loss may be carried forward indefinitely. In addition, it limits the amount of a net operating loss carryover that may be used in any taxable year to 80% of the taxpayer’s taxable income, determined without regard to the net operating loss deduction.

 

Special rules apply to property acquired before, and placed in service on or after, September  28, 2017. However, these changes in the rules relating to net operating losses do not apply to insurance companies.

The TCJA is likely to have a significant effect on private funds, with consequences for portfolio companies, investors and investment professionals. This memorandum discusses the treatment of “carried interest” under the TCJA and provides a brief overview of a number of other provisions of the TCJA that may affect private funds, including changes in tax rates, the repeal of the allowance of “miscellaneous itemized deductions” and the deduction for state and local income taxes, new rules affecting the taxation of pass-through business income, new rules affecting U.S. tax-exempt and non-U.S. investors, and the TCJA’s overhaul of the international tax regime.

Carried Interest

Typically, the general partner of a private fund or a separate entity owned by the fund’s investment professionals (such entity, the “Carry Entity”) holds an equity interest in the fund that entitles the Carry Entity to a share of the fund’s profits that is larger than the Carry Entity’s percentage interest in the capital invested in the fund.

This “carried interest” gives the Carry Entity a percentage (e.g., 20%) of the profits that would have been allocated to the fund’s other investors if all fund profits had been allocated pro rata according to capital contributions.The fund vehicle that issues the carried interest is an entity treated as a partnership for U.S. federal income tax purposes. A partnership is not subject to entity-level tax, but instead allocates its items of income, gain, loss and deduction to its partners, who include their shares of those items in determining their own tax liability.

Under current law, a carried interest is treated in the same manner as any other partnership interest, with the result that the character of the income and gains recognized by the issuing fund vehicle (e.g., as long-term capital gain, short-term capital gain or ordinary income) flows through to the Carry Entity. The Carry Entity, in turn, is typically itself a partnership for tax purposes, so that the character of the underlying fund income flows through to the individuals who hold interests in the Carry Entity.

Over the last several years, various bills have been introduced in Congress that, if enacted, would have treated all carried interest allocated by an investment partnership as ordinary income derived from the provision of services by the Carry Entity and its members. While the TCJA contains a provision that modifies the treatment of carried interest, it does not take this approach.

Instead, it retains the general treatment of carried interest under current law, but imposes a three-year holding period for the determination of whether capital gain derived by the fund is long-term or short-term. The principal features of the carried interest provision are outlined below.

Three-year Holding Period

Individuals are subject to U.S. federal income tax on net capital gain (that is, the excess of net long-term capital gain over net short-term capital loss) at rates that are substantially lower than the rates applicable to ordinary income and short-term capital gains (under the TCJA, a maximum rate of 20% vs. a maximum rate of 37%).

Unless otherwise noted, this memorandum assumes that the private fund investment vehicles described herein are entities that are treated as partnerships for U.S. federal income tax purposes. In hedge funds, this profits interest is generally called an “incentive allocation” or “performance allocation,” rather than a “carried interest.” In general, gain from the sale or other disposition of a capital asset is treated as long-term capital gain if the owner has held the asset for more than one year as of the date of disposition and as short-term capital gain if the owner has held the asset for a shorter period.

The TCJA changes this rule for carried interest allocations. Under the TCJA, gain allocated in respect of carried interest will qualify as long-term capital gain only if the fund has held the relevant investment for more than three years at the time of the disposition. If the fund has held the investment for a shorter period of time, the gain will be treated as short-term capital gain.

Sale of Carried Interest

The three-year holding period requirement also apparently applies to gain derived from the sale or other disposition of a partnership interest attributable to carried interest (called an “applicable partnership interest”). The taxpayer will be required to have held the “applicable partnership interest” for more than three years in order for gain on the disposition to qualify as long-term capital gain.

Qualified Dividend Income Unaffected

“Qualified dividend income” (generally, dividends from U.S. corporations and certain non-U.S. corporations) is subject to U.S. federal income tax at the rates applicable to net capital gain (i.e., 20%, plus the 3.8% tax on net investment income, in the case of an individual). The TCJA does not modify the treatment of carried interest allocations of qualified dividend income, and therefore these allocations will continue to qualify for the 23.8% rate.

Limited to “Applicable Partnership Interests”

For purposes of imposing the special three-year holding period requirement, the TCJA defines a carried interest as an “applicable partnership interest” – specifically, the three-year holding period requirement applies only to capital gain derived with respect to an “applicable partnership interest.”

An “applicable partnership interest” is a partnership interest that is transferred to, or held by, a taxpayer in connection with the performance of substantial services by the taxpayer (or by a person related to the taxpayer) in an “applicable trade or business.” The TCJA provides no guidance as to what will constitute “substantial services.”

An “applicable trade or business” is generally defined to mean

(i) raising and returning capital and

(ii) either investment or development activities with respect to “specified assets.” “Specified assets” are
(i) securities, commodities, real estate held for rental or investment and cash or cash equivalents and

(ii) options or derivative contracts with respect to, and interests in partnerships relating to, any of these assets.

No Effect on Capital Interests.

An “applicable partnership interest” does not include a partnership interest that provides the taxpayer with a right to share in partnership capital commensurate with either

(i) capital contributions made by the taxpayer or

(ii) amounts that were included as compensation income by the taxpayer at the time of grant or vesting of the relevant partnership interest (in either case, a “capital interest”).

As a result, the new three-year holding period rule will not apply to any capital interest. These are the U.S. federal income tax rates. Net capital gain is generally also subject to the 3.8% tax on net investment income. Any ordinary income that constitutes net earnings from self-employment will be subject to the hospital insurance tax (that is, the Medicare tax), generally at the rate of 3.8%.

An “applicable partnership interest” does not include any partnership interest directly or indirectly held by a corporation.

For this purpose, the amount of capital contributed by a taxpayer in respect of a partnership interest is determined at the time of the taxpayer’s receipt of the partnership interest. In private funds other than hedge funds, it is typical for investors to make capital commitments that are drawn down as capital contributions over a number of years. While it is not entirely clear how

the TCJA’s definition of a capital interest would apply in this situation, it seems likely that the requirement was not intended to preclude capital interest treatment, but instead that the Carry Entity (and each of its members) will be treated as receiving a separate capital interest each time the Carry Entity (and the relevant member) makes a capital contribution.

The timing requirement may be aimed at arrangements in which a portion of the management fee otherwise payable by the fund is replaced with a special profits interest held by the Carry Entity, providing for a targeted amount of allocations equal to the management fee reduction, and the capital contributions that the Carry Entity would otherwise have made to the fund are reduced by the amount of allocations to be made in respect of this special profits interest. Under the TCJA, any such special profits interest would be treated as an “applicable partnership interest,” rather than as a capital interest.

IRC Sec. 83(b) Elections

In general, a person who receives property in connection with the performance of services must include in income, as compensation income, an amount equal to the excess of the fair market value of the property over the amount, if any, that the person paid for the property, with the inclusion occurring on the date of grant if the person’s rights to the property are fully vested on grant or on the vesting date if the person’s rights to the property are subject to vesting conditions. I

IRC Sec. 83(b), as amended allows a person who receives unvested property in connection with the performance of services to elect to ignore the vesting conditions and to recognize the compensation income, if any, as of the grant date.

Under guidance issued by the IRS (the “Profits Interest Guidance”), these rules do not apply to a partnership profits interest that is issued to a person in respect of services the person provides to or for the benefit of the partnership in a partner capacity (as opposed to another capacity, such as an employee of a related entity).

The IRS has explicitly stated that IRC Sec. 83(b) elections are not required in the case of the issuance of a partnership profits interest that is subject to the Profits Interest Guidance. It is typical, however, for individuals who hold interests in a Carry Entity also to be employees of a related entity (generally, a management company that provides services to the fund), and as a result, there may be some uncertainty as to whether the IRS would view the individuals’ services are being provided in their capacities as partners of the Carry Entity, rather than in their capacities as employees. It is therefore common for an individual to make a “protective” IRC Sec. 83(b) election in connection with the receipt of an interest in a Carry Entity.

While an earlier version of the tax bill provided that IRC Sec. 83 (and thus a IRC Sec. 83(b) election) would not apply to a grant of an “applicable partnership interest,” the TCJA contains no such provision. Indeed, the TCJA specifically contemplates the possibility that a taxpayer will

make a IRC Sec. 83(b) election in respect of an “applicable partnership interest” by stating that the three-year holding period rule applies notwithstanding any IRC Sec. 83(b) election.

The TCJA does not limit the definition of “applicable partnership interest” to the provision of substantial services “in a partner capacity.” Thus, if an individual receives an interest in a Carry Entity in connection with services that he or she performs as an employee of another entity, the three-year holding period requirement will apply except in respect of the portion of the interest that is treated as a capital interest, as described above.

Exclusions for Certain Service Providers.

The three-year holding period requirement will not apply to a partnership interest held by a person who is employed by an entity other than the issuing partnership if

(i) such other entity conducts a trade or business other than an “applicable trade or business,” as defined above, and

(ii) the person to whom the partnership interest is issued provides services only to that other entity.

Although not entirely clear, this provision may be intended to clarify that the three-year holding period requirement does not apply to executives of a portfolio company who hold profits interests in a holding vehicle for the portfolio company (sometimes referred to as a “top hat” vehicle).

Related Party Transfers

Although not entirely clear, a special rule appears to treat a direct or indirect transfer of a carried interest to certain specified persons as a taxable sale of the carried interest, even if the transfer would otherwise be entitled to non-recognition under another provision of the Code. The specified persons are

(i) any family member or

(ii) any person who performed services in the current year or the preceding three years in any “applicable trade or business” in or for which the taxpayer performed a service.

Changes in Tax Rates

The TCJA revises the tax rates for both corporations and individuals.

Corporate Tax

The TCJA dramatically reduces the highest corporate rate from 35% to 21%. This rate reduction has no “sunset” provision and is effective for taxable years beginning after December 31, 2017. The TCJA also repeals the corporate alternative minimum tax (the “AMT”), unlike a version of the Senate tax bill, which would have retained the corporate AMT. Given the lower corporate tax rate, the amount of the dividends-received deduction (which a corporation may claim in respect of dividends received from U.S. corporations and the “U.S.-source portion” of dividends received from certain foreign corporations) has been reduced.

Individual Tax

The tax brackets for individuals have been modified, with the highest marginal individual rate reduced from 39.6% to 37%. The reduced rates are temporary – they will be effective for 2018 through 2025. Although the corporate AMT has been repealed, the TCJA retains the individual AMT, but increases the relevant exemption amount and the threshold amount of “alternative minimum taxable income” after which the exemption is phased out.

The TCJA also significantly increases the standard deduction available to individuals.

Restrictions on Deductions for Individuals

For 2018 through 2025, the years in which the reduced marginal tax rates apply to individuals and other non-corporate taxpayers, the TCJA imposes certain significant restrictions on the deductions that an individual or other non-corporate taxpayer may claim, thereby increasing the base on which the income tax will be imposed.

Disallowance of “Miscellaneous Itemized Deductions”

The TCJA disallows all miscellaneous itemized deductions for 2018 through 2025. For non-corporate taxpayers,

investment-related expenses (called “IRC Sec. 212 expenses”) are miscellaneous itemized deductions. These expenses generally include an investor’s share of the expenses of a private equity fund or other private fund that is not an active trader in securities or other assets, including the investor’s share of the management fee paid by the fund.

If such a private fund enters into a swap (i.e., an interest rate swap), a non-corporate investor’s share of payments made on the swap will be disallowed miscellaneous itemized deductions and will therefore not be netted against the investor’s share of the payments made on the swap. Disallowed miscellaneous itemized deductions may not be capitalized, with the result that the investor will not receive any tax benefit in respect of such expenses.

Under current law, a non-corporate taxpayer’s ability to deduct miscellaneous itemized deductions is subject to significant limitations. In particular, miscellaneous itemized deductions are allowable for any taxable year only to the extent that they exceed 2% of the taxpayer’s adjusted gross income for that year (a limitation known as the “2% floor”). After 2026, these limitations will again be applicable.

Expenses incurred in connection with trading activities by funds that are active traders in securities or other assets are treated as business expenses, rather than miscellaneous itemized deductions, and as a consequence the new disallowance will not apply to these expenses. In addition, an investor’s share of the expenses of a portfolio company that is engaged in a trade or business and is treated as a partnership for U.S. federal income tax purposes (an “operating partnership”) will generally constitute business expenses, rather than miscellaneous itemized deductions.

An investor’s share of interest paid or accrued by a private fund will not constitute a miscellaneous itemized deduction, but is subject to separate limitations on deductibility, including primarily the pre-existing limitation on the deductibility of “investment interest,” under which a non-corporate taxpayer’s deduction for “investment interest” is limited to the amount of the taxpayer’s “net investment income.

Disallowance of Deduction for Excess Business Losses

For 2018 through 2025, a non-corporate taxpayer will not be entitled to deduct an “excess business loss.” An “excess business loss” is the amount, if any, by which

(i) the taxpayer’s aggregate deductions attributable to trades or businesses exceed

(ii) the taxpayer’s aggregate gross income or gain attributable to trades or businesses plus an amount equal, in 2018, to $250,000 (or $500,000 in the case of a joint return) and indexed for inflation in subsequent taxable years.

Any disallowed excess business loss will be treated as a net operating loss carryover. In the case of a partnership, this limitation applies at the partner level by taking into account each partner’s share of the partnership’s items of income, gain, loss and deduction.

The same approach applies to shareholders of S corporations.

The “passive activity rules,” which pre-date the TCJA, limit the ability of taxpayers other than widely held corporations to deduct losses from a “passive activity,” generally defined as an activity that involves the conduct of a trade or business in which the taxpayer does not materially participate. The passive activity rules limit the ability of investors in private funds, as well as members of a Carry Entity, to deduct their shares of the losses and deductions of operating

For this purpose, “net investment income” does not include long-term capital gains or qualified dividend income unless the taxpayer elects to be subject to tax on such income at the rates applicable to ordinary income.

The TCJA has also revised the rules applicable to net operating losses: it eliminates the two-year carryback, provides an indefinite (as opposed to a 20-year) carryover and limits the amount of a net operating loss carryover that may be used in any taxable year to 80% of taxable income, as computed without regard to the net operating loss deduction partnerships in which the fund invests.

The new excess business loss limitation will apply after application of the passive activity rules.

This limitation will also apply in situations in which the passive activity loss rules do not apply. In particular, trading in actively traded personal property is not treated as a “passive activity,” and therefore an investor’s share of the income, gains, losses and deductions derived by a fund from trading in actively traded securities or other assets is not subject to the passive activity rules.

The new limitation on excess business losses will apply to investors in active trading funds. In addition, this limitation will apply in situations in which the taxpayer materially participates in the relevant business and in which the passive activity rules therefore do not apply. For example, it will apply to fund managers who hold interests in a management company that is treated as a partnership for tax purposes and to managers of an operating partnership who hold equity interests in the operating partnership.

Limitation on Deduction for State and Local Taxes

For an individual taxpayer, the TCJA limits to $10,000 (or $5,000 in the case of a married individual filing a separate return) in any taxable year the deduction for the aggregate amount of:

(i) state and local income taxes; and

(ii) state and local property taxes, other than taxes paid or accrued in carrying on a trade or business or an investment activity.

These rules will apply for 2018 through 2025.

Corporations, unlike individuals, have retained the deduction for state and local income taxes.

The rules will apply not only to state and local income taxes paid directly by an individual, including in respect of the individual’s share of the income of a partnership, but also to an

individual’s share of any state and local taxes paid by a partnership. As a consequence, individual investors in private equity funds and individual members of any Carry Entity will not be able to deduct state and local income taxes imposed with respect to their shares of income derived from an operating partnership, regardless of whether those taxes are payable by the individuals or by the relevant portfolio company. In addition, individuals who are members of “management company” partnerships operating in New York City will not be able to deduct state and local income taxes imposed with respect to the management company’s income, including their shares of any New York City unincorporated business tax paid by the management company.

Special Deduction for Pass-Through Business Income

The TCJA establishes a new deduction for business income derived by individuals from partnerships and other pass-through arrangements (a “pass-through deduction”). For this purpose, pass-through arrangements include sole proprietorships, S corporations and entities that are treated as partnerships for U.S. federal income tax purposes, including limited liability companies that are treated as partnerships.

This deduction will be available for 2018 through 2025.

In general, U.S. persons other than widely held corporations may deduct their losses from “passive activities” only to the extent of their income from “passive activities.” Disallowed passive activity loss deductions in respect of any passive activity may be carried forward to future years as passive activity losses and, subject to the new limitation on excess business losses, are allowed in full when the taxpayer disposes of its entire interest in the relevant passive activity, provided that the acquirer is unrelated to the taxpayer.

Deduction for “Qualified Business Income”

An individual may deduct an amount equal to 20% of the “qualified business income” he or she derives from each “qualified trade or business” in which he or she is engaged, either directly or through ownership of an interest in an entity that is treated as a partnership, subject to the wage cap and the taxable income cap described below.

In general, a “qualified trade or business” means any trade or business other than

(i) a specified service trade or business, as discussed below, or

(ii) the performance of services as an employee.

“Qualified business income” generally includes the net income derived from the relevant trade or business, but does not include (i) capital gain or loss, dividends, investment interest and certain other types of investment income, (ii) any compensation paid to the individual for services

rendered with respect to the “qualified trade or business,” whether paid as salary, as a “guaranteed payment” by a partnership or otherwise or (iii) any qualified REIT dividends or qualified publicly traded partnership (“PTP”) income, which give rise to a separate pass-through deduction, as described below. Net loss of a trade or business is carried over for purposes of determining the amount of an individual’s “qualified business income” for subsequent taxable years.

Deduction for REIT Dividends and PTP Income

Subject to the taxable income cap described below, an individual may also deduct 20% of

(i) any dividends he or she receives from real estate investment trusts (“REITs”), other than any portion of any REIT dividend that constitutes a capital gain dividend or qualified dividend income (“qualified REIT dividends”) and

(ii) his or her share of the “qualified business income” of any PTPs, as well as the ordinary income that he or she recognizes on a disposition of an interest in a PTP in respect of certain non-capital assets of the PTP. (“qualified PTP income”).

The pass-through deduction will generally be available for income derived from a PTP that is engaged in a natural resources business, such as an oil and gas business, but generally will not be available for income derived from an investment management PTP because the income derived directly by such a PTP will generally constitute investment income, rather than “qualified business income.”

Taxable Income Cap

The amount deductible by an individual in respect of qualified business income, qualified REIT income and qualified PTP income for any taxable year may not exceed 20% of the individual’s taxable income, reduced by his or her net capital gain, for such taxable year.

Wage Cap

In general, an individual’s deductible amount in respect of any “qualified trade or business” is capped at the greater of

(i) 50% of the individual’s share of the W-2 wages paid to employees in connection with the qualified trade or business and

(ii) the sum of 25% of such W-2 wages and 2.5% of the individual’s share of the tax basis, dividends” and

(iii) his or her taxable income, reduced by net capital gain. This memorandum does not address qualified cooperative dividends.

An individual is subject to U.S. federal income tax at a maximum marginal rate of 20% in respect of both REIT capital gain dividends and qualified dividend income.

Under IRC Sec. 751 of the Code, a person who disposes of an interest in a partnership may recognize ordinary income or loss to the extent that the sale proceeds are treated as attributable to certain unrealized receivables and inventory held by the partnership.

This cap does not apply to an individual whose taxable income is no more than a certain threshold amount ($157,500 or, in the case of a joint return, $315,000) and is phased in on a sliding scale for individuals whose taxable income is between this threshold amount and a higher specified amount ($207,500 or, in the case of a joint return, $415,000). The wage cap also does not apply to qualified REIT income or qualified PTP income.

Service Businesses Excluded

The pass-through deduction will not be available in respect of income derived from a “specified service trade or business,” generally defined as a trade or business involving the performance of services in which the reputation or skill of one or more individuals is the principal asset. These categories of business include investment management and investing, trading or dealing in securities, partnership interests or commodities.

As a consequence, the special 20% deduction generally will not be available with respect to an individual’s share of income derived from a partnership that sponsors and manages investment funds, regardless of whether the individual is actively engaged in the fund management business or is a passive investor.

Similar to the wage cap, however, this exclusion does not apply to an individual whose taxable income is less than a certain threshold amount ($157,500 or, in the case of a joint return,
$315,000) and is phased in on a sliding scale for individuals whose taxable income is between the threshold amount and a higher specified amount ($207,500 or, in the case of a joint return,
$415,000).

Fund investors who are individuals will generally be entitled to claim the pass-through deduction in respect of their shares of any “qualified business income” generated by an operating partnership in which the fund invests, as well as their shares of any qualified REIT dividends and qualified PTP income derived by the fund.

Although it is not entirely clear how the pass-through deduction rules will apply to individuals who are members of a Carry Entity, it would appear that these individuals may claim deductions for their shares of such “qualified business income,” qualified REIT dividends and qualified PTP

income, including the portion of any such income that is allocated to the Carry Entity as carried interest.

Tax-Exempt Investors in Funds

Certain provisions of the TCJA will affect investors that are organizations generally exempt from
U.S. federal income tax, including the provisions described below.

Excise Tax on Net Investment Income

The TCJA imposes a 1.4% excise tax on the “net investment income” of a private institution of higher education if

(i) the institution has at least 500 tuition-paying students more than 50% of whom are located in the United States and

(ii) the aggregate value of its assets (other than assets used directly in carrying out its educational purpose) is at least $500,000 per student.

“Net investment income” is defined by reference to rules similar to those applicable to private foundations, which are subject to an excise tax on net investment income under current law, and would generally include income (net of certain expenses) from interest, dividends, rent, payments with respect to securities loans, royalties and capital gains. This tax would generally apply to such an institution’s share of the income of an investment fund.

UBTI Separately Computed for Each Trade or Business

In general, tax-exempt organizations are subject to U.S. federal income taxation with respect to any unrelated business taxable income. However, engineering and architecture are exempted from the “specified service trade or business” category of (“UBTI”) they derive.

UBTI is generally defined as income derived from any trade or business that is not substantially related to the purpose constituting the basis for the organization’s exemption from tax. Most types of investment income are excluded from UBTI, but investment income that would otherwise be excluded will constitute UBTI to the extent it constitutes “debt-financed income” (that is, to the extent that it is derived from property in respect of which “acquisition indebtedness” is outstanding).

A tax-exempt investor’s share of all or most of the income of an operating partnership will constitute UBTI. While some tax-exempt organizations elect to participate in operating partnership investments through investment vehicles that are treated as corporations for U.S. federal income tax purposes (“blockers”), other tax-exempt entities do not elect to participate in

these investments through blockers, in large part because, under current law, they can offset net UBTI with net losses derived from UBTI-generating investments.

Under the TCJA, a tax-exempt organization will be required to calculate UBTI separately with respect to each trade or business in which it has an interest. Thus, a tax-exempt organization will not be entitled to use a net operating loss from one trade or business to offset UBTI from another trade or business: the net operating loss will be available only to offset net income generated by the same trade or business in subsequent years. However, the use of a net operating loss arising in a taxable year beginning before January 1, 2018 will be grandfathered.

Any such loss may be carried over to subsequent years and used to offset UBTI from a different trade or business. It is not entirely clear how the new limitation applies to debt-financed income, but presumably, a tax-exempt organization would compute its UBTI separately in respect of all of its debt-financed income that consists of income that would otherwise have been excluded from UBTI.

As a result of this “no netting” provision, an increased number of tax-exempt investors may elect to invest in operating partnerships through blockers. Tax-exempt investors may also be less likely to invest in funds that are likely to make a significant number of investments in operating partnerships and more likely to request contractual limitations on the portion of the investors’ commitments that a fund may invest in operating partnerships. In situations in which tax-exempt investors have unblocked interests in a fund with operating partnership investments, the investors will need the fund to provide information that separates the net income or net loss generated by each such operating partnership.

State and Local Governments

State and local governments, including pension plans for state and local employees, do not pay
U.S. federal income tax on UBTI. An early version of the tax legislation that was introduced in the House would have subjected state and local governments to tax on UBTI. The TCJA contains no such provision.

Non-U.S. Investors in Funds

Effectively Connected Income on Sale of Partnership Interest

In general, under pre-TCJA law, the sale by a non-U.S. individual or corporation of an interest in an entity that is treated as a partnership for U.S. federal income tax purposes is not subject to
U.S. federal income or withholding tax. However, the Code provides that if a partnership holds one or more “U.S. real property interests” (“USRPI’s”) and a non-U.S. person disposes of an interest in the partnership, the portion of the sales proceeds attributable to the USRPI’s will be treated as a disposition of the USRPI’s, and any gain from this deemed disposition will constitute “effectively connected income” (“ECI”).

The non-U.S. person is required to file a U.S. federal income tax return reporting any ECI and is required to pay U.S. federal income tax on a net income basis, at the rates applicable to U.S. persons (either the individual or the corporate rates, as the case may be), in respect of the ECI. In addition, if the non-U.S. person is a corporation, it will be subject to a U.S. branch profits tax at a flat rate of 30% on its “dividend equivalent amount” attributable to certain ECI (very generally, the after-tax amount of certain ECI that is not treated as reinvested in a U.S. trade or business).

In a 1991 ruling, the IRS extended this rule to cover other ECI-generating assets. The ruling adopted the position that gain derived by a non-U.S. person from the sale or other disposition of an interest in a partnership constitutes ECI to the extent that the gain is attributable to partnership assets, other than USRPI’s, the sale of which by the partnership would have given rise to gain that is treated as ECI (i.e., assets used in a U.S. trade or business conducted by the partnership).

In 2017, the U.S. Tax Court rejected the IRS’s position, holding that such gain is not subject to
U.S. tax. The TCJA codifies the 1991 IRS ruling, effective for dispositions of partnership interests on or after November 27, 2017. The new rule applies to dispositions of interests in PTPs (sometimes referred to as “master limited partnerships” or “MLPs”), as well as to dispositions of interests in private partnership.

The TCJA also provides that a non-U.S. person will recognize gain on the disposition of an interest in a partnership even if the disposition is within the ambit of a non-recognition provision of the Code (e.g., a contribution of a partnership interest to another partnership that would not otherwise be a recognition event). The TCJA gives Treasury regulatory authority to prescribe circumstances in which certain non-recognition provisions will apply to defer the recognition of gain under the new provision.

Withholding Tax on Sale of Partnership Interests

The TCJA generally requires a buyer of a partnership interest to withhold 10% of the gross purchase price on the sale of the interest unless the seller can establish that it is a U.S. person or that no portion of the seller’s gain is attributable to ECI-generating assets. While not explicitly provided in the legislation, the withholding tax would likely also apply to a redemption of a partnership interest.

If the buyer fails to withhold, the partnership is liable for the withholding tax, plus interest. Although the substantive tax is applicable to gain realized on dispositions of partnership interests on or after November 27, 2017, as described above, the withholding tax requirement is effective only for dispositions after December 31, 2017.

As a consequence of these new rules, a private fund with a non-U.S. partner that wishes to transfer its interest will need to provide the non-U.S. partner with information regarding the non-U.S. partner’s share of the partnership’s ECI-generating assets. In general, it would be prudent for the fund to require the transferor and transferee to inform the fund of the sale price and to provide the fund with a copy of the relevant withholding certificate and proof of payment of the withholding tax, if applicable.

Because the fund will have ultimate liability for the withholding taxes, private investment funds should consider amending their organizational documents and transfer documents to ensure that the fund is indemnified by the transferor and transferee for any withholding tax imposed under this new provision.

Limitations on Deduction for Business Interest

The TCJA limits the deductibility of “business interest,” defined as any interest expense properly allocable to a trade or business. Business interest includes any interest paid or accrued by a Treasury has exceptions for non-recognition events in the case of certain transfers of USRPI’s by non-U.S. persons. Although these rules would not apply to the portion of any gain that is not attributable to USRPI’s, they may serve as a template for eventual exceptions in the case of such non-USRPI gain.

The legislative history states that Treasury may provide guidance permitting a broker to withhold 10% of the sale proceeds as an agent of the transferee (for example, on the sale by a non-U.S. person of units in a PTP) corporation. This limitation may affect portfolio companies in which funds invest, blocker entities formed by funds and investors in funds.

The deduction for business interest for any taxable year is limited to the sum of

(i) the taxpayer’s “business interest income,”

(ii) the taxpayer’s “floor plan financing interest”and

(iii) 30% of the taxpayer’s “adjusted taxable income” (“ATI”) for the taxable year.

In general, a taxpayer’s ATI is its taxable income computed without regard to

(i) items not properly allocable to a trade or business,

(ii) business interest income or business interest expenses,

(iii) any net operating loss deduction,

(iv) any pass-through deduction, as discussed above and

(v) for taxable years beginning before January 1, 2022, any deduction for depreciation, amortization or depletion.

“Business interest income” is any interest income properly allocable to a trade or business. Any business interest that is not deductible as a consequence of this limitation may be carried forward indefinitely. Following a change of control of a corporation, the corporation’s carryforward of unused business interest expenses would be subject to limitation under IRC Sec. 382 of the Code, which limits the use of a corporation’s net operating losses and other tax assets following a change of control.

Existing debt Will Not Be Grandfathered

The limitation on the deductibility of business interest will not apply, however, to interest attributable to an electing real property trade or business or to certain other narrowly defined businesses.

In the case of a partnership, the limitation on the deductibility of business interest will apply at the partnership level, by reference to the partnership’s ATI and business interest income. After application of the limitation, any partnership deduction for business interest will decrease the net income, or increase the net loss, allocated by the partnership to its partners.

For purposes of determining the deductibility of business interest paid or accrued directly by a partner, the partner’s ATI will be determined without regard to the partner’s share of any items of income, gain, deduction or loss of the partnership.

If a partnership has excess capacity for business interest deductions, each partner’s ATI will be increased by its share of the partnership’s “excess ATI” (that is, its share of the partnership’s ATI that corresponds to such excess capacity).

A partnership may not carry forward any of its business interest that it is not permitted to deduct. Instead, the excess business interest will be allocated to the partners and may be deducted by the partners to the extent, and only to the extent, of their shares of excess ATI, if any. The allocation of excess business interest to a partner results in certain adjustments to the basis of the partner’s interest in the relevant partnership.

If a taxpayer holds an interest in more than one partnership, the limitation is calculated separately for each partnership. As a result of the application of the limitation at the partnership level, a partner’s overall deduction for business interest, including the partner’s share of the partnership’s business interest expenses, may be less than the overall deduction would have been if the

“Floor plan financing interest” means interest paid or accrued on indebtedness used to finance the acquisition of certain motor vehicles held for sale or lease and secured by the inventory so acquired.

Specifically, it will not apply to any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business that elects not to have the limitation apply. A real property trade or business that makes such an election will be required to recover the cost of certain of its property over a longer period of time (and thus will have lower annual cost recovery deductions) than a real property trade or business that does not make such an election.

Limitation Applied At The Partner Level

Rules similar to the rules for partnerships will apply with respect to S corporations and their shareholders.

The limitation on the deductibility of business interest will affect portfolio companies that are treated as corporations for tax purposes and investors in operating partnerships. Moreover, it will significantly reduce the impact of debt incurred by a blocker entity. A blocker generally has no income other than its share of the income of the operating partnership(s) for which it serves as an investment vehicle.

As a result of the partner-level calculation described above, the blocker will have no ATI other than ATI that is attributable to its share of any excess ATI of the operating partnership. In the absence of any excess ATI, a leveraged blocker would not receive a current tax benefit for any interest paid or accrued on its debt. However, if gain from the sale of an interest in an operating partnership is treated as ATI (a point that is not clear), the blocker could use its carryforward of business interest expense to offset its share of any gain from the sale of the blocker.

In general, this limitation will not affect a non-corporate partner’s share of interest paid or accrued on fund-level indebtedness because that interest would generally be considered investment interest, rather than business interest. Instead, the non-corporate partner’s share of this interest would be subject to the pre-existing limitations on the deductibility of investment interest. It is not clear whether the interest in any fund-level borrowing that is incurred to finance the fund’s investment in an operating partnership would be treated as business interest.

Certain Provisions Affecting Portfolio Companies

Some of the provisions of the TCJA that may have a significant effect on portfolio companies are described below.

Full Expensing for Certain Business Assets

Under current law, a taxpayer is allowed a first-year depreciation deduction equal to 50% of the adjusted basis (generally, the cost) of certain depreciable property it acquired and placed in service before January 1, 2021 (“bonus depreciation”). This deduction is allowed only if the taxpayer was the first user of the property.

The TCJA extends the application of the first-year deduction to property placed in service before January 1, 2027. Moreover, for property placed in service after September 27, 2017 and before January 1, 2023, the deduction will be equal to 100% of the adjusted basis of the relevant property. The percentage ratchets down for property placed in service during subsequent years: 80% for 2023; 60% for 2024; 40% for 2025; and 20% for 2026. Each of these dates is extended one year in the case of certain property with a longer production period.

The TCJA also removed the requirement that the taxpayer be the first user of the property, thus permitting a taxpayer to claim the deduction for used property that it acquires. Certain restrictions on the deduction in respect of used property, including the requirement that the property be acquired from an unrelated party, are intended to prevent abuse of this provision.

Net Operating Loss Deduction

Under current law, a taxpayer is permitted to carry a net operating loss back for two years and forward for twenty (20) years and could use a net operating loss carryback or carryover to offset all of its taxable income (determined without regard to the net operating loss deduction) for a taxable year. The TCJA eliminates the two-year carryback and provides that a net operating loss may be carried forward indefinitely. In addition, it limits the amount of a net operating loss carryover that may be used in any taxable year to 80% of the taxpayer’s taxable income, determined without regard to the net operating loss deduction.

Special rules apply to property acquired before, and placed in service on or after, September 28, 2017. However, these changes in the rules relating to net operating losses do not apply to insurance companies.