10 Ways Tax Reform Is Impacting Financial Services
The effects of tax reform are far-reaching, but for financial services professionals – including alternative investors, broker-dealers, registered investment advisors, and wealth managers – the impact will be keenly felt not only in the financial services industry itself but also in the industries in which they are invested.
Here are just ten of the ways that tax reform will impact financial services:
- Pass-Through Deduction
The new law provides owners of pass-through entities (i.e., sole proprietorships, partnerships, limited liability companies, and S corporations) a deduction equal to 20 percent of “qualified business income” (QBI), excluding most service-based businesses, effectively dropping the top marginal tax rate to 29.6 percent. This reduction is subject to a limit based on wages or a combination of wages and capital investment. The deduction is the lesser of 20 percent of QBI or:
- 50 percent of the wages with respect to a qualified trade or business; or
- The sum of 25 percent of the wages with respect to a qualified trade or business plus 2.5 percent of unadjusted basis of qualified property.
The definition of a qualified trade or business explicitly excludes certain types of professional service businesses when the taxpayer’s income is above certain thresholds ($207,500 for single filers and $415,000 for married couples filing jointly). The definition of a service-based business generally includes broker-dealers, registered investment advisors, and hedge fund managers. Therefore, many of those in the financial services industry are unlikely to be eligible for the QBI deduction. However, if the taxpayer’s income is below those thresholds, they would be eligible for the QBI deduction.
- Corporate Income Tax Rate
The new tax law reduces the corporate tax rate from a graduated 35 percent rate to a flat 21 percent (for tax years after 2017). When compared to the top individual rate of 37 percent, it appears that a corporate entity structure would be advantageous. But deciding which entity structure to implement will require further analysis. For instance, corporations are still subject to double taxation, a 20 percent top tax rate on dividends of net income, and the 3.8 percent net investment income tax. On the other hand, pass-through entities may be eligible for the pass-through deduction, which can result in a deduction of up to 20 percent of QBI.
While the tax rate differential is the beginning of the analysis, it is also important to consider the impact of other individual tax law changes, including the $10,000 state and local tax deduction limitation and the non-deductibility of miscellaneous itemized deductions subject to the two percent floor. A corporation can fully deduct both of these expenses, but this is not the case for pass-through entities.
Corporations that are engaged in the active conduct of a trade or business may benefit from a lower tax rate by deferring and reinvesting profits. However, it is worth noting that there are provisions allowing the IRS to assess a 20 percent accumulated earnings tax on corporations keeping cash beyond the reasonable needs of the business. There is also a 20 percent personal holding company income tax on certain closely held corporations that have greater than 60 percent of their income derived from passive sources. These taxes have received minimal attention in past years, but the new tax legislation is likely to change that.
- Suspension of Miscellaneous Itemized Deductions
Under prior law, individuals could deduct investment expenses, such as management fees, to the extent they exceeded a floor subject to two percent of adjusted gross income. Under the new law, however, individuals will not be entitled to this deduction.
Companies that pass management and investment expenses on to individuals may not be able to capture the value of these expenses. Since the new law will put additional focus onto the classification of such funds, it would be wise to consider how to classify these expenses.
If the fund is an active trader rather than a mere investor, then such expenses would still be deductible as trade or business expenses. If the fund will not qualify as an active trader, the fund’s management may elect to place the fund in an offshore corporate feeder fund, which would qualify as a passive foreign investment company (PFIC) instead of an onshore partnership. Corporations are not subject to the miscellaneous itemized deduction rules. Therefore, expenses that would have been nondeductible by a partnership’s members may be deductible on the corporate return. In order to report the PFIC activity (net of the investment expenses) on his or her individual tax return, a U.S. shareholder would then make the qualified electing fund (QEF) election.
- Entertainment Expenses
Businesses, under previous law, were entitled to deduct 50 percent of expenses incurred for entertainment, amusement, or recreation. The new tax law does not permit a deduction for entertainment, amusement, or recreation expenses. However, the law does retain the 50 percent deduction for food and beverage expenses. Companies will need to account for entertainment expenses separately from food and beverage expenses to ensure accurate reporting for tax purposes.
- Carried Interest
The benefit of carried interest is its preferential long-term capital gain tax rate, provided that the hold period is sufficient. Under prior law, the requisite hold period was one year; the new law increases the hold period to three years. If realized before the three-year holding period, the treatment of this income would become short-term capital gain. The new law does not provide a grandfathering provision, meaning existing investments will need to be tested against the three-year hold period.
It is important to note that to the extent the general partner receiving carried interest puts in equity, the long-term treatment can be separated. The portion related to equity interests still follows the general taxpayer holding period of greater than one year.
Additionally, the provision appears to apply to long-term capital gain only. It does not change the treatment of qualified dividends, which are also taxed at the long-term capital gain rate.
- Interest Expense Limitation
For tax years after Dec. 31, 2017, the annual business interest expense deduction of a trade or business will be generally limited to 30 percent of earnings before interest, taxes, and depreciation. The interest limitation is further restricted after 2021 to 30 percent of earnings before interest and taxes. There is no grandfathering provision for existing debt; therefore, current debt structures will be affected immediately. Any interest that is disallowed as an expense under this provision will be carried forward indefinitely.
Limits on the deductibility of interest will make debt more expensive (on an after-tax basis), which will likely influence the mix of debt and equity employed in leveraged transactions. This may be tempered slightly by reduced tax rates, which in turn will make interest deductions less valuable.
While there is an exception to the interest limitation for businesses that have average gross receipts of $25 million or less, this will have limited applicability to financial services since portfolio companies will need to be aggregated for this purpose.
Please note: Investment interest expense under section 163(d) is still exempt from this limitation.
- Sale of a Partnership Interest: Foreign Partner
Under prior law, a foreign partner that owned an interest in a partnership that engaged in a U.S. trade or business would generally not be subject to U.S. income tax on the disposition. The income will now be treated as effectively connected income to the extent that the partnership has assets connected with a U.S. trade or business. The new law generally imposes a requirement on the purchaser of the partnership interest to withhold 10 percent of the sale price (unless the seller confirms it is not a non-resident alien or a foreign corporation). If the purchaser does not withhold, the partnership is required to withhold on distributions.
- Deemed Repatriation of Deferred Foreign Income
The new tax law requires that U.S. shareholders of controlled foreign corporations and certain shareholders of other foreign corporations include in income their share of the foreign corporation’s deferred foreign income. The timing of the income inclusion for calendar-year taxpayers could impact 2017 tax returns.
The income inclusion is subject to reduced rates of tax. The portion of the inclusion that is attributable to the foreign corporation’s cash and cash equivalents is subject to an eight percent tax rate. The remaining income inclusion is subject to a 15.5 percent tax rate. Additionally, the tax liability associated with this income inclusion can be paid in annual installments over eight years. The installment amounts are eight percent of the net tax liability for each of the first five installments, then 15 percent of the net tax liability is paid with the sixth installment, and 20 percent and 25 percent is paid with installments seven and eight, respectively.
This change could negatively impact cash flows for companies that own such foreign subsidiaries.
- Deduction for Foreign Source Portion of Dividends
U.S. C corporations will be entitled to a 100 percent deduction for the foreign source portion of dividends received from specified 10-percent-owned foreign corporations. This deduction is available to C corporations that are not regulated investment companies (RICs) or real estate investment trusts (REITs) and applies to tax years of foreign corporations that begin after Dec. 31, 2017.
The value of this deduction must be considered whenever 10-percent-owned foreign corporations are included in the underlying organizational structure. This deduction could also impact any analysis of whether portfolio companies should be operated as pass-through entities versus corporations.
- Global Intangible Low-Taxed Income – Subpart F Inclusion
The new law creates a new Subpart F inclusion for global, intangible, low-taxed income (GILTI) for tax years that begin after Dec. 31, 2017. Generally, U.S. shareholders of controlled foreign corporations (CFCs) do not include income from the CFC until they receive a dividend distribution. However, a U.S. shareholder must include their share of the CFC’s Subpart F income whether it is actually distributed or not. The new Subpart F inclusion for GILTI requires a complicated analysis of the foreign corporation’s income and asset holdings, but the inclusion amount can be summarized for discussion purposes as the CFC’s income over 10 percent of the CFC’s basis in its tangible assets. Also, C corporations are entitled to a special deduction attributable to any GILTI income inclusion.
Companies owning shares in CFCs may have Subpart F inclusions from CFCs that did not previously generate Subpart F inclusions.
If you have questions about how tax reform could impact you or your investments, our team of experienced advisors is here to help.
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