Investors in Hedge Funds and Private Equity Funds and Fund Managers Should Consider the Impact of the Fiscal Cliff Tax Deal on their Fund Investments and Fund Structures
As you know, Congress and the President hammered out a last minute fiscal cliff deal on taxes as 2012 came to an end. President Obama promptly signed the "American Taxpayer Relief Act of 2012" ("Tax Act") into law on January 2. The most significant income tax increases included in the Tax Act, described below, apply beginning in 2013 and are targeted at high income individuals, including investors and fund managers. It is important to note that the Act does not contain any provisions modifying the provisions of the 3.8 percent Medicare Surtax on net investment income of high income individuals which went into effect on January 1, 2013. In addition, the Act did not extend the 2 percent employee payroll tax cut that was in effect for 2011 and 2012. Also, despite the fact that the proper tax treatment of carried interest income received considerable attention during the presidential election, there are no specific tax changes on carried interest in the Tax Act.
The fiscal cliff deal delays the onset of mandatory federal spending cuts (sequestration) for two months (i.e., through February 2013). In addition, the deal does not address the federal debt ceiling, which will likely need to be extended by late February or early March.
I. The most significant 2013 tax increases affecting high income fund investors are the following:
Individual Income Tax Rates:
The Act extends permanently the 2012 tax rate structure for taxable incomes up to $450,000 (joint filers)/$400,000 (single). Taxable income of individuals above those thresholds is now subject to a 39.6% rate instead of the 35% rate, beginning in 2013.
Capital Gains/Dividends: The top long-term capital gains and qualified dividend rates are increased from 15% to 20% for taxpayers with incomes above $450,000 (joint filers)/$400,000 (single), beginning in 2013. The Medicare Surtax of 3.8%, if applicable, has the effect of raising the federal income tax rate on such capital gain and dividend income for such taxpayers to 23.8%. The 15% maximum rate on long-term capital gains and qualified dividends has been permanently extended for other individual taxpayers.
Personal Exemption Phase-Out: The Act reinstates the personal exemption phase-out (PEP) beginning in 2013, but only for taxpayers with adjusted gross incomes above a certain threshold. The new threshold is $300,000 for married individuals filing a joint return, $275,000 for head of household filers and $250,000 for single individuals. This deduction limitation is permanently repealed for other taxpayers.
Limitation on Itemized Deductions: The Act reinstates the Code section 68 limitation on certain itemized deductions which was phased out by the Bush era tax legislation, but only for taxpayers with adjusted gross incomes above a certain threshold. The applicable threshold is the same as for the PEP provision, $300,000 for married taxpayers filing a joint return, $275,000 for head of household filers, and $250,000 for single individuals. These dollar amounts will be adjusted for inflation in tax years after 2013. This provision reduces the total amount of a higher income taxpayer's otherwise allowable itemized deductions by three percent of the amount by which the taxpayer's adjusted gross income exceeds the applicable threshold. However, the amount of itemized deductions is not reduced by more than 80 percent. Certain itemized deductions, including investment interest, medical expenses and certain casualty losses, are excluded from this limitation.
Fund managers and investors should realize that management fees and other investment-related expenses that pass through to individual investors from partnership funds as separately stated section 212 expenses (non-trader funds) rather than qualifying as section 162 trade or business expenses are subject to being reduced by the itemized deduction phase-out provision. Deductions for investment interest are not affected. in addition to these federal income tax restrictions, a number of the states currently have some limitations on, or disallow entirely, the ability of individual taxpayers to claim deductions on their state and local income tax returns for expenses which are classified as miscellaneous itemized deductions for federal income tax purposes.
II. Impact of the Act on Tax Planning for High Income Individuals
Since the most significant tax increases in the Tax Act are targeted at taxpayers with taxable income or adjusted gross income above a "magic number" (e.g., $450K/400K and $300K/250K), the most obvious tax planning would be income splitting among family members and relatives. Earned income is not easily transferred, but investment income can be effectively assigned through formation of family limited partnerships or gifts of appreciated property. The Tax Act provides a $5 million gift tax exemption (indexed for inflation), which enables taxpayers to make gifts of appreciated capital assets to other individuals. High income professionals should also consider tax deferral strategies that allow reduction of adjusted gross income. Such strategies include deferred compensation (if the taxpayer is an employee) and defined benefit plans which enable businesses and self-employed individuals to make fully deductible contributions to retirement plans far in excess of the limitations that apply to profit sharing/401K plans.
III. Impact of the Tax Act on Private Investment Funds
As we discussed in our Tax Alert dated July 5, 2012 (http://www.sglawyers.com/admin/PDFs/205.PDF), the new 3.8% Medicare Surtax on net investment income ("NII Tax") significantly raises the tax stakes for individual investors in funds that are structured as tax partnerships. Most of the income derived from such funds will be classified as investment income subject to the NII Tax, even if the partnership fund is classified as a trader in securities. However, if the partnership fund is classified as an investor fund, the investment-related deductions, including management fees, will be required to pass through to individuals as miscellaneous itemized deductions. Deductions that are disallowed for regular federal income tax purposes will also be disallowed in calculating the NII Tax. In addition, as discussed in detail in our Tax Alert, an individual's "net gain" from sales of securities and other property is subject to the NII Tax, but net losses in a given year do not reduce the taxable base for the NII Tax. Alex Gelinas has recently written a tax article on these issues which can be found on the Sadis & Goldberg LLP website. (Tax Efficient Hedge Fund Structuring in Anticipation of the New 3.8% Surtax on Net Investment Income and Proposals to Limit Individuals' Tax Deductions, Hedge Fund Law Report, vol. 5, no. 40 (Oct. 18, 2012) - http://www.sglawyers.com/admin/PDFs/231.PDF).
IV . Impact of the 2013 Tax Law Changes for Managers of Private Investment Funds
Fund managers should anticipate that individual investors and their tax advisers are likely to become more concerned about the tax efficiency of the funds in which such investor invest. As discussed above, the new limitations applicable to high income individuals on deductibility of investment-related expenses for the federal income tax as well as the new 3.8% Medicare Surtax will cause investors to be more attentive to the difference between the pre-tax and after-tax returns from competing investment alternatives.
Fund managers may also wish to consider restructuring all or a part of their business in order to minimize the impact of the new tax law changes. As an example, we would note that certain businesses may be able to avoid the imposition of the Medicare taxes by converting from tax partnership form to S corporation status. Under this strategy, the business owners would pay themselves a "reasonable" low-end salary and take their remaining income in the form of a dividend from the S corporation. Under recently proposed Treasury regulations, a dividend from an active business paid to a shareholder that is an active participant in the business will not be classified as net investment income for purposes of the 3.8% Medicare Surtax. Under current law, such dividend would also not be treated as wage income for payroll tax purposes.