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What we learned from the first post-tax reform season

James Casey, Ed Daley and Doug Puckett from Deloitte Tax discuss investment management firms’ just concluding tax compliance season.

This article is sponsored by Deloitte. 

James Casey

Many provisions of the law popularly known as the Tax Cuts and Jobs Act of 2017 were effective last year, which means that the 2018 Schedules K-1 and tax returns that firms released in recent months to investors and the IRS, respectively, were the first to address most of the new law’s provisions. So, what are some of the key takeaways from this tax season?

Simplicity was not on the menu

From the new carry rules to the limitations on interest expense and the qualified business income (QBI) deduction, significant new provisions impacted the industry. Adding to this were major changes within the international tax area (including some interesting new acronyms such as BEAT, GILTI, and QBAI – pronounced “Q-Bye”) and the release of hundreds of pages of guidance on the new law from the US Treasury and the IRS. That’s a lot to consider.

Carry: The new law requires at least a three-year-and-a-day holding period for those who receive carry to have otherwise qualifying income taxed as long-term capital gains. The standard one-year-and-a-day period still applies to gains allocated to a fund’s limited partners. It also still applies to the internal team if the gain is attributable to money they put into the fund or, arguably, if the gain is from so-called section 1231 (or business) assets.

Without detailed guidance from the IRS on how to report these changes on the Schedules K-1, we’ve seen the industry struggle with how to report gain from carry, especially where the gain is from non-section 1231 assets that were held more than a year but not more than three years. Lines 8 (short-term capital gain); 9a (long-term); 10 (net section 1231 gain/loss); 11A (other portfolio income/loss); 11I (other income/loss); and 20AH, item 16 are all places the carry recipients might find information needed to complete their personal returns. Thus, it’s important to read Schedule K-1 footnotes associated with any of these lines to make sure it is clear what is being reported on the face of the K-1.

Business interest expense limitation: With a few exceptions (including for real property trades or businesses that elect out of the limitation, certain smaller businesses and for interest treated as investment interest expense), the new law typically restricts a business’s current year deduction of interest expense to no more than the sum of its business interest income, any floor plan financing interest, and 30 percent of its taxable income (after adding back to taxable income business interest expense, the QBI deduction and a few other adjustments, including adding back depreciation in tax years beginning before 2022).

Using an 11-step calculation, the interest expense limitation applies at the entity level, which within the investment management industry, frequently means a partnership. If business interest expense is limited at the partnership level, partners receive an allocation of excess business interest expense (“EBIE”) that’s carried forward at their level. This EBIE is then treated as paid or accrued by the partner in a later year only to the extent the partner receives what the rules refer to as excess taxable income or excess business interest income from the same partnership in a later year. Even then, this “freed up” EBIE is only deductible by the partner to the extent it is run through the interest expense limitation provisions at the partner level.

This added complexity regarding business interest expense deductions makes it more likely partners have much more substantive footnotes on their 2018 Schedules K-1 and increases the likelihood that they will have certain information from these footnotes that must be tracked by them (rather than the partnership) on a go-forward basis. Failing to do so could mean missing out on potentially significant future deductions.

Ed Daley

QBI deduction: With the 2017 Tax Act’s reduction of the corporate tax rate to 21 percent, Congress wanted to offer businesses operating outside of a corporate shell (so called flow-through businesses such as those operating as a partnership) a rate reduction as well. This Congressional desire was the catalyst for the 20 percent QBI deduction, bringing the federal rate tax for owners of qualifying flow-through businesses down to a maximum of 29.6 percent on eligible business income. Qualified REIT dividends and qualified publicly traded partnership income is also eligible for the 20 percent QBI deduction.

For the 20 percent QBI deduction against qualifying business income, the income generally must be effectively connected income to the US, from a non-service business (thus excluding those in the fields of consulting, law, accounting, performing arts, health and financial services) and the deduction is typically further limited if the business doesn’t have sufficient wage expense or hasn’t purchased a significant amount of qualifying tangible property. However, neither of these limitations apply (or they apply at a reduced level) if the ultimate individual business owners have taxable income below a certain threshold ($415,000 for married filing jointly taxpayers and $207,500 for others, adjusted for inflation post 2018).

All of this to say there’s a lot of QBI deduction information that was pushed out to investment firms’ internal and external investors, because that’s what the rules require. But it isn’t clear yet how much those investors will benefit from the deduction.

This is especially true for investors with substantial net long-term capital gains and qualified dividend income because there’s an overall limit on the QBI deduction of 20 percent of taxable income net of these two types of favorably taxed income.

Doug Puckett

International tax changes: While the new Base Erosion and Anti-abuse Tax (BEAT), Global Intangible Low-taxed Income (GILTI) and Foreign-Derived Intangible Income (FDII) all applied in varying degrees and with different levels of complexities to investment firms’ portfolio companies and structures, the GILTI rules, applicable to many PE firms given the repeal of Internal Revenue Code Section 958(b)(4), may have caused the most complexity during the 2018 compliance seasons. More than halfway through the filing season, the IRS released generally favorable GILTI related regulations that caused the GILTI income included on some firms’ previously released Schedules K-1 to be overstated, sometimes by significant amounts, and left these firms in the difficult position of potentially needing to issue revised Schedules K-1.

Looking ahead

Unless Congress decides to make significant changes to the 2017 Tax Act provisions, the complexities discussed here plus various other provisions (such as related state tax issues) are here to stay – at least until many of them sunset in a few years. Thus, perhaps the biggest lesson we learned from this tax season is that we have a new normal in terms of the investment community’s tax reporting requirements.

James Casey is the leader of Deloitte’s investment management tax practice in New Jersey. He provides tax compliance and advisory services to private investment funds and their sponsors, with a focus on utilizing technology to deliver timely accurate tax reporting for annual and transactional filings.

Edward Daley is the national leader for Deloitte’s private equity tax practice. His primary area of specialty is in providing income tax planning and compliance services to private equity firms, M&A advisory firms and other types of professional service firms and privately held businesses.

Doug Puckett is the deputy national leader of the private equity practice and a regional private wealth practice leader for Deloitte Tax. He works closely with the firm’s national investment management leadership to bring leading practices to private equity, hedge funds and family offices of high-net-worth clients.