Now that the New Year is well underway, thoughts will begin to turn, if they haven’t already, to the preparation of tax returns for 2013. This is the first year for which limited and general partners in investment funds will have to contend with the 3.8% tax on “net investment income” (“NII”). The NII tax is summarized below and several aspects of the NII tax that are most relevant to investment funds and their managers/general partners are also discussed.
Background
The NII tax, also known as the “Obamacare tax”, is effective for tax years beginning after December 31, 2012. This new tax will apply to both investors on their investment returns and to managers/general partners on their incentive allocations. The NII tax is complementary to the long-standing tax on self-employment income that applies to many managers/general partners on their salaries and fee income, and which also is now at 3.8% for high-income taxpayers. This combination of taxes means that going forward there will be fairly limited types of income that will escape the imposition of an additional 3.8% tax on top of regular income taxes.
Proposed regulations for the NII tax were released in December of 2012. The proposed regulations were expansive in scope, and raised many concerns among advisors to investment funds about administrability and compliance costs. In addition, the proposed regulations were unclear as to whether partners in certain investment funds would be able to net gains and losses for purposes of calculating the tax. Late in 2013, final regulations were released that addressed many of the concerns raised by the proposed regulations. In addition, new proposed regulations were released that addressed several issues that the final regulations did not definitively address.
Summary of Tax
The NII tax applies to U.S. individuals, as well as certain trusts and estates. For individuals, it is imposed on the lesser of NII and the excess of adjusted gross income, as modified for Section 1411 purposes, over $200,000 for a single taxpayer, $250,000 for a taxpayer filing jointly, and $125,000 for a married taxpayer filing a separate return. Thus, for taxpayers with unearned income over those threshold amounts, all of their NII will be subject to the tax.
NII consists of the following three categories of income:
Category 1: Gross income from interest, dividends, annuities, royalties and rents, except to the extent derived in the ordinary course of a trade or business that is not either (A) a passive activity1 with respect to the taxpayer or (B) a trade or business of trading in financial instruments or commodities (a “trading business”);
Category 2: Other gross income derived from a trade or business that is either a passive activity or a trading business; and
Category 3: Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property, except to the extent attributable to property held in a trade or business that is not a passive activity or a trading business.
These categories of income are to be summed up and then reduced by certain “properly allocable deductions.” Income that is excluded from the calculation of the regular income tax, such as tax-exempt income, is generally excluded from the calculation of NII. There is also a special exclusion for distributions from qualified plans, such as IRAs (both Roth and non-Roth).
Any income described above that is derived by a taxpayer through a passthrough entity, i.e., a partnership or an S corporation, is included in the NII calculation. Thus, the owners of managers/general partners that are structured as partnerships or S corporations for tax purposes (which would include LLCs) will have to include in their NII calculations any investment income that flows through to them. This generally would include most items of income attributable to incentive allocations, because incentive allocations consist of a portion of each of the items of income (and loss) generated by a fund’s investments. For instance, to the extent an incentive allocation consisted of interest and dividends, those items would be included in NII under Category 1, and to the extent the allocation consisted of net gains, those items would be included under Category 3. For purposes of determining whether any income is attributable to a passive activity or a trading business, income derived through a passthrough entity is tested at the individual level for a passive activity and at the entity level for a trading business.
Special Considerations for Investment Funds and Managers/General Partners
Netting of Gains and Losses
The 2012 proposed regulations appeared to prevent the netting of certain gains and losses for investment funds that were “trader” funds. This was effected by including trading income as Category 2 income and allowing losses to be taken into account solely for calculating net gain under Category 3. Fortunately, the final regulations have fixed this problem. Now, all gains and losses from the disposition of property (including any mark-to market gains and losses that a fund may have) will be netted in Category 3.
Any excess losses remaining may be considered properly allocable deductions and be used to reduce income taken into account under Category 1 or 2, but only to the extent allowable for normal income tax purposes. So, for instance, a fund that has made an election to mark to market its securities under Section 475(f) of the Code (a “475(f) fund”) with net trading losses would be able to use those losses to offset dividend or interest income, but a fund that is not a 475(f) fund would not be able to do so because the losses would generally be capital losses. That is because in the latter instance the losses would be capital in nature and for regular income tax purposes such losses would not be allowed to offset interest or dividends.
Multiple Entities
If income is derived through multiple passthrough entities, then the determination of whether the income is attributable to a trade or business will be determined at the level where the income is generated. For instance, if a trader fund invests in an operating partnership (for instance, an MLP), then operating income from the operating partnership will not be taken into account for purposes of determining NII, because the income was generated at the operating partnership level. Likewise, income generated from a trading fund that flows to a partner through an intermediary fund that is an investor rather than a trader, will be considered to be income from a trading business. The latter could have implications for an election that may be made with respect to PFICs or CFCs (this election is discussed below).
PFICs and CFCs: “(g)” election
Inclusions of income for regular income tax purposes under the qualified electing fund (“QEF”) regime are not considered to be dividends and thus are not includable as such under Category 1 for NII tax purposes. Trader funds, however, are required to take such income into account under Category 2 for NII tax purposes. Non-trader funds, on the other hand, are required to take such income into account for NII tax purposes only when a distribution is received or the PFIC shares are sold, unless an election is made (a “(g) election”) to take such income into account at the same time as for regular income tax purposes. The 2012 proposed regulations allowed only individuals and not partnerships to make the (g) election, and tax advisors were concerned that funds would have to track the basis of PFIC stock differently for normal income tax and NII purposes in those cases where it had some investors who made the (g) election and some that did not (or if the fund had no way of ascertaining which investors had made the (g) election). The final regulations now allow domestic funds to make this election, which should eliminate this administrative burden for funds that choose to do so. Foreign funds that are partnerships are not allowed to make the (g) election. As stated, this is only a concern for non-trader funds.
However, there is a complicating matter with respect to 2013. The final regulations allow a domestic fund to make the (g) election without investor consent for tax years beginning in 2014. But with respect to 2013, the final regulations require a fund to get the consent of all of its investors (even, apparently, those to whom the NII tax does not apply). It is not clear what exactly constitutes consent for this purpose.
The discussion above applies equally to subpart F income from CFCs, although it is fairly rare for an investment fund to have subpart F income.
Incentive Allocation v. Incentive Fee
Because an incentive allocation (sometimes also called a carried interest) retains the character of the income from the underlying fund, a general partner’s profit allocation will generally be subject to the NII tax. However, an incentive fee would not be subject to the NII tax with respect to principals who are actively engaged in the investment management business. Thus, it may make sense for managers/general partners of certain funds (mainly, 475(f) funds or other funds that generate few long-term capital gains) to choose an incentive fee rather than an incentive allocation. The incentive fee might, however, be subject to self-employment tax, depending upon the manager’s/general partner’s current position on self-employment taxes on fees. Managers/general partners based in New York City will have to contend with the New York City unincorporated business tax, which will make this strategy less attractive. In addition, there could be tax accounting issues relating to the timing of the deduction of the incentive fee if a member owns more than 50% of the manager/general partner and is also invested in the fund.
Net Operating Losses (“NOLs”)
The 2012 proposed regulations did not allow NOLs to be carried forward for NII purposes. The final regulations allow a portion of NOLs relating to NII to be carried forward to future years. The formula for carrying NOLs forward is somewhat complicated, and permanent disallowance is still a possibility depending upon particular circumstances. The ability to carry forward NOLs is most likely to be relevant to limited partners in 475(f) funds and possibly to managers/general partners and their principals.
Capital loss carryforwards continue to be allowed for NII purposes to the extent taken into account in computing regular income taxes.
Other Issues
Swaps: Both periodic and nonperiodic payments under swaps should now be included in the calculation of NII in Category 1 income.
Foreign Tax Credits: Foreign tax credits are not creditable for purposes of calculating the NII tax. If foreign tax credits are not taken into account by a taxpayer under Section 901, foreign taxes paid can be deducted for NII tax purposes.
Deductions for Debt Instruments: Negative adjustments under contingent debt instruments and amortizable bond premium are treated as properly allocable deductions for NII tax purposes.
REMICs: Income from holding a REMIC residual interest is includable in NII under Category 1, and a net loss is a properly allocable deduction.
We will continue to keep you updated on any developments regarding the NII tax. If you have any questions regarding this topic, please contact: Jon Brose (212-574-1615, brose@sewkis.com), Jim Cofer (212-574-1688, cofer@sewkis.com), Ron Cima (212-574-1471, cima@sewkis.com), or Dan Murphy (212-574-1210, murphyd@sewkis.com).
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1 Very generally, a passive activity is a trade or business in which a taxpayer does not materially participate.
