Defense to offense: Asset management’s tax plan

Private equity is often under regulatory scrutiny. Lawmakers from both sides of the aisle have sometimes used it as a political target and a potential revenue source. The threat will not abate any time soon. While split government and gridlock may prevent legislative action immediately, the IRS is actively litigating self-employment issues against the industry.

Macroeconomic factors also seem to be lining up in opposition to PE. Volatility and economic headwinds present challenges, and persistently high interest rates and inflation are upending traditional equity and financing structures. Recent tax changes are only making the situation worse.

A new, stricter limitation on the ability of taxpayers to deduct interest expense can undermine the leverage models for many portfolio company structures. Portfolio companies in capital intensive or innovative industries are also hurt by changes that reduce how much equipment taxpayers can deduct immediately and require taxpayers to capitalize and amortize research expenses.

“International funds have many more issues to address,” Patanella said. “How funds structure investments can make a big difference in the treatment. Funds should be carefully reviewing the entire international tax policy landscape both now and several years into the future.”

The IRS is pursuing its own compliance initiatives and has an unprecedented $60 billion in special funding that it’s planning to use to step up enforcement efforts. The asset management industry is expected to be a subject of that scrutiny, particularly at the fund level. Partnerships are poised to see the biggest jump in audit activity and are already facing new burdensome reporting requirements.

“Fund compensation structures need to evolve along with changing tax policy,” Patanella said. “The IRS is looking at employment taxes, capital accounts, guaranteed payments and international reporting.”

As 2023 closes and the new year begins, it’s an ideal time for asset management leaders to assess their investment plans and identify key tax planning considerations.

Other industry tax guides

GUIDE

Power up on energy industry tax strategy -->

GUIDE

Healthy habits for healthcare systems heading into 2024 -->

GUIDE

Sound hospitality tax planning strategies can serve savings -->

GUIDE

Tax planning at a crucial juncture in manufacturing -->

GUIDE

Services firms face moving targets for tax plans -->

GUIDE

New taxes, new solutions for tech firms -->

Persistent high interest rates and changes to the ability to deduct interest expense are forcing asset managers to revisit the costs and benefits of borrowing. Although inflation has eased, debt is still significantly more expensive than many investors became accustomed to during the decade-plus era of cheap money. The tax impact should be part of any analysis.

The deduction for net interest expense is generally limited to 30% of adjusted taxable income under Section 163(j). Previously, adjusted taxable income was similar to earnings before interest, taxes, depreciation and amortization (EBITDA). For tax years beginning in 2022 or later, depreciation and amortization must be included, lowering adjusted taxable income to an amount similar to EBIT. The change can be particularly relevant for portfolio companies that make significant capital investment in equipment and have large depreciation deductions. Although taxpayers can carry forward their unused interest deductions, the 30% limit will continue to apply, so projections can show a near perpetual disallowance well beyond any exit plans.

“The new limit on interest deductions curbs the ability to achieve a tax-efficient return from portfolio companies using debt,” said Eric Coombs, Grant Thornton Leader, Tax Services, Asset Management. “Changes in the deduction for interest can also affect other items on the return, so modeling is key. Fortunately, there are planning opportunities to mitigate the impact.”

For other types of asset management structures, such as hedge funds, real estate investment trusts, and regulated investment companies, the more important consideration is whether the interest is considered investment interest expense and excluded from the Section 163(j) calculation altogether.

There is some bipartisan interest in reversing the new tax rules legislatively, so pay attention to Congress this winter. Assuming those efforts fail, there is a variety of planning strategies available to taxpayers. Portfolio companies may have opportunities to reduce the amount of interest subject to Section 163(j) by allocating that interest to the research and development, production, construction or acquisition of a wide range of tangible and intangible property. Once recharacterized to another asset, the interest becomes part of the cost of that asset and is recovered using the accounting method applicable to that item. For example, if interest is recharacterized to a fixed asset, it would be recovered through depreciation deductions. See our previous article for a more detailed discussion.

“How interest is allocated can affect how quickly the cost is recovered,” Patanella said. “Careful planning can also affect international provisions such as FDII and GILTI. It’s important to model out the interactions to see what levers can be pulled to achieve the best tax result.”

Asset managers should also consider the impact of changes to deductions in research investment and tangible equipment on their portfolio companies. For tax years beginning in 2022 and later, domestic R&E costs under Section 174 must now be amortized over five years instead of being expensed. Since a midyear convention must be used, this effectively reduced the deduction for these domestic R&E costs in 2022 by 90%. Foreign R&E must be amortized over 15 years.

The IRS released expansive guidance on how to apply these rules just weeks before returns were due for many calendar-year corporations. The guidance clarifies key areas, such as the definition of software, the treatment of research performed under contract, and cost-sharing arrangements. Taxpayers should analyze the new rules, which are proposed to be applicable for tax years beginning after Sept. 8, 2023. Some of the rules provide favorable results, while others could present challenges and compliance burdens.

For investments in tangible property, bonus depreciation is also shrinking. Property placed in service this year can no longer be fully expensed and is instead eligible only for 80% bonus depreciation, with the rest of the cost recoverable over the normal depreciable period. The bonus rate is scheduled to drop over time, disappearing entirely in 2027. 

Losing the ability to immediately deduct 40% of the cost of investments can make a significant impact on the tax return. The good news is that there are plenty of planning opportunities to manage the fallout. Taxpayers forgot about some of these strategies because 100% bonus depreciation has been available for so long.

An analysis to identify costs that can be considered repairs has always been valuable when looking at structural property that doesn’t qualify for bonus depreciation. With bonus depreciation at 60% next year, this repairs analysis could also now significantly accelerate the cost recovery of other types or property. Portfolio companies can also consider a broader cost segregation analysis, which identifies costs eligible for recovery as property with a shorter depreciable period. This effort can be paired with Section 163(j) planning to accelerate the recovery of any related interest expense.

Like the limit on interest deductions, there remains some Congressional interest in reversing these unfavorable changes legislatively. Asset managers should monitor legislative developments for any last-dich effort to move a year-end tax package.

Asset managers should expect major scrutiny from the IRS over the next few years. The Inflation Reduction Act (IRA) provided the IRS with $80 billion in new funding, and over 50% is earmarked for enforcement. The debt limit deal included a handshake agreement to reallocate $20 billion of that money to other spending priorities, but $60 billion is still a staggering sum compared to normal IRS funding. It represents more than four years of annual appropriations based on recent IRS funding levels, and it comes on top of regular annual funding with no restrictions on when it can be spent.

The increased enforcement may come more quickly than some taxpayers expect. The IRS has already significantly expanded its workforce in the last two years and is actively recruiting 3,700 new auditors. Much of the activity will be focused on partnerships, which have seen a dramatic decrease in audit rates over the last several years.

In September 2023, the IRS announced that it would expand its partnership compliance program with exams of the largest and most complex partnerships, opening exams of 75 of the largest partnerships averaging assets exceeding $10 billion. The IRS also plans to mail compliance letters to 500 partnerships with over $10 million in assets due to balance sheet discrepancies. The new compliance efforts will be aided by new AI.

Asset managers will be a prime target. The IRS is most interested in large, complex partnership structures, and that means private equity.

The IRS has been gearing up for the partnership compliance push for several years by imposing new reporting requirements on partnership returns, including on capital accounts and international items.

Capital account management

We are now three years into new rules for partnerships to report the tax basis of partner capital accounts, and transition relief has fully expired. Capital accounts involve the economic relationship of the partners, so capital account maintenance is important, not just for tax reporting, but for many other reasons. The computational work involved in maintaining capital accounts includes potentially significant compliance burdens that entail collecting information from partners and reviewing partnership agreements, debt documents and compensatory award documents. While there are software solutions that can help with this computational work, the economic arrangement between partners can be very complex, and a deep analysis of documents and tax rules may be needed. 

The IRS may also finally be done tweaking new international reporting requirements for partnerships that first took effect for 2021 returns. The rules generally require partnerships to report a variety of information on new Schedules K-2 and K-3, including details related to international transactions, FTC limitations, and information on Passive Foreign Investment Companies. There is limited ability for partnerships to escape these requirements even if they have little international investment.

The domestic filing exception only applies to partnerships with certain types of partners and requires the partnership to perform notification and request procedures. The partnership also must either have “no foreign activity” or “limited foreign activity.” For partnerships that do need to report, the rules may require businesses to make changes to their current systems and processes to track and provide the required information in a different way, collect additional information from partners or shareholders, or modify agreements to facilitate information sharing. 

The tax treatment of fund manager income is a key consideration for structuring fund investments. The addition of Section 1061 as part of the Tax Cuts and Jobs Act, which now requires a holding period of three years for certain profits interests to receive long-term capital gains treatment, affected some investment strategies. Gridlock in Washington will likely protect funds from further changes to the taxation of a profits interest in the near term, but the IRS is now targeting management fee income for self-employment taxes.

Professional service partnerships should consider how partners are treated for self-employment taxes. The IRS has launched an audit campaign and is actively litigating the issue. The treatment of income for employment and investment taxes for limited partners may hinge on three pending cases in the Tax Court involving investment management funds (Denham Capital Management LP v. Commissioner, Point72 Asset Management LP v. Commissioner, both pending, and Soroban Capital Partners LP v. Commissioner, partial summary judgment in November 2023).

The issue revolves around an exception from self-employment tax under Section 1402(a)(13) for the distributive share of partnership income of a “limited partner.” Partners in a management company entity can potentially avoid self-employment tax on their distributive share of management fee income if they can establish that they are limited partners. But for this position to benefit the partners, they would also need to exclude the income from the tax on net investment income (NII). The NII tax under Section 1411 generally imposes an equivalent 3.8% tax on partnership income (if partner income exceeds certain thresholds) unless partners can establish that they are not passive in the underlying trade or business.

Since the Tax Court ruled in favor of the IRS in Renkemeyer, Campbell, & Weaver, LLP v. Commissioner (136 T.C. 137) in 2011, it has become much more difficult for taxpayers to argue that they are limited partners in a partnership while also being active enough in the business to avoid passive treatment. The Tax Court analysis established in Renkemeyer looks less at legal liability and more at whether activities the partner engages in are consistent with the general concept of a “limited partner.” The Tax Court has applied this analysis to LLCs and other entities organized as partnerships, but the new cases would address entities that are established as limited partnerships under local law.

A recent partial summary judgment in Soroban indicates the court intends to apply the same functional analysis to limited partnerships as it has to other entities, meaning it may be very difficult for partners to escape both self-employment tax and NII at the same time.

“Fund managers should be monitoring the outcome of the cases closely and scrutinizing their own structures,” Coombs said. “The IRS has paused opening new examinations specifically targeting this issue, but will raise it if it comes up as part of a broader exam.”

The IRS is also considering regulations to address the self-employment tax issue. It originally proposed regulations in 1997, but never finalized them after they were heavily criticized, and Congress enacted a one-year moratorium on their finalization. In addition, Democrats have proposed legislation that would generally close the gap between self-employment tax and NII tax, though it is not likely to be enacted in the near term.

Asset managers with pass-through structures have a unique opportunity to provide owners with relief from the $10,000 cap on the federal state and local tax (SALT) deduction. To date, 33 states and one locality have enacted regimes that allow pass-through businesses to deduct SALT taxes at the entity level in exchange for a credit or exemption from state tax on the pass-through income of owners. This allows a partnership to fully deduct state tax for federal purposes against the distributive share of owner income, rather than having owners pay tax and take a limited SALT deduction at the individual level. It can be especially powerful in years where there is a transaction that causes significant state tax on capital gain.

The explosion in state pass-through entity (PTE) regimes over the last two years came partly in response to IRS guidance (Notice 2020-75) confirming the viability of the entity-level deductions. Although these regimes can offer significant benefits to owners, there are potential drawbacks. Whether making a PTE tax election ultimately makes sense is a complex determination that depends on a variety of factors.

The lack of uniformity among state laws presents particular challenges. State rules vary on when taxpayers can make an election to shift tax to the entity level. The timing of an entity-level deduction may depend both on when the election is made and when the entity makes tax payments. State laws also vary (and are not always clear) on whether PTE taxes paid in one state are creditable against other PTE regimes or personal income tax liability in other states.

It’s also important to understand that PTE elections may benefit certain partners more than others, particularly for partnerships operating across many states or with partners residing in different states. Partnerships should weigh the burdens of paying the entity-level tax against the benefits of passing the entity-level deduction to partners, and also consider whether the partnership agreement will permit any necessary adjustments to allocations or distributions. States are still updating their laws to address technical considerations. Asset managers considering the election should carefully analyze the most current state laws and fully assess the potential implications.