Applying the net investment income tax to private equity managers
INSIGHT ARTICLE |
Private equity managers may face significant new tax burdens from the new 3.8 percent tax on net investment income. In some cases, these new tax burdens can be minimized through careful planning.
Interplay with SECA and FICA taxes
The impact of the new 3.8 percent tax on net investment income imposed by section 1411 cannot be understood without considering the parallel taxes imposed on self-employment income under SECA (or wages and salaries under FICA). From one perspective, it might appear that Congress intended all types of income to be subject either to one of these two employment taxes (SECA or FICA), or to the net investment income tax. However, that is clearly not the case. Both the statute and the regulations make clear that an owner’s share of the operating income of a trade or business that is not considered to be a passive activity for the taxpayer, and that is not the business of trading financial assets, is exempt from section 1411.
At the same time, an owner’s share of the business income passed through by an S corporation is exempt from self-employment taxes, as is the owner’s share of such income (other than guaranteed payments for services) earned by a limited partner, although the exact meaning of that term for these purposes is unclear. Many practitioners believe that income (other than guaranteed payments for services) that represents a true return on capital (and not a disguised payment for personal services) is exempt from self-employment taxes in the hands of a limited partner in a limited partnership or any member of an LLP or limited liability company (LLC). Of course, wrapping a limited partnership or S corporation around a stream of fee income received for personal services that are, in fact, provided by the owners of such an entity may not suffice to exempt that income from self-employment taxes. Thus, management fees are likely to be subject to self-employment taxes.
Income from carried interests, however, may be treated differently in some cases. A carried interest that provides a general partner with a portion of operating income would likely be subject to self-employment taxes, since the exception for income earned by a limited partner would not apply. In addition, a fund holding a general partnership interest through a limited partnership or S corporation would appear to present the same issue as attempting to wrap such an entity around a stream of income that is a fee for personal services.
That leaves, however, the important category of carried interests that generate capital gains (or dividends). By statute, capital gains are exempt from self-employment taxes, and dividends are exempt unless received in the course of a trade or business as a dealer in stocks or securities. That means that capital gains and dividends earned as part of a typical private equity carried interest will be exempt from self-employment taxes, even if viewed as a form of compensation for the services provided by the recipients. The open question is whether such capital gains and dividends will also be exempt from section 1411.
Section 1411 and portfolio companies organized as C corporations
If a portfolio company is a C corporation, any capital gains on the sale of shares or corporate dividends will likely be subject to section 1411. The private equity fund itself will not likely qualify as a “trade or business,” and C corporation dividends or gains from the sale of corporate stock will not likely qualify as earned or derived in the course of a business as to which the holder of the carried interest is considered to be “active” for purposes of section 469, which is the test for excluding such amounts from section 1411.
Section 1411 and portfolio companies organized as LLCs, LLPs or LPs
Where a portfolio company is a pass-through entity and a member of the management group actively participates in its management, the possibility exists that capital gains from the sale of the entity’s membership interests, or business assets, could qualify as gains exempted from section 1411 with respect to that individual. (In addition, as explained above, such amounts would also be exempt from the self-employment tax.)
To use a simple example, if the private equity fund held interests in only three companies, each of which was engaged in a trade or business, and each member of the management group regularly spent over 100 hours actively managing the activities of each of the three companies (for a total of over 300 hours per individual), it is likely that any capital gains from the sale of the business assets of (or membership interests in) such entities would be exempt from section 1411 for those individuals.
If a member of the management group does not spend over 100 hours in a particular entity, there may be another solution. In certain cases, multiple activities may be “grouped” and then subjected to a 500-hour test for demonstrating “material participation” in the entities. If grouping is permitted, a manager spending, for example, 450 hours with one entity and 51 hours with another entity could qualify both of them. Grouping is only permitted, however, if (1) a grouping election is timely made, and (2) the activities constitute an “appropriate economic unit.” For section 1411 purposes, a taxpayer generally may make a timely grouping election on either a 2013 return filed in 2014 or on a 2014 return filed in 2015, but taxpayers should consult their tax advisors for the detailed requirements applicable to their particular circumstances.
The regulations do not provide definitive guidance on what constitutes an appropriate economic unit but do provide some factors that could be relevant to the determination, such as economic interrelationships, common ownership and management, shared locations or similarity of businesses. For example, a partnership that held and controlled 10 automobile dealerships in the same geographical area operating under the same brand (e.g., Smith Chevy, Smith BMW, etc.) would likely qualify as an “appropriate economic unit,” while a partnership holding economically unrelated companies operating in different industries and different geographies would have a more difficult time and might not qualify for grouping. There are also special rules (and special uncertainties) that apply if an interest in a company (or a private equity general partner) is held by a trust.
Private equity fund managers should consult with their tax advisors to ensure that they are complying with the requirements of the new law, but not paying more than the law requires.