Hot tax topics for private equity firms and partnerships
INSIGHT ARTICLE |
Moshe Metzger, RSM partner, discussed tax issues for hedge funds and private equity partnerships at RSM’s 9th Annual Investment Industry Summit on Sept. 19. His presentation covered developments related to U.S. vs. foreign blocker corporations, family limited partnerships in gift and estate planning, management fee waivers, and state-sourced revenue.
The following is a synopsis of his remarks:
1) Sales of U.S. partnership interests by private equity blocker corporations: impact of court ruling
Private equity firms with foreign or tax-exempt partners should consider the merits of setting up a foreign “blocker” corporation to handle U.S.-sourced income, in the wake of a recent court ruling.
Blocker corporations are sometimes established by private equity funds with foreign or tax-exempt partners to handle U.S.-effectively connected source income from U.S. portfolio companies structured as partnerships.
The blocker can be set up either as a foreign corporation or a U.S. C corporation. If the blocker is U.S.-based, it will have to file tax returns and pay taxes on income it earned whether or not the income is US sourced. Foreign blockers must file a U.S. tax return to report US source income. Either way, taxes are paid at the corporate level and the shareholders will not have to file US tax returns to reflect the corporate income.
When a fund decides to sell its interest in the U.S. partnership, the Internal Revenue Service (IRS) IRS traditionally has viewed gains from such sales as taxable U.S.-sourced income (Revenue Ruling 91-32) depending on the makeup of the assets of the partnership.
A recent court ruling, however, held that in the case of a foreign blocker (GMN), profit from such sales are capital gains and a look-through principle should not apply. The court agreed with GMN’s argument that if a foreign investor sold stock in IBM no U.S. tax would be due, as capital gains aren’t necessarily taxable in the U.S. Because a partnership interest is – like stock -- a capital asset, GMN said, its sale is a capital gain.
The court agreed, ruling against the IRS.
The IRS still has time to appeal. The bottom line is, if you’re forming a blocker think seriously about a foreign blocker vs. a U.S. blocker.
2) Estate planning: Family Discount Limited Partnerships
The new Administration’s decision to put all 2016 regulations on hold pending review has at least temporarily lifted a ban on family discount limited partnerships.
Background: Everyone can make a total of $5 million-plus in tax-free gifts in their lifetime to descendants -- $10 million-plus counting the spouse. Financial services professionals are likely to have far more than $10 million to pass along, and therefore are likely subject to estate tax at death.
Estate planning in this area includes family loans where fund owners lend money to the next generation to invest in the fund. The original loan is repaid to the fund owner with interest, and if the fund earns more than the IRS rate – about 2.5% in today’s low interest rate environment – the rate of return of the fund and, if properly structured, even a piece of the carried interest is passed along to the next generation without triggering gift tax or counting against the lifetime estate tax exclusion.
Another method for generational transfers is known as a Grantor Retained Annuity Trust (GRAT). Effectively, the fund owner gives away the earning capacity on the money in excess of IRS interest rates to the next generation.
For example, a fund owner lends $1 million to a descendant to invest in his fund. The grant is structured so that the loan is repaid with interest over three years – approximately $350,000 a year, at the current IRS interest rate, for a total of $1,050,000. Any income in excess of that is retained by the descendant.
If the fund owner chooses to pay the tax on the earnings of the fund in the interim, the tax paid is not deemed to be a gift and doesn’t count against the fund owner’s lifetime exclusion.
An even more effective method of granting earnings capacity is to put an interest in the hedge fund to into a family partnership and give a limited partnership interest in the family partnership to the descendant. Because a limited partnership interest lacks control and marketability, its value can be discounted in the 20% range.
Thus, $1 million of value placed into the family partnership is counted as worth only $800,000. When the $800,000 is returned with interest, the fund owner receives approximately $840,000 rather than $1,050,000. Therefore, the $200,000 discount is passed to the descendant without being counted against the lifetime exclusion.
About a year ago, the IRS imposed a regulation that severely limited the use of family discount limited partnerships. When Donald Trump took office, he ordered all the regulations issued in 2016 be put on hold pending review.
The regulation on discounts, swept in together with other regulations, is under analysis right now. Meanwhile, discounts are still available. Go out and do a GRAT today!
3) IRS targets management fee waiver abuses
Managers of private equity funds can waive their scheduled management fees in exchange for a share of fund income at some point in the future. The advantage is that fees are taxed as ordinary income, while fund the income is usually taxed at lower long-term capital gains rate.
Such fee waiver arrangements are fine so long as a degree of risk is involved. The manager gives up the certainty of the fee for a chance to receive a share of future profit that would be taxed at a lower rate.
The industry, however, began structuring fee-waiver arrangements so as to guarantee the manager would receive income even if the fund lost money. The IRS took a dim view of this development, and began auditing to uncover fee waiver abuses.
To enhance the validity of a management fee waiver, one must be careful regarding when payment will be received as well as providing for a clawback provision in the agreement.
Another concern expressed by the IRS with respect to why some management fee waivers may not operate as they are designed is when the management company waves the fee but the subsequent income share goes to the fund’s general partner. The IRS found such arrangements invalid for the special exception to the rules of “profits interests” in a 1993 revenue procedure ruling,
Most funds formed in New York City, however, have this type of structure in place,. When the IRS cracked down recently, fund managers protested. Final regulations have yet to be issued.
4) State-sourced income
Historically, determining if an entity is subject to taxation in a particular state involved three questions:
a) Am I paying any rent or wages in this state?
b) Do I have any fixed assets located in this state?
c) Am I earning revenue in this state?
In general, if any of the three answers were yes, the entity, corporation, and partners of a partnership would have state-sourced income. Over the past five or so, however, the focus has been shifting to the third question, where revenue originates.
Under the “economic nexus concept” or “market sourcing concept,” it doesn’t matter if an entity doesn’t pay rent or wages or have hard assets in a particular state; all that matters is if revenue is generated there.
Twenty-two states have adopted the concept in some form; however, every state has different rules.
Funds trying to determine where to file state tax returns risk entanglement in irreconciled complexities.
For example, a partnership which is a management company is based in New York State, which still hews to the old rule. If the services were performed in New York, New York deems the partners to have received New York state-sourced income.
If the same management company has a contract with a out-of-state hedge fund whose partners are all California residents, New York still regard the income as New York-sourced income. The other state, however, might regard all the revenue as their revenue, based on the fact that the company delivered its services to that state.
For its part, California views all the revenue to be California-sourced, as the benefit was received by the California-dwelling limited partners of the partnership.
The same income: taxable in New York, taxable in another state, and taxable in California.
Bottom line: Management companies may wish to conduct an analysis of their sourced income to gauge their state filing and tax exposure.