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NII Tax: Highlights and Planning Considerations for the Alternatives Industry
By Kara Friedenberg, CPA, and Sol Basilyan, CPA

The Patient Protection and Affordable Care Act of 2010 imposes on individuals, estates, and trusts a new Medicare tax equal to 3.8 percent on Net Investment Income (NII) starting in the 2013 tax year (Section 1411). As much has been written on the NII rules in general, this article will highlight some of the issues noted with the regulations, as well as recommendations made to the IRS, and discuss some of the planning considerations for alternative investment funds, their investors, and principals.

First, some background: NII as defined in the proposed regs includes income from three different categories of income. The grouping of income among each of those categories has particular significance on the operation of the rules. NII is the sum of the following:

  • Category 1 - gross income from interest, dividends, annuities, royalties, rents, substitute interest, and substitute dividends (except to the extent they are derived in the ordinary course of a trade or business that is not described in category 2).
  • Category 2 - other gross income derived from a trade or business that is either:
    • income from a trade or business that is a passive activity for the individual (that is, income generated from an interest in a partnership that is a trade or business whereby the partner does not actively participate in the activities of the partnership); or
    • income from trading in financial instruments or commodities.
  • Category 3 - net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property, other than property held in a trade or business not described in category 2).

This income is then reduced by properly allocable expenses that are allowed for federal income tax purposes.

The NII tax was originally drafted to tax “un¬earned income,” and the intent was to capture most income that is not already being taxed by either Medicare employer withholding or self-employment tax. However, there are many issues with how the statute and the proposed regulations are drafted, including the way income is grouped into the three categories above. Some income streams escape all of these taxes, and some income streams are taxed differently depending on the types of entities generating them. Particularly relevant to the alternative investments industry is the distinction in treatment of income allocated from investor funds and trader funds.

Highlights: Summary of Key NII Rules

  • Practitioners have made recommendations to the IRS regarding several issues with netting of gains and losses mechanics, as well as the distinction between gross and net gains in various sections. For example, gains and losses from trader funds are consid¬ered NII, but only net gains (not net losses) from investor funds are considered NII.
  • Swap income (periodic payments and mark-to¬-market inclusions) earned by a trader fund is considered NII, but swap income earned by an investor fund is not. Gains from the sale of swaps would be NII for both investor and trader funds.
  • Current inclusions of income from passive foreign investment companies (PFICs) and controlled foreign corporations (CFC) are taxed under the NII regime if the PFIC or CFC is held through a trader fund. However, they are not taxed until cash is received, if income is held through an investor fund. Investment in a PFIC/CFC through an investor fund creates a timing difference requiring investors to keep (either directly or through a partnership) a separate set of records to track the basis and income inclusion for regular and NII tax pur¬poses. There is a conformity election that allows for the same timing as for regular tax purposes, but the election must be made by the individual tax¬payer for all PFICs owned. Recommendations have been made to the IRS to either allow the conformity election to be made at the partnership level, or alternatively allow the taxpayer to make a separate election for each PFIC.
  • There is a special rule for traders that allows any excess trading expense deductions to offset their trading income subject to NII tax. The deductions must first be used to offset net income subject to self-employment tax, and only then can the remainder be used to offset NII. Although this rule was included as a taxpayer-friendly measure to ensure that a trader did not lose the benefit of the excess deductions, it provides an ordering rule that is less than optimal.
  • Currently foreign tax credits (FTCs) cannot be used as a credit against NII. Again, practitioners have recommended to the IRS that a taxpayer should be able to use any excess FTCs that are not already being used for regular tax purposes.
  • If a taxpayer has an ordinary loss (for example, a section 475 loss) in a year in excess of other ordinary income, she would not be able to carry that forward to a subsequent year to offset NII because it is part of an NOL. A fairer result might be to allow a taxpayer to carry over the ordinary loss portion of an NOL that is associated with NII (for example, a section 475 loss); we'll await future IRS guidance on this

Planning Considerations Regarding NII

New rules often offer new planning opportuni¬ties. As is always the case with tax planning, everything depends on the specific facts and cir¬cumstances, and care should be given to proper structuring.

Incentive Allocation vs. Incentive Fee. The incentive allocation earned by a fund manager is generally subject to NII tax; however, the fee income is not. There are potential opportunities to structure an incentive allocation as an incentive fee and pay it to the management company that is not a partner in the fund. Because the effect on investors would be detrimental if the fund were not respected as a trader, the structure of the incentive as a fee in a partnership with U.S. investors would likely not be as attractive as it would be for offshore funds. In addition, to the character of the income, the structure of the management company, SALT ramifications, self-employment tax and potential carried interest legislation must be considered.

Limited Partnership and S-Corp Management Companies. Of particular importance in the NII planning is the structure of the management company as a limited partnership, S corporation or limited liability company. Fee income received by an S corporation or a limited partnership relying on the LP exclusion (Section 1402(a)(13) provides that earnings from partnerships that are attributed to a limited partner are excluded from the definition of net earnings from self-employment) is not subject to either NII or self-employment tax. Therefore, if properly struc¬tured, an incentive fee would not be subject to either NII or self-employment tax (aside from any reasonable guaranteed payments made).

NII Tax v. Self-Employment Tax. Those management companies that are organized in ways other than limited partnerships or S corporations (usually as an LLC) subject their management company income to self-employment tax. Again, the benefit of restruc¬turing an allocation as a fee may not be as apparent in this situation in which an investor is trading a 3.8 percent NII tax for a 3.8 percent self-employment tax. However, two significant differences should be considered. First, 1.45 percent of the self-employment tax is deductible for regular tax pur¬poses, whereas none of the NII tax is deductible. Further, only 92.35 percent of self-employment in¬come is subject to tax. A basic analysis comparing $100 of gross income subject to NII tax versus self-employment tax will demonstrate there is a 0.56 percent tax savings. As a result, absent carried interest legislation, it may still be beneficial for management companies that do subject their distributive share of fee income to self-employment tax to structure it as an alloca¬tion instead of a fee.

State and Local Tax ("SALT") Considerations. One of the most significant SALT considerations is obviously the 4 percent NYC UBT that most NYC-based management com-panies pay on their fee income. An incentive allocation, however, is generally not subject to the NYC UBT due to the "trading for your own account" exception. The structuring of incentive allocation to a fee in NYC would essentially be trading a 3.8 percent tax for a 4 percent tax. Importantly, how¬ever, the NYC UBT is deductible for regular tax purposes. When apply¬ing the specific facts and circumstances, consid¬eration should be given to the amount of income apportioned or allocated outside of New York City.

Carried Interest Considerations. If carried interest legislation passes as currently drafted, any carried interest income treated as ordinary income under that legislation would be subject to self-employment tax. The carried interest legislation does not, how¬ever, say that fee income received for the purposes of providing investment advisory or management services is subject to self-employment tax. In other versions of the legislation, there was a separate section that specifically applied to fee income received by a partnership engaged in a professional services business (including invest¬ment advice or management) that essentially sub¬jected that income to self-employment tax, even when it was earned by an S corporation or limited partnership. If the professional services legislation is enacted and thus eliminates the lim¬ited partner exclusion and the S corporation rules, structuring an incentive allocation as a fee is not as effective. However, if only the carried interest leg¬islation passes in its current form, structuring an allocation as a fee when a management company does not subject its fee income to self-employment tax is still beneficial.

Allocation of Management Company Expenses. In situations where a fund is maintaining an allocation and not a fee, there has been considerable discus¬sion around the potential for a fund manager to allocate a portion of its management company expenses to its incentive allocation, thereby reducing its NII base. It is important to note, however, that the allocation of expenses between management company income and the carried interests should be consistent for NII and regular tax purposes. As a result, while this structure may be more palatable for a manager in a trader fund (where the deduction is not limited), it is difficult to argue that the expenses are properly allocable to the incentive allocation of trader funds but not to the incentive allocation of investor funds.

Charging a Management Fee on GP Invested Capital. Another planning consideration that has been discussed is charging a fund manager’s invested capital a management fee. Essentially, a manager will reduce the amount subject to NII and report that same income in the management company. At first blush, this appears to be beneficial (particularly when the management fee income is not subject to self-employment tax or NYC UBT). However, the economic impact should be closely examined because every dollar of income that is paid to the management company is a dollar of income that is not staying in the fund to benefit from the fund’s rate of return. Generally, that rate of return is higher than any tax savings associated with the 3.8 percent tax paid.

PFIC Planning. From the investor’s perspective, a planning opportunity would be to invest in offshore funds. Absent an election otherwise, the NII tax is deferred for investment in PFICs until the cash is distributed. Consequently, an investor can get a deferral on 3.8 percent of the PFIC's earnings that is not available if she is invested in a partnership and taxed at the time of income allocation. Additionally, there are regular federal and SALT benefits of PFIC investing as well. Because of this, it will be interesting to see if a trend develops toward U.S. investors investing in the offshore fund instead of the onshore fund.

Looking Forward

The asset management industry is gearing up for what may turn out to be one of the most complex chapters of the Internal Revenue Code. As can be seen, the reporting ramifications of this new tax will be difficult. Aside from the new NII form that will be required of individual taxpayers, there will be changes to pass through entities forms as well, and there will be an expectation that the fund will provide all of the necessary detail to the investors that they will need to do their individual calculations. Investors and funds should continue to closely monitor the regulatory activity around the proposed regulations, and guidance, which is anticipated to be issued by the IRS later in 2013. It is anticipated that further guidance will address some of the undue complexity and hopefully alleviate the administrative burden for taxpayers and their service providers. In the interim, the NII should be taken into consideration when analyzing estimated income tax payments and taxpayers should focus on potential planning.


Kara Friedenberg, CPA is an alternative investments tax partner in PricewaterhouseCoopers' asset management practice. She provides both tax consulting and tax compliance services to a wide range of alternative investment clients, including hedge funds, private equity funds, fund of funds, and investment advisors. Friedenberg a frequent speaker at various alternative investments industry conferences, including those sponsored by the NYSSCPA, Financial Research Associates and BNA and has published widely. She is a member of the NYSSCPA, AICPA, Managed Funds Association, and Wall Street Tax Association and is active in many nonprofit organizations. She can be reached at 646-471-5748 or kara.l.friedenberg@us.pwc.com.

Sol S. Basilyan, CPA, is an alternative investments tax director in PricewaterhouseCoopers' asset management practice. He has extensive experience serving alternative investment funds of various strategies, master limited partnerships, and multinational investment management companies. Basilyan is a frequent presenter on technical issues at PwC’s national webcasts and industry events and has co-authored alternative investment fund tax technical alerts. He is an active member of NYSSCPA's Taxation of Financial Products Committee, as well as a member of the AICPA, Managed Funds Association, and Wall Street Tax Association. He can be reached at 646-471-0306 or sol.s.basilyan@us.pwc.com.

 
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The views expressed in articles published in Tax Stringer are those of the authors and not necessarily those of Tax Stringer, unless otherwise indicated. Articles contain information believed by the authors to be accurate as of original publication. The reader should not construe the content included in Tax Stringer as accounting, legal or other professional advice. If specific professional advice or assistance is required, the services of a competent professional should be sought.