Author Archives: E. John Wagner, II

Tax Reform Swings a Hand Ax at Carried Interests; What Does it Mean and How Can I Plan Around It?

While tax reform has a long march before becoming law, the amended House of Representatives bill passed yesterday swings an ax at lower-tax-rate-capital-gain-eligible “carried” partnership interests, though it swings a smaller ax—like a hand ax rather than a full-sized ax—than proposals in years past.

This latest proposal focuses on limited industries and allows an escape hatch for interests held more than three years. Here are the details:

How Do I Know if I Have a Carried Interest, and Why are Carried Interests Special?

The phrase “carried interest” applies to a partnership interest granted to a partner for services.  The idea is that the capital-investing partners “carry” the service partner, who does not make a capital contribution in proportion to the service partner’s interest.

Partnerships often structure carried interests to have little or no value at grant, causing the recipient to recognize little or no wage or other compensation income at that time.  Later, if the partnership recognizes long-term capital gain, the partnership allocates part of that gain to the service-providing partner.  This results in the service partner paying tax at a tax rate as little as half the rate on wage or compensation income (approximately 20%, as compared to approximately 40%, depending on the circumstances).

Why Change the Tax Treatment of Carried Interests?

Critics complain that carried interest partnership allocations amount to a bonus that should be taxed at the higher ordinary rates, like wage income and other incentive compensation.  The most vocal criticism focuses on hedge funds, private equity firms, and real estate investment firms, where critics see carried interest allocations as the equivalent of management fees.  Past Congressional proposals would have recharacterized a percentage or all partnership allocations to carried interests as compensation income, without regard to industry.

Carried interest advocates respond that many carried interest holders invest years of effort before receiving an allocation to their partnership interests, and therefore make the equivalent of an investment associated with a capital contribution.

Proposed Changes in the House Bill

The amended House bill takes a middle ground between the current law and prior Congressional proposals to curb the eligibility of carried interests for long-term-capital gain allocations. The bill focuses on carried interests in hedge funds, private equity firms, and real estate investment firms, not traditional operating businesses.

In targeted firms, the bill allows a partnership to allocate long-term capital gain to a carried interest partner who has held his or her partnership interest more than three years. If the partner has held the interest for three years or less, the proposal recharacterizes the allocation as short-term capital gain. In most cases, short-term capital gain characterization results in income taxation at the same rate as wage or other compensation income, but still allows the partner to avoid employment taxes.

It remains uncertain whether this proposal will survive reconciliation with a to-be-passed Senate tax reform bill.

Future Planning

Even if the proposal becomes law, look for motivated taxpayers to form “shelf” entities to begin the running of the three-year holding period while undertaking limited business activity. The taxpayers will then have such partnerships ready to use in the future, when a more substantial opportunity arises.

Read the carried interest proposal (see Section 3314 of the House amendment to the Tax Cuts and Jobs Act).

What’s Not to Like About the Proposed Tax Rate Reductions for Small Businesses?

If you run a small business (or even a large closely-held business) taxed as an S corporation or partnership, don’t get too excited about the tax rate reduction headlines in Congress’ latest tax reform proposals.

The House bill touts a 25% tax rate for business income from these entities. Passive investors would enjoy the 25% rate on all business income, which may encourage more investment and lower equity financing costs.  But for an entrepreneur actively involved in the business, the lower rate only applies to 30% of annual income from the business, or to annual business income up to approximately eight percent of adjusted tax basis (roughly, the un-deducted investment amount) in the business assets.  So the House bill is friendly to passive investors, and offers only limited benefits to traditional entrepreneurial small business operators.

The Senate proposal touts a 17.4% deduction against S corporation and partnership business income, but limits that deduction to 50% of the amount the individual taxpayer business owner receives in wages.  In other words, you have to pick up a dollar of income tax at the full individual tax rate and pay employment taxes on that amount, to enjoy the reduced tax rate on fifty cents of non-wage income.  This mix is not much different than the House’s 70% wage income-to-reduced-tax-rate business income ratio.

Like the House plan, the Senate small business tax rate proposal limits benefits to entrepreneurs.  Unlike the House bill, the Senate does little for passive investors, who may have a hard time justifying high wages to bolster their deduction.

The proposed 20% tax rate for traditional C corporation income is more straightforward than the S corporation and partnership tax rate proposals.  This may cause some small businesses to consider converting to C corporation status (the tax status of many larger companies and the vast majority of publicly-traded companies).  But in so doing the businesses (including, especially, Florida businesses) may become subject to state income taxes they otherwise avoid.  Further, any cash removed from the business will either be subject to the full individual tax rates or to a 23.4% dividend tax.  Finally, when the business is sold, the seller may receive a lower price (because the buyer can’t depreciate the purchased assets) or pay tax at an effective tax rate significantly higher than received or paid by the seller of a business structured as a S corporation or partnership.  So while taking advantage of the 20% C corporation tax rate may seem desirable to a growing business that reinvests its profits, the business owner may suffer a significant detriment upon a business sale and pay a higher tax rate on cash removed from the business in the meantime.

Conceivably, if you operate a small business, some flavor of the House and Senate proposals could reduce your tax liability.  There are some clean wins.  For example, both bills would allow many small businesses to immediately deduct much larger volumes of annual asset purchases, rather than take depreciation deductions over time. But if enacted, the tax rate proposals will not make life more simple or reduce difficult choices.

Changes to business tax rates are just the tip of the tax reform iceberg. The bills would make significant changes to many other areas of the tax law.  More to come…

Here is a link to a summary of the House bill: https://waysandmeansforms.house.gov/uploadedfiles/tax_cuts_and_jobs_act_section_by_section_hr1.pdf

Here is link to a summary of the Senate bill: https://www.finance.senate.gov/imo/media/doc/11.9.17%20Chairman’s%20Mark.pdf

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Applicable Federal Rates for October 2017

The Internal Revenue Code prescribes minimum imputed interest rates and time-value-of-money factors applicable to certain loan transactions and estate planning techniques. These rates are tied formulaically to market interest rates. The Internal Revenue Service updates these rates monthly.

These are commonly applicable rates in effect for October 2017:

Short Term AFR (Loans with Terms <= 3 Years)                                          1.27%

Mid Term AFR (Loans with Terms > 3 Years and <= 9 Years)                    1.85%

Long Term AFR (Loans with Terms >9 Years)                                              2.5%

7520 Rate (Used in many estate planning vehicles)                                     2.2%

Here is a link to the complete list of rates: https://www.irs.gov/pub/irs-drop/rr-17-20.pdf.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Why the President’s Latest Tax Reform Proposal Isn’t Even Nine Times Very Little

In April, the last time tax reform bubbled into the news cycle, we discouraged readers from paying much attention. President Trump’s “proposal” was this single page of bullet points that told us too little to evaluate its merit.

Tax reform returned to headlines this week, with the President offering this nine-page proposal.

If we use the “number-of-pages” method to evaluate work product, we might expect the new plan to include nine times as much meaningful information. Even if we discount the new document three and one-half pages for including a cover page and five pages only half-full of text, we might hope the new plan offers five and one-half times the information we gathered from April’s one-page plan.

It doesn’t. The new plan largely replicates the prior plan’s bullet points, adding some additional nontechnical explanation and a more impressive presentation format. It adds little, if anything.

Our advice hasn’t changed.  Don’t get excited.  Don’t exert energy seeking substance about tax reform just yet.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

IRS Declines to Follow Tax Court Decision Liberalizing Reverse 1031 Exchanges

Last year on the blog, we reported a Tax Court decision approving “reverse” 1031 Exchanges in which a taxpayer acquires replacement property more than 180 days before disposing of relinquished property.

The IRS recently announced it will not follow the Tax Court decision, and may seek future challenges in other courts to overturn it. This limits the Tax Court decision’s impact until the courts establish more precedent.

The IRS announcement should not, however, deter all taxpayers needing more than 180 days to dispose of relinquished property from attempting 1031 Exchanges. In any reverse 1031 Exchange transaction, a person unrelated to the taxpayer must hold the replacement property or relinquished property until the ultimate buyer acquires the relinquished property. The Tax Court decision and IRS announcement only affect transactions in which an agent or straw man holds the replacement or relinquished property for the taxpayer in the interim period, without bearing risks normally associated with property ownership. Sometimes a taxpayer can find an unrelated person willing to bear some of the benefits and burdens of ownership for the property, differentiating the arrangement from an agent or straw-man structure. This opens the door to a taxpayer taking the position a longer holding period may exist, even if financing or other arrangements remain in place between the interim titleholder and the taxpayer.

The IRS announcement can be read at irs.gov.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Applicable Federal Rates for September 2017

The Internal Revenue Code prescribes minimum imputed interest rates and time-value-of-money factors applicable to certain loan transactions and estate planning techniques. These rates are tied formulaically to market interest rates. The Internal Revenue Service updates these rates monthly.

These are commonly applicable rates in effect for September 2017:

Short Term AFR (Loans with Terms <= 3 Years)                                          1.29%

Mid Term AFR (Loans with Terms > 3 Years and <= 9 Years)                    1.94%

Long Term AFR (Loans with Terms >9 Years)                                              2.6%

7520 Rate (Used in many estate planning vehicles)                                     2.4%

Here is a link to the complete list of rates: https://www.irs.gov/pub/irs-drop/rr-17-17.pdf.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Applicable Federal Rates for August 2017

The Internal Revenue Code prescribes minimum imputed interest rates and time-value-of-money factors applicable to certain loan transactions and estate planning techniques. These rates are tied formulaically to market interest rates. The Internal Revenue Service updates these rates monthly.

These are commonly applicable rates in effect for August 2017:

Short Term AFR (Loans with Terms <= 3 Years)                                          1.29%

Mid Term AFR (Loans with Terms > 3 Years and <= 9 Years)                    1.95%

Long Term AFR (Loans with Terms >9 Years)                                              2.58%

7520 Rate (Used in many estate planning vehicles)                                     2.4%

Here is a link to the complete list of rates: https://www.irs.gov/pub/irs-drop/rr-17-15.pdf.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Applicable Federal Rates for July 2017

The Internal Revenue Code prescribes minimum imputed interest rates and time-value-of-money factors applicable to certain loan transactions and estate planning techniques. These rates are tied formulaically to market interest rates. The Internal Revenue Service updates these rates monthly.

These are commonly applicable rates in effect for July 2017:

Short Term AFR (Loans with Terms <= 3 Years)                                          1.22%

Mid Term AFR (Loans with Terms > 3 Years and <= 9 Years)                    1.89%

Long Term AFR (Loans with Terms >9 Years)                                              2.60%

7520 Rate (Used in many estate planning vehicles)                                     2.2%

Here is a link to the complete list of rates: https://www.irs.gov/pub/irs-drop/rr-17-14.pdf

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Applicable Federal Rates for June 2017

The Internal Revenue Code prescribes minimum imputed interest rates and time-value-of-money factors applicable to certain loan transactions and estate planning techniques. These rates are tied formulaically to market interest rates. The Internal Revenue Service updates these rates monthly.

These are commonly applicable rates in effect for June 2017:

Short Term AFR (Loans with Terms <= 3 Years)                                          1.18%

Mid Term AFR (Loans with Terms > 3 Years and <= 9 Years)                    1.96%

Long Term AFR (Loans with Terms >9 Years)                                              2.68%

7520 Rate (Used in many estate planning vehicles)                                     2.4%

Here is a link to the complete list of rates: https://www.irs.gov/pub/irs-drop/rr-17-12.pdf

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Why You Probably Can Ignore President Trump’s Tax Proposal for Now

On Wednesday, President Trump released his tax proposal.

Take a look. It won’t take long. That’s it. One page of bullet points.

For comparison, now look at this discussion of then-candidate Trump’s tax proposals during the presidential election campaign last fall.

Anything new? Not really.

While restating campaign promises may initiate the legislative discussion, doing so tells us little about what might actually appear in legislation hammered out by competing factions in Congress.

So whether you are excited or disappointed about lower corporate tax rates or estate tax repeal, we suggest re-averting your attention to other matters for the time being.

To that end, this missive also ends without further elaboration.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037