Investors in billion-dollar hedge funds might be able to take advantage of a new, lower tax rate touted as a break for small businesses. Private equity fund managers might be able to sidestep a new tax on their earnings. And a combination of proposed changes might allow the children and grandchildren of the very wealthy to avoid income taxes in perpetuity.
These are some of the quirks that tax experts have spotted in the bill passed by the House on Nov. 16, just two weeks after it was introduced. Whether they were intentional or accidental, it will be up to congressional tax writers to keep or revise them before a final bill makes it to President Donald Trump’s desk — assuming both chambers can work out a compromise. Senate leaders plan to vote on their own version of tax legislation by the end of this month.
“There sure are a lot of glitches and loopholes, in large measure because there’s so much complexity in this bill that’s being raced through,” said Steven Rosenthal, a senior fellow with the Urban-Brookings Tax Policy Center, a Washington policy group.
Loopholes aside, the biggest features of the Republican tax plans in both chambers bear a mix of news for wealthy investors.
The good: a potential cut in the top marginal income tax rate; big cuts in business taxes; an end to the alternative minimum tax; and a cut or repeal of the estate tax. The bad: limits or the outright end of individual deductions for state and local taxes and tax hikes on the debt financing that fuels private equity deals.
The loopholes are deep in the details.
The House bill contemplates a major shift in how most American businesses are taxed. Right now, profits from “pass-through” entities, like sole proprietorships and partnerships, show up on their owners’ individual income taxes. The House bill replaces that with a new, 25% top tax rate on pass-throughs’ business income. Supporters describe the change as a boon for small business owners, a way to keep them relatively even with corporations, which stand to see their tax rate drop to 20% from 35% .
The bill’s drafters probably didn’t mean for investors in partnerships like hedge funds to use the new pass-through rate, according to David S. Miller, a tax partner at Proskauer Rose LLP in New York. Capital gains, the kind of income these funds tend to generate, would be excluded.
But there may be a workaround. In a note published on Nov. 13, Miller highlights what he calls “an unusual set of drafting glitches.”
Here’s how it would work, according to Miller: A fund could choose to be taxed the same way a securities dealer is. It would have to mark its portfolio to market regularly and record any profits as ordinary income. Doing so would allow it to characterize the money it makes as “business income” rather than investing income, and qualify for the pass-through rate.
For a hedge fund that generates short-term capital gains, this strategy could have the effect of dropping an investor’s tax rate to 25% from 39.6%. The manager of the fund probably wouldn’t get the full benefit, Miller said.
(Photo: Allison Bell/TA)
The Senate bill, which was released Tuesday, would overhaul taxes for pass-through businesses in a completely different way.
Another provision in the House bill is aimed squarely at fund managers. It targets the so-called carried interest tax break that Trump called for ending during his campaign when he said “hedge fund guys are getting away with murder.”
Hedge fund and private equity managers typically get some of their pay in the form of carried interest — a% age of their investors’ profits. Under current law, if those underlying profits stem from investments held for more than a year, the managers enjoy the same preferential, lower rate on the carried interest that their clients pay on their investments.
The House bill preserves this break, but limits it by extending the holding period from one year to three.
Even that tax hike might be avoidable, according to Monte Jackel, a senior counsel at Akin Gump Strauss Hauer & Feld LLP. Jackel notes that the provision doesn’t apply to corporations that hold carried interest. So a fund manager could collect his carried interest through a type of corporation that doesn’t itself pay taxes.
“It looks like that’s what they’ve written,” Jackel said, adding that it’s the type of discrepancy that’s likely to get fixed once someone notices it. The Senate bill contains identical language about corporations.
Another quirk in the House bill is so glaring that Richard Levine, a special counsel at Withers Bergman LLP in New Haven, Connecticut, says he can’t believe it was accidental. This one involves the estate tax, a 40% levy that applies to the estates of a few thousand of the richest Americans each year.
The House bill would limit the tax to even fewer estates right away, and then eliminate it entirely in 2025. But it leaves in place a related measure that allows heirs to sell assets without having to pay income tax on the appreciation that took place before they inherited them.
Taken together, that means that a family whose fortune derives from a long-held asset — think Warren Buffett’s Berkshire Hathaway Inc., or the Walton family’s Wal-Mart Stores Inc. — might never have to pay tax on the bulk of that wealth at all. The founding generation could borrow against the stock to meet expenses, and the next generation could sell it income tax-free.
The last time the estate tax was repealed, during the single year of 2010, Congress changed the rules on inherited assets to avoid this result, said Robert Gordon, who advises clients on the tax implications of investments at Twenty-First Securities Corp. in New York.
He predicted the same thing will happen this time, but that it’s being held back as a negotiating tactic. (The Senate bill would limit the estate tax to fewer people but not repeal it.)
Levine helps wealthy individuals with tax planning, and he said the House proposal is “very welcome for my clients.”
“As a matter of tax policy it’s completely indefensible,” he said. “It permits income that is obviously income, in a constitutional sense, to go entirely untaxed.”
—Read Mulvaney Says It Would Be OK to Drop Mandate Repeal in Tax Plan on ThinkAdvisor.