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.