Press Room: Tax Release
2010 Legislative Updates Impacting Alternative Investment Funds
This edition of the FUND WATCH provides a concise summary of the year-end calendar 2010 tax legislative developments impacting Alternative Investment Funds (AIFs), their sponsors and their investors.
As each year closes, tax practitioners rush to assist their clients with year-end planning. In some ways, 2010 was no different. But in other ways, 2010 was quite unique. Most importantly, as we neared December 31, 2010, the expiration of the so-called Bush-era tax cuts loomed large. With the prospect of increasing tax rates, traditional notions of income deferral and expense acceleration were eschewed. Practitioners and taxpayers alike began thinking in terms of income acceleration and expense deferral. Even the choice between the single taxation of a partnership or S corporation seemed questionable when compared to the potential savings of a C corporation facing lower corporate tax rates. Then, in the proverbial eleventh hour, Congress stepped in and extended the tax cuts for another two years.
Did this extension equate to status quo? Not exactly. Following the enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (The Tax Relief Act), planning opportunities and pitfalls abound. What follows is a brief highlight of those legislative provisions and activities that we believe will be of great interest to alternative investment funds, their sponsors and their investors looking forward in 2011.
II. CARRIED INTERESTS – PARTNERSHIP PROFITS INTERESTS OF AIFs
Given its prominence of the last few years, no discussion of taxes affecting alternative investment funds would be complete without mentioning the government’s efforts combating a perceived abuse involving carried interest. In 2010, we saw a bill introduced by Senate Finance Committee Chairman Max Baucus (D-MT) and acting House Ways and Means Committee Chairman Sander Levine (D-MI)—the American Jobs and Tax Loophole Closing Act of 2010—which would have raised a projected $18 billion by taxing carried interest as 75% ordinary income and 25% capital gains. The bill, which passed the House in June, quietly died an unceremonious death in the Senate a few weeks later. The revenue raiser was not included in the Tax Relief Act and conventional wisdom suggests that carried interest legislation is off the table, at least for the next two years. Though, as Mark Twain might have said, the reports of the larger effort’s demise are greatly exaggerated.
At the time of this writing, there is no active legislative proposal that would tax carried interests differently than other profits interests. Nevertheless, President Obama and the new Chair of the House Ways and Means Committee, Representative Dave Camp (R-MI) have been clear that tax code reform is overdue and on their wish list for the legislative year. It is possible that carried interest legislation, while unpalatable as a stand-alone, would be part of a larger debate on tax reform. Finally, it remains uncertain what effect the finalization of certain proposed regulations could have on carried interests. These regulations were proposed in 2005 and addressed property transferred in connection with the performance of services. Controversial when proposed, the regulatory project may have faded from the memories of many taxpayers while the carried interest legislation was debated. Nonetheless, these proposed regulations, if finalized in current form, arguably would apply and affect the taxation of carried interests. Accordingly, new funds and funds contemplating this issuance of carried interests or promotes should consider the impact of the proposed regulations when planning.
III. INCOME TAX RATES OF INDIVIDUALS AND BUSINESS ENTITIES
The Tax Relief Act extends the Bush era tax cuts so that individual tax rates remain, generally, lower than corporate tax rates. Anticipating higher rates, some business taxpayers explored corporate structures that would effectively reduce their overall tax obligations. When the rates did not go up, most business taxpayers once again concluded that some type of pass-through form (e.g., partnership, S corporation) was preferable from a tax standpoint. However, important advantages can still be found in the Tax Relief Act.
IV. QUALIFIED SMALL BUSINESS STOCK (QSBS) – ZERO (0%) TAX RATE
Perhaps most notably, the 100% exclusion for qualified small business stock was extended through 2011. In fact, the Administration recently proposed to make the exclusion permanent. This exclusion, with its effective 0% tax rate, clearly will impact the tax metrics used by business owners facing the choice of entity decision.
V. LIFETIME PLANNING/ESTATE TAX MATTERS
One of the major themes of the Tax Relief Act is an emphasis on lifetime giving. The 35% gift tax rate set to expire at the end of 2010 was extended into 2011 and 2012. Automatically, the now re-unified lifetime exclusion (i.e., the amounts of cumulative gifts and devises that can be made free of tax under a federal transfer tax credit) is raised dramatically from $1 million ($2 million where a husband and wife gift together) to $5 million (again, $10 million in the case of a married couple). Similar changes made by the Tax Relief Act apply to the generation-skipping tax imposed on transfers to grandchildren or more remote descendents of a grantor.
Under the new provisions that apply in 2011 and 2012, a grantor can transfer significant wealth to children, grandchildren and other beneficiaries who are two or more generations below without incurring a transfer tax liability. The largess in this respect was not offset by restrictions rumored to be considered by Congress. Such restrictions would have placed limits on the use of short-termed grantor retained annuity trusts (GRATs) as well as valuation discounts applied to family limited partnerships and limited liability companies. None of these restrictions are found in the Tax Relief Act.
Owners of interests in AIFs have always faced opportunities and pitfalls when dealing with transfers of these interests. The generous lifetime gifting provisions found in the Tax Relief Act remove some of the tax hurdles that previously existed. One can imagine the owners of such interests using the advantages of GRATs, valuation discounts, and the $5 million to $10 million lifetime exclusion to transfer significant wealth to future generations.