Rebuilding Better Tax Proposals: Considerations for Private Equity Funds and Sponsors | Foley & Lardner srl
On September 13, 2021, the House Ways and Means Committee presented tax proposals that, if passed, would make significant changes to the U.S. federal income tax system. This alert summarizes some of the proposals that may be relevant for private equity funds.
Article 10611 requalifies the long-term capital gain allocated in respect of an applicable investment in a partnership (API) or recognized on the disposal of an API as a short-term capital gain, unless the asset sold has a holding period of more than three (3) years. An API is an interest held in connection with the performance of services and generally includes a profit sharing or deferred interest. Gains determined under articles 1231 and 1256, eligible dividend income are not subject to requalification.
The proposed rule generally extends the scope of the re-qualification of Section 1061 to all âapplicable net partnership gainsâ with respect to an API, unless an exception applies. The “net gain applicable to the partnership” is defined as the sum of: (i) the net long-term capital gain determined by taking into account the gains and losses relating to one or more APIs, and (ii) other amounts which are included in the gross income relating to these APIs which are treated as capital gains or are subject to tax at the rate applicable to capital gains. This would include the section 1231 gain and the section 1256 gain and eligible dividend income.
The applicable net gain of the partnership excludes any amount realized five (5) years after the later of the following dates: (i) the date on which the taxpayer acquired substantially all of his API, (ii) the date to which the partnership in which the API is held has acquired substantially all of the assets held by the partnership, or (iii) in the case of a multi-level partnership, the latest date on which lower-level partnerships have acquired substantially all of their assets. For any income attributable to a business or a real estate business, the holding period is three (3) years.
The changes would apply to taxation years that begin after December 31, 2021 and therefore apply to any gain recognized after that year.
Limitations on the interest expense deduction
Section 163 (j) limits business interest deductions to 30% of the taxpayer’s adjusted taxable income for the year. The amount of interest expense exceeding the 30% limit can be postponed indefinitely. The limitation generally applies at the level of the partnership.
The proposal would apply section 163 (j) at the associate level rather than the associate level, and limit the carry forward of unauthorized business expenses to five (5) years. The proposal includes a transitional rule that allows a partner whose excess business interest charge amount is carried forward under the current rules to treat that amount as paid or accrued in the partner’s first tax year beginning. after December 31, 2021.
The changes would apply to taxation years that begin after December 31, 2021.
Amendments relating to individual pension plans
Ban on investment of private funds. The proposal prohibits an individual retirement account (IRA) from investing in a security if the issuer of the security requires the individual to have a minimum amount of income or assets. This rule would prevent IRAs from holding private funds when the investor must qualify under the accredited investor test. If at any time during a tax year an IRA holds a prohibited investment, it will lose its status on the first day of that tax year. For IRAs that currently hold private funds, the rule will apply to tax years that begin after December 31, 2023. Thus, if an IRA currently holds a prohibited investment, it must sell the investment before January 1, 2024, or it will lose its status.
Limitation of substantial interest. The proposal prohibits an IRA owner from investing IRA assets in the securities or interests of an entity that are not listed on a stock exchange if they have a 10% or more interest in the entity. . The IRA would lose its status from the first day of the tax year if it is invested in these assets. Implied ownership rules apply: a person would be considered the owner of interests held by certain family members. There is a two-year transition rule that would allow IRA holders to dispose of these investments by December 31, 2023.
Contribution limits. The proposal prohibits additional contributions to pension plans, including IRAs, for people whose total accumulation in applicable retirement accounts is at least $ 10 million. If a prohibited annual addition is made, an excise tax will apply.
Distribution requirement. If a person’s total retirement account balance exceeds $ 10 million at the end of a tax year, the proposal requires a minimum distribution in the following tax year. The amount of distribution required is typically 50 percent of the amount by which the person’s overall retirement balances exceeded $ 10 million in the previous year.
These rules would apply to taxation years that begin after December 31, 2021.
Personal income tax changes
Personal income tax rate increase. The proposal would increase the top marginal personal income tax rate from 37% to 39.6%, which would reduce the top rate to the pre-2018 rate. The proposal also significantly reduces the personal income tax threshold. income at which the maximum rate of 39.6% applies: $ 450,000 for married filers filing jointly, $ 400,000 for single filers and $ 425,000 for heads of household. The rates would apply to tax years beginning after December 31, 2021.
Increase in capital gains rate. For individuals, estates and trusts, long-term capital gains and eligible dividends are currently subject to a marginal income tax of 20%. The proposal would increase this rate from 20% to 25% and, effective for tax years beginning after December 31, 2021, lower the income thresholds to which this maximum rate applies.
The proposal would generally be in effect for tax years ending after September 13, 2021 and would therefore generally be in effect as of January 1, 2021 for taxpayers in the calendar year. A special transitional rule provides that the proposed maximum tax rate of 25% would only apply to eligible dividends and long-term capital gains realized after September 13, 2021.
Tax on net investment income. Singles with adjusted gross income over $ 200,000 and married people jointly filing with adjusted adjusted gross income over $ 250,000 are generally subject to an additional Net Investment Income Tax (NIIT) of 3.8 % on their capital gains, interest and dividends. , annuities, royalties, rents and other income, insofar as such income arises from the passive activities of a taxpayer.
The proposal expands the scope of NIIT to include all applicable income, whether or not the taxpayer is a passive investor. The change applies to singles with taxable income over $ 400,000 and to married people filing jointly with taxable income over $ 500,000, as well as estates and trusts. The provision would not apply to wages and would come into effect for tax years beginning after December 31, 2021.
Supplement for high income individuals, trusts and estates. The proposal introduces a new 3% surtax for taxpayers whose income exceeds certain levels. The tax would apply to modified adjusted gross income (MAGI) over $ 5 million for singles, heads of households and married people filing jointly, $ 2.5 million for married people filing separately, and $ 100,000. for estates and trusts. The provision defines MAGI as adjusted gross income less any allowable deduction for investment interest (as defined in Section 163 (d)). The supplement would apply to taxation years that begin after December 31, 2021.
Limitation of the deduction for eligible business income. Section 199A allows an unincorporated taxpayer a deduction of up to 20% of the taxpayer’s qualifying business income and 20% of qualifying dividends from real estate investment trusts and qualifying income from listed partnerships. scholarship, subject to certain restrictions.
The proposal limits the maximum aggregate deduction allowed to $ 500,000 for married people filing jointly or surviving spouse, $ 250,000 for married people filing separately, $ 10,000 for an estate or trust, or $ 400,000 for any other taxpayer. . The limitation would apply to tax years beginning after December 31, 2021.
Increase in corporate tax rate
Currently, C corporations are subject to a flat tax rate of 21%. The proposal provides for a phased structure as follows: 18% on the first $ 400,000, 21% on revenues over $ 400,000 but not more than $ 5 million, and 26.5% thereafter. For corporations with income over $ 10 million, the rate is 26.5% on all income. These rates would be in effect for tax years beginning after December 31, 2021.
Exemption from portfolio interest
Under current law, a foreign natural person or company is generally not subject to withholding tax of 30% on interest related to certain portfolio debts which also applies to certain types of income. US source liabilities, such as interest and dividends (the âPortfolio Interest Reliefâ). However, the portfolio interest exemption does not apply to interest received by 10 percent shareholders or by a controlled foreign corporation (SEC) from a related person. A 10 percent shareholder is any person who owns 10 percent or more of the total combined voting rights of all classes of shares or 10 percent or more of the capital or profits of a partnership.
The proposal changes the definition of 10 percent shareholder to include an owner of 10 percent of the total combined voting rights of a company or 10 percent or more of the value of a company’s shares. This change would apply to bonds issued after the promulgation date.
In addition, the proposal restores the limits on the downward attribution of foreign ownership for the purpose of determining SEC status. This would reduce the number of foreign companies that are unable to use the portfolio interest exemption because it is SEC. The amendment would apply retroactively to tax years of foreign corporations that begin before January 1, 2018 and to each subsequent tax year.
1 All references to the âSectionâ are to the Internal Revenue Code of 1986, as amended, or to Treasury regulations promulgated thereunder.