With the K-1 season right around the corner, now is the perfect time to highlight a few key concepts that will directly affect fund managers from the Tax Cuts and Jobs Act (“TCJA”) that was enacted on December 22, 2017.
Limits on Deductibility of Business Losses
TCJA imposes a new limit on the deductibility of business losses incurred by taxpayers other than corporations. A taxpayer’s loss from a non-passive trade or business is now limited to $500,000 for married individuals filing jointly ($250,000 for other taxpayers) for tax years beginning after December 31, 2017 and before January 1, 2026.
These amounts are indexed for inflation for tax years beginning after December 31, 2018. Any excess business loss is treated as part of the taxpayer’s net operating loss (“NOL”) carryforward to be used in subsequent years.
Excess business losses are the taxpayer’s excess deductions from trades or businesses over the taxpayer’s income from trades or businesses, plus the statutory threshold amount described above. Excess business losses for a partnership are determined at the partner level. Thus, each partner’s share of items of income, gain, deduction, or loss of the entity is considered in determining the partner’s limitation. Disallowed excess business losses will be treated as an NOL and carried forward under the NOL carryforward rules.
This will have a key impact on fund managers that have a management company running at a loss. The manager will be limited to the amount of the loss that can offset their other income, and the loss from the management company can only offset income from other trade or businesses. The incentive that is earned from an Investor Fund is not considered income from a trade or business and cannot be offset by the loss from the management company. It is important to test the Fund each year to see if qualifies as a Trader Fund which would generate income from a trade or business.
Revenue Code Section 199A
TCJA also introduced the Internal Revenue Code Section 199A, which will not have a major impact on the managers but will require additional reporting at the Fund level. This new code section grants a deduction of up to 20% of qualified business income from certain trade or businesses. This does NOT include service businesses, including asset management. Asset managers may benefit from the 20% deduction but the phase-out limits are very low.
If the Fund holds an underlying interest in a trade or business, the information needed to calculate the 20% deduction must be reported out to the investors on the Fund’s Schedule K-1. Some pieces of information needed from this underlying investment include total wages and unadjusted basis of property; it is important to keep this need in mind during any K-1 planning meetings with your accountant.
The Repeal of Itemized Deductions
The repeal of the itemized deduction, subject to a 2% floor, affects an investor’s deductibility of management and professional fees that the Fund would incur. Under TCJA, these fees are now considered a non-allowable expense for Investor Funds, but are still deductible for Trader Funds since they are treated as a trade or business. This is one more reason to test a Fund’s trading activity each year and determine if it operates under trader status.
The concepts above are relevant with respect to many asset managers. Please speak with your Prager Metis advisor to determine how the new law affects your unique situation, and to determine what year-end tax planning should be considered.