Private lenders may benefit from 199A tax regulations has been saved
Private lenders may benefit from 199A tax regulations
Potential impact on private equity and hedge fund taxation
In Bloomberg Tax’s Daily Tax Report (October 15, 2018), Ted Dougherty of Deloitte Tax LLP discusses the possible but likely limited benefit that private lenders—usually private equity or hedge funds—may qualify for with the up to 20 percent deduction under Section 199A enacted in the Tax Cuts and Jobs Act.
- The new provision
- Background on lending activities
- The Section 199A deduction
- The W-2 Wage Limitation
- Additional insights
The new provision
Section 199A is a new provision enacted as part of the broader tax reform bill which was passed in late December 2017 as part of the Tax cuts and Jobs Act (the Act). Generally, tax code section 199A provides that income attributable to a trade or business activity conducted in the US either in pass-through or sole proprietor form may qualify for a deduction of up to 20 percent. The new deduction on qualified business income (Section 199A deduction) applies to many businesses, but most financial services activities are not qualified under the statute. Recently the treasury department and the internal revenue service clarified that the activity of making loans (without selling them) is indeed a qualifying activity. This development has generated a lot of discussion in the investment management industry, but as the reader will see, the benefit is likely to be relatively small.
"Investment managers who are managing funds engaged in the business of lending and who do not sell any of their loans should analyze the numbers and determine whether they and/or their investors may receive more benefit under Section 199A by causing the fund to pay W-2 wages."
–Ted Dougherty, partner, Deloitte Tax LLP
Background on lending activities
After the financial crisis of 2008-09, when many financial institutions significantly scaled back their lending, private lenders stepped in to fill the void. In particular, some organizations that called themselves private equity or hedge funds (depending primarily on liquidity terms) began to lend money, most notably to middle market companies that were challenged with securing sources of borrowing.
In the early days, taking into account that much of the capital they had to lend came from non-US investors who were not engaged in a US trade or business, most offshore funds were not designated as the lender of record due to their organizational structures. More recently, some funds have decided that these structures imposed limitations on their business activities that were no longer in line with broader business strategy, and so have moved into what may be called direct lending. That is, these funds (acting through the investment manager of the funds) are now finding borrowers, negotiating terms, and performing other activities that would likely give rise to a US trade or business for a non-US investor. The tax issues are still mitigated for non-US investors to the extent possible, but these direct lending funds acknowledge they are in the business of making loans.
The Section 199A deduction
As mentioned above, Section 199A generally allows an individual taxpayer a deduction for qualified business income equal to 20 percent of qualified business income from a domestic trade or business (allowing for allocable deductions); however, for taxpayers whose income exceeds a certain threshold, this deduction is limited to:
- 50 percent of the Form W-2 wages (W-2 wages) of the entity in which the business activity takes place (or associated with the activity in the case of a sole proprietorship), or
- 25 percent of the W-2 wages of such entity plus 2.5 percent of the unadjusted basis of qualified property (i.e., tangible property used in the trade or business).
Any deduction computed under these rules is subject to a final limitation, namely that the deduction cannot exceed 20 percent of the taxpayer’s taxable income from all sources, less net capital gain the “overall limitation”. For purposes of this article, we will ignore the limitation which includes the unadjusted basis of property as tangible property is generally not a material factor in direct lending business. (The Section 199A deduction also is allowable for certain dividends from REITs and income from publicly traded partnerships, both of which are outside the scope of this article).
The income threshold that drives taxpayers to consider the limitation based on W-2 wages starts when an individual’s taxable income is $157,500 (or $315,000 for a joint tax return) and is fully effective when an individual’s taxable income is $207,500 (or $415,000 for a joint tax return). These income thresholds will be adjusted for inflation. The Section 199A deduction is allowable in taxable years beginning after Dec. 31, 2017, and expires, as do many provisions of the Act impacting individual taxpayers, after 2025.
The Section 199A deduction is not allowable for taxpayers above these phase-out ranges if the trade or business is a “specified services trade or business” (SSTB). In the preamble to proposed regulations recently issued by the Treasury Department and the Internal Revenue Service, the government confirmed that, while most financial services activities would not generate qualified business income for purposes of Section 199A, the activity of making loans (without selling them) is indeed a qualifying activity. This is consistent with the statutory language as drafted by Congress and recognizes the important role that non-bank lenders have in financing business growth. It is important to note that while making loans is a qualifying activity if the taxpayer sells more than a negligible amount of such loans, the taxpayer could become a dealer in securities, in which case the overall activity would not qualify for the Section 199A deduction.
The W-2 wage limitation
In the financial services business, many individual taxpayers that are partners in a partnership or operating as a sole proprietor may likely find themselves above the phase-out ranges. Therefore, in calculating any benefit from the Section 199A deduction, the W-2 wages limitation must be considered. In the case of investment funds organized as partnerships, whether they consider themselves as private equity or hedge funds or something else altogether, most do not have employees and so W-2 wages. Instead, a management fee equal to a percentage of assets in the fund is paid to an investment manager who has been hired to manage the fund. It is the investment manager who typically employs the individuals engaged in the activity of making loans. Often, the fund also pays a performance fee or a carried interest to the general partner, which is related in terms of ownership to the investment manager. Without any W-2 wages, the typical fund that is making loans will not generate any income that would benefit from the Section 199A deduction.