On November 16, the US House of Representatives passed the “Tax Cut and Jobs Act.” The bill's proposed effective date is January 1, 2018. Separately, the US Senate Finance Committee has released the legislative text of its own tax bill. The Senate is set to take up the bill following the Thanksgiving recess. Both the House and the Senate bill contain a number of provisions that may impact the operation of family offices and family investment vehicles.
Many dynastic families structure their affairs to be managed by a family office, often characterized as a partnership for US tax purposes. Additionally, within family wealth structures, families will typically consolidate investment assets in collective investment partnerships, such as family limited partnerships or limited liability companies.
The use of entities characterized as partnerships for business and investment activities with in-house investment professionals, whether related to business asset-management or investment services, is beneficial because it allows for the flow-through of tax attributes to the ultimate partners, while providing a mechanism for incentivizing those who participate in the management and operations of such vehicles. The following provisions of the House and Senate bills are relevant to family offices and investment structures:
- The House bill would allow a portion of net business income allocated by pass-through entities, such as partnerships, limited liability companies, S corporations and sole proprietorships, to individual partners, owners, and shareholders to be subject to a maximum rate of 25%. In some cases, it appears that owners of family offices and family investment vehicles might benefit from this new rate structure as the maximum federal ordinary rate is currently 39.6%.
- In determining what income qualifies as “business income” under the House bill, partners, owners and shareholders would be able to elect to: (1) treat 30% of their distributive share as business income, and 70% as wage income, or (2) determine the ratio of business income to wage income based on capital investment. However, an owner receiving income from passive business activities would be able to treat 100% of his distributive share as business income. Income currently subject to preferential rates, such as net long-term capital gains and qualified dividend income, would retain its character and would thus be excluded from business income. Professional service providers, such as doctors, lawyers, accountants and others, would not qualify for the new reduced rate on pass through business income.
- The Senate bill contains a different structure for pass-through entities. The Senate bill would give pass-through business owners a 17.4% deduction on their income, which would effectively reduce the effective tax rate of pass-through business owners. The deduction would be limited to 50% of the taxpayer’s allocable pro rata share of W-2 wages of a partnership or S corporation. Like the House bill, professional service providers, such as doctors, lawyers, accountants and others, would not be eligible for this deduction, with an exception for service income to taxpayers with taxable income below $150,000 for joint filers and $75,000 for others.
- Both the House and Senate bills would repeal the alternative minimum tax (“AMT”). The repeal of the AMT could dramatically benefit high net worth individuals.
- Both the House and Senate bills would limit deferral of gain on like-kind exchanges after 2017 to real property. Consequently, the utilization of sophisticated investment partnerships that navigate the contributed property built-in gain rules may become more popular as a means of deferring gain on non-real property investment assets.
- Effective tax years beginning after 2017, the House bill would repeal the Section 708 technical termination rules. This change would greatly simplify family structuring transactions that might otherwise be subject to the technical termination rules.
- Both the House and the Senate bills have provisions affecting carried interest, which would limit long-term capital gain treatment to gains arising from the sale of assets held by a partnership for more than three years (as opposed to the normal one year rule), subject to certain exceptions.
- The Senate bill would eliminate deductions for investment expenses, thereby making partnership incentive allocations to advisors all the more attractive from a deductibility perspective.
- Both the House and the Senate bills contain provisions limiting interest deductibility. Effective for tax years beginning after 2017, the House bill would limit the deduction for net interest expenses incurred by a business in excess of 30% of the business’s adjusted taxable income. Similarly, the Senate bill would limit the deduction for net interest expenses incurred by a business in excess of 30%. These limitations would not apply to qualifying small businesses with average annual gross receipts under $25 million (House) or $15 million (Senate) during the three preceding years, indexed for inflation. These limitations would not apply to real property business indebtedness.
- The Senate bill contains a provision to prevent the use of active net operating losses to offset portfolio income. For example, this provision would prevent family offices from using actively managed real estate losses to offset portfolio income.
- Finally, neither the House nor the Senate bill contain any provision to repeal the 3.8% net investment income tax. As such, family investment activities that often generate income associated with the net investment income tax would still be subject to this additional 3.8% levy.
President Trump has declared an end-of-year deadline for tax reform. Whether the House or the Senate bill (or a combination thereof) will garner the requisite votes remains to be seen. Nonetheless, if tax reform is signed into law, it will likely have a significant effect on family offices and family investment vehicles taxed as partnerships.