In this article, we present some thoughts on how the Tax Cuts and Jobs Act of 2017, officially known as "An Act To Provide For Reconciliation Pursuant To Titles II And V Of The Concurrent Resolution On The Budget For Fiscal Year 2018," (the "Act") will impact single family offices in 2018 and beyond.
The Act is effective January 1, 2018, but many of the individual provisions have a sunset date of December 31, 2025, whereas the corporate changes have no such expiration date.
Maximizing economic efficiency
The Act has no doubt created a tidal wave of questions and concerns about the structuring of various business and investment activities. For families with multi-generational business or investment concerns, tax changes affecting the efficiency of their family enterprises is a leading issue. The Act will certainly affect families with family offices and their managers. This note will specifically address key developments in tax reform that may affect family offices and family office managers.
Structures implemented to manage a family enterprise are as diverse as the families they serve. While there is great variety in the nature and scope of family offices, certain common structural features do emerge. This article therefore addresses tax reform in the context of the single-family office from three general perspectives: first, the corporate family office (a family office structured as a US C corporation); second, from the “fund style“ family office (a family office structured in a manner similar to a private placement fund or investment management partnership); and third, certain key points that will generally affect families and their family offices, regardless of whether the family office is structured as a corporate vehicle or fund style vehicle.
I – Corporate style family offices
Family offices formed as corporate vehicles will be affected by the many changes that were enacted to enhance corporate business operations and reduce tax costs for C corporations. Therefore, corporate family offices will likely see a benefit from tax reform. Relevant changes include:
- A new 21 percent flat corporate income tax rate now applies to C corporations, including personal service corporations. However, the personal holding company and accumulated earning rules still apply and therefore deemed dividends taxed at 20% of undistributed personal holding company income or excess accumulated taxable income to the C corporation shareholders are still a relevant risk.
- The corporate alternative minimum tax has been repealed, therefore corporations will benefit from tax credit planning going forward. Corporations will also be better able to use life insurance planning in light of the corporate AMT repeal, as proceeds of corporate owned life insurance will no longer be taxed under the corporate AMT.
- The Act limits the net operating loss ("NOL") deduction to 80% of taxable income and provides that amounts carried to other years be adjusted to account for the limitation for losses arising in years beginning on or after January 1, 2018. The Act also eliminates NOL carrybacks, but allows unused NOLs to be carried forward indefinitely. As such, single family offices with income generating operations but historic losses, or cyclical economic activities with income in some years and losses in others, will find that tax liabilities may become more likely, thereby adversely affecting cash flow.
- Corporate taxpayers, with average annual gross receipts of less than US$25 million measured over the three prior tax years, can elect to use the cash method of accounting. This election will simplify tax reporting and constitute a change in accounting method but any adjustments can be spread over four taxable years.
II – Single family offices in a "fund style" structure
Family offices established as pass-through vehicles (partnerships, S corporations, and certain LLCs) will also be affected by the many changes that were enacted, in particular the new pass-through entity provisions allowing for a new deduction on certain types of income. Relevant changes include:
- 20 percent deduction available to non-corporate partners in partnerships (and other flow-throughs) that generate “Qualified Business Income” or QBI; however, such deduction cannot exceed the greater of (i) 50 percent of wages paid by the trade or business and (ii) 25 percent of wages paid by the trade or business plus 2.5 percent of the original tax cost of certain depreciable assets. QBI is essentially income that is effectively connected with a US trade or business. However, income generated by certain services is specifically excluded from the definition of qualified business income. This includes accounting, legal, and investment services. Therefore, family offices that provide these services would not be eligible for the 20 percent deduction associated with the generation of QBI. Ambiguity remains, however, and we anticipate that US Treasury guidance may provide much needed clarity in this area.
- Business activity loss rules will also come into greater focus for family offices and their investment entities because there is a new limit on use of excess business losses by non-corporate taxpayers. The new rule limits use of business losses to offset other types of income to US$500,000 per taxpayer. This rule could significantly affect active real estate developers / investors with business losses who have historically offset portfolio, carried interest or compensation income with active business losses from other sources.
- If the calculation of tax under the limitations described above creates a less efficient outcome than previous income and loss offsetting, investors may want to consider private REIT or proactive PFIC planning. In both of these cases, the netting of income and expenses/losses maybe more flexible than the standard rules of the Act and Joint Committee explanations provided thus far. We are expecting the US Treasury Department to issue regulations that could provide much needed clarity in this area.
- All deductions for "miscellaneous itemized deductions" are eliminated and deductions for state income taxes are limited to US$10,000 per taxpayer through December 31, 2025. The miscellaneous itemized deduction exclusion means that expenses incurred for the production of non-business income of a taxpayer would be disallowed. Family offices are often funded with fees charged against investment entities and this disallowance may change the pattern of family office funding from a fee model to a distributive share (profit interest) model. Additionally, there is also a late 2017 Tax Court case, Lender Management, LLC v. Commissioner, that could cause family office operations to be restructured so as to generate more business expenses rather than investment expenses.
- Profits interests issued by a single family office to key persons in the form of a carried interest are now subject to new limitations. Prior to the Act, profits interests were treated like any other partnership interest, allowing a profits interest holder to report partnership income based on its underlying character. Consequently, holders of profits interests benefited from long-term capital gains rates to the extent their distributive share of partnership income related to such long-term gains. Under the new rules of the Act, a holder of a profits interest may only receive the benefit of long-term capital gain treatment if the assets in question have been held for three years or more. While many investments are made with an anticipated holding period in excess of three years (real estate, private equity, venture-capital, etc.) some are not. For example, in some distressed situations, the investment strategy may be to acquire and then divest within a 12 to 18 month period, which would presumably be caught by this new three-year limitation. We are expecting further guidance from the US Treasury Department.
- While not part of the Act specifically, new partnership audit rules effective January 1, 2018 will greatly impact (i) how partnerships are audited by the IRS and (ii) which partners become liable for adjustments to partnership income and losses. (See the Withers Bergman LLP client alert link here).
III – General observations applicable to all
The Act limits the interest expense deduction against active business income for all taxpayers. As a general matter, the ability of any active business to deduct interest expense is now limited to 30 percent of entity level adjusted gross income. There is no grandfathering for historic debt. However, any accumulated and unused interest expense can be carried forward indefinitely. There are some important exceptions, including for smaller businesses (those with average annual gross receipts of US$25 million or less over a three year period) and for those in the real estate sector to whom this interest expense deduction limitation does not apply if an election is made. Electing real estate businesses would be required to lengthen asset depreciation periods; however, these extensions are not meaningful.
Preserving cash flow through the use of Section 1031 like-kind exchange is now limited to investments in the real estate sector. Like-kind exchange benefits for luxury assets and other tangible personal property (such as art, aircraft, and boats) are no longer available through Section 1031, although some investors may still benefit from similar deferral strategies through the use of certain investment partnership vehicles.
The Act contains significant changes relating to executive compensation, including a new excise tax on tax-exempt organizations that pay an employee compensation greater than US$1,000,000 per year. This new tax may affect certain family office structures with private foundations. In some cases, family structures may want to consider restructuring executive compensation so as to avoid the new excise tax. (See the Withers Bergman LLP client alert link here).
Deductions relating to meals and entertainment and fringe benefits have been reduced, which could have a noticeable effect on larger single family offices that employ numerous employees. Under the Act, meals are limited to a 50 percent deduction and entertainment expenses are no longer deductible. Employee parking expenses when payment is made by a family office itself are also no longer deductible absent changes to the parking expense reimbursement plan.
Since most single family offices are not asset intensive, new rules allowing immediate expensing and depreciation (with higher tax-deductible amounts) for assets held may not be of great consequence. However, those running family offices that are capital asset heavy, such as those in the real estate development business where the family office may own and lease heavy machinery for use by various development entities, should keep this change in mind.
Finally, regardless of how a family office is structured, family office decision makers should carefully consider how to structure underlying investments going forward, as the Act represents a paradigm shift with respect to choice of entity. Choice of entity decisions should consider the facts and circumstances of each business or investment so as to ensure tax efficiency.