The Bracewell Tax Report is a periodic publication focused on developments in federal income tax law, including the recently enacted Tax Cuts and Jobs Act (TCJA), with emphasis on how such developments impact the energy, technology and finance industries. The publication provides summaries of changes in tax law and its interpretation, as well as related practical guidance critical to making strategic business decisions and negotiating transactions.
Treasury and IRS Issue Guidance Concerning Carried Interests Held Through S-Corporations
By Liz McGinley and Steven Lorch
On March 1, 2018, the Treasury Department and the IRS issued an advanced version of Notice 2018-18, stating that forthcoming Treasury regulations would provide that applicable partnership interests, commonly referred to as carried interests, held by S-corporations will be subject to the three-year holding period requirement to achieve long-term capital gain treatment under Code Section 1061. Such Treasury regulations will have a retroactive effective date, applicable to all tax years beginning after December 31, 2017.
Currently, Code Section 1061, enacted under the Tax Cuts and Jobs Act (TCJA), includes a broad exception to the three-year holding period requirement for long-term capital gain treatment in the case of applicable partnership interests held directly or indirectly by corporations. (Click here for a more detailed discussion of the new holding period rules and the corporate exception.) Such corporate exception generally is viewed as appropriate in the case of an applicable partnership interest held by a C-corporation because, if an individual holds the interest directly or indirectly through a C-corporation, the gain with respect to the interest would be subject to federal income tax in the hands of the C-corporation, and the individual shareholder would be subject to a second level of federal income tax when the C-corporation’s earnings are distributed, resulting in an effective maximum federal income tax rate of 36.8% on such gain.1 In other words, the ownership of an applicable partnership interest by a C-corporation precludes an individual shareholder from achieving a 20% federal income tax rate on gains attributable to the interest without satisfying the three-year holding period, which is the very result that Congress intended to limit by including new Code Section 1061 in the TCJA.
The language in the statute, however, does not expressly limit the corporate exemption solely to applicable partnership interests held by C-corporations, but applies to all applicable partnership interests held directly or indirectly by a “corporation.” Assuming the term “corporation” also includes an S-corporation, individuals easily could evade the three-year holding period for long-term capital gain with respect to applicable partnership interests by interposing an S-corporation, which generally is treated as a pass-through entity for federal income tax purposes, as a direct or indirect owner of an applicable partnership interest. As a result, gains attributable to the applicable partnership interest would be long-term capital gain if the underlying property were held more than one year, and the individual S-corporation shareholder would be subject to tax on such gain at a 20% federal income tax rate. The practical result of including S-corporations within the scope of the corporate exception is that the application of the new three-year holding period essentially would become elective.
Although Notice 2018-18 threatens to close this potential opportunity for individual taxpayers, including fund managers, it was hardly unexpected. Almost immediately after the TCJA was enacted, commentators widely agreed that the corporate exception should apply to C-corporation owners, only, and the application of the corporate exception to S-corporations was largely perceived to be an unintended drafting error in the TCJA. In February, Steve Mnuchin confirmed this view in a public statement and promised that future guidance would close the loophole for S-corporations.
Still, despite Mr. Mnuchin’s public statement and the release of Notice 2018-18, the application of the corporate exception to S-corporations remains uncertain. Treasury regulations are given the full force and effect of law only to the extent they are not in conflict with the Code. Excluding S-corporations from the term “corporation” for purposes of the corporate exemption under Code Section 1061 reasonably can be interpreted as conflicting with the plain meaning of that Code section, and therefore it may be necessary for Congres
s to amend the TCJA in order to effect this change. Accordingly, individual taxpayers, including fund managers, that hold applicable partnership interests directly or indirectly through S-corporations, and expect to recognize gains with respect to partnerships interest they have held for more than one than one year, but not for more than three years, may be motivated to challenge this attempt by the Treasury Department and the IRS to close the S-corporation loophole without the help of Congress.
1 All income tax rates provided herein are exclusive of the Medicare tax on unearned income.
The View from Silicon Valley: Select Issues with Tax Reform and the Technology Industry
By Michele Alexander and Ryan Davis
The Tax Cuts and Jobs Act (TCJA) contains a number of provisions that will have consequences for the technology industry, affecting companies’ choices about entity classification, where they do business and hold assets and the manner in which they receive or make investments.
Perhaps the change garnering the most attention is the 40% reduction in the corporate tax rate, which was lowered from 35% to 21%. This lower rate obviously impacts income at the entity level, but it also means that each dollar of income distributed to a corporation’s shareholders will be subject to an effective federal income tax rate of 36.8% (21% at the entity level and an additional 20% at the shareholder level), significantly lower than the pre-TCJA effective rate of 48%.1 This obviously will yield major benefits to technology companies operating as corporations and their shareholders, particularly for smaller companies with primarily domestic operations (and may help offset the disproportionate benefit that the largest companies get from the low repatriation rates discussed below). That said, larger companies benefit greatly from this reduction as well, as evidenced by bonuses distributed by a number of corporations in response to the TCJA’s passage and other raises and investments that followed. Many technology companies, of course, already operate as C corporations due to their venture capital (VC) investor base; this type of investor tends to scrupulously avoid pass-through investments, as many have “zero tolerance” for “ECI,” or income effectively connected with a U.S. trade or business (see our discussion here). Most technology companies would cause their owners to incur ECI if operated through a partnership or LLC treated as a partnership for U.S. tax purposes. This affects not just the immediate technology investment, but rather “taints” the investor with a trade or business that can change the taxation of its other investments, namely those that are otherwise passive. Even domestic VC investors prefer to avoid the relatively minor consequences of being engaged in a technology business, though this view may evolve as this investor space begins feeling the impact of tax reform (including changes to deductibility limits on certain expenses). Therefore, the new lower rate is a “bonus” for those who already are operating in corporate form. For other, smaller technology companies that have engaged in long-term planning such as an IPO (or Up-C structure), the long-term plan to convert to a corporation may be accelerated to take advantage of lower rates.
Although they will not benefit from the new lower corporate tax rate, technology companies that operate as pass-throughs may also reap the benefit of the new so-called “qualified business income” (QBI) deductions (click here for more). New Code Section 199A generally permits a 20% deduction against taxable income for QBI, which is taxable income earned from certain U.S. trades or businesses. Under prior law, an individual taxpayer’s QBI would have been subject to the ordinary federal income tax rates applicable to individuals, with a maximum rate of 39.6%. Under the TCJA, unless limitations apply, the QBI deduction could reduce the maximum effective rate imposed on an individual’s QBI to 29.6% (or 80% of the new maximum ordinary rate of 37%). This lower rate may make participating as a partner in a partnership (or more likely in this space, as an LLC taxed as a partnership) more attractive, thus leading individuals involved in the technology industry to choose to operate their company as a pass-through rather than a corporation (except to the extent of constraints by their investor base, as noted above). However, the limitations on the QBI deduction may limit the benefit for certain higher-income individuals. Potential partners with taxable income in excess of $415,000 (married filing jointly) or $207,500 (single or filing separately) may be unable to take the QBI deduction, meaning any QBI would be taxed at the maximum ordinary rate of 37%. Moreover, both the reduced rates for individuals and the QBI deduction are scheduled to expire at the end of 2025 and, if not extended, the effective C corporation rate discussed above would be lower than the maximum individual rate applicable to pass-through income (39.6%). Taxpayers now choosing to operate their technology-related businesses as pass-throughs may rethink this decision later if both the new individual rates and the QBI deduction expire after Dec 31, 2025. However, these taxpayers then could benefit from the lower corporate rate, which is not scheduled to expire.
Perhaps more so than other industries, the technology sector has been affected by changes made to the Code’s international provisions. Along with lowering the corporate tax rate, a primary objective of tax reform was transitioning to a so-called “territorial system” of taxation. In order to accomplish this policy aim, lawmakers had to focus on certain anti-base erosion measures in order to ensure that a territorial tax system did not allow vast amounts of income to escape taxation by remaining abroad. This is particularly true in the case of the technology sector, as the five largest technology companies have approximately $457 billion of assets held in foreign subsidiaries that were not subject to U.S. taxation before the TCJA (click here for more). These assets abroad have garnered headlines in recent years as the result of widely-publicized corporate inversions which were disproportionately utilized by companies holding valuable intangible assets, especially technology companies. Such inversions allowed the value of the company’s intangible assets to be attributed to the foreign jurisdiction which was considered the company’s post-inversion residence, while allowing it to maintain its significant U.S. operations.
In order to encourage the return of this capital to the U.S. – and thus the tax base – the TCJA provides for a low one-time repatriation tax on income previously kept abroad in foreign corporations (15.5% on foreign cash and other liquid assets and 8% on all residual assets, in each case, to the extent of earnings and profits), regardless of whether the related cash or assets actually are distributed. Companies may be more inclined to take advantage of this repatriation opportunity in light of recent EU court decisions which are forcing Amazon and Apple to repay millions in taxes. Corporations subject to the repatriation tax will go on to enjoy the benefits of the new, mostly territorial system by virtue of the new 100% dividends received deduction (DRD) for distributions from a foreign subsidiary to its 10% US shareholders. This deduction applies only to the foreign-source portion of dividends received from a foreign corporation by its U.S. corporate shareholders and, as a result, may be another reason for technology companies to consider operating as corporations. Of course, even a 21% rate is double taxation, but depending on a company’s profits and where such profits are generated, incorporating may be an efficient long-term strategy (especially given the temporary nature of the QBI deduction and noncorporate tax rates).
While the repatriation tax is seen as the cost of switching to a new territorial system, the new Base Erosion Anti-Abuse Tax (BEAT) generally operates to limit deductibility of payments to affiliates of U.S. taxpayers that are in low or no tax jurisdictions. The BEAT generally requires corporations with average annual gross receipts of $500 million to pay a tax equal to 10% for years before 2025, with a phase-in at 5% for 2018. Notably, the new provision provides an exception for research and development activities. This tax, and this exception, may be highly relevant for technology companies that have research and development activities abroad –particularly in jurisdictions with incentives for this type of development – and that are considering moving activities to the United States rather than be adversely impacted by other base erosion measures. In addition, the $500 million threshold for the BEAT may not deter small to mid-size technology companies (as they would fall outside the scope of the tax), but still may be a consideration for many large technology corporations as they consider whether to bring these activities back to the United States. However, aside from the new DRD, the TCJA does little by way of positive incentive to bring production activities back onshore. In fact, the TCJA repealed Section 199, which provided a deduction for domestic production activities, in what was a major blow to many industries, including technology. Rather than being rewarded for keeping innovation in the United States, the TCJA takes away the most significant tax benefit for U.S. production and manufacturing and focuses instead on negative consequences to convince domestic companies to move their assets and activities back to the United States.
Another new international provision in the TCJA designed to impose a tax on companies that hold valuable intangible assets offshore could also (along with a related deduction) encourage repatriation – though likely of assets/activity. The global intangible low-taxed income (GILTI) tax requires U.S. shareholders holding at least a 10% share of a controlled foreign corporation to include in gross income for the tax year such corporation’s income from intangible assets held abroad that would not otherwise be taxable in the United States. The new tax applies only where a company’s non-U.S. tax bill is below a minimum threshold or where there is “excess foreign profit.” Although there are deductions available that will allow corporations to be taxed at an effective rate of 10.5% through 2025 and at 13.125% beginning in 2026, given that this income otherwise would not be taxed until repatriated, it is a liability for technology companies to consider when choosing whether to repatriate offshore assets. Perhaps more significantly, the deduction is not available to non-corporate taxpayers. This may be another new reason to consider converting to or, especially in this industry, to appreciate existing in corporate form. As we noted in our first installment, the new GILTI rules are under intense scrutiny for certain potential unintended consequences, so future guidance and regulations that could impact how this provision is interpreted and/or enacted may be forthcoming.
As illustrated above, many of the most discussed new provisions contained in the TCJA have particular significance to the technology industry. In future Bracewell Tax Reports, we will discuss further the impact of tax reform on the technology and media sectors along with tax planning opportunities going forward.
1 This does not take into account the deductibility of state and local taxes which is no longer available.
Keeping Up the BEAT: Offset Outlook Beyond 2025
By Vivian Ouyang and Liam Donovan
One of the more pronounced quirks of the Tax Cuts and Jobs Act (TCJA) is the law’s deliberately staggered schedule. Within five to eight years a broad range of provisions are slated to expire, phase down, or ramp up in ways that are generally bad news for the taxpayer and good for the Treasury Department. Among others, the base erosion and anti-abuse tax (BEAT) is poised to climb from 10% to 12.5% beginning in 2026, while taxpayers lose the ability to offset any portion of BEAT liability with research and development, low-income housing, or renewable energy-related tax credits. This was not imposed as a policy choice so much as a means of structuring the bill so that the revenue arithmetic worked—curtailing costly corporate and individual benefits while dialing up new international levies in the later years. While Congress no doubt would have preferred these provisions remain permanent, GOP leaders found themselves handcuffed by reconciliation instructions laid out in the FY2018 budget resolution, which limited Congressional tax-writers to $1.5 trillion in deficit addition within the 10-year fiscal window.
The idea is simple: introduce as much tax relief as possible on the front end, while putting the onus on future Congresses to extend—in essence, daring them to let it expire. While this gambit provides little in the way of certainty, as a political calculation it would seem to have history on its side. The last time Republicans passed large scale tax cuts via budget reconciliation, employing a similar sunset mechanism, the ensuing “fiscal cliff” was resolved by a Democratic President signing legislation to make the vast majority of the cuts permanent. It would be foolish to speculate what Congress might look like in 2025, let alone what they’ll choose to do at that time, but there will clearly be political pressure to preempt many of the more onerous changes scheduled under current law.
The good news for taxpayers who might otherwise find themselves exposed to a beefed up BEAT tax is that there is political strength in numbers. Not only does the BEAT’s IP-focused counterpart, the global intangible low-taxed income (GILTI) tax, pack a bigger punch beginning in 2026, both international provisions happen to be synced with the broader expiration of the Act’s individual title, which would amount to a $300 billion net tax increase for individuals, families, and unincorporated businesses. If undermining the value of R&D, ITC, and PTC credits would be politically untenable, allowing an across-the-board rate hike would be unthinkable. Whatever the makeup of the 118th Congress, it will have little choice but to act—and for international companies facing the BEAT, that can only be good news.
Treasury Issues Tax Guidance Limiting Carried-Interest Provision
IRS Seeks to Close Hedge-Fund Tax Loophole for Carried Interest
The Bracewell Tax Report will be distributed on a regular basis. Upcoming topics will include:
Electing out of the new partnership audit rules
The impact of super tax-exempt investors in pass-through structures
If there are topics of interest that you would like us to cover, please click here.