On September 13, 2021, the House of Representative Ways and Means Committee introduced tax proposals that, if enacted, would make significant changes to the U.S. federal income tax system. This Alert summarizes some of the proposals that may be relevant to private investment funds.
Section 10611 recharacterizes long-term capital gain allocated with respect to an applicable partnership interest (API) or recognized upon the disposition of an API as short-term capital gain unless the asset sold has a holding period of greater than three (3) years. An API is a partnership interest held in connection with the performance of services, and generally includes a profits interest or carried interest. Gain determined under Sections 1231 and 1256 qualified dividend income are not subject to recharacterization.
The proposed rule generally expands the scope of the Section 1061 recharacterization to all “net applicable partnership gain” with respect to an API unless an exception applies. “Net applicable partnership gain” is defined as the sum of: (i) net long-term capital gain determined by taking into account gains and losses with respect to one or more APIs, and (ii) other amounts which are includible in the taxpayer’s gross income with respect to such APIs that are treated as capital gain or are subject to tax at the rate applicable to capital gain. This would include Section 1231 gain and Section 1256 gain and qualified dividend income.
Net applicable partnership gain excludes any amount realized five (5) years after the latest of: (i) the date on which the taxpayer acquired substantially all of its API, (ii) the date on which the partnership in which the API is held acquired substantially all of the assets held by the partnership, or (iii) in the case of a tiered partnership, the latest date on which the lower tier partnerships acquired substantially all of their assets. For any income that is attributable to a real property trade or business, the holding period is three (3) years.
The changes would apply to tax years beginning after December 31, 2021, and therefore would apply to any gain recognized after this year.
Limitations on Deduction for Interest Expense
Section 163(j) limits business interest expense deductions to 30 percent of the adjusted taxable income of the taxpayer for the year. The amount of interest expense in excess of the 30 percent cap may be carried forward indefinitely. The limitation generally applies at the partnership level.
The proposal would apply section 163(j) at the partner level rather than the partnership level, and would limit the carryforwards of disallowed business expense to five (5) years. The proposal includes a transitional rule that allows a partner with a carryforward excess business interest expense amount under the current rules to treat such amount as paid or accrued in the partner’s first tax year beginning after December 31, 2021.
The changes would apply to tax years beginning after December 31, 2021.
Modifications Relating to Individual Retirement Plans
Private funds investment prohibition. The proposal prohibits an individual retirement account (IRA) from investing in a security if the issuer of the security requires the individual to have a minimum amount of income or assets. This rule would disqualify IRAs from holding private funds where the investor must qualify under the accredited investor test. If at any time during a tax year an IRA holds a prohibited investment, it will lose its status on the first day of that tax year. For IRAs that currently hold private funds, the rule will apply to tax years beginning after December 31, 2023. Thus, if an IRA currently holds a prohibited investment, it must sell the investment prior to January 1, 2024, or it will lose its status.
Substantial interest limitation. The proposal prohibits an IRA owner from investing IRA assets in the securities or interests of an entity that is not publicly traded if he or she has a 10 percent or greater ownership interest in the entity. The IRA would lose its status as of the first day of the tax year if it is invested in these assets. Constructive ownership rules apply—an individual would be treated as owning interests held by certain family members. There is a two-year transition rule that would allow IRA holders to dispose of such investments by December 31, 2023.
Contribution limits. The proposal prohibits additional contributions to retirement plans, including IRAs, for individuals with an aggregate accumulation in applicable retirement accounts of at least $10 million. If a prohibited annual addition is made, an excise tax would apply.
Distribution requirement. If an individual’s aggregate retirement account balances are in excess of $10 million at the end of a tax year, the proposal requires a minimum distribution the following tax year. The amount of the required distribution generally is 50 percent of the amount by which the individual’s aggregate retirement balances exceeded $10 million in the prior year.
These rules would apply to tax years beginning after December 31, 2021.
Individual Income Tax Changes
Individual income tax rate increases. The proposal would increase the top individual marginal income tax rate from 37 percent to 39.6 percent, which would return the top rate to the pre-2018 rate. The proposal also significantly reduces the income tax threshold at which the 39.6 percent top rate applies: $450,000 for married individuals filing a joint return, $400,000 for single filers, and $425,000 for head of household filers. The rates would apply for tax years beginning after December 31, 2021.
Increase in capital gains rate. For individuals, estates, and trusts, long-term capital gains and qualified dividends currently are subject to marginal income tax of 20 percent. The proposal would increase this rate from 20 percent to 25 percent, and effective for tax years beginning after December 31, 2021, lower the income thresholds to which this top rate applies.
The proposal would generally be effective for tax years ending after September 13, 2021, and thus generally would be effective from January 1, 2021, for calendar year taxpayers. A special transition rule provides that the proposed maximum tax rate of 25 percent would only apply to qualified dividends and long-term capital gains realized after September 13, 2021.
Net investment income tax. Single individuals with modified adjusted gross incomes in excess of $200,000, and married individuals filing jointly with modified adjusted gross incomes in excess of $250,000, generally are subject to an additional 3.8 percent net investment income tax (NIIT) on their capital gains, interest, dividends, annuities, royalties, rents, and other income, as long as such income is derived from a taxpayer’s passive activities.
The proposal expands the scope of the NIIT to include all applicable income, regardless of whether or not the taxpayer is a passive investor. The change applies to single individuals with taxable income in excess of $400,000, and married individuals filing jointly with taxable income in excess of $500,000, as well as for estates and trusts. The provision would not apply to wages, and would be effective for tax years beginning after December 31, 2021.
Surcharge on high-income individuals, trusts, and estates. The proposal introduces a new 3 percent surcharge on taxpayers with income above certain levels. The tax would apply to modified adjusted gross income (MAGI) in excess of $5 million for single individuals, heads of household, and married individuals filing jointly, $2.5 million for married individuals filing separately, and $100,000 for estates and trusts. The provision defines MAGI as adjusted gross income reduced by any deduction allowed for investment interest (as defined in Section 163(d)). The surcharge would apply to tax years beginning after December 31, 2021.
Limitation on deduction for qualified business income. Section 199A provides a non-corporate taxpayer a deduction of up to 20 percent of the taxpayer’s qualified business income and 20 percent of qualified real estate investment trust dividends and qualified publicly traded partnership income, subject to certain limitations.
The proposal limits the maximum allowable aggregate deduction to $500,000 for married individuals filing jointly or surviving spouse, $250,000 for married individuals filing separately, $10,000 for an estate or trust, or $400,000 for any other taxpayer. The limitation would apply to tax years beginning after December 31, 2021.
Corporate Income Tax Rate Increase
Currently, C corporations are subject to a flat income tax rate of 21 percent. The proposal provides a graduated structure as follows: 18 percent on the first $400,000, 21 percent on income over $400,000 but not over $5 million, and 26.5 percent thereafter. For corporations with income in excess of $10 million, the rate is 26.5 percent on all income. These rates would be effective for tax years beginning after December 31, 2021.
Portfolio Interest Exemption
Under current law, a foreign individual or foreign corporation generally is not subject to the 30 percent withholding tax on interest related to certain portfolio debt that otherwise applies to certain types of passive U.S. source income, such as interest and dividends (the “portfolio interest exemption”). However, the portfolio interest exemption does not apply to interest received by 10-percent shareholders or by a controlled foreign corporation (CFC) from a related person. A 10-percent shareholder is any person who owns 10 percent or more of the total combined voting power of all classes of stock or 10 percent or more of the capital or profits interest in a partnership.
The proposal modifies the definition of 10-percent shareholder to include an owner of 10 percent of the total combined voting power of a corporation or 10 percent or more of the value of the stock of a corporation. This change would apply to obligations issued after the date of enactment.
In addition, the proposal reinstates limits on the downward attribution of ownership from foreign persons for purposes of determining CFC status. This would decrease the number of foreign corporations that are not able to use the portfolio interest exemption because they are CFCs. The change would retroactively apply to tax years of foreign corporations beginning before January 1, 2018, and each subsequent tax year.
1 All “Section” references are to the Internal Revenue Code of 1986, as amended, or the Treasury Regulations promulgated thereunder.