The impact of tax reform to asset and wealth managers: Part II

by AM admin on March 14, 2018

Brian Rebhun, US Asset & Wealth Management Tax Leader –

My first blog on how the Tax Cuts and Jobs Act (TCJA) will influence the asset and wealth management industry (click here for a link to that blog) looked at how higher effective tax rates will require principals of AWM firms to reconsider where they live and where they conduct their business. Here we turn our attention to a second key issue—the impact on compensation models.

The TCJA addresses the so-called carried interest “loophole” by reclassifying the long term capital gains (LTCG) holding period from one to three years for anyone providing services to the fund. While private equity and real estate managers aren’t likely to be impacted as they generally hold their assets longer than three years, many hedge and credit fund managers will be. Because many of these managers hold assets longer than a year but less than three, their carry on these assets will be treated as short term capital gains (STCG) taxed at 37% rather than 20% (not factoring in the net investment income tax of 3.8%).

As a result, many of these hedge and credit managers are evaluating whether to convert their carried interest, generally an allocation of income from onshore and/or master funds, to a fee to the management company. Some key questions fund managers should consider in this decision process are:

  • Is the fund an investor or trader fund? Since miscellaneous itemized deductions were eliminated as part of the TCJA, individual partners in investor funds get the benefit of deducting carry as an allocation that they will not get as a fee. Individual partners in trader funds most likely will be indifferent as the fund is deemed engaged in a trade or business. The classification of investor versus trader will have even more impact with the loss of miscellaneous itemized deductions and if a trader fund decides to convert its carry to a fee.
  • What is the type of income the fund is generating? If the fund generates significant IRC Sec. 1256 income (60/40 split LTCG/STCG) or qualified dividend income (QDI), it is still taxed at the 23.8% rate (top 20% rate + 3.8% net investment income tax). Many trading funds may generate significant 1256 income and QDI, so it may be beneficial to keep the carry allocation rather than taking a fee. As it relates to credit managers, most special situations and mezzanine funds that generate significant LTCG from some of their investments may also benefit from keeping an allocation. On the other hand, direct lending funds, which take the position that they are engaged in a lending business and generally report most of their income as interest, may be better off taking their carry as a fee.
  • How will state and local taxes affect having more fee income come into the management company? Many asset and wealth managers operate in high tax jurisdictions like New York City and California. More fee income would be sourced based on either of the location of the investment management services or the investors in the fund (market sourcing). For asset and wealth managers doing business in New York City, there could be an additional cost for unincorporated business tax (UBT) as a fee versus an allocation as many carry vehicles claim exemption from the UBT.
  • How will you compensate your talent? Many asset and wealth managers give their employees “carry points.” If converting carry allocation to to a fee, the compensation model may revert to paying incentive compensation in the form of W-2 wages. Employees may want to take their after-tax wages and invest back in the fund.

Significant modeling should be undertaken to determine the appropriate structure of your carry based on these considerations. Besides the potential of not paying the net investment income tax on the carry if paid as a fee, there are obviously non-tax issues to consider as well as the impact to your investors. Investors that are super tax exempts, insurance companies and certain institutional investors, may be indifferent of fee versus allocation and separate “managed accounts” or funds of one may become more commonplace as a result.

These changes to the carried interest rules will have a significant business impact on AWM firms, and I’m eager to hear your thoughts.

 

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