INSIGHT: Private Lenders May Benefit From New Tax Law

Section 199A is a new provision enacted as part of the broader tax reform bill which was passed in late December 2017 as part of the Tax Cuts and Jobs Act (the Act). Generally, tax code Section 199A provides that income attributable to a trade or business activity conducted in the U.S. either in pass-through or sole proprietor form may qualify for a deduction of up to 20 percent. The new deduction on qualified business income (Section 199A deduction) applies to many businesses, but most financial services activities are not qualified under the statute. Recently the Treasury Department and the Internal Revenue Service clarified that the activity of making loans (without selling them) is indeed a qualifying activity. This development has generated a lot of discussion in the investment management industry, but as the reader will see, the benefit is likely to be relatively small.

Background on Lending Activities

After the financial crisis of 2008-09, when many financial institutions significantly scaled back their lending, private lenders stepped in to fill the void. In particular, some organizations that called themselves private equity or hedge funds (depending primarily on liquidity terms) began to lend money, most notably to middle market companies that were challenged with securing sources of borrowing. See, for example, “What’s Direct Lending? Bank Loans Without a Bank”, Bloomberg Business Week, by Hannah George and Sridhar Naratjan (Sept. 17, 2017), and more recently, “Wall Street Rushes into a new asset class: Direct Lending” Financial News, by Mary Childs (July 24, 2018).

In the early days, taking into account that much of the capital they had to lend came from non-U.S. investors who were not engaged in a U.S. trade or business, most offshore funds were not designated as the lender of record due to their organizational structures. More recently, some funds have decided that these structures imposed limitations on their business activities that were no longer in line with broader business strategy, and so have moved into what may be called direct lending. That is, these funds (acting through the investment manager of the funds) are now finding borrowers, negotiating terms, and performing other activities that would likely give rise to a U.S. trade or business for a non-U.S. investor. The tax issues are still mitigated for non-U.S. investors to the extent possible, but these direct lending funds acknowledge they are in the business of making loans.

The Section 199A Deduction

As mentioned above, Section 199A generally allows an individual taxpayer a deduction for qualified business income equal to 20 percent of qualified business income from a domestic trade or business (allowing for allocable deductions); however, for taxpayers whose income exceeds a certain threshold, this deduction is limited to:

1. 50 percent of the Form W-2 wages (W-2 wages) of the entity in which the business activity takes place (or associated with the activity in the case of a sole proprietorship), or

2. 25 percent of the W-2 wages of such entity plus 2.5 percent of the unadjusted basis of qualified property (i.e., tangible property used in the trade or business).

Any deduction computed under these rules is subject to a final limitation, namely that the deduction cannot exceed 20 percent of the taxpayer’s taxable income from all sources, less net capital gain (the “overall limitation”). For purposes of this article, we will ignore the limitation which includes the unadjusted basis of property as tangible property is generally not a material factor in a direct lending business. (The Section 199A deduction also is allowable for certain dividends from REITs and income from publicly traded partnerships, both of which are outside the scope of this article.)

The income threshold that drives taxpayers to consider the limitation based on W-2 wages starts when an individual’s taxable income is $157,500 (or $315,000 for a joint tax return), and is fully effective when an individual’s taxable income is $207,500 (or $415,000 for a joint tax return). These income thresholds will be adjusted for inflation. The Section 199A deduction is allowable in taxable years beginning after Dec. 31, 2017, and expires, as do many provisions of the Act impacting individual taxpayers, after 2025.

The Section 199A deduction is not allowable for taxpayers above these phase-out ranges if the trade or business is a “specified services trade or business” (SSTB). In the preamble to proposed regulations recently issued by the Treasury Department and the Internal Revenue Service, the government confirmed that, while most financial services activities would not generate qualified business income for purposes of Section 199A, the activity of making loans (without selling them) is indeed a qualifying activity. This is consistent with the statutory language as drafted by Congress, and recognizes the important role that non-bank lenders have in financing business growth. It is important to note that while making loans is a qualifying activity, if the taxpayer sells more than a negligible amount of such loans, the taxpayer could become a dealer in securities, in which case the overall activity would not qualify for the Section 199A deduction.

The W-2 Wages Limitation

In the financial services business, many individual taxpayers that are partners in a partnership or operating as sole proprietor may likely find themselves above the phase-out ranges. Therefore, in calculating any benefit from the Section 199A deduction, the W-2 wages limitation must be considered. In the case of investment funds organized as partnerships, whether they consider themselves as private equity or hedge funds or something else altogether, most do not have employees and so have no W-2 wages. Instead, a management fee equal to a percentage of assets in the fund is paid to an investment manager who has been hired to manage the fund. It is the investment manager who typically employs the individuals engaged in the activity of making loans. Often, the fund also pays a performance fee or a carried interest to the general partner, which is related in terms of ownership to the investment manager. Without any W-2 wages, the typical fund that is making loans will not generate any income that would benefit from the Section 199A deduction.

How Can a Fund Get Credit for Paying W-2 Wages?

There need to be employees who provide direct services to the fund who receive wages that are properly reported on Form W-2, and the fund needs to be treated as the employer of those employees under common law. Even if the fund satisfies these requirements, the mathematics associated with the Section 199A deduction may make the ability to generate a Section 199A deduction challenging in a fund context, as discussed below. It should be noted that, since the Section 199A is available to individual taxpayers, both investors and the fund manager may benefit.

Replacing Existing Compensation Arrangements With W-2 Wages

As noted above, most investment management agreements between a fund and its manager provide for an asset-based fee, which is typically between 1-2 percent of the fair market value of the fund’s assets. It may seem obvious that investors would only allow wages to be paid by a fund if the manager is willing to reduce its management fee on a dollar-for-dollar basis for any wages (and related expenses) pushed into the fund, but it is reasonable to conclude that investors should generally be indifferent between paying a management fee and paying wages as long as the amount is the same. Converting the management fee alone into wage expense, however, may provide a relatively low limit on how much Section 199A income could be generated. Consider the following formula which assumes that the entire management fee is replaced with W-2 wages paid by the fund:

When the management fee for a fund is 1 percent, this formula indicates that the maximum deductible amount is equal to the lesser of A x 0.50% or A x R x 20%. In a well-managed fund, the limitation based on W-2 wages will generally be lower than 20 percent of A x R x 20%, which is a proxy for the fund’s qualified business income. In other words, the maximum Section 199A deduction generated for U.S. individual taxpayers would be 0.5 percent of the assets of the fund. If the management fee was 2 percent, this would increase the maximum Section 199A deduction to 1 percent of the assets of the fund. This may be a rather small benefit, which begs the question, is it worth the effort to explain to employees and investors why a manager is structuring or restructuring a fund to have employees and payroll, which today is often outside the norm?

The tax savings replacing a 1 percent management fee with W-2 wages into the direct lending fund would be very modest—only 0.1850 percent of the fund’s AUM. For example, if the AUM is $1 million, the fund’s W-2 wages would be $10,000. Half of these wages would be $5,000, the maximum deductible amount. If all of the fund’s investors are individuals that are not subject to the overall limitation, their aggregate deduction would be $5,000. If all of those investors are taxed at the highest marginal rate of 37 percent, the aggregate tax benefit would be only $1,850.

What About the Performance Fee?

As noted above, many funds provide for a fee or carried interest allocation to be paid to the general partner in addition to the management fee paid to the manager, typically 20 percent of the investment return of the limited partners. Sometimes there is a hurdle rate which the fund must exceed before the general partner is entitled to any performance-based income. In a direct lending fund, most of the income would be taxed as ordinary income anyway, at the highest marginal rate, and so the recipient of a carried interest or a performance fee may be relatively indifferent between the two. For reasons outside the scope of this article, such general partners may want to consider converting the carried interest into a fee if they choose not to move from a carried interest to the compensatory structure discussed here.

Since replacing the management fee with W-2 wages isn’t likely to provide much of a benefit as discussed above, could the general partner trade in its right to performance fee or carried interest for income that would be treated as W-2 wages? This may alter some of the legal aspects of managing a fund, but would it increase the ability of the partners to reduce their tax liability through the Section 199A deduction? Consider the following formula which assumes that the entire management fee is offset by W-2 wages borne by the fund (as in the first example), and that the general partner exchanges all of its total 20 percent performance entitlement (with no hurdle rate) for W-2 wages, and the fund returns a positive performance:

In this case, first prong of the formula can be simplified to the lesser of A x (50%F + 10%R). So, the maximum section 199A deduction generated for U.S. individual taxpayers would be equal to the lesser of (i) half of the management fee plus 10 percent of the fund’s return, or (ii) 20 percent of the fund’s return (which is a proxy for the fund’s qualified business income). Assuming a 12 percent return by the fund and a 1 percent management fee, the tax savings generated by replacing both the management fee and the carried interest with W-2 wages would be work out to be 0.629 percent of the fund’s AUM. For example, if the AUM is $1 million, a 12 percent return would be $120,000, and a 1 percent management fee would equal $10,000. The total W-2 wages paid by the fund would be $34,000, which is the sum of 1 percent of the AUM ($10,000) and 20 percent of the return ($24,000). If all of the fund’s investors are individuals that are not subject to the overall limitation, their aggregate deduction would be $17,000. If all of those investors are taxed at the highest marginal rate of 37 percent, the aggregate tax benefit would be only $6,290.

It is important to note that wage income as an employee does not qualify for the Section 199A deduction, and so any carried interest converted into wages as discussed herein would not provide a Section 199A benefit to the wage recipients. Considerations in addition to those noted above should include (but are not necessarily limited to):

1. Investor reaction and approvals if needed;

2. Structuring considerations (for example, this new structure may be easier to implement in a new fund than by restructuring an existing fund);

3. Legal and other non-tax implications;

4. Payroll tax issues including FICA and SECA, as well as net investment income tax issues (e.g., there may be a small benefit to the managers resulting from the non-deductibility of the net investment income tax as compared to payroll taxes);

5. State and local tax consequences; and

6. The scheduled expiration of the Section 199A deduction after 2025.

Conclusion

Investment managers who are managing funds engaged in the business of lending and who do not sell any of their loans should analyze the numbers and determine whether they and/or their investors may receive more benefit under Section 199A by causing the fund to pay W-2 wages. Investors should generally be indifferent between paying an asset-based management fee and a performance fee, on the one hand, and employee’s base salaries and bonuses which could be tied to assets and investment returns, on the other hand, and so the administrative issues surrounding a new structure should be compared to the benefits derived in determining the path forward.

This article contains general information only, and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this article.

Ted Dougherty is a partner in the financial services practice at Deloitte Tax LLP in New York. He current serves as the National Managing Partner for Investment Management Tax, as well as Deloitte’s Hedge Fund Leader.

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