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A Few Additional Thoughts on the Net Investment Income Tax
January 25, 2013
Administrative Actions
I spent some more time with the NIIT proposed regulations and I also reviewed quite a few alerts by reputable firms and articles by renowned tax practitioners.  There are two buzz words that popped up in my NIIT adventures: “S-corporation” and “grouping activities.”  It seems like practitioners are focused on these two elements in their tax planning pitches to potential clients looking to minimize NIIT.  I have my doubts about carrying out any tax planning based on proposed regulations, considering that the regulations could change, and in the interim Treasury would have the benefit of knowing practitioners “plans” to minimize the effect of these regulations, but with that in mind, here is what I think about these two buzz words.

Let’s take the S-co planning first.  As probably most readers know, both hedge funds and private equity funds right now are structured mostly as partnerships for tax purposes and their managers derive a 2% management fee and a 20% carry.  Some hedge funds shifted to this set up in part due to the enactment of Sec. 457A and the shutdown of comp deferral. In both types of investment funds, managers generally participate through one or two flow through entities which hold the fee and carry together or separately.  LPs participate in the fund either directly or through a feeder/blocker.  Hedge fund managers and investors are generally taxed at ordinary income rates where as private equity managers and investors are taxed at cap gains. So with this prelude, what is this S-co planning and where does it come up? The planning generally entails converting the partnership entity through which the manager performs services to the fund into an S-corporation. Then rely on the so-called “reasonable compensation” argument that has been around for many, many years in the employment tax context.  The planning can further entail converting the manager’s carry into a service fee, i.e. instead of being compensated by distributive share, the manager is compensated entirely by a fee.

So does this make sense? For a private equity fund this makes little sense, at least to me. Converting the carry to a fee obviously obviates any capital gain/ordinary income arbitrage.  In addition, at the fund level it creates a deduction (instead of an income allocation away from the LPs to the manager) which could pose a problem to the LPs since the fee deduction would be likely subject to the 2% floor (absent some type of QEF planning in place).  Let’s assume for the sakes of argument that the carry is not converted to a fee but is instead directly fed as a distributive share into the manager’s entity. In that case, I still do not see what the reason for converting to S-co would be.  If the distributive share fed into the manager’s entity is on account on NIIT type of income, then it would be subject to NIIT regardless of whether it is allocated to an S corporation or a partnership.  Conversely, if it is not NIIT type of income, then the type of entity still does not matter, but the ultimate result boils down to whether the manager is active or passive vis-à-vis the entity generating the distributive share.  I personally am not aware of any cases that apply reasoning like in Renkemeyer and attack the “limited partner” status of managers deriving investment income type of distributive share so that to make the conversion to an S-co advantageous. Arguably, if managers were participating through a partnership and relying on 1402(a)(13), then it could be reasoned that by “actively” participating, and thus, increasing their chance to avoid NIIT, they are also increasing their chance to get hit with SE tax, but that to the best of my knowledge is not the case because managers’ carry is exempted from SE under 1402(a)(3)(A) and not 1402(a)(13).

On the other hand, does this S-co strategy make sense in the case of a hedge fund manager? To me it makes more sense than in the case of a private equity fund.  In the case of a hedge fund you do not have the capital gains and deduction issue.  Say in that instance the hedge fund manager converts the carry into a fee and the partnership into an S-corporation.  In that case, the manager’s S-co will be deriving non-NIIT type of income and will be exclusively in the domain of “reasonable comp” S-co cases such as the Watson case. Then the issue boils down to convincing the IRS or a judge that it is OK for an S-co that derives only service income to pay a reasonable compensation to its managers that is way lower than the income derived by the S-co.  While I think that this is a tough argument considering that it appears that Congress intended to hit hedge fund manager’s earnings either with SE tax or NIIT tax, it is nonetheless a possible argument the merits of which could depend on the specific circumstances such as whether the income of the S-co could be attributed to the services of non-shareholder employees or to capital and equipment.  As I said above, I am somewhat skeptical of this argument, but it appears that this is just about the only viable planning for hedge fund managers.  Otherwise, active participation or not, if the manager keeps the carry as distributive share, it will attract NIIT.

What about private equity funds?  As I mused above, the S-co planning makes little sense for PE managers. How about “grouping activities?”  The “grouping activities” planning basically focuses on assuring that a PE manager is viewed as actively participating in the portfolio company’s business. The planning relies on a narrow exception in the regulations that basically states that you look through the assets of an S-corporation or a partnership and that gain is taken into account in NIIT only to the extent that gain from the sale of the underlying assets of the S-co or partnership would have been taken into account if sold for FMV.  In most basic terms this means that if the portfolio company S-co or partnership is engaged in a non-financial trading trade or business, its assets are held in that trade or business, and the manager is “active” in respect of that trade or business, then some of the gain may escape NIIT.  The grouping activities rules of Sec. 469 basically provide some flexibility in determining whether a particular person is “active” or “passive” in respect of some business. Businesses could be grouped together for purposes of determining whether a particular person was “active” as long as the businesses are an “appropriate economic unit.”  Of course, most private equity fund managers do not participate in the portfolio company’s business. They pick investments for the fund.   However, that is not always the case.  Based on these “grouping” rules, some managers in small specialized industries such as real estate, energy and so on, may be able to minimize their NIIT to the extent the manager’s activity raises to the “active” level.

Lastly, above I talked about managers. Is there anything about investors?  As of now, I personally did not find any room for minimizing NIIT to investors in private equity and hedge funds unless they are participating through some qualified retirement plan such as a Roth IRA. There are some possibilities for deferral of NIIT both to investors and managers if the fund is structured as a QEF but that has its own issues because it requires that cash proceeds are kept by the fund while the investor or manager still has to pay income tax (i.e. phantom income situation).  Unless an LP or manager solves this phantom income problem by some sort of a monetization strategy, e,g., seeking a source of funds that is unrelated to previously taxed QEF income, this strategy to me at least makes little sense.  This is not to say, however, that generally there are no feasible solutions for investors in other industries.  Passive investors in operating non-fund businesses may consider, for example, the application of the qualified small business stock rules of Sec. 1202, which as of now afford 100% gain exclusion (arguably applicable to NIIT as well).  Unfortunately, the QSBS rules do not apply to fund or service business entities per the definition of QSBS.  So there you have it.  I hope that people were able to follow this since I took some shortcuts in the above narrative, but to the extent that something is unclear or you disagree, let me know.
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Tags: net investment income tax, NIIT, NIIT proposed regulations