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Tax News
Net Investment Income Tax and Tax Distributions
January 02, 2014
Miscellaneous
Now when the New Year celebrations are out of the way, more prosaic duties poke their head around the corner, such as, Tax Time. Depending on the investment fund, K-1s may start rolling out in late February or March, if investors are lucky. This year, funds and their investors will have to deal with yet another tax, the net investment income tax (NIIT). This tax is brand new and the IRS forms and instructions are still being finalized. One thing is clear though, that investment funds will have to provide investors with enough information so that investors can compute their NIIT. Investors on the other hand will have to file a separate form (Form 8960 – still in draft form) and pay their 3.8% NIIT. I will not go into detail about NIIT because I’ve covered some of the key points before. Also quite a bit has been written on the topic. I want to point out, however, that investment funds will have to figure out whether they will make tax distributions on account of NIIT.  Chances are that for most funds (particularly private equity funds, which as a general matter have tax distributions language), the operating agreements have not been amended to address NIIT. So what do you do if that’s the case? This may depend on the tax distribution language in the agreement. Many agreements would have language that sets the distribution percentage based on a fixed parentage or the highest cumulative federal and state tax rate in a particular jurisdiction. Often, the jurisdiction is NY but sometimes it could be different depending on the investor profile. This is a rule of administrative convenience since many funds would not want to compute specific tax rates and distributions for each investor in accordance with their jurisdiction. If that’s the case and the investor resides in a jurisdiction other than NY, he or she may receive enough cash that will cover the NIIT. However, if the investor resides in NY or it happens that the fund agreement specifically computes tax distributions based on the investor’s individual jurisdiction and rate (I’ve seen some that do), the investor may be left in an unanticipated phantom income situation.

Whether the investor would be entitled to a distribution as a legal matter would hinge on the definition of “tax rate” “assumed tax rate” or whatever other construct the agreement is using to refer to the taxable rate applicable to the investor’s income allocable from the fund.  Now, unfortunately, many agreements that go into this much detail to pinpoint the tax rate, usually specify  that the rate is the highest applicable marginal federal, state and local income tax rate applicable to individuals in the particular state, taking (or not) into account the deductibility of state and local taxes.  The term marginal tax rate is widely understood to mean the rate in IRC Sec. 1. For example, the federal rate for married filing jointly for 2013 on ordinary income is 39.6%. Nowhere does this section reference the 3.8% NIIT rate set forth in Sec. 1411. Thus, my sense is that an investor may have a difficult argument in asserting that the 3.8% NIIT tax is covered under the most typical tax distribution language. The provisions were drafted prior to the NIIT being in existence, which would buttress the view that NIIT couldn’t have been covered by the language in the operating agreement (i.e. no change in law language like in most credit agreements). One avenue would be to argue that the NIIT, as its name suggest, is still a tax imposed on federal income and therefore it should be added to the investor’s “normal” tax rate. Moreover, the tax is imposed under Subtitle A of the Code, which covers “income taxes.”  As it may be, the amicable thing to do here, at least to me, is to amend agreements going forward and address NIIT expressly so that there is clarity regarding the issue.  As to distributions with respect to 2013, good practice would dictate to treat investors uniformly – either make NIIT distributions or don’t, but treat investors equally. The main goal of tax distributions is to prevent a phantom income situation for investors. If one would begin with this premise, paying out tax distributions in 2013 on account of NIIT seems equitable but this is an economic and logistic issue that each fund needs to decide for itself.
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Tags: net investment income tax, NIIT, NIIT and tax distributions, Section 1411