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New Tax Law Basics for Businesses and Families

James M. Godbout & Catherine M. Kane

The Tax Cuts and Jobs Act of 2017 (TCJA) changes tax law in ways that impact individuals, C corporations, and pass-through entities, and family law practitioners will need to advise their clients accordingly. This article focuses on:

  • carried interest;
  • meals and entertainment;
  • certain fringe benefits;
  • excess employee compensation; and
  • repeal of the domestic production deduction and the corporate alternative minimum tax (AMT).

Carried Interest

Carried interest is a share of any profits that the general partners of private equity and hedge funds receive as compensation, regardless of whether they contributed any initial funds. Typically, investors pay private equity firms a 2 percent annual fee on assets under management, plus any carried interest. A carried interest represents an additional share of fund profits paid to the fund manager if fund returns exceed a certain level of performance. This carried interest might accrue from year to year until investments are harvested and a cash payment is made.

The carried interest is intended to incentivize managers to achieve a higher fund performance. The fund manager might distribute any carried interest, on a largely discretionary basis, among the deal team, the principals, the chief financial officer, the controller, and other employees, in part to reduce employee turnover.

Prior to the passage of the TCJA, carried interest, i.e., the receipt of a profits interest in a partnership in exchange for the performance of investment services, were taxed at the more favorable capital gains tax rate. For an individual, long-term capital gain is taxed at a lower rate than short-term capital gain or ordinary income. To qualify for the reduced rate, the individual must generally have held the asset for more than one year. When a partnership distributes carried interest, the receiving partner may recognize gain or loss upon the receipt of distributions from the partnership. This gain or loss is generally capital gain or loss. If the partner has held the partnership interest for more than one year, the capital gain or loss is generally long term. The partnership’s holding period for its assets does not matter.

Thus, the carried interest debate has been about whether the compensatory portion of a service partner’s return from a partnership should be characterized as ordinary income or should retain its pass-through character. This long-standing debate has resulted in numerous scholarly articles arguing for and against the tax treatment.

Private equity funds had good reason to worry about the tax treatment of carried interest when Congress turned to tax legislation in 2017. President Donald Trump repeatedly had promised on the campaign trail to eliminate the so-called carried interest loophole. Even before his emergence as the Republican candidate, legislators had regularly proposed bills in Congress to treat carried interest as ordinary income.

The TCJA enacted new § 1061, which effectively extends the holding period from one year to three years in order to qualify capital gain as “long term.” The capital gain must relate to a certain “applicable partnership interest.” Under § 1061, an applicable partnership interest does not include a partnership interest that is received in exchange for a capital contribution. If the three-year holding period is not met on the applicable partnership interest held by the partner, the partner’s gain from the carried interest is treated as short-term capital gain and taxed at ordinary income tax rates.

In the end, the only significant provision of the TCJA concerning carried interest is an extension of the holding period required to secure long-term gains treatment. Previously, taxpayers had to hold carried interest for at least one year to avoid having it taxed as ordinary income. Now, they must hold the carried interest for at least three years. The longer waiting period should prove irrelevant for many private equity funds, which customarily hold investments for five to seven years.

Many commentators, including those in the White House, have expressed frustration that § 1061 does not change the tax rate advantage applicable to the holders of carried interest. Stay tuned, because this hot topic may circle back in the future.

Meals and Entertainment

Prior to the TCJA, I.R.C. § 274 allowed taxpayers to deduct 50 percent of the costs of meals and entertainment directly related to or associated with a trade or business. To take the deduction, the meal and entertainment expense was required to be an ordinary and necessary business expense. In addition, the food and beverages provided by the taxpayer could not be lavish or extravagant, the business owner or an employee had to be present at the time the food and beverages were furnished, and the meal and entertainment were required to be either directly related to or associated with substantial business discussions. A “directly related” meal and entertainment expense meant an activity where the taxpayer had an expectation of a business benefit, actual discussion of business during the activity without substantial distractions, and a primary business purpose. An “associated with” meal and entertainment expense meant that such expenses were deductible if a substantial and bona fide business discussion took place immediately preceding or following the entertainment activity.

The TCJA amended § 274 to disallow a deduction of entertainment expenses, such as those for amusement or recreation. Expenses for membership dues for clubs organized for business, pleasure, or social purposes were also disallowed. It will be interesting to see whether companies stop paying for employees’ memberships and find other ways to entertain clients for business development purposes.

Many divorce cases involving small businesses require that a forensic accountant be asked to dive into meal and entertainment expenses to see whether personal expenses are being run through the business. The battleground often lies in the determination of what’s personal versus what’s business in terms of meals and entertainment. Now that entertainment expenses are disallowed, these small business owners may try to become even more creative in allocating personal expenses in various other expense categories.

The disallowance of entertainment expenses caused tax professionals to question whether business meals remained deductible if such expenses were incurred during an activity that constitutes entertainment. The IRS recently issued IRS Notice 2018-76, interim guidance regarding the entertainment disallowance. The Notice states that business meals remain 50-percent deductible. However, if business meals are provided during an entertainment event, taxpayers must separately account for the meals expense from the entertainment expense to deduct the meal costs.

Numerous companies have season tickets to sporting events, skyboxes, suites, and the like. The TCJA does not allow these companies to deduct 50 percent of the costs. Will these companies continue to keep their season tickets and corporate suites? Will these sports teams lower the corporate suite cost but increase the food and beverage costs? Time will tell how companies will change their business entertainment practices.

Certain Fringe Benefits

Under I.R.C. § 132, employers were able to deduct certain employee transportation fringe benefits such as qualified parking, transit passes, vanpool benefits, and qualified bicycle commuting reimbursements, and employees were able to exclude these benefits from their gross income. The payment or reimbursement of certain moving expenses by an employer were excluded from the employee recipient’s gross income. Section 217 allowed individuals to deduct certain moving expenses that were not paid for or reimbursed by employers.

The TCJA amended portions of § 132 to disallow deductions by employers for certain transportation fringe benefits and to suspend the exclusion of the benefits from employees’ gross income. A deduction is disallowed for the employer for the payment or reimbursement of transportation costs for an employee’s work commuting expenses except if such expense is to ensure employee safety. The exclusion of payment or reimbursement of certain moving expenses from gross income of the recipient is suspended as of December 31, 2017. However, pursuant to IRS Notice 2018-75, if the expenses were incurred before January 1, 2018, and paid or reimbursed after December 31, 2017, the exclusion from gross income under § 132(a)(6) still applies. Section 217 is also amended to disallow the deduction for certain moving expenses by individuals who incurred such expenses beginning after December 31, 2017. An exception was created for a member of the Armed Forces on active duty who moves pursuant to a military order and incident to a permanent change of station.

Excess Employee Compensation

To encourage the reasonableness of compensation paid to certain executives in publicly held corporations, the deduction for compensation is generally disallowed for compensation over $1 million paid to certain top executives and the highest-compensated officers. Under I.R.C. § 162(m), a covered employee included the principal executive officer or one who is among the three highest-compensated officers of the company. The deduction limitation did not apply to commissions or performance-based remuneration (including stock or stock options).

The TCJA expands the deduction limitation by repealing the performance-based compensation exceptions and expands the meaning of “covered employee” to include the chief executive officer and the chief financial officer, in addition to the three highest-paid employees. Once an employee is treated as a covered employee, future payments made to that employee are covered by the deduction limitation.

The TCJA also addressed excessive compensation in exempt organizations to create parity with publicly traded corporations. Effective for taxable years beginning after December 31, 2017, an applicable tax-exempt organization is liable for a 21-percent excise tax on annual remuneration paid to any covered employee in excess of $1 million plus certain separation payments deemed excessive in relation to historic compensation.

Repeal of the Domestic Production Deduction and the Corporate AMT

The TCJA repeals I.R.C. § 199, the deduction for qualified production activities for domestic manufacturing companies. The deduction was replaced with the newly enacted § 199A, the qualified business income (QBI) deduction.

The corporate alternative minimum tax (AMT) under § 53 was repealed by the TCJA. The purpose of the corporate AMT was to create a minimum threshold of tax liability for corporate taxpayers. A corporate taxpayer’s tax liability was the greater of its regular tax liability and the tax liability computed by applying special AMT tax rates to a taxpayer’s recomputed taxable income that accounts for adding and subtracting certain adjustments. After December 31, 2017, corporate taxpayers no longer must compute their regular income tax by comparing their regular tax liability with the tax liability calculated for purposes of AMT.

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James M. Godbout, ASA, CDFA, CFE, CVA, CFP, is a principal at CLA (CliftonLarsonAllen LLP) in Chicago, Illinois, where he provides specialized advisory services.

Catherine M. Kane, CPA, CFP, is a principal at CLA (CliftonLarsonAllen LLP) in Oak Brook, Illinois, where she provides tax advisory services.