Tax Reform and Entity Choice: How Should You Structure Your Fund and Management Company
August 8, 2018 - By: SC&H Group
In light of tax reform, fund managers may be wondering whether it makes sense to restructure their funds and management companies to take advantage of new, favorable tax laws under the Tax Cuts and Jobs Act. Before you do so, make sure you consider all of the factors.
What Factors Are Important to Consider?
Tax Rates. For C-corporations, the IRS now imposes a flat tax rate of 21%. Additionally, the highest individual rate has been reduced to 37% which will benefit funds and management companies structured as pass-throughs with individual investors. With the new qualified business income (“QBI”) 20% deduction, the top individual tax rate can be effectively reduced to 29.6%. However, for most investment funds, this deduction will not apply. For more information regarding the QBI deduction and to see if it will apply to your fund, see our article here.
Does this mean you should incorporate your fund or management company to take advantage of lower corporate rates? The answer depends on more than just the tax rate. Let’s discuss some other factors for your decision-making process:
Distributions. Are you distributing out cash to your investors in excess of their tax liability? If investors expect consistent significant cash distributions, they will be subject to double taxation through a c-corporation structure which will result in an effective federal rate of 44.8% (21% Corporate, 20% dividend, 3.8% Net Investment Income Tax). Alternatively, if the fund is a partnership they will take out distributions tax free. Often investors may be tax exempt or tax deferred entities, so in those cases, a C corporation structure would not make sense.
Itemized Deductions. Individuals will no longer be able to deduct miscellaneous portfolio deductions such as management fees and professional fees passed through to them. For many investors this is a significant number. If the fund is a corporation, these items would be deductible.
Flexibility – Creation & Operation. There tends to be more flexibility when creating a partnership and developing operating agreements. Partnerships may specially allocate tax items to their investors while C corporations cannot. In addition, management companies are permitted to receive a profits interest or carried interest in a fund structured as a partnership for their services. In order to achieve this flexibility with a fund setup as a corporation, you need to have multiple entities.
Flexibility – Changing Structure. Be aware that if you do change from a pass-through entity to a C corporation, switching back is not a simple task. If a C corporation wishes to convert to a partnership, appreciated assets will face double taxation. Before changing your entity type, it is important to discuss the potential tax consequences with your tax advisor.
State and Local Considerations. C corporations can deduct their state and local income taxes in full in calculating their federal taxable income whereas individuals will only be able to deduct $10,000 of state and local taxes beginning in 2018. You also need to look at the difference in the tax rate between a corporation and an individual for your state.
Additional Considerations. (1) Corporate AMT has been repealed, (2) active shareholders of a C corporation will have to take reasonable compensation in the form of a W-2, and (3) funds with foreign investors should consider the additional reporting and withholding requirements.
As a general rule, most management entities will not see benefits from changing to C corporations despite the lowered tax rate. However, this decision is entirely situational. You should speak to a knowledgeable tax advisor regarding this important issue. To discuss with an advisor at SC&H, please contact us.