The Qualified Business Income Deduction and Investment Funds – Will Your Investors Receive the Benefit?
August 10, 2018 - By: SC&H Group
With the passing of the Tax Cuts and Jobs Act, noncorporate taxpayers, meaning individuals, trusts, and estates, are now eligible to take a twenty percent deduction on domestic qualified business income (QBI). Put simply, QBI is “qualified trade or business” income (non-investment income) passed through to an investor from a partnership or s-corporation. This deduction is often referred to as the “pass-through deduction.”
The QBI rules have many limitations that can reduce or eliminate the deduction for certain taxpayers. Of most importance for investment funds is the exclusion of investing, trading, and investment management services from the definition of a “qualified trade or business.” These types of services are referred to as “specified service trade or businesses” (SSTB). Above certain income thresholds, taxpayers whose trade or business income is derived from a SSTB will not be eligible for the deduction.
There are also wage and asset base limitations to be aware of in conjunction with income thresholds. For a more thorough explanation of the qualified business income deduction, see our article here (“How Does the New IRS Qualified Business Income Deduction Work?” posted 2/6/2018).
So what does this mean for your fund and its investors?
If you are a private equity fund treated as an investor and are generating investment income, you generally would not have QBI, therefore, your investors would not be eligible for the 20% deduction. However, if your fund has underlying investments in partnerships, which pass through ordinary or rental income from a qualified trade or business, your fund’s share of the underlying investment’s QBI will be passed through to your investors.
If you are a trader fund, your non-investment income may be eligible for the QBI deduction, such as mark-to-market income under Section 475(f). Specific guidance from the IRS has not been released regarding QBI and its application to trader funds and 475(f) income; however, based on how the law is interpreted currently, this income could qualify as QBI.
However, even if the income from a trader fund qualifies as QBI, the business itself may be considered a SSTB in which case income threshold limitations may apply to your investors. Also be aware that if your fund does foreign exchange trading, there will be no QBI deduction.
What about your fund’s management company? As you can expect, the service performed by your management company is considered a SSTB. As such, the management fee income does not qualify for the QBI deduction.
Other key takeaways from the QBI rules to keep in mind as you analyze the impact of this new tax law: (1) QBI does not include wages or guaranteed payments paid from a business, (2) QBI should retain its character as it flows through tiered-entities and from the originator of QBI to the ultimate taxpayer, and (3) the deduction directly reduces taxable income, instead of adjusted gross income. It should be noted that most states will not provide this same deduction to its residents, given how the deduction is crafted as a reduction to taxable income and not adjusted gross income.
From an individual perspective, this deduction effectively reduces the tax rate of the highest income individuals from 37% to 29.6%. Reaching out to your investors now about how this change in tax law may impact them can add value to your fund-investor relationship and help your investors with their 2018 tax planning. While some or even all of the income passed through to investors may not qualify, there will be the need to report various disclosures to investors since the SSTB exclusion is tied to investor taxable income, which is not a known variable when preparing fund returns.
The IRS is expected to provide additional guidance regarding the qualified business income deduction later this year. If you have any questions or would like to learn more about this law as it develops, please contact us.