What Tax Reform Could Entail for Businesses And Investors

What Tax Reform Could Entail for Businesses And Investors
Tax, Trusts & Estates Update June 2015

In recent years, politicians on both sides of the aisle in Washington have advocated for tax reform, particularly with regard to U.S. federal income taxes.  The last substantial revisions to the Internal Revenue Code occurred in 1986.  Not surprisingly, the proposals for tax reform put forward by Democrats and Republicans differ dramatically in a variety of respects.  Also not surprisingly, in today’s polarized political climate and with a presidential election looming next year, most commentators now agree that significant tax reform before the next President of the United States is inaugurated is unlikely.

Nevertheless, there are already indications that at least certain elements of reform are likely to emerge in any significant tax reform package, regardless of which party wins the White House and takes control of the House and Senate in 2016.  This article highlights three such elements that may significantly impact real estate owners and art collectors, private equity and hedge fund managers, and small and middle-market business owners, respectively.

Limiting 1031 Exchanges

Under Section 1031 of the Code, no taxable gain or loss is recognized when property that a taxpayer owns for business or investment purposes (as opposed to for personal use) is exchanged for “like kind” property that will also be held for business or investment purposes. Such like-kind or 1031 exchanges may be direct – two parties exchange properties with one another – or indirect – one party sells a property but directs the proceeds to an intermediary, which in turn acquires a replacement property and delivers it to the seller.  For years, real estate owners have relied on such exchanges to change their investments without incurring any significant tax.

In February, President Obama’s Administration proposed substantial limits on 1031 exchanges – limiting the amount of taxable gain that may be deferred by a real estate owner through such exchanges to $1 million per year, and prohibiting like-kind treatment for exchanges involving art and other collectibles.  But this proposal is less dramatic than that of former Chairman of the House Ways and Means Committee David Camp, a Republican, who in February 2014 proposed the complete repeal of Section 1031, thereby eliminating the ability of taxpayers to defer tax on cashless exchanges of like-kind property. With both Democrats and Republicans agreeing to reduce the current scope of Section 1031, some new limitations in this area seem likely.

Eliminating Capital Gain Treatment for Carried Interest

For years, Democrats have argued that carried interest – the share of a private investment fund’s profits that is given to fund managers to compensate or incentivize them – should be subject to tax at ordinary income tax rates applicable to compensation, and not at the lower capital gains rates typically applicable to investment profits.  Under current law, fund managers are not taxed when given the right to receive this share of the profits, and when the profits are then realized, fund managers are treated like every other fund investor and entitled to capital gain treatment.

The Democrats’ argument – that fund managers should not be able to pay a lower rate of taxes on what is essentially their compensation than the rate to which other professionals are subject – appears to be resonating.  There are now several indications that Republicans may relent to a change in current law.  While such a change is unlikely to occur prior to 2017, it may not be long off.

Extending Self Employment Tax to S Corporations

Business owners often have a choice of whether their businesses should be taxed as partnerships or S corporations.  A limited liability company (LLC) with multiple owners is by default taxed as a partnership, but if an LLC or corporation meets the applicable requirements (e.g., 100 or fewer shareholders who are all U.S. citizens or residents for tax purposes, estates, certain trusts or pension plans, or charities), it may elect to be taxed as an S corporation.  Partnership treatment generally allows for more flexible economics (i.e., partners may have differing interests in each of the entity’s investments and activities) and are better for holding real estate (as the proceeds of a refinancing may typically be distributed to the partners without resulting in any tax).  However, some business owners prefer to operate through S corporations for a particular reason.  All partnership income of a partner who works in the partnership’s business is typically subject to self-employment tax – a tax imposed on self-employed individuals in lieu of Social Security and Medicare-related payroll taxes imposed on the wages of employees.  In contrast, typically only the portion of an S corporation shareholder’s earnings that is designated as salary (assuming the amount designated as such is not unreasonably low) is subject to payroll taxes, and self-employment tax is not imposed on the rest.

In February, President Obama’s Administration proposed that the same rules that currently apply to partnerships with respect to self-employment taxes should also apply to S corporation shareholders.  If the proposal were enacted, an S corporation shareholder could no longer designate a small portion of his/her earnings as compensation and avoid payroll or self-employment tax on the rest.  While former Chairman Camp’s February 2014 proposal on this subject did not go as far, he did propose requiring that at least 70% of an S corporation shareholder’s earnings be subject to payroll tax.  With agreement by Democrats and Republicans that most, if not all, S corporation shareholders’ earnings should be subject to Social Security and Medicare-related taxes, some change in this regard seems likely.