Investment Funds: Lots to Consider for 2020 Tax Planning

CARES Act provisions bring tax relief, while IRS rules clarify ECI and disregarded entity reporting

Fund managers should be aware of a few changes in reporting requirements for tax year 2020, including several Coronavirus Aid, Relief and Economic Security (CARES) Act provisions that suspend, delay or modify parts of the 2017 Tax Cuts and Jobs Act (TCJA).

Proposed changes to carried interest regulations are out

On July 31, 2020, the Treasury Department and the IRS released long-awaited proposed regulations to the treatment of carried interest, clarifying parts of the 2017 Tax Cuts and Jobs Act.

Among the most important points in these proposed regulations is that partnerships should not recharacterize carried interest gains on Schedule K-1s, but instead should footnote the long-term capital gains line to indicate that it might need to be recharacterized. This essentially leaves the decision on how to characterize carried interest income up to the general partner or fund manager, or their personal tax advisor.

Other important points include clarification that carried interest rules apply to real estate funds as well as other types of funds, and that certain carried interest waivers that have been added to fund partnership agreements may be challenged.

Net business interest deduction limitation temporarily increased

For tax years 2019 and 2020, The CARES Act increased the Internal Revenue Code’s Section 163(j) limitation on allowable deductions for business interest expense to 50% of the taxpayer’s (individual or business entity) adjusted taxable income. This CARES Act provision also allows the use of 2019’s adjusted taxable income to calculate the limitation for 2020. The limitation returns to 30% of adjusted taxable income beginning in 2021.

For traders and private equity funds that were concerned about borrowing money because of limits on interest deduction, you may want to increase borrowing, given this temporary change.

It’s important to note, however, that the above does not apply to partnerships for 2019.

Suspension of NOL limitations may affect your portfolio and pending deals

The CARES Act provided temporary reprieve from provisions in the TCJA that had limited net operating loss (NOL) deductions:

• The act granted a five-year carryback period for NOLs arising in tax years beginning January 1, 2018, and ending December 31, 2020.
• It also temporarily suspended the 80% of taxable income limitation on the use of NOLs.

With the ability to use NOLs to fully offset taxable income during the allowed tax years, regardless of when the NOL was generated, you may want to review the tax implications of transactions that have closed since 2018 to see whether you may be entitled to additional tax refunds. This may include amending or modifying tax returns for tax years dating as far back as 2013.

These changes may provide tax benefits and immediate cash flow benefits to companies in your portfolio. You should also factor these temporary tax changes into any in-progress deals – including when deciding whether to close those deals this year or next year.

Excess business losses may be used to offset nonbusiness income

The CARES Act retroactively waived the TCJA’s limits on the ability of noncorporate taxpayers to deduct aggregate excess trade or business losses for tax years 2018, 2019 and 2020 against all other income. The limit ($250,000/500,000-MFJ) includes amounts passed through from IRC 475(f) and trader funds. For trader funds, capital gains and losses are limited to the net gains. The TCJA provision, which will go back into effect on January 1, 2021, will limit the ability to use such excess losses to offset nonbusiness income. Losses disallowed under this TCJA provision would be carried forward as NOLs.

Knowing this limit will go into effect next year, you may want to consider using your losses for this year, or retroactively for the previous two years via return amendment.

Tax basis capital reporting for partners now required

Starting with 2020 K-1s (Form 1065), funds will be required to report each partner’s capital account using a tax basis capital method. While this was expected to be effective for 2019 K-1s, Notice 2019-66 postponed it to 2020.

The IRS released an early draft of instructions related to tax-basis capital reporting on October 22, 2020. These instructions indicate that partnerships should calculate partner capital accounts using the transactional approach as the tax basis method, and report the partner’s contributions, share of partnership net income or loss, withdrawals and distributions, and other increases or decreases using tax basis principles.

The draft of instructions also offers several allowable methods for calculating tax basis by partnerships that have not maintained tax basis capital account records. In those cases, each partner’s 2020 beginning tax basis capital account balance can be computed using one of these methods:

• Modified Outside Basis Method
• Modified Previously Taxed Capital Method
• Section 704(b) Method, as described in the instructions, including special rules for publicly traded partnerships

The IRS has also asked for public comment on other possible methods of reporting capital accounts to partners. And, it intends to issue a notice providing penalty relief for tax year 2020: It will not assess a partnership for errors in reporting partners’ beginning account balances if it takes “ordinary and prudent business care” in following the instructions.

Include disregarded entity information on K-1s

Schedule K-1 isn’t expected to contain many changes for tax year 2020. As a reminder, as of tax year 2019, disregarded entity names, types and Taxpayer Identification Numbers must be included, along with the individual beneficial owner’s information. The IRS issued a useful FAQ to help clarify reporting on disregarded entities.

There are new rules for reporting REIT dividends

The IRS issued final regulations on dividends from real estate investment trusts (REITs). Regulated investment companies that receive qualified REIT dividends can report those as Section 199A dividends – meaning S corps, partnerships and individuals can deduct up to 20% of this income as qualified business income (QBI). REIT dividends should now be broken out on 1099s. Remember that REITs and RICs with REIT dividends must be held unhedged for more than 45 days at the ex-dividend date to be eligible for the 20% deduction.

Final regulations are out for U.S. withholdings on partnership interest transfers with ECI

When a non-U.S. person engages in a trade or business in the U.S., income from sources within the U.S. connected with the conduct of that trade or business is generally considered to be Effectively Connected Income (ECI). If any portion of a net gain on disposition of a partnership interest by a non-US person is treated as ECI, the party on the opposite side of the disposer is required to withhold 10% of the realized amount. The responsible party is the recipient-transferee of the disposed partnership interest, including the partnership itself.

This withholding was new for the 2018 tax year, and the IRS just released final regulations in October 2020. The regulations include some stringent rules that can adversely impact foreign investors. The final regulations incorporate most of the proposed regulations with certain modifications.

Fortunately, there are a good number of exceptions that may allow you to avoid this issue entirely via certifications signed under penalties of perjury. You should speak with your tax advisor to learn more about these exceptions and how they may impact your tax liability.

Other tax considerations

In addition, take note of the following year-end planning and tax reporting considerations.

• Opportunity zones: Qualified Opportunity Funds that invest in Opportunity Zones must provide addition information to the IRS, through Form 8996. Funds must report the value of business properties, the census area tract number for each property, the value of investments allocated to each area, each investments’ current valuation and other information.
• W-9s and W-8s: Assess whether you have current W-9s and W-8s for all your investors. Some of these forms have expiration dates and need to be filled out and signed again.
• K-1 and other form changes: The information required by Schedule K-1, as well as several other forms, has expanded in recent years. This is a good time to touch base with your tax professional to get an idea of new information you may need to prepare.
• Qualified business income: Maximize your QBI deduction. Most likely, your tax advisor has already explored this area with you. The rules haven’t changed since last year.
• Reconciling 1099s: As 1099s start coming in, they need to be reconciled with the fund’s records. Brokers may record transactions differently from the way the fund has recorded them. It’s a good idea to have your tax professional review and resolve these differences early in the tax preparation process.
• Wash sales: Keep in mind January 2021 transactions can impact 2020 wash sales. The Wash Sale rule is triggered if “substantially identical” securities are purchased within 30 days prior to or 30 days after the sale of another security at a loss.
• Disposition of partnership interests: New Schedule K-1 box 20 codes AB and AD were added in 2019. These are used for non-corporate taxpayers that have disposed of their partnership interest. Any capital gain or loss on disposition will be reclassed to ordinary for the amounts shown. Tax preparers should be on the lookout for these amounts that will impact the tax calculation.
• Constructive sale rule: You may be familiar with the “constructive sale,” which adds unrealized gains into your taxable income. It occurs when a taxpayer is holding at year-end (December 31, 2020) appreciated property (e.g., stock), while also holding a short position with respect to the same or “substantially identical” property. During January and February of 2021, the following circumstances can help you avoid the constructive sale rule:
  • offsetting position is closed within 30 days after the end of the year,
  • appreciated financial position is held throughout the 60-day period beginning on the date such transaction is closed, and
  • during that 60-day period the taxpayer does not enter into certain transactions that would diminish the risk of loss during that time on such position.

Contact us to learn more about what these year-end tax planning considerations may mean for you and your investment firm as you prepare for the upcoming tax season.