15 February 2016 President's 2017 budget proposals have implications for asset managers A number of items in President Obama's FY2017 Budget Proposal, released February 9, 2016, would affect the current taxation of asset managers and their investors from both an operational and individual tax perspective. Many of these items are the same or similar to previous Administration proposals. In addition to the overall changes to tax rates, the most relevant provisions potentially affecting asset managers relate to carried interest, derivative taxation and self-employment tax. Similar to last year's version, the budget proposes increasing the highest tax rate on long-term capital gains and qualified dividends from 20% to 24.2%. Because the 3.8% net investment income tax would continue to apply, the maximum total capital gains and dividends tax rate, including the net investment income tax, would rise to 28%. The budget includes a proposal similar to ones in previous years to tax "carried interest" as ordinary income, thereby eliminating the ability for income to be eligible for reduced rates that apply to long-term capital gains and qualified dividends, regardless of the character of the income at the partnership level. The proposal would also require the partner to pay self-employment taxes on such income. The budget continues to acknowledge the need for action by Congress to clarify the calculation of enterprise value to assure a recharacterization to capital gain for any amounts attributable to the goodwill of the business. The budget proposal, as drafted, would eliminate asset managers' ability to retain preferential tax treatment on their entire share of carried interest, as well as on the sale of their partnership interest. The proposal continues to allow the investment portion of capital gains allocable to a partner that has contributed "investment capital" to the partnership to be taxed as capital gains. Similarly, the portion of gain recognized on the sale of "investment capital" would also be eligible for capital gain treatment. The definition of net investment income would be expanded to include gross income and gain from any trades or businesses of an individual that is not otherwise subject to self-employment taxes. This change would affect individuals in entities taxed as partnerships that materially participate in their firms but claim the limited partner exclusion from Self-Employment Contributions Act (SECA) taxes. The "Buffett Rule" provision would implement a "Fair Share Tax" under which taxpayers earning over $2 million would be subject to a 30% minimum federal income tax rate on adjusted income, less a credit for charitable contributions. The tax would be phased in for incomes between $1 million and $2 million. A charitable credit would apply equal to 28% of itemized charitable deductions allowed after application of the overall limit on itemized deductions (i.e., the Pease limitation). Similar to previous proposals, the budget would require gain or loss on a derivative contract whose value is determined by the value of actively traded property to be marked to market at year end and treated as ordinary income or loss. Mark-to-market accounting would not apply to business hedging transactions. The proposal provides that a transaction would satisfy the tax hedge identification requirement if it is identified as a business hedge for financial accounting purposes and it hedges price changes on ordinary property or obligations. In addition, the proposal would amend or eliminate a number of provisions in the code, such as the so-called 60/40 treatment under Section 1256, and make a number of other related changes. The proposal would require taxpayers to take accrued market discount into income currently, in the same manner as original issue discount (OID). The accrual would be limited to the greater of: (a) the bond's yield to maturity at issuance, plus 5% or (b) the applicable federal rate, plus 10%. The proposal would require the use of average basis for all identical shares of portfolio stock held by a taxpayer with a long-term holding period. Shares held by a taxpayer in a nontaxable account, such as an IRA, would not be subject to this provision. The budget proposal would limit the total amount that an individual can contribute to a tax-favored retirement plan such as an IRA, a Section 401(a) plan or a Section 403(b) plan. An individual would not be able to accumulate in those plans any more than the amount necessary to provide the maximum annuity permitted for a qualified defined benefit plan under current law, which is $210,000, payable in the form of a joint and 100% survivor benefit commencing at age 62. Once the limit is reached, an individual would not be allowed to make any further contributions, but the individual's account balance could continue to grow with investment earnings. The proposed budget would eliminate the step-up in basis for appreciated property acquired from a decedent by treating the bequest of that property (other than to the decedent's spouse) as a sale. The decedent would realize a capital gain at the time the asset is bequeathed to another. Decedents would be allowed a $200,000 per couple ($100,000 per individual) capital gains income exclusion, as well as a $500,000 per couple ($250,000 per individual) exclusion for personal residences. The proposal would exclude tangible personal property other than certain collectibles. Similarly, the proposal would treat a lifetime gift of appreciated property to one other than a spouse as a deemed sale. The President's proposal would require grantor retained annuity trusts (GRATs) to have a minimum term of 10 years and a maximum term of the life expectancy of the annuitant, plus 10 years. The proposal also would require the remainder interest in the GRAT at the time the interest is created to have a minimum value equal to the greater of 25% of the value of the assets contributed to the GRAT or $500,000. In other words, an individual would not be able to virtually "zero-out" a GRAT so that there are no gift tax consequences related to its creation. Additionally, a grantor would be prohibited from engaging in a tax-free exchange of any asset held in the trust, which is something that many who use GRATs regard as a means to enhance the overall wealth transfer benefit of the technique and to preserve some flexibility to keep a valuable asset from passing to a later-disfavored beneficiary. Any of these proposals, which would be effective for GRATs established after date of enactment, would curtail the potential wealth transfer benefit or planning flexibility of a GRAT. Taken together, these proposals would severely limit the GRAT's utility as a wealth transfer vehicle. The budget also proposes to limit Roth IRA conversions to pre-tax dollars, thereby eliminating the ability to convert after-tax amounts (i.e., those attributable to basis) held in traditional IRAs or eligible retirement plans. Although the budget includes a number of proposals that would potentially affect the asset management industry, it offers little in the form of bipartisan compromise and is unlikely to meet with approval from a GOP-led Congress, particularly in an election year. In fact, initial public comment from several members of Congress has indicated little appetite for the proposals in the President's budget. Because these same proposals continue to be resurrected, however, taxpayers should monitor and discuss these issues in case broader and more comprehensive tax reform occurs in the future. For further discussion on a number of significant additional proposals within the budget see Tax Alert 2016-286.
Document ID: 2016-0321 | |||||||||||||
