On January 5, 2021, the Department of the Treasury released new final regulations pertaining to the deductibility of business interest expense under IRC Section 163(j). These regulations supplant proposed regulations issued in November 2018 and July 2020, and supplement final and proposed regulations issued in July 2020. Specifically, the new final regulations provide clarity on some outstanding issues not addressed in the earlier guidance that will impact private funds with business interest expense activity, such as hedge funds and private equity funds.
1. Which Private Funds, Investor or Trader Funds, Are Impacted by the New Business Interest Expense Limitation and Related Regulations?
Private funds engaged in a trade or business activity and otherwise ineligible for an exemption will be subject to the business interest expense limitation under Section 163(j). Implemented as part of the Tax Cuts and Jobs Act of 2017 (TCJA), Section 163(j) limits the deduction for business interest expense to the sum of a taxpayer’s business interest income, 30% of the taxpayer’s adjusted taxable income (ATI) and floor plan financing interest.
For tax purposes, private funds will either be categorized as being engaged in investor or trading activities. Differences in portfolio turnover, transaction frequency, transaction volume, and other issues go into an annual facts and circumstances analysis under which a fund determines whether it is an investor or a trader. Investor funds are not considered to be in a trade or business activity, but a trading fund is considered a trade or business activity. Accordingly, only trader funds will be subject to the business interest expense limitation.
Further, trader funds may be shielded from the effects of the business interest expense regulations through exceptions in the law, most notably the small business exception. Specifically, if a fund has average annual gross receipts of less than $26 million over the preceding three years and is not considered a tax shelter, the fund will qualify for this exception. In the context of the small business exception, a tax shelter would include any entity considered a syndicate, or one that allocates more than 35% of its net losses to limited partners.
2. What Must Trader Funds do to Comply with the New Business Interest Expense Limitation Rules?
The preamble to the proposed regulations issued in 2018 suggested that trader funds would be subject to the business interest expense limitation at the partnership level and that all partners would be impacted. Historically, whether trading fund interest expense was business interest or investment interest had been determined at the partner level based on whether a partner materially participated in making trading decisions for the fund. Partners who were materially participating would have business interest expense, and partners not materially participating would have investment interest expense.
The final regulations sought to address this disparity while still fulfilling the statutory requirement that a business interest expense limitation be applied at the partnership level. As such, a bifurcation procedure is now available. Funds will have to determine which partners are material participants and which are not. Then, the fund will apply the business interest expense limitation and related rules to the amounts allocated to material participants, allocating them excess business interest expense (EBIE), excess taxable income (ETI), and/or excess business interest income (EBII) and leave amounts allocated to non-material participants to be treated as investment interest expense at the partner level. For bifurcation purposes, corporate partners would likely be grouped with the materially participating partners since such partners do not distinguish between business and investment interest.
While the new procedure resolves a significant issue, the proper application of the bifurcation process to tiered partnerships remains ambiguous. The 2020 proposed regulations suggested the IRS will strictly apply an entity approach, which removes some complexity by not requiring Section 163(j) items to be passed through multiple times. However, in common private fund structures, such as the Master-Feeder, an upper tier partnership may itself have a combination of materially and non-materially participating partners, which is an issue not explicitly addressed by the final regulations. Accordingly, it remains unclear whether an upper tier entity should be treated as materially participating, not materially participating, or itself bifurcated when the lower tier partnership is considering whether to bifurcate for Section 163(j) matters. A case can currently be made for each, but the IRS is likely to favor the first approach because the business interest limitation is a partnership level calculation and the regulations, by taking an entity approach, do not specifically allow a look through approach with respect to upper tier partnerships.
3. Which Items Common to Trader Funds Fall Under the Business Interest Expense Limitation Rules?
The final 2021 regulations clarified that interest expense includes amounts paid, received, accrued, or imputed as compensation for the use or forbearance of money under the terms of a debt instrument or a similar transaction. Transactions of this nature may include:
- Transactions involving traditional debt instruments, which would include amounts of stated interest like bond coupons, original issue discount and market discount;
- Interest expense on margin trading;
- Swaps with significant nonperiodic payments that have a time value component viewed like an embedded loan;
- Substitute payments related to interest if not entered in the ordinary course of business; and
- Transactions subject to the anti-avoidance rule, whereby an expense is economically equivalent to interest and the transaction’s principal purpose is to disguise or to avoid interest expense.
One item not specifically addressed by the regulations but is important to trader funds is the classification of short dividend expense, which is generally classified as interest expense if the payment is made on a short position open for more than 45 days. Though it will take on interest expense tax character, short dividend expense does not fit neatly into the general understanding of interest as related to the time value of money or the use of money. That means short dividend expense may not be a component of business interest expense when considering the new limitations.
4. How Does the CARES Act Benefit Trader Funds and Their Materially Participating Partners for the 2020 Tax Year?
The CARES Act, which was signed into law in March 2020 as a response to the ongoing Covid-19 pandemic, provides an opportunity for trader funds and partners to deduct more business interest expense than normally permitted. For 2020, trader funds may deduct up to 50% of their adjusted taxable income (ATI) allocated to materially participating partners, as opposed to the 30% threshold originally established by the TCJA. Additionally, a fund may elect to apply its 2019 ATI instead of its 2020 ATI to take a greater deduction. Partners may also immediately deduct up to 50% of any unused EBIE carryover at their level.
5. What Happens to Carryforwards of Excess Business Interest Expense If an Investor is No Longer Subject to the Business Interest Expense Limitation?
The final regulations provide a transition rule for such cases. If an investor has an EBIE carryforward for interest expense that is actually investment interest expense and is not considered a material participant in the activity for the period(s) over which the EBIE was allocated to the investor, the investor should be able to deduct the full amount of the EBIE carryforward in 2021.
Despite the clarity the final regulations provide, the business interest expense limitation rules are a complex issue for trader funds and should be considered closely with your tax advisors.
Contact Brandon Miller at firstname.lastname@example.org, Peter Gilroy-Scott at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.