The risk of legislation to charge common tax rates on an exclusive fund manager’s transported interest has overshadowed the impact on finance managers of the web Investment Income Tax (“NII tax”). 3.8 million, which is on top of any normal income or capital increases tax already enforced. The NII tax applies to managers of private collateral and real estate funds differently. Below can be an overview of the way the NII tax impacts the manager of every type of fund. Private Equity Funds. For private collateral fund managers, preventing the NII tax on the transported interest requires both the manager’s “material participation” in the fundamental stock portfolio business and the right possession structure.
However, if these two elements jointly come, a private collateral fund manager might be able to avoid the NII tax on the all-important capital gains resulting from the ultimate sale of a stock portfolio company. In order to avoid the NII tax on carried interest, the account manager needs to be able to demonstrate regular, substantial, and continuous involvement in the underlying portfolio business producing the income. Generally, the passive activity rules under Federal tax law require an individual to invest at least 500 hours annually performing personal services in the business.
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In some situations, it may be possible to group multiple portfolio companies jointly for purposes of get together the annual hours test, provided such businesses constitute an “appropriate financial unit,” a subjective facts and circumstances analysis recommended by IRS regulations somewhat. Hours spent in direct management or operational activities at the portfolio business level count–monitoring, supervisory oversight, and financial analysis at the fund level do not.
For this reason, private equity fund managers taking minority possession positions in profile businesses may have significantly more difficulty in avoiding the NII taxes than managers taking control positions and performing meaningful operational activities. This analysis should be made for every individual owner of the account manager entity predicated on his / her participation in the fund’s stock portfolio businesses. As mentioned above, fund structure is important to be able to rely activities to achieve the requisite level of participation. For this function, a preferred framework could start using a limited liability company (LLC) or other pass-through entity for income tax purposes to hold each profile business.
This framework allows the owners of the account manager entity (also typically pass-through) to count up their activity at the stock portfolio business level in identifying whether the NII tax applies. Real estate finance managers may have significantly more difficulty preventing the NII tax on properties they develop for resale or hold for investment purposes.
Non-rent-generating properties are at the mercy of the general grouping rules highlighted above as appropriate to private equity funds. Conclusion The NII tax represents nearly a 20% upsurge in the Federal tax rate imposed on fund supervisor carried interest. However, there are important planning opportunities that private collateral and real estate fund managers may be able to take benefit of to steer clear of or reduce this significant additional tax burden on finance managers.