US budget seeks to close PE tax loophole

President Obama’s 2017 budget proposal would amend a gap in legal definitions of net investment income and self-employment earnings, imposing a 3.8 percent tax on management fee income.

Private equity professionals, along with those in hedge funds and other businesses organised as pass-through vehicles, would be subject to an additional 3.8 percent income tax under US President Barack Obama’s newly released 2017 budget proposals.

This proposal would close a current tax loophole between the self-employment contributions act (SECA) and the net investment income tax (NIIT), which allows limited partners and shareholders of management companies organised as partnerships and S corporations, respectively, to avoid paying the 3.8 percent net investment income tax on their share of management fees net of salaries and other expenses.

Since 2013, individuals with incomes over $200,000 ($250,000 for joint filers) have been subject to a 3.8 percent tax on net investment income under the net investment income tax (NIIT). However, the NIIT does not apply to wages or income that is otherwise subject to the self-employment tax or to passive income from a trade or business in which the individual materially participates, so it has not generally been applicable to private equity professionals with respect to income from their management companies.

Those who do not pay the 3.8 percent tax under NIIT generally pay a 3.8 percent tax on self-employment earnings and wages under SECA. However, this tax does not apply to income received by limited partners beyond guaranteed payments or to S corporation shareholders beyond reasonable compensation, so net profits on private equity management fees have not been subject to this tax either.

“Differential treatment is unfair and inefficient. It distorts choice of organisational form and provides tax planning opportunities for business owners, particularly those with high incomes, to avoid paying their fair share of taxes,” noted the Department of Treasury.

The proposal would ensure that all trade or business income of high-income taxpayers is subject to the 3.8 percent Medicare tax, either through NIIT or SECA, by amending the definition of net investment income to include “gross income and gain from any trades or businesses of an individual that is not otherwise subject to employment taxes,” Treasury noted.

Congress is likely to oppose Obama’s budget plan overall, but for this particular loophole, the question is not whether it will get closed, but when, Proskauer tax partner Amanda Nussbaum told Private Equity International's sister title  pfm.

“Clients aren’t surprised that this issue has gotten noticed by the administration. However, it's not going to change the way they’re doing business,” she added