Tax Reform: The Impact on a Financial Services Business
Posted on 11.15.17
By Bryan Freschcorn, Tax Manager
Within the last several weeks, we have begun to see bills from both the House and Senate for Tax Reform. Neither side has entitled their legislation as “tax simplification” because each simply adds more complexities.
While the debate about what the Reform accomplishes will continue within Congress and the media, it is important to note some of the provisions that will have impacts on financial services businesses.
Proposed Tax Rates
The proposed tax rate reductions to 20% for C corporations are generally looked upon favorably by corporate businesses. However, many financial services businesses are currently operating as “flow-through entities” under an S corporation or partnership tax regime. For those businesses, and especially service-based businesses, the new provisions are not all that favorable.
Income recognized from passthrough entities is often taxed at levels above the top C-corporation rate, when the taxable income from other sources is taken into account. Most business entities are pass-throughs, so Congress felt compelled to reduce pass-throughs’ effective rates.
The House’s solution is very complicated.
- Under the bill, a new 25% tax rate is applied against “qualified business income (QBI).” In general, QBI is the sum of 100% of “net business income” from a “passive business activity” plus 30% of net business income from an “active business activity.”
- A passive business activity is an activity in which the taxpayer does not materially participate – the taxpayer is more or less an investor. An active business activity is any activity which is not passive.
One aspect of the bill that affects many financial services pass-throughs is that “Specified service activities (SSAs)” are, by default, ineligible for the 25% rate. SSAs are health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. This includes investing, trading, or dealing in securities, partnership interests, or commodities.
However, the 30% of net business income used to calculate QBI (and the 0% for SSAs) are default percentages. If individual partners can determine that their “applicable percentages” are higher, then they can irrevocably elect to use their particular applicable percentages for the current year and the next four years.
- The applicable percentage is the partner’s “specified return on capital” from the activity divided by the partner’s net business income from that activity for the year.
- “Specified return on capital” is the taxpayer’s share of the activity’s “asset balance” multiplied by the deemed rate of return (the short-term applicable federal rate plus 7%) reduced by deductible interest attributable to that activity.
- The “asset balance” is the partner’s share of the business adjusted basis of any depreciable property (and land), not taking into account bonus depreciation or Section 179. It appears that intangibles such as goodwill are not part of the calculation.
The Senate plan is more straightforward, allowing a 17.4% deduction for passthrough income but the deduction does not apply to specialized service businesses. The deduction is also limited to 50% of the taxpayer’s wages from either a related S-corporation or other employers of the taxpayers.
Simply put, the proposed adjustments for flow-throughs generally favor capital-intensive businesses not financial services businesses.
While much of the focus of interest limitations has been focused on the loss of interest deductions to the homeowner, financial services businesses could very well feel the ripple effect of such legislation. Additionally, the financial services organization could be impacted directly as well.
Under the House proposal, For businesses with receipts above $25 million, their interest expense deductions would be limited to 30% of essentially EBITDA.
While the Senate bill is more “interest friendly”, the debt markets could clearly face impacts of these provisions.
Also, certain investments would be impacted. Under the House Plan, new private activity bonds would be eliminated. The Senate is silent. Bonds used to finance professional sports stadiums would no longer be tax-exempt under the House Plan. The Senate is silent.
Many financial services “funds” have significant investors that are tax exempts, including colleges and univesities. Under the House Plan, private colleges with at least 500 full-time equivalent students and endowments of at least $250,000 (increased from the original $100,000 proposal) would be subject to a 1.4% excise tax on their net investment income.
Many financial services firms benefit from so-called carried interest provisions which allow for more favorable capital gains on investment returns attributable to certain services. The House tax bill would restrict preferential treatment of carried interest to investments held for three or more years. The Senate bill in its present form does not make any changes, but Sen. Chuck Grassley, R-Iowa, a senior member of the Senate Finance Committee, has said some changes will probably be made when the committee takes up the bill.
So while tax legislation continues to be much of the focus of Congress and the media, it likely will not be beneficial for many financial services firms. The direct and indirect impacts should be analyzed to determine the impacts.
It’s important to remember that this framework is proposed — any tax reform legislation that is passed by Congress will likely look very different in its final form.
Additional Resources on this topic:
- “Tax Proposal Update: 'The Tax Cuts and Jobs Act'”
- New Tax Law: What You Need to Know
- “How will proposed federal tax changes impact you?”
- “In GOP Tax Bill, How You Get Rich Matters”
- 2018 Tax Planning Guide