The tax reform bills introduced in the House of Representatives and the Senate dramatically reduce the corporate tax rate from 35% to 20% and create added incentives for taxpayers to invest capital into U.S. businesses with expanded expensing and reduced flow-through rates.

But the bills were drafted quickly, Congress is rushing to get them passed by the end of the year, and the Internal Revenue Code is a complicated thing. Unintended consequences result, and pass-throughs offer opportunities.  In fact, a drafting glitch may provide hedge and lending fund investors with an inadvertent tax reduction.

Using a Pass-Through to Avoid the Excise Tax on Tax-Exempt Entities That Hire Well-Paid Employees.

Both bills impose a 20% excise tax on tax-exempt organizations that pay salaries in excess of $1 million. However, this penalty is entirely avoidable if the tax-exempt organization uses a partnership to pay its executives.

Assume that a university pays its president a salary of more than $1 million. Under both bills, the university would be subject to an excise tax of 20% on the excess.  Instead, the university forms an LLC that is treated as a partnership for tax purposes.  The members of the LLC are all of the professors, the president, and the university.  The president and professors invest very modest sums.  Students write their tuition checks out to the LLC.  The university controls the LLC.  At the end of the year, the university allocates the net income of the LLC among the professors and the president, and the president gets his $1+ million.

This structure appears to entirely bypass the 20% excise tax. The excise tax applies only to employees, and the president is not an employee; he is a partner in a partnership with the professors and the university.  Alternatively, the president and the professors could form their own LLC, and the university could hire it.  The Senate bill does authorize regulations to prevent avoidance of the excise tax by compensating employees through a pass-through or other entity.  It remains unclear how avoidance will be defined.  Hospitals routinely enter into joint ventures with doctors, and some of the doctors may earn more than $1 million.  Will those arrangements now subject the hospital to an excise tax?  These arrangements predated the tax bills.

Neither arrangement would appear to jeopardize the tax-exempt status of the university or subject it to tax. In Revenue Ruling 98-15, the IRS approved of joint ventures between tax-exempts and non-exempt organizations.  Although there are differences between the first LLC and the joint venture described in Revenue Ruling 98-15, because the university controls it and it conducts exempt activities (education), its income would appear to be exempt income to the university.

As discussed below, under the Senate bill, any married professor making $500,000 or less would benefit from the 23% pass-through deduction.[1]

Finally, with a little structuring (described below), the president and the employees might be able to avoid the self-employment tax that normally applies to partners in a partnership.

Using a Pass-Through to Get Back the Deduction for Public Company Compensation Paid to Well-Paid Employees.

Both bills also deny deductions to public companies that pay compensation of more than $1 million to any employee. A similar strategy can effectively get back the deduction. Public companies could operate through an “Up-C” structure.  In an Up-C structure, the public shareholders invest in a corporation, but that corporation, in turn, owns an interest in a partnership.  The well-paid executives would hold carried interests in the partnership, which would allocate a portion of the profits to the executives.  Because the executives would not be employees of the corporation, and because the corporation would not be relying on a deduction, no deductions would be denied under the bill.

Private companies subject to the $1 million salary cap could avoid the denial of compensation deductions more simply by operating in partnership form, issuing carried interests to its executives, and allocating income to the executives. An executive would get two added benefits from this structure.  First, she would have a carried interest and could receive capital gain treatment and, unless his or her employer is a money manager, she wouldn’t be subject to the bill’s three year requirement for long-term capital gains from carried interests.  Second, as described below, the executive might be able to avoid self-employment tax.  In contrast to the excise tax on tax-exempt organizations that pay more than $1 million in salary, there is no authorization of regulations to prevent abuse.

Using Carried Interests to Avoid Self-Employment Tax.

Under current law, employees are subject to federal and state income, social security and Medicare withholding; general partners are subject to self-employment tax. However, limited partners are not subject to self-employment tax (or withholding).  This allows individual partners in a service partnership to own very small general partnership interests (like 1% or less collectively) and very large (99% or more collectively) limited partnership interests and take the position that income allocated to them in their capacity as limited partners escapes the self-employment tax to which general partners are subject.  The original version of the House bill would have changed this rule and imposed self-employment tax on the limited partners, but this was deleted in the Chairman’s mark.  The Senate bill retains current law.  Thus, both bills still permit their individual partners to avoid self-employment tax by receiving their compensation through carried interests held as limited partners.

Reduced Tax Rate for Investors in Mark-to-Market Hedge Funds, Lending Funds, and Distressed Debt Funds.

A drafting glitch in the House bill appears to qualify the gains of flow-through investors in trading hedge funds that elect to be taxed on a mark-to-market basis, and for the interest income of lending funds (and possibly distressed debt funds), for the reduced blended rate of 35.22%. This result appears to be entirely unintended.  A provision in the Senate bill would deny (however inadvertently) the 23% deduction for investors in trading hedge funds, but permit it for the interest income of investors in lending and distressed debt funds.  The explanation that follows is quite technical.

The reduced 25% rate under the House bill applies to the “capital percentage of any net business income derived from any active business activity”. “Active business activity” is any business activity that is not a passive business activity.  A hedge fund that is a trader is treated as engaged in a trade or business for tax purposes.  That activity is a business activity.  A “passive business activity” is any passive activity as defined in section 469(c) (without regard to paragraphs (3) and (6)(B)).  Under temporary regulations section 1.469-1T(e)(6), the activity of trading personal property is not a passive activity.  So a hedge fund that is a trader is engaged in an active business activity.

It is less clear that a fund that makes loans is engaged in a business activity. The IRS believes that lending is a trade or business for purposes of subjecting foreigners to tax, but a U.S. taxpayer that makes loans as investments is not normally be engaged in a business activity.  However, because of this ambiguity, US taxpayers do take the position that they are engaged in a trade or business when their funds make loans, and in light of the reduced rates under the House and Senate bills, they will have an additional incentive to do so.  Because lending is not a trading activity, lending would be a passive activity for an investor.  (This turns out to be a good thing for the investor under the House bill.)  Distressed debt funds may materially modify debt, which technically gives rise to a deemed sale and deemed origination.  These deemed originations may also rise to the level of a trade or business, which would also be a passive activity for an investor.

Under both bills, the reduced rate is not available for investment income. Investment income is defined as capital gains and losses, dividends and dividend equivalents, interest (other than interest income that is properly allocable to a trade or business), certain commodity income, certain notional principal contract income, and certain annuity income.  A hedge fund would normally generate capital gains and losses.  However, section 475(f) permits a trader to elect to be subject to mark-to-market taxation, and all mark-to-market gain and loss is ordinary gain and loss.  Thus, a fund that has elected under section 475(f) never has capital gain or loss.  This is the point that the drafters apparently missed.  The net amount of mark-to-market gains and losses is net business income.

As mentioned above, although interest income is generally investment income, interest income that is properly allocable to a trade or business is not investment income. The interest income from a fund that is engaged in a lending or distressed debt business is properly allocable to that trade or business, so it is not investment income.

Under the House bill, investors in a pass-through that is engaged in an active business activity that is not engaged in a “specified service activity” (described below) may treat 30% of their income from the pass-through as entitled to the 25% rate; the remaining 70% is deemed to be attributable to labor activity subject to ordinary income treatment. This gives rise to a blended rate of 35.22% ([25% * 30%] + [75% * 39.6%]).

However, under the House bill, if a fund is deemed to be engaged in a “specified service activity,” then its capital percentage is deemed to be zero and the 25% rate is unavailable to its investors. Specified service activity means any activity involving the performance of services described in section 1202(e)(3)(A), including investing, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(c)(2)).  Section 1202(e)(3) describes any trade or business involving the performance of services and includes the fields of consulting and financial services.

There are two ways to read the definition of specified service activity. On the one hand, if specified service activity includes any activity involving the performance of services described in section 1202(e)(3)(A), and, in addition, any trading in securities, regardless of whether that activity involves the performance of services, then trading hedge funds’ capital percentage would be deemed to be zero because they do trade in securities.  On the other hand, if specified service activity means any activity involving the performance of services described in section 1202(e)(3)(A) as well as the performance of trading services (which is not specifically listed in section 1202(e)(3)(A)), then a hedge fund that trades in securities would not be engaged in a specified service activity.

The words and apparent intent of the statute are more consistent with the latter interpretation than the former. The carve-out for specified service activity appears to be designed to prevent labor-intensive industries from benefitting from the 25% rate.  While section 1202(e)(3)(A) includes the performance of financial services, it is unclear whether that term includes security trading services and so it appears that the drafters specifically included trading services in the definition of specified service activity in order to prevent hedge fund managers from benefitting from the 25% rate.  They were not addressing hedge funds investors in this definition; they thought they had already addressed hedge fund investors by excluding investment income.  However, as mentioned above, they inadvertently missed mark-to-market gains under section 475.  Therefore, while a hedge fund manager is denied the pass-through rate because it provides trading services, a trading fund does not provide services, it only receives them and so its investors are not denied the pass-through rates.

The analysis for a lending fund is trickier. Some courts have treated lending as a “service,”[2] although courts generally have held that the activity of making loans to hold and not for purposes of resale to a customer or otherwise to earn a spread is not a service.[3]   Moreover, although one might view lending as a financial service, it would not be natural to refer to lending as being in “the field” of financial services.  The categories described in section 1202(e)(3) are all labor intensive activities, and lending is not.  It is more likely that the drafters contemplated a financial adviser (or the manager of a lending fund) as practicing in the field of financial services, and not the fund itself.  If a lending fund is not engaged in the service of providing loans, it would not be in a specified service activity.  It seems even less likely that a distressed debt fund would be treated as providing a financial service.

Thus, investors in hedge funds that elect mark-to-market under section 475(f), and investors in lending or distressed debt funds, appear to get a tax reduction under the House bill. Trading gains for a mark-to-market fund are taxed at the highest marginal rate of 39.6% under current law but, as drafted, the House bill appears to reduce the rate to 35.22%.  To fix this apparently technical error, the drafters should expand section 4(c)(3) to include gains and losses taken into account under section 475 by reason of an election under section 475(f).  In any event, the drafters should address the issue.  Even if my interpretation is wrong, absent some clarification, there will be hedge funds that take this position, and they will be difficult to catch.

Treating the interest income of a lending fund as benefitting from the 25% rate is less clearly due to a technical error. After all, the drafters did specifically contemplate that interest income “that is properly allocable to a trade or business” would qualify.  They might have been thinking of an appliance store that offers financing to its customers, but even so, a lending fund is not very different.  (If a distressed debt fund is viewed as making loans, the analysis is the same.)  Also, under both bills, investors in a mortgage REIT get the benefit of the 25% rate, even if the REIT is not a lender and is a pure investor.

The Senate bill is similar to the House bill, except for four major changes. First, the Senate bill provides a 23% deduction rather than a reduced rate (for a maximum effective 29.645% rate).  Second, the Senate bill limits deduction to income and gain that are “effectively connected with the conduct of a trade or business within the United States.”  Third, the Senate bill limits the deduction to 50% of the taxpayer’s share of the W-2 wages of the flow-thorough, unless the taxpayer’s taxable income is less than $500,000 ($250,000 for a single taxpayer).  Finally, these less-than-$500,000/$250,000 taxpayers would be entitled to the deduction even if they work for a firm that is engaged in a “specified service trade or business” (which is the Senate bill’s equivalent of a “specified service activity”).

The summary of the Senate bill indicates that it is intended to apply only to “U.S.-source income.” Apparently, the Senate wanted to encourage U.S. activities and not benefit the U.S. taxpayers whose flow-throughs operate abroad.  But the Senate chose a very peculiar mechanism to achieve this policy objective: it limited the deduction to U.S. taxpayers that are effectively connected with the conduct of a trade or business in the United States.  Until the Senate bill, this phrase has only been applied to foreigners.  Foreigners are subject to normal U.S. income tax only if they are engaged in a trade or business in the United States and only to the extent of their income and gain that is “effectively connected” to that business.  Tax lawyers refer to foreigners that are “engaged in a trade or business” in the United States as “ETB” and the income and gain that is “effectively connected” with that business as “effectively connected income” or “ECI”.  Weirdly, the Senate bill requires that US taxpayers have ECI to qualify for the deduction.

Unfortunately for U.S. taxpayers in trading funds, there is a “safe harbor” that permits foreigners to invest in a trading fund without being treated as engaged in a trade or business in the United States for tax purposes and therefore foreigners that invest in these trading funds do not earn ECI. This is helpful to foreigners, but deadly for U.S. taxpayers under the Senate bill because a U.S. taxpayer who invests in a trading fund also wouldn’t have ECI and therefore wouldn’t get the deduction.

On the other hand, there is no safe harbor for lending (including the deemed lending that arises when the terms of distressed debt held by a fund are materially changed) and the IRS says that foreigners who invest in lending funds are engaged in a trade or business in the United States, earn ECI, and are subject to U.S. income tax. Since a foreigner that invests in a lending fund would have ECI, a U.S. investor who invests in a lending fund would also have ECI and would qualify for the deduction under the Senate bill.  Granting the deduction to investors in lending funds and distressed debt funds but denying it to investors in trading funds does not seem like a considered policy decision, but simply the inadvertent result of using the ECI test as the basis for the Senate’s pass-through deduction.

As mentioned above, the Senate bill also limits the deduction to 50% of the taxpayer’s share of the W-2 wages of the flow-thorough, unless the taxpayer’s taxable income is less than $500,000 ($250,000 for a single taxpayer). Lending funds don’t normally have their own employees.  Instead, funds usually employ an investment management company to run them; this separate management company often has employees.  The Senate bill would require that the fund itself hire employees, who would presumably be the owners and employees of the investment management company.  If the owners of the management company become employees of the fund, they would become subject to wage withholding.  However, because being subject to wage withholding would dramatically reduce the tax rate of individual investors in the lending fund, the owners of the management company might be willing.

The last minute Senate change extending the pass-through rate to investors in publicly-traded partnerships (PTPs) might allow investors in a distressed debt fund that is a PTP but is not taxable as a corporation to avoid the 50% W-2 requirement with respect to the interest on loans that are materially modified as part of a trade or business.[4]

Avoiding the Exclusion for Specified Service Businesses

As mentioned above, under both bills, partners in a partnership that is engaged in “specified service activities” are denied the pass-through rate and are taxable at the highest marginal rates. (The House bill has a very narrow exception for very highly capitalized flow-throughs.)  However, because specified services is determined at the flow-through level, a taxpayer could do the exact same job for two different partnerships and get the reduced rate for one, but be denied it for the other.

Assume that a single partner in a law firm earns annual compensation of $1 million. Because her law firm performs specified service activities, she is denied the pass-through rate under the House bill and entirely phased out under the Senate bill.  However, assume that she does all of her work for a single client that is an industrial partnership (which, we’ll assume earns only active, non-investment income).  The client hires her as an in-house lawyer where she is entitled to an annual allocation of net income of the partnership at the discretion of the CEO.  Although she is not given any guarantees, she is told that she should normally expect at least the same compensation as she received at her firm.

If she remained a law firm partner, under the House bill, she would be in the 39.6% bracket, and would pay about $342,319 of tax.[5] However, if she is hired by the client, her share of flow-through income would qualify for the blended rate and her taxes would be reduced by $103,000.[6]

Under the Senate bill, if she remains a partner at her law firm, she would pay $338,620 in tax.[7]  However, if she is hired by the client, under the Senate bill, she would be entitled to a 23% deduction ($230,000), which (assuming that it doesn’t exceed 50% of the industrial partnership’s W-2 wages), would reduce her taxes by $88,550.[8]

Get the Pass-Through Rate by Becoming a Partner

The pass-through rate is not available to employees, but is available to pass-through owners. And the Senate bill is particularly generous for employees who become partners to reduce their taxes. Assume that a group of young married investment bankers (or consultants or lawyers) work for a pass-through firm. They all earn $500,000. If they stay employees, under the Senate bill they would be taxable at the 35% marginal rate, and would each pay about $118,079 in tax. [9] However, if they were to become partners and their compensation remained the same, they would reduce their taxes by $34,280 under the Senate bill.[10]

Equally, if the group formed their own pass-through firm which, in turn, was hired by their former employer, they would also qualify for the pass-through rates under the Senate bill.

Pass Through Rate for Entertainers and Athletes.

Athletes and entertainers aren’t supposed to get the pass-through rate. Each of the bills denies the pass-through rate for specified services, which includes the performance of services in the fields of performing arts and athletics.  However, the exclusion for specified services applies only to the performance of services.  Entertainers and athletes also receive royalties for product endorsements, and entertainers receive royalties for their songs.  Royalties are not for services.  However, to receive the special pass-through rate, each bill would require the income to be received from a “trade or business”.  In Goosen v. Commissioner,[11] the tax court held that the South African golfer Retief Goosen was engaged in a trade or business when he entered into endorsement agreements with Izod, Rolex, and Electronic Arts, and deemed a portion of his income to be for services and a portion to be royalties.[12]  Artists who regularly compose and license their works may also be engaged in a trade or business.

Each bill denies the special pass-through rate for “investment income”. However, royalties are not included in the list of investment income.  Because an entertainer must be engaged in a trade or business to receive the pass through rate, likely they would be sufficiently active to fail to qualify for the House bill’s 25% rate for passive activity and therefore would be taxable at the 30.22% blended rate.  The Senate bill would provide a 17.4% deduction (for a maximum effective rate of 31.80%), regardless of the level of the athlete’s involvement, but the Senate bill would limit the athlete’s deduction to 50% of his or her share of the pass-through’s W-2 wages.


[1]       Taxable income would be less than $500,000/$250,000.  It is unclear whether the President could benefit from the pass-through deduction.  Teaching is not on the list of specified service trades or businesses.  However, a specified service trade or business includes any trade or business where the principal asset is the reputation or skill of one or more of its employees.  This might describe the LLC, except that the LLC wouldn’t have any employees.  All of its workers would be partners.

[2]       See, e.g., Burbank Liquidating Corp. v. Commissioner, 39 T.C. 999, 1010–11 (1963), aff’d in part, rev’d in part, 335 F.2d 125 (9th Cir. 1964). Cf. Giblin v. Commissioner, 227 F.2d 692 (5th Cir. 1955) (receipt of real estate lots and stock was compensation for services rendered in the United States).

[3]       See Investors Diversified Servs., Inc. v. Commissioner, 325 F.2d 341 (8th Cir. 1963) (loans made for investment purposes were not made in the ordinary course of a trade or business for services rendered and therefore constituted capital assets). Cf. TAM 9822007, TAM 9822008. In TAM 9822007 and TAM 9822008, the foreign subsidiary of a foreign lending company made a loan to a U.S. borrower. The loan was negotiated by an international banking institution. Although the IRS did not specifically consider whether the loan (or similar loans) would cause the lender to be treated as engaged in a U.S. trade or business, the IRS did advise that the lender was not a bank (because it did not take deposits) and would receive the interest income free of U.S. withholding tax.

[4]       A PTP is taxable as a corporation if more than 10% of its income is non-qualifying income.  Interest income is qualifying income unless it is derived in the conduct of a “financial or insurance business”.  While a lending business is likely to be treated as a financial business, a distressed debt fund that modifies loans is much less likely to be treated as engaged in a financial business.  In any event, a PTP could have up to 10% of nonqualifying interest income without being taxable as a corporation.

[5]       $1,000,000-$12,200 standard deduction is $987,800.  The first $45,000 would be subject to tax at 12% ($5,400).  The next $155,000 would be subject to tax at $25% ($38,750), the next $300,000 would be subject to tax at 35% ($105,000) and the remainder of $487,800 would be subject to tax at 39.6% ($193,169) for a total of $342,319.

[6]       Her qualified business income would 100% of $1 million or $1 million.  Under section 4(a)(1), her tax would be reduced by 10% of $1,000,000-$200,000 or $80,000, plus 4.6% of $800,000 over $500,000-$200,000, or $23,000, for a total deduction of $103,000.

[7]       $1,000,000-$12,000 standard deduction is $988,000.  Her tax would be $150,739.50 plus 38.5% of the excess over $500,000 ($488,000), or $187,880, for a total tax of $338,619.50.

[8]       $1,000,000-$230,000-$12,000 is $758,000.   Her tax would be $150,739.50 plus 38.5% of the excess over $500,000 ($258,000), or $99,330 for total tax of $250,069.50.

[9]       $500,000- $24,000 standard deduction is $476,000.  Tax would be $91,479 plus 35% of the excess over $400,000 ($76,000) or $26,600, for total tax of $118,079.

[10]     $500,000-$100,000-$24,000 is $376,000.  Tax would be $65,879 plus 32% of the excess over $320,000 ($56,000), or $17,920, for total tax of $83,799.

[11]     136 T.C. 547 (2011).

[12]     Under the U.S.-South African tax treaty, Goosen wasn’t subject to U.S. tax on his royalty income because he didn’t have a permanent establishment in the United States.