Comparing Tax Reform’s Impact on Publicly-Traded Investment Funds: A Pass-through Investment Guide

By Stuart E. Leblang, Michael J. Kliegman and  Amy S. Elliott

There are numerous types of pass-through investment vehicles traded on public exchanges, several of which, as we have written, will benefit from the new pass-through tax relief in the tax reform bills under consideration by Congress. ¹ However, not all pass-throughs receive similar treatment. There are some pass-through-type investment vehicles, namely traditional mutual funds (known as regulated investment companies or RICs) and business development companies (BDCs) that, absent changes, may be disadvantaged relative to their publicly traded partnership (PTP), master limited partnership (MLP) and real estate investment trust (REIT) cousins.

The primary forms of tax relief available to pass-throughs in tax reform are the House bill’s 25 percent rate (which may be limited when the income is from the owner’s active participation in the business) and the Senate bill’s 23 percent deduction (which may be limited by the amount of employee wages paid out by the business). ² Overall, the Senate’s deduction regime is more generous, reducing taxes on owners of pass-throughs by $477 billion over 10 years as opposed to just $362 billion over 10 years by way of the 25 percent rate in the House. ³ While the House delivers a lower effective rate, less income overall seems to be eligible for it.

There are many caveats to the pass-through provisions. Only individual (not C corp) owners of pass-throughs benefit. Investment income earned by a pass-through is generally excluded. If the pass-through is in a “specified service” business (health, law, engineering and others), its owners largely will not benefit, although the House provides an exception in the case of capital- intensive specified service businesses and the Senate provides an exception in the case of joint taxable income up to $500,000. There are many other rules. To help guide you through this complex analysis as it applies to various vehicles (from threshold eligibility to other factors that could limit the benefit of the proposals), we have developed the following table:

Guide to Applying Pass-through Provisions to Publicly Traded Pass-through Entities

How to read this table: The first column along the left identifies various types of publicly traded pass-through entities. To analyze whether and to what extent owners of these entities can take advantage of the House bill’s 25% rate or the Senate bill’s 23% deduction, the table walks through three initial eligibility questions that apply to both provisions. If satisfied (marked by a √ ), the analysis then divides (starting at #4H and #4S) to better identify what portion of the recipient’s income gets the benefit. If a pass-through fails an eligibility question, it is marked by an ×.

NOTE: All of the effective rates in the table above assume that the pass-through investors are in the top income tax bracket (over $470,700 for married individuals filing joint returns in 2017). However, note that in the House bill, joint income under $225k could benefit from a lower pass-through rate of between 9% and 11% for the first $75k and is then phased out for income up to $225k. *But certain local benevolent life insurance associations, mutual ditch or irrigation companies, mutual or coop phone companies, farmers’ coops, rural electrical coops and rural phone coops are eligible. **Among other things, capital gain and loss items, dividend and dividend equalivalents (except in the case of REITs), and interest income not allocable to a trade or business are generally excluded from the special pass-through provisions and taxed at even more preferential effective rates at the individual level. For example, the 20% rate on income earned by owners of financial PTPs assumes that a significant portion of the PTP’s earnings is items of long-term capital gain and dividends and that those are being passed through and taxed at 20%, which is the preferential rate on such items for high-income individuals. Owners of other entities will also benefit from the 20% rate to the extent such items are earned and passed through (which occurs more readily in the case of real estate MLPs, real estate REITs and RICs). ***Specified service activities include investing (and investment management in the Senate), trading, or dealing in securities, partnership interests, or commodities and performing services in the fields of 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 1 or more of its employees.

Avoiding the Hurdles

Both the House and Senate pass-through tax relief regimes contain hurdles: the active/passive analysis in the House (which can limit the income eligible for the special rate to only 30 percent if the owner is active in the business) and the Form W-2 wage cap in the Senate (which can limit the deduction to half of the amount of employee wages paid out by the business that year and allocated to the owner in proportion to her interest in the business) (#6H and #6S in the table).

But both REITs and those PTPs that pass eligibility question #2 (simply put, all non-financial PTPs—otherwise known as MLPs—are eligible) avoid these hurdles and are not subject to either the 30 percent active limitation or the 50 percent wage cap limitation. (Financial PTPs generally fail eligibility question #2 as they are not in a trade or business up at the PTP level.)

Being able to avoid these hurdles gives REITs and MLPs a clear advantage. It is important to note that dividends from all REITs (in the case of mortgage REITs, no matter if they are in the active business of originating loans or if they simply acquire the loans in the secondary market) qualify for the 25 percent rate in the House, as long as they are not capital gain or qualified dividends.

Distinguishing the Losers

Why did Congress choose to extend tax relief to some types of pass-throughs and not others? While RICs and BDCs are taxed as C corporations, they—like REITs— benefit from a dividends- paid deduction that effectively wipes out their corporate-level tax. They are essentially pass- through entities in that the only tax paid is at the owner level (but owners do not get the preferential rate on RIC or BDC dividends). Why are they, as a threshold matter, not included in these provisions?

The simple answer is that Congress may have assumed that REITs and MLPs are more active than RICs or BDCs, or Congress may not have considered it all that thoroughly. RICs are generally mutual funds, vehicles that pool investor dollars to trade in securities. Mutual funds generally pass through to investors capital gains, dividends and interest, items of a character that are generally excluded from the House and Senate provisions (and that benefit from lower rates in any case). In addition, the House and Senate provisions are not available to income from businesses engaged in investing and trading in securities—a “specified service” activity.

The problem with Congress drawing the line for favorable pass-through treatment to include all REITs and exclude all RICs is that not all RICs are mutual funds that passively invest in public securities. Certain types of RICs—BDCs in particular—invest in smaller, private companies and take a more active role in the businesses in which they invest.

A BDC industry group that has organized to challenge this line-drawing that arguably harms BDCs ⁴ makes the following case: “BDCs, MLPs, and REITs have historically (for decades) been taxed similarly. It is inequitable to treat them differently now; in addition, BDCs serve the policy mandate of financing private U.S. middle-market business, and providing them managerial assistance. REITs do not have this same mandate.”

The group goes on to point out that the House and Senate bills, as drafted, leave “BDC shareholders taxed at current rates, even though BDCs, MLPs and REITs provide the same type of retirement income and are generally owned by the same type of retail investor.” There are currently over 50 publicly traded BDCs. ⁵ 

Although there are no clear lines, some have argued that BDCs should be considered more active than passive. Absent change, they seem to be treated as passive in tax reform. An amendment sponsored by Sen. Jim Risch (R-ID) (Amendment #1829^[6]) proposes to treat qualified BDC dividends in the same manner as qualified REIT dividends.

What Is a BDC?

A BDC that elects to be treated as a RIC has the same three basic requirements as a RIC: 1) at least 90 percent of its gross income must be derived from dividends, interest, payments from securities loans (generally in the form of a so-called coupon), gains from the sale of stock or securities, or other income derived in connection with its business of investing in stock or securities; 2) at least 50 percent of its assets (by value) must be made up of cash, government securities, securities of other RICs, or other securities (as long as such other securities are limited to less than 5 percent of the BDC’s total assets, by value, and no more than 10 percent of the outstanding voting securities of the issuer), tested quarterly; and 3) no more than 25 percent (by value) of its assets can be invested in the securities of any one issuer, tested quarterly.^[7]

In addition, a BDC must elect to be treated as such under the Investment Company Act of 1940. The ‘40 Act provides that BDCs must make “available significant managerial assistance”— defined as “significant guidance and counsel concerning the management, operations, or business objectives and policies”, “controlling influence over the management or policies”, or “the making of loans to”—to certain of the portfolio companies in which it invests.^[8]

Specifically, pursuant to Section 55 of the ‘40 Act, at least 70 percent of a BDC’s assets, by value, must be invested (by way of debt or equity securities) in “eligible portfolio companies” (generally either private companies or small, with a market cap of less than $250 million, public companies) and cash and short-term government securities.

BDCs primarily invest in small and middle-market portfolio companies, providing a source of capital to firms that may struggle to secure loans on favorable terms from traditional banks. The industry takes the position that if BDCs lose their tax advantage, small businesses could be hurt.

BDCs Disadvantaged Relative to REITs

Consider how mortgage REITs are treated by the House and Senate bills. In the House, retail investors in mortgage REITs generally will qualify for the 25 percent rate on the dividends they receive (which otherwise would be taxed at a top rate of 39.6 percent, not including the impact of the 3.8 percent net investment income tax or NIIT).

In the Senate, retail investors in mortgage REITs generally will be able to take the full 23 percent deduction. Not only are dividends from a REIT largely considered qualified business income for purposes of the regime, but also they are fully exempt from the wage cap and the “investment” income limitation. That means mortgage REIT investors will effectively be taxed at 29.6 percent (for investors in the top bracket, not including the NIIT).

The BDC industry is focused on the fact that BDCs are not treated the same as REITs in tax reform. But investors do not seem to be similarly concerned. One Seeking Alpha article suggested that the potential benefit to BDCs from tax reform “is being greatly underestimated,” because while they “might not directly benefit from a lower corporate tax rate, the companies they lend to certainly would,” which would reduce loan risk and make warrants more valuable.^[9] A StreetAuthority article was similarly positive, writing “favorable corporate tax rates will encourage acquisitions of small- and mid-sized businesses in the private space. This should in turn boost returns and share prices for the BDC sector.”^[10]

The BDC industry is working hard to educate members of Congress on the equity issue presented by excluding BDCs from the pass-through provisions. They are asking for a technical correction that would treat dividends from BDCs just like dividends from mortgage REITs. If the dividends paid out by a BDC are subject to a top rate of 39.6 percent in the House or 38.5 percent in the Senate, that is significantly higher than the 25 percent rate in the House or the 29.6 percent rate in the Senate received by mortgage REIT investors.

One or more Akin Gump partners may be registered to lobby on behalf of BDC issues in tax reform, although the authors are not involved in that effort.

^{[1] Prior reports: Nov. 3, “Some Unexpected Impacts of Proposed Tax Bill: REITs Could Be Big Winners, Impact on MLPs Mixed and Complicated, and Threat to Certain Multinationals from New Related-Party Payment Excise Tax”; Nov. 12, “Senate Bill—With Deduction for Pass-through Income—May Have Radically Different Impact on Certain MLPs than House Bill; Treatment of REITs More Ambiguous, But Likely Favorable; Nov. 15, “Senate Modifies 17.4% Deduction for Pass-through Income to Expand Benefit for MLP Investors with Less than $500k Taxable Income”; Nov. 30, “Seeking Parity with REITs, Lawmakers Want MLPs to Get Exemption from Pass-through Deduction Wage Cap”; Dec. 3, “Senate Agrees to Exempt MLPs from the Wage Cap and Increases the Pass-through Deduction to 23 Percent”; Dec. 4, “Mortgage REITs Could Be Big Winners in Tax Reform”.}

^{[2] For the version engrossed in the House Nov. 16, see https://www.congress.gov/115/bills/hr1/BILLS-115hr1eh.pdf. Page 37, Sec. 4 “25 percent maximum rate on business income of individuals.” For the version engrossed in the Senate Dec. 8, see https://www.congress.gov/115/bills/hr1/BILLS-115hr1eas.pdf. Page 21, Sec. 11011 “Deduction for qualified business income.”}

^{[3]Est. revenue impact of House bill (Nov. 14 report JCX-57-17, https://www.jct.gov/publications.html?func=startdown&id=5038) and Senate bill (Dec. 6 report JCX-63-17, https://www.jct.gov/publications.html?func=startdown&id=5047).}

^{[4] The group is the Small Business Investor Alliance’s BDC Council.}

^{[5] http://bdcsworkforamerica.org/}

^{[6] https://www.congress.gov/amendment/115th-congress/senate-amendment/1829/text (and scroll down to 1829)}

^{[7] See tax code Section 851.}

^{[8] https://www.sec.gov/about/laws/ica40.pdf.}

^{[9] McCammon, Darren, Oct. 3, 2017, “Tax Reform And Its Effect On Small Cap, High Cash Flow Stocks: Part 2,” Seeking Alpha (https://seekingalpha.com/article/4111254-tax-reform-effect-small-cap-high-cash-flow-stocks-part-2).}

^{[10] Fischbaum, Adam, Oct. 16, 2017, “Cash In On Tax Reform With These 3 Funds,” StreetAuthority (http://www.nasdaq.com/article/cash-in-on-tax-reform-with-these-3-funds-cm860348). However, given the multiple limitations on the deductibility of interest expense in the tax reform bills, some businesses may look to reduce their debt loads.}