As we approach the tax season we are starting to get more clarity on the Tax Cut and Jobs Act (TCJA or sometimes referred to as “The Keep CPA’s and Lawyers well employed Act”). I recently attended an excellent event specifically focused on Private Investment Fund Accounting and Taxes and wanted to share a few key takeaways from that event that may be relevant to you and your business. Some of the changes particularly relevant to SBRE entrepreneurs include:
- Deduction for Qualified Business Income
- New limitations on Business Interest Expense
- Best practice for footnotes and disclosures
Deduction for Qualified Business Income: One key provision of the TCJA is the 20% deduction for Qualified Business Income (QBI) in calculating net taxable income for individuals, estates and trust, which takes the federal tax rate from 37% to 29.6% (subject to various factors). This deduction was put in place by Congress to discourage people from switching entity types in response to the drop in the corporate tax rate. QBI is generally the net income from a qualified trade or business; investment income is excluded, except for REIT ordinary dividend income.
It is important to note that a qualified trade or business may not be a specified service trade or business (SSTB), the definition of which can be found here. There is, however, a de minimus exception for taxpayers with taxable income below certain thresholds who may still claim the 20% deduction even if the income is from a SSTB. Depending on your business model this means that you may only be taxed on 80% of your share of net income!
New Limitations on Business Interest Expenses: Another key provision for businesses is the limitation on business interest expense, which is limited to the sum of the taxpayer’s business interest income, plus 30% of the taxpayer’s adjusted taxable income, which approximates EBITDA (until 2022) and EBIT thereafter. This limitation does not apply to a “small business,” generally defined as a partnership or corporation with average annual gross business receipts over a rolling three-year period of $25M or less. There is a special provision that allows real estate businesses to opt out of these interest deduction limitation rules if they adopt the “Alternative Depreciation System,” a concept your tax service provider can help you with. At the State tax level, most states have adopted the Federal standard, although many states have deferred adoption dates. Depending on your entity structure and use of leverage, you may not want to take this exception.
Best practice for footnotes and disclosures: The conference I attended also included audit and investor focused discussions, and discussions around current topics of interest to regulators. Key issues included:
- Desire for transparency, consistency and clarity from investors when it comes to audited financial statements (make it simple for investors to understand by including charts and graphs in lieu of verbiage)
- Ensure all footnotes are consistent with the Fund documents
- Related parties are becoming more of a hot topic – disclose what is happening (loans, guarantees, family ownership, board seats, etc.)
- Consistency in valuation approach
- Disclosure of subsequent events such as redemptions (actual and requested), contributions, related party activity, and significant changes in asset performance
As always, you should consult with your duly licensed CPA to ensure that you are applying these rules appropriately for your fund. Although Redwood is not a CPA, we can help you understand how these issues may be treated, as well as ideas about which issues you should raise with your CPA. If you have any questions don’t hesitate to reach out to us if you have any questions.
Erica England, C.P.A
Redwood’s Chief Accounting Officer Erica England C.P.A. has 10+ years of experience working in the private equity industry and is always happy to discuss how Redwood could help you with your fund administration needs. Feel free to reach out to Erica at firstname.lastname@example.org to learn more.