OBRA's impact on securities partnerships. (Omnibus Budget Reconciliation Act of 1993)by Biondo, Gina
Rate Differential. Effective for tax years beginning after December 31, 1992, the maximum statutory rate on ordinary income has increased to 39.6%, while the maximum long-term capital gains rate remains at 28%. This creates an 11.6% maximum rate differential between ordinary income and capital gains, while under prior law the top rate differential was only 3%. Given this differential, the name of the game once again becomes generating capital gains as opposed to ordinary income (as under pre-86 rules). Therefore, investor and other "growth" securities partnerships, which are no more likely to provide long-term capital gains compared to trader partnerships, may see an increase in capital as investors attempt to take advantage of the lower capital gains rate. In addition, trader partnerships may not sell their securities as frequently as in prior years, or may attempt to extend or "age" their holding period in certain securities positions in order to generate long-term capital gains for their individual partners. Securities partnerships should reevaluate their trader status if their investment strategies significantly change.
In response to the 11.6% differential, the 1993 Act contains several provisions intended to prevent the conversion of ordinary income into capital gain. First, new IRC Sec. 1258 would recharacterize capital gain from a "conversion transaction" entered into after April 30, 1993 as ordinary income, limited to 120% of the "applicable federal rate" applied to the taxpayer's net investment in the transaction. A conversion transaction may exist if substantially all the expected return is attributable to the time value of money. In a conversion transaction the taxpayer is in the economic position of a lender-there is an expectation of a return from the transaction which in substance is in the nature of interest, and there is no undertaking of significant risks other than those of a typical lender. While most securities partnerships should not run afoul of this new provision, transactions that may be employed to mitigate risk of loss, such as "forward conversions" may require recognition of ordinary income, rather than capital gain.
Expansion of the Market Discount Rules. Second, the 1993 Act expands the application of the market discount rules, which generally treats gain on the disposition of bonds that were purchased in the secondary market at a discount as ordinary income to the extent of the market discount that accrued while the bonds were held by the taxpayer. The 1993 Act removes the exception to the market discount rules for the following bonds: 1) tax-exempt obligations (state and local obligations) and 2) obligations issued before July 18, 1984. Therefore, securities partnerships purchasing market discount obligations listed under 1) and 2) above after April 30, 1993, must treat any resulting gain as taxable ordinary income to the extent of any accrued market discount.
Investment Interest Expense Limitation. Third, the 1993 Act amends IRC Sec. 163(d), effective for 1993, by excluding net capital gain (net long-term capital gain less net short-term capital loss) from the definition of investment income for purposes of computing the investment interest expense limitation, i.e., net investment income. This amendment reflects Congress' concern that net capital gains as investment income, provided such gains are taxed at a maximum rate of 28% could create investment interest expense deductions at ordinary rates of 39.6%. Taxpayers may elect however to include any amount of their net capital gain as investment income, provided such gains are taxed at ordinary income rates. Taxpayers may, therefore, be faced with the question of whether to pay 28% today on long-term capital gains in order to preserve a carryforward of investment interest expense, which might yield a potential tax saving of 39.6% in a future year. Given this change to the definition of net investment income, securities partnerships should specifically disclose on the Schedule K-1 (or supplementary statement) the components of any investment income.
Old Provisions Take on New Meaning. Many IRC provisions that distinguish between capital and ordinary income and/or suspend or terminate holding period will take on new meaning given the 11.6% rate differential. Securities partnerships purchasing and selling bonds, notes and other evidences of indebtedness should give careful consideration to the "original issue discount," market discount (discussed above), and "short-term discount obligation" provisions in the IRC that require the recognition of ordinary income rather than capital gains. They should also note that an election made to amortize" market premium" will result in ordinary deductions, rather than capital losses or a reduction in the amount of capital gain income.
Securities partnerships should not overlook the rules of IRC Sec. 751 that may require the recognition of ordinary income as opposed to capital gain to partners who transfer their partnership interest or withdraw from the partnership, receiving amount attributable to "unrealized receivables" (market discount bonds and short-term discount obligations to the extent gain would be treated as ordinary income if the bond or obligation had been sold by the partnership).
Securities partnerships engaging in short sale transactions may be subject to the short sale rules of IRC Sec. 1233, which recharacterize long-term capital gain (short-term capital loss) as short-term capital gain (long-term capital loss), if on the date the short sale is entered into, the partnership holds "substantially identical" securities that qualify for the short-term (long-term) holding period. The short sale rules may also terminate the holding period of other substantially identical securities held by the partnership. The "straddle" rules may also terminate the holding period of the securities held by the partnership. The "straddle" rules may also terminate the holding period of the securities held by the partnership. This could produce short-term capital gain rather than long-term capital gain.
Estimated Tax Payment Rules. The 1993 Act modifies the individual estimated tax payment rules, effective for tax years after 1993, which, if followed, will result in no penalty assessment. The 1993 Act provides a safe harbor payment of 110% for individuals with prior year AGI of more than $150,000. Thus, the 1993 Act simplifies the estimated tax payment requirements, which in the past were based on current year's income although taxpayers will have the option of paying 90% of the current year's tax liability.
Self-Employment Tax: Currently, individuals are only subject to a 2.9% hospital insurance or Medicare ("HI) tax on the first $135,000 of "self- employment income" or wages. Effective January 1, 1994, the 1993 Act removes the cap to the HI tax so that all wages and self-employment income will be subject to the tax. Therefore, compensation packages should be structured in a way that would generate income not subject to the self-employment tax such as interest, dividends and capital gains as opposed to guaranteed payments.
Mark-to-Market Accounting. New IRC Sec. 475 requires mark-to-market accounting treatment for certain securities held by a "dealer in securities." Since securities partnerships do not regularly sell or purchase securities from customers (or otherwise enter into transactions with customers), they should not be viewed as a dealer in securities. It is, thus, unlikely that a securities partnership would be subject to this provision, however, those partnerships that feel that this could be a potential issue for them should consider making a "protective identification" to assure that their positions will not be marked-to- market.
Alternative Minimum Tax ("AMT"). Effective for 193, the top AMT tax rate is increased from 24% to 28%. Given the differential between the top regular rate and AMT rate of 11.6%, more individuals will find themselves subject to regular tax rather than AMT. On the other hand, individuals in high state and local jurisdictions generating large amounts of long-term capital gains in relation to ordinary income may become subject to the AMT tax, since state and local income taxes are not deductible in computing AMT.
Foreign Withholding Tax (IRC Sec. 1446). Trader partnerships are required to withhold tax on behalf of a foreign partner on the foreign partner's allocable share of the partnership's taxable income. The amount of the withholding tax is computed by applying the highest rate of tax specified in IRC Sec. 1 (noncorporate taxpayers) or IRC Sec. 11 (corporate taxpayers) against the partner's allocable share of taxable income. These applicable percentages are now 39.6% for individuals and 35% for corporations.
Offshore Trading Corporations. Many corporations trading for their own account that are marketed to foreign investors maintain their principal office outside of the U.S. so that the foreign investors will not be subject to U.S. taxation (other than withholding tax). The offshore corporation is normally set up as a side-by-side entity to a U.S. securities partnership. The general partners of the U.S. securities partnership typically render investment advice (the "investment advisors") to the offshore corporation for which a management and incentive ("20% override") fee is received and taxed to such partners at the 39.6% rate. Given the 11.6% differential in rates, the possibility to restructuring the operations through an offshore partnership should be considered to provide the investment advisors with long-term capital gain.
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