Direct Lending with a Section 199A Tax Benefit...TAX NOTES FEDERAL, SEPTEMBER 30, 2019 2229 tax...

TAX NOTES FEDERAL, SEPTEMBER 30, 2019 2229

tax notes federalTAX PRACTICE

Direct Lending With a Section 199A Tax Benefit

by Tony Tuths

Enacted at the end of 2017, the Tax Cuts and Jobs Act created section 199A, which provides a 20 percent deduction for noncorporate U.S. taxpayers for income earned from the conduct of a domestic trade or business.

This deduction effectively lowers the tax rate applicable to individuals in the highest marginal tax bracket to 29.6 percent (as opposed to 37 percent) for what the statute terms qualified business income (QBI). The section 199A deduction has largely become known as the passthrough deduction because its largest utility is for income earned through a partnership, trust, or S corporation. However, the deduction is likewise available to a sole proprietorship. Like most of the TCJA provisions affecting individuals, section 199A is set to expire at the end of 2025.1

Two main limitations to this deduction have severely restricted its utility within the asset management industry. First, the amount of QBI to which the deduction is available is generally capped at the greater of:

• 50 percent of the Form W-2 wages paid for the business; or

• the sum of (x) 25 percent of the Form W-2 wages, and (y) 2.5 percent of the unadjusted basis of specified depreciable property used in the business.2

Inside the asset management arena, this creates an immediate impediment at the fund level because rarely are significant wages paid, or depreciable property held, in the fund (although a real estate or other hard-asset fund would likely have depreciable property).

Second, the section 199A benefit is denied for income earned through a specified service trade or business (SSTB).3 As described more fully later, most of the activities within asset management would constitute an SSTB (or would not be considered a trade or business at all). Thus, the availability of the section 199A deduction is severely restricted within asset management.

The Form W-2 wage limitation and the SSTB limitation both phase in for taxpayers with an aggregate taxable income above a specified threshold and fully deny the section 199A benefit for joint filers with aggregate taxable incomes exceeding $415,000 (or individual filers with aggregate taxable incomes exceeding $207,500), as adjusted for inflation.4

Carveout From SSTB Status

Much of the asset management industry falls squarely into the definition of an SSTB, so the section 199A benefit is largely denied. The statutory list of identified SSTBs includes any trade or business involving the performance of

Tony Tuths is a principal in KPMG LLP’s alternative investment tax practice.

In this article, Tuths explains how the regulations under section 199A provide a window of opportunity for direct lending businesses to use the passthrough deduction, even though it’s disallowed for most of

the alternative investment industry.

1Section 199A(i).

2Section 199A(b)(2).

3Section 199A(d)(1)(A).

4Section 199A(b)(3) and (d)(3).

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2230 TAX NOTES FEDERAL, SEPTEMBER 30, 2019

services in the fields of financial services, brokerage services, investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).5

On January 18 Treasury and the IRS issued final regulations (T.D. 9847) that clarify and expand on the meaning of each of the SSTBs listed above.6 These definitions provide a specific carveout from SSTB status for loan origination activities and provide welcome relief to investors in some loan-originating vehicles.

According to the final regulations, the performance of services in the field of financial services includes services provided by financial advisers, investment bankers, wealth planners, and retirement advisers.7 However, specifically excluded from the financial services SSTB is the activity of making loans. But be aware that the trade or business of arranging lending transactions between a lender and a borrower is an SSTB.8 Nevertheless, the specific exclusion of originating loans provides an avenue for direct lending vehicles to avoid SSTB status.

The performance of services in the field of brokerage services includes activities in which a person arranges transactions between a buyer and a seller regarding securities (as defined in section 475(c)(2)) for a commission or fee.9 Most of the asset management industry would not typically fall into this category.

The performance of services in the field of investing and investment management refers to a trade or business involving the receipt of fees for providing investing, asset management, or investment management services, including providing advice on buying and selling investments.10 This SSTB category clearly encompasses management companies of all sorts within the asset management space. Thus, if a direct lending vehicle paid asset management fees

to an investment manager, those fees may be ineligible for the section 199A benefit in the hands of the manager. However, this does not taint the income of the direct lending vehicle itself. The management fee itself is addressed separately later.

The performance of services in the field of trading means a trade or business of trading in securities (as defined in section 475(c)(2)), commodities (as defined in section 475(e)(2)), or partnership interests.11 Whether a person is a trader (as opposed to an investor) is based on all the relevant facts and circumstances.12 This provision puts most funds out of contention for a section 199A benefit. Almost all funds (hedge, private equity, and venture) will either be a trader fund falling squarely within this SSTB category or will be classified as an investor fund, in which case it is not carrying on a trade or business and is thus ineligible for the section 199A deduction. Note, however, that all funds (particularly real estate and private equity) have the ability to derive section 199A benefits from their assets and portfolio companies.

The performance of services in the field of dealing in securities, commodities, or partnership interests means regularly purchasing those assets from, and selling them to, customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in those assets with customers in the ordinary course of a trade or business.13 Notably, the performance of services to originate a loan is not treated as the purchase of a security from the borrower in determining whether the lender is dealing in securities.14 The definition of dealing in securities in the final section 199A regulations differs in an important way from the section 475 definition. Section 475(c)(1) defines a dealer in securities as a taxpayer that regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business. By altering the definition to require both purchases and sales of

5Section 199A(d)(2).

6A corrected version of the final regulations was published February

8, at 84 F.R. 2952-3014.7Reg. section 1.199A-5(b)(2)(ix).

8Id.

9Reg. section 1.199A-5(b)(2)(x).

10Reg. section 1.199A-5(b)(2)(xi).

11Reg. section 1.199A-5(b)(2)(xii).

12Id.

13Reg. section 1.199A-5(b)(2)(xiii).

14Reg. section 1.199A-5(b)(2)(xiii)(A) (last sentence).




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securities (a loan would typically be classified as a security for this purpose), and by removing loan origination from the definition of securities purchases, the regulations ensure that the regular activity of originating loans and selling originated loans will not be an SSTB.

The culmination of all the SSTB categories outlined earlier (and their related exclusions) is that a passthrough vehicle that engages in the business of originating loans and selling originated loans can qualify for the section 199A deduction. The entity would still need to consider the Form W-2 wage limitations, but the business would not be classified as an SSTB. Also, a loan origination vehicle would want to be careful about purchasing loans not originated by it, including secondary market purchases and some syndications. This is because both the purchase and sale of loans from or to customers could push the activities into a dealing SSTB.

The treatment of loan origination activities is a change from the proposed section 199A regulations (REG-107892-18) released August 8, 2018. The proposed regulations, like the final regulations, provided an exclusion from the financial services SSTB for loan origination.15 However, for the dealing in securities SSTB, the proposed regulations exempted loan origination but only if the taxpayer engaged in “no more than negligible sales of the loans.”16 Taxpayers were directed to reg. section 1.475(c)-1(c)(2) and (4) for the definition of negligible sales.

Under the section 475 regulations, the term “negligible sales” is defined as the taxpayer selling in any tax year either (1) fewer than 60 debt instruments (regardless of how acquired); or (2) less than 5 percent of the total basis, immediately after acquisition, of the debt instruments acquired that year.17 However, the negligible sales calculation is made without regard to (x) sales of securities that are necessitated by exceptional circumstances and that are not undertaken as recurring business activities; (y) sales of debt instruments that decline in quality while in the taxpayer’s hands and that are sold under an

established policy of the taxpayer to dispose of debt instruments below a specified quality; or (z) acquisitions and sales of debt instruments that are qualitatively different from all debt instruments that the taxpayer purchases from customers in the ordinary course of its business.18

Arguably, the provision in the proposed regulations was broad enough to exempt a loan origination business from the SSTB classification, but the final regulations are more complete in this regard by allowing origination and sales without limitation.

How to Take Advantage of the Tax BenefitGiven that a loan origination business is

eligible for the section 199A deduction, how can asset managers make use of this provision? In credit funds or hedge funds that devote a portion of their assets to loan origination, the fund may have a separate trade or business (apart from its main trading strategy) that is eligible for the deduction. In that case the manager would want to set up a separate vehicle in which the loan origination activities are to take place. The loan origination vehicle will require employees directly in the vehicle, as opposed to in the management company. Although it may be possible for some or all of those employees to be dual employees along with the management company, the loan origination vehicle should issue its own Form W-2 statements. The section 199A deduction associated with the loan origination activities will be limited to 50 percent of the vehicle’s Form W-2 wages because it is unlikely the vehicle will have a significant amount of depreciable property.

Given the need for employees within the lending vehicle itself, and the related Form W-2 wage cap, managers may consider having no management fees and no separate investment manager for the direct lending business. Rather, the investment management team would all be Form W-2 employees of the lending business. The lending vehicle could be a partnership owned primarily by the main fund or as a parallel fund. If the direct lending vehicle is owned by the main fund, the fact that good section 199A income is

15Prop. reg. section 1.199A-5(b)(2)(xiii).

16Id.

17Reg. section 1.475(c)-1(c)(2).

18Reg. section 1.475(c)-1(c)(4).




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flowing through a bad SSTB will not disturb the income’s eligibility for the 199A deduction.

If the direct lending vehicle is owned by the main fund, consideration must be given to the foreign feeder or other non-U.S. investors. For non-U.S. partners, a U.S. blocker would be appropriate to trap the income that will be effectively connected with a U.S. trade or business and therefore be subject to U.S. tax. To minimize the U.S. tax effect, managers may want to use a leveraged blocker. Of course, the blocker would need to be above the fund to avoid tax affecting the income of the U.S. limited partners. For that reason, parallel funds may make the best structure.

The tax effects of a direct lending business will be markedly different for U.S. and non-U.S. investors. The U.S. investors will want to ensure a

U.S. trade or business is present and that the structure is fully transparent for U.S. tax purposes to effectuate the section 199A deduction. Non-U.S. investors, on the other hand, will want a vehicle that is either (1) not engaged in a U.S. trade or business or (2) opaque for U.S. tax purposes with minimum U.S. tax drag.

This combination points favorably to a parallel fund structure in which the U.S. fund would originate loans and produce income eligible for the section 199A deduction. At some point, after each loan’s origination, the U.S. vehicle may decide to sell all or part of the loan to the foreign fund (or to a third party). This structure permits the U.S. side to be section 199A eligible and places 100 percent of the Form W-2 wages in the U.S. vehicle (as opposed to shared




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expenses with the foreign fund).19 At the same time, the non-U.S. vehicle can avoid being engaged in a U.S. trade or business and, if structured correctly, the foreign investors will not incur any U.S. tax on the lending business income. Figures 1 and 2 demonstrate this type of structure

both as a stand-alone fund and as a bolt-on to an existing fund structure.

The horizontal season and sell method described earlier has been widely used for several years among alternative asset managers with direct lending businesses. Now, however, the section 199A final regulations provide a clear path to lowering the effective tax rate for the U.S. taxable participants. The final regulations, unlike the proposed regulations, should allow unlimited sales from the U.S. side of the structure to the non-

19The foreign fund in this situation would have no employees. All the

origination activities would take place in the U.S. vehicle. This difference would theoretically be reflected in the sales price of the loan. Origination fees, if any, collected by the U.S. vehicle would typically not be shared with the foreign fund.




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U.S. side. However, typical season and sell restrictions would still apply, including sole funding from the U.S. fund, additional risk for the seasoning period within the U.S. fund, and strict valuation methods for the sale from the U.S. fund to the foreign fund.

The principals involved in the direct lending vehicle could have a carried interest in the fund that is section 199A eligible, but that may not always be advisable, at least not in full. Any income allocated on the carry would consist mainly of ordinary interest income, so there is no long-term capital gain income available. Further, the main limitation on the section 199A benefit to the U.S. investors will be the Form W-2 wages paid within the direct lending vehicle. Thus, the principals may elect for higher Form W-2 wages (even of a variable nature) in lieu of a carried interest. That election will come at the cost of employment tax applicable to the Form W-2 wages, which would affect both the employees’ and the employer’s net return.20 This cost is substantial in relation to the section 199A benefit, so one would need to model the correct balance of Form W-2 wages and concomitant section 199A benefit against the carried interest, which is section 199A eligible.21 In fact, some funds may find that the additional cost of the employment taxes (7.65 percent on the employer side alone) will quash the benefit provided to the investors by section 199A.22 Nevertheless, there will be situations in which it is beneficial.

Structured properly, section 199A and its final regulations should permit both stand-alone direct

lending funds and parallel add-ons to existing funds. In both situations the maximum federal tax rate for the U.S. investors on the direct lending revenue (up to the Form W-2 wage limit) would be 29.6 percent, while the non-U.S. investors would enjoy zero U.S. tax.23 Specialized structuring should be considered to capture the section 199A deduction benefit wherever domestic loan origination activities are present. This may be in a fund structure but may also exist in proprietary lending platforms, merchant cash advance firms, and others. As demonstrated earlier, section 199A can create a brand of interest income (and related fees) that is tax benefited. Funds involved in direct lending may want to consider restructuring to capture the section 199A benefit for investors when the facts dictate.

In situations in which the activity of the direct lending vehicle will include mortgages, one should consider the use of a real estate investment trust. Qualified REIT dividends are eligible for the section 199A deduction regardless of the amount of QBI or the Form W-2 wage limitation.24 Qualified REIT dividends are defined as any dividend from a REIT other than a capital gain dividend or qualified dividend income.25 Moreover, the REIT can be private or public. Given that REITs are not limited by a Form W-2 wage restriction, mortgage lending should be confined to the REIT. This will ensure that 100 percent of the mortgage lending income is section 199A eligible.

Some market participants are taking the position that management fees received by a management company from a direct lending vehicle are eligible for the section 199A deduction. Although investment management is normally considered an SSTB for which the section 199A deduction is disallowed, here the management entity is managing an active trade or business

20The direct lending vehicle as the employer would be responsible

for half of the employment tax, while the employee would be responsible for the other half. In total, the wage earner (the principals) would be taxed at 2.35 percent (1.45 percent employee portion of Medicare tax plus 0.9 percent additional Medicare tax, assuming high income). The employee portion of Social Security tax, 6.2 percent, is capped at the maximum Social Security earnings amount of $132,900 for 2019, resulting in a flat tax of $8,239.80. The employer (the direct lending vehicle) would be liable for a tax of 7.65 percent (6.2 percent employer portion of Social Security tax (no maximum) plus 1.45 percent employer portion of Medicare tax). In total, the employment tax is reducing overall net returns by approximately 10 percent. The section 199A rate benefit is only 7.4 percent.

21Typically, Form W-2 wages equal to two-thirds of the QBI

(determined without regard to the Form W-2 wage limitation) are needed to fully use the section 199A benefit. That is, $100 of QBI (before wages) minus $66 of wages produces net QBI of $34. Based on $66 of wages, the section 199A limit would be $33. In this scenario, virtually all the net taxable income would be eligible for the section 199A benefit.

22In many instances this will be a shifting of the wages and

employment taxes from the management company to the fund.

23The U.S. investors would suffer state and local tax in all states in

which the direct lending vehicle has nexus. The non-U.S. investors, through the foreign fund, would buy only secondary market loans and as such would not be engaged in a U.S. trade or business and would therefore avoid both federal and state taxation.

24Section 199A(b)(1)(B).

25Section 199A(e)(3).




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(loan origination) as opposed to an investment fund.26 Thus, arguably the SSTB of investing and investment management is inapposite.27 Nevertheless, the final section 199A regulations are clear that although loan origination is not within the financial services SSTB, the arranging of a loan between a lender and a borrower is within the SSTB.28 Here the lender would be the fund (that is, the direct lending vehicle). Presumably, the management company is sourcing the borrower and arranging for the loan between the two because in the typical structure there are no employees within the fund. Still, the activities of the management company extend far beyond the arranging of the loan, and it may be that the other activities are both valuable and eligible for the section 199A deduction.29

Thus, there would seem to be several methods available to separate the financial services SSTB from the non-SSTB activities of a direct lending management company. First, the management company could simply bill the fund separately for the loan arranging activities. However, this would require the management company to treat the two activities as separate trades or businesses (that is, facilitating loans and managing the lending

business).30 Second, the management company could be split in two, with one entity performing loan arrangement (an SSTB) and the other performing the non-SSTB work (for example, credit analysis, loan servicing, etc.). Finally, one or more employees can be placed within the fund to perform the loan arranging activities such that the SSTB activities are not within the management company at all. In any case, a proper transfer pricing analysis should be completed to determine that the fair market value price is being charged for each of the services. However the activities are segregated, there will typically be a format in which some (if not many) of the fees earned by a direct lending management company are eligible for the section 199A deduction. Figure 3 represents a possible structure for a management company to capture the section 199A benefit.

Moreover, unlike the fund situation described earlier, the management company typically has Form W-2 wages being paid. Thus, the employment taxes attached to Form W-2 wages will not be an additional cost. The section 199A deduction will simply act as a tax rate reduction to the partners within the management company. Thus, between the investors and the manager, the greater section 199A benefit may lie within the management company.26

See reg. section 1.199A-5(b)(2)(B)(xi) (the specified service of investment management is limited to the receipt of fees for providing investing, asset management, or investment management services, including providing advice regarding buying and selling investments). Moreover, the specified service of financial services specifically excludes services related to making loans. Thus, the management company to a direct lending vehicle may not be an SSTB. Contrast this with a management company advising a trader fund, also an active trade or business, when the management company is still engaged in the SSTB of investment management or financial services.

27To support this conclusion, one must maintain that managing a

loan origination business, even if not taking fees for arranging the loans, is not “investment management” as that term is defined in reg. section 1.199A-5(b)(2)(xi). Investment management is defined as a trade or business involving the receipt of fees for providing investing, asset management, or investment management services, including providing advice regarding buying and selling investments. Id. If the originated loans were “investments” within that definition, perhaps management support functions would constitute an investment management SSTB. Recall that the rule that treats loan origination activities as not constituting the purchase of a security is limited to the “dealing in securities” SSTB and would not seem to extend to the “investment management” SSTB. See reg. section 1.199A-5(b)(2)(xiii)(A) (last sentence). For purposes of this discussion, it is assumed that management of a lending business is not investment management, but the conclusion is not clear.

28Reg. section 1.199A-5(b)(2)(ix).

29In examining whether management fees for a direct lending vehicle

are QBI for purposes of section 199A, one would want to consider if the management activities might fall within the SSTB of consulting. The performance of services in the field of consulting means the provision of professional advice and counsel to clients to help them achieve goals and solve problems. Reg. section 1.199A-5(b)(2)(vii).

30See reg. section 1.199A-5(c)(1)(iii). The business of facilitating loans

between the fund and borrowers would need to be treated as a separate trade or business from the management of the loan origination business. This requires separate books and records with separate employees (or an allocation of expenses including Form W-2 wages). If the two activities are not treated as separate trades or businesses and the gross proceeds attributable to the SSTB activities exceed 10 percent of the gross proceeds of the trade or business (5 percent if the gross receipts exceed $25 million for the tax year), the entire trade or business will be classified as an SSTB. Reg. section 1.199A-5(c)(1).




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