How to Skirt the Cap on Interest Deductions in the GOP Tax Plan . . . and to Make Some Money While You’re at It

A perspective from practice

The House and Senate tax plans both include provisions that limit the deductibility of business interest for individual and corporate taxpayers. Under the House version, the cap is essentially 30% of earnings before interest, (federal) taxes, depreciation, and amortization (EBITDA); under the Senate version, the cap is 30% of earnings before interest and taxes (EBIT). The Joint Committee on Taxation estimates that the House provision will raise approximately $171 billion over a decade and that the Senate version will raise roughly $308 billion.

Those estimates may prove to be far too optimistic, however. Both the House and Senate provisions can be gamed relatively easily by taxpayers seeking to retain the benefits of interest deductibility. The games get even better when one considers the pass-through provisions in the House and Senate bills, which allow a reduced rate or deduction for certain income flowing through sole proprietorships, partnerships, and S corporations. (The House plan taxes pass-through income at a maximum 25% rate; the Senate plan allows a 23% deduction for pass-through income; and the agreement reached by the House-Senate conference reportedly settles on a 20% deduction.) As a result, the Republican tax plan may add quite a bit more to the deficit than revenue estimates anticipate. [For many more loopholes in the GOP plan, see The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation.]

Here’s how a lawyer who specializes in structuring financial transactions described one such game in an e-mail:

Consider a business that currently has interest expense of $40 on $100 of EBIT[DA], consisting of $30 interest expense on senior debt and $10 of interest expense on subordinated debt. Assume that none of the current law limitations on interest deductibility apply to this business (which would be the typical case). Under the proposed legislation, the business will be limited to a $30 interest deduction and $10 will be disallowed.

Commenters have long noted that preferred equity in a partnership provides the equivalent of a tax deductible financing expense (among other alternatives to debt such as leasing arrangements and certain derivatives) . . . . Thus, if the business described above were a partnership, it could issue preferred equity to repay the subordinated debt (bringing its interest expense within the $30 deductibility limit). The preferred equity could be allocated/distributed a fixed annual amount of partnership income (for simplicity, say $10), economically similar to the previous subordinated debt interest expense. This would divert taxable income away from the common equity partners, with similar effect to preserving interest deductibility for the full $40 of financing expense.

If the business were a corporation, similar planning would be available. The corporation could drop its operations into a partnership subsidiary (likely achievable as a reorganization without the burden of actually transferring assets, etc.), and the partnership subsidiary could issue the preferred equity. If the debt remained at the parent corp level, the partnership sub could provide an upstream guarantee to avoid potential structural subordination of the senior debt.

Of course, the preferred equity would not have an identical credit profile to the subordinated debt it replaced. However, for many businesses, that profile would be similar, or similar enough that the tax benefit would exceed the marginal cost of financing using preferred equity rather than debt. Businesses could also engage in structuring to enhance the credit profile of the preferred equity — for example, by carving off a particularly low-risk business line into a partnership subsidiary and issuing the preferred equity out of that subsidiary (without an upstream guarantee). In other words, issuers would retain wide flexibility to structure the credit profile of their financing in an optimal manner.

That could be a solution for the business, but what does the rest of the structure look like? It seems there are some additional goodies, amounting to an apparent tax subsidy for the finance provider in this structure. Consider a high net worth US individual (or a partnership of multiple high net worth individuals) being the new preferred equity partner. These new preferred equity partners would earn $10 ordinary income from their partnership interest, generally taxed at the same rate as interest income. However, it appears they could also qualify for a 23% (or now expected 20%) deduction on this income under the Senate bill, or a reduced rate under the House bill, assuming several criteria are met that naturally would be in many situations. (This would still likely result in a higher tax rate for the investor than an investment in corporate preferred stock producing qualified dividend income, but that of course would not be deductible for the issuer and therefore would price differently.)

So, historic equity holders retain the benefit of $40 of deductible financing expense, while the finance provider receives a subsidy in the form of a 20% deduction for participating in the preferred equity structure versus an investment in debt. Of course the economic incidence of that deduction could occur in different places in the structure (e.g., reduced preferred rate, etc., and the tax benefit possibly could be allocated in a different way), but the net after-tax economics of the structure would be the same.

That’s not all. Many high net worth individuals engaged in service businesses will be able to take advantage of arbitrage opportunities resulting from the new pass-through provisions. For example, a law firm with relatively little debt now can take out a loan and deduct interest expense at the top marginal rate, while the partners may be eligible for the 20% deduction on passive investments via limited partnerships and S corps. As my correspondent explains:

To further highlight the point, imagine that the new preferred equity holder borrows an amount equal to the preferred equity amount he funds, both at a rate of $10 per annum (assumed for simplicity, but the arbitrage opportunity does not require this assumption). If he can deduct the $10 interest expense on his borrowings, he will effectively be economically and tax neutral, except that he will get a bonus $2 per annum deduction under the Senate bill. The proposed legislation . . . has a half-baked “double counting rule” to prevent partnership income from providing double capacity for deductible borrowing at the partnership and the partner level. However, this approach fails to recognize that money is fungible and that wealthy people have an array of portfolio holdings. . . . [T]racing funds in this context seems impossible as an administrative matter.

This last observation is an illustration of a more general point: The House and Senate plans — and apparently the conference report as well — impose different tax rates on different businesses. The word emanating from the conference committee is that the top rate on income from law firms, medical practices, consulting firms, and other service businesses will be 37%, while the top rate on income flowing through other pass-through entities will be 29.6%. Virtually any time that different entities face different rates, arbitrage opportunities will arise. The House and Senate Republicans’ slapdash process leaves little time to seal up these loopholes before the tax overhaul takes effect.