Impact of the Tax Cuts and Jobs Act on the Private Equity Industry
With the passage of the Tax Cuts and Jobs Act (“Act”) there is much concern, as well as confusion, as to the impact the legislation will have on private equity funds, fund managers, and portfolio companies. The good news is that fund managers can take advantage of some of the tax changes; the bad news is that the rules – at first blush – are rather complex.
As a first step, fund managers should carefully evaluate the structure of the fund itself, the management entities, as well as the portfolio companies to optimize their tax planning and minimize any unanticipated tax costs. The Act presents numerous tax changes, and below, we’ve summarized some significant tax changes that are likely to impact the private equity industry in the areas of funds, investors, and fund managers; portfolio companies; and deal structuring.
Funds, Investors, and Fund Managers
In many cases, fund managers have been compensated for their services through a profits interest (i.e., “carried interest”) in their fund. Typically, when the carried interest was held for more than one year, the holder of the carried interest would be taxed on income arising from such interest at a long-term capital gain tax rate, rather than the higher ordinary income tax rate. For years, changes to the carried interest provisions, looking to have income on such gains taxed at ordinary income rates, have been proposed by Congress. While the Act does not require that all income arising from a carried interest be taxed at ordinary income tax rates, it changes the holding period required to qualify for long-term capital gain treatment to three years, from one year. Accordingly, certain gains relating to a carried interest, earned after December 31, 2017 and held less than three years, will be treated as a short-term capital gain.
As many private equity funds tend to hold portfolio companies for more than three years, this change is not as problematic as earlier proposals to tax carried interests as ordinary income. However, fund managers should consider this limitation, especially when exiting positions that are close to the three-year holding period.
Deduction for Pass-Through Businesses
The Act allows non-corporate owners of pass-through entities a deduction (the “FTE deduction”) equal to 20% of qualified business income (QBI) with respect to a qualified trade or business. To qualify for the deduction, the income must be associated with the conduct of a trade or business in the United States or Puerto Rico (subject to certain conditions). Investment income (such as interest, dividends, and capital gains) and income from Specified Service Trades or Businesses (SSTBs) are excluded from QBI and generally not eligible for the 20% deduction. Some examples of an SSTB that are relevant include financial services, the performance of services that consist of investing and investment management, and trading or dealing in securities. Accordingly, in most situations, funds may not qualify for the FTE deduction, and fund managers should be certain to structure operations in a manner that would maximize any such deduction.
Further, there are complex limitations, which much be considered, including a limitation based on W-2 wages, and assets relative to the qualified business. The W-2 and/or asset tests, however, would not apply if the taxpayer’s taxable income was below the threshold amounts set forth in the Act ($315,000 for taxpayers filing a joint return; $157,500 for single filers). The limitation is phased-in for taxpayers with taxable income exceeding these amounts over ranges of $100,000 and $50,000, respectively. Note that these thresholds are based on the individual’s taxable income, not QBI.
As stated above, private equity funds themselves should not be considered a “qualified trade or business,” as they tend to generate investment income. However, funds may benefit from this deduction to the extent they invest in pass-through portfolio companies that are a qualified trade or business. Only a qualified trade or business can generate QBI and satisfy the W-2 wage or depreciable asset basis limitations described above. For this reason, careful planning must be done when structuring portfolio companies to maximize the 20% FTE deduction.
Management companies will generally not qualify for the FTE deduction due to the SSTB limitation discussed above. However, if income allocated to a management company partner is less than the income thresholds noted above, that income may qualify for the FTE deduction at the individual level.
The FTE deduction is significant for all flow-through entities as, from a practical point of view, the 20% deduction creates a 29.6% effective tax rate for individuals who would otherwise be in the top rate bracket, (plus 3.8% Medicare tax, if applicable). Keep in mind there may be potential state income tax benefits as well, if the state(s) in which the taxpayer files allow this benefit. As this is a potentially valuable deduction, fund managers will need to understand this rule and consider how to maximize their FTE deduction when evaluating the tax structure of their portfolio companies. In addition, funds must look at their limited partner base when making these decisions. For example, the 20% FTE deduction would not benefit certain partners, such as C corporations.
Individual Limitations on NOL Usage and Excess Business Losses
The Act created new limitations on how much income an individual taxpayer can use to offset portfolio income or other non-business income with losses from flow-through entities – both in the current and future years.
The first limitation relates to an “excess business loss.” An excess business loss for the taxable year is defined as the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer , over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount of $250,000 for single taxpayers and $500,000 for married filing jointly . This has a negative impact, as excess business losses incurred in a taxable year may not be used to offset other non-business income, such as interest, dividend, capital gains, etc. The excess business losses can, however, be carried forward until used and are treated as part of the taxpayer’s net operating loss (NOL) carryforward, which can be used to offset taxable income in subsequent years. The second limitation is that the amount of an NOL carryover that can be used is now generally limited to 80 percent of the taxpayer’s taxable income, determined without regard to the NOL deduction. Of course, the NOL that can be used is also limited to the amount of the NOL available – so if the 80% limitation is $100, and you only have a $70 NOL, you can only use $70 of NOL to offset your current year income. Also, net operating losses can no longer be carried back. Again – keep an eye out for the state income tax treatment of excess business losses and NOLs, as some states may not follow these rules.
As stated above, the excess business loss limitation may limit a taxpayer’s ability to use business losses to offset investment income (that’s what the “excess business loss” does). For example, if a fund manager is single and her share of the management company’s loss for 2018 is $700,000, and the only other income she has in 2018 is $1 million of capital gains, her excess business loss is $450,000 ($700,000 - $250,000 threshold amount). In this fact pattern, she can only use $250,000 of the management company’s loss to offset the $1 million capital gains and she will need to pay tax on the remaining $750,000 of capital gain. The $450,000 excess business loss will carry forward as a NOL to 2019.
Fund managers need to understand these rules and consider how their specific situation will impact their overall tax position.
Substantial Built-In Loss in the Case of a Transfer of Partnership Interest
The Act expands on this rule designed to prevent loss duplications that can occur with partnership transfers. Specifically, the Act requires that partnerships reduce the tax basis of partnership property following a transfer of a partnership interest if the transferee partner would be allocated a loss of $250,000 or more under a hypothetical taxable disposition of all partnership assets immediately after the transfer. Fund managers should consider this when receiving requests for partner transfers.
Prior to the Act being signed, there was significant discussion of how the various proposals impacted itemized deductions. For example, it was widely discussed – even in the general press – that deductions for state and local taxes would be limited to $10,000. Another, less well known change that may be relevant to the private equity industry is the elimination of portfolio deductions (such as management fee expenses and other fund level expenses). As the fund’s individual investors will no longer benefit from deducting the management fees on their personal tax returns, fund managers may want to consider alternative compensation arrangements, such as increased carried interest or management fee waiver arrangements.
In addition to the changes at the fund level, the Act will significantly impact businesses that private equity funds lend to and/or those in which they invest. Private equity firms need to understand these new provisions as fund managers look at new deals (in addition to identifying how the new rules apply to their existing portfolio companies). The following is a list of key provisions and other points that private equity funds should consider.
Corporate Rate Change
The new maximum corporate tax rate for C corporations is 21% (reduced from 35%) starting in 2018. While the tax rate change is significant, private equity funds must look at the tax rate reduction in conjunction with some of the limitations mentioned below to fully understand the impact to their investments.
Limit on Deduction of Business Interest
For tax years beginning after December 31, 2017, there is a new limitation on the amount of interest expense that a taxpayer may deduct. Generally, a taxpayer’s interest expense will be limited to 30% of the entity’s adjusted taxable income (ATI). This limitation applies at the entity level to both corporations and flow-through entities.
ATI is taxable income before deducting interest expense, depreciation, amortization or depletion, any net operating loss deduction, or interest income (i.e., EBITDA). After 2021, ATI will include depreciation and amortization (i.e. EBIT). In situations where an entity’s interest expense is greater than 30% of such entity’s ATI, such excess interest expense is “disallowed” as a deduction in the current year. Any disallowed interest is carried over – by the entity if it is a corporation, or by the owner if the entity is a flow through entity – as business interest to the succeeding tax year.
Note that an exception to the business interest limitation applies to taxpayers with average annual gross receipts of less than $25 million for the last three preceding tax years. Also note that, for purposes of the $25 million threshold, taxpayers would need to aggregate revenue from related entities and that the aggregation rules are complex. Bottom line is that fund managers need to determine how these new rules could impact the specific business in which the fund is looking to invest.
For portfolio companies that rely on private equity funds to meet leverage needs, this is a significant change, as the interest deduction may be less valuable in the future. Accordingly, private equity funds may wish to look to invest through preferred equity versus debt.
Expensing of Short-Lived Capital Investments
Certain property will now be eligible to be fully expensed in the year acquired. This 100% depreciation deduction is applicable for certain assets purchased and placed in service after September 27, 2017 and before January 1, 2023. After 2022, this deduction begins to phase out, and by 2027, will no longer be available. In addition to allowing full expensing, the Act significantly expanded the type of property eligible for bonus depreciation to now include used property. Historically, only “new” property was eligible for “bonus” depreciation. Note that the used property must have been previously owned by the taxpayer and cannot be acquired from a related party. Accordingly, this faster write-off may provide meaningful additional benefits in the year a fund acquires a business (in an asset deal), but any NOL limitations discussed above should be considered.
In addition, the Section 179 deduction limitation is increased, starting in 2018, to $1,000,000, from $500,000, and the phase-out threshold is increased to $2.5 million, from $2 million. Capital intensive businesses – such as manufacturers – will potentially see a large reduction in federal taxable income in the years to come.
Corporate Net Operating Losses (NOL)
Starting in 2018, there is no longer a two-year NOL carryback, but NOLs can now be carried forward indefinitely, rather than expiring after 20 years, with some exceptions. Also, NOLs – as noted above – can now only offset 80% of taxable income going forward. For example, if a corporation has $10 million of taxable income in 2018 and $20 million of net operating losses carried forward, the corporation will pay approximately $420,000 in federal income taxes ($10 million - $8 million NOL (as limited) multiplied by 21%). Taxpayers need to take this into account when forecasting cash flow, determining estimate tax payments, and preparing financial statements.
In prior years, under the now repealed corporate alternative minimum tax (AMT) regime, corporations could offset 90% of AMT income with AMT NOLs. While the new 80% limitation on the use of regular NOLs will probably have a negative impact, the effect should be somewhat ameliorated by the new lower corporate tax rate. Nevertheless, private equity funds should analyze this provision as it could significantly affect cash flow.
Tax on Foreign Earnings
U.S. portfolio companies with foreign subsidiaries will be required to include in income, for the 2017 taxable year (or the first fiscal year ending thereafter), any foreign earnings that were historically deferred. Earnings measured in cash will be subject to a 15.5% tax rate, and an 8% rate will apply to all other earnings. Although the tax rate is much lower than the corporate tax rate, this may be an unexpected tax expenditure for 2017. The Act does, however, allow taxpayers an election to pay the tax over a period of eight years. Portfolio companies that have offshore subsidiaries with prior year offshore earnings will need to calculate the subsidiaries’ accumulated post-1986 foreign earnings and profits (E&P) as of November 2, 2017 and December 31, 2017 (the “measurement dates”), as well as accumulated tax pools. The larger of the accumulated E&P on the two above measurement dates will be the amount of the income inclusion. This may be a difficult exercise, especially where E&P and tax pools have not been properly tracked in the past and/or the subsidiary has been in existence for many years. As these calculations can be time-consuming, and records difficult to locate (especially older records), we recommend undertaking this analysis sooner, rather than later.
In order to determine the cash versus non-cash E&P, U.S. shareholders will be required to prepare U.S. tax basis balance sheets on a consolidated basis for all foreign subsidiaries at each of the measurement dates and determine cash assets over total assets. The higher percentage of cash at the two measurement dates will be the percentage of the income inclusion taxed at the 15.5% rate. For this purpose, cash includes currency, marketable securities, accounts receivable less accounts payable, term notes receivable with a term of less than one year, commercial paper, and anything else the IRS later determines should be treated as cash. U.S. shareholders of foreign subsidiaries have never been required to prepare consolidated U.S. tax basis balance sheets for all their subsidiaries, so this likely will be a time-consuming exercise which also needs to be addressed promptly.
For calendar year taxpayers, the election to pay the tax on an installment basis and the first installment of tax will be due with the initial due date for the U.S. shareholder’s 2017 tax return, without regard to extensions. Therefore, it is imperative that this issue, if relevant to you, be addressed immediately.
Research and Experimentation Expenses (R&E)
Specified R&E expenses paid or incurred after December 31, 2021 must be capitalized and amortized over five years (15 years for activities conducted outside of the U.S.), and will, at that time, no longer be allowed to be claimed as a current deduction. While not relevant today, fund managers will need to keep this in mind when making investments in businesses that expect to have significant R&E expenditures in 2022 and future tax years.
Choice of Entity
The changes summarized above (and other changes not discussed), raise a number of questions, opportunities, and challenges for fund managers: How should I structure my business? Should I change any of my portfolio companies from a pass-through entity to a corporation or vice-versa? Should I immediately deduct all fixed asset purchases prospectively or on future acquisitions (regardless of entity type)?
Historically, choosing the type of entity was a fairly straightforward, although a bit cumbersome, process. The changes discussed above, including the 20% deduction for flow-through businesses, the reduction in the corporate tax rate, the expansion of bonus depreciation provisions, the implementation of interest expense limitations, and the new carried interest rules may make new entity selection a complicated process. It is important not to presume that forming a C corporation is more beneficial than forming a pass-through entity. The double tax trap still exists, and there are other considerations – including interplay with existing investments, exit strategy and timing, and impact on financing flexibility and ownership structuring – which could impact what is right for you.
Additionally, many changes on the individual side, such as the enactment of “excess business loss” rules, increases in the standard deduction, the limit on deducting state income and property taxes to $10,000, and the increase in the alternative minimum tax exemption amounts, may also play into the entity selection process.
Debt Versus Equity
As noted, with the new interest expense limitations and changes in tax rates, the Act may make debt a less attractive investment for private equity funds. Going forward, if a fund lends to a C corporation portfolio company, the portfolio company (borrower) could take a 21% tax deduction for interest (or possibly none), and the fund and its LPs (lender) could pick up the full interest income taxed at the maximum rate of 37% (depending on type of investor). This is not a good result. As discussed above, preferred equity may be an option, as the portfolio company does not have to dilute their ownership, and the private equity fund may be able to defer the dividend income (no phantom income). Regardless, this matter should be examined closely.
Purchase Price Allocation in Asset Acquisitions
With expanded immediate expensing provisions for capital assets, there may be increased tension between buyers and sellers in taxable asset acquisitions (or deemed asset acquisitions such as Section 338(h)(10) transactions). Buyers will have an increased appetite for allocating a greater amount of purchase price to hard assets, rather than goodwill or other intangibles, which may cause sellers to incur more tax from ordinary income recapture of prior depreciation.
Section 1202 Stock
Although the Act did not modify IRC Section 1202, for private equity funds that invest in middle market companies, there is a special exclusion of the gain on the sale of qualified small business stock (QSBS) that may now be more relevant to you. QSBS is defined as stock purchased at original issuance, has less than $50 million in assets, meets an active business test, and other requirements. For non-corporate taxpayers, the gain is 100% excluded from income for up to $10,000,000 or 10 times the fund’s tax basis, whichever is greater. This can be a tremendous benefit for private equity funds that have not explored this in the past. If the portfolio company profits are taxed at a 21% federal corporate tax rate, and the gain on the QSBS is taxed at a 0% federal tax rate (as opposed to a top rate of 23.8 %), the private equity fund’s after-tax return on this investment could increase significantly. The 1202 stock rules are complex, and fund managers should review if any of their investments would qualify for such treatment.
Stay tuned. We expect many states to decouple from various provisions within the Act as it stands today, some of which include the bonus deprecation, Section 179, and flow-through entity deductions.
What Does CohnReznick Think?
What was standard practice in deal structuring and buying/selling investments in 2017 is likely changed for 2018 and beyond. Taxpayers who understand these rules, plan their business operations, and implement changes will be the real winners. Fund managers need to be proactive, informed, and flexible as they look to maximize the benefits that the Act can clearly provide.
There are also numerous open questions regarding provisions of the Act. While we expect some clarification, it will take time to resolve all open issues. This uncertainty creates opportunity. We will provide additional insights when further information becomes available.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.