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Seven Tax Tips Private Equity Firms Should Consider for 2011


As we bid farewell to 2011, private equity funds and their accountants will scour aspects of existing portfolios and pending transactions in search for possible tax savings opportunities before the new year. For this reason, Limited Partners like to know that fund managers are on top of tax issues, planning accordingly, and maximizing returns. Naturally, fund managers focus on the broad economic environment when making fund decisions, but a comprehensive tax strategy can be a great profit driver.

Below we outline seven tax tips focused on portfolio company transactions to consider before filing 2011 in the books:

  1. Cancellation of Debt Income ("COD Income") - With the economy in recovery mode, many portfolio companies have been restructuring their debt positions. If a portfolio company is structured as a partnership, relief of liabilities from the portfolio company's lender would generate income to the fund. Consider postponing this COD income until 2012.
  2. Worthless Securities - If a portfolio company has become worthless during 2011, the fund may write off this investment for tax purposes and possibly reduce other 2011 gains realized. The portfolio company must not have any value at year end and no reasonable expectation of value in the future. Going out of business, bankruptcy, and abandonment of assets are some examples of events that can cause an investment to become worthless. The rules are stringent on taking losses, so careful examination of the facts and available documentation is important.
  3. Carried Interest Legislation - The recently proposed American Jobs Act of 2011 proposes to treat income attributable to a carried interest as ordinary income (the highest rate is currently 35 percent). As a result, fund managers should consider carefully the timing of recognizing gains if possible to take advantage of the current long-term capital gains rate (15 percent).
  4. Proper Use of Tax Elections - For income tax purposes, the use of certain tax elections may be beneficial. For example, a 338 election may provide benefits attributable to a stock sale by treating it as an asset sale. An asset sale could result in larger depreciation and amortization deductions and possibly increase the after-tax cash flow of the company (i.e. increase shareholder value).
  5. State Taxes - Since many portfolio companies do business in multiple states, fund managers should focus on possible state filing obligations for the fund and portfolio company. For example, if the fund owns a company (pass-through entity) that operates in states where the investors are not located, the fund may be required to file in these states. In some circumstances, the investors could also be required to file in many states. Getting a handle on state filing obligations now can avoid a surprise for investors come tax filing time.
  6. International Taxes - Funds should be aware of possible international filings if either they a) own an interest in a foreign entity or b) have an investor who is a non-U.S. taxpayer. Non-compliance with international tax filings could result in significant penalties. For example, a penalty for late filing of a return could be as high as 25 percent of the unpaid tax. In addition, there has been a lot of buzz about the Foreign Account Tax Compliance Act ("FATCA"). FATCA requires non-U.S. financial institutions and non-U.S. entities (including offshore investment funds) to provide information to the IRS identifying U.S. persons invested in non-U.S. bank and securities accounts. The legislation is motivated by incidents of U.S. persons failing to report foreign-source income for U.S. income tax purposes. A 30 percent withholding tax applies on any "withholdable payment" made to a foreign financial institution ("FFI") unless the FFI agrees with the Internal Revenue Service to take a number of specific steps pursuant to an FFI agreement. The specific steps are designed to ensure that U.S. persons are identified and U.S. tax is imposed on their investment income.
  7. Dividend Income - For funds that may receive a large dividend before year-end, inquire whether the dividend is considered "qualified." The dividend must be paid by a U.S. corporation or qualifying foreign corporation and be held for 120 days starting with 60 days before the ex-dividend date. Some distributions such as capital gain distributions and dividends from tax-exempt corporations are not qualified dividends. (IRS Publication 550 has a full list of non-qualifying dividends.) The current law states that qualified dividends are taxed at a maximum rate of 15 percent instead of 35 percent.

In addition to the above, The American Jobs Act of 2011 and the Budget Control Act of 2011 are two pieces of important proposed tax legislation that can affect private equity funds. Under the Budget Control Act, the "Bush tax cuts" are set to expire at the end of 2012. This would end preferential tax rates for "qualified" dividends and long-term capital gain rates, and move them to 35 percent (highest bracket) and 20 percent from 15 percent and 15 percent, respectively. Under the American Jobs Act, as stated above, carried interest would be taxed at ordinary income tax rates.

For more information about this or other matters that may impact your business, please contact Dom Esposito, leader of J.H. Cohn's Private Equity initiatives, at desposito@jhcohn.com or 212-297-0400.

Download the full PDF.

Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters. 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 J.H. Cohn 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.

Published date: 12/21/2011

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