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Private Equity - Untangled: What the New Tax Provisions Mean to You

Key Takeaways

  • The American Tax Relief Act of 2012 (ATRA) will have a significant impact on private equity deals not only for purposes of tax planning but for investment timing and strategy as well.
  • Opportunities and challenges of the Act include the impact of new tax rates, installment sales nuances, the state of the Alternative Minimum Tax, and ATRA’s extension of the 50 percent bonus depreciation rules.

In his economic overview of the new tax provisions that Congress agreed on before the clock struck 12:00, Patrick J. O’Keefe, CohnReznick’s Director of Economic Research, says that the “American Tax Relief Act of 2012 (ATRA) adds some level of certainty to the tax code. Many of ATRA’s policy changes permanently extend what had been temporary exemptions or fixes.  Some of these changes accompany tax increases while others provide systemic relief. There is a real benefit from the longer-term stability implicit in these ‘permanent’ fixes: By giving businesses and households added confidence, it should bolster their willingness to invest and spend.”

As a private equity investor, seller or fund manager, you are likely wondering how the recently enacted ATRA provisions will specifically affect you. In fact, ATRA will have a significant impact on private equity deals not only for purposes of tax planning but for investment timing and strategy as well. You will be interested in learning about the opportunities and challenges that lie ahead – including the impact of ATRA’s new tax rates, installment sales nuances, the state of the Alternative Minimum Tax and ATRA’s extension of 50 percent bonus depreciation.

Permanent Extension of Tax Relief
One of the main provisions of the Act extends the Bush era tax cuts for those not considered “high earners”—individual filers with taxable income at or below $400,000, heads of household with taxable income at or below $425,000 and married filing jointly and surviving spouses with taxable income at or below $450,000. Those not considered “high earners” will also continue to have dividends and long-term capital gains taxed at 15 percent. Those in the “high earner” category, however, will have their marginal tax rate on ordinary income (and short-term capital gains) increase to 39.6 percent and their dividend and long-term capital gains rate increase to 20 percent starting January 1, 2013.

Impact on sellers
Under the provisions of ATRA, sellers may be further incentivized to sell shares for long-term capital gains, given that ordinary income above the “high earner” thresholds is taxed at approximately twice the long-term capital gains rate. Even when shares are being sold for long-term capital gains, however, the new rates can also be expected to exert upward pressure on share prices, as “high earner” sellers look to recoup some of their increased tax liability with the long-term capital gain rate increasing from 15 to 20%. However, if sellers cannot negotiate higher prices for their shares, they may be willing to keep a greater piece of a deal if it includes a preferred return that would qualify as a dividend subject to the 20 percent capital gains rate instead of receiving employment, non-compete or consulting income, which would be taxed at 39.6% for “high earners.”

“High earners” who sold shares in 2012 need to do some strategizing: Installment payments received in 2013 and after from pre-2013 sales pay higher 20% long-term capital gains rate - so sellers may want to consider electing out of installment sales treatment for 2012 sales when preparing their 2012 returns. The fact that a sale took place in 2012 or before but is reported on the installment basis for payments received after the year of the sale does not subject the installments received after 2012 to the 15% long-term capital gains rate applicable to long-term capital gains in 2012 and before.  However, if the recipient of those installments in 2013 or a later year is a “high earner” in such years, the installments received in 2013 and after are taxed at the new 20% federal long-term capital gains rate unless the seller specifically elected out of the installment sale method of reporting in the return for year of the sale. Accordingly, those with 2012 sales should calculate their tax liabilities both with installment sales reporting and without to determine which method produces the lowest liability. Remember to take into account the time value of money for the tax that would be accelerated versus deferred under the installment sales method. It is important to keep in mind that the reporting method chosen for Federal filing will likely carry over to state filing as well with many states following federal tax treatment. (Those with sales in 2011 or before are likely stuck with the treatment they chose when they filed their taxes for the year of sale. An amended return to elect out of installment reporting must be approved by the IRS—and is not permitted where the motive is to avoid taxes.)

Impact on investors, fund managers and private equity firm management
ATRA will affect investors and fund decision makers both in terms of investment strategy and compensation policy. “High earner” investors and fund managers will need to recalibrate their internal rate of return (IRR) models to take into account the higher tax rates. A resulting decrease in IRR is likely to set off a search by decision makers for increased efficiency from labor, systems/processes and, to the extent a company’s market will permit it, increased prices to customers.

To maintain the same after-tax IRR to investors despite the increase of capital gains to 20 percent, fund managers will be under more pressure to favor asset purchases rather than stock purchases. As they have in the past, investors and fund managers will try to allocate as much of the purchase price to assets and inventory that depreciate over shorter periods. Fortunately, IRS regulations do not require sellers and buyers to allocate the purchase price amongst the individual assets in the same manner if they do not agree to the purchase price allocation in the deal documents.

As for compensation, “higher earners” in the management group that take part in a deal are likely to either want an increase in their cash compensation (to offset their higher ordinary income tax rates), or want their compensation structured so that more of it is subject to the lower 20 percent  capital gains and dividends  rate. This will mean more in restricted stock or preferred stock with a cumulative dividend feature and less in stock options where the spread between the exercise price and the market value at exercise date is taxed at ordinary rates. In addition, fund managers and sponsors may decide to forego more of their usual fees and take greater amounts of carried interest, given that carried interest still is taxed as capital gains.

However, remember that the benefits of the capital gains and dividends rate is somewhat mitigated by the Affordable Care Act’s (ACA) 3.8 percent tax on net investment income, which generally applies to capital gains and dividends. Further, the ACA’s net investment income tax applies at a lower threshold (for example, $250,000 for a married couple filing jointly) than does the “high earner” tax rates.

Permanent individual alternative minimum tax (AMT) relief
ATRA increases the AMT exemption amounts for 2012 to $50,600 for individuals and $78,750 for married couples filing jointly and indexes the exemption and phase-out amounts thereafter for taxable years beginning after December 31, 2011. The Act also allows certain nonrefundable personal credits against the AMT.

The Act does not alter the capital gains tax rate a “high earner” seller in AMT will pay on his or her long-term capital gains. The 20 percent maximum federal long-term capital gains rate for high earners will apply versus the maximum 28 percent marginal AMT rate. However, some speculate that during the ongoing negotiations in Congress on spending, a proposal may be made to replace the  AMT with the “Buffett rule”, in which taxpayers making over $1 million annually would pay at least a 30 percent effective tax rate. If adopted, it may mean the end of the 20% capital gains rate for “high earners.”

Private equity taxpayers may also want to consider other ATRA provisions that may be of interest including the Research and Development credit, credits for hiring certain veterans or targeted groups and the extension of the 50% bonus depreciation provision. Bonus depreciation can significantly impact cash tax rates – for a more in depth analysis of ATRA’s bonus depreciation provisions, please click here.


For more information, please visit the CohnReznick Private Equity and Venture Capital webpage or contact Sharon Bromberg at 732-635-3128.

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.


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