How the Tax Reform Is Affecting U.S. Private Equity Funds
President Donald Trump’s reform bill, known as “Tax Cuts and Jobs Act” (the Act) came to the American people on Dec. 22, 2017 when he signed it into law. The ACT will benefit business owners big and small and give individual taxpayers a slight break in 2018. There are many changes to the law, especially changes within private equity funds. Consequently the tax reform will not only affect the private equity fund, but also their managers and investors. Some of these new changes include:
- New three- year holding period for carried interest
- Lowered income tax rates for businesses and their balance sheet impact
- Ability to write off the cost of all depreciable assets acquired
- New interest expense limitation to 30% of EBITDA
- Limitation on NOL usage
- Effect on the buyout market of lower taxes and the mandatory repatriation of offshore funds
- Partnership interests owned by foreign partners
The extent to which a private equity fund is leveraged will determine how much or how little their tax position has altered. The biggest tax change that most funds will see will be the new three-year holding period that a fun most do in order to receive long-term capital gains on carried interest. Obviously this will need to be considered when wanting to withdrawal or close a fund.
Carried interest is a share of any profits that the general partners of private equity and hedge funds receive as compensation, regardless of whether they contributed any initial funds. As you can see carried interest affects the taxation on the return profit to the managers of the fun and doesn’t tax the fun itself. Some feared the tax reform would view the gain/returns paid to the managers would be considered ordinary income that was earned from their work. This would result in a higher tax percentage on the carried interest. This did not happen and instead the final outcome of Trump’s tax law required that a funds general partner hold the applicable investments for three years.
Listed below are some of the changes/details under the Act, New Code section 1061.
Applicable partnership interest- gains are considered short-term capital gains; which are taxed at an ordinary income rate. Previously they were taxed as long-term capital gains- to the extent that gains relate to property that doesn’t have a holding period of longer than 3 years.
- Applicable partnership interest is defined as a partnership, which directly or indirectly, is transferred to a taxpayer in connection with the performance of “substantial services” by the taxpayer or by a person related to the taxpayer. Partnership interests held by a corporation and interests that are received in exchange for a capital contribution are excluded from this definition.
- Applicable trade or business is defined as the activity of raising or returning capital and investing in or developing “specified assets.”
- Specified assets- are securities; such as, commodities, real estate, shares of stock and promissory notes, cash or cash equivalents, options or derivatives and partnership interests but only to the extent the assets of the partnership are comprised of the preceding items.
Most private equity funds will be held to these new laws except for the ones owned and operated as C or S corporations for tax purposes. For manager and private equity funds that hold their assets longer than three years they will not see much of a difference in carried interest tax; however that will not be the case for those who receive carried interest in hedge funds. Where these funds usually have a short-term trading period this new law will affect their access to long-term capital gains. But the trading history for many hedge funds have historically been short, consequently they were never able to obtain long-term capital gain anyway.
This new law has placed importance on attentive calculation of the applicable holding period. When purchasing stock in a corporation the holding period begins on the day of the purchase, likewise, when purchasing share in that stock the holding period begins on the day of the purchase. The same goes for the holding period for interest in an LLC or partnership. It begins on the date of purchase/issuance, but the holding period for interest in the partnership is split in proportion to the interest amount gained on each date. For example, if a partner invests in a partnership in Year 1 for a $100 capital contribution and in Year 2 for $300, upon a sale of the interest that is three years after the Year 1 investment, only 25% of the gain will be considered to have been derived from property with a three-year holding period. Likewise, in a partnership interest if ownership were increased through purchases over time, gain on the sale would be prorated across the holding periods arising from each purchase. It is impossible to connect what part of interest belongs to what specific holding period of a partnership interest.
The problem with the new Code section 1061 is that there are many unanswered questions about the loopholes it has created. A big question is does this rule apply to both gains that flow through a fund up to a manager or general partner, as well as gains that might be realized by a manager or general partner upon sale or redemption of its interest in the fund. The statutory provision (new Code section 1061) applies to “gain with respect to” the applicable partnership interests, which covers both gains from disposition or redemption, as well as earnings on the assets of the partnership. But what happens when some of the gain comes from managers interest from a three-year holding period but the holding period on the partnership/portfolio companies for the stock is shorter?
It is thought that the carried partner could not get ahead by selling the partnership interest rather than the partnership’s assets. But if a taxpayer transfers any applicable partnership interest to a person related to the taxpayer, the taxpayer shall include in gross income, (as short term capital gain) any interest of any asset not held for longer than three years. It is believed that the carried partner’s transfer to non-related party will be treated as entirely long-term capital gain regardless of the shorter holding period, regarding assets. It is also believed that that law views the sale of assets the same as the sale of an interest by a partnership and depending upon the level at which the sale occurred it is hard to believe differently.
Interest Received for Combination of Services and Capital
Another loophole in the tax law is how the carried partners interest earnings is defined. It has always been believed that it is a result mostly from the performance of services. The new law applies to gains received with respect to applicable partner interest which insinuates interested earned for the managers performance of substantial services. It is unclear what part of the interest can be excluded from the interest earned for capital contributions. Many have concluded that the gains are then prorated between the interest that was received for the performance of services (API) and the interest that was received in exchange for the capital contribution, with the three-year holding period requirement only being applied to the proportionate share of the gains with respect to the performance of services. It will be difficult to determine the difference between the amounts of the return received by performance services as compared to the amount received with respect to capital (even if partial application is allowed).
Avoidance of the Rule if all Portfolio Companies are Partnerships
What is the definition of specified assets? It includes “an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing [specified assets]”, ex, real estate, securities, cash or cash equivalents, commodities, and options and derivatives. How does the law deal with partnership interests as “specified assets?” The partnership must invest, all or part of, in specified assets, for the three-year holding period requirement to apply. One way private equity funds can avoid the tax is by turning the funds portfolio company into an LLC that is a partnership for tax purpose, only having a specified asset if the portfolio company already them. A portfolio company that does not invest in real estate and is not a holding company would not have very many, if any specified assets as well. If a fund does not have specified assets then it is not in an applicable trade or business, and if that fund is only invested in operating partnerships it does not meet the requirements for the three-year holding period. Keep in mind that this does not apply to funds invested in both S and C corporations where applicable trade or business is established or if the fund invests in ANY part in specified assets; such as cooperate stock.
Portfolio Company Employees May Avoid the Three-Year Requirement
Another loophole in the tax law is when the manager receiving the interest is also an employee of another entity affiliate. “Applicable partnership interest” does not apply to an interest held by a person employed by another entity that is managing a business/trade and who only provides services to that other entity. Many believe this exception was written because that certain employee may not be providing services for the fund and therefore his taxes should be held accordingly. So this is useful to an employee who receives benefits for their services through the form of a profits interest in the fund that has invested in that said portfolio company. The exception would not appear to be available in situations where managers are also employees of the management company and receive a partnership interest in the fund. The employment needs to be with a business that is not an investment management business. Because the definition of applicable trade or business states, “regardless of whether the business is conducted in one or more entities,” it is impossible to separate the fund itself from the regular management company for the private equity fund when trying to use the employee exception.
Interest Expense Limitation
Under section 163(j) the Act restricts the deduction for interest expense by corporations and puts in place analogous rules to limit the amount of the business interest deduction by pass-through entities. For corporations, the Act limits deductible interest to an amount equal to the corporation’s interest income plus 30% of the corporation’s earnings before reductions for interest, depreciation and amortization (termed “adjusted taxable income” but comparable to EBITDA) until 2022 and thereafter further restricts the deduction to 30% of earnings after depreciation and amortization (comparable to EBIT, i.e., a lower number). The rules do not apply to businesses with average gross receipts for the prior two years of $25 million or less, electric cooperatives and regulated public utilities.
The Acts rules limit the interest deduction by businesses in partnership form and the interest deduction cap is applied to partnerships at the partnership level. If the partnership has unused interest expense limitation, they can use this surplus, as long as the partner ignores the partner’s distributive share of all items of income and deduction. However, if the cap limits an interest deduction, the extra interest expense is given to the partners (is not treated by the partnership as interest expense) and is carried over next year for the partnership. Instead, the partner treats it as additional deductible interest expense of the partner the following taxable year so that the partner is allocated excess limitation from the partnership.
It is unknown how the interest deduction limitation will affect the private equity business. It clearly makes sense that borrowing to finance acquisitions or growth is better when interest is entirely deductible. Capitalization through equity issuances will be preferred if earnings are low enough to trigger the new interest deduction cap. Most private equity funds and their portfolio companies borrow money but now that they need to consider the earnings expectations may limit their ability to deduct interest expense they may shift from debt and use more preferred equity. If this happens it will put pressure on the characterization of such preferred interests as equity. Previously, a partner’s taxable income could be reduced by the same amount regardless of whether it was because of the partner’s share of the partnership’s interest deduction or because additional equity had weakened the partner’s interest and taxable income was being distributed away from the partner and to the new equity. Hence, the characterization of the preferred interest in a partnership as debt/equity was generally without a tax consequence. Now, the interest deduction might be limited whereas the allocation of taxable income to the preferred partner would reduce the non-preferred partner’s taxable income dollar-for-dollar. Because of this new risk, the new Act will require vigilant predictions and demonstrating.
The new Law may need to reexamine the structure when foreign and tax-exempt investors invest in funds through a U.S. blocker corporation and then financed those investments with leverage applied at the blocker level. This type of a U.S. corporate blocker would be accountable to the interest expense limitation rules however leverage at the foreign or tax-exempt investor level would not.
Under the new law Act, 100% (previously 50%) first year bonus depreciation is allowed for qualifying assets placed in service between September 28, 2017 and December 31, 2022. To qualify for this depreciation property must: fall within the definition of “qualified property”, be acquired by the taxpayer after September 28, 2017, and be placed in service between Sept. 28, 2017 – Dec. 31, 2022. Quality property is defined to include: property depreciated under the MACRS with a 20 year or less recovery period, specified plants, water utility property, some computer software, and qualified film, television and live theatrical productions.
After the first year, the bonus depreciation is phased down by 20% each year for four years until it expires at the end of 2026. They are delayed a year for certain property with longer production periods and aircraft.
Surprisingly the gaining of used property is eligible for bonus depreciation IF the property wasn’t used by the tax payer before the gaining of the property and they can not be a related person or entity. Hence, a taxpayer can write off the purchase price immediately after purchasing operating and in service used property.
The previous depreciation laws apply to any property that was acquired before September 27, 2017 (50% bonus in 2017, 40% in 2018, and 30% in 2019.) If the property’s acquisition was subject to a binding written contract it will be subject to the older and less favorable laws determined by the date of said contract. The property could obtain the new rules if another taxpayer purchases it after September 27, 2017.
The availability of 100% bonus depreciation for even used assets is yet to be determined as a positive change. There will be lots of mergers, buying and selling for capital asset-intensive industries. The tax-effected purchase price is reduced if a buyer can immediately expense the capital assets. Consequently a seller may list a higher purchase price and/or require the buyer to split some of the tax windfall.
Tax Rate Changes
Tax Rate Drop for Corporations
The federal corporate rate dropped from 35% to 21% under the latest version of the bill. While this rate is beneficial to corporate taxpayers, careful considerations will need to be made for portfolio companies when deciding what is best for them.
The Act also revokes the corporate alternative minimum tax but it does allow taxpayers to claim a refund of any remaining minimum tax credit that would have usable in the future under the old rules. (50% refund in 2018-2020 and 100% refund beg. 2021
The balance sheets are remarkable as a result of the tax rate cut. Companies that have created DTA’s (deferred tax assets) due so when taxes are paid and carried forward but not recognized in the income statement. The opposite occurs with DTL’s (deferred tax liabilities) as they reflect taxes that will be due on future taxable amounts and can increase taxes. Both items are measured using the tax rates expected to be in effect when the deductions or liabilities are completed. The value of a DTA will be cut and the exposure from a DTL will be reduced as a result of the corporate tax rate drop. Companies with considerable DTAs must record a charge to earnings when they write down the value of those assets and companies with considerable DTLs will report a big one-time earnings gain as they write down the amount of their liabilities. The write down will not be positive for private equity companies that have valued DTAs in their earnings multiples for buyout purposes; however, it may be alleviated by the benefit of the ongoing lower tax rate on earnings.
Tax Rate Drop for Pass-Throughs
Many people ask what about the smaller business’s and their tax cuts. Can they receive similar tax breaks like the large corporation? The answer is yes, Congress reduced the tax on income from “pass-throughs,” (ex. S corporations, partnerships, LLCs taxed as partnerships, and sole proprietorships. This is done by allowing taxpayers to take a deduction from income of 20% of the “qualified business income” received from pass‑throughs. The other 80% of the pass-through income is taxed at regular rates.
There is a limit on the amount of income allowed deducted; it is limited to the pass-through owner’s share of certain jobs-related amounts. Then the limit on the amount is whatever is greater of (i) 50% of the pass-through business’s payroll (W-2) amount or (ii) 25% of the payroll amount plus 2.5% of the unadjusted basis of the business’s assets to the extent such assets consist of “qualified property.”
The second formulation of the limitation restricts the deduction to 25% of payroll plus 2.5% of the “unadjusted basis” of the business’s assets, allowing capital- intensive businesses a chance at the deduction. This is beneficial to businesses in pass through-form with few employees and decent investments in capital assets. Note that the limitation is based on the unadjusted (i.e., undepreciated) basis of “qualified property,” which is defined as tangible, depreciable property held for use in the trade or business, subject to an age limit of the later of 10 years or the last year of the cost recovery period.
Partners in service business (defined as a “specified service trade or business”) making a certain income are not able to access the deduction. Now a specified service trade or business is defined to include the provision of services in the areas of: athletics, accounting, consulting, health, financial services, law, performing arts, actuarial science, brokerage services or “any trade or business where the principal asset of such trade or business is the reputation nor skill of one or more of its employees.”
Investing and investment management, trading and dealing in securities, commodities or partnership interests is also included as a specified service trade or business; however architectural and engineering services are exempt form the definition. With the unclear guidelines many are hoping the IRS will give direction on this situation.
Most likely owners of a management company in pass-through form that provide services to a private equity fund will not be able to use the deduction since investment management is under the definition of specified services.
Remember that the business earnings is business income exclusive of capital gains and dividends (which are currently taxed at lower rates anyway). Therefore, if the income running to the management company through its carry is capital gains, it wont be necessary to worry about the loss of the deduction
Impact on Choice of Entity Decisions
Most private equity businesses will not qualify for the 20% pass-through deduction and most funds will be an investment management business under the definition of service business; therefore, not able to receive the deduction (minus the partners below the specified income amount.) This results in corporate earnings around 37% imposed on individuals receiving pass through income, and portfolio companies in partnership or corporate form funds around 36.8% rate. With such a minimum difference it is likely there will be any change.
Net Operating Loss Usage
Before the Act, “NOL’s” (Net Operating Losses) could be transferred back to reduce tax to zero in previous years, but now they can no longer do that. Now they can be used against a maximum of 80% of income and goes into affect January 2018. There is unlimited carryforward to any future years with the portion of NOL’s limited by the new 80% cap. For example the full 20% of any NOLs disallowed can be carried forward indefinitely whereas previously the carryforward was limited to 20 years. Investors may think twice about buying into turn-around situation because of these limitations.
In addition the Act continues with more limitations, this time on the individual tax payer’s capability to deduct net operating losses that flow through to the taxpayer from pass-through procedures. Management company owners’ abilities to use losses passed through from portfolio companies in partnership form will be limited because the Act prohibits a deduction for business losses in excess of business income plus $250,000.
Portfolio Company Management Compensation
Code section 162(m) enforces a limitation on publicly traded corporations, on the deductibility of compensation above $1 million, including performance-based compensation. Having this law present may have an influence on the optics of providing compensation of this amount to portfolio company management teams, even when the company is not publicly traded.
Partnership Interests Owned by Foreign Partners Subject to U.S. Tax on Sale
The Act states that gain or loss on the disposition of a partnership interest by a foreign partner is treated as effectively connected income and subject to tax in the United States if the partnership itself is engaged in a U.S. trade or business. The seller must certify that the buyer is not a foreign person or else a withholding tax is imposed on the seller. In the report it states that it is intended that regulations be promulgated that will allow a broker, as agent of the buyer, to deduct and withhold 10% of the sales price on behalf of the buyer. This was created to override the results of the Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (July 13, 2017). That case concluded that a foreign person’s gain on a sale of an interest in a partnership is not taxed even if it’s operated in the US.
The provision applies as of November 27, 2017, while the withholding tax obligation only applies after
December 31, 2017. This provision affects sales of interests in portfolio companies, in partnership form, private equity funds, and in some structures, sales of the interests in fund management companies.
Impact on Market from Rate Cut and Repatriated Cash
The Act is designed for the US to have more of a territorial tax system by taxing only earnings for US procedures (internal taxation). In the past, profits most by foreign companies wouldn’t have to pay US tax until said earning were dispensed to the US parent; consequently, US businesses have loads of untaxed foreign profits offshore. The Act enforces a one time mandatory tax on them, and then repatriation of the cash to the US parent wouldn’t be taxed. The tax rate is 15.5% on cash equivalent assets and 8% on non-cash assets. The tax is inflicted on the larger earnings of the foreign subsidiary as measured on either November 2, 2017 or December 31, 2017. After corporations have paid this tax on their foreign profits, they should bring the cash back to the United States, where it will no longer be taxed.
US companies are estimated to have about $3 trillion in untaxed offshore profits. If those profits, or even part of those profits come back to the US, multinational banks and companies; such as, Apple and Citibank can get some of that money. This may be just the token for these companies to get ahead and compete against private equity funds for the open contracts.
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