With the passage of the tax reform act (formerly known as the Tax Cuts and Jobs Act or the "Act") by Congress this week and the expectation that President Trump will sign it into law, many of the changes to the Internal Revenue Code (the Code) that impact private equity funds and their investors that have been discussed in connection with tax reform will now go into effect, including the treatment of carried interest, reduction in tax rates, limitations on interest deductions, and the move to a territorial tax system. These changes could impact the taxation of private equity investors and portfolio companies, and as a result, could change the preferred operating and acquisition structures with respect to their portfolio companies.
We plan to discuss the tax reform changes as they specifically relate to private equity in more detail in a webinar that is scheduled for the week of January 8th. Until then, the following is a high-level summary of certain changes and potential impacts that the Act will have on private equity.
Under the Act, certain carried interests will have to be held for more than three years in order to qualify for long-term capital gain rates (for which the highest rate of 20% remains the same). If the applicable carried interests (or any underlying assets) are not held for more than three years, then the gain recognized from the sale of such interests (or gain allocated with respect to such interests from the sale of such underlying assets) will be treated as short-term capital gain, which is subject to ordinary income tax rates (for which the highest individual rate is 37% under the Act). While these changes will need to be considered and monitored, such changes may not be applicable in many situations because private equity funds generally have an investment horizon of more than three years.
Reduction in Tax Rates
New Effective C Corporation Tax Rate The Act permanently reduces the corporate tax rate to a flat 21% beginning in 2018. When combined with the maximum 20% tax rate on qualified dividends paid by a C corporation to an individual shareholder, the effective tax rate on income of a C corporation distributed to its shareholders will be 36.8% (or 39.8% after the 3.8% Medicare tax on dividends).
New Effective Partner Tax Rate The Act reduces the maximum individual tax rate to 37%, beginning in 2018 (subject to sunset at the end of 2025). In addition, the Act provides in certain cases a deduction to individual partners generally equal to 20% of the partnership’s U.S. business income (the "Section 199A Deduction"). However, for an individual partner with income over $315,000 (or $157,500 if the partner does not file joint returns), the Section 199A Deduction is subject to a limit based either on W-2 wages paid or W-2 wages paid plus a capital element. In such a case, the Section 199A Deduction is limited to an amount equal to the greater of (a) 50% of the W-2 wages paid with respect to a "qualified trade or business" and (b) the sum of 25% of the W-2 wages with respect to the "qualified trade or business" plus 2.5% of the unadjusted basis (determined immediately after an acquisition) of all "qualified property" held by the "qualified trade or business" at the close of the relevant tax year.
Table of Effective Tax Rates Before and After the Act As the table below shows assuming an individual partner is in the highest tax bracket, the effective tax rate spread between a C corporation and a partnership has been decreased slightly if the full Section 199A Deduction is available or even flips in the extreme case if no Section 199A Deduction is available.
Observations Prior to the Act, the 48% (or 50.47% after the 3.8% Medicare tax on dividends) effective double tax rate, combined with the premium that could be received for tax basis step-up on exit, often resulted in private equity funds preferring to have their portfolio companies classified as pass-through entities for U.S. federal income tax purposes (e.g., partnerships or disregarded entities). While the Act also reduces the highest individual tax rate to as low as 29.6% for pass-through business income for taxpayers entitled to the full amount of the Section 199A Deduction, the relative advantage that partnerships had over C corporations has been reduced and can even be eliminated in cases where the Section 199A Deduction is materially limited. As a result, private equity funds with individual investors will need to consider the impact of the reduced rates and the anticipated Section 199A Deductions to determine the optimal structure for investing in and disposing of their portfolio companies.
Interest Deduction Limitation
The Act imposes a new limitation on interest expense deductions for all business taxpayers, including private equity funds and their portfolio companies, for all tax years beginning in or after 2018 if average annual gross receipts for the three-tax-year period ending with the prior tax period exceed $25 million. The Act limits net interest expense deductions of an entity to 30% of its "adjusted taxable income." "Adjusted taxable income" is taxable income computed without regard to:
- business interest expense,
- business interest income,
- the 20% deduction for pass-through entities,
- net operating losses, and
- for taxable years prior to 2022, depreciation, amortization, and depletion.
The limitation is calculated and applied separately for each entity, in a manner that is intended to avoid double-counting. For example, in calculating the limitation on a private equity fund’s ability to deduct its own interest expense, the fund would take into account net income allocated to it from a subsidiary partnership only if the subsidiary partnership’s interest expense fell short of 30% of the subsidiary partnership’s adjusted taxable income, and in proportion to that shortfall. Similarly, an investor of the fund would take into account net income allocated to it from the fund in calculating the limitation on the investor’s interest expense only if the fund's interest expense fell short of 30% of the fund's adjusted taxable income, and in proportion to that shortfall.
Disallowed interest expense allocated to an investor can be carried forward indefinitely, to a year in which the investor's share of the fund's interest expense does not exceed 30% of the investor's share of the fund's adjusted taxable income. The disallowed interest expense immediately reduces the investor's basis in the fund, but any amounts that remain unused upon disposition of the interest in the fund are restored to basis immediately prior to disposition.
This interest deduction limitation could result in less debt being used in certain leveraged acquisition structures with respect to portfolio companies and dividend recapitalizations. Private equity funds now will need to take this interest deduction limitation into account in modeling the expected tax impacts and benefits of debt, and this limitation could lead to the use of more preferred equity.
Under the Act, the bonus depreciation percentage is generally increased to 100% (from its current level of 50%) for property placed in service after September 27, 2017 and before 2023. After 2022, the bonus depreciation percentage is phased-down to 80% for property placed in service in 2023, 60% for property placed in service in 2024, 40% for property placed in service in 2025, and 20% for property placed in service in 2026. Importantly, the Act expands the availability of bonus depreciation to non-original use property, as long as it is the taxpayer's first use. Accordingly, a portfolio company that acquires assets may be able to deduct a significant portion of the purchase price, as compared to the acquisition of the equity interest of a target business.
Sale of Foreign Investor’s Interest
Under the Act, gain or loss realized by a foreign corporation or a foreign individual from the sale or exchange of an interest in a partnership engaged in a U.S. trade or business is treated as effectively connected with a U.S. trade or business to the extent that the sale of all the partnership assets would have produced effectively connected gain or loss. This provision applies to sales, exchanges, and dispositions occurring on or after November 27, 2017. This provision repeals the result in Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (2017), where the Tax Court held that a foreign partner was not subject to U.S. tax on sale of a partnership interest, rejecting the holding of Rev. Rul. 91-32 to the contrary.
After the Tax Court's decision in Grecian Magnesite, private equity funds and their investors were considering alternative structures for the foreign investors to hold their investments in the fund. As a result of the legislative repeal of Grecian Magnesite, those structures should no longer be pursued.
Territorial Corporate Tax System
Another one of the more notable changes in the Act is the shift in the corporate tax system from a worldwide tax to a territorial tax system. Under this new territorial system, a U.S. corporation generally will not be subject to U.S. federal income tax on dividends received from foreign corporations or gains recognized from the disposition of foreign corporation stock to the extent that such dividends or gains are attributable to foreign earnings and profits and the U.S. corporation owns 10% or more of the foreign corporation. This is a significant change from the worldwide tax system currently in place, which would subject a U.S. corporation to U.S. federal income tax at 35% on such dividends or gains and then allow the U.S. corporation a foreign tax credit for foreign taxes incurred on such foreign earnings and profits. This worldwide system ultimately resulted in foreign earnings and profits being subjected to a minimum worldwide tax rate of 35%. The new territorial system will generally cause most foreign earnings and profits to not be subject to any additional U.S. corporate tax.
Under the worldwide tax system, portfolio companies that operated in pass-through entities generally preferred to hold foreign operations through foreign entities that were also pass-through vehicles for U.S. federal income tax purposes. Such a structure allowed individual investors to be able to claim foreign tax credits to offset the U.S. federal income tax liability attributable to the foreign operations, which helped prevent double taxation of the foreign earnings and profits. This shift to a territorial tax system, together with the inapplicability of the Section 199A Deduction previously discussed to non-U.S. business income, could lead to a preference by funds to have their portfolio companies with foreign operations hold such operations through foreign corporations wholly-owned by a U.S. corporation, even if the portfolio company operates in pass-through form with respect to its U.S. business and operations. This structure may allow the foreign earnings and profits to be taxed at an effective worldwide tax rate that is lower than the highest individual rate of 37%.