With the House version of the tax bill passed by the Ways and Means Committee on November 9, 2017, and a framework with key differences (but no bill text yet) reported out from the Senate Finance Committee, the state of tax reform is in flux. However, if either bill becomes law as currently envisioned, there are a small number of changes targeted at private equity funds and venture capital funds, but a myriad of provisions that will affect owners, employees, and other persons related to PE Funds and VC Funds, with a secondary effect on how funds invest, how business owners are compensated, and how fund managers participate and are compensated.
The three most important points for PE Funds and VC Funds generally are: (i) the treatment of carried interest; (ii) the deductibility of interest income (most relevant to buyout funds); and (iii) changes to the tax rate on pass-through ordinary income generated by a business activity.
We are working with our clients to plan ahead and navigate these waters. Needless to say, the proposals in Congress are just a starting point for tax reform. We expect significant lobbying and other activities to change many aspects of the bills. Below, we outline the relevant changes (or lack of change) in categories.
Returns to Fund Managers/General Partners
- Carried Interest: The House proposal includes holding period changes to the current system of carried interest, with carried interest retaining the favorable flow-through treatment (generally capital gains) only if held for three years for gain to be treated as long-term capital gain. The Senate proposal does not mention carried interest at all, but we expect to see further changes with respect to carried interest.
- Pass-Through Rate Reductions: The House proposal includes a maximum tax rate of 25% on some business income from partnerships for individual investors (subject to a number of limits), but it is not clear how this would apply to fund managers receiving allocations of ordinary income. By contrast, the Senate proposal only promises a “deduction” to pass-through businesses, perhaps indicating that some portion of business income would be exempt from tax.
- Capital Gains Rates: The house proposal provides that long-term capital gains would continue to be subject to lower rates. The Senate proposal does not provide information on what changes will be made, if any, to capital gains rates and thresholds.
- No Changes for QSSB Stock: Neither the House proposal nor the Senate proposal provide changes to the tax treatment of the qualified small business stock, which should continue to qualify for a reduced (or a zero) tax rate on disposition, provided that a number of requirements are satisfied.
Effects on Portfolio Companies
- Reduced Corporate Rate: Both the House and the Senate proposals contain a maximum corporate tax rate of 20% and the elimination of US corporate taxation of earnings by foreign corporate subsidiaries of US corporations, which will affect the returns of funds. It appears the Senate proposal would only lower the rate beginning in 2019.
- Pass-Through Rate Reductions: The rate reductions on pass-through income described above will also be particularly relevant for portfolio companies.
- Limits on Deductibility of Interest: The House proposal disallows the interest expense deduction in excess of 30% of adjusted taxable income (adjusted to be essentially EBITDA). This provision will be most relevant to buyout and mezzanine funds, negatively affecting returns of portfolio companies. Small businesses with gross receipts of $25 million or less per year will not be affected by the interest deductibility limitations. The Senate proposal promises to allow “Main Street” business to continue deducting interest expense, which indicates that larger businesses may be unable to deduct interest expenses.
- Net Operating Losses: Under the House proposal, no NOL carrybacks would be allowed for NOLs generated starting in 2018, with only carryforwards permitted. The Senate proposal does not provide information on what, if anything would be done to NOLs.
- Immediate Expensing: Both the House and the Senate proposals provide that depreciable property other than real estate will generally be subject to immediate expensing, which will provide an immediate deduction and eliminate the complications of depreciation for many businesses.
- Incentive Stock Options: Under the House proposal, incentive stock options (“ISOs”) are not subject to rules regarding acceleration of non-qualified deferred compensation. The Senate Finance Committee’s Policy Highlights does not mention ISOs or other deferred compensation.
While many of these changes will significantly affect the after-tax returns of investors in PE Funds and VC Funds, most of these changes will not likely change the manner in which funds operate. The one notable exception is that the limit on deductibility of interest expense is likely to cause a shift toward PE Funds using preferred equity instead of debt. A change to the holding period for carried interest to obtain long-term capital gain may affect the structure and practices of a limited number of funds, and may more directly affect practices and returns in real estate development, but is not likely to affect portfolio companies (including on the issuance of profits interests) because the longer holding period applies to a limited set of activities that are clearly targeted at funds and not portfolio companies.
Congress and President Trump are under significant pressure to pass a tax reform bill by the end of 2017, which is a very tight schedule for such an important bill. Congressional leaders have indicated that they will pass something by Thanksgiving if at all possible. At the same time, we expect some of these provisions to face intense pressure for change. Given the differences between the House and Senate proposals, the lack of the text of a complete bill from the Senate, and substantial debate about some provisions, the resulting bill is almost certain to look different than either of the current House or Senate proposals and Thanksgiving is a very optimistic deadline.