On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA), the most extensive overhaul of the United States tax regime in over thirty years. The new tax law will have a significant impact upon individual taxpayers in all income tax brackets, all businesses and every sector of the economy, including private equity. This alert provides a brief summary of some of the provisions that are likely to impact private equity, both at a fund level and the portfolio company level, and provides some insight in terms of what private equity professionals should consider in their tax structuring going forward.
Fund Level Considerations
- Carried Interest. The TCJA now imposes a three-year holding period in order to qualify for long term capital gains rates with respect to profits interests held in connection with the performance of services in the business of raising or returning capital, investing in stocks or securities, or “developing” such assets. This limitation likely will capture most private equity “promote” interests. Such interests held for three years or less would be subject to tax at the highest ordinary income rate, which would be 37%. Although most promote interests are held for longer than three years (and thus should not be impacted by this change), capital gains in respect of a portfolio investment disposed of within the first three years of a fund’s life would be subject to these limitations.
- 20% Deduction With Respect to Pass-Through Business Income. The TCJA adds a new deduction for non-corporate taxpayers of 20% of such taxpayer’s share of domestic “qualified business income” from pass-through entities (e.g., partnerships, S corporations, sole proprietorships, etc.). The deduction is limited to the greater of:
- 50% of the W-2 wages of the business or
- 25% of the W-2 wages of the business plus 2.5% of the initial asset basis of the tangible assets of the business
This favorable deduction will increase the incentive to structure funds using pass-through entities, and to limit “blocker” structures to foreign and tax-exempt investors.
- Corporate Income Tax Rate. Corporate income tax rates have been reduced from 35% to 21%. This favorable rate reduction significantly increases the after-tax return to foreign and tax-exempt investors of investing through “blocker” corporations. As a consequence, these types of investors can be expected to find private equity investments increasingly attractive.
Portfolio Investment Considerations
- General. The TCJA is very business friendly and will benefit portfolio companies in many ways, including the reduction of corporate and individual tax rates and the ability to immediately expense certain assets, among others.
- Pass-Through Deductions. As discussed above, the TCJA adds a new deduction for non-corporate taxpayers of 20% of such taxpayer’s share of domestic “qualified business income” from pass-through entities (e.g., partnerships, S corporations, sole proprietorships, etc.). The deduction is limited to a percentage of wages and/or asset basis, and as such, the benefit of this deduction and the new lower tax rates will primarily benefit businesses with large payrolls relative to profits and businesses that make large capital expenditures in depreciable property. To the extent these types of businesses can be held in a pass-through structure (i.e., through a partnership or LLC taxed as a partnership), these types of businesses will become inherently more valuable.
- 100% Expensing Creates Built-in Tax Shield. The TCJA permits 100% expensing of certain depreciable property acquired and placed in service by a trade or business, including active business assets acquired in an asset sale (and, presumably, in a transaction with a Section 338 election). Thus, the new rule will allow 100% expensing of the purchase price allocated to tangible assets, creating an immediate “tax-shield” for businesses with meaningful tangible assets.
- Interest Deduction Limitation. The deduction for business interest would be effectively capped at the sum of business interest income plus 30% of earnings (generally calculated as EBITDA for four years, and EBIT thereafter). Interest not allowed as a deduction is to be carried forward for five years. As a result, highly leveraged portfolio companies will likely need to defer interest deductions to later years, and companies should consider implementing the use of preferred equity instead of issuing debt going forward.
- Territorial Regime. The changes to the international aspects of the tax law under the TCJA essentially create a “participation exemption” relating to dividends received by U.S. corporations from certain foreign subsidiaries and moves the U.S. corporate tax system towards a quasi-territorial regime.
- Portfolio companies should experience significantly less tax “leakage” in repatriating foreign earnings to the United States, and in structuring cross-border transactions with foreign affiliates. The benefits associated with the new “participation exemption” rules are, however, tempered somewhat by certain new anti-base erosion provisions, including particularly a new tax on “global intangible low-taxed income” (“GILTI”) earned by a U.S. taxpayer’s foreign subsidiaries.
- The 2017 year-end retained earnings of a U.S. corporation’s foreign subsidiaries will be subject to a one-time “repatriation” tax of 8% (for property other than cash equivalents) and 15.5% (for cash equivalents), whether or not such earnings are actually distributed. Although this repatriation tax is mandatory, the amount of tax triggered is significantly less than a repatriation at current rates, and will incentivize companies to bring some of that cash back to the U.S.
- The prohibition on guarantees by, and pledges of the stock of, controlled foreign corporations remains in place. As a consequence, foreign subsidiaries generally should continue to be prohibited from making pledges or guarantees to support the acquisition financing of a U.S. parent borrower.
- Net Operating Losses. Net operating losses are deductible only to the extent of 80% of the taxpayer’s taxable income starting in 2018. In addition, while NOLs may be carried forward indefinitely, there will be no carrybacks of NOLs. These rules are only effective for NOLs arising in taxable years beginning after 2017, and existing NOLs are subject to the rules in existence prior to the enactment of the TCJA (i.e., may be carried back 2 years, carried forward 20 years, and offset 100% of taxable income). As a result, newly created NOLs will not be as valuable as they have been in prior years, and taxpayers that engaged in taxable transactions in 2017 with the idea that they would be able to carryback future NOLs to offset any income triggered will not be able to do so.
This alert is intended to briefly summarize some of the provisions of the TCJA that will have an effect upon private equity groups. It should be noted that there are many other provisions in the TCJA which may impact private equity funds in the coming years. Further, Treasury Regulations are expected to be issued in the future, which may change the way some of these provisions operate.