On December 22, 2017, President Trump signed into law a bill generally referred to as the Tax Cuts and Jobs Act (the Act). The Act makes significant changes to the federal income tax laws for both individuals and entities. This alert summarizes the principal provisions of the Act expected to impact the private equity industry including managers, investors and portfolio companies.
The Act permanently reduces the corporate tax rate to a flat rate of 21% for tax years beginning after December 31, 2017. This rate combined with the maximum tax rate on “qualified dividends” generally paid by corporate portfolio companies will cause the effective tax rate on income from corporate portfolio companies to be 36.8% (or 39.8% after the 3.8% Medicare tax on dividends).
The Act temporarily reduces the maximum individual tax rate to 37% until the end of 2025. Individual partners of funds or target pass-through entities may have a lower effective tax rate depending on whether they can take a 20% deduction on their pass-through business income. The deduction is also temporary and expires at the end of 2025. Individual business owners who are able to take advantage of the full deduction on pass-through business income would likely want to use a pass-through entity to operate the business because their effective tax rate (after taking into account the 20% pass-through business income deduction) would be 29.6%, as opposed to an effective tax rate of 36.8% when operating the business as a corporation (in both cases before the 3.8% Medicare tax). See the discussion below for more information on the pass-through business income deduction.
Finally, the Act eliminates the corporate alternative minimum tax (AMT), which means that corporations typically will lower their effective tax rate below 21% by claiming various deductions.
The Act requires fund managers to hold carried interests in pass-through portfolio companies for more than three years in order to qualify for long-term capital gain rates upon the sale of such interests (or the sale of the underlying assets that comprise such interests). The new provision currently does not apply to corporations that hold carried interests. However, the IRS has signaled that it will issue guidance to clarify that the provision covers corporations as well.
The Act does not change the treatment of “qualified dividend” income received by a fund on its investment in corporate stock.
The Act imposes a significant added expense on many leveraged acquisitions and leveraged recapitalizations of portfolio companies. Net business interest expense in excess of 30% of “adjusted income” is no longer currently deductible. Until December 31, 2021, adjusted income is essentially earnings before interest, taxes, depreciation, and amortization (EBITDA). After that, adjusted income is essentially earnings before interest and taxes (EBIT). Thus, from 2022 onward, even less interest will be deductible than is allowed currently. Disallowed interest expense is subject to carryforward and potentially deductible in a later year subject to the same limitation. Existing debt obligations and interest expense are not grandfathered under the Act. Leveraged corporations therefore may need to revisit their capital structure.
Corporations and pass-through businesses with gross receipts under $25 million (determined on a consolidated or combined basis) are exempt from the interest deduction rules. Furthermore, certain electing real property businesses and other designated businesses are also exempt. IRS regulations are expected to provide further guidance on how the $25 million in gross receipts will be determined and how the election to opt out of these rules will be made.
Funds may also want to consider alternative financing mechanisms to purchase portfolio companies with higher leverage such as preferred stock or shifting greater amounts of debt outside the United States.
The limitation on deductibility of interest expense could result in less debt being issued to finance leveraged acquisitions and dividend recapitalizations. At a minimum it will increase the cost of debt capital. For portfolio companies operating as corporations, the lower corporate rate will offset these increased tax costs.
The Act generally provides a 20% deduction for “qualified business income” from a pass-through entity. However, the rules are rife with qualifications, phase-outs, etc., that taxpayers should be aware of.
First, pass-through income that is a “qualified REIT dividend” or derived from a “qualified publicly traded partnership” always qualifies for the 20% deduction regardless of the taxpayer’s income level.
Second, pass-through income that is investment income or compensation income does not qualify for the 20% deduction. Investment income includes income from pass-through entities engaged in investment activity, such as a private equity fund or a hedge fund that has made a section 475 election.
Third, pass-through income from various personal service activities (e.g., income with respect to health, law, accounting, actuarial science, performing arts, consulting, athletics, various investment or financial services or the performance of services as an employee) does not qualify for the 20% deduction if the income flows through to a taxpayer whose income level exceeds $157,500 (for single filers) or $315,000 (for joint filers).
Fourth, pass-through income with respect to a trade or business where the principal asset of the business is the reputation or skill of one or more of its employees does not qualify for the 20% deduction if the income flows through to a taxpayer whose income exceeds the levels listed above.
Finally, if none of the above apply, the pass-through income may qualify for the 20% deduction; however, the amount of the deduction allowed is limited based on wages paid to employees and amounts of capital invested in depreciable property by the pass-through entity, in each case in connection with a qualified trade or business.
Given the complex rules and the potential benefit of the 20% deduction, private equity funds may want to reassess whether to make investments through corporate or pass-through portfolio companies. The choice may also depend on the kinds of investors in the fund (e.g. tax-exempt entities) and whether their target investments could qualify for the qualified small business exception if operated as C corporations.
Certain types of new and used property will qualify for bonus depreciation. For qualified property acquired and placed in service after September 27, 2017, and before December 31, 2022, taxpayers may take 100% bonus depreciation. Property acquired prior to September 28, 2017, but placed in service after September 27, 2017, remains eligible for 50% bonus depreciation. Allowable bonus depreciation generally decreases annually beginning in 2023 by 20% such that 60% can be expensed during 2024 and 20% during 2026. With some qualified exceptions, buildings, some building improvements and land do not qualify for bonus depreciation. For example, if a taxpayer wants to claim bonus depreciation on certain building improvements, the taxpayer may not claim the $25 million small business exemption from the 30% limitation on business interest expense (see above for details on the small business exemption).
The Act also expands section 179 expensing, increasing the annual allowable deduction from $500,000 to $1 million, and raising the phase-out threshold from $2 million to $2.5 million. The Act also expands the definition of “qualified Section 179 property” to include roofs, HVAC systems, fire protection and alarm systems, and certain other items for non-residential property as well as beds, furniture and the like for hotels and apartment buildings.
Because of the Act’s changes to expensing and depreciation, funds have a greater incentive to consider pursuing asset acquisitions for capital intensive targets rather than stock purchases. Taxable asset acquisitions were generally desirable for the purchaser even previously because the purchaser could take a step-up basis (i.e., fair market value basis) in the purchased assets. Under the new law, the step-up basis, coupled with bonus depreciation, will provide the purchaser with a significant additional incentive to push for an asset acquisition. Typically, sellers of C corporations prefer not to do asset sales because of double taxation and generally demand a higher purchase price to offset this tax. The new law may result in more asset sales occurring because the benefit to the buyer may be greater than the cost to the seller.
Net operating losses (NOLs) can no longer be carried back but can be carried forward indefinitely. Current NOLs and NOL carryforwards now can only be used to offset up to 80% of taxable income per year.
Individuals cannot use more than $250,000 ($500,000 on joint return) in losses from pass-through entities in a given year to offset other income. This rule is applied after the hurdles of tax basis, special allocations, at-risk rules and passive loss limitations have been overcome. Losses disallowed under this rule are added to the NOL carryover and, subject to the 80% limitation, will be allowed in later years.
The limitation on NOLs means that taxpayers cannot fully offset their taxable income with losses. Therefore, starting with the 2018 tax year, taxpayers will be subject to a 4.2% minimum tax rate for any profitable tax year.
Often when funds pursue acquisitions of corporate target companies, the transaction will generate an NOL for the target (as a result of cashing out options, refinancing debt and paying banking and other professional fees) at the time of sale. Typically, the negotiation over the rights to tax refunds arising from the NOL is a significant part of the deal and often results in a higher purchase price of the target company. The Act reduces this ancillary benefit by lowering the corporate tax rate (so that the value of target NOLs is less) and limiting the NOL deduction.
New partnership audit rules go into effect this year that generally will allow the IRS to collect taxes from a partnership rather than from the partners.
The rule that a partnership could be deemed terminated if 50% or more of the total interests in the partnership’s capital and profits were sold or exchanged has been repealed. This is a positive change for private equity funds generally because they can spend less time tracking the sale or exchange of interests in the fund and/or filing additional tax returns for terminated years.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.