US Tax Act will benefit PE investors provided they plan properly

When the Trump administration ushered in the Tax Cuts and Jobs Act (the Tax Act) on 22 December 2017, US federal corporate tax rates were slashed from 35 per cent to 21 per cent. It was the biggest cut in three decades and as far as private equity managers are concerned, the news was greeted with open arms. 

“The corporate tax rate reduction was a big change,” says E George Teixeira (pictured), Tax Partner, Financial Services Tax Practice Leader and Co-Chair of the Private Equity Practice, Anchin. “Given that a lot of the PE investments that family offices and private investment funds make are done in a corporate vehicle, the 14 per cent reduction was always going to be welcome. To boot, at the corporate level they are also still able to fully deduct state taxes.”
Part of the back story as to why the US administration cut taxes was that it would create more jobs and make America’s corporate tax rate more competitive and in line with other countries (especially those in Europe). Moreover, it would reduce the risk of US companies (continuing to) move their businesses abroad to use cheaper labour. 

The Tax Act contains a wide array of details that impact the US private equity industry but whereas the corporate rate reduction is the only permanent piece of this tax bill, most of the other tax benefits are temporary and have a 2025 sunset period.  

With respect to the corporate tax rate reduction, Teixeira explains that there is both an upside and a downside to how this will affect the valuation of companies. Both deferred tax assets and deferred tax liabilities are measured using the tax rates expected to be in effect when the deductions or liabilities are realised. The downside to the corporate tax rate reduction, therefore, is the value of the deferred tax asset will be cut and the exposure from a deferred tax liability will be reduced.

“Every time you value a portfolio company when contemplating making an investment you take into account deferred tax assets and deferred tax liabilities as part of the calculation. Now that the corporate rate has been slashed to 21 per cent, the deferred tax asset values are much lower and this decreases the value of the target investment,” says Teixeira. He adds that for private equity funds that have valued deferred tax assets in their earnings multiples for valuation or buyout purposes, “this write-down will not be welcome news”. 

The upside, however, is that in respect to deferred tax liabilities the net result is that it changes the balance sheet of the company and increases its value thanks to the lower tax impact on future earnings. 

Of course, private equity managers have always looked at this but they would previously have calculated deferred tax assets and liabilities over five years, for example, at the 35 per cent that was in place (and that was projected to be in place for the foreseeable future). 

Now it’s dropped 14 per cent so it materially changes the tax asset and liability value, and therefore changes the overall value of the target company.   

“Speaking to our clients, they very much welcome this rate reduction. There’s really nothing not to like about a 14 per cent drop in a corporate tax rate,” asserts Teixeira.

One potential tax windfall for PE investors to consider is to avail of Section 1202 of the Internal Revenue Code. Any gains from the sale of qualified small business stock that have been held for five years or more are not included in gross income and are fully tax deductible. There are strict criteria to adhere to: the stock must be held in a domestic C corporation for the whole investment period, it must be bought on the primary market and the corporation cannot have more than USD50 million in assets at the date of the stock issue and thereafter. 

Teixeira explains that paying zero per cent tax on a stock that meets the Section 1202 criteria is something that people should look at for some but not necessarily all portfolio investments. 

“The IRS may issue additional guidance to clarify some unclear items but if you clearly meet the criteria then paying zero per cent tax versus 21 per cent on long-term gains is a significant saving. Recently, I have seen various articles written on this, so it is something that is being discussed now more than prior to the Tax Act. It’s something that we were talking to clients about previously and continue to discuss with many of our PE fund and portfolio company clients. Note that while the Section 1202 criteria are quite narrow, it is still a very worthwhile discussion. If someone has the ability to even save USD1 of tax, they want to know about it before the fact, not after,” he says.

Business interest deductions

The Tax Act has set a 30 per cent business interest limitation. Previously, there was no such ceiling and those who had a C corporation would avail of leverage so that they could have an interest deduction at the corporate level and minimise their corporate-level tax. 

This could impact the way that PE funds use leverage (in the form of debt financing) to acquire portfolio companies and lead to a shift in using more equity. 

“They can still leverage,” says Teixeira “but there is now a 30 per cent limitation in place on the deductibility of that business interest. Even prior to the Tax Act there was always a limit on how much debt versus equity you could have in a corporation. Those rules are still there, but now you have this extra layer to address.”

Tax deductions as they apply to qualified business income (QBI)

For tax years beginning in 2018, the Tax Act establishes a new deduction based on a non-corporate owner’s qualified business income (QBI). This new tax break is available to individuals, estates and trusts that own interests in partnerships, S corporations or sole proprietorships. 

This is not going to be beneficial to PE managers and the management entities they operate, which collect the management fees and pays payroll, office rents etc., because they are specified service businesses and cannot avail themselves of the 20 per cent deduction. Their portfolio companies, however, could potentially benefit. 

Teixeira explains that the pass-through income deduction is calculated at the individual level not the entity level; this could be as high as 20 per cent for businesses contained in the portfolio, provided they are not on the list that would disqualify them for this deduction. These businesses include: health, law, accounting, consulting, financial services firms “and other businesses where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners”.

An individual owner of a specified service business whose taxable income is below the threshold of USD157,500 (USD315,000 for joint filers) could still benefit from the deduction but this is likely to be limited given that most partners in private equity groups will be earning amounts significantly higher than those thresholds. 

The pass-through deduction is one of the provisions that requires additional clarity and guidance in its application and is just one of numerous provisions that will have a phased sunset that comes into effect in 2025. While structuring portfolio companies as corporations may be the pull now due to the 14 per cent drop in the corporate tax rate, structuring portfolio companies as pass-through entities still needs to be discussed and explored due to the new pass through deduction rules as well as some tried and true factors such as one layer of tax at the entity level and the ability to structure and exit with preferential buyer benefits. 

Carried interest impact

The main point to make here is that whereas partners could treat capital gains as long term if the partnership’s holding period in the assets sold exceeded one year, this has now been extended to more than three years. 

In many respects, this should have minimal impact on private equity investors given that most portfolio companies are generally held for greater than three years. 

In some cases, the GP might be holding a portfolio company whose value pops and they decide to take the gains regardless of the carried interest change but this is likely to be more the exception than the rule so the carried interest implications are not considerable at all.

“The carried interest change does not affect the limited partner who invests in a PE fund but for a manager, who general doesn’t put up much (if any) capital in the GP entity and just provides his services, if he takes a piece of the carry then the asset will need to have been held by more than three years for the partner to enjoy the lower (long-term capital gains) tax rate.

“If you hold an asset for two years, the carried interest will be re-characterised as short-term capital gains as opposed to ordinary income. Short-term capital gain is still the same as the ordinary income tax rate, the high rate being 37 per cent, but if you have capital losses you can offset those against the short-term capital gains,” outlines Teixeira.   

Excess business loss provision

If one were to summarise this new Tax Act, the upshot is that if you make money you should pay less tax but if you lose money, you most likely are going to pay more tax. 

Take a PE fund that performs well and earns the carry for the year. Within the management company, the GP collects the management fees, pays staff and the entity runs at a USD10 million loss, overall. The partner benefits from long term capital gains and pays his tax on the carried interest earned from the funds’ performance but at the management company level he has a USD10 million operating loss, of which (when filing a joint return), the partner will only be able to take USD500,000; the new threshold that applies to deductions for excess business losses.

The key point is that PE groups will be limited in terms of how they use losses in the management entity to offset partners’ investment income in the form of dividends, capital gains and interest. 

“Under the new Tax Act, If the GP entity makes USD20 million in gains and the management company entity makes a USD10 million loss, the partner is going to have to pay more tax because his loss is kept at USD500,000. He doesn’t lose the other USD9.5 million. He just gets to carry it forward as a net operating loss (NOL).  

“Managers might need to reconsider how they do things. Previously, they might have funded the management company to pay out bonuses and keep high performing employees. Going forward, they might have to give a higher proportion of carried interest to retain talent,” says Teixeira.

If this hasn’t hit home yet, it will come April 2019 when GPs file their personal tax returns or an extension and inquire why they are paying so much tax. 

Giving high-performing employees a (larger) piece of the carry will potentially lower the overall tax burden and give them skin in the game, which could incentivise them to stay in the firm. That’s not a bad thing. 

Overall, Teixeira is in no doubt that the Tax Act is a positive development for the US private equity industry. 

“That 14 per cent drop in the tax rate equates to real savings but it will require more planning. You will need to model out how the corporation will be paying tax in different US states, not just over one year but over a three or five year period, just to be sure that a corporation makes sense. Many states source revenues to corporations differently than they source revenues to partnerships. 

“Speak to your service providers to make sure you have all the facts in front of you.” 

While there are still many ambiguous and unanswered questions with the Tax Act, opportunities exist for tax savings through proper planning.