United States: The New Tax Act: Key Provisions for Private Equity Investors

The new tax law signed by President Bush in May (the Act) contains several amendments to the Internal Revenue Code that will provide modest benefits to private equity funds and their investors. This article highlights three changes that have received extensive coverage in the popular press: (1) the reduction in long-term capital gain tax rates from 20% to 15%; (2) the reduction in dividend tax rates from 35% to 15%; and (3) the sunset provisions of the Act, under which these tax benefits expire after several years. A key feature to note is that these rate changes generally apply only to individual taxpayers.

Capital Gain Tax Cut. Prior to the Act, short-term capital gain (i.e., gain on assets held for one year or less) was taxed at ordinary income tax rates of up to 38.6%, and long-term capital gain was taxed at 20%. For sales of capital assets on or after May 6, 2003, the Act reduces the long-term capital gain tax rate for individuals to 15%. This reduction applies for purposes of both the regular tax and the alternative minimum tax. Short-term capital gain, however, continues to be taxed at ordinary income tax rates, which under the Act range up to 35%.

One consequence of reducing the long-term capital gain tax rate is the indirect reduction in tax benefits associated with "qualified small business stock." A non-corporate taxpayer who owns "qualified small business stock" (generally, stock of a domestic corporation with gross assets of $50 million or less) may exclude from taxable income 50% of any gain recognized on the disposition of such stock if the stock has been held for more than five years. The remaining 50% of gain recognized is taxed at a rate of 28%, so that the effective rate of tax for the entire amount of gain recognized is 14%. As a result of the new reduced tax rate on long-term capital gain, however, non-corporate taxpayers now have an effective tax rate on all long-term capital gains of 15%.

For taxpayers subject to the alternative minimum tax (AMT), the benefits of investing in qualified small business stock are further reduced. In calculating the AMT, a holder of qualified small business stock must treat a portion of the amount otherwise excluded from tax as a preference item, which increases the holder’s alternative minimum taxable income. The Act modifies the amount of qualified small business stock gain treated as an AMT preference item, and, as a result, the effective rate of tax for non-corporate taxpayers subject to the AMT who dispose of qualified small business stock is 14.98% — only .02% lower than the new regular tax rate on long-term capital gains. Thus, as a result of the long-term capital gain rate reduction, the tax rate benefits of investing in qualified small business stock are largely eliminated for taxpayers who are subject to the AMT. However, one very important benefit of investing in "qualified small business stock" remains. When a non-corporate taxpayer sells the stock of a qualified small business that has been held for more than six months, the taxpayer can roll taxable gain over to the extent that the proceeds of the sale are reinvested in the stock of other qualified small businesses (if the rollover occurs within a prescribed time period). The ability to defer tax on sales of qualified small business stock will continue to benefit taxable individual limited partners of private equity funds.

Dividend Tax Cut. Like the reduction in long-term capital gain tax rates, the Act’s reduction in dividend tax rates is favorable for many non-corporate taxpayers. However, the new 15% rate does not apply to all dividends. To be eligible for the reduced rate, dividends must be paid from one of the following sources: a domestic corporation; a foreign corporation incorporated in a U.S. possession; a foreign corporation with respect to stock that is readily tradable on an established U.S. securities market; or a foreign corporation that is eligible for benefits under a comprehensive income tax treaty with the U.S., which has been recognized as an appropriate treaty for purposes of the dividend rate reduction. The 15% rate also does not apply to dividends paid from a "foreign personal holding company," a "foreign investment company" or a "passive foreign investment company" — regardless of whether the company would otherwise be a qualified foreign corporation. Also, to qualify for the reduced rate, non-corporate shareholders must hold their shares for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date. In addition, the dividends must be paid to a U.S. non-corporate taxpayer. Any dividends that do not satisfy these requirements continue to be taxed at ordinary income rates which, pursuant to the Act, may be as high as 35%.

In the private equity context, where many limited partners are either corporations, tax-exempt organizations or foreign persons, the dividend tax rate reduction, although of some benefit to individual limited partners, likely will not change fundamentally the types of securities acquired by private equity funds. Private equity funds typically have structured preferred stock to provide liquidity only on an initial public offering, a sale of the company or after some period of time (if the company simply goes "sideways") through a redemption provision. Private equity funds do not expect that dividends will be paid out of the proceeds of financing transactions. Even with the new lower rates, however, it is not likely that private equity funds will adopt a current pay (including payment in kind) form of preferred stock as a standard equity investment.

But the new lower rate on dividends will reduce the tax effect of constructive stock dividends. Under current law, there is a risk that a portion of the fund’s return on a preferred stock investment might be deemed to be a taxable stock dividend received over the holding period of the equity. Preferred stock frequently entitles a private equity fund to receive an amount on redemption, either in the form of accrued dividends or a redemption premium, that exceeds the amount paid for the stock. These accrued dividends or redemption premiums may be treated as constructive stock dividends even before they are paid out, representing a form of "phantom" taxable income to the fund’s partners. Under the Act, the rate of tax on these deemed dividends will be the 15% reduced rate (assuming the other requirements listed above are satisfied), rather than the 35% rate now applicable to other ordinary income.

Sunset Provisions. The Act’s tax rate reductions are scheduled to "sunset" for tax years beginning after December 31, 2008. If these sunset provisions remain unchanged, the tax rate on long-term capital gain will revert to 20% and the tax rate on all dividends will begin (again) to track ordinary income tax rates in tax years beginning after the sunset date. Private equity funds should be aware of these sunset rules because many new and proposed preferred stock investments may be outstanding after December 31, 2008.