As it has always been, Federal income tax issues drive many of the structures of private equity funds and portfolio company investments. In addition, as we all know, the Administration and Congress continue to change the tax landscape. Most recently, The American Taxpayer Relief Act of 2012 (the "Fiscal Cliff Bill") that Congress passed in January resulted in numerous changes to the Internal Revenue Code and permanent extensions of various aspects of the "Bush tax cuts." This summary discusses certain of these recent trends and changes in the tax law and their implications for private equity and M&A transactions.
Using Partnerships for Portfolio Companies
One trend in private equity is an increased willingness for PE transactions to invest in a portfolio company taxable as a partnership. The partnership tax structure allows for a single level of tax, as described below. From a state law perspective, the portfolio company typically will be a limited liability company.1
Using a portfolio company taxable as a partnership offers many opportunities for tax savings. However, the flow through treatment offered by a partnership presents specific issues that the private equity investor needs to address.
Flow through treatment generally - In an entity taxable as a partnership, the owners are taxed on the company's income at the time it is earned, not when this income is distributed. The character of the earned income passes through up to the owners as well. The owners will increase or decrease the tax basis in their interest in the company for their share of the company's income or loss each year.
The investor-owner will not be taxed on cash distribution he or she receives unless that distribution exceeds his or her basis in his or her interest in the entity. In addition to increases or decreases to the tax basis for the amount of income earned, the investor-owner's basis in his or her interest will increase or decrease for his or her share of contributions and distributions.
Leveraged recapitalizations - The partnership tax rules provide more flexibility in a leveraged recapitalization of the company, which might allow for deferral of taxation. In a leveraged recapitalization transaction, the portfolio company borrows money from a third party lender and distributes proceeds of the loan to the existing owners. Under partnership tax rules, the owners' basis in their interest is increased by their share of the partnership's liabilities.
As discussed above, partners are not taxed on distributions of cash until the amount exceeds their basis in their interest. Thus, the partnership generally can distribute the proceeds from the loan to the investors without a current tax effect.
Compare this result to a leveraged recapitalization transaction involving a portfolio company taxable as a corporation. In that case, the distribution of the loan proceeds would be a dividend at the time of distribution (or possibly a capital gain) subject to the 20% Federal income tax rate for high income individuals.
Section 754 elections - A partner's purchase of an interest in the partnership from another partner generally doesn't cause an increase in the basis of partnership assets to take into account the gain recognized by a selling partner. This means that the investor would not get the benefit of additional depreciation or amortization of the partnership's assets.
The partnership tax rules do provide for an elective fix to this issue. The partnership may make what is commonly called a Section 754 election, named for the Internal Revenue Code section that authorizes the election. This election will allow for the contributing investor to receive a step-up in the basis of his or her share of the partnership assets which may result in additional depreciation and amortization deduction for that investor. This election is available for minority purchases of partnership equity. Thus, the Section 754 election is more readily available than the analogous 338(h)(10) election for purchases of S corporations, which require a purchase of 80% of the stock of the S corporation.
Reverse 704(c) allocations - A contribution of cash by a new investor for equity in a partnership portfolio company does not result in step-up in basis of the partnership assets. Thus, similar to a purchase of an interest, the contributing partner would not get the benefit of additional depreciation or amortization of partnership assets that accompanies such a step up.
Certain allocations of items of income or loss of the partnership provide a similar depreciation result to the basis step-up for new investors. These allocations are referred to as reverse 704(c) allocations. When an investor contributes cash, the capital accounts (book accounts) of the company are revalued to reflect their fair market value at the time of the contribution. This revaluation may result in a "book-tax difference" for the existing partners in the basis of the assets reflecting the built-in gain or loss of the assets. In order to ensure that this built-in tax gain or loss is allocated to the existing partners and not the new investor, the tax rules provide that items of income, gain, loss or deduction must be allocated such that the gain or loss is born by the existing partners. For example, the new investor may be allocated additional depreciation while the existing partners are allocated additional income to offset this book-tax difference.
Applicable partnership tax rules provide three methods for making these allocations, the traditional method, the curative method and the remedial method. The traditional method favors the existing partners. The remedial method favors the new investor. The curative method often is in between the other two.
UBTI and Blockers - Many, if not most, private equity funds have tax-exempt investors. Tax-exempt investors have their own set of concerns when determining where to invest. Their primary concern is that the investment does not result in taxable income to them. With certain exceptions, income that is not related to the tax-exempt investor's exempt purpose is generally taxable as unrelated business income (commonly referred to as unrelated business taxable income, "UBTI"). If the tax-exempt investors invest in a company taxable as a partnership then it may receive UBTI because the character of the income earned by the portfolio companies passes through to the investor.
As stated above, there are certain exceptions to what constitutes UBTI, one such exception is dividend income. Thus, the solution to the UBTI problem for direct investment in the portfolio company is to insert a corporation between the tax-exempt and the portfolio company. This blocker entity would be taxable on its share of the portfolio company's income and could make dividend distributions to the tax-exempt investor which would not constitute UBTI.
ECI and Blockers - Similar to tax-exempt investors, foreign investors have their own concerns when choosing where to invest. With US private equity, the concern for the foreign investor is that they do not want to be subject to reporting or tax obligations in the US. As with the tax-exempt investor, direct investment by the foreign investor would result in the foreign investor being taxed subject to tax in the US. Under the rules dealing with foreign persons, the foreign investor would be treated as if he or she is engaged in the, US in the business of the partnership and the partnership income would be effectively connected to a US trade or business (commonly referred to as effective connected income, "ECI"). This would result in US taxation of the foreign person on the ECI.
Similar to the tax-exempt investor, a common solution is to insert a blocker corporation between the foreign investor and the portfolio company. While the dividend income paid to the foreign investor is still subject to tax in the US at a flat rate of 30%, the tax is collected through withholding by the blocker corporation; therefore, the foreign person is not required to file returns in the US unless they wish to seek a refund of the tax. The US also has numerous bilateral tax treaties that might lower the 30% withholding rate or eliminate it entirely if the foreign person meets certain requirements.
New Rate Structure
Recent acts by Congress resulted in changes to both the individual and capital gains rates.
Long-Term Capital Gains - Prior to 2013, the maximum Federal income tax rate on long-term capital gains was 15%. One of the key questions in the fiscal cliff negotiations was whether the long-term capital gain rate would revert to 28% as proscribed by the sunset provisions of the Bush tax cuts. The Fiscal Cliff Bill set the long-term capital gains rate for individual taxpayers at a rate of 15% generally for individuals whose taxable income is less than $400,000 ($450,000 for married filing jointly) and at 20% for those individuals whose taxable income is more than $400,000.
Qualified Dividends - Prior to 2013, certain qualifying corporate dividends were taxable at the same 15% rates as long-term capital gains tax rates. The sunset provisions of the Bush tax cuts provided for all dividends to be taxable at the same rate as ordinary income (generally 39.6%). The Fiscal Cliff Bill maintained the applicable tax for qualified dividends to be the same as long-term capital gains (see above).
Individual rates - The Fiscal Cliff Bill also extends the existing lower individual tax rates that were part of the Bush tax cuts with one major change. The act created a new 39.6% bracket. This new bracket will apply to the amount of taxable income (for 2013) that exceeds $400,000 for single individuals, $425,000 for heads-of-household, $450,000 for marrieds-filing-jointly, and $225,000 for marrieds filing separately. For tax years after 2013, these highest bracket threshold amounts are adjusted for inflation.
Impact on Private Equity and M&A- The good news is that while long-term capital gains rate increased, they remain at relatively low historical levels, so deal flow should not be impacted. Also, the maintenance of the equivalent rate between qualified dividends and long-term capital gain rates make leveraged recapitalization transactions tax efficient for target shareholders looking for liquidity.
The use by fund managers of carried interests in the fund remains a hot topic of debate in Washington. Many critics maintain that the carried interest gives fund managers an inappropriate long-term capital gains tax rate for income from services rendered.
If properly structured, the receipt of a carried interest has no tax effect because the interest is deemed a zero value. Instead, as the partnership earns income the fund manager holding the carried interest is taxable on his or her share of the profits and losses.
The character of the income allocated to the fund manager is the same as the character of income received by the fund. Because most of the income earned by a private equity fund consists of long-term capital gains or qualifying dividends, the fund manager's share of income will generally be subject to the lower Federal income tax rate applicable to those types of income.
As has been widely reported, the taxation of carried interests has been a hot button in Congress for several years now. Congress has considered several proposals to do away with this perceived loophole, but none of the proposals have gained any significant momentum. Most recently, President Obama has included a new proposal to tax income attributable to carried interests as ordinary income as part of his solution to avert the so called sequester. While it remains to be seen whether this proposal will become part of any legislation in the near future, it seems clear that the debate is not going away any time soon.
On March 30, 2010, President Obama signed into law the Health Care and Education Reconciliation Act of 2010 which added Section 1411 to the Code and the IRS has issued proposed regulations interpreting the application of the section. This section requires certain individuals, estates and trusts to pay a 3.8% Medicare surtax on "net investment income". This surtax applies for taxable years beginning after December 31, 2012. Net investment income can be broken into three distinct groups of income, as follows:
- Gross dividends, interest, royalties, annuities, and rents, other than those derived in the ordinary course of a trade or business that is not either a passive activity or the trade or business of trading in financial instruments,
- Other gross income derived from a passive activity or the business of trading in financial instruments, and
- Net income attributable to the disposition of property other than property held in a trade or business that is not listed in bullet two.
The income may be reduced in each of the above cases by allowed deductions that are properly allocable to the gross income.
Impact on Private Equity M&A - The Medicare surtax applies to those who receive dividends or recognize capital gains in liquidity events. This increase reduces the after tax proceeds available to exiting shareholders and managers.
In addition, fund managers should be cognizant that the Medicare surtax will add to the tax costs of the capital gain and dividend income allocated to the managers with respect to their carried interest. Thus, notwithstanding the lack of any Congressional action on carried interests specifically, fund managers will pay more tax with respect to their income from carried interests starting in 2013.
1. References in this section would also apply to a member of a limited liability company if the limited liability company is taxable as a partnership.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.