United States: Implications Of Recent Tax Law Developments On Private Equity Mergers And Acquisitions

Last Updated: March 6 2013
Article by Lynn E. Fowler and Cristin A. Burke

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.

Carried Interests

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.

Medicare Tax

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.

Footnotes

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Lynn E. Fowler
 
In association with
Related Video
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert
Email Address
Company Name
Password
Confirm Password
Mondaq Topics -- Select your Interests
Accounting and Audit
Anti-trust/Competition Law
Consumer Protection
Corporate/Commercial Law
Criminal Law
Employment and HR
Energy and Natural Resources
Environment
Family and Matrimonial
Finance and Banking
Food, Drugs, Healthcare, Life Sciences
Government, Public Sector
Immigration
Insolvency/Bankruptcy, Re-structuring
Insurance
Intellectual Property
International Law
Law Practice Management
Litigation, Mediation & Arbitration
Media, Telecoms, IT, Entertainment
Privacy
Real Estate and Construction
Strategy
Tax
Transport
Wealth Management
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.