United States: How Proposed Tax Reform Will Impact Private Equity

Last Updated: November 23 2017
Article by Ashley E. May and Raj Tanden

Both the House of Representatives and the Senate have proposed their own versions of tax reform (the "House Proposal" and "Senate Proposal", respectively, and together, the "Proposals") which will drastically change the current U.S. federal income tax structure and the Internal Revenue Code of 1986, as amended (the "Code"). Both Proposals will be effective for tax years beginning after December 31, 2017, though certain provisions have a later effective date. This Alert highlights the impact the Proposals will have on private equity and discuss the following topics:

  • Corporate and Individual Tax Rates
  • Tax Rates on Pass-Through Income
  • Interest Deductibility
  • State and Local Income Taxes
  • Carried Interest
  • Source of Gains Upon Transfer of Partnership Interest
  • State Pension Plans
  • Self-Employment Tax

Corporate and Individual Tax Rates

The current corporate tax rate is graduated, with a maximum marginal rate of 35 percent. The House Proposal eliminates the graduated tax rate structure and will apply a flat 20 percent rate, except in the case of personal service corporations, which would be subject to a 25 percent rate. The Senate Proposal also eliminates the graduated tax rate structure, and will apply a flat 20 percent rate for all corporations. The corporate tax rate of the Senate Proposal will be effective for tax years beginning after December 31, 2018.

Under current law, there are seven ordinary income tax brackets at 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent and 39.6 percent. The Senate Proposal changes these rates to 10 percent, 12 percent, 22.5 percent, 25 percent, 32.5 percent, 35 percent and 38.5 percent.

The House Proposal collapses the tax rate structure into four brackets at 12 percent, 25 percent, 35 percent and 39.6 percent. The House Proposal also creates a new tax bracket for owners of pass-through entities. A 9 percent tax rate would apply to the first $37,500 of an individual's share ($75,000 if filing jointly) of active business income from a pass-through entity. This rate would gradually phase out for individuals who have greater than $75,000 in taxable income ($150,000 if filing jointly), and is fully phased out at $112,500 ($250,000 if filing jointly). The 9 percent rate will be gradually phased in over the next five years.

Tax Rates on Pass-Through Income

Under current law, owners of a pass-through entity report net income on their individual tax returns, which is subject to ordinary tax rates (as discussed above under "Corporate and Individual Tax Rates"). Under the House Proposal, a portion of net income that is distributed by the pass-through entity to the partners may be treated as "qualified business income," and is subject to a maximum tax rate of 25 percent rather than ordinary income tax rates. For tax years that straddle December 31, 2017, the reduced rate will apply proportionately for the period after December 31, 2017.

"Qualified business income" under the House Proposal is meant to include all passive business activity and certain active business activity, reduced by carryover business losses and certain current year net business losses. It does not include income subject to preferential rates (e.g., capital gains or losses, dividends, interest and other generally passive types of income). The remaining portion of net business income that is not qualified business income will be taxed as ordinary income.

Under the Senate Proposal, an individual may generally deduct 17.4 percent of domestic qualified business income received from a pass-through entity. The amount of the deduction for qualified business income received from a partnership is limited to 50 percent of the W-2 wages of the individual. If the amount of qualified business income is less than zero, the amount of the loss will be deducted from the individual's qualified business income in the following tax year. The deduction is phased out for certain income thresholds ($500,000 for married couples under the bill that passed the Senate Finance Committee).

"Qualified business income" under the Senate Proposal generally means the net amount of domestic income generated from the taxpayer's business. It does not include amounts distributed to a partner who is acting outside of his or her capacity as a partner, or amounts that are guaranteed payments for services actually rendered to a partnership to the extent that the payment is in the nature of compensation for those services.

Individual investors in private equity funds that invest in portfolio companies organized as pass-through entities are generally eligible for the 25 percent tax rate under the House Proposal and the 17.4 percent deduction on qualified business income with respect to such investments. However, income received by individuals for their involvement in the management of the fund will not be eligible for the preferential rates.

Interest Deductibility

Under current law, a business is generally allowed to deduct all interest paid or accrued in the taxable year, subject to limitations. Under the House Proposal, "business interest" deductions are limited to the sum of "business interest income" plus 30 percent of the "adjusted taxable income" of the business. The amount of interest expense in excess of 30 percent of the business's adjusted taxable income may be carried forward up to five years after the interest was paid or accrued, and will be deducted on a first-in, first-out basis.

"Adjusted taxable income" under the House Proposal means the taxable income of the taxpayer without regard to: (i) any item of income or loss not properly allocable to a trade or business; (ii) any business interest or business interest income; (iii) any net operating loss deduction; and (iv) any deduction for depreciation or amortization.

Although the business interest deduction limitation is determined at the entity level, special rules allow for the partners of a partnership to use any unused interest expense deductions. If the amount of business interest deductions is below the 30 percent cap, the limit on the amount allowed as a business interest deduction is increased by a partner's distributive share of the partnership's unused interest expense deductions. There are corresponding rules to prevent double counting of such unused interest expense deductions.

The Senate Proposal is generally the same as the House Proposal, except that "adjusted taxable income" includes the 17.4 percent pass-through deduction (as discussed under "Tax Rates on Pass-Through Income"), and does not include depreciation and amortization. The Senate Proposal also allows for interest expense deductions to be carried forward indefinitely.

The limitation on interest expense deductions will increase the cost of capital, particularly in the private equity context, where a significant amount of debt is often used to acquire a target company. This may cause private equity funds to reconsider how they finance acquisitions to avoid the payment of interest.

State and Local Taxes

Under current law, amounts paid for state and local income taxes and property taxes are fully deductible for both individuals and corporations on their U.S. federal taxes. The House Proposal repeals the state and local income tax deduction for individual taxpayers, and limits the deductibility for state and local property taxes to $10,000 ($5,000 for a married individual filing separately). Corporations will be able to continue to take these deductions.

Initially, the House Proposal was interpreted as allowing individual owners of pass-through entities to take such deductions. However, the House Ways and Means Committee Chairman later clarified that state and local income taxes paid by individual owners of pass-through entities would not be eligible for such deductions.

The Senate Proposal also repeals the state and local income tax deduction for individual taxpayers, but not for corporations. Unlike the House Proposal, the Senate Proposal eliminates the state and local property tax deduction entirely. There is still uncertainty at this time whether this provision applies to owners of pass-through entities.

This remains a controversial issue in both Proposals, and is likely to change before any tax bill is enacted.

Carried Interest

Under current law, profits paid to private equity fund managers that are generated from investments (commonly referred to as "carried interest") held for more than one year are taxed at capital gains rates. Under the House Proposal, an investment must be held for more than three years to receive capital gains treatment. Such profits attributable to gains on investments held for three years or less will be taxed as short-term capital gains (which is taxed as ordinary income).

Moreover, to receive capital gains treatment, the gain must be derived from an "applicable partnership interest," which is generally intended to account for a profits interest of a partnership. An applicable partnership interest includes any interest held in connection with the taxpayer's substantial services in a trade or business that involves raising and returning capital and investing or trading in securities, commodities and/or certain other assets (which is generally intended to include a portfolio management business).

The Senate Proposal has no proposed change to carried interest.

The House Proposal will likely not affect private equity funds that typically invest in assets long term. However, this may disproportionately affect activist funds, which generally hold assets for one or two years. Asset managers that have investment horizons of less than three years should consider how the House Proposal will apply to their individual circumstances.

Source of Gain Upon Transfer of Partnership Interest

As held by the recent U.S. Tax Court case Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3 from July 2017, the sale of a non-"FIRPTA" partnership interest generally will not be taxable to a foreign holder, even if the partnership engages in a U.S. trade or business. We have previously written about this case, which you can read more about here.

Under the Senate Proposal, gain or loss upon such a sale generally would be treated as effectively connected with a U.S. trade or business. This provision effectively overrules Grecian Magnesite. As a result, foreign investors will likely continue to use "blocker" entities to avoid effectively connected income in the private equity context.

The House Proposal does not have any provision similar to the Senate Proposal described above.

State Pension Plans

Under current law, certain organizations are exempt from U.S. federal income tax. However, even if an organization is otherwise deemed to be exempt from U.S. federal income tax, it may still be required to pay tax on unrelated business income that is not substantially related to the performance of the organization's tax-exempt status (commonly known as unrelated business taxable income, or "UBTI"). State and local entities (including state pension plans) that are exempt from U.S. federal income tax are not usually subject to the UBTI rules.

Under the House Proposal, all entities exempt from U.S. federal tax under Code Section 501(a), regardless of the entity's exemption under any other provision of the Code, will be subject to the UBTI rules. This means that state and local entities that are tax exempt under both Section 501(a) and 115(1) as a government-sponsored entity will be subject to the UBTI rules. The Senate Proposal does not change current law.

Self-Employment Tax

Under current law, a limited partner's share of income received from a partnership is excepted from self-employment tax. The initial House Proposal repealed this exception, and instead provided that a limited partner's "labor percentage" of trade or business income is subject to self-employment tax. However, the second amendment to the House Proposal on November 9 returns to the current law. The Senate Proposal does not change current law.

Below is a summary of the Proposals and how they differ from current law:

Current Law House Proposal Senate Proposal
Corporate Tax Rate 35% 20%, 25% for personal service corporations. 20%, effective for tax years beginning after December 31, 2018.
Individual Tax Rate Brackets at: 10%, 15%, 25%, 28%, 33%, 35% and 39.6% Brackets at: 12%, 25%, 35% and 39.6%

An additional bracket at 9% for pass-through income, phased out at certain income thresholds; phased in over five years.
Brackets at: 10%, 12%, 22.5%, 25%, 32.5%, 35% and 38.5%.
Pass-Through Tax Rate Owners of pass-through entities are taxed on income at individual rates. Certain "qualified business income" is taxed at 25%.

Remaining net business income is taxed as ordinary income.
Certain "qualified business income" is allowed a 17.4% deduction.

The deduction is limited to 50% of W-2 wages.
Interest Deductibility Businesses are allowed a full deduction for interest paid. Interest expense deduction is limited to business interest income plus 30% of adjusted taxable income before net operating loss deductions and depreciation and amortization. Interest expense deduction is limited to business interest income plus adjusted taxable income before net operating loss deductions (excluding depreciation and amortization) and 17.4% pass-through deduction.
SALT Amounts paid SALT are fully deductible. For individuals (including owners of pass-through entity), state and local income taxes are not deductible. Certain amounts of state and local property taxes are deductible.

No change for corporate deductions.
For individuals, state and local income taxes are not deductible. Certain amounts of state and local property taxes are deductible. It is unclear if this applies to the owners of a pass-through entity.

No change for corporate deductions.
Carried Interest Profits interest paid to fund managers is taxed as capital gain if investment is held for more than one year. Investments must be held for more than three years to receive capital gains treatment. No proposed change from current law.
Source of Gains The sale of a non-"FIRPTA" partnership interest generally will not be taxable to a foreign holder, even if the partnership engages in a U.S. trade or business (Grecia Magnesite). Gain or loss on the sale of a partnership interest by a foreign person will not be subject to U.S. tax. Gain or loss on the sale of a partnership interest by a foreign person will be ECI to the extent that the foreign person would have had effectively connected gain or loss had the partnership sold all of its assets.
State Pension Plans State pensions do not pay UBTI. All entities from U.S. federal tax under Section 501(a) are subject to the UBTI rules. No proposed change from current law.


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
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

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 or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq 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 of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions