On April 28, 2021, President Biden announced the American Families Plan to propose funding for education, child care, and the extension of certain tax credits for lower- and middle-income individuals. The White House released a fact sheet describing these proposals, and President Biden discussed them in an address to a joint session of Congress. President Biden's plan would fund these proposals through increased taxes and other significant tax law changes. These changes would be in addition to the tax law changes proposed in the American Jobs Plan announced by President Biden on March 31, 2021, which we covered here.
While it remains to be seen whether the proposals in the American Families Plan will be enacted into law, they may have significant effects on private equity funds and their portfolio companies, including changes that impact the tax treatment of a sponsor's carried interest in a private equity fund and on the relative benefits of conducting business through an entity treated as a partnership for tax purposes (tax partnership) vs. a C corporation, particularly when combined with revenue raisers in the American Jobs Plan. These changes could impact the taxation of private equity investors and portfolio companies, and as a result, could change the preferred operating and acquisition structures with respect to their portfolio companies.
Proposed Revenue Raisers Potentially Affecting Private Equity Funds and Portfolio Companies
Proposed revenue raisers in the American Families Plan of particular interest to private equity funds and portfolio companies include:
- Closing "the carried interest loophole" so that
"hedge fund" partners will pay ordinary income rates on
their income "just like every other worker"
- Increasing the top federal income tax rate on ordinary income
to 39.6% for high-earning individuals-it has been reported that
this rate would apply to individual single taxpayers with taxable
incomes greater than $452,700 and to married couples filing jointly
with incomes greater than $509,300
- Increasing the top federal income tax rate on capital gains and
dividends to 39.6% (plus 3.8% Medicare tax) for households with
income greater than $1 million per year
- Extending permanently current limitations restricting deduction
of "excess business losses"
- Expanding the 3.8% tax on unearned income (sometimes referred
to as Medicare tax) to unspecified categories of income currently
- Requiring "financial institutions to report information on
account flows so that earnings from investments and business
activity are subject to reporting more like wages already
The plan also calls for increased IRS enforcement discussed in more detail here.
These proposed changes would presumably be combined with the American Job Plan's proposed increase in the top federal income tax rate on C corporations to 28%, discussed here.
The American Families Plan proposes to "close the carried interest loophole" so that "hedge fund" partners will pay ordinary income rates on their income "just like every other worker." This presumably refers to the ability of a service provider to pay tax at capital gain rates, rather than ordinary income rates, on disposition of a profits interest.
The scope of the proposal is uncertain. In particular, it is unclear whether the proposal would extend beyond "hedge fund" partners to partners of private equity funds. It is also unclear whether the proposal would extend to eliminate or curtail the other principal advantage of the treatment of carried interests-the deferral of tax resulting from carried interests not being taxed upon grant or vesting. It is also unclear whether the proposal would supplant the new holding period requirements imposed by the 2017 Tax Cuts and Jobs Act on certain carried interests. In any case, it may be useful to revisit management fee waiver provisions for fund managers and to potentially consider phantom equity plans or bonus plans (perhaps in lieu of profits interests) for portfolio company key employees, if, as and when the proposal takes on more detail as it moves through Congress.
Choice of Entity: Tax Partnership vs. C Corporation
The proposed increase in the top corporate tax rate (to 28% from the current level of 21%) and the top dividend and capital gain tax rate (to 43.4% from the current level of 23.8%, taking into account the effect of the 3.8% Medicare tax) would substantially increase the tax benefits of owning businesses through a tax partnership rather than a C corporation, particularly in the case of businesses eligible for the 20% deduction under section 199A that currently distribute their cash flows to their owners. Click here to view a table comparing effective tax rates under current law and under the Biden Administration proposals.
Under current law, the effective tax rate advantage of tax partnerships fully eligible for the 20% section 199A deduction is 6.4% - this is the excess of a 39.80% effective tax rate on income earned and distributed by a C corporation over a 33.40% effective tax rate on income earned and distributed by a tax partnership, in both cases taking into account the effect of the 3.8% Medicare tax.
Under the Biden proposals, the effective tax rate advantage for investors with income over one million dollars would rise to 15.85% even before taking into account any additional benefits available under section 199A - this is the excess of a 59.25% effective rate on income earned and distributed by a C corporation over a 43.40% effective tax rate on income earned and distributed by a tax partnership, in both cases taking into account the effect of the 3.8% Medicare tax.
Simplified illustration of effective tax rate calculation for a C corporation. Assume a corporation earns $100, pays tax of $28 (28% of $100) and pays a taxable dividend of $72 ($100 minus $28). Assume the shareholder pays income tax of $28.51 (39.6% of $72) and Medicare tax of $2.74 (3.8% of $72) on the dividend. The total tax payments with respect to the original $100 would be $59.25 ($28 paid by the corporation and $31.25 paid by the shareholder), for an effective tax rate of roughly 59.25%.
In cases where the relevant entity is a foreign entity or operates in foreign jurisdictions, the choice of entity (tax partnership v corporation) will be further impacted (and complicated) by the international tax proposals included in the American Jobs Plan, including the proposals to (i) increase the minimum rate, and make certain other modifications to the rules, applicable to global intangible low-taxed income (GILTI), (ii) eliminate the corporate deduction for foreign-derived intangible income (FDII), (iii) deny deductions for expenses related to "offshoring" jobs and provide a credit for expenses related to "onshoring" jobs, (iv) significantly expand the corporate anti-inversion rules and (v) replace the base erosion and anti-abuse tax (BEAT) with a more fulsome limitation on deductions for payments to foreign related parties subject to a low effective tax rate. These American Jobs Plan proposals were previously discussed by us here and a Treasury Report discussing the proposed expansion of the corporate anti-inversion rules and replacement of BEAT was previously discussed by us here.
It remains to be seen exactly how the effective tax rate advantage for a passthrough structure will be affected for investors with income below $1 million per year. Nonetheless, private equity funds with individual investors or foreign investors (which often invest in U.S. tax partnerships through U.S. corporate blockers) will need to closely follow these proposed changes to understand the potential impact of these tax law changes on structuring investments in portfolio companies.
Expanded Base for 3.8% Medicare Tax
Relevant to private equity funds with individual investors, the Administration is also encouraging Congress to close what it sees as loopholes in the 3.8% net investment income tax. The fact sheet asserts that this tax is "inconsistent across taxpayers due to holes in the law," and the proposal would target those with income in excess $400,000 per year. The details of this proposal have not been released, although it may include imposition of the 3.8% Medicare tax on certain types of business income that is not subject to self-employment tax (e.g., income from private equity portfolio investments of persons actively engaged and materially participating in the businesses generating such income).
Excess Business Losses
The American Families Plan would make permanent the current rule disallowing excess business losses of non-corporate taxpayers. This rule was enacted as part of the 2017 Tax Cuts and Jobs Act and generally disallows certain business losses (including losses allocated from partnerships) in excess of specified thresholds. The provision is currently set to expire at the end of 2025, but the Administration is proposing to make it permanent.
Expanded Information Reporting Requirements
The Administration also previewed expanded information reporting requirements by financial institutions on "account flows." The fact sheet cited a 2019 economics working paper broadly critical of underreporting by tax partnerships and a lack of cross-party reporting with respect to certain items of income, but the text of the proposal refers only to expanded reporting for "financial institutions." According to a press release issued by the Department of the Treasury, this proposal "leverages the information that financial institutions already know about account holders, simply requiring that they add to their regular, annual reports information about aggregate account outflows and inflows."We will continue to monitor developments and will provide further updates as more details are released. In the meantime, Baker Botts would be pleased to assist you in your analysis of these proposals.
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.