As private equity investors aim to maximize returns and minimize taxes over the investment term, the structure of their entities can play a crucial role. Recently, many private equity groups have opted for a pass-through structure, such as a partnership, due to the flexibility it provides in terms of economic deals among investors. However, changes in tax laws and recent proposals raise the question of whether a C corporation structure would better minimize taxes and maximize returns for investors.
In this article, we will examine the potential benefits and drawbacks of using a C corporation in a private equity transaction. Overall, the tax advantages of utilizing a C corporation are not available in a partnership structure, making the use of a C corporation potentially more beneficial for private equity transactions.
It is important to note that the use of a C corporation in a private equity transaction is a complex decision that should be carefully considered. Tax laws and regulations are subject to change, and it is essential to consult with a tax professional and conduct a thorough analysis of the potential tax implications before making a decision. Additionally, tax structure should be reassessed over the life cycle of the business, particularly when tax law changes may occur.
By understanding the positives and negatives of using a C corporation, investors can make an informed decision and optimize the structure of their investment for the best possible outcome.
Potential Benefits of a C Corporation Structure
Section 1202 of the Code. The use of a C corporation in a private equity transaction can provide a significant tax advantage through Section 1202 of the Internal Revenue Code of 1986 (the Code). This section allows for shareholders of a C corporation to exclude gain realized in connection with the sale of qualified small business stock (QSBS) held for more than five years from federal income taxation. This exclusion is significant, as it can provide eligible shareholders with the ability to exclude the greater of (i) $10 million or (ii) ten times the relevant shareholder's tax basis in their shares, which can greatly increase returns for the investors. Additionally, any future increases in capital gain tax rates would make the benefits of this gain exclusion even more significant. It is important to note Section 1202 has several requirements that must be met, and it is advisable to consult with a tax professional to ensure compliance with the rules and to determine the amount of gain exclusion that can be realized under the provision.
Additional Cash on the C Corporation's Balance Sheet. The use of a C corporation in a private equity transaction offers a significant advantage by allowing the retention of additional cash on the C corporation's balance sheet. In a private equity transaction involving only pass-through entities, the holding company is typically required to distribute up to 45 percent of its earnings as a tax distribution to its members or partners. This distribution is designed to cover the taxes attributed to the income allocated to each partner of the pass-through entity. However, with a C corporation, there is no income allocated to the shareholders, and as a result, there is no need for tax distributions. Furthermore, the tax rates applicable to C corporations are generally lower than the rates applicable to individuals, allowing the C corporation to retain more cash on its balance sheet. This retained cash can be used to fund future investments or growth opportunities and can provide a significant advantage in terms of financial flexibility and stability. Additionally, dividends paid by the C corporation are at the discretion of the board of directors, giving shareholders more control over the distribution of profits.
Simplified Accounting for Shareholders. By choosing a C corporation structure for their private equity transaction, shareholders receive a simplified accounting process, which can be an attractive advantage. Unlike pass-through entities, C corporations do not require the preparation or filing of Schedule K-1s, which can be time-consuming and complex. Shareholders of a C corporation do not need to report their share of the corporation's income, gains, losses, and other tax items on their personal tax returns. Instead, they simply receive a Form 1099 for any dividends received.
A "Blocker" Corporation Would Be Unnecessary. Another key benefit of using a C corporation in a private equity transaction is the elimination of the need for a "blocker" corporation. A "blocker" corporation is typically established to shield foreign or tax-exempt investors from being directly subject to U.S. taxation and having their investment activities attributed to a U.S. trade or business. However, when all business activities are conducted directly or indirectly by a C corporation, there is generally no need to form a second "blocker" corporation for foreign or tax-exempt investors. Foreign or tax-exempt investors can still participate in the C corporation without worrying about being subject to direct U.S. taxation or having their investment activities attributed to a U.S. trade or business, as the C corporation bears the entity-level tax. This can simplify the overall structure of the transaction, reduce costs associated with setting up and maintaining an additional corporate entity, and attract a wider range of investors to increase the potential pool of capital available for the private equity transaction.
Potential Drawbacks of a C Corporation Structure
Limited Flexibility on Depreciation Allocation. Rollover transactions utilizing a C corporation may limit the private equity sponsor's ability to allocate depreciation of the target's assets. In a rollover transaction where a C corporation is utilized, the step-up in basis can only be allocated at the corporate level. On the other hand, by electing to use the remedial method of allocations under Section 704(c) of the Code, with a pass-through entity, the sponsor may choose to allocate the step-up solely to the members investing new money.
Lower Internal Rate of Return (IRR) for the Purchaser. The lack of tax distributions in a C corporation structure could also mean that the investor's capital is tied up for a longer period, further lowering the overall IRR. This is because the investor will not be able to receive their share of profits until they receive a dividend from the C corporation. In addition, the potential for double taxation as well as the required five-year hold period for Section 1202 treatment could result in fewer operating distributions and a longer investment term than in a pass-through structure. In contrast, in a pass-through structure, the investor could receive their share of the profits on a regular basis through tax and operating distributions, which would increase the overall IRR of the investment.
A Future Purchaser Could Try to Eliminate Any Section 1202 Benefit. The future purchaser of the C corporation may attempt to acquire the C corporation's underlying assets rather than acquiring the C corporation's stock. The goal of this strategy is to receive the benefit of a fair market value step-up in basis of the target's assets, rather than being restricted to a carryover basis. By acquiring the assets of the C corporation, the purchaser could potentially eliminate any benefit provided under Section 1202 of the Code, since this benefit can only be realized through the sale of stock. It is important to keep this in mind and consult with a tax professional when considering the use of a C corporation structure, as it may affect the overall financial outcome of transaction.
Corporate Governance Limitations. Utilizing a C corporation comes with a set of specific rules and governance requirements as mandated by state law. This can limit the flexibility in terms of form and governance of the entity. In contrast, other entities such as limited liability companies and partnerships provide more flexibility and can be tailored to better suit the needs of the partners. However, it is worth noting that incorporating a C corporation as a subsidiary of a holding company that is structured as a limited liability company or partnership, or electing the pass-through holding company be taxed as a C corporation, could help circumvent most of the governance limitations associated with C corporations. This allows for the benefits of a C corporation structure while maintaining the flexibility and customizable governance of a pass-through entity.
Double Taxation Risk. Another potential drawback to using a C corporation structure is the risk of double taxation. This occurs when the profits generated by the C corporation are subject to corporate income tax at the entity level, and then again when distributed to shareholders as dividends, which are subject to personal income tax. However, it is worth noting that the Tax Cuts and Jobs Act of 2017 lowered the corporate tax rate from 35 percent to 21 percent, reducing the potential impact of double taxation. Additionally, companies can also opt to retain earnings instead of distributing them as dividends to shareholders, avoiding double taxation. It is important for companies to evaluate the potential tax implications and consult with a tax professional to determine the best strategy for their specific situation.
Increased Administrative Burden. C corporations may have additional administrative responsibilities and requirements compared to pass-through entities, which could result in higher accounting and legal costs. These may include filing annual reports with the state, holding regular meetings for shareholders and directors, and maintaining separate financial records. While these requirements may not be as extensive as those for publicly traded companies, they can still add to the overall burden of running a C corporation.
There are a number of potential benefits to using a C corporation structure in a private equity transaction, including the ability to take advantage of Section 1202 of the Code and the potential for additional cash on the balance sheet. However, it is important to also consider the potential disadvantages of such a structure, such as double taxation, the potential for future purchasers to eliminate any Section 1202 benefit, and the corporate governance restrictions that may be imposed. Careful analysis and consideration of the specific facts and circumstances of each transaction is crucial in determining the optimal tax structure. Additionally, investors should consider the potential changes to tax laws and regulations as well as the potential impact on their returns over the life cycle of the business. It is important to consult with experienced tax professionals to determine the most efficient tax structure for your specific situation.
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.