How the New Tax Law Affects Private Equity and VC Firms
Six months after the Tax Cuts and Jobs Act (TCJA) was enacted, businesses are still trying to decipher its nuances and impact on their specific industries. The private equity sector in particular will be greatly affected, with immediate effects already underway.
It is imperative that private equity and venture capital firms understand how these changes will impact their funds, portfolio company investments, investors and management team. In this piece, we will explore the most important changes that will affect the private equity sector moving forward.
There is no denying that the carried interest rules are a topic of contention. The TCJA imposes limitations on long-term capital gain treatment on gains associated with a carried interest. Application of certain aspects of the new rules is the subject of debate, but generally for a taxpayer to receive long-term capital gain treatment related to gains associated with a carried interest, the underlying property sold must have a greater than three-year holding period. Gains related to carried interests with less than the three-year holding requirement will be reported as short-term capital gains. The rules do not apply to carried interests held by corporations; however, the IRS announced that it intends to issue "regulations clarifying that taxpayers will not be able to circumvent the three-year rule by using 'S corporations.'"
Private equity funds also should pay close attention to the different ways the TCJA will affect C corporations and pass-through entities, as it could impact the operations of such entities, the valuation of the investments at time of exit, and how such investments are structured going forward.
1. C corporations
The TCJA reduces the top corporate income rate from 35 percent to 21 percent, effective Jan. 1, 2018, and eliminates the corporate alternative minimum tax (AMT). It also places limitations on the use of net operating losses (NOLs), which could affect the valuation of entities with significant losses.
In lieu of two-year carry back and 20-year carry forward rules, NOLs arising after Dec. 31, 2017 have unlimited carry forward periods and are limited to 80 percent of taxable income, and the carryback provision is eliminated. This means sellers looking to benefit from transaction cost deductions (which create a NOL in the pre-acquisition year) will not be able to carry back NOLs to offset income earned in prior taxable years.
2. Pass-through entities
The TCJA attempts to line up the effective tax rates for owners and investors of pass-through entities with the newly reduced corporate tax rate. Beginning in 2018, new Section 199A allows a 20 percent deduction from a taxpayer's share of qualified business income in a qualified business.
Unfortunately, the investment income that private equity firms generate does not meet the definition of "qualified business income," so this tax saving opportunity may not benefit all investors. However, they may find value in tiered structures, where the fund or an alternative investment vehicle can receive qualified business income from an investment in a lower-tier pass-through entity.
Portfolio company operations
Funds should also be aware of the TCJA's limitation of interest expense deductions when managing portfolio company operations. Beginning in 2018, the annual deduction of net business interest expense will be limited to the entity's interest income plus 30 percent of its adjustable taxable income. This is calculated at the entity level, and disallowed business interest deductions are carried forward by pass-through owners indefinitely.
Due to the fact that debt is often used by private equity funds in acquisition transactions, the limitation of interest expense deductions will have an impact on the overall cost of capital. In addition, the benefit of using blocker entities to shield tax-exempt and non-U.S. investors from adverse U.S. federal tax consequences may be reduced if such blocker entity can no longer fully utilize interest expense deductions to offset other income. Private equity funds may need to reconsider how they structure and finance acquisition transactions due to the imposition of the interest expense limitation.
Changes to individuals' taxes
Changes affecting individuals could also have an impact on private equity investors and management team members. The largest changes come from the reduction of the top marginal tax rate from 39.6 percent to 37 percent, and the elimination or cutback of certain itemized deductions. The reduction of individual tax rates are currently set to expire after 2025.
Business losses for individuals are now limited to $250,000 per year (or $500,000 for joint filers) for tax years starting Jan. 1, 2018, though these limits also expire after 2025. The limitation applies to the aggregate of all personal and pass-through losses for the year from a trade or business, and as such, precludes individuals from deducting such losses from a management company or pass-through portfolio in excess of these levels.
Private equity firms and investors impacted by the TCJA should develop a plan to address any changes that may be made to effective tax rates, preferred operating and acquisition structures and Schedule K-1 disclosures.
The full effect of this new law generally applies on Jan. 1, 2018 and will not be officially measured until next tax season, but the sooner one can plan for and implement changes, the better. Understanding how the changes impact your business is the first step to creating the best plan for your private equity and venture capital endeavors. As always, speaking to a professional is the best way to tackle any changes you may face as the TCJA takes effect.