On December 22, 2017, the tax reform bill commonly known as the Tax Cuts and Jobs Act (the “Act”), was signed into law by President Trump. The Act is the most sweeping tax reform legislation in over 30 years and will have significant impacts on the private equity industry and on M&A activity in general.
On the domestic front, the headline reforms are a reduction in the corporate tax rate from 35% to 21% and a new deduction for non-corporate owners of pass-through entities (such as partnerships, LLCs taxed as partnerships and S corporations) and sole proprietorships that effectively lowers the tax rate on certain owners of such businesses. The Act also contains several revenue raisers that will impact private equity and M&A, including modifications to the taxation of carried interests and limitations on the deductibility of interest and net operating losses (NOLs).
The following is a high-level summary of important features of the Act that will affect private equity and M&A transactions in 2018 and beyond.
Effective for tax years beginning after December 31, 2017, the Act reduces the corporate tax rate from a top graduated rate of 35% to a flat rate of 21%. The Act also repeals the corporate alternative minimum tax.
The reduced corporate tax rate should impact the valuation of corporate targets for future deals and possible purchase price adjustments for currently pending transactions. In addition, this change should reduce the tax impact of an asset sale by a C corporation and, correspondingly, it also reduces the value of stepped-up asset basis for a corporate buyer (at least after the expiration of the temporary 100% bonus depreciation provision discussed below). As a result, the reduced corporate tax rate will change the calculus of whether a potential acquisition should be structured as a stock or asset acquisition.
The 21% corporate rate, when combined with the top qualified dividend rate of 23.8% for individuals, results in an effective tax rate of 39.8% on corporate earnings distributed to individual shareholders (this effective tax rate was previously about 50.5%). This is now comparable to the highest individual tax rate of 37% (plus the 3.8% Medicare or Net Investment Income tax, if applicable), which was reduced from 39.6% under the Act. As a result, the use of a C corporation and the resulting double taxation of earnings that are distributed to shareholders does not have the same impact as in the past (particularly when the new 20% deduction for qualified business income discussed below is unavailable).
The new attractiveness of C corporations will be further increased for new or existing companies that can qualify as a “qualified small business” under the Section 1202 rules, which remain unchanged by the Act. These rules provide for a 100% exclusion on the gain from the sale of stock of certain C corporations (up to the greater of $10 million or 10 times the basis in such stock) that was acquired at original issuance and held for at least five years.
As a result of the lower corporate tax rate, we believe there will be some increase in the use of C corporations for new ventures where a pass-through entity was historically the preferred option, as well as some conversions of existing pass-through entities into C corporations. There are many factors that influence the choice of entity that should be used in any particular business structure, but the more likely a business is to generate operating profits that will be reinvested in the business (rather than distributed to the owners), the more attractive a C corporation might become due to the lower 21% tax rate, the benefits of deferral on the second level of taxation at the shareholder level, the reduced tax filing obligations for shareholders, and the potential of excluding gain on the sale of qualified small business stock.
The Act provides for a 20% deduction for a non-corporate taxpayer’s allocable share of qualified business income (QBI) from partnerships, LLCs taxed as partnerships, and S corporations. In addition, although the deduction is commonly referred to as a “pass-through” deduction, it also applies to QBI from a sole proprietorship that is not operated through an entity.
QBI is generally taxable income with respect to a trade or business within the U.S., but excludes passive income (generally capital gains, dividends, and interest). Amounts paid for employee-type services to a business, such as a guaranteed payment from a partnership in exchange for services or amounts paid by an S corporation that are treated as reasonable compensation, are excluded. This will likely lead to increased scrutiny by the IRS over what constitutes reasonable compensation to S corporation shareholders and the characterization of partnership profits earned by service partners.
There are several limitations on the deductibility of QBI, and they are applied separately to each qualified trade or business. The deduction is capped at the greater of (i) 50% of the individual’s share of the W-2 wages paid by the business to employees and (ii) 25% of such W-2 wages plus the individual’s allocable share of 2.5% of the unadjusted cost basis of the business’s “qualified property” (generally depreciable assets used in the business).
Because of the limitations on QBI being keyed to wages paid by the qualified trade or business (or wages paid plus capital invested), careful consideration will be needed in designing the organizational structure of a business to ensure that wages paid to employees are appropriately credited to the qualified trade or business. For example, many partnerships that issue equity to employees have setup employment companies as separate entities to avoid certain self-employment issues for those employees. These structures may need to be reexamined to ensure that wages paid by the employment company count towards the pass-through deduction limitation. In addition, this limitation creates an incentive to treat service providers as employees rather than as independent contractors.
The pass-through deduction is generally not allowed for income from a “specified service trade or business,” which includes (but is not limited to) service businesses in health, law, accounting, consulting, and financial services, unless an individual’s taxable income is below a certain threshold. The specified service trade or business exclusion phases in for a taxpayer with taxable income in excess of the applicable threshold amount, currently $315,000 plus $100,00 for joint filers, and $157,500 plus $50,000 for other taxpayers. The exclusion for service related businesses means that management fees received by an investment manager of a private equity fund would not be QBI, but pass-through income earned by the fund from its non-corporate portfolio companies could qualify as QBI.
The pass-through deduction applies at the individual partner or shareholder level. Existing tax distribution provisions in partnership agreements and LLC operating agreements, therefore, generally will not account for the deduction. Accordingly, such provisions should be amended if the relevant parties want to account for the deduction in calculating tax distributions.
For taxpayers that are in the top individual income tax bracket of 37% and also able to take advantage of the full 20% deduction for QBI, this will result in an effective top marginal rate of 29.6% (plus the 3.8% Medicare or Net Investment Income tax, if applicable). This effective rate remains appreciably lower than the 39.8% effective rate applicable to income of a C corporation distributed to individual shareholders.
Although, as mentioned above, we believe the reduced corporate tax rate will likely result in at least some increase in the use of C corporations, we believe the majority of portfolio companies will continue to operate as pass-throughs. The traditional benefits of pass-through entities (e.g., flowing losses through to owners, a single-layer of tax, and the ability to give a buyer the benefit of a basis step-up in the company’s assets), coupled with the new pass-through deduction, will likely outweigh the benefits provided by the lower corporate tax rate. In addition, if corporate tax rates are raised in the future, the costs of converting from a corporation to a pass-through could be prohibitive, while if the opposite were to occur, a pass-through entity generally can convert to a C corporation in a nontaxable transaction.
The Act extends the holding period from 1-year to 3-years for assets held by an investment fund before service providers holding carried interests in the fund can recognize long-term gains on the sale of such assets. The extended holding period only applies to “applicable partnership interests” that are received in connection with the performance of substantial services in a trade or business that consist of (i) raising or returning capital, and (ii) either investing in (or disposing of) certain investment assets or developing such assets. This definition of “applicable partnership interests” should capture virtually all carried interests issued to principals of an investment fund. The provision applies to interests issued prior to the effective date of the Act (i.e., no grandfathering).
The extended holding period may have limited effect on most private equity investments, as there is typically an investment horizon beyond 3 years, but this obviously creates concern in cases where there is a potential for a quick flip. In addition, funds should monitor add-on investments made by their portfolio companies to ensure, to the extent possible, that they do not lose the benefit of a historic holding period with respect to such investments. Depending on how such investments are structured, they could result in a bifurcated (or new) holding period that would implicate the application of this rule.
This new rule does not apply to partnership interests held by a person employed by a company (other than the issuing partnership) that is engaged in an “applicable” trade or business (i.e., not an investment management-type business) if such person provides services only for that company. We therefore believe that most profits interests issued to executives and employees of a portfolio company should not be subject to the new holding period requirement.
While the increased holding period requirement applies to the traditional carried interests in a private equity fund, it should be noted that it does not apply to the interests held by the sponsor that directly relate to cash investments in the fund and only provide returns commensurate with other capital contributed. This exception should apply to basic capital interests, but it will likely not apply to “catch-up” type interests embedded in a capital interest.
Probably the most interesting aspect of this new rule is that it creates a new environment where the long-term holding period for fund sponsors is different than that of investors. Sponsors and investors will need to carefully address this potential conflict when structuring future investments.
The Act provides for 100% bonus depreciation for qualified property placed in service between September 27, 2017 and January 1, 2023. Qualified property generally includes most tangible property (other than buildings and some building improvements) and computer software. The 100% bonus depreciation rate is scheduled to be phased down for property placed in service starting in 2023 with a 0% rate applying in 2027 and thereafter.
Previously, bonus depreciation was 50% and only applied to new property placed in service for the first time. Expanding bonus depreciation to 100% provides full expensing for new equipment purchases for businesses, providing a substantial incentive for capital investments. However, including used property should have even larger implications for M&A transactions, as structuring a transaction as an asset acquisition (or as a deemed asset acquisition such as a stock acquisition with a Section 338(h)(10) election) now provides an immediate deduction to the buyer for any purchase price allocable to equipment or other qualified property. Accordingly, when looking at a potential acquisition or sale of an operating business with significant tangible property, there will be a substantial advantage from the buyer’s perspective to structure as an asset sale (or deemed asset sale) and an increased importance will be placed on the allocation of the purchase price among the assets of the business.
While nothing is certain when it comes to planned phase outs, as there is often political pressure to extend taxpayer favorable provisions as sunset provisions get closer, private equity funds should consider these planned phaseouts in long-term strategic planning, as valuations for portfolio companies could change for a potential buyer if full expensing is not available.
The Act will have a significant impact on the role of NOLs in M&A transactions. The reduced 21% tax rate applicable to corporations will reduce the value of NOLs to potential buyers. In addition, under the Act, NOLs can no longer be carried back to prior years, but can be carried forward indefinitely (previously, NOLs could be carried back two years and carried forward 20 years). NOLs created after 2017 can only be used to offset a maximum of 80% of a taxpayer’s taxable income.
A target corporation will often incur substantial transaction-related expenses that generate an NOL for the target corporation’s year that ends (or is deemed to end) on the closing date. Previously, this NOL could be carried back to receive refunds of prior year income taxes, and selling shareholders frequently would be compensated for the tax benefit arising from the NOL generated by these transaction-related deductions (either through an increase in the purchase price paid at closing or through post-closing payments as the tax benefits are realized by the buyer). Now that such an NOL cannot be carried back to obtain an immediate tax benefit and can only be carried forward, the value of such NOL will be limited by the application of both the new 80% limitation as well the Section 382 limitation, which remains intact under the Act. These changes will affect negotiations regarding whether, and how, sellers get compensated for tax benefits arising from transaction-related expenses.
Under the Act, taxpayers can deduct business interest expenses only up to 30% of adjusted taxable income (ATI). ATI is generally defined in a manner equivalent to earnings before interest, taxes, depreciation and amortization (EBITDA) until 2022, but after 2022 will not include deductions for depreciation, amortization, or depletion (EBIT). These new rules will not apply to certain small businesses with average gross receipts of under $25 million. Disallowed interest deductions can be carried forward indefinitely
These new limitations on the deductibility of interest will impact the ability to highly lever a portfolio company and could result in the use of more preferred equity in place of subordinated debt. In addition, given the lack of grandfathering of outstanding debt, companies that are potentially subject to these limitations should assess whether they should adjust their capital structure.
While the Act provides many taxpayer benefits that are likely to encourage private equity and M&A activity, there are also several areas where more restrictive rules are being applied. Although many of the historic strategies and structures for private equity and M&A will continue to be utilized, we believe the Act will provide opportunities to improve on these past structures and to create new ones. As the Act is modified and clarified by future technical corrections and guidance from the Treasury Department and the IRS, DGS will continue to monitor and provide updates on key developments.
For more information on the Act and its potential impact on existing organizational and transaction structures, please contact the authors of this alert.