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How the New Tax Law Impacts Funds and Investors
The Tax Cuts and Jobs Act (TCJA) of 2017 represents a major overhaul of the U.S. tax code, with corporate, individual, and international tax reform taking center stage. The legislation contains several provisions that could potentially boost capital investments in the middle market and increase deal flow across the U.S.
Many of these changes will alter the fundamental tax principles upon which investment and organizational decisions by the private investment community are made.
Corporate Tax Rate and AMT
For tax years beginning after December 2017, the TCJA provides for a permanent reduction of the corporate tax rate from a top graduated rate of 35% to a flat rate of 21%.
While the reduced rate takes effect in years beginning after 2017, corporations with fiscal 2017-2018 years will benefit from a blended rate under Code Sec. 15. The result is that these corporations will receive a benefit of the reduced corporate rates prior to its first fiscal year that occurs after December 31, 2017.
In addition, the TCJA repeals the alternative minimum tax (AMT) on corporations, eliminating some of the complexity inherent in U.S. corporate taxation. This will allow some corporations to use certain tax benefits to pay significantly below the new 21% rate. The change takes effect for tax years beginning after December 31, 2017.
What This Means
The reduction in the corporate tax rate and repeal of corporate AMT will increase the after-tax profitability of corporations, giving them more income to invest back into the business and thereby setting the stage for M&A activity. Companies will also benefit from more cash to fund acquisitions, increasing the value of private equity-owned companies.
Additionally, certain qualified small businesses structured as C corporations should make appealing targets for acquisition, since the reduction of taxable gain from the sale of qualified small business stock is still allowed under the TCJA.
The 21% corporate rate change will also impact any decision made to do an asset versus a stock purchase in any M&A transaction.
Deduction for Pass-Through Income
The TCJA created a temporary deduction (Section 199A deduction) for taxpayers with income from pass-through entities (sole proprietorships, partnerships, LLCs taxed as partnerships and S corporations), effective January 1, 2018, through December 31, 2025
This deduction is generally equal to:
However, for higher-income taxpayers, the qualified trade or business income component is limited to the greater of (a) 50% of the taxpayer’s share of W-2 wages from the qualified trade or business or (b) 25% of the taxpayer’s share of W-2 wages from the qualified trade or business plus 2.5% of the taxpayer’s share of the business’s unadjusted basis immediately after the acquisition of all qualified property.
The deduction cannot exceed taxable income. Qualified business income items are typically those items of income, gain, loss and deduction effectively connected with the conduct of a qualified trade or business in the U.S. Qualified business income does not include investment-type income (such as capital gains, dividends and non-business interest), reasonable compensation and guaranteed payments.
The provision, however, includes a limitation for high-income taxpayers in “specified service trades or business” (SSTBs). As a result, it’s likely these entities will need to alter their business structure due to the severe limitations imposed on their eligibility for the pass-through election. While there are several ways around this limitation, such as spinning off equipment or real estate into a separate entity to generate a pass-through deduction from that entity, these options are complicated.
Since REITs are classified as pass-through entities, their investors will benefit from the new 20% deduction. This should interest corporate managers who are considering conversion.
The new deduction is also good news for private equity investors. Pass-through corporate structures such as partnerships and LLCs is the preferred tax structure for private equity investment since it avoids the issue of double taxation and allows for flexibility in defining a company’s ownership and management structure.
For those seeking to acquire a company, these pass-through deductions could be problematic for targets that are non-qualifying businesses. It’s important for investors to understand the tax profile of the target acquisition as well as the other provisions of the TCJA which may affect the timing of a potential exit due to carried interest limitations, new limitations on business interest deductions and net operating losses, and the other aspects of the company being acquired.
Net Operating Losses and Limitation on Losses for Non-Corporate Taxpayers
The rules for net operating losses (NOLs) have changed so that they can now only offset up to 80% of taxable income. Carrybacks of these losses are no longer allowed, but these NOLs can now be carried forward indefinitely. This does not apply to NOLs that arise in tax years that began on or before December 31, 2017. These NOLs remain subject to the two-year carryback and 20-year carryforward rule until their expiration. They will also continue to be available to offset 100% of taxable income.
What This Means
This provision is likely to impact real estate operators and developers who typically conduct business as a pass-through entity. However, any non-corporate taxpayer who experiences significant business losses will be affected. Dealmakers should carefully review purchase price adjustments for deals in the pipeline, to the extent transaction expense tax benefits are included in deal economics.
The Carried-Interest Rule
The TCJA introduced the concept of an applicable partnership interest, which means that holders of carried interest, or profits interest, held by a general partner, will only be eligible for long-term capital gains rate on dispositions of capital assets held for more than three years. This applies if the business consists of -
In addition to the extended holding period applying to gain upon the disposition of the partnership interest itself, some observers suggest it likely also applies to assets that are disposed by the partnership when the taxpayer has an allocable share of any gain. In other words, the three-year holding period may apply both to the partnership interest (the carried interest) itself as well as to the disposition of assets by the partnership where gain will be allocated to the taxpayer with a carried interest.
Interests disposed of before the three years are met are taxed at ordinary income rates, rather than the more favorable capital gains rates.
General partners of private equity funds may continue to enjoy carried interest tax benefits as they could prior to the TCJA. However, the underlying investments and property (which may include investments in the form of partnership interests) that gave rise to the gain are held for more than three years. The new three-year holding period may not have much of an impact on general partners since this length of trading strategy is typical for most private equity funds.
Note: Under the provision, there is no grandfathering of existing investments. Exiting a position during the current year that was held three years or less would be subject to the short-term gain conversion. Fund managers should also take note of any splitting of holding periods when exiting positions that would result in a three-year or less holding period.
The Limitation on Business Interest
Prior to the new law, bona fide interest expenses were fully deductible for most businesses. The TCJA limits net interest expense deductions up to 30% of adjusted taxable income (roughly the equivalent to EBITDA prior to 2022, and EBIT after 2021).
There are two important exceptions:
What This Means
The new limits on the deduction of interest expense by businesses will reopen the issue of debt versus equity financing. In the future, the balance is likely to shift to favor equity financing.
Furthermore, the limitation on business interest deduction reduces the advantage of financing M&A transactions with debt since the cost of debt-financed acquisition will be higher under the new law. Also, carryforward of disallowed interest is an item considered for certain corporate acquisitions described in Code Sec. 381 and is treated as a “pre-change loss” subject to limitation under Code Sec. 382. This means that highly leveraged corporations will be considered loss corporations and will be subject to Code Sec. 382 solely because they have disallowed interest.
The Participation Exemption System
The TCJA introduced a participation exemption (territorial) system of taxing foreign income. This takes the form of a 100% deduction of the foreign-source portion of dividends received from specified 10%-owned foreign corporations by U.S. corporate shareholders. This will allow U.S. corporations to access the cash on the balance sheets of their foreign subsidiaries at a lower U.S. tax cost. This could fuel additional acquisitions by U.S. entities, although many may find that very little of their foreign subsidiaries’ income will be eligible for the 100% deduction due to global intangible low-taxed income (GILTI).
The TCJA significantly expanded the application of Subpart F, including adding a new inclusion rule for CFC (controlled foreign corporation) income, aka GILTI. The GILTI rules apply higher tax rates to GILTI attributed to individuals and trusts who own CFC stock (either directly or through LLCs or S corporations) than to C corporation shareholders.
Expect a Big Impact in Coming Months
We can expect significant regulations and explanations from the Department of the Treasury and IRS in the coming months to address many of the areas of uncertainty in the wide-reaching and complex new tax law. Also, the legislation passed without any support from Democrats. Should the Democrats regain control of Congress, they may seek to modify the TCJA. However, it might prove difficult to undo provisions in the new tax law favored by U.S. businesses.
Regardless of the outcome, private equity and other alternative funds may wish to reconsider their stance on taxes with future portfolio companies in terms of pass-through versus corporate structures. The decision will be heavily influenced by the make-up of the fund’s investor base and business characteristics, such as location of operations (domestic versus foreign), and the type of operation.
To learn more about how CT can help you better manage your compliance requirements, contact your CT representative or call 855.316.8948 (toll-free U.S.).
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