Tax Takeaways for
Private Equity

• The Wyden proposal is intended to close of number of so-called “loopholes” and limit existing flexibility inherent in the current partnership tax rules.
• Of particular importance to Private Equity partnerships and their portfolio companies is the proposed requirement that economic capital account revaluations would be mandatory upon the occurrence of certain events. Under current rules, most revaluations are optional. Mandatory revaluations may increase the overall complexity of required partnership reporting.
• Related to mandatory revaluations, the Wyden Proposal would also require use of the “remedial” allocation method as it relates to unrealized built-in gains or losses. Except in situations where the partnership holds only corporate stock, the remedial allocation method would significantly increase the reporting requirements of portfolio companies and would likely impact the timing of income/expense recognition.
• Finally, the Wyden Proposal would fundamentally change the manner in which partnership liabilities are allocated among partners. For partnerships that make debt-financed distributions, the ability of partners to defer gain recognition may be significantly hindered.

• Accelerate Income prior to the potential corporate rate increase by utilizing one of the following methods:
  • Recognize advance payments as income via the one-year deferral method or full-inclusion method
  • Elect out of the installment sale method for any proceeds associated with a sale that are received after the close of the taxable year thus recognizing the total gain in the year of sale
  • Sale Lease-back transactions to recognize the gain in year of sale
• Defer deductions so the liability comes due in a year where the tax rate is higher, such as:
  • Certain accrued liabilities which are generally deductible when paid
  • Certain accrued compensation is deductible upon accrual if the payment is made 2.5 months after year-end.  If the payment is delayed the deduction would follow to the tax year in which the payment is made
  • Certain related party payments are typically not deductible until payment is made or income is recognized by the related party
  • Capitalize expenses to deduct over future tax years rather than the full expense in the current year
  • Forego bonus depreciation on fixed assets to depreciate over the tax lives of the assets instead of fully deducting in the year the asset is place in-service

• Under current legislation, active limited partners of state law limited partnerships can possibly avoid both the net investment income tax (“NIIT”) and the self-employment tax on their distributive share of partnership income.
• The proposed legislation would require limited partners who are active in a trade or business to be subject to the self-employment tax on their distributive share of partnership income, thus adversely affecting many Private Equity funds and their management company entities

This potential exit strategy can provide tax benefits to both the owner and the company such as:

• Deferral of capital gain from the sale of stock to an ESOP (if certain conditions are met)
• ESOP’s are tax-exempt thus any profits from an S-Corporation owned by an ESOP are not subject to federal income tax (and potentially certain states)
• Contributions to an ESOP from the company are tax deductible
• Dividends paid from stock held by an ESOP are tax deductible to C-Corporations
• Estate and Gift planning opportunities

• PE funds and the fund sponsors may benefit from the passthrough entity tax election (“PTE”) in which the state would allow partnerships and s-corporations to be taxed at the entity level as a workaround for individuals capped at the maximum deduction of $10,000.
• PE Funds and their portfolio companies could be subject to audit for the tax years impacted by the TCJA for incorrect changes to the federal tax returns that would affect the state tax calculations
• Portfolio companies should be aware of the bright-line economic nexus thresholds for remote retailers and marketplace providers as this would affect sales and use tax nexus.

• Asked what tax changes funds are planning for or most concerned about in the next year, the increased taxation of digital products and services was the biggest concern (58.5%), beating out concerns for a potential capital gains tax increase by 8 points.
• Taxation of digital products and services carries broader implications and uncertainties than some other tax concerns, as there are both domestic (state income tax) considerations as well as global implications for sales into foreign jurisdictions that funds may need to navigate.
• Impacts of the interest expense deduction calculation being based on EBIT instead of EBITDA took third place for biggest tax‑related concerns (50%). Changes to the ability to deduct business interest expense may result in the need to put more capital into portfolio companies, thus constraining, to a degree, firms’ ability to be acquisitive.

• For partner’s invested in private equity funds, their share of income that is categorized as “carried interest income” under Section 1061 could be taxed at ordinary rates as opposed to capital gain rates if their income from all sources exceeds $400,000 for the tax year and would also be subject to the self-employment tax.
• Limited partners and LLC members who materially participate in their partnership’s trade or business would be subject to the 3.8% self-employment tax on their distributive shares of income should it exceed certain threshold amounts. This is of significant relevance to private equity management companies as high-income active owners of pass-through businesses often pay little or no self-employment tax under the current regime.
• Private equity portfolio companies would be affected by an increase to the corporate tax rate from 21% to 28%.

• An “earnout” or “contingent consideration” is something to take into account while negotiating a deal to buy or sell a PortCo as it may allow for a better risk-sharing arrangement between the buyer and seller.
• Earnouts included in the purchase price of an acquisition may create a tax benefit to the seller as they might be able to defer some or all of the gain recognition upon sale if certain criteria are met.
• Earnouts can also be tied to performance of the company post-acquisition, where the Seller is to remain employed and the amount of consideration paid is contingent on the earnings of the company into the future.
  • This can have both favorable and unfavorable tax consequences
    • The Buyer is entitled to take a tax deduction for the earnout paid as compensation
    • The Seller who stays on as an employee is taxed at ordinary income rates up to 37% rather than at the 20% capital gains rate if the earnout were tied to the purchase price
• When considering an earnout as part of deal negotiations there are many tax and non-tax advantages and disadvantages to consider and many require a deep analysis of the facts and due diligence is encouraged on both the Buy and Sell side of the deal.

• Portfolio companies that have a significant decline in gross receipts or had operations fully or partially suspended due to a COVID government order are eligible to claim the employee retention credit in 2020 and 2021  
• Eligible portfolio companies can claim a credit up to $33,000 per employee for qualified wages paid in 2020 and 2021
• Individual portfolio companies can be eligible depending on the facts and circumstances and should be evaluated to determine if aggregation with other portfolio companies is necessary

• NEXUS AND THRESHOLDS - Private equity firms should factor into their investment strategies and decisions not only the administrative and compliance issues that may result from having to file in multiple new jurisdictions, but the additional tax costs and advisor fees that would necessarily attend additional filings.
• ASCERTAINING IMPACT ON EBITDA, INCOME TAX – A gross receipts tax, which characterizes most digital taxes, is above the line and would impact on EBITDA.
• HOW TO NAVIGATE COMPLEXITY AND MAXIMIZE RETURNS – Scenario planning to determining how OECD digital tax proposals, if enacted, would affect global investment strategies and targets' tax positions for impact on EBITDA and potential liabilities.

• Private Equity funds may be eligible to exclude up to 100% of the gain upon exit from an investment in a qualifying small business as the sale or exchange of Qualified Small Business Stock (“QSBS”) held for more than five years, is eligible for exclusion under IRC Section 1202 (subject to limitations), providing tremendous tax savings for PE Funds and their sponsors.
• Section 1202 gain exclusion can apply to many of the typical exit strategies utilized by PE firms such as:
  • Sale of Stock as part of an IPO
  • Exchange of QSBS for publicly traded stock
  • Sale of a company for cash, or cash, stock, and debt instruments
  • Sale of a PE firm’s securities back to the company in a redemption transaction
• The eligibility criteria is complex and should be carefully considered when structuring a new target acquisition, especially as it relates to private equity funds, as the hold period of investments are generally five years or less, and the corporations chosen generally exceed the $50 million aggregate gross assets threshold, thus not qualifying as QSBS.