• Tax Takeaways for
    Private Equity

    As an asset class, changes in regulatory and tax regimes
    can significantly affect private equity.

    View our Takeaways

With the tax landscape experiencing dynamic changes both domestically and globally, businesses across sectors are challenged to mitigate their tax risk and stay up to date with new reporting and compliance requirements.

 

BDO’s Private Equity practice makes it easier for you to understand the tax implications that arise from new developments—from tax reform to taxation of digital products and services, and more. Read below for the latest in tax takeaways for private equity firms and their portfolio companies.

 New Insight Icon NEW TAX TAKEAWAY | FEBRUARY 2022

Tax Considerations for Private Equity Funds and Investors 

The federal income tax rules that apply to private equity funds and investors have been the subject of much debate. Private equity funds and fund investors should continue monitoring proposed legislation for tax considerations.
 

 Tax Takeaways for Private Equity

  • Recent proposals in both the House and Senate have sought to either further extend the holding period requirement for long-term capital gain treatment from three to five years or effectively tax all carried interest allocations as ordinary income, except in the case of taxpayers with taxable income below $400,000.
  • H.R. 5376 in its current form would limit the gain exclusion for Qualified Small Business Stock to 50% for dispositions occurring after September 13, 2021, subject to a binding contract exception.
  • H.R. 5376 would ensure that all trade or business income earned by high-income taxpayers (taxpayers with adjusted gross income in excess of $400,000) is subject to either the NIIT or self-employment tax. If enacted, the proposed legislation would result in fund managers earning more than $400,000 paying either self-employment tax or NIIT on their distributive shares of partnership income at a likely rate of 3.8%.
  • Partnerships, including private equity funds, that have items relevant to the determination of the U.S. tax or certain withholding tax or reporting obligations of their partners under the international provisions of the Internal Revenue Code must complete the relevant parts of new Schedules K-2 and K-3 beginning with the 2021 tax year.

 New Insight Icon NEW TAX TAKEAWAY | NOVEMBER 2021

Third Time's the Charm? 

The third version of the Build Back Better Act highlights several proposed tax law changes that could affect Private Equity funds and their investors.
 

 Tax Takeaways for Private Equity

  • The latest draft aims to aid with the current SALT “cap” by increasing the limitation on an individual’s state and local tax deduction from $10,000 to $80,000 for tax years beginning after December 31, 2020
  • Taxpayers earning an adjusted gross income (“AGI”) of $400,000 or more are currently eligible for 75% and 100% exclusions from the sale of qualified small business stock (“QSBS”).  The proposal reduces the exclusion to 50% for all taxpayers with an AGI in excess of $400,000 for QSBS acquired and sold within a certain period, thus potentially making Section 1202 planning opportunities less attractive
  • The proposal seeks to broaden the definition of net investment income subject to the net investment income tax (“NIIT”) by including income derived in the ordinary course of a trade or business and income from the disposition of property earned outside of a passive activity and therefore imposing the NIIT on taxpayers whom historically may not have been subject to it.
  • High-income individuals defined as individuals with a modified adjusted gross income (“MAGI”) exceeding $10 million would be assessed a 5% surcharge on their MAGI with additional surcharges for MAGI in excess of $25 million for tax years beginning after December 31, 2021.
Tax Pulse Survey

 

OCTOBER 2021
Our fall 2021 survey examines the trends that 200 middle market private equity fund managers are seeing and the tactics they are deploying throughout the deal lifecycle.

  • The tax change that is most concerning to PE Fund managers is the potential capital gains tax increase, causing PE firms to exit investments at a rapid pace to take advantage of the current lower tax rate.  Further, the potential tax change has put additional emphasis on exit strategy at the initial phase of a potential investment.
  • PE Funds are also keeping a close eye on the proposed legislation to close the Carried Interest “loophole”, which aims to significantly lengthen the holding period to obtain capital gain treatment until substantially all capital has been invested. 
    • While the Senate’s response to the House bill has not yet been revealed, the current draft legislation does not include any change to the current carried interest rules.
  • Integrating ESG into a PE Fund manager’s strategy is more popular than ever.  Creating sustainability amongst their portfolio creates value and bolsters the communities in which the portfolio companies reside by generating higher tax revenues, job creation and community outreach.

Senator Wyden Releases Far-Reaching Partnership Taxation Proposals

 

SEPTEMBER 2021
Senate Finance Committee Chair Ron Wyden, D-Ore., on September 10 unveiled a discussion draft of legislation that would significantly change the way passthrough entities, primarily partnerships, are taxed.

  • 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.

How to Realize Tax Savings When Tax Rates Increase

 

AUGUST 2021
There may be several tax planning strategies that corporate portfolio companies may want to consider in light of the potential corporate tax rate increase.

  • 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

The Self-Employment Tax Exemption May Be Ending for Some Limited Partners. Will You Be Impacted?

 

AUGUST 2021
Details on changes proposed by the Biden Administration that aim to rationalize the net investment income tax (NIIT) and the self-employment tax imposed under the Self-Employment Contributions Act.

  • 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

Unlocking Liquidity: Selling Your Business to an ESOP

 

AUGUST 2021
Employee Stock Ownership Plan (“ESOP”) transactions can be advantageous to private equity companies who do not necessarily want to sell a portfolio company to a third-party.

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
Although there are many tax benefits of selling a portfolio company to an ESOP, there are also many considerations, both tax and non-tax, to take into place when structuring this type of sale.

SALT Watch: 5 Issues to Consider in 2021

 

MAY 2021
States are revisiting taxpayers’ compliance with their “nexus” rules and other tax policies and considering new taxes on digital services. In addition, many state governments are reconsidering the extent to which they are willing to conform to federal tax rules and legislation.

  • 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.

BDO’s Private Capital Pulse Survey

 

SPRING 2021
BDO’s Private Capital Pulse Survey – Spring 2021, surveyed 200 PE and VC fund managers on a number of topics from M&A, ESG, and Tax to name a few. No longer in triage mode and with a better understanding of which sectors are thriving or struggling, private equity is gearing up for a highly competitive year of M&A.

  • 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.

Treasury’s Green Book: Impact on the Asset Management Industry

 

JULY 2021
On May 28, 2021, the Treasury Department released its General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals, commonly referred to as the “Green Book.

  • 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%.

Book and Tax Implications of Earnouts

 

MARCH 2021
One of the many challenges in any deal negotiation is for the buyer and seller to reach an agreement on the purchase price. This is especially true during times of economic turbulence, like the COVID-19 pandemic, when current business results may not reflect the past or future earnings of the target. To reach an appropriate purchase price that takes this uncertainty into account, the parties may choose to include an “earnout” in the acquisition agreement.

  • 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.

Private Equity Funds Maximize ROI with Employee Retention Credit

 

APRIL 2021
Private equity (PE) funds looking to maximize their return on investment (ROI) may generate cash by claiming the recently enhanced employee retention credit (ERC) for their eligible portfolio companies.

  • 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

Global Taxation of Digital Transactions Considerations for Private Equity

 

FEBRUARY 2021
Private equity firms contemplating investing in or divesting themselves of digital businesses should be considering the potential impact of a global digital tax.

  • 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.

Qualified Small Business Stock Can Provide a Strategic Advantage to Private Equity Groups and Venture Capitalists

 

FEBRUARY 2021
With the 100% exclusion now permanent, Section 1202 can present a valuable tax savings opportunity for PE funds and their investors upon their exit from investment in a qualified small business.

  • 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.


Professional Headshot of Verenda Graham
Verenda Graham
Partner; Private Equity Tax National Leader

Verenda Graham is BDO’s national Private Equity Tax leader and a partner in the firm’s Tax  practice. In her role, Verenda is responsible for overseeing BDO’s delivery of tax services to private equity funds and their portfolio company investments. Verenda has more than 23 years of experience providing strategic tax advice to private companies, private equity-backed portfolios, and inbounds. 

 

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