Tax Takeaways for
Private Equity

• 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.

• 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.