Welcome to the post Tax Cuts and Jobs Act era. With the ink still drying on the final bill, private equity investors and sponsors need to start focusing on provisions that could alter the mechanics of equity investing and the expected returns from those investments. In the immediate aftermath of enactment, the work to be done will likely focus first on identifying and framing the questions surrounding the most salient provisions affecting private equity investment funds. Here’s a quick look at a few of the key provisions that may affect private equity, some of the questions those provisions generate, and early indications of what the answers might be.
Limits on deductibility of interest expense. The new law limits the deductibility of net interest expense to 30 percent of EBITDA for the next four years, then increases the limitation to 30 percent of earnings before interest and taxes after that. Investors and managers should be asking:
How much leverage does a fund’s investment strategy entail? Does the strategy need to change? While deductibility of interest is not the only reason private equity relies on debt to finance transactions, this change could have a fundamental impact on the after-tax ROI of any leveraged acquisition.
Are there new structures for funds or transactions that could reduce the negative effect of the provision? The negative impact would be partially offset by the reduced corporate tax rate but would definitely have an impact on distressed funds.
Corporate income tax rate lowered to 21 percent. This change will affect C corporation portfolio companies as well as groups that employ a “blocker corporation” structure to accommodate certain types of investors. Consider:
If a fund is structured to benefit from a lower corporate rate, has it projected the expected increase in cash flow that will result? Given the limitations on deductibility of interest, has management considered paying down debt with the increased cash flow from the lower tax rate?
If the group uses a blocker corporation structure, are existing and potential tax-exempt and foreign investors aware of its increased value under the new rules?
The reduced corporate tax rate may make the pass-through entity structure less attractive. While individual rates are reduced to 37 percent, the deductibility of state and local taxes have now been limited.
Has the group considered the potential negative impact on tax receivable agreements? The lower tax rate will decrease the benefit of the step-up, in turn possibly reducing the typical 85 percent payout to pass-through recipient sellers.
With the value of step-ups decreased, the amount that a purchaser should be willing to pay in order to obtain a step-up will also be decreased. This may impact future deal structures and pricing.
100 percent expensing of business assets. Consider the following questions:
Since this provision now applies to new and used assets, could it make asset acquisitions or deemed asset acquisitions more attractive? If so, it could shift the calculation of ROI for an asset deal and make it more attractive than purchasing an equity interest.
Will the states follow suit? If the feds tax a transaction one way and states tax it differently, the cost of compliance and the risk of errors may increase to the point of making some deal structures undesirable. This would also make the corporate solution more attractive since corporate state tax obligations are met at the corporate level and not passed up to individual investors.
20 percent deduction of qualified business income from certain pass-through businesses. On its face, this provision sounds like it should affect many private equity operations. However, wage limitations and the fact that the deduction does not apply to certain service-based activities may reduce, but likely not eliminate, the advantage this provision will provide to investors. The limitation on service activities will also preclude the deduction from applying to the management company’s income.
Segregation of UBTI gains and losses. If a fund investment generates unrelated business taxable income (UBTI) for a tax-exempt investor, the new rules will prohibit netting that income against losses from other taxable trades or businesses carried on by the tax-exempt investor. Currently all UBTI is allowed to be netted to arrive at a net income or loss. Tax-exempt and foreign investors will likely look more closely at the types of investments a private equity fund holds.
With any change in tax law, the early days after enactment tend to generate more questions than answers. We’ve discussed a few of the broad-brush questions and possible answers that come to mind based on common business practices among private equity groups. However, much still remains to determine how these provisions apply to the multitude of individual structures that entrepreneurs have created to manage private equity investments. If you have questions, please give us a call.
To learn more about how the new tax reform impacts private equity, please feel free to contact Annette Tenerelli-Lemke at Plante Moran
Annette Tenerelli-Lemke | Partner
Plante Moran, PLLC, 1000 Oakbrook Dr #400, Ann Arbor, MI 48104 Direct Dial: 734-302-6407