Private Equity: 2015 Year-End Tax Matters
Nov. 2, 2015
Taxpayers face uncertainty surrounding changes to federal tax law. Regardless of when – or if – any further tax law changes are passed, tax planning this year will be challenging. Taxpayers need to be able to revise their tax plans quickly if necessary and understand potential tax changes that may be forthcoming.
Knowing which areas are subject to change and implementing possible tax-reduction strategies will help taxpayers identify where they might need to take action should the need arise. The Crowe Horwath LLP year-end tax planning guide provides an overview of some important tax provisions taxpayers need to be aware of and offers a wide variety of strategies to help taxpayers minimize their tax obligation.
For private equity firms, we’ve laid out potential tax changes that may come about in 2016. In addition, we have highlighted existing deal issues with tax implications to be considered when looking at new investment opportunities, during a portfolio company’s holding period, or upon exit.
Carried Interest Tax Update
For well over a decade, legislation aimed at taxing carried interests at ordinary income rates has been proposed by Congress and the president. (As commonly described, a carried interest represents an allocable share of fund profits paid to its managers for services performed that exceeds the manager’s capital contributed to the fund.) Under current tax law, generally this income is taxed at more favorable capital gains rates (20 percent) rather than as compensation subject to tax at ordinary income tax rates (39.6 percent maximum).
In 2007, 2008, and 2009, bills passed the U.S. House of Representatives aimed at increasing tax on carried interests, but such legislation stalled in the Senate. In 2010, separate bills addressing the taxation of carried interests were introduced in the House and Senate. These bills, if passed, would have taxed as ordinary income up to 75 percent of the carried interest allocated to the fund manager. (The remaining carried interest would continue to be taxed at capital gains rates.) In June 2015, the issue of taxation of carried interests was resurrected by House Resolution 2889, which, if enacted, will tax 100 percent of a carried interest as ordinary compensation.
And this issue will continue to be raised. Republican and Democratic 2016 presidential candidates have shown overwhelming support for legislation addressing increased taxation of carried interests. Under Jeb Bush’s plan, for example, a carried interest would face a top tax rate of 28 percent. According to Hillary Clinton’s campaign website, she “supports ending the ‘carried interest’ loophole.” According to Donald Trump’s tax proposal, he, too, supports increased taxation on carried interests.
It seems inevitable that change is coming. Overall, however, time will tell whether the recently proposed legislation and presidential candidates’ support for increased taxation of carried interests leads to substantive changes of the tax code or if, as in the past, legislation will continue to stall. For 2016 anyway (and until further legislative action), taxation of receipt of a carried interest remains at capital gains rates. Post-election however, there is a stronger likelihood of action on carried interest taxation.
It is common practice for fund managers to waive the right to a current management fee in exchange for a profits interest in the fund. This effectively converts current ordinary income from management fees into capital gains. In July, the IRS proposed regulations that would significantly limit fund managers from executing a fee waiver without current taxation. It remains to be seen if the regulations will be finalized and, if finalized, whether they will be substantially similar to the proposed regulations.
Washington Legislative Update
In July, the Senate Finance Committee approved a two -year extension of a bundle of tax provisions, commonly known as the tax extenders. The package of tax extenders includes the research credit and the Work Opportunity Tax Credit. In September, the House Ways and Means Committee approved tax and healthcare reform measures, most of which could become part of any extenders package.
Most focus remains on consideration of certain tax incentives that have historically been passed into law on a temporary basis. Year over year, however, such provisions addressing stimulus and business incentive measures such as bonus depreciation and the research and development (R&D) tax credits have been extended and essentially become semipermanent. The question is, will such incentives indeed be adopted in some form as a permanent tax law change or again simply “extended”? For 2015, it remains to be seen.
Both the Senate Finance Committee and the House Ways and Means Committee provisions will be reconciled, and eventually an extenders package will emerge. As of this writing, however, taxpayers are waiting. History has shown that Congress likely will finalize this package in December and probably make such provisions retroactive to the beginning of the year.
Merger and Acquisition Update
In the area of tax treatment of transaction costs incurred in business acquisitions, there has been some uncertainty regarding the proper treatment, namely to deduct or capitalize such costs. Depending on the structure of an acquisition, costs incurred to facilitate a transaction generally are capitalized to the tax basis of the stock or assets so acquired. However, expenses that do not facilitate a transaction may be currently deductible. Further muddying the waters, while costs incurred before a “bright-line date” generally are treated as nonfacilitative to the transaction and may be deductible, certain costs are treated as inherently facilitative and therefore not currently deductible regardless of when incurred. The bright-line date occurs when the letter of intent or exclusivity agreements is signed or when both boards (of the buyer and the target company, or its owners) approve material terms of the deal. Uncertainty remains, although the IRS has provided some guidance – most notably Revenue Procedure 2011-29, which permits a taxpayer to elect to treat 70 percent of any success-based fee as nonfacilitative and currently tax deductible (the remaining 30 percent is capitalized).
Allocating costs. Uncertainty exists about transaction costs incurred and whether such costs should be allocated to the stock (or assets) acquired or whether such costs should also be allocated to the time and effort incurred to obtain financing for the transaction. Private equity buyers most often consider placement of increased leverage in the capital structure when buying a company. As such, a question arises about the proper tax treatment of an expense potentially allocable between the equity or assets acquired and debt costs facilitating such acquisition. Generally, costs to obtain financing (that is, debt issue costs) are capitalized and amortized over the life of the loan. If debt is refinanced, the debt costs that have not been amortized generally become currently deductible. With respect to a newly acquired portfolio company, some have taken a “Fort Howard” approach (Fort Howard Corp. v. Commissioner, 103 T.C. 345 (1994)), allocating the transaction costs between debt and asset or equity based on the percentage of debt in the overall purchase consideration.
Management fees. Private equity firm owners typically charge management fees to the firm’s portfolio companies. Besides providing financial and operational oversight, management fee agreements often contain provisions that require additional fees to be paid when the portfolio company undergoes a capital transaction. Uncertainty may arise about the tax treatment of management fees charged to a newly acquired or existing portfolio company with respect to a capital transaction. A capital transaction may come about as a result of the acquisition of the portfolio company itself, an add-on acquisition, or a refinancing of the portfolio company’s existing debt and equity capital structure. The challenge many private equity firms face is how to bifurcate such capital transaction management fees charged between the equity or asset purchase or restructure and the related debt financing or refinancing.
Sales and Use Tax Update
As technology continues to evolve, on-demand e-commerce services related to cloud computing are expanding significantly. Not surprisingly, states are aggressively pursuing sales taxes with technology-based businesses. Increasingly, these businesses and the products and services they deliver to customers are attracting the attention of municipalities as well.
What is it that’s being sold to the customer? Due to the inconsistencies between the states’ treatment of the sales taxation of similar transactions, tax departments and tax advisers need to be proactively involved with the characterization of a customer sale. They should answer questions such as these:
- What is the true object of the transaction?
- Is the object prewritten or customized software?
- Is the transaction for tangible personal property?
- Does the transaction involve sale or delivery of a service?
- Is the object a licensing agreement?
- How and where is the product delivered?
Given such questions and differing states’ views, private equity firms should consult their tax department or tax advisers. While it is important to parse through state-by-state guidance and interpretations, thoughtful consideration also must be given to the contractual language of the customer contract. The answers to these questions will be instrumental in determining whether a sale is taxable or nontaxable in a specific state. A lack of tax collection, remittance, or filing can result in a considerable amount of potential taxes in back years if the states come calling.