Tax structuring in the private-equity world: How you can react to potential tax changes

The Georgia congressional run-off results are in. Upon President-elect Joe Biden’s inauguration on January 20, 2021, the Democratic party will not only control the presidency but also both houses of Congress.

Biden’s plan for his first 100 days in office focuses on additional COVID-19 legislation and a vaccine distribution plan. However, he also has an aggressive plan for sweeping tax law changes — a plan that is much easier to accomplish with a party-aligned Congress.

Below are the tax law changes that may be on the horizon and how those changes impact private equity companies and their investors.

Minimizing the tax burden

Investors care most about investment returns, and one way to maximize those returns is to minimize taxes over the investment term as much as possible.

A key part of minimizing taxes is operating with the most efficient tax structure, and tax structure is not a decision that is made at inception and then forgotten. Tax structure should be reassessed over the life cycle of the business, particularly when tax laws changes may occur.

Many private equity groups own their underlying operating entities through partnerships. Partnerships are often used because they provide the most flexibility with respect to the economic deal among the investors. However, considering Biden’s tax plan proposal, many private equity groups have raised the question of whether the partnership structure is still the best choice, or whether a C corporation structure would better minimize taxes, and thus better maximize returns to investors.

Because partners are taxed on their distributive share of partnership income, a partnership must have important knowledge about its investors to properly analyze whether it is operating with the most efficient tax structure, including an understanding of the following:

• Involvement of the investors
• Tax classification of the investors
• State taxation of the investors

This knowledge plays a key role in deciding whether the overall burden of taxes (both current and future) imposed upon the investor’s returns would be best minimized through the existing partnership structure or whether it is more advantageous to convert to a C corporation structure.

Involvement of investors

Often, there are two types of investors: those materially participating and actively involved (for instance, fund managers or other key personnel) and those investors who are passive with respect to their investment.

Involvement can impact the types of taxes the investor incurs on partnership income. For example, in addition to income taxes, those partners who are actively involved are often subject to self-employment taxes, and partners who are passive are often subject to net investment income tax.

Although the active-passive classification does not change under Biden’s plan, his plan increases the top rate partners would pay on partnership income to 39.6%. Biden’s plan also proposes to eliminate the 20% qualified business income deduction for high-income filers, which may cause some partners to see a rate increase of as much as 10%, moving from a rate of 29.6% to 39.6%.

Furthermore, actively involved investors may also see an increase in self-employment taxes, as Biden’s tax plan imposes additional FICA taxes on wages or self-employment income over $400,000. Thus, actively involved partners may see a federal tax rate as high as 52% (39.6% + 12.4%).

Passive investors would face an overall federal tax rate as high as 43.4% (39.6% + 3.8%).

Under Biden’s plan, both actively involved and passive investors may yield a significantly higher tax burden on partnership income. Partnerships with investors that may experience these tax increases should evaluate whether a C corporation structure may be more tax efficient.

Although Biden’s plan calls for increasing the C corporation rate from 21% to 28%, the increased C corporation rate is still well below the highest individual tax rates that would apply on partnership income. However, beware that a partnership-to-C-corporation conversion may yield current tax savings that may be overburdened with future tax cost, particularly if the investor does not hold qualified small business stock (QSBS). More on this below.

Tax classification of investors

Another important consideration is the tax classification of the investors. Not all investors are individuals, estates or trusts. In fact, investors may use other types of entities, such as partnerships, C corporations or perhaps tax-exempt organizations. Failing to understand the tax classification of investors may lead to a tax structure that is more costly than it should be.

Thus, it’s important to proactively inquire whether partners may themselves be making entity structure changes, and whether those changes have any corresponding impacts on the investment’s tax structure as a partnership.

State taxation of the investors

The best tax structure looks at not only the federal tax cost to investors but also the state tax cost, including the federal benefit of deducting state taxes. Several years ago, the deduction for state taxes was reduced to $10,000 at the individual level, indirectly increasing the tax cost of pass-through structures such as partnerships.

Although Biden’s tax plan seeks to reinstate the state tax deduction, investors may face itemized deduction limitations as the tax plan would cap the benefit at a max 28% rate. In contrast, C corporations do not incur any limitations on the deductibility of state taxes.

Thus, in addition to federal tax rate changes, any private equity group examining whether to convert an existing partnership to a C corporation should consider the changing landscape for state taxes — including Biden’s potential reinstatement of the state tax deduction with limitations, or even the entity-level state tax workaround recently blessed by the IRS.

In addition to knowledge of investors, another important consideration is what happens when there is a sale and/or liquidation of the investment, and what are the differing tax consequences under a partnership versus a C corporation structure.

Sale and/or liquidation of investment

Although the nuances related to sales and liquidations of partnerships and/or C corporations are beyond the scope of this article, the following is worth noting:

• Upon a sale of the partnership interests, the partners would generally be taxed at capital gains rates, unless there is ordinary income from hot assets. Under Biden’s tax plan, those with income (presumably taxable income) above $1 million may pay tax on capital gains at ordinary income rates of 39.6% versus the current capital gains rate of 20%. Thus, a sale of partnership interests could be very costly for those investors with more than $1 million in income.
• Upon a sale of C corporation stock, the investors would also generally be taxed at capital gains rates, which again may be at a rate as high as 39.6% for those with $1 million or more of income. The investors would also be subject to the 3.8% net investment income tax. However, the C corporation structure has an advantage over the partnership structure because if the investor holds qualified small business stock (QSBS) under IRC 1202, the investor may be able to exclude the greater of $10 million of gain or 10 times basis from income tax.
• Upon a sale of partnership assets and distribution of proceeds in liquidation, the partners would generally be taxed from a federal perspective the same as under a sale of partnership interests.
• Upon a sale of the corporate assets and distribution of proceeds in liquidation, the corporation would need to pay tax under Biden’s proposed corporate rate of 28%, and then the investors would be taxed again on the distributed proceeds. Once again, those investors with income above $1 million may pay tax at ordinary income rates of 39.6% in addition to the 3.8% net investment income tax rate. If the investor holds IRC 1202 stock, then the investor may be able to avoid income tax on the distribution.

What this tells us is that private equity groups cannot merely focus on what is happening today. They need to be thinking forward to tomorrow and the coming years, and how significant tax reform impacts structuring decisions.

To properly assess tax structure, private equity groups must have full knowledge of investors and their tax situations; and consider the interplay of tax rates (current and future) on both operating income and the eventual gains upon a sale and/or liquidation event. The best tax structures are those that are properly thought out based upon all the available facts.

Contact us today so we can help your private equity group assess how existing and future investments may be impacted by Biden’s tax plan proposal.

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