While there are no provisions of the TCJA that are exclusively applicable to private equity (PE) ownership structures, it is important to trace the impact of the general provisions through the PE ownership structure to realize the ultimate impact. This update will explore some of the general changes likely to impact the tax situation and decisions of private-equity-owned businesses. If you find an area below intriguing, many of these topics are covered in more depth in recent postings in our Tax Reform Resources Series. We will also analyze merger and acquisition implications in a separate update to the series.
Corporate and General Business Provisions
Corporate ownership structures and related blocker corporations will realize a 21% flat corporate tax rate starting in 2018, and corporate AMT is also repealed. One may think it would be easier to project a multiyear tax situation because there are no longer varying tax brackets applying based on annual results; it will simply be that flat 21%. However, in thinking through the various other changes discussed below, it will actually make the situation more complex to analyze and may require a more expansive analysis to see how current decisions will impact future tax year liabilities. Since the tax rate has been lowered, the dividends received deduction has also been reduced (for those corporations which own other dividend-paying corporations).
With many PE acquisitions structured with the leverage of debt as opposed to equity, many PE-owned business operations will need to keep a close tab on how much interest expense they will be allowed to deduct at each level in the ownership structure. Net business interest expense will generally be limited to 30% of adjusted taxable income (taxable income before interest expense). Through 2021, taxpayers will also be able to perform the 30% calculation prior to tax depreciation, depletion and amortization expenses. Excess interest expense is carried to future years when a new limitation is again calculated annually. A special depreciation election allows an entity in a real property trade or business to avoid this interest expense limitation.
Immediate capital expensing of fixed assets has also been expanded significantly. Section 179 expensing thresholds have increased, and qualifying assets have expanded. Also, 100% bonus depreciation will now be allowed for both qualifying used and new items through 2022, with a 20% decrease each year thereafter. Thus, an asset acquisition of used assets that in the past would not have been eligible for bonus depreciation can now be fully written off in the year of acquisition. There is no dollar cap on the amount of bonus depreciation that can be claimed, and bonus depreciation can also increase a net operating loss (NOL).
Speaking of NOLs, these can no longer be carried back two years, but instead may only be carried forward indefinitely to offset future income. No, I did not say all of the future income right away; there is another kicker in the new law: You may offset only up to 80% of a future year’s income with an NOL. If the NOL is larger than that, the remainder will be carried forward to the following year and again will be subject to the 80% limit. Old NOLs from prior to 2018, however, do still utilize the old rules of 100% offset against future income.
So let’s put just these few concepts together, and maybe you will see how decisions become more complex. Consider a corporate entity doing an asset acquisition of a manufacturing entity in 2021 (or just a bolt-on asset acquisition by a current corporation). Do you take 100% bonus depreciation on the acquired assets in 2021? Maybe, maybe not. If you take all the depreciation on the equipment in 2021, it won’t reduce your interest expense limitation in 2022. (You must calculate the interest limit after depreciation in 2022.) However, if the depreciation expense creates or increases an NOL in 2021, some of that NOL will not be immediately usable going forward as a result of the 80% NOL limitation. As you can see, making the best depreciation decision today will now require a multiyear projection analysis.
Partnership and Pass-Through Considerations
In a tiered ownership structure of pass-through entities, there will be an increased volume of information required to be disclosed on a Schedule K-1 to allow each taxpayer in the chain to perform similar calculations and limitations at each level in the chain. For example, a complex set of rules is in place so that the 30% interest expense limitation is tested at each level, and there are mechanisms to avoid gaming the system or getting limited twice on the same interest expense. Investors with unused interest expense at the time of disposition of the partnership interest will receive an increased basis in their investment to account for the disallowed expense. However, this effectively converts what in the past would have been an ordinary tax rate deduction into a capital gain rate benefit under the new regime.
While the corporate tax rate was decreased to 21%, the top individual rate now sits at 37%. Qualifying business income from a pass-through entity could be eligible for up to a 20% deduction, which lowers the effective tax rate on such income to 29.6%. This “phantom” deduction could be limited to something less than 20% depending on the level of W-2 wages paid by the pass-through entity and the level of tangible assets deployed in the business. Since the determination of this 20% deduction is made at the individual (or trust/estate) level, several pieces of information now need to be calculated and provided with each K-1, even though such information may not even be used by the ultimate taxpaying owner. This information will need to be aggregated and passed through each level of partnership ownership until it hits the taxpaying owner. Essentially, pass-through deals will require more effort because the entity will need to provide additional layers of information so the taxpaying owners at the end of the chain can determine their 20% deduction amount accurately.
Many service-based businesses will not produce income that qualifies for the up-to-20% phantom income tax deduction. So while pass-through income of a manufacturing portfolio company may fully qualify for the deduction, the management fee revenue paid by that manufacturing company to a related entity may not qualify for a 20% deduction at the management entity level. Thus, the income that could have qualified at the payor entity was stripped out and then effectively taxed at a higher rate than it might have realized if income were left in the manufacturing entity. Of course, this arrangement is typically needed to appropriately compensate for varying ownership and management duties performed, but whether that could that have been achieved via another mechanism will be fact specific.
Further, if taxpaying owners of pass-through entities have an overall loss from their business activities, they may run into a limitation on being able to use that loss. This new limitation, referred to as an “excess business loss,” will limit the overall loss claimed from these activities to $500,000 annually for a married filing jointly taxpayer. Losses in excess of the $500,000 will then carry over under the NOL rules described above. Perhaps many of these investors are already being limited on taking losses under the passive activity loss rules; however, this new limitation could kick in for a year when such excess business losses exist, such as in a year of sale, which triggers the deduction of previously suspended passive losses.
Carried Interests – Ordinary Versus Capital Gain Rate
Many carried interests held for under three years will now be taxed at ordinary income rates rather than the lower capital gain rates. This is not a relevant change for a 5- or 10-year hold on a manufacturing portfolio company, but many real estate deals that build and sell in a shorter period will need to monitor this closely. Some of the early strategies for working around this three-year hold provision have been shot down by the IRS already. So, as with many of these topics, it is important to continually monitor guidance as it becomes available.
From an international tax perspective, the United States has shifted toward a territorial tax system (rather than a worldwide tax system with foreign tax credits). Calendar year-end taxpayers have already dealt with some of the impacts of this change via the repatriation tax determination and decisions. Going forward, cash previously “trapped” in a foreign corporation may more likely be brought back to the United States. Also, future dividends from a 10%-or-greater-owned foreign subsidiary are generally exempt from tax if attributed to non-U.S. earnings of that subsidiary (since that was not income of the United States, to illustrate the territorial concept). Also, having a foreign investor in a partnership may require U.S. withholding tax on a transaction unless the transferor certifies that it is not a foreign person. Be sure to explore other international provisions in our series.
It is often common practice when hiring new leadership to cover the costs of moving them into the area. In the past, either these costs could be excluded from the taxable wages of the new employee, or qualifying moving costs could be deducted “above the line” on the personal tax return of that employee. Starting in 2018, moving costs are no longer allowed to be excluded by the employer and are also not allowed as a deduction by the employee. Perhaps employers will now be looking to gross up the moving costs added to taxable wages to cover the incremental tax cost as well. The main point here is to be aware of the reimbursements that the business is going to provide and the costs that are expected to be incurred by the employee. Miscommunications may not surface until those new leaders get to the point of filing their personal tax return and realize their W-2 is much higher than the cash compensation they saw.