Detailed Discussion of Applicable Changes
Three-Year Holding Period for Carried Interest
The Bill imposes a special three-year holding period with respect to certain income realized from carried interests. More specifically, starting in 2018, a holder of carried interest will need to satisfy a three-year holding period requirement to obtain long-term capital gain rates in respect of:
- Gains from sales or dispositions of investments allocated by the partnership in respect of the carried interest. The holding period will be determined based on the partnership’s holding period in the asset which gave rise to the gain.
- Gains from sales or dispositions of the carried interest. In this case, the holding period will be determined based on the holder’s holding period in the carried interest.
This rule, however, will not change the treatment of dividend income allocable to carried interest holders. Thus, even if a private equity fund has held a corporate portfolio company for under three years, dividends (as determined for U.S. federal income tax purposes) from the portfolio company could still flow through to holders of carried interest as “qualified dividend income” taxed at favorable long-term capital gain rates. Additionally, if a distribution by a corporate portfolio company exceeds its E&P, the distribution is then a non-taxable return of capital to the fund to the extent of the fund’s tax basis in the portfolio company (which initially would be the invested capital). Accordingly, a corporate portfolio company will generally be able to distribute to a private equity fund an amount equal the fund’s unreturned capital plus the corporation’s E&P without triggering this new rule.
Another important exception may permit investment partnerships to continue to grant “profits interests” to employees of an operating business conducted by a subsidiary of the partnership without subjecting such employees to this new rule. Such structures have frequently been used by private equity funds to structure employee equity in their portfolio companies.
21% Corporate Rate
The Bill permanently reduces the corporate tax rate to 21% from the prior top rate of 35%. This change will be effective starting in 2018. As discussed further below, the lower corporate rate, together with the other changes in the Bill, will impact the cost-benefit analysis for private equity funds in assessing the structure for acquiring a business that has been operated in flow-through form.
Favorable Rates for Flow-Through Business Income
The Bill reduces the effective tax rate on qualified business income earned by individuals and certain trusts and estates through flow-through entities (i.e., partnerships, S corporations and sole proprietorships). The Bill will generally permit such taxpayers to deduct up to 20% of such income (the “Flow-Through Deduction”), thus reducing the top effective tax rate on such income to 29.6% when the full deduction is available. The Flow-Through Deduction will be available starting in 2018 but will expire after 2025.
The Bill has complicated rules governing qualification for the Flow-Through Deduction that will limit its applicability. Under the Bill:
- The Flow-Through Deduction will only apply to “qualified business income” which is defined as income effectively connected with a U.S. trade or business and excludes capital gains, dividend income and certain compensation-related income.
- The Flow-Through Deduction will generally be limited to the greater of (1) 50% of the W-2 wages paid by the applicable business or (2) the sum of 25% of such W-2 wages plus 2.5% of the tax basis of certain depreciable property used by the business. For a business with a relatively small labor force and a limited amount of depreciable property, this will impose a significant practical limitation on the benefits available from the Flow-Through Deduction.
Flow-Through Versus Corporate Structures
The proposed changes to corporate and flow-through rates will significantly impact how private equity funds will assess the benefits from preserving the flow-through status of LLCs and S corporations in which they invest. In particular, the lower corporate rates may reduce the benefit to maintaining portfolio companies in flow-through form.
- First, a corporate investment will involve less corporate tax leakage over the holding period than under prior law.
- Second, there will be less value ascribed to the future basis step-up that could be delivered on exit in a flow-through structure.
- Additionally, the favorable flow-through tax rates described above may not be available to all holders in a flow-through structure.
While the above considerations suggest potentially greater use of corporate structures after tax reform, there will not be a single answer that is right for every structure and the analysis will continue to be complicated. Despite the lower corporate rate, there will still be significant benefits to maintaining flow-through status in many situations. For example, a flow-through target with continuing individual holders who are able to benefit fully from the Flow-Through Deduction may continue to stay in flow-through form. On the other hand, a flow-through target whose holders do not materially benefit from the Flow-Through Deduction and that intends to reinvest rather than distribute its earnings and exit through the public markets may benefit from converting to a corporation. Additionally, state and local government pension funds will continue to be exempt from taxation on income from flow-through businesses and will generally continue to view investing in such businesses in flow-through form as providing significant advantages. Thus, private equity funds with significant state and local government pension plans as investors will have to take the special tax status of these investors into account in the analysis.
New Limitation on Business Interest Deductibility
The Bill imposes a new limitation on the deductibility of business interest without any exception for existing debt.
- Under the Bill, the deduction for net business interest expense generally will be limited to 30% of the earnings of a business before interest, taxes, depreciation and amortization (EBITDA) for taxable years before 2022. However, beginning in 2022, deductions for depreciation and amortization must be taken into account, so the 30% limit will be applied against EBIT, which will result in many more businesses being subject to the limitation. Many corporations may find their effective corporate tax rate to be well above the new headline rate of 21%.
- Any disallowed deductions may generally be carried forward indefinitely. This limitation not only impacts portfolio companies that are C corporations, but will also apply on a flow-through basis to the direct and indirect holders in flow-through structures (e.g., blocker corporations and U.S. taxable investors in a private equity structure). This limitation, together with the other changes described herein, will have to be carefully modeled in connection with any future transactions or leveraged recapitalizations.
Repeal of NOL carryback
The Bill repeals the prior-law rule that permitted corporations to carry back NOLs to prior tax years. This change will impact the manner in which sellers of corporations can monetize transaction tax deductions in corporate transactions.
- Under prior law, NOLs could be carried back to the two preceding tax years. Thus, if transaction tax deductions in a corporate transaction resulted in an NOL for the tax year including the closing date, the corporate target could often monetize the NOL shortly after the transaction by carrying it back to the two preceding tax years and filing tax refund claims for such prior years (and, if required by the transaction documents, paying such refunds over the seller).
- Going forward, the ability to monetize NOLs in this manner will not be available.
- Instead, if such NOLs are to be monetized, the parties to a sale transaction will generally have to agree that future tax savings in post-closing periods would be paid to the seller as the target corporation (or its acquiring entity) uses the NOLs in subsequent tax years.
- In conjunction with the lowered corporate rate, this change will generally reduce the value of transaction tax deductions arising in corporate transactions.
One-Time Transition Tax on Retained Earnings of CFCs
The Bill makes several changes to the way the U.S. tax system treats foreign entities and earnings, moving the U.S. tax system closer to a territorial regime in which certain foreign earnings are not subject to full taxation in the U.S.
- In connection with these changes, the Bill imposes a one-time transition tax on the retained earnings of certain foreign subsidiaries. Under this rule, U.S. shareholders that own 10% or more of the voting stock of certain foreign corporations will generally include in income their pro rata share of the foreign corporation’s post-1986 accumulated earnings and profits that were not previously subject to U.S. tax.
- The retained untaxed earnings and profits determined in this manner will be subject to tax at a 15.5% rate to the extent attributable to cash and cash equivalents and an 8% rate for non-cash assets. A U.S. shareholder may elect to pay the tax over eight years without an interest charge.
- If a private equity fund entity owns stock in a U.S. corporate portfolio company, the portfolio company will generally be the payor of any such tax liability resulting from this rule. However, if a domestic fund entity owns stock in a foreign corporation, the U.S. taxable general partners and limited partners in the fund will be required to take into account their pro rata shares of any resulting deemed dividend if the fund entity is a 10% shareholder of the foreign corporation.
- On the other hand, if the foreign corporation is held through a foreign fund entity, the foreign fund entity will not be a U.S. shareholder subject to these rules, but direct and indirect owners of the foreign fund entity could, in certain circumstances, be deemed to be a U.S. shareholder subject to these rules with respect to the underlying foreign corporation.
 A distribution from a corporation is generally a “dividend” for U.S. federal income tax purpose to the extent of the corporation’s current and accumulated earnings and profits (E&P).
 Only after the non-taxable return of capital distribution would the private equity fund realize capital gain from the distribution that would be subject to the new holding period requirement.
 This limitation generally applies only to taxpayers with income above a specified threshold ($157,500 or, for joint returns, $315,000).
 Note that transaction tax deductions may still result in refunds shortly after closing if such deductions result in estimated taxes having been overpaid for the tax year that includes the closing date.
] The accumulated earnings and profits of a foreign corporation for these purposes is determined as of either November 2, 2017, or December 31, 2017, whichever date produces a higher number.