CFOs fret over tax proposals, and fear worse to come – Fall Forum

Carried interest, capital gains and SALT all sting but worse may be coming.

Congress is likely to pass painful tax increases this year, a panel at Private Equity International’s virtual COO & CFO’s Forum agreed, but feared the possibility that the worst is yet to come.

“Something will probably pass,” said the CFO and CCO of a private equity fund based in the Southwest. “I don’t think it’ll be as aggressive as Biden proposed. It’s not going to be good for us and our industry by any means, but its not as bad as it could have been.”

The virtual Forum was held under so-called Chatham House rules, which require reporters to keep panelists anonymous.

On September 13, the House Ways and Means Committee approved legislation that would, among other things, raise the capital gains tax to 25 percent, keep state-and-local tax deductions off the books and – most important for industry – require funds to hold assets for at least five years before they could qualify for a tax break on carried interest. It’s part of a $3.5 trillion tax package President Biden says he needs to fund infrastructure, schools and healthcare.

The bill is not yet a sure thing. Only four Democrats need to defect to torpedo it. Even then, the more conservative Senate may have something to say about the tax package if it arrives intact. Still, Biden had proposed eliminating the carried interest break altogether. The panelists said they were hopeful that the blow could be blunted, but they doubted it could be ducked altogether.

“Hopefully, there is some wiggle room where things can be reduced or dropped, or changed in some manner,” said the CFO/CCO of a New York firm. “It’s a massive tax burden on industry.”

‘Drive… as quickly as we can’

If passed as is, the carried interest legislation would tax funds at the 25 percent capital gains rate as long as they waited the five years out. Managers whose funds exited earlier than that would be taxed at the highest net personal rate – which would be raised to more than 38 percent under the bill.

All these changes would be effective September 13 under the current legislation. That deadline has already scotched a couple of deals, said a managing director, CFO and CCO at another NY-based firm. The effective date could be pushed back, but some people aren’t willing to wait around to find out.

“People are still driving hard to get what can be done, done this year,” that panelist said. “Certainly there’s consensus on both sides of the table that you should still drive to a definitive agreement as quickly as we can.”

As written, the carried interest legislation would start the five-year clock ticking when “substantially all” of a fund’s money is invested. The second NY-based executive said he worried about the effect it might have on continuation funds – a structure that’s become particularly popular recently.

“Does it tamper some of enthusiasm on continuation funds?” the second panelist asked. “Does it start a whole new clock of another five years, and you’re effectively better staying in an old fund?”

It’s not a great outlook

More than that, though, the second NY-based exec said he was worried about the next time the feds come around with their hands out. The U.S. economy is facing a labor shortage, which may well cause inflation. The market is “frothy,” and at least 10 major American cities are at or near bankruptcy. If the public markets should tumble again, further tax hikes could materialize.

“I just worry that there’s going to be so much tax that has to get passed to fill these major shortfalls in federal and state governments. That coupled with a downturn – if you just take the big picture, it’s not a great outlook,” he said. “I hope I’m 1,000 percent wrong. But there are too many levers out there that are down and there’s just no way to pull them all up.”

The first panelist said relief might come in next year’s Congressional elections. Biden’s approval ratings are dipping in the polls, and off-parties typically do well in mid-terms. Then again, “It’s hard to predict crazy.”

The old bill

In the meantime, firms are still coming to grips with Washington’s last tax act. The Tax Cuts and Jobs Act, passed under President Trump, eliminated the SALT deductions. That landed hard on the professional classes along the coasts. One audience member said her firm – which follows the flow-through model – has been “overwhelmed” with requests from LPs about SALT questions.

The second NY-based exec said that “a lot of people” in New York, Connecticut and New Jersey were working around the SALT deduction problem by forming their own LLCs where their firms are located.

The Trump bill had some carrots in there, though, the first panelist said. For instance, firms can qualify for an employee-retention tax credit. The first panelist said his firm “has been aggressive” in seeking out the credit for its portfolio companies. The results have been miraculous, he said.

“It’s high seven-figure numbers that count as EBITA and add liquidity,” he said. “If you’re not talking to your tax adviser about that, you’re leaving some money out there.”

Uncomfortable, not apocalyptic

Despite their concerns about the pending legislation, none of the panelists at the session saw an existential threat in the tax bills.

“We all have to do deals, and we have to invest our capital while we have it,” the first panelist said. “We’ve got to be careful about the tail wagging the dog, so to speak.”

More than anything, it’s the uncertainty of Washington politics that has bedeviled funds, he added. Among other things, it’s forced firms to hire an army of tax consultants to help them get through the day.

“We always get our tax advisers in there before we do any sales,” said the first panelist. Chores include SALT nexus analyses; for instance, the fund “talks to the managers who’ve got skin in the game.”

That drew a last lament from the second panelist. He said that outside accountants aren’t yet in tune with private equity’s wants and needs, and it can cause friction. Too often, accounting firms approach private equity’s tax problems transactionally – completing this form for this need will cost this much – when what firms really need is for the outside accountants “to get inside the bubble.”

“Compliance is so tough,” he said. “We’re not experts on this in-house and we’re not necessarily of size to do all that work in-house. We need our partner to be insourced. Tax providers have to figure out how to better service, particularly on the middle market.”