What are the important points in the tax law?
ED: We think about our private equity clients on three levels: the fund; the general partner, management company and the internal professionals above the fund (the so-called upper-tier); and then the portfolio companies below the funds. Several provisions could have a significant impact on these clients, depending on which level of the firm you’re considering.
For example, with carried interest that’s a big change for the partners in the upper-tier entities (and potentially the funds if the structure or arrangement for carry is changed), and it hits private equity as well as hedge funds. Another example is the interest expense limitation that potentially impacts the cost of leverage – an important component of a typical fund’s investment.
JC: Tax reform impacts each of these levels differently and some very specifically so we need to know how they relate to the whole firm from the portfolio company to the general partner and the outside investors.
DP: The deal professionals typically are focused on trying to get the best internal rate of return for the funds’ investments. That’s one reason it is so important to understand how the tax law changes will impact the investments. Of course, we’re still waiting on lots of guidance for last year’s changes and it is uncertain how the tax law is going to change in the future. We have expectations and views – but we don’t know for sure, so we help clients plan and act based on what we know today and what we learn tomorrow.
Let’s start with carried interest. How is the tax law changing the way private equity firms are currently booking their profits, particularly the adjustment on the holding period to qualify for capital gains?
ED: The average holding period is probably four to six years. Thus, changing to a greater than three year holding period for long-term capital gains on carry might not seem so bad. However, when a fund sells an investment within three years, it’s generally a pretty good investment. Thus, there have been plenty of discussions with clients this year in that situation about whether there are alternatives when a deal exit is relatively quick.
Private equity funds, for example, have looked at forgoing their right to carry. So, instead of taking carry on a specific investment, they might consider forgoing the right to the carry now and hope to get it out of future investments and make up for it. And if it’s structured the right way and assumes appropriate economic risk, that could work under the tax rules.
Firms are considering other options as well. For example, perhaps the exit strategy of a portfolio company is an initial public offering. If the GP is eligible for promote on this transaction, instead of selling the stock it receives and paying tax on the gain at higher rates, it’s possible the GP might be able to take the carry in stock, and keep the stock until it meets the holding period requirement. The GP could also contribute it to charity.
Firms should be aware of split holding period issues in situations where they have added on to existing investments, or contributed additional capital to their pass-through portfolio companies.
DP: In the situation where the GP holds the stock but the fund sells, you may need to balance fiduciary responsibilities and perhaps also seek LP advisory committee approval. For example, if the GP continues to hold the stock, why is it the right time for the fund to sell?
Have there been any cases of limited partners seeking changes in their limited partnership agreements over the changes in carry?
ED: The GP might want to have more flexibility in terms of what they can do, whether they can defer carry, or do some of the things we mentioned. That could require some changes in the agreement but that might come from the GPs. But I haven’t seen anything from the LP side that is causing changes in agreements around these rules. But to Doug’s point, GPs may be sensitive to doing things that look like they are in their self-interest at the expense of the LPs.
DP: Even eight or nine months into it, it’s still sort of early for LPA changes on existing funds. Changes are usually easier with a new fund. To go back to an existing fund with changes – unless it’s clearly to the LP’s benefit – may be, as Ed just said, hard to do unless you have a good track record and strong LP relationships.
JC: Although there are several things to consider, firms are discussing forgoing their right to carried interest early in the life of a fund. The additional economic risk is likely why we haven’t yet heard of LP pushback on modifying existing agreements.
Does it make sense for firms to switch their status from partnership to C-corporation? And does it affect mid-market PE firms differently than the biggest firms?
JC: The corporate rate going from 35 percent to 21 percent is a significant benefit, and that gets many of the headlines. Also, there is the corporate deduction for state and local taxes. But when you start to weigh other things like the chances of a potential sale in the short to medium term, the need for corporations to potentially address the accumulated earnings tax, and the 20 percent qualified business income deduction under Section 199A (that brings the rate differential closer from a tax perspective) the decision gets more complex. If a significant number of states switched to taxing a pass-through entity rather than its owners, that might put things on a more level playing field again if the entity were to get the state income tax deduction for federal purposes.
ED: One thing to keep in mind when discussing the big publicly traded private equity funds that have converted is that those changes are generally driven by multiple factors such as market conditions rather than by tax considerations alone. The reduction in the corporate tax rates may have made it more palatable to do it. But they’re going to pay more tax if they do convert to a corporation.
Another issue is if you incorporate, it’s very hard if not impossible to reverse that without tax costs. If corporate tax rates go up, you may be stuck with your structure. So, as Jamie was saying, there’s a ton of variables you need to look at. I’ve looked at it for a few of my clients. Unless you can retain a lot of earnings inside the corporation, it’s probably not going to make sense.
How has the general partner residency domicile issue affected the decision on where to live and do business?
ED: A key issue is the significant reduction of the state tax deduction for individuals. For example, if you live in California, with the highest marginal income tax rate above 13 percent – in the past you might have been able to deduct those taxes (if you didn’t owe alternative minimum tax), which reduced your net cost. The new limit on that tax benefit is a significant tax increase for some individuals. For residents in the high tax states, this issue by itself may offset the benefits from the Tax Act changes.
So, GPs may be looking at Texas, Florida, Nevada or other states where there are no or relatively low state income taxes. But asserting a change of domicile requires the individual to establish connections, such as business activities, to the other state.
JC: In the Northeast, the limitation on the state income tax deduction is potentially a sizeable tax increase to these GPs and other wealthy taxpayers. Together with rising state income taxes, there is an expectation that wealthy taxpayers will relocate. It remains to be seen whether this will in fact happen.
DP: Yes, and whether people that do want to relocate will be willing to make the potential lifestyle changes, including distance from extended family and other impacts on their lifestyle (such as new schools for the kids and new doctors, etc.) that will be required.
James Casey is the leader of Deloitte’s investment management tax practice in New Jersey. He provides tax compliance and advisory services to private investment funds and their sponsors, with a focus on utilizing technology to deliver timely accurate tax reporting for annual and transactional filings.
Edward Daley is the national leader for Deloitte’s private equity tax practice. His primary area of specialty is in providing income tax planning and compliance services to private equity firms, M&A advisory firms and other types of professional service firms and privately held businesses.
Doug Puckett is the deputy national leader of the private equity practice and a regional private wealth practice leader for Deloitte Tax. He works closely with the firm’s national investment management leadership to bring leading practices to private equity, hedge funds and family offices of high net worth clients across the US.
This article is sponsored by Deloitte and first appeared in the September 2018 issue of pfm.