Traditionally, private equity funds (“PE funds”) have invested in US companies that were formed as corporations. Corporations are often highly tax inefficient vehicles, as a corporation’s earnings are subject to “double tax”. First, the corporation is taxed on its earnings (currently at a marginal US rate of 35 percent). The shareholder is then taxed on receipt of a distribution1 from a corporation to the extent of the corporation’s current or prior earnings (currently taxed at a rate of 15 percent2). Accordingly, the marginal US tax rate on corporate earnings may be as high as 44.75 percent3.
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Mark Berkowitz |
This can be particularly burdensome when the private equity firm chooses to exit the investment. If the corporation sells its business, the shareholders are subject to this double tax. But a sale of the corporate stock to a buyer allows the PE fund to avoid the first level of tax. As discussed further below, the “penalty” for this, however, is that the buyer must assume the historical cost basis of the corporation’s assets. Accordingly, if the buyer has paid a premium over the historical cost (i.e., there has been appreciation in the value of the business), then the buyer will eventually bear the burden of the tax on that appreciation. And of course, any buyer will discount the price it is willing to pay for having assumed this liability. As such, at least to some significant extent, the PE fund will bear the burden of the double tax.
Unlike corporations, partnerships and limited liability companies (“passthrough entities”) are not subject to tax on their earnings.4 Earnings of a passthrough entity are included in the tax returns of its members. The character of the income, as ordinary or capital gain, will also pass through. Accordingly, these earnings are typically subjected to marginal US tax rates of 35 percent on ordinary income and 15 percent on capital gain income5. In general, however, distributions from a passthrough entity are not subject to tax. Thus, earnings of a passthrough entity are subject to only one level of tax.
But there is further advantage on exit. Upon sale of the business, whether through a sale of assets or the interests in the passthrough entity, the gain is often taxed as capital gain income and thus subject to the non-corporate member’s 15 percent capital gain rate6. And the benefits don’t end there. The buyer’s cost basis in the assets is adjusted to its purchase price, giving rise to increased depreciation or amortisation deductions.
If the sale of a corporate business results in an inherent discount to value, the sale of a business in a passthrough form may result in a premium to value as the buyer pays for the increased tax benefits.
Obtaining these benefits does come at the cost of increased complexity both in organisational structure and tax reporting. The benefits (and burdens) of acquiring a target in a passthrough entity form can perhaps be understood best by viewing the life cycle of the investment – acquisition, operations and exit.
ACQUISITION OF A PASSTHROUGH ENTITY
Increase in depreciation and amortisation
One of the most significant benefits of structuring the acquisition of a target as a passthrough entity is the tax benefit provided by the increase in the tax basis of the target’s assets.
The purchase of stock in a C corporation does not affect the corporation’s tax basis in its assets, regardless of whether the assets (including goodwill) have appreciated in value. The buyer merely succeeds to the historical tax basis. Accordingly, the buyer will not obtain any immediate tax benefit for the purchase price in excess of historical cost. As detailed below, this can have significant negative impacts on the after-tax operating results and on exit.
Structuring the investment as the purchase of an interest in a passthrough entity7 allows the buyer to increase its share of the tax basis of the assets to an amount equal to the purchase price, thus allowing the buyer to obtain the tax benefit of its investment through increased depreciation and amortisation to shelter current cash flow.8 In general terms, the buyer’s purchase price of the interest in the entity is allocated among the entity’s assets based on fair value, including goodwill. In most circumstances, purchased goodwill can be amortised over 15 years, thus providing significant “non-cash” deductions for the buyer.
Top side structuring
The cost of the tax benefit is increased administrative and reporting complexity. The administrative complexity is precipitated by the need to adjust the fund’s organisational (“top side”) structure due to the varying tax requirements of its investors.
Income recognised by the PE fund from its investment in a passthrough entity will likely create Unrelated Business Taxable Income (“UBTI”) and Effectively Connected Income (“ECI”) for its tax exempt and non-US investors, respectively. Most fund partnership agreements have varying degrees of prohibition against generating these types of income without providing the investors an opportunity to either elect out of the investment or elect an alternative means to invest.
Providing the investors an alternative investment structure necessarily complicates the top side structure of the fund. The alternative structure can take many different forms, but, in the case of a US trade or business in a passthrough entity, will most often include using a US C corporation to “block” the UBTI and ECI. In general terms, the tax exempt and non-US investors (“tax sensitive investors”) will hold their interests in the passthrough vehicle through a C corporation (“blocker”). The result of this structure is that the tax sensitive investors only receive a part of the tax benefit of the passthrough vehicle – the increased tax depreciation and amortisation will shelter the blocker’s income. The net income and potentially the gain on sale are still subject to corporate level tax. But the net taxable income will be reduced by the increased depreciation and amortisation.
Leveraged blocker
In order to reduce the corporate level tax, many funds will further structure the tax sensitive investor’s investment in the blocker partly in the form of debt. If respected as debt and if various limitations are satisfied, the interest expense will reduce the blocker’s taxable income, thus reducing the tax burden of using a blocker. 9As noted below, the exit gain may, however, be a significant burden, thus requiring further structuring.
Fee waiver provisions
Earnings from a passthrough investment may further complicate the general partner’s use of fee waiver provisions. The general partner will need to review the terms of its fee waiver to determine the effect of allocations of ordinary income, if any, generated by the passthrough entity’s operations.
Increased reporting requirements
In addition to increasing the complexity of the top side structure, the fund and its investors will face additional tax reporting requirements, particularly state and local reporting and accounting for the increase in tax basis. In general, owners of a passthrough entity are required to file income tax returns in the states in which the entity does business. Accordingly, the fund and its investors may be required to file many state income tax returns.10 In addition, many states impose tax withholding requirements on passthrough entities. As such, the fund may be required to withhold income tax from distributions made to its investors.
Management compensation
The passthrough structure can also provide an efficient means to compensate high value employees. In the case of a C corporation, these employees often are granted restricted stock or non-qualified stock options. In the case of a passthrough entity, if carefully structured, the employees can be granted
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interests in the passthrough entity without current tax consequences. The employee would then be treated as a partner for all purposes and potentially receive the benefit of the appreciation in the form of capital gain income on exit.11 In comparison, the exercise of non-qualified stock options will typically result in ordinary income, at least in part. Restricted stock may come at current tax cost, as the employee will recognise ordinary income for the value of the stock if the employee elects to treat the stock as fully vested for tax purposes.12 If the employee does not make this election, she will risk incurring significantly more ordinary income when the stock does vest if the corporation has increased in value. Granting interests in a passthrough entity can avoid or minimise these issues.
OPERATIONS OF A PASSTHROUGH ENTITY
One level of tax
The tax implications of the operations of a passthrough entity differ significantly from that of a C corporation. As noted previously, C corporation earnings are subject to double tax. A passthrough entity does not pay tax on its income. Instead the owners of the entity include the entity’s income in their returns whether distributed or not. Distributions from a passthrough entity, however, generally, are not taxable to the owners – thus one level of tax (at the owner level).
In addition to eliminating one level of tax, the purchasing partner further decreases the taxable income allocable to her from the passthrough by the increased depreciation or amortisation resulting from the basis increase to the entity’s assets achieved on purchase. The combined benefit of the single level of tax and the basis increase can significantly increase the after tax return to the taxable investor.
Implications of the blocker
As noted above, the tax sensitive investors will likely maintain their ownership through a blocker. The result is that these investors are placed in the same position as if target were a C corporation. There are, however, two advantages. First, as noted above, the investor may have an ability to leverage the blocker, thus reducing its taxable income by the interest expense deduction. Interest income generally does not constitute unrelated business taxable income for tax exempt investors. In addition, non-US investors may not be subject to US tax on this income if the debt qualifies as “portfolio debt” for US tax purposes. In very general terms, the loan may qualify as portfolio debt unless the non-US investor owns stock, directly or indirectly, possessing at least 10 percent of the voting power of the blocker shares.13
Second, in addition to the opportunity to leverage the blocker, as noted below, the owners of the blocker may be able to exit in a tax efficient manner through the sale of the blocker shares. In general, the gain from the sale of the blocker shares will not be unrelated business taxable income or taxable to the non-US investor.
Leveraged recapitalization
A PE fund will often further leverage a target company subsequent to acquisition in order to finance out its equity or monetise increased value. In the case of a C corporation, the leveraged distribution may be taxable as a dividend to the shareholders due to earnings and profits accumulated prior to the PE fund’s acquisition. A leveraged distribution from a passthrough entity is significantly more tax efficient. In general, the distribution of debt financed funds will not be taxable to the owners. And the interest expense related to the financing may provide the owners with a further tax benefit.14
Passive activities
The Internal Revenue Code limits the use of losses from “passive activities”. These rules were enacted in 1986 to limit the use of tax shelters. In very general terms, the losses from a trade or business activity in which the owner does not materially participate can only be used to offset income from other such investments. If the owner does materially participate, then the losses can be used against any income of the owner.15 Although the target may have positive EBITDA, the additional depreciation and amortisation from the basis step-up may create a loss. If it does not create a loss, the income would likely qualify as passive income to the limited partners, thus allowing them to use other passive losses. It should be noted that the active members of the general partner may be able to qualify as materially participating in the activity. In this case, the losses would be considered active and thus could be used to shelter other income, producing a significant benefit to the general partners.
Tax distribution benefits
As noted above, the income of a passthrough entity is included in the income of its owners whether distributed or not. As such, PE funds typically insist on tax distribution requirements when acquiring a passthrough entity. The tax distribution is most often defined as a stated or calculated percentage of the entity’s income. It is important to note that it is typically the entity’s income that is used for this calculation. If the PE fund’s investment was made as the purchase of an interest, the PE fund’s increased depreciation and amortisation is not part of the entity’s taxable income calculation. Accordingly, the fund often receives tax distributions that greatly exceed the investors’ actual tax liabilities due to the shelter provided by the increased depreciation and amortisation.
IT’S TIME FOR AN EXIT
Delivering the step-up
Although utilising a passthrough entity creates significant complexity, in addition to the tax benefits realised during operations described previously, significant benefits can also be realised on exit. Just as the PE fund obtained an increase in the tax basis of the assets on purchase of its interest in the passthrough entity, it can now offer that same benefit to a buyer without incurring an entity level tax.
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Jessica Duran |
In the case of a C corporation, providing a similar benefit to the buyer would come at the cost of an entity level tax. As noted above, if the exit from a C corporation investment is structured as a stock sale, the buyer does not receive the valuable increase in the tax basis of the entity’s assets. Pricing and value inevitably are impacted, as the buyer succeeds to the historical basis in the target’s assets.
While highly advantageous, the sale of a passthrough entity does come with additional complexity. Although structured legally as a sale of the interests in the passthrough entity, the PE fund and its investors will encounter the host of issues that typically accompany an asset sale (including depreciation and amortisation recapture).
In recent years, sellers of passthrough entities have, in some cases, negotiated the right to be paid on a continuing basis for a part of the tax benefit realised by the buyer due to its increased tax basis. This has had the effect of generating a cash flow stream that may survive long beyond the date of closing, as tax benefits reaped by the buyer are conveyed back to the selling PE fund as additional purchase price payments.
As discussed above, most PE fund structures have accommodated tax sensitive investors by structuring their investment into the passthrough entity through a corporate blocker. The PE fund will endeavor to sell the shares of the blocker to the buyer rather than allowing the blocker to sell its interest in the passthrough entity. This allows the blocker’s owners to avoid the tax liability that the blocker would incur on sale of its interest in the passthrough entity. But, of course, the sale of a corporate entity will impact pricing negotiations, as the buyer will succeed to the blocker’s historical cost basis and therefore its inherent tax liability.
Exit Structuring – some complexities
A further issue arises if the buyer refuses to purchase the blocker shares but rather insists on purchasing the passthrough entity interests from the blocker. Allowing the general partner to avoid the effect of the double tax on its share of carry attributable to the interest in the target held by the blocker introduces further organisational complexity. This is often accomplished by interposing another passthrough entity (“Splitter”) to hold the blocker’s interest in the target passthrough entity. The Splitter is often owned by the blocker and the general partner. In this case, preceding the exit, the general partner will cause the Splitter to distribute the general partner’s carry interest in the passthrough entity in redemption of its interest in the Splitter. This allows the general partner to sell its carry interest in the passthrough entity without incurring the corporate tax liability within the blocker.
Recapture
In general, the gain from the sale of a passthrough entity is treated as capital gain income. As noted above, however, for certain purposes, the sale can result in treatment similar to the sale of the assets of the entity. As such, to the extent the sale of assets would have resulted in recapture of depreciation or amortisation, the gain will generally be re-characterised as ordinary income. In this manner, the ordinary non-cash deduction claimed for the amortisation or depreciation reverses as ordinary income on sale to the extent the asset has not actually depreciated in value below cost.
State tax considerations
Just as the acquisition and operation of a passthrough entity increases the complexity of state tax reporting, the fund’s sale of partnership interests requires a jurisdiction-by-jurisdiction assessment. This often requires the PE fund to model the exit by jurisdiction to determine how the exit gains will be treated and sourced for state income tax purposes. It is important to complete the analysis before cash distributions from the sale are made to determine state withholding requirements.
State tax laws vary on the treatment of the sale of a passthrough entity and various factors may influence the state tax treatment of the exit gain. One of the key considerations is whether the fund is viewed as engaged in a trade or business or as merely holding the passthrough entity for investment purposes. Depending on the facts and the state law, the fund may report all of the gain to one state or be required to apportion the gain among many states.
Basis step-up that continues on after the deal – tax receivable agreements
As noted above, income tax receivable agreements have become more prevalent. While having the potential to deliver significant additional value to the seller, these agreements add significantly to the complexity of the exit. The agreements provide for additional proceeds to the PE fund to the extent the buyer receives cash tax benefits from the depreciation or amortisation of the increased tax basis. This is often priced at generally 85 percent of the cash tax benefit. As the payment is made in the form of additional purchase price, the buyer obtains more increased tax basis, thus giving rise to more payments under the income tax receivable agreement.
Installment sale implications
Income tax receivable agreements present challenging tax issues for the selling PE fund. Because the agreement provides the PE fund with rights to contingent payments, the fund is required to apply the complex contingent selling price rules, including the requirements to impute interest with respect to subsequent payments and interest on the tax deferred under the installment sale method.16
PLANNING FOR COMPLEXITY
The use of passthrough entities by the private equity industry is likely to continue to proliferate as the benefits become more widely understood. The elimination of double tax, the increase in after tax operating cash flow and the ability to deliver additional value to the buyer on exit far outweigh the additional complexity, when managed with proper planning. ?
Copyright 2012 Deloitte Tax LLP. All rights reserved
This article contains general information only and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this article.
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1 In general, tax exempt investors are not taxed on the receipt of dividend income and thus may escape this second level of tax. Non-US investors may be subject to a different tax rate depending on treaty provisions.
2 This rate is set to expire at the end of 2012. Absent legislation to the contrary, the highest marginal income tax rate on dividend income will revert to 39.6% on January 1, 2013.
3 With rates expiring at the end of 2012, the highest marginal income tax rate on corporate earnings may be as high as 60.74% on January 1, 2013.
4 The ensuing discussion assumes that a limited liability company will not elect to be treated as an association taxed as a corporation.
5 These rates are set to expire at the end of 2012 with the highest marginal rate on ordinary income reverting to 39.6% and the highest marginal rate on capital gains reverting to 20%.
6 A part of the gain may be taxed at ordinary rates due to depreciation/amortisation recapture and other items.
7 A passthrough entity can elect to allow a transferee of an interest in the entity to adjust its share of the basis of the passthrough entity’s assets. The election, once made, can only be revoked with the consent of the Internal Revenue Service. The election does impose additional burdens on the passthrough entity for calculations and record keeping. In addition, a transfer at a value less than applicable basis will result in a reduction in the transferee’s share of asset basis. (In certain circumstances, a downward adjustment is required even if an election has not been made.)
8 With proper structuring, the PE fund can accomplish this even if a target business is currently operated in C corporation form (e.g. the corporation can contribute the operating business to a partnership prior to its sale of interest to the PE fund). There may be a tax detriment to the seller, however, that would likely require negotiation.
9 The Internal Revenue Code applies many limitations on the deduction of interest, including limitations with respect to related parties and limitations to prevent or discourage over-leveraging an investment or utilising an above market interest rate.
10 Many states allow passthrough entities to file “composite” state tax returns on behalf of its owners. Eligibility for participation in the composite return, however, is typically limited to owners who have no other sources of income in the particular state. This often greatly limits the use of these returns for PE funds.
11 A part of the income may be taxed at ordinary rates as further discussed below.
12 An employee or other service provider can elect to treat restricted stock as fully vested upon receipt. When such an election is made, the employee is required to include the value of the stock in income taxed at ordinary tax rates. The employee does not recognise income when the stock vests and will typically recognise capital gain income upon sale of the shares.
13 Certain other requirements must also be satisfied in order to qualify for portfolio debt treatment.
14 The Internal Revenue Code applies many limitations on the deductibility of interest expense. Interest incurred by a passthrough entity on debt used to make distributions may require the owners to trace the use of the funds to determine the character of the interest expense. The passthrough entity may, however, be able to elect to determine the character at the entity level in certain circumstances.
15 Treasury regulations provide various tests for determining material participation.
16 The Internal Revenue Code provides rules that govern the recovery of tax basis by the seller in a sale involving contingent payments. Factors that will impact how basis is recovered include whether a maximum selling price (a cap) exists. The absence of a maximum selling price may result in ratable basis recovery (over the period in which payments are expected to occur, which may be an extended period of time if the payments are to occur over the life of the amortisable/depreciable assets). If the fund determines that basis will not be recovered in a satisfactory manner, it may elect out of installment sale reporting. In this case, the fund may recover all of its basis immediately, but it is required to value the contingent part of the sale and include this in its calculation of the gain.
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