Private equity firms are not overly concerned about the three-year minimum holding period for investments required under the tax law to qualify for lower rates of capital gains tax, according to executives at pfm‘s Private Fund Compliance Forum last week.
The law requires that portfolio companies be held in a fund for at least three years, instead of one, for carried interest to qualify as long-term capital gains. The Internal Revenue Service said in March it was addressing the issue and regulations would be issued.
When asked how the three-year hold period would affect their firm, in the audience of more than 100, about 80 percent of those who responded — many of them chief compliance officers and chief financial officers — said it wouldn’t make much difference as most of the carry comes from investments held for three years or longer.
Only about 5 percent answered that the long-term capital gains will impact many of the deals and be a burden to the firm.
Joshua Cherry-Seto, chief financial officer for Blue Wolf Capital, a mid-market PE firm, is one executive who expressed concern as to whether add-on acquisitions after the three-year period but within three years of an exit would be considered long term.
Cherry-Seto, in an interview with pfm, cited as an example a company that his firm has held on for five years, and in the fourth year, there was an add-on acquisition. He added that if the company was sold in the fifth year, the add-on acquisition in the fourth year would be treated would be treated as short term.
“There’s a part of where the law is not clear about how this should be treated,” Cherry-Seto said. “If we do an add-on in such a way there’s no change in control, then it shouldn’t affect this issue in the three-year hold. If you’re doing an accretive add-on and then you sell the company, you shouldn’t run afoul of the three-year limit. It is a particularly perverse outcome for an add-on which required no additional investor capital. Thus the fund investment is wholly greater than three years but manages to attract short-term capital gains.”
Notwithstanding the change in the length of the long-term capital gains tax, some tax experts say that won’t necessarily lead to changes in the limited partnership agreement.
“There is no need to change LPAs to deal with the change in law,” said Pepper Hamilton tax partner Steven Bortnick. “Although PE funds may recognize capital gains within the three-year period, I think five years is a little more standard.”