Some very taxing issues for PE funds

Whether it is President Trump’s reforms, changes to partnership audit and fee waiver rules or the fallout from the Grecian Mining court case, GPs and funds face some big changes to the US tax regime in 2018, says Jerry Musi, a partner specializing in private equity fund tax issues at accounting and advisory firm RSM

Tax reform is top of mind not just for the industry, but for the entire US. What should GPs expect?
Jerry Musi: There’s a lot to like in the early releases of tax reform for some industries that has come out from Congress over the past few months. The highlights are that the corporate rate could fall to 20 percent from 35 percent, and the pass-through rate from 39.6 percent to 25 percent. However, it’s important to put things in context for funds. On the plus side, the mention of carried interest has not been too alarming with a three-year hold period and on the downside, an interest deduction 30 percent limitation of taxable income. The recent Senate bill avoids carried interest change.

For some perspective, the last major tax reform in 1986 was eventually over 3,000 pages, as opposed to the much shorter recent early drafts, so there’s a lot of work, amendments and discussions to take place.

But if those lower rates end up in place, PE funds and GPs might choose to convert their majority owned portfolio companies’ into C-corps and be freed of any state tax issues that exist when relying on pass-through entities.
Certain pass-through entities would enjoy major savings. Currently the highest rate for partners of PE funds allocated business profits of operating investments is 43.4 percent once you add the Medicare tax of 3.8 percent.
Before the PE industry gets too excited with the 25 percent pass-through rate proposed, President Trump was quoted as saying shortly after his election win that alternative investment firms would not enjoy the lower rate. So that 25 percent rate may not apply to the private equity funds that invest in flow-through entities, where there may be operating trade or business income allocated to PE limited partners.

Commenting on recent tax reform Congressional reports, the Treasury Secretary said that the 25 percent rate would not cover service entities, such as accounting firms. But they’re using accounting firms only as one example – service entities also include PE fund management entities.

What deductions are likely to go?
JM: It’s important to recall these cuts don’t exist in a vacuum, and the bill will attempt to recoup the revenue lost due to these lower rates. At first, they considered eliminating 100 percent of the interest deduction, but since that includes anyone with a home mortgage, it hit a political wall. Instead, recent tax bills have put limitations on interest deduction for businesses. This raises a concern for PE portfolio companies that obtain loan financing from banks. Also, PE funds make leverage investments, where they provide leverage financing to portfolio companies as investments. These will be affected if interest deduction is compromised.

Will carried interest be back on the table?
JM: It’s possible. If it were up to President Trump solely based on campaign promises, favorable carried interest tax rules would change. Thankfully for the PE fund industry the discussion so far on carried interest has not been tax detrimental. But if Congress wants to make these deep cuts for corporations, pass-through entities and individuals, they’ll have to look for ways to fund these cuts and may use carried interest to recoup some of lost revenue. The reality is that a lot can happen to that tax reform before it becomes law.

How do you think PE funds and their GPs should prepare for the changes to partnership audits due to take effect in 2018?
JM: They should look to their LPA. I have a sense that the industry might not be taking these changes seriously enough. They should be looking at amending the LPAs to address these changes now.

Some folks aren’t aware that the new- ly defined “partnership rep” isn’t simply a new name for the tax matters partner. These partnership reps will have broad authority to bind partnerships like PE funds to whatever arrangement grows out of any audit, including the decision as to whether a general partner will pay the tax directly on behalf of the underlying partners. Many issues remain unresolved like partnership push-out of adjustments.

PE funds should make sure they’re comfortable passing that authority on to the current tax matters partner or to someone else. Some outside consulting firms are raising their hands to serve as their partnership reps, for a fee, of course.

But these changes also force the part- nership to pay for any adjustments in the current year, even if the audit was for a previous one. This requires a mechanism to collect monies from old partners who might have left the partnership, and ensure new partners aren’t footing the bill.

These are complex issues and GPs should be consulting their lawyers and accountants to make the best decisions, before the end of the year. As for the opt-out option for partnerships that have less than 100 partners, this does not ap- ply to investment partnerships

This year’s court decision regarding the Grecian Magnesite Mining Company was regarded as a victory for non-US LPs. Why does it matter?
JM: Prior to the court case, the IRS had said unofficially that if I’m a foreign partner in a US partnership and the private equity firm were to sell the LLC units of a pass-through portfolio company then that would be subject to ECI. There was a revenue ruling back in 1991 that has been relied on, and since then, we’ve taken a conservative position, that yes, the capital gain is effectively connected income (ECI).

Private equity fund serve as the withholding agent. The IRS wants that money upfront. The PE fund would then get their money back when they make a distribution to non-US LPs from exit proceeds and subtract out the withholding tax from the foreign partner’s distribution.

But in the recent court decision, a Greek mining company named Gre- cian, which had an investment in a US mining LLC, decided to sell their LLC’s partnership units. Their tax advisors took a contrary position that it was not ECI.

The IRS audited them and disagreed. The taxpayer and their advisors brought the matter to court which ruled in their favor saying it was not ECI. For the time being, we can be comfortable in saying the capital gain from the sale of LLC units is not ECI to a foreign partner.

The private equity fund won’t need to do withholding for a foreign partner for the sale of a partnership unit any longer and foreign partners would not have to report ECI on a US tax return. It appears to be a win-win for the PE fund and their foreign investors based on the court case, but the recent Senate tax bill was looking to codify the gain as ECI. Stay tuned.

Could funds potentially get refunds of money previously withheld?
JM: Some PE funds are using the court case to argue that since they withheld money for previous years, they should get those funds back. But the IRS is taking a strong stance, and forcing the foreign partners to file a return to get any funds back.

Back in 2015, there was a lot of talk about management fee waivers. Where does the issue stand now?
JM: The final regulations on these waiv- ers have yet to be issued, but a lot of GPs have ceased using them over the last few years. The IRS announced its view that improperly used fee waivers give PE funds and their GPs an unfair tax advantage by allowing them to increase their carry, thereby skipping the ordinary income rates applied to management fees, so plenty of PE firms stopped employing them. We’ve heard word that a few management fee waiver audits have begun. Our clients haven’t had any yet, but all the indications are that the IRS won’t be dropping this issue. 