The sweeping tax reform legislation, commonly referred to as the Tax Cuts and Jobs Act (the Act), P.L. 115-97 was signed into law on December 22, 2017. At DHG, we recognize that the new tax landscape may present more questions than answers and a feeling of uncertainty. That is why we have prepared this article which provides a high-level summary of the Act‘s key provisions affecting the private equity community.
Three-Year Holding Period for Carried Interest
With respect to dispositions of carried interest or “applicable partnership interest,” the Act imposes a three-year holding period to be eligible for long-term capital gain tax rates. Prior to provision implementation, the holding period was one year for long-term capital gain treatment. Dispositions of applicable partnership interest which fail the three-year holding period, will be taxed at the short-term capital gains rate.
An applicable partnership interest is a partnership interest held by a U.S. taxpayer in connection with the performance of substantial services in a trade or business. In general, an applicable trade or business is the activity of raising or returning capital, and either investing in or developing securities, commodities, real estate held for rental or investment, cash, options, or derivative contracts.
Application to Private Equity
The new three-year holding period, related to carried interest provision, will broadly apply to most private equity groups. However, because private equity funds generally hold investments for longer than three-years, it is expected the new provision will result in a minimal impact.
An exception in the Act provides that an applicable partnership interest does not include an interest in a partnership held directly or indirectly by a corporation. Accordingly, carried interest held by corporations are not subject to the three-year holding period to be eligible for the long-term capital gains treatment. On March 1, 2018, the Internal Revenue Service (IRS) announced, in Notice 2018-18, that it will issue regulations stating that carried interests held by S corporations will not qualify for the exception from the Act’s carried interest provision for interests held by corporations. Accordingly, S corporations are subject to the new extended three-year holding period applicable to carried interests.
Interest Expense Deduction
Under the new Internal Revenue Code (IRC) section 163(j), the deduction of net business interest expense is limited to 30 percent of a business’ adjusted taxable income (ATI). The limitation applies to interest expense properly allocable to a trade or business. For tax years 2018 through 2021, ATI is generally calculated using tax earnings before interest, taxes, depreciation and amortization (an EBITDA based calculation).
For tax years beginning after 2021, depreciation and amortization are not added back to determine ATI (an EBIT based calculation).
For partnerships and S corporations, the limitation applies at the entity level and there is no provision for grandfathering the deductibility of existing debt. In addition, rules limit the netting of income and expense between related partnerships and S corporations.
Disallowed interest may be carried forward indefinitely. Taxpayers with average gross receipts for the previous three taxable years of less than $25 million are exempt from the limitation. Real estate trades or businesses can elect to not apply the interest expense limitation, which requires the use of slower depreciation of property.
Application to Private Equity
According to the Congressional Joint Committee on Taxation’s Estimated Budget Effects of the Conference Agreement for H.R 1 (dated December 18, 2017), the limitation of the net interest deduction is expected to raise $253 billion of taxes over the next 10 years.
Private equity funds utilizing debt to leverage their acquisitions may experience a significant increase in the cost of financing. Accordingly, it is recommended that alternative transaction structures, such as leasing, convertible debt instruments and preferred debt financing be considered.
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