In December 2017, the president signed the Tax Cut and Jobs Act (the “Act”) into law. There are many changes in the Act that could impact the way independent sponsors structure their investments. Some of these changes are permanent and some are temporary. Here are five key provisions of the Act that independent sponsors should be aware of.
Reduction in the corporate tax rate. Starting in 2018 the federal corporate tax rate will be reduced from a 35% maximum tax to 21% flat tax. This is one of the permanent changes in the Act. The “double tax” issue that often steers sponsors away from electing for their portfolio companies to be taxed as corporations still exists, but the lower tax rate does make it worth modeling the tax effect of both corporate and pass-through structures to determine which is best.
Always start with the end in mind. Who do you expect to sell your investment to? Will you be selling the assets of the business or the stock? It is very important for independent sponsors to have their exit in mind when they are setting up their legal structure. If the portfolio company is a corporation and the buyer is looking for an asset deal, you will be paying tax on the gain inside the corporation before making a taxable distribution to the investors. A selling corporation may have turned down offers for asset sales in the past, but the reduction in the corporate rate makes the “double tax” hit more tolerable than it used to be.
Lower taxes = More free cash flow. In a partnership structure, operating agreements usually require tax distributions to investors to cover the tax liability from pass-through income from the portfolio companies. With the corporate rate being so much lower than the highest individual tax rates, the cash required to cover the tax liability each year will be significantly lower for a corporation. As a result, the corporation ends up with more cash to reinvest in the business, pay down debt, or acquire add-on businesses.
20% Pass-through Deduction. For the next 8 years (starting in 2018), individuals who own an interest in a pass-through business (LLC, S Corp, sole proprietorship) could be eligible for a 20% deduction on their allocated income. The deduction is taken at the individual level and is subject to limits based on the wages of the pass-through entity and the taxable income of the individual receiving the deduction.
Do I qualify for the deduction? The act defines a qualified business as any trade or business other than a “specified service trade or business” that involves the performance of services in health, accounting, law, actuarial services, consulting, performing arts, athletics, finance and brokerage services and any trade or business where the principal asset is the reputation or skill of one or more owners or employees. The good news is that the typical target companies for many independent sponsors are not on this list. The bad news is that the management company will likely be considered an excluded business.
What does this mean for my existing structure? This deduction could lead independent sponsors and their capital providers to revisit their operating agreements to reduce mandatory tax distributions since the tax burden of the pass-through income could be going down. Since each investor’s personal tax situation is different, it might be prudent to keep distributions at the same level but it is worth a look. It is also worth noting that investor returns are generally calculated off of cash payments not the investor’s after-tax cash flows. Finally, investors who were not interested in a pass-through structure that generates ordinary income might have more interest if a 20% deduction comes along with it.
Business interest expense limitation. Independent sponsors that are using debt to acquire a business could see a limit on the interest expense deduction going forward. Starting in 2018 the deduction for business interest expense is limited to 30% of adjusted taxable income. Adjusted taxable income is defined as follows EBITDA + business interest income from 2018 to 2021, and then EBIT + business interest income thereafter. The interest that is not deductible in the current year is not lost but is instead carried forward with no expiration date. Many companies will not have to worry as much about the limitation while depreciation and amortization are added back to arrive at adjusted taxable income. However, when the limitation applies, a company could be faced with a significant increase to its taxable income.
100% expensing on capital investments. For portfolio companies that require significant capital investment,determining when to expense the cost of fixed assets for tax purposes has a big impact on taxable income. Prior to the Act, a company was allowed to expense 50% of new personal property acquired (machinery & equipment, furniture & fixtures and other shorter lived assets) in the year placed in service. Under the new rules, a company is allowed to expense 100% of new and used tangible personalproperty in the year placed in service. Assets acquired after September 27, 2017 qualify for the tax deduction. This is a big change that can provide significant acceleration of tax deductions, deferring tax liabilities to future years.
Carried Interest Characterization of Certain Gains in the Case of Partnership Profits Interests Held in Connection with Performance of Investment Services. Starting in 2018, carried interest requires a three-year holding period to qualify for the long-term capital gains rate treatment.
Independent sponsors should consult with their tax advisors to understand the sweeping changes in the current tax reform bill. Careful consideration of the restrictions and temporary nature of flow through business tax deductions compared to the new decrease in tax rates for corporations should be evaluated when deciding how to best structure a deal.
Bill Conron is a tax partner at Citrin Cooperman and a member of the Private Equity and Capital Markets Practice. Bill advises private equity firms, family offices, independent sponsors, and business owners on complex mergers and acquisitions. He can be reached at (203) 847-4068 or at firstname.lastname@example.org.