Considerable changes are coming to the private equity and venture capital industries under the new tax law informally called the Tax Cuts and Jobs Act (TCJA). Provisions generally take effect in 2018, but some affect 2017, as well. Private equity and venture capital firms should develop a course of action to address the changes imposed by the TCJA, particularly those that will affect areas such as effective tax rates, preferred operating and acquisition structures, and the potential need for additional K-1 disclosures.
DEDUCTION FOR QUALIFIED BUSINESS INCOME OF PASSTHROUGH ENTITIES
The TCJA enacted new Section 199A that provides a 20 percent deduction for qualified business income from a qualified business. Certain businesses are excluded from the deduction, including those in the fields of consulting or financial services, or those that perform services involving investing and investment management trading, or dealing in securities, partnership interests, or commodities. As a result, sponsors of private equity funds may be ineligible for the Section 199A deduction and should evaluate other tax mitigation strategies for their companies and portfolios.
LIMITATIONS ON INTEREST EXPENSE DEDUCTIONS
Net business interest expense is limited to a taxpayer’s interest income plus 30 percent of the entity’s adjusted taxable income. Disallowed business interest deductions are carried forward indefinitely. Adjusted taxable income excludes non-business items and is defined similar to EBITDA for taxable years beginning in 2018 and ending before Jan. 1, 2022. Starting in 2022, adjusted taxable income is defined similar to EBIT.
Small businesses (under $25 million average gross receipts for prior three years) are exempt, and certain real estate and farming businesses can elect out of this provision at the cost of longer depreciations periods. Highly leveraged funds should assess re-capitalization strategies and whether any real property trade or business should elect out.
NET OPERATING LOSSES AND EXCESS BUSINESS LOSSES
Net operating losses (NOLs) for individuals and businesses are limited to 80 percent of taxable income for losses arising after Dec. 31, 2017. In addition, the TCJA eliminates the carryback provision, which may be a disadvantage to sellers who are looking to capture the tax benefit of transaction cost deductions by creating an NOL to carry back to preacquisition years. The valuation of entities generating NOLs may also be affected.
Business losses for individuals are limited to $250,000 per year ($500,000 for joint returns) for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026. Disallowed losses are added to the individual’s NOL carryforward.
Beginning in 2018, partners with carried interests will have to hold them for three years to be eligible for long-term capital gains; otherwise, the gains will be treated as short-term capital gain. The application of the holding period rule is not entirely clear regarding property sold by the partnership and distributions treated as capital gains. Additional interpretive guidance may clarify current uncertainty.
TECHNICAL TERMINATIONS OF PARTNERSHIPS
The TCJA permanently repeals the technical termination partnership rule and eliminates the disincentives to engage in sales or exchanges of a greater than 50 percent interest in a partnership. The repeal of this rule will allow partnerships to continue through ownership changes without resetting depreciation periods. It also removes the requirement for the partnership to establish new tax elections.
Private equity funds owning more than 10 percent of controlled foreign corporations are subject to a one-time repatriation tax on untaxed foreign earnings and profits. This provision could potentially affect portfolio companies and certain fund structures that directly or indirectly hold investments in foreign subsidiaries. The tax may be paid over eight years.
The transition tax will impact immediate and future cash flows and thereby influence the valuation of investment portfolios. Private equity and venture capital funds will face challenges in determining which of their foreign investments are considered specified foreign corporations whose earnings and profits (E&P) will be subject to deemed repatriation under the TCJA. A comprehensive E&P study may be needed to calculate what is owed.
Jim Slouber is a Managing Director in the Los Angeles office of CBIZ and MHM. He specializes in tax planning and consulting, transaction and partnership structuring, and mergers and acquisitions.
JAMES K. SLOUBER, CPA, MST MANAGING DIRECTOR, TAX CBIZ and MHM JSLOUBER@CBIZ.COM