IVCA Feature: Highlights of the IVCA Event 'Tax Reform Update and Action'

IVCA Feature: Highlights of the IVCA Event ‘Tax Reform Update and Action’

 

January 31, 2018

The Illinois Venture Capital Association has hit the ground running in the new year, with its first “IVCA Event,” a comprehensive overview on January 16th, 2018, of the recently signed-into-law U.S. Tax Reform overhaul. The co-sponsors of the event were Katten Muchin Rosenman LLP and Andersen Tax LLP, and the speakers were...

  • Saul Rudo, Katten Muchin Rosenman LLP
  • Kevin Burns, Andersen Tax, LLC
  • Brad Rode, Andersen Tax, LLC

Katten Muchin Rosenman is a law firm founded in the 1970s, which expanded internationally in 2005 under the present name, and ultimately created a diverse financial services practice. Andersen Tax was founded in 2002 by 23 former partners of Arthur Andersen, as WTAS, and then adopted the iconic brand name in 2014. Today, it is one of the largest tax firms in the world.

SUMMARY OF PRESENTATION

The demonstration of the issues in Tax Reform was split into three sections... one, a general overview (Mr. Rudo). Two, a closer look at key provisions impacting Private Equity and M&A transactions (Mr. Burns). And finally, International Provisions and what you need to know (Mr. Rode).

Getting right to point – and then going into details – Saul Rudo began by simply stating that tax rates are going down, cash flow for portfolio companies and tax payers are going up, but also that the new tax is complicated and was “hastily put together.” He emphasized that there are plenty of planning opportunities and incentives within the new law for people and entities to take advantage of... the advice is to rethink the structuring of transactions going forward.

The main codicil of the Act is that it could only increase the deficit by $1.5 trillion dollars, and therefore there are provisions that are in effect for a few years and then expire. Rudo warned that this was a “cliff,” and that planning for the sunset of certain provisions was as important as the current changes in the law. On the accounting side, the SEC is allowing companies to make a reasonable estimate of the impact of the reform, because of the complexities. Technical corrections are still being negotiated between the two parties in Congress.

On Carried Interest.  This does not affect the management share of profits/interest in an operating partnership or an LLC on top of the corporation. Technically, this also doesn’t apply to interest held by “S Corps” (that could also be subject to the ongoing negotiations).

Rates on ordinary income from pass-through entities. Allows for a 20% deduction for “domestic qualified business income” from a partnership, S Corp or sole proprietorship. This is limited, depending on the portfolio company, to the greater of 50% of the W-2 wages from the qualified trade/business OR the sum of 25% of the W-2 wages with respect to the qualified trade/business PLUS 2.5% of the unadjusted basis, immediately after acquisition, of all qualified tangible real and personal property. Rudo pointed out that this was part of the ‘11th hour’ negotiations, because folks in Congress wanted to include real estate businesses, with hard assets rather than employees.

Net Operating Losses for Taxpayers Other than C-Corps. For married individuals, those losses are capped at $500,000 (under the old two-years carried back or 20 years carried forward).

Change to Federal Corporate Income Tax Rate. From 35% to 21%. Unlike individual tax rate changes, subject to negotiation and sunsets in 2025, this change is permanent. There is more cash flow in general and the opportunity is there for a change in structured deals... the pain of doing asset sales and dividends for C-Corps is reduced. For example, Amazon has a possibility of increasing their cash flow by $868 million dollars in 2018. Also the corporate Alternative Minimum Tax is eliminated.

Changes to Depreciation and Amortization. This complex system of cost recovery over a period years will now have a full and immediate deduction for tangible personal property placed into service after September 27th, 2017, for five years. A reduced percentage will begin in 2023, and this also applies to asset sales in acquisitions. Rudo warns that this could increase the friction between buyers and sellers on purchase price allocations because of asset sale responsibilities acquired from either side.

Changes to business interest expense and definition of Adjusted Taxable Income. Through 2022, the deduction for any net interest expense which exceeds 30% of a business’s adjusted taxable income is disallowed... adjusted taxable income is defined as taxable income including depreciation. After 2022, adjusted taxable income will not include depreciation, amortization and depletion. Does not apply to smaller businesses with average gross receipts of $25 million or less. Rudo added the thinking is that if you have an operating entity that is an LLC, and instead of debt you have preferred partner interest or LLC interest, that will not be subjected to the 30% described above.

Excise Tax for Private University and College Endowments. Private universities and colleges with $500,000 endowment assets per student and at least 500 full-time students will now be subject to a 1.4% excise tax.

Changes in Taxation of Overseas Income. Repatriation (Transition) Tax... the accumulated foreign earnings will be subject to a tax... liquid assets at 15.5% and Illiquid assets at 8%, paid over 8 years.

Estate and Gift Tax Exemption. This doubles in the next few years, so Rudo recommends that if you have estate planning or valuable assets – carried interest or private equity funds, for example – now may be the time to give them away to take advantage of avoiding state taxes.

Impact of tax rate environment on entity selection – current status. The key considerations include:

  1. The double taxation of dividends with a C-Corp;
  2. The basis buildup during holding period for earnings from pass-through interest;
  3. The impact of state tax and deductibility of state taxes;
  4. The taxation of earnings from foreign subsidiaries;
  5. LP restrictions on UBTI, ECI, etc.;
  6. The ability to deduct operating losses during a holding period against other portfolio company income;
  7. The seller’s ability to obtain a premium for providing a tax basis step-up to the buyer;
  8. The amount of ordinary income recapture upon a sale;
  9. And, the flexibility to tax efficiently the divestiture of business units and/or tax efficient recaps with a passthrough.

Current portfolios of companies.  Corporation rates down to 21%. Can exit profitable deals with stock sales and one level of tax. There should be less of a discount on stock sale exit, because a “step up” is less valuable to the buyer. Option and transaction expenses tax deductions will become less valuable on the sale of a company. Spinoffs are recommended for currently low value growth businesses, because with tax rates now lower costs today may be a lot less than selling that division out of the C-Corp.

On pass-through businesses, rates are down 29.6 to 37% for individuals. They still allow for asset sales and dividends with one level or tax (and buyer step-ups in tax basis). And they are still tax efficient on sales of divisions, spinoffs, debt recaps and UP-C IPO’s (the public invests in a company in a pass-through form).

Saul Rudo commented that it was worth noting that there were no specific changes to management compensation or self employment tax within the tax reform act.

Regarding new investments. If you are buying assets, you can choose to use a pass-through or choose to use a C-Corp. If you use a pass-through it is generally more tax efficient for Private Equity portfolio companies because of no double tax on operating distribution and asset sales; increases in tax basis for equity interests; spinoffs; and tax deferred recaps. But, according to Burns, it’s become a closer call because corporate structures are viewed as less complicated and more viable with the new 21% rate, and less to deal with on state tax reporting requirements. Also with the 21% rate, there is an opportunity to purchase stock in companies worth less than $10 million, hold it for five years, and pay zero tax on the sale of that stock.

Regarding operations of new investments. For corporations state taxes are still deductible, while pass-throughs those taxes are not deductible. Pass-throughs prefer W-2 employees, but employees may prefer an independent contractor status so they can take advantage of the lower tax rate. In pass-throughs, owning real property is more attractive than leasing. Debt becomes more costly for high leveraged businesses, so there may be a use of convertible debt or preferred LLC interests.

Regarding a sale of a new investment company. First, the determination of whether it will be done as one entire business or the selling of divisions. The corporate double tax on asset sales now may be less painful because of the lowering of the corporate tax rate. Buyer’s value from step-up in tax basis on asset purchases decreases, but higher when there is a lot of Property, Plant & Equipment (PP&E). State income tax planning on pass-through exits becomes more important because of higher tax states, and because of new deduction limits for state and local taxes.

Capital expensing issues. As was expressed in talking about changes to depreciation and amortization, the complex system of cost recovery over a period years will now have a full and immediate deduction for tangible personal property placed into service after September 27th, 2017, for five years, and the expensing of 100% of costs of certain depreciable assets, which as mentioned previously can affect implications for purchase price allocation between buyers and sellers. It can also effect the difference between leasing property and owning it, and the option to elect out of 100% expensing. Also the interplay with 80% limitation on Net Operating Losses (NOL) is affected, and the treatment for state tax purposes.

The interest expense limitation. This applies to net interest expense (excess interest expense over interest income from a trade or business). The deduction will be limited to 30% of an adjusted taxable income. Businesses that are excluded include those with gross receipts of $25 million or less, the broad exception of electing real property trades or businesses, the broad exception of farmers and floor stock financing.

The considerations to the interest expense limitations is based on the ratio of weighted average cost of debt to a leverage multiple over-holding period. In the year of selling a company, the transaction cost deductions may impact the interest deductibility in that year of disposition... that can carry over to a buyer. Burns expressed again that investment interest expense not subject to limitation may provide for planning opportunities.

The treatment of Net Operating Losses. There is an elimination of NOL carryback, which will create challenges for sellers to obtain tax benefit of transaction costs in situations where an NOL is created. Buyers can have generated a cash flow benefit from an NOL carryover, but the application of Annual Section 382 limitation will become increasingly important.

Carried Interest. There is a recharacterization of certain gains with respect to Applicable Partnership interests from long-term to short-term with a holding period of less than three years. That applies to the partnership interest held in connection with the performance of substantial services by the taxpayer in an applicable trade or business. The applicable trade or business is defined as an activity of raising or returning capital and investing in or developing securities, commodities, real estate or partnership interests. Application of the three year holding period is with respect to capital gains from portfolio investment companies. This applies to the eventual waterfall fund and the equity sponsors, a fund carry and a deal-by-deal carry.

Exclusions include the profits held in manager unit holders, may exclude the treatment of capital interests and fee waivers. The “Holding Period” is generally measured with respect to holding period of portfolio company investments. but there most likely will be some guidance issue with technical corrections, according to Burns, especially in consideration of treatments of new issuances, redemptions and changes to the holdings of GP interests.

Burns also expressed to be wary of the impact of add-on investments and restructuring to the holding period. The three year period applies to capital gain, so an opportunity could come by generating the carry through a dividend, according to Burns, because of the dividend recap, or other sorts of income.

Other Considerations in the Tax Rate Environment on PE and M&A. This includes considering what states will do, and expect them to decouple from key areas, such as full expensing of depreciable assets. There will also be a limitation of deductibility of excess business losses. For LPs, there are structural changes in respect to “Blocker Corporation Investments,” and you don’t want to have a foreign investor holding interest in a pass-through, because of the changes in the treatment of tax on these sales. Also for LPs, the investment fees and state taxes are not deductible for individuals or trusts... Burns spoke of possibly pushing those fees to portfolio companies.

Overview of International Provisions. Brad Rode began this section by indicating that the United States has dramatically altered the way foreign investments and foreign business activities by U.S. taxpayers are taxed. Historically (since 1962), foreign investments and foreign business activities have been taxed on a deferred basis. Deferral means that if a U.S. taxpayer or company has income off-shore in foreign subsidiaries, the income wasn’t taxed until it was brought back as a dividend... that system was regulated by Subpart “F Rules.”

What these new tax rules are designed to do is prevent U.S. taxpayers/businesses/shareholders from parking passive income into a controlled foreign corporation (CFC). This regulates the deferral system before the income is parked. So the status before the tax act was that U.S. investors have had CFCs all over the world and have built up significant amount of foreign earnings that have not been brought back to be taxed domestically.

Participation “Dividends Received Deductions” (DRD) exemption. This only applies to domestic C-Corps... it’s important to understand that if you are a non-corporate shareholder in a foreign corporation you will not get the Participation exemption. This is a deduction for a foreign source portion of a dividend if you own 10% or more of a foreign corporation.

Mandatory Deemed Repatriation Tax. This applies to any U.S. shareholder of foreign corporations. It looks at the deferred foreign income for the investments, and will be deemed taxable income... this applies whether or not it is distributed, and it is mandatory and not elective. This becomes retroactive to 2017, and interested parties are now figuring out what their exposure is in this case, and the SEC has built in time for these parties to understand the tax.

Subpart “F Rules” Retained and Modified. These rules – which regulate foreign investments by U.S. shareholders – have been retained, but with additions of several new concepts, according to Rode. They include stock attribution repealed retroactively, the U.S. shareholder definition expanded to include the value of the stock owned, the elimination of the “30 Day Rule” under Section 951, elimination of foreign-based oil company related income and the repeal of Section 955.

Global Intangible Low Taxed Income (GILTI, pronounced “guilty”). Rode pointed out that GILTI doesn’t just apply to global intangible income and low taxed income, which is an important consideration. This means that any U.S. shareholder, individual or corporate or partnership, will have to look at all their CFCs, and aggregate all their income from those holdings every year. They will then compare that income with a routine return on their tangible assets from all those CFCs (10% deemed return on tangible property, based on a U.S. tax basis... a thin margin for most taxpayers). Any income in excess of that will become taxable income. Unlike the Subpart “F rules,” it will be harder to avoid the GILTI provisions.

For domestic C-Corps, GILTI is bad news but not the end of the world, according to Burns. There is a 50% deduction at the C-Corp level, and a foreign tax credit for 80% of the foreign taxes. For U.S. corporations, this translates into a global minimum tax, coming out to at least a 13% tax on all foreign earnings.

If you are an individual, a domestic partnership or an S-Corp, you do not get the benefits of the C-Corps. The GILTI means you are currently taxes on the income of all your CFCs, with no deduction or no foreign tax credit.

Foreign Derived Intangible Income (FDII). Rode defined “intangible income” in this case as dubious, and only domestic C-Corps get this benefit. If you sell property or services to a foreign person you can get a tax deduction of 37.5%, reduced to 21.875% after 2025. Again, works as an opportunity to get to a 13% tax on all foreign earnings.

Base Erosion Anti-Abuse Tax (BEAT). This looks at payments that U.S. taxpayers are making outbound to foreign-related persons, and if they are yielding a deduction domestically, there is a BEAT tax that is the excess of the amount to 10%. With this provision, you look at your normal tax liability, or you come up with a alternative tax liability as if you didn’t get deductions from any of those payments to foreign interests. Whichever is higher, you pay the 10% on it. The rate will increase to 12.5% by 2025.

Foreign Tax Credit Rules Modified. According to Rode, one of the main provisions is that if the transition tax inclusion uses up some of your NOL (for a corporate tax payer), that can create what is call an “Overall Domestic Loss” (ODL). If you’re taking deductions generated domestically and offsetting foreign income, for the next ten years this rule enhances your ability to re-capture that deduction if you have positive taxable income, which can increase your ability to use foreign tax credits.

Sales of Partnership Interests and Withholding Tax. In a provision that was implemented in 1991, the IRS position is that the sale of partnership interest by foreign persons, which includes U.S. businesses within those partnerships, should be taxed. The provision has been controversial, and was even overturned in tax court case last year (Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3). In the Tax Act, Congress is backing the original IRS provision, and codifying it. Under the new law, a foreign person can be subject to tax on gains from disposition of partnership interests, and there is a withholding of 10% of proceeds.

Summary. The transition tax exposure, even for straight-forward structure, the rules to complete the tax are somewhat overwhelming. For larger multi-nationals, it will take their accounting auditing network, with the IRS auditing, to figure it out. The deferrals had been in place since 1962, with no calculating details.

There is planning that can be done. Cash positions can be modified through fiscal year subsidiaries, through the applicable end year of 2018, and make sure the cash position is not higher that the other measurement dates... accounting methods and tax year ends can also be considered. Corporations can elect not to use their NOLs against the transition tax, if they can get a better answer with their foreign tax credits. There is also an election to pay the transition tax over eight installments.

Another unintended consequence, according to Rode, is the expansion/modification of the Subpart “F Rules.” One of those rules that was taken away previously limited attributing stock from a foreign person to a domestic person, defining a CFC. So in a case where a foreign fund and taxpayer owns foreign corporations and at least one domestic corporation, that overall foreign corporation fund is now a CFC, when it wasn’t one before. If there is a circumstance where a domestic feeder in such a fund contributes 10% or more, that part of the fund will be subject to the transition tax moving forward. The legislative language on this modification is vague, and there could be a technical correction on it.

For transactions, the transition tax is a significant issue for buying and selling foreign corporations. If you are buying or selling a foreign corporation that has a tax year that begins in 2018, you are essentially buying and selling the transition tax. Considering the history of a company or earnings, that could be a significant number. One way to push the liability to the seller, is to make a deep asset election (338). That will cause the seller to be responsible for the transition tax, because that election cuts off the tax year for the foreign corporation, and treats the company as a brand new corporation the day after the transaction.

Finally, one more word on GILTI. There will be difficulties between buyers and sellers regarding asset allocations and stock vs. asset deals. When there is a U.S. seller selling stock to a foreign subsidiary, there will be significant adverse interest in terms of making deemed asset sale elections, and otherwise on how the transaction will be structured.

The next IVCA Event will be Wednesday, February 14th, 2018... UNRAVELING CRYPTOCURRENCIES AND BLOCKCHAIN. Click here for more details and to register.