On-Demand Webinar: U.S. Tax Reform
Nick Gruidl and Tommy Wright of RSM US LLP discuss the sweeping changes to tax legislation and how the Tax Cuts & Jobs Act may impact your fund, firm, and portfolio companies.
Nick Gruidl and Tommy Wright of RSM US LLP discuss the sweeping changes to tax legislation and how the Tax Cuts & Jobs Act may impact your fund, firm, and portfolio companies.
U.S. Tax Reform: How Will It Affect Private Equity Firms and Portfolio Companies?
David Snow, Privcap:
Hello and welcome to a Privcap webinar. My name is David Snow. I’m CEO and co-founder of Privcap. Today we have a very hot topic for you, the impact of U.S. tax reform on private equity firms, private equity funds, and on the personal taxes of private equity principals. We have a couple of seasoned tax experts with us today who are going to guide us through this very important, somewhat complex topic. I’m very pleased to ask each of them to introduce themselves. Why don’t we start with Nick Gruidl of RSM?
Nick Gruidl, RSM:
Thank you. Yes, my name is Nick Gruidl. I am a partner with our Washington National Tax practice. My practice is focused on subchapter C corporations, M&A, and private equity transactions. With tax reform, we have been spending a lot of time just looking at how is this, one, going to affect deal issues, and two, how is it going to impact your decision as to how to hold a portfolio going forward. With that, I think I’ll let Tommy introduce himself.
Tommy Wright RSM:
Yes, Tommy Wright, RSM Houston office. I work in the Private Client Services division where we deal with individuals, executives, owner operated businesses, wealthy families, and of course private equity fund principals, owners, managers, execs. I am in charge of the Private Client Service practice for the Central region of RSM and also work on a national basis as the leader of our Family Office practice. Of course, tax reform is a very hot and prominent topic at this point in time with really all of our clients. It’s something we’re addressing continually.
Snow: Great. Thank you, Tommy and Nick. Why don’t we get started? First, a quick reminder to our audience, this is an interactive webinar. You have the ability to submit questions. We will set aside about 10 to 15 minutes at the end of this webinar to answer some of these questions. Given the huge interest and the huge volume of people tuning in, I don’t think we’ll get to all of them, but Tommy and Nick would be very happy to talk to you offline if you have a pressing matter to throw their way. Why don’t we start with, and I’ll throw this first question to Nick, when people think of private equity and taxes, probably the first term that pops into their head is carried interest. Give us the headlines and the most important impacts of the revised carried interest treatment and why you think it’s important for people to understand them.
Gruidl: Sure. Certainly at the fund level, carried interests are probably the most significant issue. I think with tax reform, there was good and bad. The good is the idea that now carried interests are essentially defined in the statutes, so they are the law, where in the past carried interests really fell under profits interests, and there was a revenue procedure from the IRS that essentially allowed this, but with a revenue procedure, the IRS could at some point have decided to pull that. The good is we now have a statutory definition. The bad, there’s a three-year holding period now to get that carried interest long-term capital gain. That applies at both the partner level with their particular carry that they hold but also with respect to allocation of gains to the carry based on sales of investments. If there’s the fund and it holds an interest for less than three years and recognizes a gain, and there is an allocation of income to the carry on that gain, that is going to be treated now as a short-term capital gain. That’s the same rate as ordinary income, but it is a capital item. If someone had a capital loss in the same year, which generally is tougher to utilize, you could utilize it against that carry.
One of the big issues that I think funds and GPs are going to have to look at moving forward with this carry is what’s the most appropriate way to allocate income on a carry when you look at potential clawbacks or certain waterfalls, and how fixed is that carry once it’s earned on one investment if there are multiple investments in the fund, and is there some flexibility in how you may allocate income on investments that are held and sold early. Those are some of the issues that are really following the carry. A couple of things that are, I think, important to point out, this only applies to carries, not profits interests. If you continue to hold investments through flow-through entities and you are granting management in the company, a CFO, a COO, something like that, a profits interest in a flow-through portfolio company, that will continue to be treated under the old rules as a profits interest as opposed to under these new rules as a carry. There is now an actual separation between a profits interest and a carry. The carry relates to really people who are involved in the raising and returning of capital, and investing and disposing of portfolio companies, exactly what private equity does. That’s a carry as opposed to your traditional now profits interest.
Snow: Go ahead, yeah.
Wright: Sorry. Dave and Nick, I was going to say people think this is a real or may think this is a real onerous change in the law to go from a one-year hold to a three-year hold, but when you really compare it to the backdrop of what could’ve happened with a total repeal of carried interest, it’s actually not that bad of a provision in terms of how it could’ve gone on the extreme side. I did read a piece the other day that a researcher had gone back and looked at private equity deals since 2000 and said if you applied the three-year carry, approximately 24% of those deals would not have qualified for the three-year hold, and therefore would’ve been short-term gain. That’s a pretty telling sign that, as we all know in private equity, your deal flip time is generally longer than three years. Hopefully it’s not going to be that onerous to private equity owners and principals. Go ahead.
Gruidl: I was going to say from the private equity companies we have talked to and the GPs, they certainly understand we’re not going to sit on a deal if it’s the right deal to make. We’ve got to make the right investment decisions for investors. I don’t think anyone’s looking at holding a deal and not getting it done if it’s the right economic answer, that’s for sure.
Wright: Right, right.
Snow: Tommy or Nick, real quick follow-up question. What options do private funds have that are involved in more liquid strategies like hedge funds? What options do they have since they’re doing trades on a minute by minute basis in some cases?
Wright: Typically, the manager, his carry, you’ve got a high watermark, and you’ve got other issues you have to deal with. Typically, it’s going to be some period of time before that 20% is paid out to the manager.
Snow: There are some options that you have in timing the payment of the carry as opposed to when a profit is booked.
Wright: Yeah, it is an allocation issue. When the carry is earned, you get an allocation of income. If you do have a short-term trader like that, if all the gains in the fund are short-term, then that carry is going to be retained as it’s allocated to the manager.
Snow: Let’s move on to another very important issue related to tax reform, and that has to do with the kind of entity that a private equity firm would choose to use for a portfolio company whether a flow-through entity or a corporation. Again, maybe starting with Nick, how does the most recent tax reform change the calculus of that decision, and what do you think you’ll be recommending to your clients as they try to figure out the right structure for their own portfolio companies?
Gruidl: I think that’s probably the biggest impact of tax reform when you look at the portfolio company. We have significant changes in the corporate tax system. We’ve all heard the big drop in rate from 35% to 21%, so that’s huge. We have very significant change in the international tax system going to a territorial type system, which depending on your business, you maybe be able to essentially avoid paying tax on earnings overseas forever as long as you are in a C-corp structure. Many of heard of the pass-through deduction. It’s a 20% deduction off of essentially taxable income that flows through, so that could impact the flow-through side. You look at all of those changes, you say those changes alone really don’t tell you, “Oh, 14% drop in the corporate rate. We definitely need to go corporate,” because there’s still two levels of tax.
What we are really seeing is there’s two main drivers along with tax reform or how tax reform impacts your decision. One is what is your investor base, and two is what does the activity look like? If I were to say at a 10,000-foot level, I think what we are seeing is if you have significant foreign and tax exempt investors that are blocked through corporations and you have portfolios that have significant foreign activities, the idea of a corporate structure looks more and more likely because you get some of these benefits that we’ll just hit on a little later on the territorial type system where on the flip side if you have portfolios that are primarily domestic and your investor base does not require much of the income to be blocked through a corporation, you may find that even though we’ve had these favorable changes to the corporate structure, you’re going to want to stay flow-through.
A couple of quick things on a change at the fund level with tax exempts that I think are important because we just talked about how much is being blocked. There was a change to the treatment of tax exempts and how they can treat unrelated business taxable income that flows through the fund to them. In the past, tax exempts could essentially net losses from one investment and income from another to determine that they do not have UBTI. That changed with tax reform. Now if you have a tax exempt investor that is not investing through a blocker because they say, “Well, we net all our gains and losses, and they net to zero,” they can no longer net. They may need to block investments going forward. If they do that, again, we’ll come into the equation of C-corp versus flow-through. Again, the big issue is makeup of investors and type of activity. The more you’re blocking, the more corporate looks like it might make sense. If you’re all domestic and you don’t have to block much, it maybe that flow-through continues to be the way to go.
Wright: Nick, Tommy here. When we had the 35% corporate rate and you factored in the double taxation to the individual shareholder, the corporate earning a profit paying its tax, distributing a dividend, the all in effective tax rate on that income was 50.47%. With the 21% C-corp structure, the effective rate in that same scenario is dropped to 39.8%. It’s dropped from a 50% rate to a 39% rate. That’s a 20% reduction in the tax impact of double taxation in a C-corp structure. That’s fairly significant. Of course, no one wants a 39.8% rate, as you can imagine. As Nick pointed out, the flow-through is a very attractive structure at this point in time because of the 20% deduction that some flow-through income might enjoy. At a top individual rate of 37% where the taxpayer qualifies for the 20% flow-through deduction, they’re only taxing 80% of the flow-through income, and that drops the effective rate from 37% to 29.6% at the individual level.
Back to the choice of do I go the C-corp route or do I go the flow-through route, in my mind it’s largely a cashflow decision, taking into consideration how long am I going to hold the investment before it’s sold. You really just have to schedule out the cashflows to do a proper analysis of which is the best means to hold the portfolio company through C-corp versus partnership.
Gruidl: Another thing to consider in those situations is really what is the fund’s posture in terms of cash. There are very different views on this when you go fund to fund. Some funds want to return as much cash as they can to the investors immediately. The fact that there’s a higher tax cost in some ways would say that just allows us to distribute more cash to our investors because we’re distributing at the highest rate where other funds may have a very different investment strategy. They may be levering up their companies significant, taking on huge amounts of debt, and they don’t intend to distribute any cash. They need all the cash they can to pay down the debt, and the return is going to on the sale. Those then, you may end up saying what corporate makes the most sense.
I think the moral of the story here is this is very much a facts and circumstances analysis. There really is not one clear choice. You may have thought with a 14% rate, that makes corporate make the most sense. Someone would say, “Well, no, flow-through makes so much sense that it’s always going to continue to be the right answer.” I think you find as you get into this a bit more, that’s just not the case. There is no clear cut, always one way or the other.
Snow: Let’s move on to some other aspects of tax reform that are getting into a bit more of the details. Can you talk about the impact of interest deduction limitations that are found in tax reform? How do you think that’ll change the approach to doing deals and even the underwriting assumptions?
Gruidl: Certainly that is probably the worst piece of the legislation. Perhaps the one-time repatriation tax, that certainly isn’t favorable either, but this interest limitation can be very significant. If you are a fund that does a lot of LBOs and significant amounts of debt using mezzanine investors, or as the fund itself invests in a slug of equity and then also a piece of it is debt so that the companies are highly levered, this could be the tax increase act of 2018. You go back to the old idea, “Hey, 21% tax on something is a lot more than a 35% tax on zero.” Companies that were highly levered had in a lot of situations for the five-year hold period generated zero taxable income because of these significant tax deductions. Again, that could be a significant flip.
Others that take on a more modest amount of debt, this may not be an issue at all. We’ve heard at the 30% limitation based on what’s called adjusted taxable income, adjusted taxable income from 2018 to 2021 is essentially EBITDA, after 2021 it’s EBIT, so it’s worse post-2021. Important thing here though, EBITDA and EBIT, you’ve got to take GAAP and book income and throw that out the window. EBITDA and EBIT is based on taxable numbers. You take taxable income under the old rules and then you add back interest, taxes, depreciation, amortization. It’s based solely on tax, not on financials. Until there’s further guidance, the statute tells us exactly what EBITDA is with no other adjustments.
A couple quick things. It is a net interest expense. That means if you have interest income as well as interest expense, let’s assume for a corporation for a minute, you net that. If you’re making intercompany loans or loans around your global group, the income you earn is offsetting that expense. The other thing, if you’re at a partnership level and if your portfolio is a flow-through, that is going to determined at the flow-through level and if it’s only going to apply to the trader business interest. To the extent it is a flow-through and you end up with a disallowed interest amount, the interest is in excess of that 30%, that deferred interest does not stay at the partnership level. That flows out and is reported to the partner, and the in future years that partnership will, if it has income in excess of the 30% so that there’s an excess income amount, that is also then reported out to the partner to hopefully free up some of that prior deferral. Another important thing at the fund level, this only applies to business interest expense. Debt taken at the fund really is investment interest expense and that is not subject to this limitation, so that will be continued to be flowed out to your investors as investment interest expense.
There is a favorable exclusion if you have less than $25 million in gross receipts. 163(j), the interest deferral rule, just does not apply. There are related party issues you have to look at in this case and how this $25 million gross receipts might work or apply at a leverage blocker. That is an area that is unclear to say the least. We would expect significant regulatory and similar guidance to address some of the issues we have with the flow through of this deferral, and blockers that may just hold a partnership interest, and then debt. There are not at this point completely clear black and white rules. The Internal Revenue Code is very long, but we have to remember the Treasury regulations have to be three times, four times as long as the Internal Revenue Code. We would expect very significant regulations along this area. Last, Tommy, maybe you want to address this, but the real estate businesses have a separate rule in terms of 163(j) and its applicability.
Wright: Yes. Those in the real estate business or real estate funds that would otherwise be subject to this 30% limit on the deductibility of business interest can elect out of the interest limitation and instead apply some longer appreciable lives to their fixed assets. Really when you examine those “longer lives,” they really aren’t significantly longer. In the case of an office tower, normally a 39-year life, the longer life that you would have to use if you elected out of the interest limit rule is a 40-year life. In the case of multifamily housing like an apartment project, an apartment building, the tax life is normally 27.5 years. To elect out of the interest provision rule, then you’d use a 30-year life, so a 2.5 year increase in life. A 15-year property goes to 20 under this election. Really it’s not too onerous and is a very beneficial exception for those in the real estate business.
One other thing I’ll comment on. As Nick was talking about the complexity of the law, let there be no mistake that this tax reform act was in no way a simplification of the tax law. It’s highly complex. There are multiple provisions that on the surface seem relatively straightforward, but when you try to apply those in a real factual situation, the law in many cases was written and doesn’t comprehend the complex structures that all of our clients operate in. Lots of unanswered questions that, as Nick said, regulations will be addressing, but this is a highly complex bill that we’ve been presented with. I think it was probably crafted rather hurriedly and is leading to some issues in interpretation. We will have a tax reform act, we believe. It will happen much later this year to create technical errors and mistakes and issue some clarification in some areas.
Snow: Great. Let’s move on to maybe one other topic before we go to Q&A from our audience. Can you talk about immediate expensing and how that relates to M&A valuations? What does that mean?
Gruidl: Sure. Immediate expensing, we have had let’s just call it bonus depreciation. We’ve had bonus depreciation before including 100% bonus, but was is significant this time is it is not limited to the construction or acquisition of new properties. It is applicable to any property acquired with a 20-year life or less after essentially September of 2017. This is one that could apply to the 2017 tax year other than goodwill. 15-year, goodwill, and intangibles, they are not eligible for this immediate expensing. What that means now from an M&A perspective is if you go out and buy a company and they have significant machinery and equipment, if you do an asset deal, you no longer have to amortize that over five or seven years. You get to write off the full amount of that in year one. If I don’t have a lot of income, then maybe that’s not all that much of a benefit because it creates a net operating loss. If you’re a flow-through and you generate all of those deductions and then they flow through to your investors as ordinary deductions, that could be a significant benefit at your investor level. If you’re at a corporate, you have a significant NOL now, and that’s going to offset income during your holding period. Again, that could be very favorable.
From a deal perspective, it makes asset deals even more attractive than they were before. From a purchase price allocation perspective, again, thinking about the deal, this will put more strain on parties trying to agree. If I’m buying, I want as much five and seven-year property as I can. If I’m selling, I generally want to avoid a lot of allocation to that property because I may have to recapture it at an ordinary income rate. Purchase price allocation and a further benefit now to doing an asset deal versus a stock deal are going to be two pretty important factors with expensing.
Snow: Let’s talk about pass-through deduction and corporate provisions. What are the most important things that we need to know about those very important topics?
Gruidl: Right. Let me touch on a couple of the corporate provisions real quickly, particularly as they impact M&A. One is I’ll mention again, we know those have dropped to a 21% rate, net operating losses. Net operating losses post-2017 are not eligible to be carried back. That’s a pretty significant deal issue. You look at how a lot of deals are structured, someone comes in, buys a corporate target, that corporation generates significant tax deductions from stock options buyouts, transaction bonuses, transaction fees paid to investment bankers, what have you.
Generally, let’s say you closed the deal in January or February, and you’re a calendar year taxpayer. It’s going to generate hundreds of millions of dollars in some cases of net operating losses, and even in more modest deals, $10 or $15 million in tax deductions that you normally would carry back, get a $4 or $5 million tax refund, and pay that to the selling shareholders. You’re in a way financing part of your deal just through this carryback. They’ve eliminated the ability to carry it back, so those refunds are gone. You’re only going to be able to utilize those NOLs going forward, and then with that only up to 80% for any post-’27 NOLs, only 80% of taxable income. Now when it comes to identifying an attribute of value, these NOLs, I would say, are less valuable than they were prior to the act.
The other very significant corporate provision is this move to a territorial type system. What that means is two things. If you’re a portfolio company and there are controlled foreign corporations that you own within your portfolio, those generally are going to be subject to a one time repatriation fee. That repatriation fee basically is going to be taxed at either a 15.5% or 8% tax depending on what you’ve done with those earnings. Do you sit on them in cash, or are they invested overseas in property? That repatriation doesn’t matter whether you take the cash back or not. Every CFC that has earnings and profits, although you can do some netting, is generally going to be subject to this repatriation tax for the U.S. owner. That’s a significant tax up front. I’d say it’s a huge diligence issue going forward. On a go forward basis, you need to make sure that whatever company you’re acquiring, they appropriately calculated this and paid that tax.
The positive going forward is any earnings if you are a C-corp owning these foreign operations through foreign corporations, generally those earnings are going to be free of corporate tax going forward. You’ll be able to make the money overseas, repatriate it to the U.S., generally have no tax. We don’t have time to get into all of the other provisions, but if you had some very low tax intangible holding companies or low tax corporations that are not paying any tax and generating a lot of income, there are still some provisions in place for the U.S. to attack those and get some portion of those earnings taxed in the U.S. Those are the two significant corporate provisions. You think about this idea of do I want to be corporate or do I want to be flow-through? If I’ve got a lot of foreign activity and I’m already blocking up at the investor level, you think about this territorial type system, you see where corporate structure could be beneficial. Hey, I’m not paying any tax in the U.S. on all those earnings. If those are low tax countries below 21%, then that’s certainly going to be pretty favorable to you.
The other side, then you get into the pass-through deduction. Big picture on the pass-through deduction. There’s a 20% deduction on your taxable income from a flow-through if you get two things. One, you’re not a specified service business, so think of that as professional practices, doctor, lawyer, accountant, dentist. That type of business is not eligible for the pass-through deduction unless you have a very low income. The other is this 20% is limited to 50% of your wages. If you don’t pay any wages and you have a lot of taxable income, you’re not going to get a benefit. If you are a domestic business that either pays out a lot of wages or has significant CapEx, because that’s another limitation calc, then you would get the full benefit of this 20%.
Again, you think about flow-through versus corporate. I’ve got primarily domestic investors or tax exempts that are super tax exempt, so I’m not blocking a lot. I’ve got businesses that qualify, and I pay a lot of wages or I have a lot of CapEx in those businesses. If I’m going to benefit from the full flow-through deduction, now it looks like flow-through may be the way to stay. I’m not going to flip to corporate just because of the rates. I know I went through that pass-through deduction pretty quickly, but I think the real focus there is the non-specified service businesses and then either a lot of CapEx or a lot of wages.
Wright: Nick, I’ll mention that-
Snow: Go ahead, Tommy, sorry.
Wright: Sorry, Dave. I was just going to mention in that list of “bad businesses” that do not qualify for this 20% of flow-through deduction, as Nick said, they’re service type businesses, but that also drags into that definition financial services, brokerage services, investment management, trading or dealing in securities, commodities, or partnership interest. That industry does not get to avail itself of the 20% flow-through deduction. Where it has applicability in private equity would be your operating portfolio companies that operate in a flow-through setting. Ultimately that will flow up to the fund and then flow out to the partners. At the individual investor level is where this 20% deduction is computed in their personal return subject to the limits that Nick outlined, which wages is going to play a big part in that.
A point here really as it relates to the flow-through, there’s going to have to be a lot of information provided on Schedule K-1s on a go forward basis for investors. All partnerships that are going to flow through that are flow-through entities are going to have to provide a lot of data to partners on their K-1s, more than they have in the past, so that these limitations that are computed at the individual level can be computed because it’s going to require data that historically hadn’t been supplied on K-1s.
Snow: Great. Let’s move to questions from the audience. We have a lot of them. They’re all very good. I’m also going to, if it’s okay with everyone, push out the end time of this webinar to closer to 12:00 Eastern. I think that given the interest that we have in this topic and the amount of questions coming in, we probably need a bit more time. Let’s start with a question for either of you, maybe starting with Nick, about the ability to use NOLs to offset future profitability, often called a carryover and carryback. What do people in private equity need to understand about the new rules regarding carryback?
Gruidl: I think addressing the carryback issue, as we’ve discussed, going forward for any NOL incurred for any tax year ending after 12/31/17, that a carryback is not allowed. Any NOL that’s created on the final tax return of a target corporation cannot be carried back. It can only be carried forward. In pricing a deal and understanding the value of transaction-related deductions, the tax benefit of those, they’re going to be lessons a bit because you can no longer carry those back. On a carry forward basis, any NOLs generated in tax years after 12/31, beginning 1/1/18 forward, are going to be limited to 80% deduction. If you had $100 of income and $200 of NOL, the most NOL you could utilize would be $80. That’s going to, again, impact the value of that attribute. You may end up paying some tax even though you otherwise had enough NOL to fully offset that income.
Snow: Yup. Here’s an interesting question, and hopefully one of you has the answer, or maybe this comes down to, as you mentioned earlier, interpretation, which might unfold over the coming months. How does the three-year holding period apply to follow-on investments, i.e., what if the initial investment has been held for three years but a realization occurs less than three years after the most recent follow-on? Do you know the answer to that?
Gruidl: It depends on how you define an add-on investment. If you had a portfolio company that used its own proceeds to go and make an add-on, I don’t think that’s going to change anything. If there are additional funds that are brought in from the investors into a portfolio and you get a new carry on that, again, just going back, there’s no specific guidance on that in the statutes, so that first I want to clarify. These are general corporate principles. If I have stock or a partnership interest and there is new investment that comes in, and I don’t get any additional units but I have this new investment dollar come in, I actually end up with what’s called a split holding period in a unit where I could have a share of stock that has a holding period of three years for part of it and brand new for another part because of the way the investment came in. I know that’s not a specific answer to that question, but I think general tax law would tell you that your interest could be split into multiple holding periods. In the past, that’s been used to apply to a one-year holding period. Now it would be a three-year holding period.
Wright: Nick, what if you take the example of my fund has a realization event, so one of my portfolio companies is sold. Let’s say it was held more than three years, so great, met that rule. The proceeds of that sale, instead of being distributed out to the investors, are reinvested in NewCo Portfolio Company. You would think that the carry on NewCo Portfolio Company would start over, right?
Gruidl: I think there’s two things to think about there. If I have a carry that’s allocated to me and I don’t get any cash and that cash is reinvested, the whole identification of a carry is is there a difference between what I paid for the unit and my share. I wonder if you had carry that was generated, you’ve held it for three years, you get the capital gain allocable to you, and you don’t get any cash distributed, let’s forget about tax distributions, if that reinvestment would not result in you having a capital interest at least for your portion of the capital that is reinvested and then you’d have a new carry on the new investment over and above the capital you’d put in. I think certainly if you generate carry and don’t get all the cash out, you should have a capital interest moving forward that would not be subject to the three-year for at least some portion of your future carry.
Wright: Right, but the piece that’s attributable to the carry on NewCo will have the three-year rules with carry.
Gruidl: Yeah, I would think so.
Wright: Yes, yeah.
Snow: Here’s a good question from the audience. Does the 20% flow-through deduction apply to the sale of a portfolio company or only to current income?
Gruidl: I think if it qualifies, then gains would also generally qualify.
Wright: Not capital gains.
Gruidl: I wouldn’t think capital gains.
Wright: Yeah, because capital gains don’t.
Gruidl: If you had ordinary income recapture on say your machinery and equipment and that’s recaptured at ordinary income rates, that portion would be eligible. On capital gains rates, you’re already at a 15% or 20% rate.
Snow: Here’s a question from someone who clearly knows his way around the tax issue. The question is, could we define carry to be paid only out of qualified dividends and long-term gains?
Wright: Interesting thought.
Gruidl: If I’m invested in a flow-through, it gets to a question of how do you allocate the income. Right now based on what’s in the statute, I think you’re just under the normal partnership rules. Whether or not we get different guidance, if I have a carry, and there’s a waterfall, and under all of our previous allocations of this fund we would allocate you a portion of income in a year, and that allocation to you is ordinary income because it’s a flow-through portfolio company, that’s ordinary income. It’s not the carry issue. If there are gains that are allocated out, that would be subject to that three-year. Tommy, you can chime in here, but dividends are generally, I wouldn’t think, subject to the carry rule because they are a dividend and not a gain. They just happen to be at the same rate. You go back in the past, dividends were taxed at the highest rate and not capital gains. They’re a different character of income.
Wright: I think under the general partnership rules, typically you can’t allocate to one taxpayer some preferred class of income that results in a lower tax rate for them and allocate say ordinary income to another investor who’s maybe tax neutral or has a loss. In other words, you can’t manipulate the allocation of different types of income to different investors. As a general states, it’s got to be pro rata. I couldn’t allocate all the dividends, for example, to the general partner and allocate the portfolio operating income to the limiters.
Snow: Next audience question, can tax deductible goodwill achieved from prior transactions be carried forward after 2017?
Gruidl: Any basis increase that you have in assets that were acquired in a prior deal continue to be assets of the company going forward. I acquired a company in a deal in 2016, and it was a lot of goodwill, and now I’m into ’18 and ’19. I get to continue to amortize that going forward. There was no change to treatment of previously capitalized cost.
Snow: Here’s a question about interpretation from the audience saying, how should we interpret inclusion of an employment-related provision in the definition of applicable partnership interest under section 1061?
Wright: Which is the new carried interest section.
Gruidl: I’m not sure I understand that question, to be honest.
Snow: Okay, let’s move on. How does three-year timing work when you are a GP in a fund with a European format? Carry is not paid until LPs recover contributions plus a hurdle. We all know about the European waterfall calculation. Exit of one portfolio company could happen in year two but carry not paid until year five. Is that something you’ve looked into yet?
Gruidl: That’s sort of what I was addressing at the front end. How do you allocate income to the carry? That right now is general partnership rule. They say, what is a partner’s interest in the partnership? That’s how income is allocated. You have these waterfalls. In subchapter K, which covers this, there is really some flexibility say in the past in how you would allocate this. Some would look at a waterfall and say, “Well, if we liquidated today, all of the return would go and we would get an allocation,” versus then you look at this European and say, “Well, okay, we wouldn’t get a carry until everything is returned.” Based on that provision, we may think it’s reasonable to interpret that, “I’m not going to get allocated any of the gain in that year to sale because it’s not certain that I’m really eligible to receive that because if the other deals don’t pan out and the investors don’t get all their money back plus their hurdle, then I’m not going to get anything.” That’s where you get into what’s the most reasonable way to allocate the income, or what is a reasonable way.
I would think this is an area where there may be guidance. As I said, they’ve defined a new term, a new type of partnership in being a carried interest. Are just the general partnership rules of allocating income going to apply there, or will they put in something over the top? That example is exactly the type of thing that I think a lot of funds are looking at. “Hey, if I sell that and I don’t have some sort of guarantee that I’m going to receive it, that it’s not fixed, it might be reasonable not to allocate that income,” where if I said, “Look, I have a right to get that no matter what, and I’m just electing to defer receipt of the cash,” that’s going to be a lot tougher argument to make.
Snow: Why don’t we have one final question here, then I think we need to wrap up this very important, very interesting webinar. A reminder to our audience that this webinar will be available in playback mode. You can listen to it again any time you want, and we will be providing a transcript in a few days. Final question for either of you having to do with the secondary market and carried interest. If an LP bought an interest in a fund on a secondary market, the secondary buyer would take on the holding period of the underlying assets, and that would be how to calculate the holding period for carried interest. Is that correct? Is that something that you’ve looked into?
Gruidl: I don’t know, Tommy. I certainly have not looked at that issue.
Wright: No, I haven’t, but my guess is if you’re saying the investor is buying an interest in the carry as well, or the investor is going to get a carried interest … I don’t quite understand what the structure is.
Snow: Let’s say a deal is done in 2016, and a LP or an investor buys the fund that holds that deal in 2017. Does the clock on that deal start in 2016 or does it start in 2017 for the new owner of the fund interest?
Wright: The investor buys the entire fund, let’s say, giving them the GP’s right to that carry is what you’re saying.
Gruidl: If somebody has paid for an interest in cash and paid the value of what that carry would have been because they bought everything and paid out the GP, it’s really not a carry anymore. I think the carried rules actually address if you dispose of your carried interest. If I come in and buy someone’s carry, I’ve paid dollar for dollar what it’s worth. Generally at that point, it’s not really …
Wright: A carry, so to speak.
Gruidl: … a carry necessarily anymore.
Snow: This is clearly a big topic. This is clearly a big topic that continues to unfold. Any final comments?
Wright: Dave, I was just going to mention one provision that impacts fund investors and fund executives. If I own my portfolio company in a flow-through and it’s operating at a loss, and if I’m a private equity principal that is otherwise active in that underlying portfolio company so that normally I would’ve been able to work myself around the passive activity rules and would’ve been able to claim that loss on my personal return because I was active in the portfolio company, now there’s a new rule starting in 2018 that says basically if I’m married, the maximum business loss, I net all my business income and business losses, if I have a net business loss, the maximum loss that I can deduct is $500,000 for a married individual, $250 for a single. The loss that I would otherwise be entitled to that’s in excess of that carries forward as a net operating loss. The following year, I could offset 80% of my taxable income with that excess loss from 2018. That’s a new one that’s really going to catch some folks.
Snow: Interesting, and very important to know. As I was saying, I’ve learned a lot from this discussion. It’s clearly a big topic. It’s one that continues to unfold. I hope I can have both of you gentlemen back on a Privcap webinar to give us an update on the world of tax and how it affects the world of private capital investing. For now, I’m going to say thank you for sharing your expertise. To our audience that listened in and sent in so many good questions, thank you very much. Thanks again to our partner, RSM, for helping us put this webinar together. It’s time to say goodbye. Have a very nice day, everyone.