Private equity (PE) firms are in a unique position to advise their portfolio companies regarding steps that should be taken to minimize the impact of the COVID-19 pandemic from a state and local tax perspective. PE firms are typically closed-end investment vehicles that pool investments in privately-held businesses. In the COVID-19 nomenclature, these businesses can be either essential businesses or non-essential businesses subject to workforce and other government restrictions. Investors in PE firms are generally interested in long-term liquidity, which is ultimately realized when the fund disposes of its investments. Portfolio companies, like other businesses, are dealing with fundamental shifts in the nature of their business models, their employee workplace, and the volatility of the economic marketplace. In addition to PE firm concerns about long term liquidity, portfolio companies face cash flow issues due to the continuing national economic problems. PE firms should be working with their portfolio companies to minimize risks and maximize opportunities in areas such as credits and incentives, state and local income and non-income taxes.
In addition to the issues affecting portfolio companies, many of the same considerations can impact the ongoing operations of the PE firm itself or the PE firm’s management company. In particular, PE firms may be entitled to credits and incentives or other state and local tax relief related to interruption in business operations.
Credits and incentives
Prior to the COVID-19 pandemic, there were various federal, state and local tax credits and incentives available to businesses for targeted investments or specified activities such as research. Due to a number of factors, including the long-term focus of the PE firm industry, credits and incentives may not have been a primary focus for PE firms or their portfolio companies. As a result of the COVID-19 pandemic, these credits and incentives have taken a central role in providing a source of cash liquidity or other tax relief. There are an unprecedented number of new federal, state and local credits and incentives available now to assist companies dealing with layoffs or otherwise negatively impacted by the pandemic. PE firms should work with their portfolio companies, as well as their management companies, to determine whether any of these programs can provide immediate benefits and relief. See Coronavirus credits and incentives relief for small business.
Taxpayers should prepare to face greater scrutiny when participating in credit and incentive agreements as the states increasingly focus on compliance with these arrangements. Taxpayers should proactively be performing internal due diligence and review of their current and former agreements: Has all necessary documentation and compliance occurred for the period in which incentives are claimed? Have hiring or investment targets been met? Does the taxpayer have a plan for periods of noncompliance?
Taxpayers should ensure that their documentation and compliance procedures are sufficient and that they are meeting the requirements laid out in their discretionary agreements. Renewing a focus on compliance can help taxpayers avoid clawbacks as states and localities seek to recoup on investments that do not pan out. However, there may be scenarios in which failure to meet the terms of the agreement is unavoidable. Businesses need not abandon all hope in these cases, as it may be possible to renegotiate credits and incentives when needed, particularly when a business slowdown is causing a company to not meet its agreed-upon targets. Even in cases in which the state does not have specific provisions for renegotiating the provisions of credits and incentives, it frequently has latitude in waiving some requirements. For more information, please read our article, Using credits and incentives during an economic slowdown.
PE firms often contain a variety of entity types, including C corporations, limited liability companies, partnerships, tax-exempt investors and individual investors. The vast majority of state and local governments have issued guidance that would conform, at least to some degree, to the federal extended filing and payment due date of July 15, 2020. For C corporations and individuals, the state and local guidance typically provides clarity as to what filings and payments can be deferred to July 15, 2020 or another date specified by the state. However, one of the largest tax related costs for PE firms involves complying the myriad of multistate requirements applicable to flow-through entities, including the filing of partnership returns and state K-1’s, mandatory partnership withholding on behalf of nonresident partners, filing of composite returns on behalf of qualifying partners, and the imposition of entity-level taxes and fees on flow-through entities. To date, only a handful of states, including California, have provided guidance providing relief for the filing and payment requirements imposed on pass-through entities. PE firms should continue to monitor developments in this area to determine whether any filings or payments can be deferred for flow through entities. In addition, firms should keep careful track of payments made by underlying companies before the COVID-19 pandemic to determine the extent such payments can be refunded or credited in the future.
With respect to income tax requirements imposed on the individual investors in the PE firms, or related withholding requirements, the mandatory shift in the mobile workforce can have significant consequences for both the employee and his/her employer. State income tax considerations for remote employees during COVID-19 can help employers navigate a number of relevant issues related to the change in workforce dynamic because of the pandemic.
Firms should also consider any income tax positions taken in the past to determine whether any of the positions can be reevaluated in light of the COVID-19 pandemic. For PE firms, common issues including the state taxability of the sale of flow-through entities, the ability to treat certain intangible income as nonbusiness income subject to special rules, the sourcing of management fees and the application of nexus to such funds.
Most taxpayers are only beginning to unwrap the federal income tax relief provisions. A number of these provisions, such as the relaxing of the interest limitation rules or the ability to carryback net operating losses can have significant state and local income tax consequences.
Finally, another opportunity to enhance cash flow for portfolio company investments is to conduct a review of past filed state income tax returns to identify alternative tax positions. Generally, these reviews, or Reverse Income Tax Audits (RITA), provide cash for the portfolio company in the form of state income tax refunds. Given numerous changes to state income tax laws over the past five years, impactful judicial decisions in the state income tax area and state administrative guidance changing for initiatives like tax reform and others, a RITA is a viable strategy to obtain cash influx for the company.
For PE firms that have faced or are facing layoffs, furloughs or reduced work hours (either at the firm level or at an underlying portfolio), there are steps that can be taken to effectively manage the multistate employment tax and related filing obligations that would result from the workplace changes. See Unemployment tax considerations for the COVID-19 pandemic for additional details.
Sales and use tax
The various considerations for PE firms involving sales and use tax are often analyzed at the portfolio company level. As with the state income taxes, several states have provided sales tax extension and relief for businesses impacted by COVID-19, which ease cash flows immediately. At both the PE firm and portfolio company levels, businesses should review significant past liabilities to determine whether any refunds are available for items that were not taxable. Businesses frequently pay tax on purchases that qualify for exemption, especially in certain industries such as technology, health care and manufacturing. A Reverse Sales and Use Tax Audit is particularly necessary for recently acquired portfolio companies for which prior sale and use taxes have been paid.
Like most areas of the economy, the COVID-19 pandemic has significantly affected private equity groups. The RSM State and Local Tax group has identified ways in which private equity investors and their portfolio companies can improve their short term financial situation by improving cash flow.