Tax structure selection: Right fit for PE firms
In today’s competitive M&A environment, private equity firms are working quickly to complete deals. However, it’s important to take a step back and evaluate what tax structure will be the most beneficial to the private equity firm in the long-run.
The passing the Tax Cuts and Jobs Act in December 2017 brought sweeping changes to the tax code, which impacted the tax treatment of portfolio companies. Spending the time to make sure the deal is structured in the most advantageous way at the outset will save investors lots of time and money upon exit.
Right now, there is a broad spectrum on how funds are structured. The current prevailing trend is to have private equity funds structured to have flexibility to own both flow-through and corporate entities. Tax reform has resurrected the debate about which structure is better today. Flow-through used to be viewed as more attractive, but under certain fact patterns that’s not necessarily the case anymore.
The primary benefit of having a flow-through entity is that its income is subject to a single layer of tax at the owner level versus a corporate taxpayer, whose income would be subject to corporate-level taxation as well as a second layer of tax incurred by its shareholders when dividends are paid or corporate stock is sold. As flow-through entities generate taxable income that gets reported and taxed at the owner level, the tax basis of the owners’ equity increases, which would reduce the gain recognized on exit. Another benefit of the flow-through structure is the relative ease of delivering a tax basis step up for a future buyer.
By example, a $40 premium will be paid on a flow-through entity’s underlying assets that has a tax basis of $10 in assets and sells their business for $50. In a flow-through structure, assuming any applicable elections are made, the $40 would generally be amortizable by the buyer over a 15-year period, allowing the buyer to recover the premium over time. If the entity was a corporate entity with the same set of facts, that $40 would generally not be amortizable. Private equity firms like the ability to step up asset basis because the amortization would reduce the cash outflow for taxes annually.
While flow-through treatment definitely has its pros as mentioned above, it has its downside as well. Some private equity firms prefer not to utilize flow-through entities because they may have foreign and/or tax-exempt investors that, if allocated income from a flow-through entity, are subject to U.S. tax withholding or taxes on unrelated business taxable income (UBTI).
In a situation where investors are foreign or tax-exempt, private equity firms have to utilize corporate entities to shield those investors from UBTI or U.S. tax withholding, as the case may be. Tax-exempt entities do not want to pay income tax on UBTI and foreign investors generally prefer to stay out of the U.S. tax system to the extent possible.
Similar to flow-through structures, the use of C Corporations has its advantages and disadvantages.
The attractive aspect about a C Corporation structure is that the tax rates are relatively low, thanks to tax reform. The top income tax rate for C Corporations dropped from 35 percent to 21 percent. Additionally, it also shields foreign investors and tax exempt investors from having to recognize income from the operations of the enterprise.
In situations where private equity firms need to turn to a C Corporation structure, another possible benefit is the potential of taking advantage of using Section 1202 of the Internal Revenue Code. Subject to several requirements, Section 1202 allows for the exclusion from taxable income of U.S. capital gains from the sale of eligible small business stock if the stock is held for five years or more. Under the current Section 1202 provisions, capital gains on the sale of corporate stock, which have been held for five years can potentially be 100 percent excluded from taxable income of a noncorporate taxpayer.
Like flow-through structures, the C Corporation structure also has its cons. The biggest con with working with a C Corporation structure is that there are potentially two layers of tax. The corporation pays corporate income tax on its taxable income and its shareholders are subject to income taxes on any dividends that are distributed from corporate earnings and profits and sales of corporate stock.
When the corporate tax rate is compounded with the tax paid on dividends, it does end up being a pretty substantial amount of tax. For a private equity fund looking to pull cash out of a business, a corporate tax structure is probably not attractive.
No one treatment is right for every investor and the bottom line is private equity firms need to look at tax consequences earlier in the acquisition cycle to determine the best structure for their investment. Additionally, understanding a fund’s investor base and how they will be impacted by taxes is also critical to picking the most beneficial structure. There is now a lot of deliberation around how to structure the best deal. Tax modeling has become more prevalent at the outset of the deal. Some private equity firms and strategic acquirers are spending more time understanding what their objectives are and making sure their structures are appropriate to support them, which makes good sense. More private equity firms should follow suit.