The Tax Cuts and Jobs Act (the Act) is the first major re-write of the Internal Revenue Code since 1986. In regards to its effect on private equity investors and their portfolio companies, the Act contains several significant changes. The new rules are generally effective for tax years beginning after December 31, 2017. Below is a brief description of what we perceive to be some fundamental reforms impacting private equity investors:
Corporate tax rate – For private equity groups with C-corporations in their ownership structure, the regular and capital gains tax rate is reduced to 21%.
Pass-through tax treatment - Partnerships, S-corporations and sole proprietorships with qualified business income (QBI), or active trade or business income excluding passive earnings, are now entitled to a 20% deduction on the lesser of taxable income or QBI, limited to the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of qualified property. Services entities such as health, law and accounting are not entitled to the deduction.
Domestic Production Activity Deduction (DPAD) – The DPAD under section 199 that was available for manufacturing taxpayers is repealed for tax years beginning after December 31, 2017.
Bonus depreciation – Bonus depreciation is increased to 100% and applies to new and used property acquired after September 27, 2017. Private equity firms doing straight asset acquisitions, or deemed asset acquisitions under sections 336(e) and 338(h)(10) can expense 100% of the consideration allocated to depreciable personal property. The 100% expensing is allowed through 2022 with a 20% reduction per year thereafter (e.g., 80% in 2023, 60% in 2024).
Section 179 expensing – Taxpayers may expense up to $1 million of fixed asset additions. The $1 million dollar limit is reduced dollar-for-dollar when total fixed additions for the year exceed $2.5 million.
Interest expense limitation – The interest expense deduction cannot exceed 30% of “tax EBITDA” for tax years beginning after December 31, 2017 through 2021 and “tax EBIT” for tax years beginning after December 31, 2021. Disallowed interest may be carried forward indefinitely.
C-corporation net operating loss deduction (NOL) – The law limits the NOL to 80% of taxable income and eliminates the two-year carryback provision for losses incurred after December 31, 2017. The existing NOL rules apply for losses carried forward for tax years beginning before January 1, 2018.
Carried interest – To receive capital gain treatment at long-term capital gain rates private equity groups must hold their carry for more than 3 years.
Technical termination of partnership – Greater than 50% changes in partnership ownership no longer cause technical terminations.
Self-created intangibles not a capital asset – Gain or loss from the disposition of a self-created patent, invention model or design or secret formula or process will be taxed at ordinary income tax rates.
Territorial tax system – The U.S. has moved to a territorial tax system with a participation exemption (or 100% dividend deduction). This puts our tax system in line with most of our trading partners. Dividends received by US corporate shareholders from 10-percent owned foreign corporations are no longer taxable. In exchange for this deduction, no foreign tax credit is permitted for foreign taxes paid or accrued with respect to the dividend.
Individual tax rate – Tax rates have been reduced and higher standard deductions are provided. Personal exemptions have been eliminated and the deduction for state and local tax income and property deductions has been capped at $10,000 thousand. The alternative minimum tax exemption increases.
Loss limitation rules for taxpayers other than C-corporations - In a fairly significant change to the treatment of non-passive losses of individual taxpayers, active business loss deductions may not exceed $500,000 for married individuals filing jointly or $250,000 for other individuals. Any active business loss in excess of those thresholds become a NOL and are carried forward to subsequent tax years deductible up to 90% of the taxpayer’s future taxable income.
If you have questions regarding these changes in law or would like more information, please contact one of RubinBrown's Private Equity Services Group professionals.
Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.
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