On April 28, 2021, President Biden
announced the American Families Plan to propose funding for
education, child care, and the extension of certain tax credits for
lower- and middle-income individuals. The White House released a fact sheet describing these proposals, and
President Biden discussed them in an address to a joint session of
Congress. President Biden’s plan would fund these proposals
through increased taxes and other significant tax law changes.
These changes would be in addition to the tax law changes proposed
in the American Jobs Plan announced by President Biden on March 31,
2021, which we covered here.
While it remains to be seen
whether the proposals in the American Families Plan will be enacted
into law, they may have significant effects on private equity funds
and their portfolio companies, including changes that impact the
tax treatment of a sponsor’s carried interest in a private
equity fund and on the relative benefits of conducting business
through an entity treated as a partnership for tax purposes (tax
partnership) vs. a C corporation, particularly when combined with
revenue raisers in the American Jobs Plan. These changes could
impact the taxation of private equity investors and portfolio
companies, and as a result, could change the preferred operating
and acquisition structures with respect to their portfolio
companies.
Proposed Revenue
Raisers Potentially Affecting Private Equity Funds and Portfolio
Companies
Proposed revenue raisers in the
American Families Plan of particular interest to private equity
funds and portfolio companies include:
- Closing “the carried interest loophole” so that
“hedge fund” partners will pay ordinary income rates on
their income “just like every other worker” - Increasing the top federal income tax rate on ordinary income
to 39.6% for high-earning individuals-it has been reported that
this rate would apply to individual single taxpayers with taxable
incomes greater than $452,700 and to married couples filing jointly
with incomes greater than $509,300 - Increasing the top federal income tax rate on capital gains and
dividends to 39.6% (plus 3.8% Medicare tax) for households with
income greater than $1 million per year - Extending permanently current limitations restricting deduction
of “excess business losses” - Expanding the 3.8% tax on unearned income (sometimes referred
to as Medicare tax) to unspecified categories of income currently
not covered - Requiring “financial institutions to report information on
account flows so that earnings from investments and business
activity are subject to reporting more like wages already
are”
The plan also calls for increased
IRS enforcement discussed in more detail here.
These proposed changes would
presumably be combined with the American Job Plan’s proposed
increase in the top federal income tax rate on C corporations to
28%, discussed here.
Carried
Interests
The American Families Plan
proposes to “close the carried interest loophole” so that
“hedge fund” partners will pay ordinary income rates on
their income “just like every other worker.” This
presumably refers to the ability of a service provider to pay tax
at capital gain rates, rather than ordinary income rates, on
disposition of a profits interest.
The scope of the proposal is
uncertain. In particular, it is unclear whether the proposal would
extend beyond “hedge fund” partners to partners of
private equity funds. It is also unclear whether the proposal would
extend to eliminate or curtail the other principal advantage of the
treatment of carried interests-the deferral of tax resulting from
carried interests not being taxed upon grant or vesting. It is also
unclear whether the proposal would supplant the new holding period
requirements imposed by the 2017 Tax Cuts and Jobs Act on certain
carried interests. In any case, it may be useful to revisit
management fee waiver provisions for fund managers and to
potentially consider phantom equity plans or bonus plans (perhaps
in lieu of profits interests) for portfolio company key employees,
if, as and when the proposal takes on more detail as it moves
through Congress.
Choice of Entity: Tax
Partnership vs. C Corporation
The proposed increase in the top
corporate tax rate (to 28% from the current level of 21%) and the
top dividend and capital gain tax rate (to 43.4% from the current
level of 23.8%, taking into account the effect of the 3.8% Medicare
tax) would substantially increase the tax benefits of owning
businesses through a tax partnership rather than a C corporation,
particularly in the case of businesses eligible for the 20%
deduction under section 199A that currently distribute their cash
flows to their owners. Click here to view a table comparing effective
tax rates under current law and under the Biden Administration
proposals.
Under current law, the effective
tax rate advantage of tax partnerships fully eligible for the 20%
section 199A deduction is 6.4% – this is
the excess of a 39.80% effective tax rate on income earned and
distributed by a C corporation over a 33.40% effective tax rate on
income earned and distributed by a tax partnership, in both cases
taking into account the effect of the 3.8% Medicare tax.
Under the Biden proposals, the
effective tax rate advantage for investors with income over one
million dollars would rise to 15.85% even
before taking into account any additional benefits available under
section 199A – this is the excess of a 59.25% effective rate on
income earned and distributed by a C corporation over a 43.40%
effective tax rate on income earned and distributed by a tax
partnership, in both cases taking into account the effect of the
3.8% Medicare tax.
Simplified
illustration of effective tax rate calculation for a C
corporation. Assume a corporation earns $100, pays tax of $28
(28% of $100) and pays a taxable dividend of $72 ($100 minus $28).
Assume the shareholder pays income tax of $28.51 (39.6% of $72) and
Medicare tax of $2.74 (3.8% of $72) on the dividend. The total tax
payments with respect to the original $100 would be $59.25 ($28
paid by the corporation and $31.25 paid by the shareholder), for an
effective tax rate of roughly 59.25%.
In cases where the relevant entity
is a foreign entity or operates in foreign jurisdictions, the
choice of entity (tax partnership v corporation) will be further
impacted (and complicated) by the international tax proposals
included in the American Jobs Plan, including the proposals to (i)
increase the minimum rate, and make certain other modifications to
the rules, applicable to global intangible low-taxed income
(GILTI), (ii) eliminate the corporate deduction for foreign-derived
intangible income (FDII), (iii) deny deductions for expenses
related to “offshoring” jobs and provide a credit for
expenses related to “onshoring” jobs, (iv) significantly
expand the corporate anti-inversion rules and (v) replace the base
erosion and anti-abuse tax (BEAT) with a more fulsome limitation on
deductions for payments to foreign related parties subject to a low
effective tax rate. These American Jobs Plan proposals were
previously discussed by us here and a Treasury Report discussing the
proposed expansion of the corporate anti-inversion rules and
replacement of BEAT was previously discussed by us here.
It remains to be seen exactly
how the effective tax rate advantage for a passthrough structure
will be affected for investors with income below $1 million per
year. Nonetheless, private equity funds with individual investors
or foreign investors (which often invest in U.S. tax partnerships
through U.S. corporate blockers) will need to closely follow these
proposed changes to understand the potential impact of these tax
law changes on structuring investments in portfolio companies.
Expanded Base for 3.8%
Medicare Tax
Relevant to private equity funds
with individual investors, the Administration is also encouraging
Congress to close what it sees as loopholes in the 3.8% net
investment income tax. The fact sheet asserts that this tax is
“inconsistent across taxpayers due to holes in the law,”
and the proposal would target those with income in excess $400,000
per year. The details of this proposal have not been released,
although it may include imposition of the 3.8% Medicare tax on
certain types of business income that is not subject to
self-employment tax (e.g., income from private equity portfolio
investments of persons actively engaged and materially
participating in the businesses generating such income).
Excess Business
Losses
The American Families Plan would
make permanent the current rule disallowing excess business losses
of non-corporate taxpayers. This rule was enacted as part of the
2017 Tax Cuts and Jobs Act and generally disallows certain business
losses (including losses allocated from partnerships) in excess of
specified thresholds. The provision is currently set to expire at
the end of 2025, but the Administration is proposing to make it
permanent.
Expanded Information
Reporting Requirements
The Administration also previewed
expanded information reporting requirements by financial
institutions on “account flows.” The fact sheet cited a
2019 economics working paper broadly critical of underreporting by
tax partnerships and a lack of cross-party reporting with respect
to certain items of income, but the text of the proposal refers
only to expanded reporting for “financial institutions.”
According to a press release issued by the Department of the
Treasury, this proposal “leverages the information that
financial institutions already know about account holders, simply
requiring that they add to their regular, annual reports
information about aggregate account outflows and inflows.”
We will continue to monitor developments and will provide further
updates as more details are released. In the meantime, Baker Botts
would be pleased to assist you in your analysis of these
proposals.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.