As we announced last week, the Trump Administration and Congressional Republicans released their highly anticipated tax reform proposal called the “Unified Framework for Fixing Our Broken Tax Code” (the “Framework”). The Framework provides some very useful guidance and key indicators relevant to the potential future of taxation for private equity and hedge funds, their investors and fund managers.
Fund-level tax issues
The Framework would adopt a maximum tax rate of 25 percent on income of “small” businesses operating as pass-through entities. It also contemplates the need for protecting against abuse by ensuring that personal income and wages of wealthy individuals are not re-characterized as flow-through business profits. Some experts expect that funds will not be eligible for the 25 percent rate cap. However, there is no explicit carve-out or mention of income thresholds related to qualifying for this rate cap. The rate cap might also be relevant for flow-through portfolio companies, especially those that are start-ups.
Portfolio company tax issues
The Framework would adopt a 20 percent cap on the corporate income tax rate and eliminate the corporate alternative minimum tax. This type of change to corporate taxation should generally improve the free cash flow position of portfolio companies. Fund managers should start considering now the benefits or trade-offs of a tax shield created by effectuating a “step-up” in tax basis of their portfolio companies’ assets and the potential for immediate expensing or limited interest deductions.
Congressional committees, as part of the overall efforts to pass tax reform, are actively considering the elimination of many currently available business deduction and tax credits, including the Section 199 deduction for qualified domestic production activities. The elimination of such credits will generally simplify tax preparation yet need to be carefully considered when modeling cash tax expenses for portfolio companies.
The Framework would allow the immediate expensing of new investments in depreciable assets for at least five years. It also instructs Congressional committees to explore extending this or similar relief to “small” businesses, but provides no guidance on thresholds. This could be especially relevant for portfolio companies that have a high need for future capital expenditure. It could also drive a change in the tax form of transaction structures given the potential changes in the cost and benefit of obtaining a step-up in tax basis for future deals.
The Framework would “partially” limit the corporate deduction for net interest expense. The Framework does not give any details on the extent of this partial limitation, nor does it reference any potential grandfathering rules for existing debt obligations or carve-outs for small businesses. It states that further thought will be given to interest expense paid by non-corporate taxpayers (e.g., flow-through portfolio companies).
Individual income tax considerations for fund managers
The Framework would expand the zero-tax bracket by doubling the standard deduction to $12,000 for individuals and $24,000 for married couples. It would also compress the current seven income tax brackets into three brackets — 12%, 25% and 35% — with a full repeal of the individual AMT. Congressional committees are given flexibility to add a fourth rate for wealthy taxpayers, although no income threshold is specifically mentioned (e.g., such as past $1 million gross income thresholds). Given the elimination of deductions, the cash tax rate of asset management principals and professionals may actually increase.
The Framework would eliminate most itemized deductions, including most notably the state and local tax deduction — which could have a disproportionately large impact on asset management professionals based in areas with high state and local income tax rates (e.g., NJ, CT, NY, California, etc.). The loss of a deduction for state and local taxes is particularly significant as future state and local tax bills are expected to rise, largely driven by the need of many states and local governments to increase their revenues to address fiscal constraints and distress. Furthermore, many states sync the definition of their taxable income amounts to that of the federal government. As the base for federal taxable income widens (and goes up), the amount of state income tax due is also expected to rise unless if states decrease their tax rates as is being done by the federal government.
The Framework would retain the mortgage interest deduction and charitable-giving deduction and encourages committees to retain tax incentives for higher education, retirement and work.
While the Framework does not provide much detail, it is a key step in the process toward potential tax reform and does provide some insight into Trump Administration priorities and possible areas of compromise. Fund managers would be prudent to begin detailed assessments of the various corporate tax provisions addressed in the Framework for their potential cash tax, structuring and valuation impact on current portfolio companies and prospective investments.