Changes in Tax Laws and Proposed Tax Hikes Could Impact Private Equity Transactions and Mergers and Acquisitions | Kramer Levin Naftalis & Frankel LLP
The House Ways and Means Committee recently released legislative proposals as part of the “Build Back Better” reconciliation legislation that the committee is developing (the proposed legislation). The proposed legislation includes a wide range of changes to US federal tax laws.
Below are several key revisions included in the proposed legislation that, if finalized, could impact the M&A landscape as it relates to private equity (PE) firms, strategic buyers and investors. private companies.
Deferred interest. The proposed legislation generally extends the holding period required for deferred interest to qualify for the long-term capital gains treatment in effect for tax years beginning after December 31, 2021 from three to five years. proposed legislation adds rules to measure applicable detention. period, including for multi-level partnerships, and amends some other rules. In addition, the bill directs the Treasury Department to issue guidelines on porterage exemptions and other provisions designed to circumvent the purposes of these provisions. The proposed legislation maintains the three-year holding period for trades or real estate businesses and taxpayers with adjusted gross income below $ 400,000. If adopted, these provisions could have a significant impact on the tax consequences for PE promoters in the event of the sale of portfolio companies during the five-year period.
Corporate tax rate. The bill increases the U.S. corporate tax rate from 21% to 26.5% for corporations with income over $ 5 million, effective tax years beginning after December 31, 2021. If adopted, these provisions could impact a target’s value, tax attributes and the potential benefits of structured transactions to provide buyers with a stronger tax base.
Personal tax increases. The proposed legislation increases the top federal tax rate on long-term capital gains from 20% to 25% and the top regular personal tax rate from 37% to 39.6%. In addition, the proposed legislation imposes a 3% high income surtax on adjusted gross income (i.e. ordinary income and capital gains) greater than $ 5 million (or greater than $ 2 million). $ 5 million for married people filing separately). It is proposed that the increase in capital gains rates come into effect for tax years ending after September 13, 2021 (the date the proposed legislation was introduced), with a transition rule that maintains the rate. current 20% tax for capital gains recognized on or before that date (including transactions entered into before that date under a binding written contract). It is proposed that the increase in the regular income tax rate and the 3% surtax for high income come into effect for tax years beginning after December 31, 2021. To avoid the 3% surtax for high income high incomes, taxpayers may look for ways to recognize capital gains before the end of the current tax year. Going forward, these increases in the federal tax rate (along with increases in state tax rates) may cause taxpayers to cede more of their interest tax-free. For transactions involving tax base gross-up opportunities, these rate increases could impact the cost of sellers’ mark-up for a tax increase to facilitate the mark-up.
S companies in partnership reorganizations. The proposed legislation includes a provision that allows certain qualifying S corporations to reorganize as domestic partnerships for tax purposes without triggering tax. A qualifying S corporation must transfer substantially all of its assets and complete its liquidation within two years beginning December 31, 2021. A qualifying S corporation is a corporation that was an S corporation on May 13, 1996 (prior to the publication of the regulation “tick the box”). This provision provides an important opportunity for well-established companies organized as S companies to reorganize in order to diversify their capital and ownership structure (and avoid the single class restriction under the S company regime). As a result, it gives private equity firms much more flexibility to invest and partner with private companies which are currently structured as S companies.
Limitation of the exclusion of gain on qualifying small business shares. Section 1202 of the Internal Revenue Code of 1986, as amended (the Code), allows unincorporated taxpayers to exclude gains from the sale or exchange of qualifying shares of small businesses owned for more than five years. The total amount of the gain eligible for exclusion is capped and the percentage of the excluded gain depends on the year during which the investment was made. The popularity of this exclusion increased significantly when the exclusion rate of earnings was raised to 100% (subject to a cap) for qualifying shares acquired after September 27, 2010. The proposed legislation would eliminate exclusion rates special 100% (as well as the 75% Exclusion Rates applicable to eligible investments made after February 17, 2009) for gains made by taxpayers whose adjusted gross income is equal to or greater than $ 400,000. The basic 50% exclusion will remain available to all taxpayers. It is proposed that the changes apply to sales or exchanges after September 13, 2021, subject to a binding contractual exception. Much like the effect of proposed increases in personal income tax rates, these changes may encourage taxpayers who sell their businesses to shift more of the consideration into equity tax-free. Additionally, the potential benefits under Section 1202 of the Code were seen as an important factor for many entrepreneurs to organize their businesses after February 2010 as entities treated as C corporations for federal income tax purposes. Income. The reduction of the exclusion rate under Article 1202 of the Code to 50%, coupled with the proposed increase in the corporate tax rate, could cause many small-held companies to choose to organize themselves as corporations. of persons (or in limited liability companies imposed as partnerships).