Top 10 Private Equity Tax Breaks

10 Top Private Equity Tax Breaks by Terry Stidham

Victor Fleischer, University Of Colorado Law School Professor, Identified These Top 10 PE Tax Breaks

1. Carried Interest - In exchange for managing an investment fund, managers receive a percentage of the fund’s profits, known as carried interest. The amount of carried interest is typically 20 percent, and in any given year, individual fund managers earn anywhere from nothing to tens of millions of dollars. Under current law, if the fund’s profits are capital gains, the manager’s carried interest is also taxed at capital gains rates.
2. Management Fee Waivers - Fund managers receive a fixed management fee, often 2 percent of capital, for managing the fund. Management fees are normally taxed as ordinary income. To avoid this, the fees can be waived in exchange for an almost-risk-free priority allocation of profits taxed at capital gains rates.
3. The Limited Partner Loophole - As labor income, management fees would normally be subject to the Medicare tax, now 3.8% for high-income individuals. Under current law, even investment income is subject to the 3.8% tax. Through careful structuring, some fund managers take their income through a limited partnership in which they are technically “limited partners” in the management company, even though it is their labor, and not their capital, that generates the fee income. Allocations to limited partners, however, are neither subject to the Medicare tax as self-employment income nor as investment income under section 1411.
4. The S Corp Loophole - This is conceptually the same as the limited partner loophole: wages are paid through an S Corporation avoiding employment taxes.
5. Private Equity Publicly Traded Partnerships - Normally, publicly traded companies are taxed as corporations, which mean that shareholders pay both an entity-level tax and also a shareholder-level tax on dividends or capital gains. But when investment firms go public, they use the favorable tax treatment of carried interest (which is treated as investment income, not labor income) to fit into an exception to the publicly traded partnership rules for “qualifying income,” which includes investment income. This enables publicly traded private equity firms to avoid the corporate tax altogether.
6. Supercharged Public Offerings - Private equity firms that went public structured the initial public offerings to resemble a sale of the firm’s assets to the newly public company, creating for the public company a new, higher “cost basis” in the firm’s assets. The value of those assets attributable to the goodwill of the firm could then be amortized over 15 years, generating new tax deductions at a 35 percent rate. As part of the deals, the newly public companies entered into tax receivable agreements, in which the companies promise to pay 85 percent of the tax benefits back to the selling founders.  The founders pay tax on the sale at low capital gains rate and they get a check each year from the newly public companies.
7. Enterprise Value - If the carried interest legislation were passed, individual managers may cash out by selling their carried interests to a third party and recognizing capital gain. The proposed legislation closes that loophole, but still allows the managers to sell interests in the management company — most of the value of which is attributable to past and future carried interest income and management fees — at capital gains rates.
8. The Angel Investor Loophole - Section 1202 allows investors in “qualified small business stock,” mostly angel investors and venture capitalists, to exclude 100 percent of their capital gains, in most cases up to $10 million.
9. I.R.A. Stuffing - Fund managers sometimes takes risk in partnership interests or shares in underlying portfolio companies and contributes those interests to I.R.A.’s at low valuations. If the interests are inside the I.R.A., appreciation in the value of the investments goes untaxed until distributed.
10. Interest Deductions - Interest deductions from the debt to finance an acquisition in taking a company private shields the portfolio company from tax liability.

Tax Advice Disclaimer

The information on this blog should not be used in any actual transaction without the advice and guidance of a professional Tax Adviser who is familiar with all the relevant facts.

Although the information contained here is presented in good faith and believed to be correct, it is General in nature and is not intended as tax advice. Furthermore, the information contained herein may not be applicable to or suitable for the individuals' specific circumstances or needs and may require consideration of other matters.

Terry Stidham and Target Search Group, LLC assumes no obligation to inform any person of any changes in the tax law or other factors that could affect the information contained  herein.

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Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

Terry Stidham is the President and founder of Target Search Group. He is a Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

 

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

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