Whatever your political standing, it’s already clear that President elect Biden’s approach to policy making is going to be very different from President Trump’s.
For private equity, Biden’s signaled reversal of “pro-business” tax policies presents a new set of challenges, but also opportunities. While many of the specifics are unclear, it is certain that general partners will need to start preparing now for the possible changes in order to avoid the risk of leaving value on the table going into 2021.
Under the new administration, taxes are likely to rise all around – effectively rewriting the (relatively newly Trump-edited) rule book for private equity.
During the course of campaigning, President elect Biden has proposed increasing the long-term capital gains rates to match the ordinary income tax rates for anyone with income over $1 million, nearly doubling the current tax rate from 20 percent from 37 percent.
Additionally, another proposal would further change the top tax rate on ordinary income to 39.6 percent from 37 percent. Long-term capital gains tax rates range from 0 to 25 percent depending on the person’s income and this in addition to a 3.8 percent surtax on net investment income.
For high-earning fund managers, the change would effectively eliminate the preferential treatment of carried interest under a longstanding rule that generally taxes fund managers’ share of investment gains at a lower rate than ordinary income.
President elect Biden has also proposed raising the corporate tax rate to 28 percent. In 2017, the Tax Cuts and Jobs Act (TCJA) reduced the corporate tax rate from 35 percent to 21 percent. And, at the time of this writing, he has not yet shared possible changes to the deductibility of interest on corporate debt.
The proposed changes would primarily impact private equity firms by raising tax on their portfolio companies, but several of the largest firms would be uniquely affected. After the TCJA changes in 2017, firms, including Blackstone, Carlyle, and Apollo Global Management, all converted their structures from partnerships to corporations in order to make their stocks simpler to buy and own.
Given that they are unlikely to change their structure back to the partnership form due to the prohibitive tax cost, all of them are likely to have to accept a higher tax bill going forward
Renewed Focus on Opportunity Zones
Another large scale change which private equity firms are preparing for is a reform of Opportunity Zones, a program introduced as part of the TCJA meant to incentivize development in low-income communities – and a program that many feel private equity has struggled to take real advantage of.
The suggested changes to the program include creating incentives for funds to partner with community organizations and requiring developers to provide detailed reporting of their investments. Additionally, President elect Biden suggests ensuring that tax incentives have clear economic and social benefits to the community.
“In too many instances investors favor high-return projects like luxury apartments over affordable housing and local entrepreneurs,” the Biden campaign said in a statement in late July.
Currently, opportunity zone investments provide benefits by allowing investors to temporarily defer federal tax on invested gains until the investment is sold. If it is held for at least five years, the basis of the investment increases by 10 percent of the deferred gain, meaning tax on that portion does not have to be paid – a process that should realistically suit general partners well. Furthermore, holding an investment for 10 years allows investors to choose to change the basis of the investment to its fair market value on the date it is sold, meaning they do not have to pay tax on the investment if sold at fair market value.
In addition, capital gains and section 1231 qualified investment gains — referred to as “eligible gains” — can have taxes deferred as well. As long as you invest in an opportunity zone within 180 days of the date the “eligible gains” assets were sold, you can claim the tax deferral.
While the value of opportunity zones for private equity is still unclear, the President elect is unlikely to abolish the program; his principal goal is to reform it, so it fulfills its promise. While the majority of participating investments have been in large apartment buildings or other real estate rather than businesses which could create jobs for low-income communities, no doubt one of Janet Yellen’s first jobs if appointed chair, will be to have the Treasury Department review Opportunity Zone regulations to ensure the tax incentives have clear economic, social, and environmental benefits to a community
Of course, there remains the question of the Senate. While a Blue Wave is now unlikely, the Georgia runoff elections on January 5, 2021 tell us it is unclear who will hold the Senate next year and to what degree; an outcome which will hamper or accelerate certain changes, although unlikely to block them completely.
Therefore, a simplistic analysis of the proposed tax changes would encourage fund managers to take action — by selling or accelerating mergers and acquisitions — now before any of the proposals go forward to secure lower tax rates. However, we believe each individual should undertake certain considerations before making any permanent decisions.
First, consider your investment horizon. Depending on the expected future appreciation, it might be better to sell an investment soon before tax rates go up. On the other hand, selling a strong asset that will perform well in the future may cost you the ability to grow the funds that you use to pay the tax now.
Second is to look at your portfolio – current, and future targets.
With value creation dependent on the timing of deal making, the approach to identifying and valuing target companies will be equally impacted, whether through a carve-out or the purchase of an entire company. Tax implications around financing, such as the impacts to hybrid financing rules are one hurdle, but with the competition for assets remaining high, companies may seek to gain a competitive advantage by reducing cash taxes to the extent allowable under law.
Choice of target will also be important. Across the world, one of the biggest question marks remains around digital services. With private equity funds sitting on dry powder, many are seeking to invest in tech. But the questions around corporate tax rates, coupled with digital services taxation and potential profitability depending on where the target company is located – plus the current lack of a uniform global approach – could mean that valuing intangible assets is an even more difficult task.
If there is one thing that the change in administration shows us, it is that the impact of tax needs should be a priority at every stage of the private equity lifecycle. From assessing fund structure, to target company acquisition and considerations for future divestment, there are many pitfalls. But there is also value to be found. The industry is changing rapidly, and administrations can turn on a dime. That’s why tax thinking needs to be more strategic, planned and modelled and rewritten as the first chapter in the new private equity playbook.