The Tax Cuts and Jobs Act, seen to be very “business friendly,” includes a number of provisions affecting private equity and investment fund industry in positive ways … and a few negatives. Here are some of the specifics we’ve noted for our clients.
Corporate portfolio companies will benefit from provisions such as the decrease in the maximum corporate tax rate to 21%. The corporate Alternative Minimum Tax (AMT) has been repealed. Negative for many companies are the changes to treatment of net operating losses (NOLs). For losses arising after 2017, the NOL deduction is limited to 80% of taxable income. The carryback provisions are repealed, though an indefinite carryforward is allowed.
The new tax law includes a break for owners of certain pass-through entities
Pass-through entities include subchapter S corporations, partnerships and some limited liability companies. Owners of certain pass-through entities will receive a 20% deduction on “qualified business income,” effectively reducing their maximum effective tax rate from 39.6% in 2017 to 29.6% in 2018.
The deduction is limited to 50% of the W-2 wages paid, or the sum of 25% of the wages plus 2.5% of depreciable basis. There’s another plus for pass-throughs: they keep the deduction on entity-level state and local taxes.
New rules on expensing may create another benefit
The Tax Cuts and Jobs Act permits 100% expensing of certain types of property that you acquire and place in service. This may include active business assets you purchase, allowing 100% expensing of the price of tangible assets. This has been called a “tax shield” for some investment strategies.
But interest expense deductibility is limited immediately, and it will get worse
For net interest expense that exceeds 30% of adjusted taxable income (ATI), deductibility has been limited. Through 2021, ATI is computed without accounting for depreciation, amortization or depletion, but beginning in 2022 those items are included. This could decrease your ATI, and thus limit your interest expense deductibility further. Highly leveraged portfolio companies should take note and address this issue strategically.
Carried interest rule changes could be harmful
Changes to the rules on carried interest are a potential downside. Previously, carried interest from certain investments held for more than one year was taxed at capital gains rates, rather than the higher ordinary income rate. For 2018 and beyond, that threshold is three years. Carry strategies where benefits from the lower rates were allocated among partners will need re-thinking.
As regulations related to tax reform continue to evolve, please stay in touch with your tax advisor to learn more about these and other provisions that could affect you or your business.