The Taxation of Capital Gains & Carried Interests in 2021: A Look at Issues for Private Equity Funds
Following the release of the Administration’s American Jobs Plan, President Biden released a new set of proposals designed to address “human infrastructure” issues with a package of revenue-raising proposals that would result in significant tax increases for upper-income individuals. The proposals in his American Families Plan reflect his campaign pledge to ensure that wealthy individuals pay “their fair share” in taxes, and they are drawn from proposals that the President put forward during his 2020 Presidential campaign.
The President called for increasing the top individual income tax rate and the capital gains tax rate, taxing carried interests as ordinary income, eliminating stepped-up basis for certain inherited assets, and other tax increases focused on wealthy individuals. The Administration has not yet provided key details on how some of these revenue-raising proposals would work.
Many of the ideas included in the American Families Plan have already drawn criticism and opposition from Congressional Republicans. Advancing this type of package through Congress will likely face challenges from both Democrats and Republicans, especially with the tight margins of control in both the House and Senate.
Proposals from the Biden White House and others currently being considered by Congress have the potential to change tax planning considerations for investment funds, their managers, and their investors. Business taxpayers should review and monitor these tax developments as legislation is developed.
This True Insight will highlight some of the key issues that should be considered for private equity (“PE”) funds, their managers, and their investors. Issues covered include capital gains tax rates, tax rates and rules for pass-through vs. corporate income, and the treatment of carried interests.
The Biden Administration Tax Proposals
The White House has released two comprehensive packages of spending proposals that are designed to address job creation and traditional infrastructure issues, such as roads and bridges, and “human infrastructure” issues with other proposals related to child care, education, and health care. Each package was combined with a set of tax proposals to raise the revenue necessary to pay for these spending proposals that would result in major changes to the current tax rules, including several that were revised or enacted in the Tax Cuts & Jobs Act (“TCJA”). The Administration has stated that the Treasury Department soon will release a “Green Book” technical explanation that includes details of the tax proposals.
Several of the tax changes included in these legislative packages have the potential to have a major impact on PE funds, their fund managers, and their investors. These potential tax law changes could be coming very quickly – possibly by the end of the 2021. Keep in mind, however, that the White House has laid out two ambitious policy agendas, but this is only the beginning of the legislative process. It is now up to Congress to advance this legislation and they are likely to make key changes.
On March 31, 2021, the Biden Administration released their American Jobs Plan, which is a tax and spending proposal designed to address infrastructure issues and job creation. It addresses a variety of issues including spending for roads and bridges, the electric grid, broadband capacity, and water systems; the promotion of clean energy; the expansion of affordable housing; incentives for domestic manufacturing; and home and community based care for children, the elderly, and individuals with disabilities. The $2.3 trillion package would be offset by the Biden Administration’s Made in America Tax Plan, which provides for corporate-related tax increases, including raising the corporate tax rate to 28% (from the current 21%), enacting a 15% minimum tax on large corporation’s book income, and establishing a global minimum tax to discourage offshoring.
On April 28th, President Biden announced his American Families Plan, which is a $1.8 trillion plan that expands access to education, child care, and medical leave. This plan is financed by new tax increases, including increasing the personal rate for top earners from 37% to 39.6%; raising the capital gains rate for households making over $1 million; and eliminating the preferential tax treatment of carried interest.
The American Families Plan also includes these proposals:
- Repeal the step-up in basis of inherited assets at death for gains greater than $1 million ($2.5 million per couple when combined with current-law exemptions for real estate). Special rules would apply to protect family-owned businesses and farms that are passed on to “heirs who continue to run the business.”
- End the like-kind exchange rules for gains on real property greater than $500,000.
- Permanently extend the excess business loss limitation, which was extended through 2026 by the American Rescue Plan.
- Ensure that the 3.8% Medicare tax on net investment income enacted as part of the Patient Protection and Affordable Care Act is applied consistently to those making over $400,000.
- Increase IRS funding to allow the IRS to expand its audits of high-income individual taxpayers and corporations.
- Require financial institutions to “report information on account flows so that earnings from investment and business activity are subject to reporting more like wages already are.”
The Road Ahead to Enactment in 2021
Democratic Congressional leadership is focusing first on negotiating the American Jobs Plan at the committee level. Although the Biden proposals were introduced in two separate packages, it is possible that Congress could include proposals from both packages in crafting a compromise on infrastructure and job creation. House Speaker Pelosi has stated that she would like the House to approve the first infrastructure bill by the July 4th Congressional recess.
Congressional Republicans have signaled support for a traditional infrastructure package with a smaller price tag paid for by “user fees” (e.g. gasoline taxes) and compliance revenue rather than tax increases. If a bipartisan agreement can be reached on that initial package, it is then likely that the second package will be more partisan and will need to advance through Congress by the budget reconciliation process, which would allow passage in the Senate by a simple majority vote.
In a meeting at the White House on May 12th of the President and Congressional leadership, including House Speaker Pelosi (D-CA), Senate Majority Leader Schumer (D-NY), House Minority Leader McCarthy (R-CA), and Senate Minority leader McConnell (R-KY), the Republican leaders stated that tax increases are “off the table” in discussions of the infrastructure packages, also saying that they are not interested in revisiting the 2017 TCJA.
The Administration has ambitious plans to advance both of these packages in 2021, in part because they are mindful of the fact that the 2022 elections will make it complicated to pass any legislation next year. House Republicans are already intent on recapturing control of the House, especially since Democrats currently have a very slim margin of control. Control of the Senate will also be in play, but more Senate Republicans are up for re-election in 2022 than Democrats.
TPC Observation: Taxpayers should keep in mind that regardless of whether any of these tax changes are enacted before the 2022 elections, there could always be more changes after the election, including a reversion back to current law, depending on which party controls Congress and the White House.
Effective Date of Tax Changes
If any tax law changes are enacted in 2021, a key issue will be the effective dates of each rule change. Will they be effective as of January 1, 2022, or will they be retroactive to the 2021 tax year? Retroactive changes generally are not favored in Congress, especially tax rate changes, unless they are addressing an abuse of the tax system.
Treasury Secretary Yellen indicated that any proposals to increase taxes generally should be effective on a prospective basis beginning in 2022, and has also suggested the possibility of phasing in rate changes. Both chairs of the tax-writing committees have also expressed their opposition to retroactive tax increases. It will be important to watch the developments, however, as Congress could trigger the tax changes as of the date of the introduction of legislation, which has reportedly been discussed by Congressional Democrats with respect to the proposed increase in the capital gains tax rate. The effective date of tax changes will affect the proposal’s revenue estimate, which will be particularly important if legislation is advancing through Congress using the budget reconciliation process because that considers the fiscal impact of tax changes over a 10-year budget window.
TPC Observation: Before executing transactions in 2021, taxpayers should think through which tax law changes they expect to pass and when they expect it to be effective, and create models to estimate the impact. Common PE deal structures and tax mitigation strategies may appear unwise once the law changes are considered. For example, the use of rollover equity to defer recognition of capital gains may be ill advised if one expects that future gains will be taxed at a higher rate.
Interaction of the Biden Tax Proposals and the 2025 Expiring Provisions
An analysis of the various tax proposals should also consider how they might interact with other forthcoming changes to tax rates and operative rules. Since the revenue-raising proposals are intended to offset the cost of the spending proposals included in the two Biden plans, that interaction could affect revenue estimates for specific policy proposals if they affect the behavior of investors.
The number of proposed tax law changes currently on the table makes tax planning a challenge for most businesses and wealthy individuals. Additionally, taxpayers must also consider the impact of TCJA provisions that are scheduled to expire in 2025, including individual provisions and the section 199A deduction for pass-through income. Members of Congress should address those issues while debating the Biden plans.
TPC Observation: It made sense for PE firms to operate as partnerships when the corporate tax rate was 35% and there was a lower tax rate on capital gains that also applied to the fund manager’s carried interest. Many PE funds considered converting to C corporations after TCJA lowered the corporate rate to 21%, since the corporate form has other advantages including access to a wider range of investors and index funds.
Given the proposal to increase the corporate tax rate to 28%, many PE firms may think that operating as a corporation will necessarily lead to higher taxes. However, if the tax laws change to eliminate the preferential tax rate on capital gains and carried interest, those changes may offset the benefits of pass-through entity structures.
While investors should monitor the progress of these proposals and make plans for how they will react if legislation is enacted, they should also be careful to avoid reacting too quickly. There is a risk in taking action before it becomes clear what changes Congress will make to the Administration’s proposals.
Current Law: Investors pay ordinary income tax rates on capital gains from short-term investment held for a year or less. For long-term investments held more than a year, one of three capital gains rates may apply based on the taxpayers taxable income: 0% for those earning less than $80,000; 15% for those earnings between $80,000 and $441,150 for individuals ($496,600 for married couples); and 20% for those with incomes exceeding those thresholds for their filing status. The 2017 TCJA, which was enacted by a Republican-controlled Congress and White House, left the capital gains tax rate structure in place.
Administration Plan: The American Families Plan would eliminate the lower tax rate for income from long-term capital gains and certain dividends and tax the income at ordinary income rates for “households making over $1 million.” Thus, it would raise the capital gains tax rate to 39.6% for households earning more than $1 million if the proposal in the American Jobs Plan to increase the top individual tax rate on high-income taxpayers is approved. There are no details on how the $1 million threshold is defined or if it will differ by filing status.
The net investment income tax under current law applies at a 3.8 percent rate to certain investment income of individuals. The Administration Plan would expand the scope of this tax, and although there are no details yet available, the tax might apply to all unearned income, in which case the combined federal capital gains tax rate would be 43.4%.
Congressional Proposals: Senate Finance Committee (“SFC”) Chair Wyden (D-OR) and House Ways & Means Committee Chair Neal (D-MA) have both indicated that discussions about this issue are underway with the members on their committee, but no timeline is set for action. At least two members of the SFC, Senators Warner (D-VA) and Menendez (D-NJ), have endorsed the idea of increasing the capital gains tax rate, but have also expressed concern that the ordinary income tax rate may be too high.
Chair Neal has said that he believes there are a number of issues that must be discussed with respect to taxing capital gains, including the tax rate, requirements for a reduced capital gains rate, holding period rules, income thresholds, and special provisions to expand eligibility for reduced capital gains rates.
Chair Wyden has expressed that the current system allows wealthy investors to pay taxes “when they feel like it,” since they can time asset sales that trigger capital gains taxes. He is working on legislation for taxing wealthy investors’ capital gains as ordinary income based on mark-to-market accounting for easily traded investments, such as stocks and bonds. The legislation is based on a paper that he wrote in 2019 titled “Treat Wealth Like Wages.”
TPC Observation: There will be ongoing debates about whether to change the tax rates on capital gains. Some senior Democrats have suggested that the Biden proposals to increase the capital gains rate will trigger a broad review of the current tax framework for all investors. They will also consider the effect of raising taxes on businesses and investors while the economy is rebounding from the effects of the pandemic.
Opponents of changing the capital gains tax rate will argue that tax-advantaging long-term capital gains is a pro-competition policy that incentivizes investment in start-up companies and other businesses needed to support economic growth. If the top rate for individuals is increased to 39.6% as proposed, some members (Democrats and Republicans) may feel that rate is too high and will deter investments, which could result in a compromise at a lower rate.
In support of these opponents’ argument, the Joint Committee on Taxation has estimated that increasing the capital gains tax rate above a certain level could result in a loss of revenue if the effects of the higher rate are offset by a decrease in asset sales. Some analyses have suggested that the revenue-maximizing rate for capital gains is 28%. If, however, the White House proposal to eliminate the step-up in basis rule for inherited assets, there would arguably be less incentive for investors to hold assets until death, so that revenue-maximizing rate could be higher.
As discussed above, the effective date of any change in the capital gains tax rate will be an important issue for investors. It is useful to note that since 1986, capital gains tax increases all became effective prospectively after the general date of the legislation, so it is reasonable to assume that future changes in this area are unlikely to be retroactive.
The treatment of carried interest is an issue that affects the taxation of the return paid to the managers of PE funds rather than the PE fund itself. This issue has been a frequent target of criticism in the past several years, and has been termed a “loophole” by many members of Congress in both parties. The industry will continue speaking out against the proposal to eliminate the preferential treatment of carried interest, but there is some consensus growing that modification to the current rules may be approved.
Current Law: The term “carried interest” refers to compensation paid to fund managers (typically for exceeding certain return-on-investment benchmarks) in the form of an additional percentage of the fund’s profits with no associated capital contribution to the fund. Since these funds primarily generate income in the form of capital gains, the recipients of carried interest have historically paid tax at the rate for long-term capital gains on the majority of that income.
The TCJA enacted section 1061, which subjected carried interest to ordinary income tax rates if the additional profits interest was held for 3 years or less. This was achieved by recharacterizing gains derived from an “applicable partnership interest” as short-term capital gains (which are taxed at ordinary rates) to the extent the gains relate to property that does not have a holding period of more than three years. An “applicable partnership interest” is a partnership interest that is transferred to or held by the taxpayer in connection with the performance of “substantial services” by the taxpayer in an “applicable trade or business.” An “applicable trade or business” is defined as the activity of raising or returning capital and investing in or developing “specified assets.” “Specified assets” are defined as securities, such as shares of stock and promissory notes, commodities, cash or cash equivalents, real estate, options or derivatives and partnership interests but only to the extent the assets of the partnership are comprised of the preceding items.
The rule will apply to most private equity funds, other than those that are owned and operated as corporations (either C or S) for tax purposes.
Administration Plan: The plan would “permanently eliminate the carried interest loophole.” Although no additional detail has been provided, it is assumed that carried interest would no longer be subject to preferred capital gains rates and would instead be treated as ordinary income.
Congressional Proposals: New legislation has been introduced by three senators, including Senator Brown (D-OH), who is a member of the SFC, and Senators Manchin (D-WV) and Duckworth (D-IL), that would eliminate the carried interest rule by requiring that carried interest profits be taxed at ordinary income tax rates.
TPC Observation: This proposal was not included in President’s Biden’s campaign proposals. If Congress equalizes the rates on ordinary income and capital gains, then the current advantageous treatment of carried interest becomes a non-issue for taxpayers with incomes above the required threshold.
Tax Rate Changes
The TCJA lowered the tax rates for corporations and most pass-through businesses.
Current Law: The TCJA lowered the corporate tax rate to 21% (from 35%). In an effort to provide a tax cut to pass-through entities similar to that accorded to corporations, the TCJA enacted new section 199A, which allows individuals to deduct 20% of the “qualified business income” received from pass-through entities. The deduction is not available, however, to partners above certain income levels in a “specified service trade or business,” which includes the provision of services in several fields related to investing and investment management. Therefore, the section 199A deduction is unlikely to be available to PE fund managers unless their income is below the stipulated levels.
Administration Plan: The Biden plans include a proposal to increase the corporate tax rate to 28%, with a 15% minimum tax on a company’s book income if they report more than $2 billion in the US but paid zero or negative federal income taxes. Although President Biden did propose eliminating the 20% deduction for “qualified business income” for pass-through entities under section 199A during his campaign, it was not included in either of the two plans released this year.
TPC Observation: For a PE firm, the section 199A deduction is unlikely to be available to most partners unless they are below the set income levels. However, these tax rate changes are important considerations when choosing to structure portfolio companies in partnership or corporate form. The comparison should be between the rate on corporate earnings (plus the capital gains rate on qualified dividends and the net investment income tax) versus the top marginal rate imposed on individuals receiving pass-through income (plus the Medicare tax). Depending on the size of the differential, this may influence the choice of entity.
Other Issues to Consider
Managers of and investors in PE firms should also monitor developments with certain other tax laws that may be ripe for change.
Interest Expense Limitation under Section 163(j)
The limitations on interest expense deductions that were enacted in the TCJA affect the after-tax cost of borrowing to finance acquisitions and growth. The Administration Plans did not include any proposed changes to the treatment of interest expense, but it should be noted that the current law’s favorable rule that adds back depreciation and amortization expense when computing the limitation is set to expire in 2022. It is possible that this issue will be included in a broad review by Congress of the other tax changes proposed by the Administration.
Growth in PE funds and their portfolio companies has increasingly been financed with debt. If interest is all deductible, then borrowing to finance acquisitions or growth may be preferable to the issuance of additional equity, but if earnings are low enough to trigger this interest deduction cap, then capitalization through equity may be preferable. Consideration must be given to carefully modeling the earnings expectations that might limit the ability to deduct interest expense with the result possibly being to shift to using more preferred equity than debt.
Net Operating Losses (NOLs)
The TCJA made changes in the rules applicable to net operating losses (NOLs), which restricted their use in reducing taxable income. Pandemic-related legislation in 2020 made temporary changes to some of the rules that were enacted. Any restrictions on the use of NOLs could limit the ability of owners of the PE fund to benefit from the losses of their portfolio companies. It is expected that the issue of the use of NOLs will be part of the discussion in the tax-writing committees when they consider other business tax issues that are included in the Administration Plans.
Excess business losses
The American Families Plan would permanently extend the excess business loss rule, which generally limits certain losses attributable to trades or businesses for noncorporate taxpayers to $250,000 ($500,000 in the case of joint filers), indexed for inflation. This limitation was originally enacted in the TCJA with an expiration at the end of 2025, but it was suspended for taxable years beginning in 2018, 2019, and 2020 in the Coronavirus Aid, Relief, and Economic Security (CARES) Act in 2020. It was then extended through 2026 in the American Rescue Plan of 2021.
International tax rules
The TCJA included several key changes to the US rules on international investments and income, and the White House has proposed new changes, some of which would reverse or modify the TCJA changes, including changes to the rules for Global Intangible Low-Taxed Income (GILTI). This True Alert does not address those issues in the context of investment funds, but they will need to be addressed in cases where there is investment in foreign corporations. Please see our True Alert that discusses the Administration and Congressional proposals in the international area.
Companies are advised to continue evaluating and modeling the potential effects of both the Administration’s proposals and the options being proposed in Congress. If you have any questions about the information in this True Alert, please contact a member of your TPC engagement team.