Proposed Tax Law Amendments and Tax Increases May Impact Private Equity and M&A Deals

The House Ways and Means Committee recently released legislative proposals as part of the “Build Back Better” reconciliation legislation that the committee is currently developing (the Proposed Legislation). The Proposed Legislation includes a broad range of changes to the U.S. federal income tax laws.

Below are several key revisions included in the Proposed Legislation that, if finalized, could impact the M&A landscape as it pertains to private equity (PE) firms, strategic buyers and privately owned businesses.

Carried Interest. The Proposed Legislation generally extends from three to five years the holding period required for carried interest to qualify for long-term capital gains treatment effective for tax years beginning after Dec. 31, 2021. Further, the Proposed Legislation adds rules for measuring the applicable holding period, including for tiered partnerships, and modifies certain other rules. In addition, the Proposed Legislation directs the Department of the Treasury to issue guidance to address carry waivers and other arrangements intended to circumvent the purposes of these provisions. The Proposed Legislation retains the three-year holding period for real property trades or businesses and taxpayers with an adjusted gross income of less than $400,000. If adopted, these provisions could significantly impact the tax consequences to PE sponsors relating to dispositions of portfolio companies within the five-year period.

Corporate Tax Rates. The Proposed Legislation increases the U.S. corporate income tax rate from 21% to 26.5% for corporations with income in excess of $5 million, effective for tax years beginning after Dec. 31, 2021. If adopted, these provisions could impact the value of a target’s tax attributes and the potential benefits of transactions structured to provide purchasers with stepped-up tax basis.

Individual Tax Increases. The Proposed Legislation increases the top federal income tax rate on long-term capital gains from 20% to 25% and the top individual ordinary income tax rate from 37% to 39.6%. In addition, the Proposed Legislation imposes a 3% high-income surcharge on adjusted gross income (i.e., both ordinary income and capital gains) in excess of $5 million (or in excess of $2.5 million for married individuals filing separately). The increase in capital gains rates is proposed to be effective for tax years ending after Sept. 13, 2021 (the date the Proposed Legislation was introduced), with a transition rule that retains the current 20% tax rate for capital gains recognized on or before that date (including transactions entered into before such date pursuant to a binding written contract). The increased ordinary income tax rate and the 3% high-income surcharge are proposed to be effective for tax years beginning after Dec. 31, 2021. To avoid the 3% high-income surcharge, taxpayers may look for ways to recognize capital gains before the end of the current tax year. Going forward, these federal tax rate increases (together with state income tax rate increases) may motivate taxpayers to roll a larger portion of their interests on a tax-free basis. With respect to transactions involving tax basis step-up opportunities, these rate increases could impact the cost of grossing-up sellers for increased taxes to facilitate the step-up.

S Corporations into Partnership Reorganizations. The Proposed Legislation includes a provision that allows certain eligible S corporations to reorganize as domestic partnerships for tax purposes without triggering tax. The eligible S corporation must transfer substantially all of its assets and complete its liquidation within a two-year period beginning on Dec. 31, 2021. An eligible S corporation is a corporation that was an S corporation on May 13, 1996 (prior to the publication of the “check the box” regulations). This provision provides a significant opportunity for well-established businesses organized as S corporations to reorganize in order to diversify their capital and holding structure (and avoid the single class of stock restriction under the S corporation regime). Accordingly, it presents PE firms with far more flexibility to invest in and partner with privately owned businesses that are currently structured as S corporations.

Limitation of Exclusion From Gain on Qualified Small Business Stock. Section 1202 of the Internal Revenue Code of 1986, as amended (the Code), allows noncorporate taxpayers to exclude gains from the sale or exchange of qualified small business stock held for more than five years. The total amount of gain eligible for exclusion is subject to a cap, and the percentage of the gain excluded depends on the year in which the investment was made. The popularity of that exclusion increased significantly when the gain exclusion rate was increased to 100% (subject to a cap) for eligible stock acquired after Sept. 27, 2010. The Proposed Legislation would eliminate the special 100% exclusion rates (as well as the 75% exclusion rate applicable to eligible investments made after Feb. 17, 2009) for gains realized by taxpayers with adjusted gross income equal to or exceeding $400,000. The baseline 50% exclusion will remain available for all taxpayers. The amendments are proposed to apply to sales or exchanges after Sept. 13, 2021, subject to a binding contract exception. Similar to the effect of the proposed increases in individual tax rates, these changes may motivate taxpayers selling their businesses to roll a larger portion of the consideration into equity on a tax-free basis. In addition, the potential benefits under Section 1202 of the Code were believed to be a significant factor for many entrepreneurs to organize their businesses after February 2010 as entities treated as C corporations for federal income tax purposes. The reduction of the exclusion rate under Code Section 1202 back to 50%, coupled with the proposed increase in the corporate income tax rate, may result in many more closely held businesses opting to be organized as partnerships (or limited liability companies taxed as partnerships).