Tax changes under the Build Back Better Act could impact private equity
By : Michael De Prima
On November 19, the House passed the Build Back Better Act (the Act), which contains a number of tax changes affecting businesses and individuals. The House bill doesn’t include all of the proposals put forth by the Biden administration but still includes several significant changes. The legislation now moves on to the Senate where its future is uncertain. Here’s a sampling of what’s changing (and what’s not) in the bill and how private equity might be impacted if the House bill is enacted in its current form:
Carried interest taxation stays the same. There has been quite a bit of chatter regarding changes to the taxation of carried interests. The charge was led largely by Senator Ron Wyden, who has long advocated for the complete elimination of the carried interest preference, maintaining that it’s an unfair loophole for private equity fund managers. Previous proposals would have increased the holding period required to receive long-term capital gains treatment to five years (currently three years) under Section 1061. At the end of the day, however, that change did not make its way into the Act; thus, carried interests will continue to be subject to the current three-year holding period to receive long-term capital gains rates.
Rate increases were mostly scrapped. Despite tax rate increases being a centerpiece of Biden’s proposals, the Act ditches increases for both income and capital gains rates. Therefore, corporate and individual income tax rates, as well as capital gains rates, will stay the same for the time being.
While the top line rates would remain unchanged, the Act would impose a 5% surtax beginning in 2022 on individuals with modified adjusted gross income (MAGI) in excess of $10 million, plus an additional 3% if MAGI is in excess of $25 million. Such a surtax would have far-reaching impacts for business sellers, investors, and fund managers. Additionally, the surtax would apply to estates and trusts at much lower MAGI thresholds, which would be a major consideration in wealth and succession planning.
Reduction in the 1202 exclusion. Section 1202, which is a staple in venture capital tax planning, currently provides for a 100% gain exclusion for noncorporate taxpayers upon the sale of qualified small business stock (QSBS) if held for more than five years. The House version of the Act eliminates the 100% exclusion for individuals with adjusted gross income of $400,000 or more, and for all trusts and estates. This change would leave these taxpayers with only a 50% exclusion available. The change would generally apply for sales of QSBS occurring on or after September 13, 2021. This amendment would heavily impact venture capital investors and could influence their investing decisions and deal structures in light of a potentially larger tax bill upon exit.
Expansion of the net investment income tax. Under current law, limited partners and S corporation shareholders who materially participate in the business of the partnership or S corporation are not subject to the 3.8% net investment income tax (NIIT) under Section 1411. Beginning in 2022, the Act would impose the NIIT on all business income of individuals earning over $400,000 ($500,000 for joint filers) unless the income is already subject to self-employment tax. This change might impact limited partners and S corporation shareholders selling their interests, the gain on which could now be subject to the NIIT.
Corporate minimum tax. The Act would create an entirely new tax of 15% on domestic C corporations’ worldwide book profits over $1 billion that would go into effect January 1, 2023. The $1 billion threshold contains certain aggregation provisions that could result in the portfolio companies of large private equity funds being subject to the tax.
Wash sales and cryptocurrencies. The wash sale rules under Section 1091 would now extend to cryptocurrencies as well as certain commodities and foreign currencies under the House version of the bill. The changes would go into effect January 1, 2022. This change could impact hedge funds and make mark-to-market elections under Section 475 more attractive because they generally make the wash sale rules inapplicable.
State and local tax deduction increase. One of the most contentious changes under the Tax Cuts and Jobs Act of 2017 was the $10,000 state and local tax deduction cap through 2025. Under the Act as drafted, the cap would increase to $80,000 and would sunset at the end of 2030. Individuals in high-tax states like New York, New Jersey, and California have felt the sting of the limitation most, and some of the states have turned to workarounds at the state tax level to provide relief. This provision is likely going to be the subject of negotiations and further markups as it works through the Senate.
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CLA’s Private Equity Tax team works with investment funds, fund managers, and portfolio companies to navigate federal and state tax codes and optimize their filing positions. Contact your CLA advisor to understand how these potential changes could impact you and your organization.
Craig Arends is a principal at CLA and is the managing principal of CLA's private equity practice. Craig brings a concentration of experience in providing accounting and transaction structuring advice for leveraged recapitalizations, purchase accounting and SEC reporting, assessing quality of earnings, and GAAP accounting. He has far-reaching experience with critiquing financial models and reviewing target companies' financial performance to identify cost reductions and/or operating efficiencies Craig has more than 30 years of experience in public accounting serving public companies, private equity groups, and companies, including a term as principal in charge of a Big Four Capital Markets Group in Moscow, Russia. He has led financial accounting due diligence projects for private equity investor groups and venture capital funds, primarily in the technology, communications, and manufacturing industries, as well as assisting with Foreign Corrupt Practice Act matters ranging from investigation of payments made, validation of compliance with corporate policies, and review of proposed transactions to ensure compliance. When not working, Craig enjoys watching any sports, but his most favorite are baseball, football and soccer.
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