Build Back Better Act Tax Proposals: Considerations for Private Investment Funds & Sponsors
On September 13, 2021, the House Ways and Means Committee released legislative text for proposed tax changes to be incorporated in the budget reconciliation bill known as the “Build America Back Better” act (the Act). The proposal would raise tax rates for corporations and individuals and make several other changes to the Internal Revenue Code. In particular, the markup contains numerous proposals that could have an impact on private investment fund managers and their portfolio companies. This outline highlights some of the major provisions and what they would mean for fund managers, if ultimately passed into law.
Pending Corporate Provisions
Increase in Corporate Tax Rate
This provision replaces the flat corporate income tax with a graduated rate structure. The rate structure provides for a rate of 18% on the first $400,000 of income; 21% on income up to $5,000,000, and a rate of 26.5% on income thereafter. The benefit of the graduated rate phases out for corporations making more than $10,000,000. There is a slight tax break for C Corporations with less than $5,218,000 of taxable income. Effective for tax years beginning after December 31, 2021.
- Impact to Private Equity (PE): Operating in C corporations will become more expensive. The lower bracket and surcharge will need to be allocated among members of a controlled group.
Modification of Rules for Partnership Interests Held in Connection with the Performance of Services (Carried Interest)
The provision makes several changes to section 1061. First, the provision generally extends from three to five years the holding period required for gain attributable to an applicable partnership interest to qualify for long term capital gain treatment. The provision retains the three-year holding period for real property trades or businesses and taxpayers with an AGI less than 400,000. The provision also extends section 1061 to all assets eligible for long term capital gain rates. In addition, the provision adds rules for a measuring the three or five-year holding period, including in the context of tiered partnerships, and modifies the rules applicable to sale or exchange transactions, and extends regulatory authority under the provision to address carry waivers and arrangements that avoid the purposes of this section. Effective for tax years beginning after December 31, 2021.
Limitation on Certain Special Rules for Section 1202 Gains
This provision provides that the special 75% and 100% exclusion rates for gains realized from certain qualified small business stock will not apply to taxpayers with adjusted gross income equal or exceeding $400,000. The baseline 50% exclusion remains available for all taxpayers. The amendments made by this section apply to sales and exchanges after September 13, 2021, subject to a binding contract exception.
- Impact to PE: This will significantly reduce the benefit of qualifying under Section 1202. However, because of the increase in the tax rates and the surcharge as discussed above, the benefit under Section 1202 can still be significant.
Rules Relating to Common Control
The tax code aggregates certain business entities in order to apply various limitations (e.g., the gross receipts limitation in the use of the cash method of accounting under section 448(c), the exemption from interest deductibility limitations under section 163(j)). Section 52(a) addresses corporate entities and section 52(b) provides similar rules for corporate and non-corporate entities. Section 52(b) refers to “trades or business (whether or not incorporated)” and the treatment of certain for-profit activity is unclear.
The provision would provide that a taxpayer engaged in any activity in connection with a trade or business or any for-profit activity is subject to the aggregation rules under section 52(b). The provision would be effective on the date of enactment.
Pending Provisions for Individuals, Trusts and Estates
Increase in Top Marginal Individual Income Tax Rate
The provision increases the top marginal individual income tax rate to 39.6%. This marginal rate applies to married individuals filing jointly with taxable income over $450,000, to heads of households with taxable income over $425,000, to unmarried individuals with taxable income over $400,000, to married individuals filing separate returns with taxable income over $225,000, and to estates and trusts with taxable income over $12,500, as adjusted for inflation in future tax years. Effective for tax years beginning after December 31, 2021.
- Impact to PE: Higher individual rates will reduce after tax returns. Rates on ordinary income could go up to 43.4% with imposition of the Net Investment Income Tax discussed below.
Increase in Capital Gains Rate for Certain High-Income Individuals
The provision increases the capital gains rate to 25%. Highest rate applies when income reaches the top bracket. The amendments made by this section apply to taxable years ending after the date of introduction of this Act. A transition rule provides that the preexisting statutory rate of 20% continues to apply to gains and losses for the portion of the taxable year prior to September 13, 2021. Gains recognized later in the same taxable year that arise from transactions entered into before the date of introduction pursuant to a written binding contract are treated as occurring prior to the date of introduction.
- Impact to PE: Higher capital gains rates will reduce after tax returns. Rates on capital gains could go up to 28.8% with imposition of the Net Investment Income Tax discussed below.
Surcharge on High Income Individuals, Trusts, and Estates
This provision imposes a tax equal to 3% of a taxpayer’s modified adjusted gross income in excess of $5,000,000 (or $2,500,000 for a married individual filing separately). For this purpose, modified adjusted gross income means adjusted gross income reduced by any deduction allowed for investment interest (as defined in section 163(d)). Effective for tax years beginning after December 31, 2021.
- Impact to PE: All income types will have a reduced after-tax return. On income in excess of $5 million, rates on ordinary income could go up to 46.4% with imposition of the Net Investment Income Tax and capital gains rates could go up to 31.8% with imposition of the Net Investment Income Tax, as discussed below.
Limitation on Deduction of Qualified Business Income for Certain High-Income Individuals
The provision amends section 199A by setting the maximum allowable deduction at $500,000 in the case of a joint return, $400,000 for an individual return, $250,000 for a married individual filing a separate return, and $10,000 for a trust or estate. Effective for tax years beginning after December 31, 2021.
- Impact to PE: The benefit of the rate reduction due to the 20% exclusion is capped for individuals in the higher tax brackets. This provision reduces the tax benefit of operating as a pass-through.
Application of Net Investment Income Tax to Trade or Business Income of Certain High-Income Individuals
This provision expands the net investment income tax to cover net investment income derived in the ordinary course of a trade or business for taxpayers with greater than $400,000 in taxable income (single filer) or $500,000 (joint filer), as well as for trusts and estates. The provision clarifies that this tax is not assessed on wages on which FICA is already imposed. Effective for tax years beginning after December 31, 2021.
- Impact to PE: For all passive investors who are high income, the Net Investment Income Tax will apply to increase the effective tax rate by 3.8%. For PE managers and others who receive income, the Net Investment Income Tax will apply unless the income received is subject to FICA or SECA tax.
Other Often Overlooked Provisions
Prohibition of Investment of IRA Assets in Entities in Which the Owner Has a Substantial Interest
To prevent self-dealing, under current law prohibited transaction rules, an IRA owner cannot invest his or her IRA assets in a corporation, partnership, trust, or estate in which he or she has a 50 percent or greater interest. However, an IRA owner can invest IRA assets in a business in which he or she owns, for example, one-third of the business while also acting as the CEO. The bill adjusts the 50% threshold to 10% for investments that are not tradable on an established securities market, regardless of whether the IRA owner has a direct or indirect interest. The bill also prevents investing in an entity in which the IRA owner is an officer. Further, the bill modifies the rule to be an IRA requirement, rather than a prohibited transaction rule (i.e., in order to be an IRA, it must meet this requirement). This section generally takes effect for tax years beginning after December 31, 2021, but there is a 2-year transition period for IRAs already holding these investments.
- Impact to PE: PE group partners and employees will no longer be able to have their personal IRA’s invest in some of the entities that they control.
Prohibition of IRA Investments Conditioned on Account Holder’s Status
The bill prohibits an IRA from holding any security if the issuer of the security requires the IRA owner to have certain minimum level of assets or income, or have completed a minimum level of education or obtained a specific license or credential. For example, the legislation prohibits IRAs from holding investments which are offered to accredited investors because those investments are securities that have not been registered under federal securities laws. IRAs holding such investments would lose their IRA status. This section generally takes effect for tax years beginning after December 31, 2021, but there is a two-year transition period for IRAs already holding these investments.
- Impact to PE: This could have a profound impact on the types of investors that a PE group will be able to attract. Additionally, because of the divesture provisions, existing funds with IRA owners will have the necessity of withdrawing from existing funds.