The Trump administration and House Republicans have each proposed tax law changes that, if enacted, would significantly impact private equity, both directly and (potentially more significantly) through the businesses in which private equity funds invest. The consequences of the proposed changes vary by industry and therefore the proposals may have an uneven impact across the private equity sector. We highlight a few of the major proposed changes below.
Lower Tax Rates. The House and Trump plans would cut corporate tax rates to 20% and 15%, respectively.
Treatment of Pass-Through Entities (Including, Potentially, Private Equity Management Companies). The House plan would tax the “active business income” of pass-through entities at a maximum rate of 25%. However, these entities would be required to pay “reasonable compensation to their owner-operators,” which would be deductible to the business and subject to individual income tax at a maximum rate of 33%. The treatment of pass-through entities under the Trump plan is unclear. The plan does not explicitly discuss pass-through entities or corporations, but rather states that “businesses, both small and large that want to retain the profits within the business” will be taxed at a “business tax rate” of 15%.
Carried Interest. President Trump, in his tax plan and in many speeches throughout the election campaign, has repeatedly called for eliminating the favorable tax treatment of carried interest, the portion of a private equity fund’s investment profits paid to managers that is currently taxed at capital gains rates. If President Trump follows through on this promise, private equity managers could see a bump in their tax liability on certain income from the current rate of 23.8% to 33%, the maximum individual rate under the Trump plan. Although the House plan is silent on the treatment of carried interest and certain members of the Ways and Means Committee support the status quo of capital gains treatment, Committee Chairman Kevin Brady has said that the treatment of carried interest is still under consideration.
Interest Deductibility. Interest deductions may be limited or eliminated under both the Trump and House plans, which, in light of the importance of leveraged acquisitions to private equity, could have a significant impact on valuations and capital structures. The House’s proposal would limit a taxpayer’s interest deductions to the interest income earned by the taxpayer in a given year, with any net interest expense carried forward indefinitely. The House plan would, however, allow immediate deductions for investments in intangible and tangible assets, other than land. The Trump plan would provide for electivity, with businesses engaged in domestic manufacturing permitted to elect to forgo interest deductions and instead “expense capital investments.” No transition rules with respect to existing debt have been proposed by either plan, although this may change as proposals are developed. The limitations on interest deductibility could also have a knock on effect on private equity funds that acquire loans made to finance private equity acquisitions.
DBCFT. Finally, the destination-based cash flow tax (DBCFT) proposed by the House plan would fundamentally change the business activities that are subject to U.S. tax. Very generally, under a destination-based system, businesses would not be taxed on sales to non-U.S. consumers and would not be able to deduct the cost of goods purchased from overseas (for a more detailed discussion of the destination-based model, see here). Therefore, all else equal, the DBCFT would be disproportionately borne by target and portfolio companies in industries that source products or raw materials offshore, such as retail, while heavy exporters would face very low or even negative rates. Many economists predict that the DBCFT will cause the U.S. dollar to rally, effectively reducing the cost of imports and increasing the cost of exports, bringing balance to the system. However, importers are less confident, and have formed a coalition to oppose the DBCFT.