Proposed Tax Law Changes and Tax Increases May Impact Private Equity and M&A Transactions | Kramer Levin Naftalis & Frankel LLP

The House Ways and Means Committee recently released legislative proposals as part of the “Build Back Better” reconciliation legislation that the Committee is developing (the Bill). The bill includes a wide range of changes to US federal income tax laws.

Below are several key revisions included in the bill that, if finalized, could impact the M&A landscape as it relates to private equity (PE) firms, strategic buyers and private companies.

Interest carried. The bill generally extends the holding period required for deferred interest to qualify for long-term capital gains treatment effective for tax years beginning after December 31, 2021 from three to five years. , the bill adds rules for measuring applicable participation. period, including for multi-level partnerships, and amends certain other rules. In addition, the bill directs the Treasury Department to issue guidance regarding porting waivers and other arrangements intended to circumvent the purposes of these provisions. The bill maintains the three-year holding period for trades or real estate businesses and taxpayers with adjusted gross income of less than $400,000. If enacted, these provisions could have a significant impact on the tax consequences for PE promoters with respect to holding company dispositions during the five-year period.

Corporate tax rate. Bill increases U.S. corporate income tax rate from 21% to 26.5% for corporations with income over $5 million, effective for tax years beginning after December 31, 2021 If enacted, these provisions could impact a target’s capital value. tax attributes and potential benefits of structured transactions to provide buyers with an enhanced tax base.

Tax increases for individuals. Proposed legislation increases the top federal tax rate on long-term capital gains from 20% to 25% and the top ordinary tax rate on personal income from 37% to 39.6% . In addition, the bill imposes a 3% high income surtax on adjusted gross income (i.e. ordinary income and capital gains) greater than $5 million (or greater than 2, $5 million for married persons filing separately). The increase in capital gains rates is proposed to apply to tax years ending after September 13, 2021 (the date the proposed legislation was introduced), with a transition rule that retains the rate of current 20% taxation for capital gains recognized on or before that date (including transactions entered into before that date under a binding written contract). It is proposed that the ordinary income tax rate increase and the 3% high income surtax apply to taxation years beginning after December 31, 2021. To avoid the 3% surtax for high income taxpayers may seek ways to account for capital gains before the end of the current tax year. Going forward, these increases in the federal tax rate (as well as increases in the state tax rate) may encourage taxpayers to transfer more of their interest tax-free. For transactions involving opportunities to increase the tax base, these rate increases could impact the cost of sellers mark-up for the tax increase to facilitate the increase.

S corporations in partnership reorganizations. The proposed legislation includes a provision that allows certain qualifying S corporations to reorganize into domestic partnerships for tax purposes without triggering tax. The qualifying S corporation must transfer substantially all of its assets and complete its liquidation within two years of December 31, 2021. A qualifying S corporation is a corporation that was an S corporation on May 13, 1996 (prior to publication of the “check the box” rules). This provision provides a significant opportunity for well-established companies organized as S corporations to reorganize in order to diversify their capital and ownership structure (and avoid the restriction to a single class of shares under the S corporation regime). As a result, it gives private equity firms much more flexibility to invest and partner with private companies that are currently structured as S corporations.

Limitation of the gain exclusion on qualified small company shares. Section 1202 of the Internal Revenue Code of 1986, as amended (the Code), permits unincorporated taxpayers to exclude gains from the sale or exchange of qualifying shares of small business corporations held for more than five years. The total amount of gain eligible for exclusion is subject to a cap, and the percentage of gain excluded depends on the year in which the investment was made. The popularity of this exclusion increased significantly when the earnings exclusion rate was increased to 100% (subject to a cap) for qualifying stocks acquired after September 27, 2010. The bill would eliminate earnings exclusion rates. special exclusions of 100% (as well as the 75% Exclusion Rate applicable to eligible investments made after February 17, 2009) for gains realized by taxpayers whose adjusted gross income is equal to or greater than $400,000. The basic 50% exclusion will remain available to all taxpayers. The changes are proposed to apply to sales or exchanges after September 13, 2021, subject to a binding contractual exception. Similar to the effect of proposed increases in personal tax rates, these changes may incentivize taxpayers selling their business to turn more of the consideration into equity tax-free. In addition, the potential benefits of Code Section 1202 were seen as 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 to 50%, coupled with the proposed increase in the corporate tax rate, may encourage many more closely held businesses to choose to organize as partnerships (or limited liability companies taxed as partnerships) .

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