Understanding relief available for your portfolio companies
The Coronavirus Aid, Relief, and Economic Security Act (the ‘CARES Act’ or the ‘Act’) provides approximately $2 trillion in funding for relief to assist businesses to weather the economic downturn resulting from the current COVID-19 crisis. Through ownership in their portfolio companies, private equity funds will be provided much needed capital and employment during the crisis. Many of the Act’s provisions will apply to a majority of private equity portfolio companies and could be a significant source of additional liquidity for those portfolio companies. This whitepaper addresses both general business and income tax provisions in the Act. For a more detailed analysis of the CARES Act and other COVID-19 materials affecting businesses please go to the Coronavirus Resource Center and Coronavirus Tax Relief Resource Center.
General business provisions impacting private equity portfolio companies
The primary business provisions that will provide liquidity for portfolio companies include: (1) expanded eligibility for Small Business Administration (SBA) loans and possible loan forgiveness, (2) deferral of payroll tax liability and (3) a credit against certain employment taxes.
SBA – Business Loan Program (the ‘Paycheck Protection Program’ or ‘PPP’): PPP loans are general business loans guaranteed by the SBA and include many businesses employing 500 or fewer employees or meeting the size standard for the number of employees set by the SBA. Generally, determining whether a business meets the 500-employee limit requires consideration of the SBA’s affiliation rules. The Act provides for a waiver of the affiliation rules during the ‘covered period’ (i.e., Feb. 15., 2020 to June 30, 2020) for specific categories of businesses, including those in the Accommodation and Food Services Industry, franchises assigned a franchise identifier code by the SBA, and any business concern receiving financial assistance from Small Business Investment Company portfolio companies.
SBA loans issued during the covered period may also be eligible for loan forgiveness, with the potential to exclude some or all of the forgiveness from income. The total amount of the loan forgiveness is the sum of costs and payments incurred during the covered period, including: 1) total eligible payroll costs, 2) interest payments on mortgage obligations, 3) rent obligations and 4) utility payments. However, at least 75% of the amount of loan forgiveness must be used for payroll costs.
For further detail on the PPP, see our prior article, CARES Act expands access to loans for small and midsize businesses.
RSM insights: The SBA loan program is a significant source of capital that in certain circumstances may not have to be repaid. However, the current affiliation rules may treat many PE funds as employers of greater than 500 employees and disqualify their portfolio companies from the program. Understanding the definition of ownership affiliation for SBA purposes as compared to ownership for income tax rules, such as those surrounding limitations on net operating losses under section 382, is critical.
Delay of payment of employer payroll taxes: The Act provides employers (including self-employed individuals) the ability to defer the employer’s matching portion of social security taxes for the period beginning on the date of enactment and ending before Jan. 1, 2021. The deferred tax liability is payable in two installments (the first due on Dec. 31, 2021 and the second due on Dec. 31, 2022). Employers who have indebtedness forgiven under the SBA loan program under the Act do not qualify for the payment deferral.
RSM insights: The payroll tax liability deferral will increase cash flow for portfolio companies. However, an employer may not defer payment of payroll taxes and also have debt forgiven under the SBA loan program. In addition, for income tax purposes, these taxes are generally only deductible as paid, so the deferral of payment likely defers deduction of the tax. When payment of these taxes in 2020 results in an increased NOL, a portfolio company should weigh the benefit against the benefit of recouping prior tax at a 35% rate.
Employee retention credit: The Act provides for a credit against certain employment taxes for eligible employers carrying on a trade or business in calendar year 2020 that either had to fully or partially suspend operations due to orders from an ‘appropriate governmental authority’ or had a significant drop in gross receipts in an applicable calendar quarter. In general, the credit is up to 50% of qualified wages for each qualified employee for each calendar quarter, for wages paid from March 13, 2020 through Dec. 31, 2020. Qualified wages for all calendar quarters per employee cannot exceed $10,000. The credit is reduced for any credits allowed under section 3111(e) (credit for employment of qualified veterans), section 3111(f) (credit for research expenditures of qualified small businesses) and wages paid under sections 7001 and 7003 of the Families First Coronavirus Response Act (FFCRA). Employers who take a loan under the SBA PPP are not eligible for this credit. For further detail on the employee retention credit, see Employee Retention Credit FAQs released by IRS.
RSM insights: The employee retention credit could provide liquidity for businesses experiencing a significant decline in business, but that do not want to reduce their workforce. However, enhanced unemployment benefits available to employees and the inability to claim this credit if taking an SBA PPP loan under the Act will affect the decision of many portfolio companies as well as their employees.
Federal income tax provisions affecting private equity portfolio companies
The primary federal income tax relief provisions in the Act are: (1) establishment of net operating loss (NOL) carrybacks, (2) increased business loss deductions for individual investors, (3) accelerated alternative minimum tax credit refunds, (4) reduced business interest limitations and (5) a fix to the ‘retail glitch’ for qualified improvement property (QIP).
Modifications to NOL provisions for corporate taxpayers: For companies taxed as C corporations, the Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the carryback of all NOLs generated in a tax year ending after 2017 and instead permitted such NOLs to be carried forward indefinitely. The CARES Act provides that losses arising in 2018, 2019 and 2020 may be carried back to the five prior taxable years. It should also be noted that the Act excludes taxpayers from offsetting section 965 income with any NOL carryback to the 2017 tax year.
The CARES Act provides for the temporary suspension of the 80% taxable income limitation on the use of post-2017 NOLs. In other words, a taxpayer may now offset 100% of taxable income with NOL carryforwards. For tax years beginning after Dec. 31, 2021, the Act reinstates a modified 80% limitation.
Finally, the Act includes a technical correction to the TCJA for fiscal-year taxpayers. The TCJA allowed 2017 calendar-year taxpayers to carry back NOLs incurred in that taxable year to the two prior taxable years. However, a technical ‘glitch’ prevented fiscal-year 2017 taxpayers from carrying back losses from that year. The CARES Act provides a ‘fix’ such that fiscal-year taxpayers can now carry back a loss from the 2017 tax year to the prior two tax years.
For further detail on the changes under the Act to the NOL provisions relevant to corporate taxpayers, see our prior article, CARES Act delivers five-year NOL carryback to aid corporations.
RSM insights: The carryback provision allows a corporation to carry back NOLs to taxable years for which the corporate tax rate was 35% (periods prior to 2018), as compared to the current 21% rate, allowing the companies a significant tax rate arbitrage benefit with NOL carrybacks when compared to carryforwards of the same NOLs.
For transactions taking place in tax years beginning after Dec. 31, 2017 and before Dec. 31, 2020, the carryback provisions may allow sellers of portfolio companies to capture a greater benefit from M&A transaction deductions. As a frequent buyer and seller of businesses, private equity firms may encounter certain complications regarding ownership of refunds where carrybacks cross ownership periods of the portfolio company. A careful review of transaction documents is necessary prior to filing refund claims. For more details, see our prior article Private equity and the five year NOL carryback: who owns the benefit?
Additionally, the Act does not allow a taxpayer to use an NOL carryback to offset section 965 income, which may be a benefit or detriment for private equity funds that hold controlled foreign subsidiaries in their portfolios.
Lastly, the fix of the ‘retail glitch’ discussed below could increase NOL carryback opportunities.
Modification to loss limitation rules for non-corporate taxpayers: Beginning in 2018, non-corporate taxpayers became subject to an ‘excess business loss’ limitation. This provision prevents non-corporate taxpayers with significant business losses ($250,000 for single filers, $500,000 in the case of joint filers) from claiming losses that exceed the threshold amount, instead carrying the excess forward as a NOL.
The Act suspends the excess business loss rules under section 461(l) retroactively for tax years beginning after Dec. 31, 2017 through tax years ending on Dec. 31, 2020, allowing recognition of larger losses in the years incurred as well as loss carrybacks. For further detail, see CARES Act includes major amendments to excess business loss limitation.
RSM insights: This change is critical to taxable fund investors where the fund is invested in flow-through entities, as losses flow through to the ultimate taxable owner and are reported by the owner. Therefore, losses generated by portfolio companies in applicable tax years could provide fund investors with immediate tax savings and refund opportunities. Changes to the section 163(j) interest limitations discussed in more detail below will provide similar benefits.
Modification to the corporate alternative minimum tax (AMT) credit: Tax law changes in 2017 eliminated the corporate alternative minimum tax (AMT) and provided for the refund of AMT credits in each taxable year between 2018 and 2021. The Act accelerates this schedule and provides for the refund of the remaining AMT credit for the first taxable year beginning in 2019. Alternatively, a corporation may elect to receive the remaining refund in the first taxable year beginning in 2018.
RSM insights: While this change may not appear significant, the interplay of the elimination of the corporate AMT and the five-year carryback may actually result in the majority of refunds coming from refundable AMT credit. As a result, multiple refund claims may be required.
Modification on the business interest limitation: The Act makes three significant changes to the broadly applicable business interest limitation rules of section 163(j).
First, the general limitation on the amount of deductible business interest expense is increased from 30% of adjusted taxable income (ATI) to 50% of ATI. For partnerships, this change to 50% of ATI would apply to taxable years beginning in 2020. For other taxpayers, the change would apply to taxable years beginning in 2019 or 2020.
Second, the Act provides partners in partnerships a different benefit. In 2020, partners may deduct the 2019 carryforward of their 50% allocable share of the partnership’s excess business interest expense without regard to section 163(j). In other words, under the Act, 50% of a partner’s 2019 allocable share of the excess business interest expense will be treated as business interest that is not subject to any section 163(j) limitation paid or accrued by the partner in the partner’s first taxable year beginning in 2020.
Third, for a taxable year beginning in 2020, taxpayers may elect to apply section 163(j) to their ATI amount from their last taxable year beginning in 2019 instead of to their current year ATI. For partnerships, this election is made at the partnership level, not at the partner level.
For a more detailed explanation of the changes to section 163(j), see our prior article, Section 163(j) interest deduction limitation COVID-19 relief.
RSM insights: The limitation on business interest expense operated as a tax increase for many leveraged portfolio companies. The Act alleviates this to some extent by increasing the ATI to 50%, and importantly, allows the use of 2019 ATI in 2020 limitation calculations. These changes should allow portfolio companies to reduce their current year tax liability or increase refund opportunities.
For funds with flow-through portfolio companies, the changes will provide investors with larger business deductions at the investor level in 2020. The changes to the interest limitation, along with the modification to business loss deductions discussed above, should provide investors with refund opportunities. While the benefits do not directly benefit the portfolio company, the fund should consider how these changes could reduce tax distributions to retain cash in the company.
Retail glitch ‘fix’ for QIP: The CARES Act corrected a 2017 tax law change and allows portfolio companies to claim 100% bonus depreciation on QIP. This change may be applied retroactively. It is anticipated that the IRS will provide further guidance on the procedures for implementing this change for 2018 and 2019 federal income tax returns.
RSM insights: As a result of the CARES Act and the fix to the ‘retail glitch,’ portfolio companies will likely have the opportunity to claim 100% bonus depreciation on QIP for earlier taxable years. This change may also allow taxpayers to increase NOL carryback refund claims. However, procedures for the changes to QIP are in process, and further guidance is needed to properly implement these changes. See additional information at our more detailed article, CARES Act provides a fix for the retail glitch.
The CARES Act provides significant relief, from PPA loans and credits to NOL carrybacks and the acceleration of corporate AMT refunds, aimed at increasing liquidity for portfolio companies and fund investors. Given the complexities of the above provisions, taxpayers should consult with their tax, legal and financial advisors when considering the changes and impacts on their tax and business planning under the CARES Act.