Implications Of Recent Tax Law Developments On Private Equity Mergers And Acquisitions

As it has always been, Federal income tax issues drive many of the structures of private equity funds and portfolio company investments. In addition, as we all know, the Administration and Congress continue to change the tax landscape. Most recently, The American Taxpayer Relief Act of 2012 (the "Fiscal Cliff Bill") that Congress passed in January resulted in numerous changes to the Internal Revenue Code and permanent extensions of various aspects of the "Bush tax cuts." This summary discusses certain of these recent trends and changes in the tax law and their implications for private equity and M&A transactions.

Using Partnerships for Portfolio Companies

One trend in private equity is an increased willingness for PE transactions to invest in a portfolio company taxable as a partnership. The partnership tax structure allows for a single level of tax, as described below. From a state law perspective, the portfolio company typically will be a limited liability company.1

Using a portfolio company taxable as a partnership offers many opportunities for tax savings. However, the flow through treatment offered by a partnership presents specific issues that the private equity investor needs to address.

Flow through treatment generally - In an entity taxable as a partnership, the owners are taxed on the company's income at the time it is earned, not when this income is distributed. The character of the earned income passes through up to the owners as well. The owners will increase or decrease the tax basis in their interest in the company for their share of the company's income or loss each year.

The investor-owner will not be taxed on cash distribution he or she receives unless that distribution exceeds his or her basis in his or her interest in the entity. In addition to increases or decreases to the tax basis for the amount of income earned, the investor-owner's basis in his or her interest will increase or decrease for his or her share of contributions and distributions.

Leveraged recapitalizations - The partnership tax rules provide more flexibility in a leveraged recapitalization of the company, which might allow for deferral of taxation. In a leveraged recapitalization transaction, the portfolio company borrows money from a third party lender and distributes proceeds of the loan to the existing owners. Under partnership tax rules, the owners' basis in their interest is increased by their share of the partnership's liabilities.

As discussed above, partners are not taxed on distributions of cash until the amount exceeds their basis in their interest. Thus, the partnership generally can distribute the proceeds from the loan to the investors without a current tax effect.

Compare this result to a leveraged recapitalization transaction involving a portfolio company taxable as a corporation. In that case, the distribution of the loan proceeds would be a dividend at the time of distribution (or possibly a capital gain)...