The tax storm clouds have been brewing for quite some time … and they appear to be getting darker.
What’s gathering on the horizon is the likelihood of an increase in both ordinary income and capital gains tax rates. Multiple factors have converged to create this “perfect storm.”
The outcome of the election could have major ramifications on tax policy. Joe Biden has proposed increasing the tax rate for ordinary income of individuals earning $400,000 or more a year from 37 percent to 39.6 percent. Plus, the long-term capital gains rate would increase under his proposal from 20 percent to equal the ordinary income tax rate for those earning more than $1 million a year.
Obviously, what is being proposed could have significant tax implications for many private equity partners.
In addition, the trillions of dollars in stimulus spending in response to COVID-19 will likely mean changes in tax laws. The piper simply must be paid.
So, what should a successful private equity partner do? Below are three considerations to help turn your angst into action:
1. Accelerate transactions already in the works.
If a sale of a portfolio company is in the works, step on the gas. While it may be too late to begin the process of structuring a sale, push to close deals already in progress before the end of the year to lock in current tax rates.
Yes, this will likely accelerate taxes due on the sale, but this can be potentially mitigated by structuring the proceeds from the transaction to be received over several tax years (i.e. an installment sale). Doing so allows the resulting capital gains to be recognized (or taxed) over a period of years.
A decision regarding the treatment of an installment sale can be delayed until 2020 tax returns are due in 2021. By that time, we should have a better idea of any new or proposed tax legislation. If it is clear that tax rates will be increasing, and it makes sense to pay tax on the full amount of the long-term capital gain in the 2020 tax year, the taxpayer can then elect out of the installment method of reporting the sale. If on the other hand there is no, or only a slight, tax increase, the gain can be spread out over a period of years.
2. Consider a donor-advised fund.
Higher-income private equity partners may want to consider contributing to a donor-advised fund (DAF) before the end of 2020 to maximize the benefit of charitable donations. One of the proposals put forward by Joe Biden would cap the tax benefit of itemized deductions at the 28 percent rate.
Presuming you are in the 37 percent tax bracket today and itemize your deductions (versus taking the standard deduction,) you currently stand to receive a 37 cent credit for each dollar donated. That is applicable for up to 100 percent of your adjusted gross income (AGI) for cash contributions in 2020 as a result of the CARES Act provisions. The deduction limit is typically 60 percent of AGI for cash contributions. As stated, the itemized deduction tax benefit could be capped at 28 percent next year, making 2020 an attractive year to soak up accelerated realized gains through charitable deductions.
3. Defer, reduce, and eliminate capital gains taxes with a QOZ investment.
Qualified Opportunity Zones (QOZs) have become an attractive option for many investors with capital gains to be redeployed. QOZs are land tracts designated as economically depressed or underserved. Passed as part of the Tax Cuts and Jobs Act of 2017, the QOZ legislation creates sizable tax breaks to incentivize private investors who make qualified long-term investments that have the potential to promote economic growth in these zones.
Generally, investors have 180 days from the recognition of a capital gain (short- or long-term) to make a qualifying investment into a QOZ fund. However, in response to the economic impact of the pandemic, the IRS has updated the QOZ rules to allow capital gains recognized on or after October 4, 2019, or capital gains recognized through ownership of an interest in a pass-through entity in the tax year ending December 31, 2019, to be reinvested by December 31, 2020.
If an investor makes an investment equal to the capital gain into a QOZ fund within this extended 180-day period, they receive a number of tax benefits:
- The investor may elect to defer recognition of the gain until the earlier of the date the investor sells their interest in the QOZ, or 2026. Whenever the deferred gain is recognized, the tax basis of the QOZ fund is increased by the gain that is then recognized.
- If the investment in the QOZ fund is held for 5 or more years, the investor will receive a step-up in basis equal to 10 percent of the reinvested gain. That means that, assuming the QOZ investment is held until December 31, 2026, 90 percent of the capital gains tax that would otherwise have been due in 2019 or 2020 will be due December 31, 2026, at the then-prevailing capital gains tax rate.
- If the investment in the QOZ fund is held for at least 10 years, the investor’s tax basis in the QOZ fund will increase to the fair market value on the date of sale, effectively eliminating federal income tax on any appreciation of the fund interest.
Note that if capital gains tax rates do increase, the tax benefit of a QOZ investment compared to a traditional investment could become even more advantageous given the elimination of tax on the QOZ fund appreciation.