Keeping Taxes At Bay In 2008

Another tax season has come and gone, so what better time to roll out top tax-reduction strategies for 2008.

Credit the following four tips to Stefan R. Boshkov, a partner at law firm Nixon Peabody LLP who has spent the last 30-odd years advising buyout firms, venture firms, hedge funds and others on how to minimize their tax bills.

Convert Your Management Fees. How would you like to lower your tax bill, as well as that of your limited partners? Many of you already know the trick—converting management fees to carried interest. But with the clock potentially ticking on the 15 percent tax rate on carried interest, now is the time to push the envelope. Simply waive as much of the management fee as you can afford to, agreeing instead to take your fee out of later partnership profits. You pay 15 percent capital gains instead of the 35 percent ordinary income rate. Your taxable LPs get a break too. They often won’t be able to deduct management fees as an expense on their tax returns; but by getting fewer profits down the road, they pay less tax on those profits. One downside to the strategy is the possibility that your fund never becomes profitable enough to cover your management fee. The IRS also could challenge the technique on the argument that the capital gains tax rate wasn’t meant to apply to deferred income for services—even if that income is put at risk.

Convert Stock Sales To Asset Sales. Buyout firms often engage in acquisitions through holding companies where management intends to roll over a portion of its equity. Where possible, try to construct these transactions as asset sales using the so-called 338H10 tax election. Doing so allows the portfolio company to depreciate and amortize, over several years, the full purchase price of the company, rather than just the book value as in a stock sale. How do you do it? The trick, Boshkov said, is to set up a C corporation as a subsidiary beneath the holding company to perform the actual acquisition. The favorable tax deductions even carry over through the next transaction, making the company more valuable to the next buyer. Is the IRS on board with the approach? Boshkov points to Revenue Ruling 84-44 as proof that the strategy works.

Lobby hard. The industry dodged a tax bullet last year when Congress failed to pass proposed legislation that would treat carried interest as ordinary income, which is taxed as high as 35 percent. But the proposal could be resurrected any time. In addition, local lawmakers are now getting in on the act. New York City, for example, has floated a proposal that would levy a 4 percent tax on carried interest earned by local private equity firms and hedge funds under its Unincorporated Business Tax. (The actual tax paid could be as low as 2 percent after deductions and credits.) Mid-market buyout professionals would be wise to pool resources, hire lobbyists, and take their argument for the tax-friendly status quo to lawmakers before it’s too late.

Don’t Wait On Dividend Recaps. Like capital gains, most dividends get taxed at the favorable rate of just 15 percent. But that provision of the tax code expires at the end of 2010, and many expect that a Democrat-controlled White House and Congress would let it die. That could mean the return to a 35 percent tax rate on dividends for individuals. Given the prospect for a higher tax rate, it’s time to start planning ahead to complete any dividend recapitalizations before the end of 2010.

For more on tax strategies contact Stefan R. Boshkov of Nixon Peabody at 212-940-3068.