What Trump’s one-page tax-reform proposal means for private equity

The tax-reform document the Trump administration released last week was short on details, weighing in at one sparsely worded page. “Half of it isn’t even substantive,” said tax attorney Gary M. Friedman, a partner at Debevoise & Plimpton. “The first portion of it talks about general principles, competitiveness, simplification, relief to middle-class families, matters like that.”

But with the stakes so high, the bare-bones bullet points have been scrutinized for what they might foretell about the shape of proposals to come. For private equity, the document’s most noteworthy feature was probably its total silence on carried interest, which candidate Donald Trump pledged to tax as ordinary income.

White House sources have said the president still intends to eliminate carry. But it’s also been suggested that the question could be moot, in light of something that did make it on the sheet: “15 percent business tax rate.”

According to The Wall Street Journal, that represents not just the corporate rate but also the maximum tax on pass-through or flow-through businesses, whose profits pass to their owners as personal income. The New York Times reported, “it appears that if the Trump plan is enacted, private equity executives would not just avoid higher taxation; their taxes would actually decline,” since partnerships would be taxed at the new, reduced pass-through rate.

Experts consulted by Buyouts weren’t so sure. “Private equity makes its money on capital gains, and it looks as though the capital gains rate will be reduced a bit,” said Friedman. Right now the rate is effectively 23.8 percent because of the Medicare tax introduced as part of Obamacare. Trump’s plan would eliminate that, lowering the rate to 20 percent.

But according to Friedman, “that has nothing to do with the 15 percent rate that the president is proposing for business income of a partnership.” While some PE funds invest in so-called open structures, in which assets are treated as flow-through entities for tax purposes, Friedman explained that there are complications to this approach.

“The reason why you wouldn’t just automatically make your target companies transparent is that it causes all the LPs to have to file tax returns sometimes in all 50 states, depending on where the target is active, and the compliance cost of those open structures can be substantial. So some private equity firms choose to acquire targets and keep them in corporate solution, as we say, rather than make them transparent.”

David Saltzman, a tax partner at Ropes & Gray, said the 15 percent proposal “seems like it’s intended to be a rate-lowering exercise for a lot of business income in the country because huge amounts of this economy are in pass-through form, small businesses and some very large businesses, too. The Koch brothers would be one example of an enormous business that’s operating as an S corporation.”

But Saltzman was cautious about applying that rate to alternative-asset managers, whose income derives from investment or trading activity. “What’s fair to say is that in this structure, there may be opportunity for private equity investors to now themselves directly invest in an underlying partnership that may pass 15 percent taxed income to them,” he said. It all depends on the tax code’s specific provisions: “You can’t underestimate the government’s ability to write rules.”

Saltzman interpreted the terse document as staying “strategically silent” on key issues, including aspects of House Speaker Paul Ryan’s tax-reform blueprint. In addition to carried interest, the document said nothing about a border adjustment tax, or — of paramount importance to PE — interest-expense deductibility.

“Trump has twice before raised that as a potential limitation or elimination of a prior benefit, and the House proposal totally eliminates it, and he stayed silent,” Saltzman said. “And I think that’s because this document was not intended to provoke controversy. It was intended to create enthusiasm and broad-based support for a process that many people think hasn’t been proceeding quickly enough.”

The administration has thus given itself maximum room to maneuver in negotiations with Congress, while also touting cuts from which most taxpayers would benefit. Omitting any mention of offsets, which tax reform proposals traditionally include, left the White House open to charges of amateurishness, but Saltzman said, “I see more intentionality than incompetence.”

Another tax question with implications for private equity is territoriality. In contrast to today’s system, which encourages dividends from overseas subsidiaries to be invested outside the United States, a territorial system would exempt U.S. multinationals from paying a penalty to repatriate foreign earnings.

Trump’s proposal includes this change, “which could very well mean that strategic buyers would become formidable competitors to private equity when pursuing transactions,” Friedman said. “If there’s a target out there that both private equity and strategic buyers are interested in, strategics may well be flush with cash as a result of the territorial system.”

The switch to territoriality would also entail a one-time tax on all offshore earnings, at a rate to be determined. Trump’s paper did not specify how much, though the administration has floated a 10 percent repatriation penalty. The Ryan blueprint would tax foreign earnings in cash or cash equivalents at 8.75 percent and all other accumulated foreign earnings at 3.5 percent, payable over an eight-year period. Though that represents an enormous discount, it could strain highly levered U.S. multinationals held by PE firms, Friedman said.

Action Item: Reach the attorneys: gmfriedman@debevoise.com and David.Saltzman@ropesgray.com

David Saltzman, a tax partner at Ropes & Gray. Photo courtesy of the firm.