Private equity firms are entering a critical time where they will be facing greater regulatory demands. In addition, private equity firms must prepare for higher tax burdens and compliance requirements, while dealing with the uncertainty of further tax legislation. In this issue of the Tax Insight, we discuss recently passed legislation, as well as proposed legislation, which could significantly impact private equity firms.

Medicare Surtax

On January 1, a new Medicare surtax took effect and will have a significant impact on the private equity world. For individuals, the Medicare tax of 3.8% applies to the lesser of the following:

• Net investment income for the year, or
• The excess of Modified Adjusted Gross Income less the threshold amount.
• (Threshold amount is $250,000 married filing joint, $125,000 married filing separate and $200,000 for anything else (not indexed for inflation))

For estates and trusts, the Medicare tax of 3.8% applies to the lesser of the following:

• Undistributed net investment income for the year, or
• The excess of Adjusted Gross Income over the dollar amount at which the highest tax bracket begins for the year.

Net investment income includes gross income from the following sources:

• Interest
• Dividends
• Annuities
• Royalties
• Rents
• Net gain attributable to the disposition of property other than property held in a trade or_business.
• Deductions related to the income subject to the tax are allowed to offset gross income.

Executive Compensation

In recent years, various forms of executive compensation have become popular, notably carried interest, resulting in much scrutiny, particularly in how these forms of compensation are taxed. Congress is concerned that managers of partnerships are able to receive income for performance of services taxed at the 15% capital gains rate, rather than the ordinary income tax rate. To address this issue, Representative Sander Levin introduced the H.R. 1935 bill in 2009. Under the proposed legislation, carried interest compensation would be treated as ordinary income rather than capital gains. While the Bill was passed by the House of Representatives, it has not been passed by the Senate. If the legislation is eventually passed, it will be a fundamental change in partnership taxation.

Another issue with respect to carried interest is treatment of the enterprise value tax. The enterprise value tax relates to the goodwill behind a private equity firm’s identifiable assets, i.e. the value of the partnership over its physical assets. Recent proposed legislation provides that the enterprise value tax should not be treated as part of the carried interest. If the legislation is passed, valuing the enterprise value tax will be a complex task that requires the skill of an experienced valuation professional.

Waived fee programs are another contentious issue in the private equity world. In a waived fee program, the general partner (GP) funds its co-investment obligation with waived fees rather than cash. The waived fee amount is eventually paid from future profits. Ordinary income is converted to capital gains and taxed as such. New York Attorney General Eric T. Schneiderman is said to be investigating PE firms that are utilizing this strategy.

FATCA

Congress passed the Foreign Account Tax Compliance Act (FATCA) in 2010 to target non-compliance by U.S. taxpayers using foreign accounts. The purpose of FATCA is two-fold: 1) to prevent offshore tax evasion, and 2) to improve transparency through information reporting and documentation requirements.

The implication of the FATCA regulations on private equity and hedge funds is significant. A major provision which will impact PE firms is the 30% withholding tax on any “withholdable payment” made to the following:

• Foreign financial institutions (FFI) – includes banks, broker-dealers, trust companies, custodians, retirement
• plans, mutual funds, fund of funds, hedge funds, private equity and venture capital funds, and other
• managed funds and investment vehicles.
• Non-financial foreign entity (NFFE) that does not report information on U.S. holders to the IRS.

The withholdable payment refers to interest, dividends, rents, and FDAP (fixed or determinable annual or periodical) income from sources within the U.S., or gross proceeds from sale or other disposition of any property type which can produce interest or dividends from sources within the U.S. A 30% withholding tax will apply unless the FFI has entered into an FFI agreement with the IRS.

In an upcoming issue of the Tax Insight, we will provide a deeper discussion of the FATCA requirements. At VRC, our professionals understand the valuation requirements impacting private equity firms. For more information contact your VRC representative.