The Wrap Podcast | Episode 067 | Adapting to the Evolving Financial Landscape of the Private Equity Industry | Warren Averett

Commentators (0:02): You’re listening to The Wrap, a Warren Averett podcast for businesses designed to help you access vital business information and trends when you need it. So, you can listen, learn and then get on with your day. Now, let’s get down to business.

Kim Hartsock (0:19): Hey, everyone, and welcome to another episode of The Wrap. I’m Kim Hartsock, and I’m excited to be with you today. We are continuing with our series on industries, and today, we’re going to be talking about private equity groups. We have our experts with us. Today, we have Adam, David and Floyd. So welcome, guys, and some of you welcome back to the podcast. We’re excited to have you today.

Adam West (0:41): Hey, I’m Adam West. I’ve been with the firm for about 12 or 13 years now, and I spend a large part of my practice in the private equity space.

Floyd Holliman (0:50): I’m Floyd Holliman, and I’ve been with the firm for about 16 years. I also spend a large part of my time in the private equity space.

David LeGrand (0:57): I’m David LeGrand, I’m a Member in the Tax Division of our firm, and I specialize in merger and acquisition tax work.

Kim Hartsock (1:03): We’re really excited to have you guys here today. I know you are the experts, and I know you have a lot of information to share with our listeners. So, we’re going to jump right in. David, I’m going to start with you. What are the challenges or opportunities for private equity groups that you’re seeing that other industries are not? How common are the challenges that they’re facing with all the other industries?

David LeGrand (1:27): Thanks, Kim. A lot of what we’ve seen in the last 12 or 24 months is that a lot of these tax issues aren’t necessarily unique to PE, but they’re impacting businesses across multiple industries and are also significantly impacting private equity in their portfolio companies. A lot of these that we’re going to talk about come from the Tax Cuts and Jobs Act of 2017. When a big tax package is rolling through Congress and rolling through the legislative branch, they like to score it with CBO—the Congressional Budget Office. They have a 10-year period that they look at it. So, to make the math work for what they were negotiating, they took the last five years, and they have some pseudo-hidden revenue raisers backed into it. That’s coming into play starting in tax year 2022, kind of a 10-year mark from 2017 to 2026.

Starting in 2022, there are some of these revenue raisers in there that are impacting a lot of the timing of these deductions that business clients are used to having when they make tax distributions out of their portfolio companies or up to their investors to make tax payments.

These couple of issues that we’re going to talk about today are the issues that we’re seeing most often in the last, like I said, 12 to 24 months. Okay, so the first issue that we wanted to look at today was with respect to business interest and the way that the tax law used to work up to tax year 2022. Through 2021, your business interest was capped at effectively 30% of taxable EBITDA—which is earnings before interest, taxes, depreciation and amortization. Starting in tax year 2022, you were no longer allowed to add back depreciation and tax amortization to the formula.

If you have a lot of tax depreciation and tax amortization, which is usually a really large number for private equity investments, because of the way they structured their acquisitions, they get this taxable goodwill that’s amortizable and deductible, so that becomes a big number. It alters the formula to where business interest deductions are delayed in greater amounts than they were prior to this 2022 change. So, the change of the formula in business interest is a particularly big issue for private equity.

The other piece of this is that we see this hitting private equity a lot because they have a propensity to leverage up their portfolio investments with debt to increase their rate of return when they have an exit. So, interest rates being off, there’s a lot of debt and they have a lot of goodwill amortization.

With just the way the tax law works and this change in 2022 where you can no longer add back depreciation and amortization to the formula, it is becoming a big issue for private equity portfolio companies with respect to the timing of business interest deductions.

Adam West (4:01): David, just to piggyback off that, I think there is a planning opportunity out there for businesses that have inventory, to look at potentially capitalizing some of their interest and deducting it as their inventory is sold. So that’s a planning opportunity to help mitigate that penal provision of not being able to add back your depreciation and amortization.

David LeGrand (4:27): That’s a great point, Adam.

Kim Hartsock (4:30): Floyd, I know where you sit in the firm, you do a lot of specialty tax projects. So, what are you seeing as it relates to private equity?

Floyd Holliman (4:38): Kim, one of the things we’re seeing is starting in 2022, companies that incur research and development cost—also known as Section 174 cost—must capitalize those over five years for R&D cost incurred in the U.S. and 15 years for R&D costs incurred outside the U.S. I do want to point out that this is not an elective, and this is something that you have to implement starting in 2022 if you do have R&D costs. Prior to 2022, companies with R&D costs could expense those costs in the year they incurred them. So, this is a big change.

Just to go over in general what these costs include: all costs incidental to the development or improvement of a product or activities intended to discover information that would eliminate uncertainty—these are the types of costs that are pulled into this new tax law. These are pretty broad, as you can see. Some specifics related to these are the salaries of people doing R&D in your organization—or outside contractors that may be doing R&D for your company—as well as supplies used up in the R&D process and any overhead that may be related to R&D activities also have to be pulled in and capitalized starting in 2022.

Kim Hartsock (6:02): So, companies that are in the business of doing those things, which could be a pretty significant number that they’re having to add back.

Floyd Holliman (6:11): Very large negative tax impact on companies with high levels of R&D activity. Kim, it is worth noting that it’s a timing difference. The company does still get the deduction, it’s just over five years, typically, or 15 years for non-U.S. R&D. So, in general, it’s a timing difference. But there’s a very negative part of this law for companies that may be prepared to sell. If you’re selling a company, this becomes a permanent item, because if you’ve got any unamortized expense sitting there when you sell, you lose that and that goes over to the buyer. Not only do you lose that expense, but you also do not get to take the unamortized expenditures as basis against your gain or loss. It’s really a double whammy, and it’s a permanent change. This is really having a negative impact on companies that are getting ready to sell that have some unamortized R&D expenditures.

But along those same lines, another opportunity that exists with these R&D costs is the R&D tax credit, which has been in existence since 1981. It provides a valuable credit for taxpayers with R&D costs. Now, while these R&D costs related to the R&D credit are very similar to the R&D costs that must be capitalized under this new tax law that we were just talking about, the tax law has no effect on the R&D credit. So, the R&D credit still exists as it did in the past and will help mitigate some of the negative impact of the law requiring the capitalization of these R&D costs. If you have costs that must be capitalized, it just makes sense to take the R&D credit to go ahead and mitigate some of the negative impact of that new law.

Kim Hartsock (8:11): That’s good to know. For companies that haven’t taken advantage of the R&D tax credit in the past, they need to consider that, knowing now that they’ve had this change with the way that they can expense those expenditures.

David LeGrand (8:26): Exactly, yeah. Kim, along with Section 174 that Floyd’s talking about and the business interest and bonus depreciation, the ability to let taxpayers effectively expense capital expenditures one hundred percent is being phased out starting in tax year 2023. So, this year, it’s going to eighty percent. The next year sixty percent, then forty percent, then twenty percent, then gone, assuming nobody changes the tax law between now and 2026.

But at any rate, if you’re capital intensive, if you’re buying a lot of equipment, if you’re a manufacturer or distributor, if you’re in construction or if you’re doing something where you’re buying a lot of capital equipment, and you’ve been counting on that bonus depreciation to accelerate that deduction—that’s going to be getting phased down. It’s also going to be another one of those revenue raisers that’s on the back end of that 10-year period that we talked about. So, I think bonus depreciation is another one to really watch and see if that law changes.

There’s some momentum, hopefully, that people are looking at changing the 174 capitalization that Floyd was talking about. Looking at this business interest deduction formula, then also bonus depreciation. These were very popular tax provisions in the tax law prior to the implementation of these changes.

Floyd Holliman (9:36): Good point, David. We are seeing a lot of legislative activity around overturning some of these laws. We just don’t know. As of today, it’s still the law and that’s what we need to plan for, but hopefully we’ll see some relief in the future.

Kim Hartsock (9:52): Adam, I know you’ve done a lot of work with the employee retention tax credits. What are you seeing that specifically relates to private equity groups?

Adam West (10:03): Yeah, there’s been a lot going on when it comes to the employee retention tax credit (ERTC). I think one of the biggest things over the last few months has been the moratorium that the IRS put in place. It’s basically where the IRS said, “Hey, we’re not going to process any additional claims until early 2024.”

They’ve introduced a withdrawal process to where taxpayers that have filed claims that have not been paid, the taxpayers can withdraw those claims penalty free. I think as it relates to private equity, we’re seeing ERTC become a deal item; it’s simply because of all the scrutiny around it. When a portfolio company has claimed ERTC, I think they need to look at their documentation for it.

Did they apply it to the gross receipts test—which is more black and white—or are they applying under the partial shutdown test—which can be very subjective? Now would be a great time, if you did apply under that partial shutdown test—and even if you’re not being audited by the IRS—to really go back and look through your documentation and beef it up, because we do think it will be something that a potential buyer down the road is going to look at very closely.

Kim Hartsock (11:16): So, these are all pretty significant changes that business owners and leaders are having to face. What would you tell leaders that are listening on this podcast today? What should they do to position their organizations for success in the future? Floyd, we’ll start with you.

Floyd Holliman (11:33): Kim, I would say if you had R&D activities, talk to your tax advisor to identify the research expenses that must be capitalized so that you can properly budget for the upcoming tax liability for 2022, 2023 and 2024. Also, if you have R&D activities that must be capitalized, I will say strongly consider taking the R&D tax credit to mitigate some of the additional tax burden created by this new law.

Kim Hartsock (12:05): David, how about you?

David LeGrand (12:07): I would just say—like Floyd was saying—that planning for these things is key. I would look at your business interest. Look at that formula. Make sure you’re modeling it out, so you don’t have a big cash tax outlay surprise when you do your tax distributions. I’d look at bonus depreciation, if you’re capital intensive, but definitely look at the business interest.

Adam West (12:24): I think for the ERTC, the biggest thing is to make sure that you have your documentation in order. We’ve seen a lot of situations where a company has applied for millions of dollars of tax credits with only a few pages of support for the government orders or the support showing why they qualified. So, I think maintaining contemporaneous documentation that outlines your position is important, because even if you’re not audited by the IRS, we’re seeing it become a deal point. I think it’s just something you’ve got to be ready for. If you do have a claim that you’ve filed and you’re unsure of your position, now would be a good time to address it.

Kim Hartsock (13:09): So here on The Wrap, we always like to wrap it up in 60 seconds or less. So, David, what would you want to leave the listeners with today?

David LeGrand (13:17): I would just encourage everybody to do a lot of planning and a lot of forecasting to look at these specific areas of the tax law. We’re just seeing it hit clients over and repeatedly the last year or two. So, I would just try to get with your advisors and model out the business interests, the R&D credit and the capitalized expenses. I would look at any ERTC claims you have. Then, if you’re capital intensive, I would look at bonus depreciation and just try to model this out, so you don’t have any surprises. Just please reach out to us. We’d love to help.

Kim Hartsock (13:46): Thank you guys for being with us today. And thanks for listening. We’ll see you next time.

Floyd Holliman (13:50): Thanks for having us.

David LeGrand (13:52): Thanks, Kim. We appreciate it.

Adam West (13:53): Always enjoy coming on, Kim. Thank you.

Commentators (13:55): And that’s a wrap. If you’re enjoying the podcast, please leave a review on your streaming platform. To check out more episodes, subscribe to the podcast series or make a suggestion of other topics you want to hear, visit us at https://warrenaverett.com/thewrap