April 4, 2022

Biden’s second (attempted) bite at the private equity apple: Key 2023 Green Book proposals impacting private equity funds and their investors

Randy Buchanan, Robert Chase II, Frank Comparetto III, Xenia Garofalo, Clifford Muller, Jonathan Sambur, Wes Sheumaker

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Eversheds Sutherland (US) LLP On March 28, 2022, the Biden Administration released the 2023 Fiscal Year Budget (the Budget) followed by the release of the Treasury’s Green Book, which provides explanations of the Biden Administration’s revenue proposals. Of the numerous tax proposals, several are of critical importance to private equity funds, their sponsors and investors. At the core of the Biden Administration’s proposals is “ensuring that the wealthiest Americans and the biggest corporations begin to pay their fair share.”¹ A brief summary of certain key tax proposals impacting the private equity fund universe is below.

Increase in top marginal tax rate

Under the Biden Administration’s proposals, the top marginal tax rate would be increased to 39.6% for taxable income over $450,000 for married individuals filing a joint return, $400,000 for unmarried individuals (other than surviving spouses), $425,000 for head of household filers, and $225,000 for married individuals filing a separate return.

Further, a minimum tax of 20% on total income, generally inclusive of unrealized capital gains, is proposed for all taxpayers with wealth exceeding $100 million (the so-called billionaire’s tax). For purposes of the minimum tax, such tax liability would equal 20% times the sum of taxable income and unrealized gains (including on ordinary assets) of the taxpayer, less the sum of the taxpayer’s unrefunded, uncredited prepayments and regular tax.

Eversheds Sutherland Observation: Private equity fund sponsors, managers and investors are likely to fall into the highest marginal tax bracket and be subjected to an increased individual tax rate and a potential minimum tax on total income, which includes unrealized gains. However, the billionaire’s tax may be dead on arrival, with key vote Senator Joe Manchin (D-WV) opposing the tax, stating “I don’t like the connotation that we’re targeting different people,” and specifically those who “contributed to society” and “create a lot of jobs and invest a lot of money and give a lot to philanthropic pursuits.”² However, Manchin “remains seriously concerned about the financial status of our country and believes fighting inflation by restoring fairness to our tax system and paying down our national debt must be our first priority.”³ A compromise between the Biden Administration’s proposal and Manchin’s opposition is likely, as Democrats hope to make progress on the Budget before November midterms.

Increase in tax rate of capital gains

The Biden Administration also proposes to tax long-term capital gains and qualified dividends as ordinary income for taxpayers with taxable income of more than $1 million ($500,000 for married filing separately). The increased rate would apply to gains on income in excess of $1,000,000. For example, a taxpayer with $1,100,000 in taxable income of which $200,000 is preferential capital income would have $100,000 of capital income taxed at the preferential rate and $100,000 taxed at ordinary rates.

Eversheds Sutherland Observation: High-earning taxpayers are doubly hit, with a potential increased individual rate and an elimination of the capital gains tax rate preference for gains on income in excess of $1,000,000. Further, even if changes to the taxation of carried interest are not made (as described below), carried interest recipients are likely to be caught by this increase in capital gains tax rate. The increase in the capital gains tax rate for high earners goes further than the September 2021 proposal from House Democrats, which would have increased the top rate to 25%.⁴

Taxation of carried interest as ordinary income

Currently, carried interest receives a preferential capital gains tax rate, subject to certain restrictions. The Biden Administration’s proposal largely mirrors the 2022 Green Book proposal, and would tax a partner’s share of income on an “investment services partnership interest” in an investment partnership as ordinary income for partners with taxable income (from all sources) exceeding $400,000 (with the section 1061 rules continuing to apply to taxpayers with taxable income below $400,000). This change in the character of taxation at the partner level would apply regardless of the character of the income at the partnership level. Impacted taxpayers should note that the Biden Administration's proposal to increase the top long-term capital gain tax rate for gains on income in excess of $1,000,000 to the top ordinary-income tax rate similarly lessens the tax benefits arising from carried interest arrangements, although the carried interest proposal is distinguishable because it also subjects carried interest income to the self-employment tax regime.

The proposed amendments to the taxation of carried interest would significantly impact the economic returns that sponsors and fund managers receive and may ultimately result in more strategic negotiations and planning in respect of current and future carried interest arrangements.

Eversheds Sutherland Observation: To continue to incentivize top fund managers, sponsors and their employees, it is possible that the proposed changes in the taxation of carried interest may result in negotiations for increased management fees or increased carried interest percentages to account for the difference in tax treatment. Further, where existing fund agreements permit sponsors to unilaterally amend fund documents or restructure the fund or its investments to address adverse effects due to changes in tax laws, sponsors may seek to make changes to compensate for their reduced after-tax return. However, investors ─ particularly those that would be adversely impacted by the billionaire’s tax or the Biden Administration's proposal to increase the top long-term capital gain tax rate for gains on income in excess of $1,000,000 to the top ordinary-income tax rate ─ would likely receive any such changes poorly and carefully consider the sponsors with which to invest capital based on a sponsor’s approach to address the tax proposals, if enacted.

The carried interest proposal is likely to see support from Sen. Ron Wyden (D-OR), who proposed a bill targeting the taxation of carried interest in August 2021 that “would close the entire carried interest loophole – re-characterization of income from wage-like income to lower-taxed investment income and deferral of tax payments.”⁵

Increase in the corporate income tax rate to 28%

The Biden Administration proposes to increase the corporate tax rate to 28%, in a partial return to the pre-Tax Cuts and Jobs Act maximum corporate tax rate.

To the extent that a fund structure contemplates the use of US blockers, fund sponsors will need to take the increased corporate tax rate into account when modeling investment returns. This is particularly important to the extent US blockers will hold US and non-US assets.

Eversheds Sutherland Observation: A fund that holds US and non-US assets through a US blocker may want to consider whether it should restructure its investments depending on the percentage of US to non-US assets the US blocker holds. Certain fund agreements may unilaterally allow sponsors to restructure investments to account for changes in tax laws, and certain anchor or high-profile fund investors may have side letter provisions that require a restructuring to the extent it increases tax efficiency.

Amend partnership audit rules

Currently, the centralized partnership audit rules promulgated under the Bipartisan Budget Act of 2015 (the BBA Rules) only apply to income tax. The Biden Administration’s proposal largely mirrors the 2022 Green Book and would amend the BBA Rules to also cover adjustments to self-employment income tax and net investment income tax. This change is intended to further streamline the audit procedures for partnerships.

In addition, the Biden Administration proposed an amendment to the BBA Rules to provide that the amount of a reviewed-year partner’s net negative change in tax arising from an audited partnership push-out election under section 6226 that exceeds such partner’s income tax liability in the reporting year would be refundable so that the excess amount is prevented from being permanently lost. To the extent a fund utilizes push-out elections, this change would be beneficial for impacted limited partners.

Expand access to retroactive “QEF” elections

In connection with passive foreign investment company (PFIC) investments, US investors that make qualified electing fund (QEF) elections are able to avoid certain adverse tax consequences (i.e., tax on excess distributions). Under current law, if a QEF election inadvertently is not made, a taxpayer may only seek relief under a special consent procedure. The Biden Administration’s proposal would allow a taxpayer to obtain retroactive QEF elections without requesting consent, subject to certain regulatory requirements.

Eversheds Sutherland Observation: Given the sophistication of most private equity funds and their investors, an inadvertent failure to make a QEF election would be uncommon. However, expatriates that invest through offshore fund vehicles that are not accustomed to accommodating PFIC concerns or assisting with QEF elections may find the expanded relief useful.

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¹ FY 2023 Budget, The Budget Message of the President, at 2, available at https://www.whitehouse.gov/wp-content/uploads/2022/03/budget_fy2023.pdf (Mar. 28, 2022).

² https://www.nytimes.com/2021/10/27/us/politics/manchin-billionaires-tax.html?msclkid=bf5a18a9afbc11ec9778954af13b2ebb.

³ https://abcnews.go.com/Business/wireStory/biden-budget-manchin-priorities-tax-rich-cut-deficit-83733492?msclkid=dad30caeafb911eca967717e10d84c34.

⁴ https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SubtitleISxS.pdf.

⁵ https://www.finance.senate.gov/chairmans-news/wyden-whitehouse-bill-ensures-private-equity-moguls-pay-fair-share-in-taxes.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.