CARES Act: Key Tax Provisions Affecting Private Equity Funds and Portfolio Companies
- In addition to other economic stimulus provisions in response to the coronavirus (COVID-19) pandemic, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) implements several important tax provisions intended to provide relief to impacted businesses and affected individuals.
- Private equity funds and their portfolio companies are likely to be direct beneficiaries of these provisions.
- This Holland & Knight alert provides a summary of the CARES Act tax provisions that may significantly impact private equity funds and their portfolio companies.
President Donald Trump signed the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) into law on March 27, 2020. In addition to other stimulus provisions benefitting individuals and businesses in response to the economic distress caused by the coronavirus (COVID-19) pandemic, the CARES Act implements several important tax provisions intended to provide relief to impacted businesses and affected individuals. Private equity funds and their portfolio companies are likely to be direct beneficiaries of these provisions as they affect every business to some degree.
This Holland & Knight alert provides a summary of the CARES Act tax provisions that may significantly impact private equity funds and their portfolio companies.1 (See also Holland & Knight's previous alert, "Business Tax Incentives and Relief Resulting from COVID-19 Response," March 30, 2020.)
Suspension of Net Operating Loss Limitations
The CARES Act relaxes the limitations on carrybacks and carryforwards of net operating losses (NOLs).
The 2017 Tax Cuts and Jobs Act (TCJA) imposed limitations on a business' ability to utilize NOLs for tax years beginning in 2018. The TCJA repealed a business' ability to carryback NOLs to prior tax years and limited the utilization of NOLs in carryforward years to 80 percent of such business' taxable income.
To provide support to businesses incurring losses as a result of COVID-19, the CARES Act:
- suspends the 80 percent of taxable income limit on NOL carryforwards for three years, so that the limit does not apply to tax years beginning in 2018, 2019 and 2020; and
- allows NOLs arising in 2018, 2019 and 2020 to be carried back five years2
Carrying back NOLs may provide immediate refunds for taxes paid in respect of the years to which the NOL is carried. In addition, companies will have reduced tax liabilities as a result of increased NOL deductions from the suspension of the 80 percent limits on NOL carryforwards. In addition to providing tax benefits and additional cash flow to existing portfolio companies, buyers and sellers of corporate portfolio companies should consider these additional tax assets when negotiating their transactions, including factoring into purchase price, rights to pre-closing refunds and control over pre-closing tax returns. Buyers and sellers should also review the tax refund provisions of transactions that have closed since 2018 to determine their rights to any tax refunds attributable to NOL carrybacks.
Temporary Suspension of Limitation on Excess Business Losses for Noncorporate Taxpayers
The TCJA limited a noncorporate taxpayer's ability to deduct "excess business losses" for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026 (Code Section 461(l)). Excess business losses are the amount by which the total deductions attributable to all of a taxpayer's trades or businesses exceed such taxpayer's total gross income and gains attributable to those trades or businesses plus $250,000 (or $500,000 in the case of a joint return). The rules effectively limit a taxpayer's ability to use business deductions to offset nonbusiness income. Disallowed losses would be carried forward as NOLs. The TCJA made this limitation effective for tax years starting on Jan. 1, 2018, or later.
The CARES Act retroactively delays the application of this limitation to tax years starting on Jan. 1, 2021, or later (Code Section 461(l)). As a result, excess business losses that would otherwise be disallowed for taxable years 2018 through 2020 will be permitted (i.e., receive the same treatment as if the TCJA had not been enacted). This may result in significant tax refunds for 2018 and 2019.
Temporary Modification of Net Business Interest Deduction Limitation
Under the TCJA, starting in 2018, the amount of a taxpayer's deductible business interest expense was generally limited to the sum of 1) the taxpayer's business interest income for the year, 2) 30 percent of the taxpayer's "adjusted taxable income" for the year and 3) the taxpayer's floor plan financing interest expense for the year (Code Section 163(j)). Disallowed interest may be carried forward indefinitely.
The CARES Act increases the adjusted taxable income limit from 30 percent to 50 percent for tax years 2019 and 2020. Taxpayers may elect to use their 2019 adjusted taxable income for the purpose of calculating its 2020 interest deduction limitation.
Special rules apply to partnerships, and the increased limitation is only allowed for the partnership's 2020 taxable year. In the case of excess business interest expenses allocated to a partner from a partnership for a taxable year beginning in 2019, 50 percent of such excess business interest expense is treated as fully deductible by the partner in 2020 with the remaining 50 percent of such excess business interest expense subject to the 30 percent limitation and carryforward rules.
The increased availability of interest deductions is expected to provide significant relief to highly leveraged businesses and private equity funds by reducing cash taxes payable or generating or increasing NOLs that, as noted above, are now able to be utilized more freely.
Employee Retention Credit
The CARES Act provides "eligible" employers a refundable credit against payroll tax (Social Security and Railroad Retirement) liability equal to 50 percent of the first $10,000 in wages per employee (including the value of health plan benefits).3 An eligible employer includes employers that were carrying on a trade or business during 2020 and which experienced either 1) a full or partial suspension of business operations because of orders from a governmental entity, or 2) a year-over-year (comparing calendar quarters) reduction in gross receipts of at least 50 percent – (until gross receipts exceed 80 percent year-over-year).
For employers with more than 100 full-time employees, qualified wages only include those paid to employees who are not providing services because of the foregoing suspensions of their employer's trade or business or reduced gross receipts. Employers with fewer than 100 full-time employees may include all employee wages, notwithstanding the operations of such businesses.
The credit applies to wages paid after March 12, 2020, and before Jan. 1, 2021.
Employers are not eligible for this credit if the employer receives a small business interruption loan pursuant to Section 1102 of the CARES Act. Additional limits to this credit arise where the taxpayer takes advantage of certain other business tax credits.
Deferral of Employer Payroll and Self-Employment Taxes
The CARES Act permits most employers to defer payment of the employer portion of Social Security payroll taxes (i.e., FICA taxes but not Medicare taxes) attributable to wages paid during 2020 (after the enactment of the CARES Act) and permits deferral of payment of one-half of the payroll tax paid by self-employed taxpayers (one-half of the 12.4 percent).
The deferred amounts are due – half by Dec. 31, 2021, and half by Dec. 31, 2022.
Employers that receive loan forgiveness under Section 1106 (the Paycheck Protection Loan Program) or Section 1109 of the CARES Act are not eligible for these deferral measures.
Acceleration of Corporate AMT Credits
The TCJA repealed the corporate alternative minimum tax (AMT) and allowed a refundable credit for AMT paid in prior tax years to be used against a corporation's tax liabilities in taxable years 2018, 2019, 2020 and 2021 (Code Section 53).4 Under the TCJA 50 percent of the remaining AMT credit is refundable in taxable years 2018-2020 and 100 percent for the taxable year beginning in 2021.
The CARES Act modifies the credit so that corporations may take the entire amount in 2018 and 2019. Corporations may also elect to take the entire refundable credit amount in 2018.
Exclusively for purposes of the refundable AMT credit, a taxpayer may file an application for a tentative refund with the Internal Revenue Service (IRS), which then must review the application and, if appropriate, issue the related refund within 90 days.
The acceleration of a corporation's ability to recover AMT refundable credits should result in additional cash flow that can be used to address the impacts of COVID-19.
Technical Correction: Bonus Depreciation for Qualified Improvement Property
The CARES Act clarifies the bonus depreciation rules under Section 168(k) of the Code.
The TCJA permitted taxpayers to claim 100 percent bonus depreciation deductions for certain types of "qualified property," which included property with a depreciable life of 20 years or less. While these rules permit immediate expensing for equipment and other capital assets, it was intended to also apply to certain structural improvements made to commercial properties (i.e., retail establishments, restaurants, hotels). The TCJA failed to amend the general 39-year recovery period for these improvements to the interior of a nonresidential building (so-called "qualified improvement property") and thus they were not ultimately eligible for bonus depreciation.
The CARES Act corrects the drafting error by assigning a 15-year depreciable life to qualified improvement property, thereby allowing it to be characterized as "qualified property" eligible for bonus depreciation. The provision is effective retroactively to property placed in service in 2018 and beyond.
The CARES Act also revises the definition of "qualified improvement property" to limit that concept to "improvements made by the taxpayer" thereby eliminating the possibility of the taxpayer getting bonus depreciation for "used" property that was purchased by the taxpayer.5
This amendment permitting additional property to be immediately expensed under Internal Revenue Code (IRC) § 168(k) through tax years beginning in 2022 will increase the cash flow of affected businesses by allowing them to amend a prior year return (i.e., tax year 2018) and receive a refund. The provision should also incentivize affected industries to invest in improvements.
IRS Notice 2020-18: Extension of Filing and Payment Deadlines
In addition to changes to the IRC under the CARES Act, the IRS has issued Notice 2020-18 (expanding on the previously released Notice 2020-17), which extends the due date for filing individual and corporate federal income tax returns from April 15, 2020, to July 15, 2020. Notice 2020-18 also applies to payments of tax on self-employment income and federal estimated income tax payments.
Affected taxpayers need not file Forms 4868 or 7004. In addition, there is no limitation on the amount of the payment that may be postponed and no interest, penalties or additions to tax with respect to such returns or payments will accrue during such postponement.
Interestingly, while the estimated tax payments due April 15 are due July 15, Notice 2020-18 did not provide relief to the June 15, 2020, due date for second-quarter estimated tax payments.
The IRS has issued a question-and-answer page expanding on the provisions of Notice 2020-18.
Additional TCJA Technical Corrections
The CARES Act provides a few additional TCJA technical corrections:
- NOLs of Fiscal Year 2018 Corporations. The TCJA had prevented fiscal year taxpayers that incurred an NOL in a tax year beginning prior to the effective date of the TCJA and ending in 2018 from being carried back. The CARES Act provides a technical correction to the TCJA permitting fiscal year taxpayers who had NOLs arising in a tax year that began prior to Dec. 31, 2017, and ended after Dec. 31, 2017, (i.e., during 2018) with the ability to carry back those NOLs. For purposes of this carryback claim, the carryback claim is deemed timely filed only if it is filed no later than 120 days after the enactment of the CARES Act.
- Clarifications to Excess Business Loss Limitations. The CARES Act provides a number of technical amendments related to excess business losses including clarifying how excess business losses are to be carried forward to subsequent taxable years and provisions regarding the items included in the calculation of excess business losses (i.e., excess business losses to be determined without regard to income earned or deductions incurred as an employee or certain gains and losses from sales or exchanges of capital assets).
Section 139: Qualified Disaster Relief Payments
Employers considering issuing payments to employees to alleviate the COVID-19-related financial impact can deduct these expenses as disaster relief under Tax Code Section 139. As a result of President Trump's declaration under the Stafford Act on March 13, 2020, the impact of coronavirus is a "qualified disaster" for Section 139 purposes.6 Code Section 139 provides that "qualified disaster relief payments" made by employers to employees are not treated as taxable income to employees and remain fully deductible to the employer as a business expense. In addition to being exempt from income and payroll taxes, such payments are not subject to information reporting on either Forms W-2 or Forms 1099-MISC.
A "qualified disaster relief payment" includes any amount paid to reimburse or pay reasonable and necessary personal, family, living or funeral expenses (not otherwise compensated for by insurance) incurred because of a qualified disaster. No regulations have been issued to provide guidance on which expenses and under what circumstances reimbursement or payments may occur. There is also no cap on the amount of assistance that may be provided to an employee under Section 139 other than it must be "reasonable and necessary." In Revenue Ruling 2003-12 the IRS addressed a "presidentially declared disaster area" resulting from a flood. Under the ruling, grants made to employees to pay or reimburse certain reasonable medical, housing and transportation expenses were treated as qualified disaster relief payments even where the recipients were not required to account for actual expenses incurred.
To be excluded from taxable income, disaster relief payments must not include: 1) payments for expenses paid for by insurance or other reimbursements; or 2) income replacement payments, such as payments of lost wages, lost business income or unemployment compensation.
Assuming the requirements of Section 139 are satisfied, an employer may provide financial assistance to employees on a tax-free basis by reimbursing or providing in-kind benefits reasonably believed by the employer to result from the coronavirus that are not covered by insurance. Such disaster relief payments can include reasonable and necessary personal, family, living or funeral expenses incurred as a result of a qualified disaster, as well as any governmental payments to individuals and business entities affected by a qualified disaster.7
As a best practice, employers should consider establishing a program or adopting an administrative system that validates payments to meet the Section 139 requirements. Such a system can include an application or statement from the employee that the requested funds are necessary for expenses associated with the coronavirus and confirming that such expenses are not reimbursable by insurance.
This alert is intended as a general summary of the relevant provisions of the CARES Act. It does not describe every aspect of these provisions or the possible interrelationship of these provisions with other provisions of the tax law that may be applicable to a taxpayer's particular situation. These provisions may also be subject to further interpretation by regulation or IRS guidance. For more information or to discuss these or other CARES Act provisions, contact the authors.
DISCLAIMER: Please note that the situation surrounding COVID-19 is evolving and that the subject matter discussed in these publications may change on a daily basis. Please contact your responsible Holland & Knight lawyer or the author of this alert for timely advice.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.
1 The primary tax provisions affecting businesses are contained in Title II, Subtitle C of the CARES Act. Additional tax provisions affecting individuals and businesses are contained in Title II, Subtitle B.
2 Thus, NOLs arising in 2018, 2019 and 2020 could be carried back as far as 2013, 2014 and 2015, respectively. This carryback right can be extremely valuable as the maximum corporate tax rate applicable to tax years ending before 2018 was 35 percent, much higher than the current 21 percent.
3 For example, the maximum credit attributable to any employee is $5,000.
4 Refundable tax credits permit taxpayers to receive a refund in respect to the excess of the amount of the credit over the tax owed.
5 Qualified improvement property excludes improvements attributable to 1) enlargement of the building, 2) any elevator or escalator, or 3) the internal structural framework of the building.
6 The Treasury Department and IRS have not yet officially confirmed this status.
7 These eligible expenses might include unreimbursed medical and nonmedical health-related expenses (e.g., hand sanitizers and over-the-counter medications), increased home expenses resulting from telecommuting (e.g., internet, printer or cellphone charges, home-office equipment and setup), increased utility expenses, and increased child care and education expenses.