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2008 Private Equity Strategic Financial Management Conference PowerPoint Presentation
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2008 Private Equity Strategic Financial Management Conference

2008 Private Equity Strategic Financial Management Conference

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2008 Private Equity Strategic Financial Management Conference

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  1. 2008 Private Equity Strategic Financial Management Conference Workshop A: Tax Planning and Compliance Jeff Cote, CFO, Pfingsten Partners, L.L.C. Kevin Slaton, Controller, Insight Equity LP

  2. Agenda • Minimizing your tax workload • UBTI and ECI issues • What’s new?

  3. Audience Question • How many Funds use pass-through entities vs. blocker corporations to hold portfolio companies? • # using pass-through entities • # using blocker corporations • # using mix of both tax vehicles

  4. Operating LLC Minimizing your tax workload FUND • Blocker Corp tax treatment • Blocks income from operations of underlying portfolio companies from flowing into Fund partnership (potential UBTI/ECI income) • Impact on K-1 preparation • Portfolio company return preparation Blocker Corp.

  5. FUND Equity LLC Operating Company (can be either C Corp or Pship) Minimizing your tax workload • Flow through tax treatment • Advantages • Asset sale or membership interest sales vs. stock sales • No Federal tax at partnership level • Income taxed at Limited Partner level (entity or individual) • Use of LLCs to hold both Fund and management equity investments in underlying portfolio company (either blocker or pass through) • Alignment of management’s interests FundEquity ManagementEquity

  6. FUND Equity LLC Operating Company LLC Minimizing your tax workload • Flow through tax treatment • Disadvantages • State tax issues • Multi-state filing requirements • Some states allow composite return filings • UBTI/ECI issues • Complex allocations • Tax distributions • 751 issues • Ordinary income recapture • Potential surprise to LPs State tax and UBTI/ECI issues and exposure flow up

  7. Minimizing your tax workload • Schedule K-1 Preparation and Timing • Reliance on preparation of underlying portfolio companies (if pass through) • Quarterly investor reporting for tax estimate information • Complex allocations of characters of income throughout waterfall

  8. Audience Question • How many Funds deal with UBTI/ECI issues?

  9. UBTI/ECI issues • What is UBTI? • Unrelated Business Taxable Income • Unrelated Business Taxable Income, is a concern to tax exempt investors because the receipt of UBTI requires the tax exempt entity to file a tax return that it would not otherwise have to file and pay taxes on income that would otherwise be exempt, at the corporate rate. UBTI includes most business operations income and generally does not include interest, dividends and gains from the sale or exchange of capital assets. • Common Categories • Operation income generated by pass through entities • Debt-financed investments • Guarantee fee income at Fund level • Management fee offsets

  10. UBTI affects Tax-Exempt Investors • Tax-exempt investors must file form 990-T and pay tax on “Unrelated Business Taxable Income” (UBTI) • GPs often promise tax-exempt investors they will avoid UBTI on any investments. • UBTI is caused by business income which is unrelated to the investor’s exempt function. Business income earned from investments in partnerships is usually UBTI. • Director’s fees and transaction fees earned by Fund can create UBTI, unless valid “management fee offset” is used. • Capital gains and dividend income are generally not treated as UBTI, unless the investment was acquired with “acquisition indebtedness”. GP Tax-Exempt LPs Director’s Fees/ Transaction Fees Fund UBTI Loan Business Income Dividends / Capital Gains Bank Corporation Operating LLC

  11. Blockers avoid UBTI • Funds often avoid UBTI by investing only in corporate stock and debt. • If portfolio company is formed as a partnership or LLC, Fund may form a “blocker corporation” to avoid UBTI. • Cost of blocker is high: • Losses remain in blocker. • Income is taxed in blocker. • Gain on asset sale is taxed in blocker. • Operational costs often exceed $10k/yr. GP Tax-Exempt LPs Fund Passive Income Dividends / Capital Gains Corporation Blocker Business Income Operating LLC

  12. Short Term Debt and UBTI • Fund Debt: Income or gain from debt financed investments (fund is the borrower) is taxed as UBTI. UBTI taint continues for 12 months after the debt is retired. • Administrative Convenience: IRS has ruled that short term borrowing won't create UBTI if it was incurred to satisfy short term working capital needs. • Short Term Borrowing: Line of credit may not create Unrelated Debt Financed Income (“UDFI”) if: (i) The debt is incurred AFTER a capital call has been made; (ii) the debt is repaid out of the capital call; and (iii) the total loan term is very short (14 days sounds good to some, 3 days sounds good to others). However, if loan was used to invest (not to pay management fees, etc.) no clear authority exists to qualify as “working capital” GP Tax-Exempt LPs Fund UBTI Line of Credit Dividends / Capital Gains Bank Corporation

  13. Guarantee of Portfolio Debt may create UBTI GP Tax-Exempt LPs • Fund guarantee of loans to portfolio companies may create UBTI if the fund is, in substance the true borrower. • Fund guarantee of loans to portfolio companies may create UBTI if the fund receives a guaranty fee which is considered business income. • Financial accounting under FIN 45 requires the Fund to record a liability and increase the investment account for the value of the loan guarantee. under FIN 45. The valuation of the guarantee can be complex. Fund UBTI Blocker Working Capital Loan Bank Operating LLC

  14. UBTI/ECI issues What is ECI? Effectively Connected Income. A non-resident alien or a foreign corporation is subject to US taxation if it receives income that is, or is treated as, effectively connected with a U.S. trade or business Generally results in net income tax, potential branch profits tax, and tax return filing requirements Common categories of ECI Operating income generated by pass through entity (e.g., portfolio company LLC held by Fund) Fee income earned by the Fund Management fee offset in excess of management fees Investments in US real property

  15. Non-Resident Withholding • Dividends paid to Non-US entities that do not exceed earnings & profits of Blocker Corp are subject to 30% withholding requirement • Blocker Corp would be the withholding agent and officers of Blocker would be held personally liable. • Results in 55% tax rate to Non-US investors • 35% at Blocker • 30% W/H • 35% +(30% x (1-35%)) = 54.5% • No silver bullet to avoid • IRS focusing on enforcing this requirement GP Non-US Investors Offshore Fund Dividends 30% Withheld Corporation Blocker Business Income Operating LLC

  16. What’s New? • Federal Changes • Technical Termination Disclosure on page 1 of 1065 • Change in Extended Due Date of Partnership Returns • New date accelerated by one month, due September 15 • K-1 Ownership Interest Disclosure - “Various” no longer allowed • Determination of partner ownership • Use greater of Capital, Loss or Profits Interest • Determination of partnership investment ownership • Use greater of Capital, Loss, or Profits Interest • Determination of corporation investment ownership • Use Voting Percentage • Assumption that GP has 100% of voting ownership • Fund of Funds would use their ownership percentage • 1065 Expanded Schedule B Questions • Related Party Ownership questions • Form 90-22.1 – Foreign Bank Account disclosures

  17. What’s New • New Version of Form TD F 90-22.1 • Resulted from summons for lists of American account holders in foreign banks. • Severe penalties and stepped-up enforcement. • Adds that “authority” includes the ability to act thru an agent, nominee, or attorney. • Exact “maximum value” must now be reported instead of a range. • New reporting requirements for “foreign persons” in and doing business in the US. May impact: • Foreign LP’s with US business flow-thru income. • Foreign GP’s • New voluntary disclosure requirements. Due June 30th of each year

  18. What’s New? • State Changes • California • LLC Fee Structure • NOL modifications • Estimate payment changes • Illinois • Non-Resident Withholding rules • Texas

  19. California – Legislative Tax Summary • Governor Schwarzenegger signed the budget bill on 09/23/08. AB 1452 was enacted on 09/30/08 and SB 28X on 10/01/08. • LLC Fee Due Date • 2008 Taxable Year – Due 04/15/09 • 2009 Taxable Year – Due 06/15/09 • Safe Harbor equal to 100% of the prior year LLC Fee. • Expect to use this safe harbor in most all instances. • A 10% penalty is imposed on the underpayment. • Does not impact the standard $800 minimum tax that is still due on April 15 of the current year. • Example: LLC Entity payments in 2009 • April 15, 2009 $800 minimum tax • April 15, 2009 LLC Fee for 2008 • June 15, 2009 Estimated LLC Fee for 2009

  20. California – Legislative Tax Summary • Net Operating Loss (NOL) Modifications • Suspension of NOL’s for taxable years 2008 & 2009 • Starting in 2008 the NOL Carryforward will be 20 years from 10 years. (same as federal rules) • Starting for tax years beginning on or after January 1, 2011 a phased-in 2 year carry-back provision. • 2011 limited to 50%, 2012 limited to 75%, 2013 at 100%

  21. California – Legislative Tax Summary • Accelerated Estimated Tax Payments from 2008 • Q1 – 30%, Q2 – 30%, Q3 – 20%, Q4 – 20% • 50% Tax Credit Limitation for 2008 and 2009 • Tax Credit sharing for a Unitary Group from 2011 • 20% Penalty for Understatement of Tax over $1 million for corporate taxpayers • No Safe Harbor for Estimated Tax Payments for High Net Worth Taxpayers over $1 million in AGI. • For GP’s will this require more rigorous quarterly estimate data?