A&M Tax Advisor Weekly
With all eyes watching the Build Back Better Act make its way through Congress, much of the attention has been on the proposed domestic and international corporate tax provisions which, if enacted, would have far-reaching implications. But among the business tax provisions in the latest draft released by the House Rules Committee, is a proposal that would drastically change how some entities are aggregated under various provisions of the Internal Revenue Code. More specifically, the change, which appears to target private equity structures, could cause entities that have not previously been considered as a “single employer” to be aggregated for certain employment-related tax purposes, as well as for other Code sections that would rely on the “single employer aggregation rule.”
Although the draft provisions in the Build Back Better Act are in flux, and legislation, if any, might not be enacted until the latter part of December, we thought it would be helpful to highlight the proposed changes to the single employer aggregation rule, and provide some examples and observations on what might be unanticipated outcomes.
Generally, under the single employer aggregation rule, all employees of members of a modified controlled group of corporations are treated as employed by a single employer. Corporations that could be considered part of a controlled group and businesses under common control include those within a parent-subsidiary group, a brother-sister group, or a combined group if certain conditions are met. Additionally, all employees of trades or businesses (including those operated by partnerships) under common control are treated as employed by a single employer.
In a typical private equity fund structure, a partnership owns one or more chains of portfolio companies. Private equity funds, however, generally do not take the position that their portfolio companies are under common control for purposes of the single employer aggregation rule because the fund is not itself engaged in a trade or business and because the fund is widely held. Accordingly, private equity funds generally treat each of their portfolio company chains as a separate entity instead of as being part of a single controlled group. As a result, each portfolio company chain may be applying various Code provisions without regard to the attributes of other portfolio company chains controlled by the same fund.
The House’s draft legislation, which purports to clarify that the single employer aggregation rule applies to certain for-profit activities, would define the scope of “trade or business” to include any activity:
If the “clarification” is adopted, a private equity fund and all the entities that it owns may be treated as engaged in a trade or business and to be under common control for purposes of the single employer aggregation rule. The reason this technical wording change is significant for private equity funds is that many funds have been deducting fund-level expenses as incurred for the production of income (under one section of the Code) rather than as trade or business expenses (under a different Code section).
At first blush, the scope of the single employer aggregation rule seems to be limited to employment-related items. However, many provisions in the Code outside the employment context, including other proposals within the Build Back Better Act, rely on the aggregation rule. For example, the single employer aggregation rule would apply to the proposed 15% corporate alternative minimum tax (AMT). The revamped AMT would be based on adjusted financial statement income (AFSI) and would apply to a corporation (other than an S corporation, regulated investment company, or real estate investment trust), which for any three-taxable year period, after considering the single employer aggregation rule, has average annual AFSI greater than $1 billion. If the corporation is foreign-parented, the AMT would apply if that $1 billion threshold is met and the corporation has an average annual AFSI greater than $100 million after considering a limited aggregation rule.
A&M Insight: While most of the media attention regarding the AMT has focused on large corporations, the 15% corporate AMT could sweep in private equity structures because the single employer aggregation rule would apply in determining whether a corporation satisfies the AFSI threshold. If the AMT could apply, more funds might favor holding portfolio companies as passthrough entities rather than as corporations to avoid the AMT, notwithstanding the fact that the regular corporate income tax rate is not proposed to increase. Fortunately, the revamped AMT is proposed to be effective for taxable years beginning after December 31, 2022, so private equity funds will have some time to decide how they want to hold their portfolio companies.
More imminent, however, would be the effect of the proposed change to the single employer aggregation rule on the Code’s small business exception, which applies that rule to determine eligibility under various Code sections. Specifically, the Code provides benefits or relief to “small businesses,” which are businesses that have average annual gross receipts for a three-taxable year period below a specified level, after applying the aggregation rule to take into account the gross receipts of related parties. The small business exception applies, for example, in determining whether a business can use the cash basis method of accounting for tax purposes, whether a business is exempt from certain accounting requirements for inventory and long-term contracts, and whether the business is subject to the section 163(j) limitation on the business interest expense deduction. As a result of the proposal, some entities previously qualifying as small businesses would no longer qualify, and therefore would be required to change to the accrual method of accounting, change certain other methods of accounting, and subject their interest expense to a section 163(j) limitation.
Finally, the research and development tax credit (R&D tax credit) is another example of the broad reach of the proposed change to the single employer aggregation rule. For purposes of the R&D tax credit, entities that are aggregated under that rule are treated as a single taxpayer so that they must use the same computation methodology and include all their activities within a single computation. This would be a dramatic change, especially to private equity funds that do not currently consider all the portfolio companies owned by a fund as under common control.
Example: PE Fund owns 10 different portfolio companies and does not consider all of the companies to be under “common control.” As a result, each portfolio company can separately determine whether to use the regular credit or the alternative simplified credit method, which have different rates (20% versus 14%) and distinct base period calculations in determining the allowable tax credit. Under the modified single employer aggregation rule, the portfolio companies would be considered to be under common control, which would require a single R&D tax credit calculation that could be less favorable and more complex to implement, particularly when it comes to allocating the benefit among portfolio companies.
Because the single employer aggregation rule, which is proposed to be effective beginning in 2022, applies for many purposes in the Code, and the proposed modification appears destined to be included in a final bill (if one is enacted), private equity funds should review their structures and assess which of their entities would be aggregated for various Code sections under the proposed law. In addition, the aggregation requirement may require a greater level of communication and coordination among the portfolio companies that does not generally occur at this time, which could require substantial changes to operating models and procedures. As a result, funds should evaluate how the potential change could affect the ROI analyses for existing businesses as well as for add-ons, and whether a different organizational structure may be beneficial from an operational and tax perspective. A&M can assist in evaluating the applicability of the aggregation rule, modeling scenarios, and developing effective and efficient operating procedures. If you would like to discuss your situation, the changes coming, and financial and operational challenges, please feel free to contact Kevin M. Jacobs, Adam Benson, or Kathleen King.