How Tax Reform May Affect Venture Capital Funds

We’ve heard a lot about tax reform in the New Year, and as investors anxiously await delivery of their K-1 and complete tax filings, one question might still be lingering —what exactly are the effects of tax reform on Venture Capital Funds and investors? Below are a few key points of tax reform that are of particular importance to this group.

The biggest news here is that there is not much news. The previous capital gains tax rate was kept as is at a maximum of 20%. However, the change that did come about is that effective for taxable years after December 31, 2017, carry from investments held for under three years will be taxed at the higher ordinary income rate rather than the lower capital gains rate. Previously, the threshold was one year. For those that tend to hold investments for more than three years, this change doesn’t have much impact.

This one is being viewed as an overall positive as it adds a new deduction for non-corporate taxpayers that could reduce income taxable at ordinary income rates. With this change, non-corporate taxpayers can deduct 20% of their share of “qualified business income” from a pass-through entity (i.e. partnerships, S corporations, sole proprietorship, etc.). This change is also likely to cause a decline in “blocker” structures to foreign investors as there is more incentive now for structuring a pass-through entity.

This provision caps the interest deduction for a business to the sum of business interest income plus 30% of earnings and applies to both related and unrelated party debt. Previously a business was allowed to deduct all interest paid or accrued in a taxable year, subject to some limitations. Earnings, in this case, is defined similarly to earnings before interest, taxes depreciation, and amortization (EBITDA) for taxable years beginning after December 31, 2017, and before January 1, 2022, and is defined similarly to earnings before interest and tax (EBIT) for taxable years beginning after December 31, 2021.

Putting a cap on the amount of interest a business can deduct could be an issue for those portfolio companies that have taken on a lot of debt and will likely cause a shift to more issuance of preferred equity vs. debt on a go-forward basis. However, disallowed interest is permitted to be carried forward indefinitely.

In July 2017, the U.S. Tax Court issued a ruling based on a court decision that determined that non-U.S. investors’ capital gain from the sale of a partnership interest in a U.S. trade or business is generally not subject to U.S. federal income tax to a foreign holder. Under the current tax reform for 2018, the sale or transfer of a partnership interest by a foreign partner directly or indirectly connected to a partnership in a U.S. trade or business will be subject to U.S. tax and required to withhold 10% of the amount realized. This change essentially reversed the prior tax court ruling from July 2017 and applies to sales on or after November 27, 2017.

While the above provides a general overview of tax reform and the changes we expect to see, it is important to remember that particular circumstances may vary. If you have questions or want to learn more about how tax reform may affect your venture capital fund, please contact us.