This article explores an intricacy between certain private equity investments and various tax rules deferring the recognition of losses flowing up from partnerships. This article is not meant to be an exhaustive analysis of private equity structuring or the loss limitation rules. Rather, it is to illustrate how the loss limitation rules may apply to certain private equity investments.
Private equity firms invest in businesses with the goal of maximizing the value of their investment. Often this includes looking for a return on its investment through a successful exit after some time has passed. It is not unusual to see a private equity firm holding its portfolio company in a flow-through entity (e.g., partnership or LLC taxed as a partnership) for tax purposes. We sometimes see that before maturing into a successful exit, such partnerships generate losses. Because of the flow-through nature of the portfolio entities, the losses flow up to the private equity fund ultimately reaching investors (typically limited partners ”LP”) and managers (typically general partners “GP”).
Generally, partners who have been allocated a distributive share of loss from the portfolio company must satisfy four separate loss limitation rules before the loss can be used to offset income from other sources basis limitation, (2) the at-risk limitation of section 465, (3) the passive loss limitation of section 469, and (4) the excess business loss limitation under the “Tax Cuts and Jobs Act”.
We will discuss certain aspects of these limitation rules, and then explore how these rules may impact a private equity investment.
- Basis Limitation
Section 704(d) limits a partner’s deductible amount of partnership loss to the adjusted basis of the partner’s interest in the partnership at the end of the partnership year of such loss. In other words, a partner may deduct partnership losses allocated to her to the extent of her adjusted basis (typically “outside basis”) of her interest in the partnership.
While computing “outside basis” is beyond the scope of this article, a partner’s basis in their partnership interest is increased by their contribution of cash and property, and taxable income allocated to them. On the contrary, the partnership’s distribution of cash and property to the partner and tax losses allocated to them will decrease their basis in the partnership. To the extent the partnership’s debt is allocable to the partner, the partner is deemed to make a capital contribution, whereas to the extent the partner’s share of the partnership debt is reduced, the partnership is deemed to make a distribution to such partner. Therefore, debt allocated to the partner also reduces their outside basis in the partnership.
Private equity firms having the partnership structure for its investments typically use a limited liability company as an operating entity. As a result, unless a partner guarantees the partnership debt or directly lends money to the partnership, the partnership debt is generally allocated to the partners in accordance with profits and loss percentages. Thus, the partnership debt may increase its partners’ bases in the partnership even though the partners are not personally liable for such debt.
- At Risk Limitation
Section 465(a) limits the losses an individual may claim as deductions to the amount for which the individual is “at risk” in the activity.
In general, the amount at risk is the sum of (a) the cash and the other property contributed to the activity and (b) the amounts borrowed with respect to the activity, to the extent the taxpayer is either personally liable to repay such amounts or has pledged property not used in the activity as collateral for the borrowing. Similar to the basis rules, income or loss allocated generally increases or decreases the partner’s amount at risk. The key distinction from the basis rules is that unless a partner is personally liable for the debt, the partner is not generally considered to be at risk with respect to a nonrecourse debt, although that debt provides them with basis in the partnership.
When a partnership incurs a debt, it does not necessarily result in a partner being deemed at risk for a ratable share of the debt. Members of a limited liability company generally are not considered at risk for partnership debt absent the partner’s personal guarantee or if the partner uses its own property as collateral. The existence of a deficit restoration obligation (DRO) does not necessarily change this result. Thus, the partner may not be considered at risk with respect to the partnership losses (unless the partnership has sufficient equity investment in the partnership that has not been reduced by previous losses), thereby suspending the loss allocated to such partner.
- Passive Loss Limitation
Section 469(a)(1) bars any deductions for passive activity losses against income from non-passive activities. Passive activity losses are determined by summing up all losses from passive activities for the taxable year and subtracting all income from such activities.
In other words, passive losses are deductible against passive income, and thus, it is only the net passive loss that is not deductible against income from other sources. Suspended losses are carried forward indefinitely but are not carried back.
A taxpayer can avoid having his interest in a trade or business deemed passive by materially participating in the trade or business. The regulations under Section 469 provide substance to these general standards, setting out seven alternative tests for material participation in an activity. Satisfying any one of the seven will result in a non-passive status for the activity for the year. While the detailed rules relating to what constitutes material participation are beyond the scope of this article, generally, an individual has to participate in the day-to-day management or operations of the business to be considered materially participating. The legislative history of Section 469 provides that an individual materially participates in an activity in a “regular, continuous and substantial” manner if the individual has a “significant non-tax economic profit motive” for taking on the activity with a profit-making intent.
Work performed in the capacity of an investor is disregarded in applying the material participation tests. For example, time spent studying and reviewing financial statements of the activity or monitoring the finances or operations of the activity in a non-managerial capacity is not counted unless the taxpayer investor is also involved in the daily management of the business.
Special rules govern the disposition of a taxpayer’s entire interest in a passive activity. In case of a full taxable disposition of the passive activity to an unrelated party, any current or suspended passive losses from the activity and any loss realized on the disposition of the activity are treated as losses from a non-passive activity and can then offset income from other non-passive sources.
- Excess Loss Limitation under the “Tax Cuts and Jobs Act”
The “Tax Cuts and Jobs Act” (TCJA) restricts the use of excess losses to noncorporate taxpayers for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026.
Formerly, business losses recognized by individuals could generally reduce nonbusiness income without any limitations other than the three limitation rules discussed above. With the TCJA, business losses can only reduce nonbusiness income up to $ 250,000 (or $ 500,000 for married filing jointly). In more technical words, business losses will be limited at “excess losses,” that is the excess of aggregate deductions of a taxpayer attributable to trades or businesses, over the sum of aggregate gross income of the taxpayer attributable to such trades or businesses, plus an additional $ 250,000 (or $ 500,000 for married filing jointly). The numbers shall be indexed for inflation. Disallowed excess losses will be suspended and carried forward as part of the taxpayer’s net operating loss carryforwards in subsequent years.
In addition, the TCJA provides an ordering rule to apply the excess business loss limitation rule after the passive loss limitation rules of Section 469. If a loss is disallowed by the passive loss limitation rules, any income or deductions from that passive activity should be disregarded in determining whether the taxpayer has an excess business loss.
Application to Certain Private Equity Investments
The limitation rules discussed above play a prevalent role in the private equity investment stage. When the investment vehicle (in our case the limited liability company) generates losses, the rules above may apply to suspend the losses.
It is not unusual to see an increase in tax deductions after an investment due to depreciation/amortization and interest expense. However, unless the private equity investors are considered at risk with respect to debt (meaning the partners already used up equity investment through losses allocated previously), it may be difficult to claim the deduction arising from such losses because the partners are not considered at risk. Such losses will be suspended until the private equity investors have enough amount at risk in the partnership to take advantage of the losses.
If the private equity firm exits the business at a gain, such gain is likely to increase the private equity investors’ at-risk basis. As a result, the suspended losses are “freed up” to offset the gain. Better yet, if individuals that own the private equity have other sources of income that are treated as ordinary income, the losses will offset the ordinary income first. If the gain from the exit is predominately a long term capital gain, the private equity owner would have reduced his/her ordinary income through prior losses while increasing the long term capital gain on the exit.
In addition, the passive activity rules should be taken into account. While it is possible that GPs materially participate in the business, LPs generally do not. As such, the losses allocated to LPs are likely to be considered passive losses. Therefore, the losses from the activity are likely to be temporarily suspended, unless there are other sources of passive income, until full disposition. At full disposition, the suspended passive losses should become deductible.
Lastly, after navigating through the basis, at-risk, and passive loss limitation rules, a private equity investor4 will face the restrictions of excess business loss limitation rule before utilizing the loss.
As we have seen, the rules on investing in partnerships are very complicated. We recommend that you undertake detailed analysis into the loss limitation rules for careful planning.
1 There may be certain exceptions including certain corporate partners may not be limited.
2 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended (the “Code”), and all Regulation section (“Treas. Reg. section”) references are to the Treasury Regulations promulgated thereunder
3 Treas. Reg. section 1.752-3(a) provides that a partner’s share of nonrecourse liability is the sum of the partner’s share of partnership minimum gain; and any taxable gain that would be allocable to the partner under section 704(c) and partner’s share of profit or loss.
4 An Investor other than a C Corporation.