The spread of the COVID-19 pandemic through the U.S. has led to the beginnings of a financial and economic crisis with dimensions that, as of yet, cannot be estimated. Social distancing and statewide shutdown orders are grinding businesses to a halt and have been accompanied by several phases of emergency legislation and Treasury guidance aimed at providing financial and administrative relief to taxpayers facing cash flow concerns.
The first phase of emergency legislation was signed into law on March 6, 2020 and provides funding to develop vaccines and testing kits, additional state and local health department staffing and laboratory equipment needs, and federal aid for international containment. It was followed by the Families First Coronavirus Response Act, signed into law on March 18, 2020, that provides paid sick and family leave (and offsetting employer payroll tax credits) for coronavirus and related care for others, food assistance, medical testing assistance, and additional unemployment benefits. Finally, President Trump signed into law on March 27, 2020 a $2.2 trillion economic stimulus package as the third phase of emergency legislation in response to the COVID-19 pandemic. The “Coronavirus Aid, Relief, and Economic Security Act,” (CARES Act) contains tax and nontax relief measures that are designed to avert a U.S. economic collapse.
Some headline features of the CARES Act include: a one-time cash payment for eligible individuals; the expansion of unemployment benefits; the establishment of two major federal loan programs for large and small businesses; as well as a number of tax provisions relevant to private equity (PE) and venture capital (VC) funds and their portfolio companies.
This article highlights the provisions of the recent guidance that are most relevant to PE and VC funds and their portfolio companies:
- Delay of certain April 15 filing and payment deadlines to July 15
- Net operating loss carryback provisions and changes to tax loss provisions
- Relaxation of business interest expense limitation
- Retail glitch fix for qualified improvement property
- Increased deductibility of charitable contributions
- Refundable AMT credits accelerated
- Deferral of payroll tax liability
- Employee retention payroll tax credits
- Small and large business loans
Several of these provisions may provide businesses with much needed cash relief in a short period of time, some within 90 days of filing requisite forms.
Income Tax Relief
The IRS published Notices 2020-17 and 2020-20 in which it provided tax filing and payment relief for certain tax filings originally due on April 15, 2020. Specifically, the Notices extended the deadline for filing any federal income tax return and for making any payment that would ordinarily be due on April 15, 2020 to July 15, 2020. This includes corporate, individual, trust, estate, and also gift tax returns and extends to first quarter estimated payments for these filings as well. However, the filing extension does not apply to information returns such as Forms 1042-S that were extended in March 2020 and are now due on April 15, 2020, unless the filer is following the proposed regulations that were published in December 2018 and provide relief to lag method filers (see our previous article here). The extension of the filing and payment deadline also does not apply to fiscal year filers whose federal income tax returns are due on any day other than April 15, 2020.
Tax Loss Limitation and Net Operating Loss (NOL) Carryback Changes
The Tax Cuts and Jobs Act of 2017 (TCJA) essentially eliminated the ability of businesses to carryback NOLs to prior years. Prior to the TCJA there was a 2-year carryback period; the TCJA generally repealed the ability to carry back NOLs and further reduced the ability to deduct current NOLs to 80% of taxable income. The CARES Act reverses the TCJA change and expands the scope of NOL carrybacks. Under the CARES Act, businesses may carryback NOLs incurred in 2018-2020 for 5 years, and may fully offset income in the carryback years. The 80% taxable income limitation is reinstated for tax years after 2020, though with modifications.
Portfolio companies and blocker corporations should consider modeling out the impact of these provisions, including their interaction with other domestic and international tax provisions, to fully understand the cash tax impact of an NOL carryback. Corporations with income in pre-2018 carryback periods could generate a permanent tax benefit since these years pre-date the tax rate cut from 35% to 21%. These NOL deduction changes may also impact the financial statements of corporate entities, such as for current and deferred tax items.
Corporations can consider filing Form 1139, Corporation Application for Tentative Refund, to obtain a quick refund for carrying back losses to earlier years, generally within 90 days of filing the claim. However, a tentative refund claim extends the period of assessment for the carryback year for items unrelated to the NOL carryback and should be carefully compared to filing an amended corporate tax return to carry back the loss. The cash tax refund after filing an amended tax return typically takes longer than 90 days to process; however, the benefit of filing an amended return over claiming a tentative refund is that the IRS would be unable to assess additional tax on any items unrelated to the carryback.
Corporations now anticipating that they have overpaid estimated taxes for tax year 2019 have the option to file Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax. This allows a taxpayer with excess estimated tax payments for the year to obtain a quick refund of the overpaid tax, without having to wait to file a tax return for the year. This form must be filed after the close of the taxable year and before the 16th day of the fourth month after the end of the year and the expected overpayment must exceed 10% of the corporations expected tax liability and be greater than $500. The IRS will act on a property filed Form 4466 within 45 days from the date it is filed, but Requesting to large of a refund to expose the corporation to a penalty for underpayment of estimate tax.
As a part of the changes to the provisions regarding losses, the excess business loss limitation under Sec. 461(l) has been modified. The CARES Act will suspend the excess business loss limitation until 2021. This suspension of the excess business loss rules should be carefully analyzed by flowthrough portfolio companies, funds, and management companies. The BBA partnership audit rules may prevent a cash refund where there was no overpayment of tax in the reporting year and instead provide for a credit that can be carried forward.
Business Interest Expense Limitation Relief
The TCJA had introduced a new limitation on the deductibility of business interest expense and generally capped the deduction at the total of business interest income plus 30% of adjusted taxable income which is calculated similarly to EBITDA (through 2021, thereafter EBIT). This limitation on business interest will also be modified under the CARES Act. For 2019 and 2020, the 30% limit used to determine the amount of deductible business interest will be increased to 50%, though taxpayers may elect out. Further, taxpayers may elect to calculate their 2020 business interest expense limitation using 2019 adjusted taxable income.
Special rules will apply to partnerships. They will not be permitted to use the increased 50% limitation for tax years beginning in 2019. Instead, partners will be able to increase their 2020 deductible business interest expense by 50% of the amount of 2019 disallowed partnership business interest expense allocated to them. The remaining portion of the 2019 disallowed partnership business interest expense allocated to the partners will be subject to the limitation as originally provided by the TCJA. Business interest expense incurred by partnerships in tax years beginning in 2020 will be subject to the same 50% limitation that applies to other taxpayers in that year.
Retail Glitch Fix
Aside from the large amount of spending, loans, and grants outlined above, there are specific changes to the tax code designed to stimulate growth. The first is the highly anticipated fix for the “retail glitch.” The “retail glitch” resulted from a drafting error in the TCJA. The law mistakenly repealed the 15-year depreciable class life for qualified improvement, retail and restaurant property, eliminating the ability to claim bonus depreciation on such property. The CARES Act makes a technical correction to the TCJA to re-establish the 15-year depreciable class life for these assets, effective for property placed in service after Jan. 1, 2018. Companies can take advantage of this fix to prior years by amending tax returns, or may consider an accounting method change in the current year.
Flowthrough portfolio companies, funds, and management companies should consider the impact of the BBA partnership audit rules when analyzing the impact of this provision, as discussed above.
Tax Changes for Charitable Contributions
There are also changes designed to increase the deductibility of charitable contributions. This includes a new $300 above-the-line deduction for cash contributions to a qualifying charity. This provision allows a charitable deduction to those who don’t itemize. The 50% AGI limitation on cash donations is also suspended for 2020. In addition, the deduction limit for contributions of food inventory is increased from 15% to 25% of AGI. Corporations also receive an increased contribution limit for cash contributions from 10% to 25% of taxable income. The new above the line deduction may reverse some of the decline in charitable contributions that was at least in part attributable to the TCJA’s changes to the itemized and standard deduction. Charitable giving fell by an inflation adjusted 3.4% from the year prior to the passage of the TCJA to the year after, and 2% fewer individuals made charitable contributions after the passage of the act.
Corporate AMT Refunds
The corporate alternative minimum tax (AMT) was repealed as part of the TCJA, but corporate AMT credits were made available as refundable credits over several years, ending in 2021. The CARES Act accelerates the timing of these refunds and corporations may now receive the entire refundable credit in the corporation’s first taxable year beginning in 2018 or 2019. This will provide affected corporations with an acceleration of these cash tax benefits.
Payroll Tax Relief
Employer Payroll Tax Holiday
The CARES Act provides a payroll tax holiday that allows employers to defer the employer portion of their federal social security tax liability (or 50% of the self-employment tax for the self-employed) for wages paid after March 27, 2020 through Dec. 31, 2020. Businesses taking advantage of this holiday would repay 50% of the amount deferred in 2021 and the remaining 50% in 2022.
This benefit provides an immediate cash tax deferral to corporate and pass-through portfolio companies as well as management companies themselves.
Employee Retention Credit
There is also a new employee retention credit that comes in the form of a payroll tax credit for 50% of wages paid by an affected employer. An affected employer is one whose operations were fully or partially suspended due to a COVID-19-related shutdown order, or whose gross receipts declined by more than 50% when compared to the same quarter in the prior year. This credit is based upon qualifying wages paid by an affected employer and is also dependent on the size of the employer. For small employers (100 of fewer full-time employees) the credit is based upon wages paid to any employee whether the employer is open or has been closed due to a coronavirus shutdown order. For large employers the credit is based upon the first $10,000 of compensation, including healthcare benefits, paid to employees who are not providing services due to a coronavirus shutdown order. The credit covers the period from March 13, 2020 through Dec. 31, 2020, but businesses taking advantage of the Small Business Interruption loans, discussed below, are not eligible for the credit.
Paid Sick and Family Leave
This new program was established under the Families First Coronavirus Response Act and has two components, each with its own corresponding tax credit. The first is a paid sick leave program that mandates up to two weeks of paid sick leave to employees unable to work due to COVID-19 diagnosis, symptoms, or coronavirus-related quarantine and to those who are unable to work because they care for another individual in quarantine or a child under the age of 18 who is affected by a school or daycare closure. The second component of the program mandates paid family leave for an additional ten weeks to employees who are unable to work because they must care for a child under the age of 18 affected by a school or daycare closure on account of coronavirus. The first 2 weeks of such benefits are to be provided as paid sick leave under the first component of the program.
Only private sector employers with fewer than 500 employees are subject to the paid sick leave program. Small businesses with fewer than 50 employees may be exempt. The pay rate for employees unable to work due to COVID-19 diagnosis, symptoms, or coronavirus-related quarantine must be equal to the employee’s regular rate or the local minimum wage (if greater), not to exceed $5,110 ($511 per day). In the case of employees unable to work because they care for another individual or child affected by a school closure, the pay rate is two-thirds of the employee’s regular amount, not to exceed $2,000 ($200 per day) for the sick leave component of the program and $10,000 ($200 per day) for the paid family leave component.
To offset the cost of the paid sick leave program, employers will be able claim a refundable payroll tax credit equal to the applicable per-employee daily benefit ($511 or $200), not to exceed the applicable per-employee cap ($5,110 / $2,000 / $10,000, respectively).
Non-Tax Relief Measures
Small and Large Business Loans and Investments
The CARES Act establishes two major federal loan programs. The first is a $500 billion loan program for large businesses and municipalities. These funds are subject to oversight by a Treasury Inspector General who is expected to be appointed for this purpose. As a part of this oversight, there is a provision that will “prohibit businesses controlled by the President, Vice President, Members of Congress, and heads of Executive Departments from receiving loans or investments from Treasury programs.”
The other large loan program consists of $367 billion in loans and grants to small businesses with 500 or fewer employees. The bulk of this money, $349 billion, is for guaranteed loans made under the Small Business Act (SBA). The Section 7(a) component of this program allows eligible businesses to access up to $10 million each in forgivable loans for expenses such as payroll, mortgage or lease payments, or utilities. In order to obtain these loans, eligible businesses must compensate all employees for 8 weeks, and portions of the small business loans can be forgiven if the business generally does not terminate its employees or reduce their wages (monthly averaging formulas are provided), and waivers are provided for re-hiring by June 30.
The new loan program under the SBA leaves intact the standard aggregation rules for small business rules to determine if a business has 500 or fewer employees, except in the case of businesses in the hospitality industry (NAICS classification codes beginning with 72) or franchises. Therefore, PE and VC funds should work closely with their portfolio companies to determine their eligibility for these new Section 7(a) SBA loans.
Other Tax Law Changes
Additionally, the CARES Act provides for federal unemployment benefits for individuals not otherwise eligible for unemployment benefits for up to 39 weeks. Further, there is a temporary holiday for aviation fuel excise taxes and a temporary exemption from the excise tax on alcohol for all distilled spirits contained or used in hand sanitizer. This will likely help local alcohol brewers across the country, many of whom have switched to production of hand sanitizer as a response to reduced demand for alcoholic beverages and an increased demand for hand sanitizer.
The CARES Act is the largest single rescue package ever passed by Congress. With unemployment claims jumping by 3.3 million in a single week, and many states and cities expecting to be shut down for several weeks, at the least this measure is widely seen as a necessary step to recovery. Congress has also signaled that the stimulus provisions in this measure are just another step in what is expected to be an ongoing process. House Majority Leader Steny Hoyer (D-Md.) reportedly indicated that there will likely be a 4th and 5th phase of pandemic relief legislation.
Private Equity and venture capital funds as well as their portfolio companies should carefully consider the impact of the provisions in the Families First Coronavirus Response Act and CARES Act on their cash tax, 2019 tax return filings, Schedules K-1, and related disclosures. The timing of this measure could also complicate the timeline of financial statement preparation and audit for some portfolio companies and blocker corporations.
For more information about this and other coronavirus legislation, please contact us.
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Claudia Mullen is a Tax Managing Director and is a member of the Private Equity & Venture Capital Practice. She can be reached at 401.626.3241 or email@example.com.
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