November 01, 2012
In this year 2012, it becomes increasingly important to plan for write offs of investments in Private Equity Funds. Traditionally, the sooner the tax write off follows the financial book write down, the quicker the loss can be used to offset gains, either from the Private Equity Fund itself or from other investments. However, with a rise in capital gains tax looming for 2013, coupled with the Affordable Care Act’s tax of 3.8% for most Fund Limited Partners (LPs), consideration should be given to possibly deferring any losses to 2013 to get a rate advantage.
For GAAP purposes, financial statements have to reflect underlying investments at fair market value. This requires the private equity fund to have a consistent, methodical and rigorous set of valuation rules in order to value its investment portfolio. This frequently leads to write downs from cost to a lower value. However, these write downs are almost never available for tax purposes until actual disposition of the underlying investment by the private equity fund. This is because the Internal Revenue Code (IRC) requires a closed transaction to trigger recognition of the loss, generally by a sale or exchange. In extreme cases of total worthlessness, the IRC provides for a write off for worthless stock. However, due to difficulties sometimes encountered in proving worthlessness, most practitioners suggest a “belt and suspenders” approach and advise the private equity fund to sell the worthless security for a nominal amount to an unrelated third party in order to prove worthlessness.
Conservatism is mandated by GAAP and partial write downs must be booked, but this is generally not the rule for tax purposes. The reason for this cautious approach is the extremely onerous and unpleasant consequences if the Internal Revenue Service (IRS) successfully disallows the loss: LPs must then amend their personal/corporate returns, disallow the losses they took, and pay taxes, penalties and interest for the private equity fund’s timing mistake.
The IRC and Regulations are quite clear that a mere decline in the market price of a security does not create a tax loss for a traditional Private Equity Fund Treasury Regulation 1.165-4(a)). A so-called 475(f) election can be made by a trader in securities to mark to market at the end of each tax year and take losses if the values have gone down without the need to dispose of the underlying security. However, this is not available to traditional Private Equity Funds.
Generally there must be a sale or exchange for a gain or loss to be recognized. In the case of a partial write down due to market conditions or a decline in the inherent value of the investment, no sale or exchange has taken place. Conceivably, the GAAP financials can take a few years’ worth of partial write downs and the private equity fund partners can merely watch the value of their investment go down without taking a tax deduction or write down. This can be rather frustrating and the LPs often put pressure on the General Partner (GP) to write the investment off completely in order to get a deduction passed through to them.
This leads to difficult conversations between the GP and their tax advisors as to whether all the criteria have been met to take a write off under one of the following scenarios:
IRC Section 165(g) does permit a write off for completely worthless stock. However, the private equity fund will have to point to a specific identifiable event that signals the worthlessness. If the value of the investee’s assets exceeds its liabilities but it is still conducting business, even if methodically selling off assets to pay down debts, this may not be sufficient to indicate current worthlessness.
A review of relevant Court cases points to four types of identifiable events that may be evidence of worthlessness:
- Bankruptcy filing
- Termination of business activities
- Liquidation of business assets, both tangible and intangible
- Receivership appointment by a Court.
Financial insolvency, by itself, is not sufficient. This is where a Fund may jump the gun and try to get an earlier tax write off than may be permitted. They receive a set of current financials from the investee company that clearly shows liabilities exceeding assets. They even estimate the value of non-booked assets such as software, lease value, R&D, going concern value, and they still come up negative. They, therefore, assume that they can write off their convertible preferred and other equity instruments at that point. However, this would not qualify as a worthless stock deduction because there is no single identifiable event with a fixed occurrence date that supports the write off. If the insolvency is coupled with another event such as liquidation, cessation of business, wholesale firing of the work force, etc., then the write off becomes much more supportable.
Other examples of events that may support a finding of worthlessness without a closed transaction are a catastrophic loss of inventory due to an uninsured event, a key customer with a large payable due being suddenly bankrupted, a Grand Jury empaneled to investigate corrupt practices, key assets seized by a foreign government, and other catastrophic events that will clearly lead to dissolution.
If a write off is still desired due to worthlessness, without one of the enumerated or other catastrophic events, then the private equity fund should consider closing the transaction.
Selling the ostensibly worthless stock to an unrelated party for no or nominal consideration can create a clear case for a tax write off. However, some Funds still want to hedge their loss and sell to a related party, a friendly party, the GPs individually, and other less than arm’s length buyers so as to preserve any future value that may come back. This doesn’t work. The loss of the write off if this subterfuge is discovered or challenged by the IRS will likely far outweigh any potential benefit from a less than arm’s-length transaction.
Timing Considerations in 2012
With tax rates on capital gains currently scheduled to increase for sales or exchanges beginning January 1, 2013, a Private Equity Fund should consider deferring any sale or argument of worthlessness into 2013 so as to get a higher tax benefit from the loss for its LPs. Capital gain rates are scheduled to increase to 20% in 2013 and the Affordable Care Act’s investment income tax of 3.8% is also scheduled to begin in 2013. Thus, a loss in 2013 could be used to offset capital gains with a federal tax rate as high as 23.8% in 2013. In 2012, that same offset will only be worth 15%. That is a large enough difference to make up for any time value of money lost due to deferral of the loss.
If a Private Equity Fund has sold an investment at a gain in 2011 and there are payments that are to be made in the future--an “installment sale”--part of the gain is deferred until the payments are received. This is the default tax treatment. With rates slated to rise so significantly in the future, GP’s should determine whether it is more beneficial to elect out of this treatment. To do so, they have to affirmatively make an election on their 2011 partnership tax return not to have installment sale treatment apply (IRC Sec. 453).
Small Business Investment Companies (SBICs) that have invested in debt instruments that are then sold at a loss or are deemed worthless can treat the loss as an ordinary loss (IRC Sec. 582(a)(2)(A)(iii)).
C corporation SBIC’s that are sold at a loss may provide their selling stockholders with an ordinary loss on the sale of the shares. However, there are not many such organizations (IRC Sec. 1242).
Finally, special loss rules apply to SBICs that invest in convertible debt: if they sell the stock into which the debt was converted at a loss, they can get ordinary loss treatment (IRC Sec. 1243).
A Fund that abandons a partnership interest in an underlying investment or a partner that abandons its interest in a partnership may qualify for ordinary loss treatment if there are no liabilities attributed to the partner that are deemed relieved upon abandonment. This is a very tricky area and one not readily understood or accepted by IRS agents, so consulting a tax advisor is key to this strategy (Echols v. Comm., 935 F.2d 703).
Certain losses in stock may be treated as ordinary losses if they qualify under IRC Section 1244. Generally, because this requires a market capitalization of no more than $1 million at the time of investment, only seed Funds will likely qualify for this tax break since they may have invested early enough to meet the $1 million maximum threshold (IRC Sec. 1244).