The CARES Act comes on the heels of the IRS’s release of Notice 2020-18, postponing the due date for the filing of federal income tax returns and making federal income tax payments.
As the outbreak of the coronavirus (COVID-19) continues to plague the United States, on March 27, 2020, the U.S. House of Representatives passed the previously approved U.S. Senate version of the much anticipated Coronavirus Aid, Relief and Economic Security Act (CARES Act), providing a needed $2 trillion in relief to the U.S. economy that is teetering on the border of a recession. The CARES Act is the largest of its kind in U.S. history and will provide $500 billion to distressed companies, $350 billion in small business loans and $250 billion in direct payments to individuals and families. As of the timing of the release of this Alert, President Trump has not yet signed the Act into law, however, he has indicated that he intends to do so.
This Alert serves as a brief overview of a few of the important provisions of the CARES Act and IRS Notice 2020-18 that will have a significant impact on private equity funds and their portfolio companies moving forward.
Notice 2020-18: Temporary Extension of Filing and Payment Deadlines
The CARES Act comes on the heels of the IRS’s release of Notice 2020-18 (which expanded upon Notice 2020-17) postponing the due date for the filing of federal income tax returns and making federal income tax payments from April 15, 2020, until July 15, 2020. Notice 2020-18 also applies to payments of tax on self-employment income and federal estimated income tax payments.
In a recently released FAQ, the IRS stressed that the foregoing postponement only applied to individuals, trusts, estates, corporations and any other type of unincorporated business entities that had April 15 tax deadlines; taxpayers with different filing or payment due dates were not granted any relief. Furthermore, while the estimated tax payments due April 15 are now due July 15, Notice 2020-18 did not provide relief to the June 15 due date for second-quarter estimated tax payments.
Temporary Repeal of Net Operating Loss Limitation
Beginning in 2018, the Tax Cuts and Jobs Act (TCJA) originally modified the Internal Revenue Code’s (Code) section 172 net operating loss (NOL) rules by limiting the amount of NOLs a business could utilize in a given year to 80 percent of such business’s taxable income. The amended provision also repealed a business’ ability to carryback its unused losses.
In an effort to provide support to businesses incurring significant losses as a result of COVID-19, the CARES Act temporarily repeals the foregoing 80 percent limitation and the prohibition against carrying back such losses. The Act thus permits taxpayers to utilize 100 percent of their current losses against past and future profits. Further, the temporary amendment applies to losses realized for tax years beginning before January 1, 2021, and allows businesses to carry back such losses for up to five years. Effectively, the amendment would permit businesses to request a refund for recently paid taxes.
Temporary Modification of Limitation on Losses for Noncorporate Taxpayers
In addition to the modification of Code section 172, the TCJA also added Code section 461(l), prohibiting noncorporate taxpayers from utilizing their “excess business losses” for the taxable year in which they are incurred. A noncorporate taxpayer’s “excess business losses” means the excess of the taxpayer’s business deductions over the sum of the taxpayer’s business income plus a threshold amount. The new limitation was intended to apply to tax years beginning after December 31, 2017, and before January 1, 2026.
Consistent with Congress’ efforts to permit taxpayers to utilize what would be prohibited business losses incurred as a result of the COVID-19 pandemic, the CARES Act amends section 461(l) to only apply to years beginning after December 31, 2020. Effectively, the CARES Act temporarily permits noncorporate taxpayers to utilize their business deductions to reduce or eliminate their nonbusiness income in the same year.
Temporary Modification of Net Business Interest Deduction Limitation
The TCJA also made amendments to the Code’s section 163(j) interest deduction limitation. For tax years beginning January 1, 2018, the amount of a taxpayer’s deductible business interest expense was generally limited to the sum of (1) the taxpayer’s business interest income for the year, (2) 30 percent of the taxpayer’s adjusted taxable income for the year and (3) the taxpayer’s floor plan financing interest expense for the year. Private equity funds were particularly affected by the limitation due to the highly leveraged nature of the industry.
As with the temporary repeal of the NOL limitation above, the CARES Act modifies the net business interest deduction limit from 30 percent of the taxpayer’s adjusted taxable income for the year to 50 percent for the 2019 and 2020 tax years. The provision is meant to provide much needed relief to those businesses that rely on debt to function as well as the corresponding interest deductions of such debt to shield their taxable income. Highly leveraged private equity funds in particular will greatly benefit from the adjustment, as they now will be permitted to utilize even more of their outstanding business interest expense deductions than previously expected upon the enactment of the TCJA.
Employee Retention Credit for Employers Subject to Closure Due to COVID-19
The CARES Act provides “eligible employers” a refundable credit against their payroll taxes for each calendar quarter equal to 50 percent of wages paid by such employers. The term “eligible employer” means any employer that was carrying on a trade or business during the 2020 calendar year and whose trade or business is (1) fully or partially suspended due to orders from an appropriate governmental authority due to COVID-19, or (2) experiencing an approximate 50 percent decrease in gross receipts compared to the same calendar quarter in the previous year.
Eligible employers under the amendment may only take into account $10,000 of compensation for each employee when determining their share of the credit. Furthermore, wages eligible for the credit’s calculation vary depending on the size of the employer. For example, for employers with more than 100 full-time employees, qualified wages only include those paid to employees who are not providing services due to the foregoing suspensions of their employer’s trade or business. Conversely, employers with fewer than 100 full-time employees may include all employee wages, notwithstanding the operations of such businesses. Finally, the credit shall only apply to wages paid after March 12, 2020, and before January 1, 2021.
Deferral of the Employer Portion of Social Security Taxes and One-Half of Self-Employment Tax
The CARES Act provides for the deferral of the employer portion of payroll taxes (effectively 6.2 percent of Social Security tax paid by employers) and one-half of the payroll tax paid by self-employed taxpayers (one-half of the 12.4 percent). Under the Act, one-half of the postponed payments will not be due before December 31, 2021, and the other half will not be due before December 31, 2022.
Technical Correction to Qualified Improvement Property
The TCJA also made amendments to the Code’s expensing provisions in an attempt to permit businesses to expense 100 percent of certain business property. However, in doing so, Congress failed to make an adjustment to the definition of “qualified improvement property” thereby excluding the application of the new 100 percent bonus depreciation provision to certain categories of property. Such excluded property generally includes interior improvements to buildings such as lighting, signs, etc. The failure has been frequently referred to as the “retail glitch” as retail and restaurant businesses alike frequently employ the type of property that was mistakenly excluded from the provision.
In an effort to provide businesses with even more cash flow (with tax scholars espousing that a 100 percent expense deduction is equivalent to a zero percent tax rate), the CARES Act finally corrected the retail glitch, thereby permitting all businesses to immediately deduct the cost of such property, and potentially greatly reducing their taxable income. As such, the Act finally rectifies one of the TCJA’s foremost mistakes that has materially affected the retail and restaurant industry since its enactment.
The CARES Act also made other changes that may affect the private equity industry, including, inter alia, the modification of (1) the credit for prior year minimum tax liability of corporations; and (2) Code section 2308 with respect to a temporary exception from excise tax for alcohol used to produce hand sanitizer. Please note that a discussion of the foregoing modifications to the Code beyond the scope of this Alert.
As the foregoing provisions show, the intent of both the CARES Act and Notice 2020-18 is to provide businesses with an excess amount of cash to keep them afloat during the pandemic and the corresponding economic downturn and kickstart the movement of cash during this period. For example, some experts have estimated that the deferral of Social Security and self-employment taxes will provide businesses with an estimated $732 billion in extra cash over the next two years. Consequently, private equity funds and their portfolio companies are likely to be direct beneficiaries of these provisions as they affect every business at both the fund and portfolio company level.
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Duane Morris has created a COVID-19 Strategy Team to help organizations plan, respond to and address this fast-moving situation. Contact your Duane Morris attorney for more information. Prior Alerts on the topic are available on the team’s webpage.
For More Information
This Alert is not intended to be an exhaustive analysis of the tax consequences that the CARES Act and Notice 2020-18 may have on private equity funds and their portfolio companies. If you would like more information on how the CARES Act and Notice 2020-18 may specifically affect you, please contact David A. Sussman, Maximilian Viski-Hanka, any member of our Private Equity Group or the attorney in the firm with whom you are regularly in contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.