There is considerable discussion about possible reform of the U.S. tax code in 2017.
Donald Trump campaigned on the issue of simplifying the tax code and lowering tax rates for individuals and companies.
Paul Ryan, Speaker of the House of Representatives, has advocated changes to the tax code for the past several years. There seems to be an emerging Republican consensus that tax rates should be lower, deductions should be reduced, the number of tax rates should be consolidated, the estate tax exemption should be raised or the tax eliminated, the carried interest capital gains treatment should be eliminated, and taxes should be reduced on overseas corporate profits brought back to the U.S.
There does not seem to be a consensus on what the exact tax rates should be, what specific deductions should be reduced or eliminated, whether corporations which move operations to other countries should pay an added tax, and how workers with low and moderate wages should be protected. There is also no apparent consensus how big a federal budget deficit should be tolerated.
When the politicians and tax experts gather, I hope they consider another change to fix the code and remedy a common practice that rewards investors for taking excessive risk, often leading to job losses and corporate closures. Private equity investors rely mostly on debt to fund corporate takeovers. This high-risk behavior is due to the potential for greater returns and favorable treatment under the current tax code.
In a typical takeover, the investors use as much debt as they can obtain and which they believe can be paid by the acquired company’s operations. For example, if they buy a company for $100 million and use $80 million in debt and $20 million in equity, and the company’s value rises $20 million to $120 million after expenses, the investors make a return of 100% (invest $20 million and receive $40 million). If they only used 25% debt, the investment return would be about 27% (invest $75 million and receive $95 million).
This encourages maximum use of debt and associated risk taking.
When an investment does not work and values decline, the use of high levels of debt can be catastrophic. Using our $100 million acquisition example, if the value declined 25% to $75 million and there was only $20 million in equity, the company would default on its debt. With only $25 million of debt, the investors would lose money but the company would remain viable.
U.S. tax laws allow interest on debt to be deducted, which further incentivizes investors to maximize use of debt. Depending on how the deal is structured, tax loses may even be used to offset other gains in the same fund. Equity invested does not receive the same tax treatment. In the case of our $100 million investment using a loan rate of 8%, the annual cost of the debt is about $6.4 million assuming no amortization ($80 million x 8%), which is fully deductible.
If the private investor required a 20% annual return, the partnership would pro forma $4 million in equity so total cost would be $10.4 million of which $6.4 would be deducted on taxes. With the second example of less debt, annual deductible debt cost would be $2 million ($25 million x 8%), required equity returns would be $15 million, for a total annual cost of $17 million.
While debt interest is deductible, dividends on equity are fully taxable. For investors who use more equity and less debt, their distributions will generally be taxed.
The consequences of using excessive debt can have dramatic effects on companies and employees when investors lose money. In late 2007, private equity investors acquired the Tribune companies using mostly debt. The acquisition included the Chicago Tribune, Los Angeles Times, Baltimore Sun, and other newspapers and media channels. The acquired company was bankrupt within a year with $13 billion in debt, mostly from the acquisition, and it remained bankrupt for four years with extensive layoffs and cutbacks clearly diminishing the quality of news coverage. Our tax policy of subsidizing debt led to the diminution of great newspapers, which many relied on for information as well as the loss of many jobs.
There are so many companies that have been lost or harmed by use of debt in takeovers such as Chrysler, Linens and Things, Sports Authority, TXU, etc. If acquisition debt were not tax deductible, there would still be acquisitions but the taxpayer would not be subsidizing the high-risk buyers. The marginal highest risk deals would likely not occur without subsidized debt.
It the new administration wants to preserve American jobs, they should stop subsidizing takeovers through the tax code by limiting the tax deduction of debt incurred. Why penalize use of equity and subsidize use of debt?
Scott MacDonald, a successful CEO with a history of turning around struggling companies, is the author Saving Investa: How An Ex-Factory Worker Helped Save One of Australia’s Iconic Companies. MacDonald’s decades of corporate experience include serving as a senior consultant for Morgan Stanley, president of New Plan Excel Realty Trust and CEO of Center America Property Trust.
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