Overview
Most models taught in schools and on-the-job training programs spend little time diving into the practical complexities of taxes in the context of business acquisitions. One example relates to a company’s entity type for tax purposes – nearly all LBO templates assume the entity being acquired is a corporation (typically a U.S. C-Corp), that pays corporate tax at the entity level before being able to pay dividends to its shareholders.
There are other entity types, however, that are commonly encountered in private equity. This note explores “flow through” or “pass through” entity types, such as U.S. Limited Liability Companies (“LLCs”) and S-Corps, and how they differ from traditional C-Corporations when modeling a leveraged buyout transaction. For simplicity throughout the note, we’ll refer to all such entities as LLCs and all C-Corporations as “C-Corps.”
There are three primary characteristics that make LLCs different the C-Corps from a deal modeling perspective:
No Entity-Level Taxation. C-Corps pay a corporate tax (~26% in the United States) on any positive taxable income generated by the entity. Then, dividends paid to the C-Corp’s shareholders are once again taxed, but at a lower dividend tax rate. LLCs on the other hand, do not pay any tax at the entity level. Shareholders of the LLC, however, pay income tax annually on their proportionate share of the entity’s taxable income (i.e., if you own 20% of an LLC, you will owe 20% of its tax burden annually).
Tax Distributions. Due to the ongoing annual tax payment obligation by shareholders of an LLC, it is standard for LLCs owned by private equity firms to pay their shareholders a yearly dividend (typically referred to as a “tax distribution”) greater than or equal to the tax obligations of the highest marginal tax payer in their shareholder base (typically 51% to accommodate high-earners based in NYC). While this creates a cash flow burden on the operating company (this cash would otherwise be available to pay down debt, or reinvest into the business, etc.), it also has the benefit of pulling forward return of capital in the deal, in turn increasing deal IRRs, all else being equal.
Tax Shield from Tax Basis Step-up. LLCs have “tax basis” which can be thought of as the relevant tax authority’s (e.g., IRS) view of the value of the LLC’s assets net of past tax depreciation. When a private equity firm buys an LLC, they typically pay more for the LLC than its tax basis. The new, higher purchase price, then becomes the tax authorities’ updated view of the LLC’s tax basis, and the difference between this new, higher value and the original tax basis is referred to as “step-up” (i.e., because the tax basis has stepped up to this new, higher value). The step-up value can be amortized over some period of time (typically 15 years) and the resulting amortization can be used as an expense to reduce the LLC’s taxable income. This reduction of steady-state tax payable can be highly valuable and can create a material tax asset for a private equity buyer. Because the life of the tax asset (~15 years) is longer than the typical life of a private equity hold period (~5 years), the tax asset created will likely have some value to the next buyer of the LLC when the first buyer sells it, and as such may be reflected in the exit value as an additional source of exit proceeds.
Benefits of LLCs over C-Corps in Private Equity Deals
Some private equity firms really, really prefer buying LLCs over C-Corps. This is particularly the case when a large portion of their LP base is comprised of tax-exempt investors (e.g., government pension funds). All else being equal, these investors benefit materially from an investment in an LLC over a C-Corp, because their tax-exempt status doesn’t help them shield any taxes at the entity level – only at the shareholder level. As we noted above, LLCs pay zero entity-level tax, but pass the full taxable income burden directly to shareholders. For tax-exempt investors, this can result in no income taxes being paid whatsoever, which can be a material boost to investment performance (e.g., IRR, MOIC) when compared to a like-for-like C-Corp investment where ~26% of the business’ earning power goes to the government instead.
Even for non tax-exempt investors, the tax distribution mechanism described above means investors receiving some of their return of capital sooner under an LLC structure vs. a C-Corp. While the C-Corp could theoretically pay an annual dividend to mimic this benefit, the practical reality is that cash flows in a levered investment are typically used to pay down debt ahead of dividends to shareholders during the investment hold period.
Drawbacks of LLCs vs. C-Corps in Private Equity Deals
The only practical drawback of the LLC structure is the significant administrative burden of monitoring and tax reporting (K1s to each unit holder, etc.) associated with LLCs vs. C-Corps. Large private equity firms have armies of dedicated finance professionals tasked with executing this activity across hundreds of portfolio companies and hundreds of LPs – whereas the task might be a bit more daunting for smaller private equity firms.
If a private equity firm’s LP base has few or no tax-exempt investors, and the potential tax basis step-up is not significant, they might conclude that the cost associated with the administrative burden is not worthwhile and convert the LLC to a C-Corp.