Annual Accounting & Tax Update for Private Equity Funds

Transcription

1 Annual Accounting & Tax Update for Private Equity Funds January 13, 2015

2 Today s Presenters Matthew Rotta Nick Maroules Tom Lenz Joe Bergthold Private Equity Audit Partner Private Equity Audit Sr. Manager Private Equity Tax Partner Private Equity Tax Sr. Manager 1

3 Accounting Update

4 Accounting Update Agenda New and proposed accounting standards Best practices in back office operations SEC focus areas SBIC update 3

5 New Accounting Standards

6 ASU Presentation of Financial Statements (Topic 205) - Liquidation Basis of Accounting The ASU requires entities to report using the liquidation basis of accounting when liquidation is imminent, unless the entity is following a liquidation plan established at its inception - Costs expected to be incurred through the end of liquidation should be accrued as of the reporting date, when such costs are reasonably estimable - Liquidation Determination Date (LDD) is the date at which an entity changes from the going-concern basis to liquidation basis of accounting - Required vs. Optional Financial Statements Disclosure requirements 5

7 ASU Investment Companies (Topic 946) ASU set forth a new approach for determining whether a public or private company is an investment company - The ASU also clarified the characteristics and set measurement and disclosure requirements for an investment company. 6

8 Proposed Accounting Standards

9 Proposed ASU Fair Value Measurement (Topic 820), Disclosures for Investments that Calculate NAV Disclosures for Investments in Certain Entities that Calculate Net Asset Value (NAV) per Share (or Its Equivalent) - If finalized, the proposed ASU would remove the requirement to categorize within the fair value hierarchy investments for which fair values are measured at NAV using the practical expedient - Continued use of the practical expedient to determine fair value and disclosure of information on such investments to help users understand the nature and risks of the investments 8

10 Proposed ASU Financial Services Investment Companies (Topic 946), Disclosures About Investments in Other Investment Companies Disclosures about Investments in Other Investment Companies - If finalized, the proposed ASU would REQUIRE a feeder fund in a master-feeder structure to provide the master fund s financial statements along with its financial statements - The ASU would also expand the scope of the current requirement to disclose certain information about investments held by investee funds that exceed 5% threshold of the reporting entity s net assets 9

11 Consolidation Dec. 2014, FASB completed its consolidation project and review process of the proposed ASU - Final standard anticipated to be issued in Feb Standard will apply to all industry sectors no exception for investment companies - FASB to provide interpretive guidance to clarify how voting rights held by the shareholders of these entities should be evaluated when determining whether that fund is a VIE 10

12 Consolidation (cont.) Determination of a VIE - An entity is a VIE if a simple majority or lower threshold of the partners (including the general partner and its related parties) lack substantive kick-out, liquidation, or participating rights - Consideration of related party relationships between partners that would make the contractual rights they hold unlikely to be exercised - Additional consideration of indirect interests Considerations involving consolidation of holding companies and blockers 11

13 Best Practices in Back Office Operations

14 Best Practices for Private Equity Valuations Internal controls around inputs, review and overall processes - Valuation policy - Valuation committee - Documentation requirements - Decision flow-chart or checklist - Approval process - Consistent application of process - Segregation of Duties between investment, valuation, and accounting/financial reporting Real involvement from the General Partner Use of a valuation specialist to help you develop your models, provide access to comparable information and provide related guidance Understand why your Limited Partners require fair value reporting 13

15 Best Practices for Private Equity Valuations (Cont.) Detailed investment valuation narratives to explain: - Overview of the portfolio company describe the past performance and expectations for the future - What is the principle or most advantageous market - Identify the valuation techniques used - Why a specific valuation technique was used or given a greater weight - Why specific public or M&A multiples were used and why they are valid comparisons - Explain the reason for the selection of specific multiple - EBITDA add-backs - Unusual items in the waterfall (preferences, etc.) 14

16 Best Practices for Private Equity Valuations (Cont.) Use of multiple methodologies (income and market approaches) Determine a range of values before reaching conclusion Build up an internal database of M&A transactions (wins and losses) Don t automatically add back cash without considering working capital Additional documentation and support when the most recent financing is considered the best evidence of fair value Provide documentation that can be audited to support your inputs Do not consider the cost to sell in the valuation Day one gains or losses are possible Public stock: - Discounts only if trading is restricted - Some public stock is not traded in an active market 15

17 Valuation of Early Stage Portfolio Companies Generally, for early stage companies, private equity funds should, to the extent possible, obtain observable data points & market data points (Revenue/EBITDA/Multiples) and use market approach and/or income approach the more mature operations are the greater reliability of such methods Option Pricing Model should be considered. Transaction (entry) price may equal exit price and therefore represents fair value at initial recognition, unless: The transaction is with related parties, the transaction occurs under duress for either party - Therefore valuations set at most recent financing is often used in early stage investments - the validity of a valuation obtained in this way inevitably is eroded over time. Consideration should be given if price in last transaction is affected by: Change in performance/prospects for company (indicators could be failure to meet milestones, breaches of covenants, deterioration in budgeted or forecast performance) Significant adverse change in company s business, technological or regulatory environment in which it operates Market conditions deteriorated Company raising money and it seems that it may be under significantly different terms & conditions than original investment 16

18 Valuation of Early Stage Portfolio Companies (Cont.) Investment narratives documenting actual performance and potential Demonstrate monitoring of budgets and milestones In determining which method to use - consider: When the investment was initially made how was the valuation determined? If you were to sell the investment how would you determine if an offer is acceptable? 17

19 Best Practices for Private Equity - Capital Account Maintenance Understand your LPA Interest charged to LPs entering after the first close Preferred return computations start on day 1 Understand the differences between income allocations and distributions Targeted capital accounts and the importance of tracking cumulative allocations - Track sources and uses of capital - Track cumulative waived fees and waiver contributions - Track cumulative components of income (loss) Special tax distributions and tax withholdings - Including tax paid by portfolio companies on behalf of LPs Clawbacks 18

20 Other Best Practices Accounting manual to document procedures Standardized forms and templates - Investment summary (cap table other key investment terms) - Cash management - Capital accounts and related computations including waterfalls, preferred return computations, income tracked by type on a cumulative and annual basis - Investor reporting, capital calls, distribution notices, quarterly reports - Tax worksheets - Investment deal flow tracking - Portfolio company investment monitoring 19

21 ILPA Guidelines and Best Practices What is the Institutional Limited Partners Association (ILPA)? ILPA Private Equity Principles - Alignment of interest - Governance - Transparency ILPA Standardized Reporting Templates - Guidelines - Sample quarterly reporting package, including financial statements - Sample quarterly reporting checklist - Sample capital call and distribution notices 20

22 Other Key Accounting Issues

23 Revenue Recognition Sale of portfolio companies - Expense of the transaction - Escrowed proceeds - Other non-cash proceeds - Earn-outs - Date of agreements Accounting for investments in LLCs - Flow-through entities still carried at fair value - Distribution from flow-through entities are analyzed to determine if they are return of capital or income - Generally, tax distributions would be income to the fund when declared 22

24 New Fund and Start Up Issues Accounting for organization and syndication costs Admitting new partners after the initial close: - True-ups - Interest charges, including interest to GP if applicable - Refund of excess contributions and allocation to investments Set up process to track preferred return Set up process to track sources and uses of capital 23

25 Accounting and Recognition of Secured Borrowings Arise from loan participations or syndications where the original terms end up changing - First-out / last-out features If a transfer or sale of a loan or portion of a loan occurs (as is the case with a loan participation), the transfer is subject to ASC 860, and a determination must be made of whether or not the transaction qualifies for sale treatment If a participation or partial loan sale does not meet the definition of a participating interest, the portion transferred should remain on the books and the proceeds recorded as a secured borrowing liability until the definition is met Recent McGladrey white paper on this topic 24

26 SEC Focus Areas

27 SEC Independence The Requirement to Be Independent SEC independence impacts more than just public companies - Funds with registered investment advisers Hedge funds PE funds including portfolio companies Independent of audit client and all affiliates of that client - Control - Significant influence 26

28 Summary of Independence Rules Investment Company Complex Type of Audit RIA Registered Independence Fund Yes SEC SEC Yes State SEC Yes Exempt AICPA Fund No N/A AICPA Adviser (no fund audits) Yes SEC AICPA Adviser (including fund audits) Yes SEC SEC 27

29 SEC Independence Prohibited Services Financial statement preparation Providing templates - Tax provision - Stock option pricing models - Goodwill or long-lived asset impairment - Fair value allocation in connection with a business combination - Any other templates Involvement with financial information systems - Operating or supervising the operation of the client s information system - Managing the client s local area network - Providing hosting services for the client or its affiliates Loaned staff 28

30 SEC Independence Prohibited Services (Cont.) Prohibited involvement - Typing - Word processing - Assembling - Proofing - Printing - Binding 29

31 SEC Presence Exam Update Continued focus on fee and expense disclosure practices Recent enforcement actions: - Clean Energy Capital, LLC - Lincolnshire Management, Inc. 30

32 SEC Presence Exam Update Recent areas of SEC attention: - Disclosure of calculation of average net returns in marketing materials - Private equity consultants ( Operating Partners ) - Valuation practices 31

33 SEC s Operation Broken Gate Update Initiative of the Enforcement Division to hold gatekeepers accountable for the important roles they play in the securities industry Focus/findings areas: - Past: Independence violations Partner rotation Improper engagement quality reviews - Potential future: Audit committees and directors 32

34 SEC s Broken Windows Strategy Former NYC Mayor Giuliani applied this theory to the city s policing SEC applied to the securities markets Tougher approach leads to tougher sanctions by enforcement division 33

35 SBIC Update

36 SBIC Update SBA status update fiscal year end 9/30/14 results Latest pooling rates Licensees drawing at 3:1 leverage rate SBA exams Amendments to the SBA regulations Legislation update Filing Form SBIC Fund CFO Conference 35

37 Tax Update

38 Tax Update Agenda Legislative Update and 2015 Outlook FAQ: Tax-Planning Considerations FAQ: Common Tax Compliance Issues 37

39 Legislative Update The Tax Increase Prevention Act of 2014 (Tax Extenders) 2014 Cases, Rulings and Developments 2015 Legislative Outlook FATCA Update State Tax Update 38

40 Tax Increase Prevention Act of 2014 Before the end of 2014, Congress passed the Tax Increase Prevention Act of 2014 New law extends more than 50 tax incentives (called tax extenders ) - Extension of a number of individual and business tax provisions Retroactive for 2014 tax year 39

41 Tax Increase Prevention Act of 2014 Relevant Business Provisions - Extension of temporary exclusion of 100% of gain on certain small business stock (QSBS) - Extension of bonus depreciation - Extension of increased expensing limitation provided under Section Extension of various credits (research credit, work opportunity credit) - Extension of a number of energy tax extenders 40

42 2014 Cases, Rulings, and Developments

43 Self-Employment Tax CCA P1 P2 P3 W-2 Salaries Paid Management Company (LLC) Profits G.P. (LLC) LPs GP GP Management Fees Managed Fund, LP Trading & Investing 42

44 CCA Taxpayer argued that wage amounts were reasonable compensation and that distributable share of income was not subject to SE Tax IRS concluded treatment was improper as partners of the management company performed significant services For more information visit: 43

45 CCA Who Must Sign the Partnership Return? Who is able to sign our fund s partnership tax return? - The return must be signed by a partner to be valid return Partnerships must be signed by general partner Limited liability companies must be signed by member manager An officers or employees is not a valid signatory of the partnership tax return Only a natural person may sign a return CCA reinforces this requirement Even if the entity return is invalid, the return that starts the running of the statute of limitations period is that of the partner or LLC member 44

46 Potential Consequences of Wrong Person Signing Return Partnership monetary penalties Potential open statute of limitations TEFRA audit proceedings Invalidated elections Loss of deductions and credits Return preparer penalties Potential liability to innocent partners 45

47 Change in Responsible Party New for 2014, a change in responsible party must be reported to the IRS within 60 days of the change Form 8822-B should be filed to report change Responsible Party defined as - The person who has a level of control over, or entitlement to, the funds or assets in the entity that, as a practical matter, enables the individual, directly or indirectly to control, manage, or direct the entity and the disposition of its funds and assets Principal officer of a corporation General partner of a partnership 46

48 Tangible Property Regulations Effective for 2014 The tangible property regulations should have been addressed at the year-end planning meetings of your portfolio companies All companies are required to comply by effective date - Need to review capitalization policies and compliance with new rules - Review of old tax methods and new tax methods - Implement new capitalization policies in Elections and/or change in accounting method changes may need to be filed to comply with new regulations - If utilizing safe harbor provisions: Policy or procedure must be in place by January 1, 2014 Financial statement must be consistent with tax treatment - Company to update internal policy memos 47

49 2014 IRS Examination Trends Increased interest in investment management industry Potential increase in audit rate of partnership returns IRS budget-constrained How to prepare for an examination Key audit issues based on entity - Fund - Management Company - General Partner - Blocker Corporation - Portfolio Company 48

50 2015 Outlook: Legislative Position Changes Paul Ryan (R-WI) new chair of House Ways and Means Committee Orrin Hatch (R-UT) new chair of Senate Finance Committee January 6, 2015: House passed change to revenue scoring Top legislative issues for

51 Foreign Account Tax Compliance Act (FATCA) FATCA is now in effective Busy year for Treasury/IRS - Issuance of regulations - Executed several Intergovernmental Agreements - Issuance of final version of forms and instructions (Forms W- 8BEN, BEN-E, IMY, EXP, 1042, 1042S, Published listing of registered foreign financial institutions via website: Foreign-Financial-Institution-List-Search-and-Download-Tool - Issued Notice providing further guidance on FATCA implementation and withholding provisions - IRS recently released updated Publication 515 Withholding of Tax on Nonresident Aliens and Foreign Entities, 2015 Form 1042S and Form

52 Foreign Account Tax Compliance Act (FATCA) Refresher what is FATCA? - Prevents offshore tax evasion and better transparency of U.S. individuals holding assets offshore through offshore accounts/investment vehicles - Enforcement through compliance and withholding requirements Two prongs of reporting - U.S. individuals must self-report foreign financial assets - FFIs must report U.S. account holders Failure to comply results in withholding on certain types of U.S. income (FDAP) 51

53 FATCA Foreign Account Tax Compliance Act (FATCA) How does it impact my fund? Depends upon if your fund is a domestic or foreign fund? - Domestic fund Gather required data on foreign LPs, reconcile any conflicting data, will be deemed a withholding agent and required withhold on noncompliant LPs - Foreign fund Gather required data on foreign LPs, reconcile any conflicting data, withhold on noncompliant LPs Register with Treasury via portal - PFFI or follow IGA - Obtain GIIN - PFFI annual disclosure 52

54 Planning Foreign Account Tax Compliance Act (FATCA) What can be done to prepare for FATCA? Planning should start now Phase 1 planning - Review fund and organization structures and determine entity classification under FATCA - Determine which entities will need to file an FFI agreement with Treasury or if foreign fund is domiciled in a jurisdiction with an IGA Portal now open - Review documentation of investment account and classify investor accounts into FATCA categories - Request and Review investor documentation U.S. indicia Proper certification documentation (forms W-9, W-8BEN, W- 8BEN-E, W-8IMY etc. - Verify foreign status (articles of incorporation) - Verify GIIN numbers with IRS Published list. - Verify foreign investor has provided foreign tax ID or U.S. ITIN 53

55 Foreign Account Tax Compliance Act (FATCA) Phase 2 Planning: - Remediate investor accounts - Establish database to store required FATCA documentation - Create investor information checklists - Establish on-boarding procedures for new investors - Offering documents should contain FATCA language Example: should discuss fund s intention to register as a PFFI - Discuss FATCA implementation with all teams of the organization as FATCA is more than just an accounting department issue Phase 3 Planning: - Establish protocols and accounting procedures for FATCA withholding and reporting Investor communication and education about FATCA implementation and the additional requirements of the investor to provide information will be crucial 54

56 Foreign Account Tax Compliance Act (FATCA) Key Dates in May 2014 FFI finalized FATCA registration in IRS Portal - June 30, 2014 Earliest FFI Agreement date - U.S. Withholding Agents (USWAs) and FFIs began due diligence procedures on pre-existing accounts - July 1, 2014 FATCA withholding began on new accounts held by documented non-participating FFIs PFFIs begin withholding on recalcitrant account holders - December 31, 2014 USWAs and PFFIs Expiration of withholding certificates delayed - December 31, 2014 Due diligence should be completed for prima facie FFIs and for pre-existing accounts 55

57 FATCA Key Dates January 1, 2015 Withholding begins on undocumented, pre-existing, non-participating FFIs March 31, 2015 First FATCA reports for 2014 due on Form 8966 (must be filed electronically); Automatic 90- day extension available via Form 8809 July 1, 2015 Withholding begins on pre-existing accounts September 30, 2015 Model 1 IGA requires competent authority to begin reporting to IRS on annual basis December 31, 2016 Withhold on gross proceeds from the sale or other disposition of any property of a type that can produce interest or dividends 56

58 State Tax Update Illinois - Reduction in individual and corporate tax rates Individual rate reduced from 5% to 3.75% Corporate tax rate reduced from 7% to 5.25% No change to replacement tax rates (2.5% corporations/ 1.5% trusts, S-corporations and partnerships) - Net Operating Losses no longer limited for C-corporations NOLs previously limited to $100,000 for tax years prior to tax years ending on or after December 31, Nonbusiness income sourced to Illinois now subject to nonresident withholding - Form IL 1000 (Nonresident withholding form) and Form IL 1023-C (Composite form) have been retired. Amounts will now be reported on 2014 forms IL-1065, 1120-ST, and 1041 Payments will be made with Form IL 505-B 57

59 State Tax Update California - Swart Enterprises Inc. v. California Franchise Tax Board Blocker corporations and LLCs that own an interest in an LLC doing business in California Superior Court held that mere passive investment in LLC is insufficient to meet CA doing business standard - Business entities required to electronically file returns - Sale of Partnership Interests and Chief Counsel Ruling Proposed amendment to Regulation Sourcing of management fees based on ratio of partners/shareholders domiciled in CA over fund s partners/shareholders everywhere 58

60 State Tax Update New York - Corporate tax reform Rate to reduce from 7.1% to 6.5% Phase out of capital base tax - Market-based sourcing required for corporations - For non-us corps, adopted effectively connected income as starting point - Economic Nexus provisions are based on gross receipts >$1M 59

61 Tax Planning Considerations and Common Compliance Issues - Frequently Asked Questions

62 FAQ Net Investment Income Tax Are there any strategies to help reduce the 1411 Net Investment Income Tax? Do you anticipate changes to be forthcoming? 61

63 1411 Net Investment Income Tax The Net Investment Income ( NII ) tax is in addition to all other taxes, including the Alternative Minimum Tax Called the 1411 Tax, Medicare Tax, the 3.8 Percent Tax, the NII Tax Applies to individuals, estates and certain trusts that have income above the statutory threshold amounts Effective January 1, 2013 Tax is levied on the LESSER of net investment income (NII) or the amount by which modified adjusted gross income (MAGI) exceeds a threshold amount Applicable Threshold Amounts (which are NOT indexed for inflation) - Married Filing Jointly $250,000 - Married Filing Separately $125,000 - Other returns (Single/HOH) $200,000 Tax is applied at a rate of 3.8%. No credits are applicable 62

64 Typical Private Equity Fund Structure Individual A Individual B Individual A Individual B 50% 50% General Partner, LLC ( GP Entity of Upper Tier ) 2% Management Fee Fee Offset Management Company (S Corp) Limited Partners 99% 1% 20% Carry PE Fund I, LP (The Fund of Middle Tier ) Employees Advisor Fee Others Loans C Corporation Stock (aka Portfolio Company) Warrants OpCo, LLC ( OpCo or Lower Tier or Portfolio Company ) 63

65 NII Tax Takeaways Review the structure of your management company and GP entities Consider how you should group your activities under the fund structure Consider any potential grouping elections 64

66 FAQ Investing in an Operating LLC We recently made an investment in an operating LLC What should we be aware of? - Impact to foreign/tax-exempt investors Withholding Change needed to structure - In what states is the LLC active? State withholding considerations - When will the LLC K-1 be received? Does this impact the timing of fund K-1s? - Exit Issues Sale of Assets vs. Sale of Member Interest Overall, procedures should be in place to ensure a tax sign-off on the deal structure 65

67 FAQ - Electronic Schedule K-1 Distribution What are the rules? - Consent required for electronic distribution according to Revenue Procedure Consent must include several specific items Provide taxpayer with notification tax info is available - Include in Subject Line IMPORTANT TAX RETURN DOCUMENT AVAILABLE If posted on website, must be available for the later: - 12 months following the tax year - 6 months after issuance of the K-1 $100 Penalty per payee for failure to comply Without consent or response MUST provide paper copy The duration of the consent must be stated 66

68 FAQ Worthless Stock When can I take a worthless stock deduction? - Must prove worthlessness no liquidation or future value - Should point to an identifiable event - Must substantiate tax basis in the security 67

69 FAQ Non-accrual The borrower is in financial difficulty. Can I put the loan on non-accrual status for tax purposes? - If collection is doubtful can put on non-accrual status - Would usually match book accounting - Contrast with OID portion of loan 68

70 FAQ Impaired Loan The borrower is in financial difficulty and the loan is impaired. Can I write down the loan for tax purposes? Does it matter if any recovery is remote? - Security or debt? - Business or non-business? 69

71 FAQ Impaired Loan C IRC 165 IRC 166 Capital Asset Non-Capital Asset Security Write-off is capital loss Partial write-off not allowed Write-off is ordinary Partial write off is not allowed Non Security Write-off is capital loss Non-business: partial write-off is not allowed Business: Partial write down is ordinary Write-off is ordinary Partial write down is ordinary 70

72 FAQ Qualified Small Business Stock Earlier you mentioned that the temporary 100% gain exclusion was extended for tax year To what other tax years does this apply? 71

73 FAQ Qualified Small Business Stock Generally, 50% gain exclusion 75% gain exclusion for stock acquired between Feb. 18, 2009 and Sept. 27, % gain exclusion starting 9/28/2010 through 12/31/ % gain exclusion for 2015 unless re-extended or made permanent 72

74 FAQ Qualified Small Business Stock Requirements: - Stock in a domestic C Corporation - Acquired at original issue - Gross assets $50M or less (before and after issuance) - Active business requirement Generally excludes service businesses - Exclusion limited to greater of $10M less any prior exclusions Ten times basis - Must hold stock for more than 5 years - Gain exclusion applies to non-corporate taxpayers Best Practice Note proper documentation when investment is made and disclosure on Schedule K-1 footnotes 73

75 FAQ Rollover of Gains from Small Business Stock I ve heard that you are able to rollover the gains from the sale of small business stock. Can you elaborate on how that would work? 74

76 Questions? For more information, please contact: Matthew Rotta Nick Maroules Tom Lenz Joe Bergthold mcgladrey.com mcgladrey.com cgladrey.com mcgladrey.com

77 Before we conclude How did we do? Please take a moment to participant in the attendee survey by following the link in the Resource List to the right of your screen CPE credit Eligible participants will receive 1.0 credit for attending today s event Visit the Certification panel to the right of your screen - Be sure to download and save your certificate to your computer before the event concludes - McGladrey employees: CPE will automatically appear on your LearningLinks transcript within 30 days (no further action is required) Follow-up We will respond to all questions following today s event The presentation slides and a link to the call recording will be sent to all participants within a few days

78 This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute assurance, tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. McGladrey LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person. McGladrey LLP is an Iowa limited liability partnership and the U.S. member firm of RSM International, a global network of independent accounting, tax and consulting firms. The member firms of RSM International collaborate to provide services to global clients, but are separate and distinct legal entities that cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party. McGladrey, the McGladrey logo, the McGladrey Classic logo, The power of being understood, Power comes from being understood, and Experience the power of being understood are registered trademarks of McGladrey LLP. McGladrey LLP One South Wacker Drive Suite 800 Chicago, IL