All for One or None for All: Aggregating Entities for the Corporate Minimum Tax
As the Senate debated the newly-enacted Inflation Reduction Act earlier this month, the interaction between the corporate minimum tax, the aggregation rules of section 52, and the private equity industry came under the spotlight. This post explains the issue and offers a few considerations for the future.The corporate minimum tax (CMT) in the Inflation Reduction Act (IRA) signed into law yesterday by President Biden (the enacted IRA) is significantly more favorable to the private equity (PE) industry than the version proposed in the Build Back Better Act (BBBA). The CMT evolved in several ways since the BBBA, but the change that is particularly relevant to the PE industry ensures that fewer portfolio companies will be subject to the tax. The relevant text in the enacted IRA is similar to the corresponding text in the BBBA; the substantive difference derives from an underlying cross-reference to section 52. That cross-reference attracted significant attention as the Senate entered its “vote-a-rama” on amendments to the IRA and played a pivotal role in the final negotiations leading to its passage. This post reviews the relevant procedural and technical background of this issue before considering some consequences of the change, including the potential for future legislation, regulatory guidance, and planning opportunities.
Section 52
Section 52 provides rules for aggregating various groups of entities. These aggregation mechanics are incorporated in many other Code provisions including sections 41, 51, 59A, 163(j), and 448(c). They are also incorporated in the CMT, as discussed below.
Section 52(a) provides rules for corporate groups, and section 52(b) provides rules for groups that include both corporate and non-corporate entities, such as partnerships. The two regimes, which share the same basic mechanics and ownership thresholds, are generally intended to achieve similar results (as the flush language in section 52(b) indicates).
However, there is an important difference between section 52(a) and (b). The regulations under section 52 (and arguably the language of section 52(b) itself) require that each entity in the aggregated group be engaged in a trade or business. The statutory language of section 52(a) includes no such requirement.
Neither the statute nor regulations define a “trade or business” for purposes of section 52. However, the term is typically understood to refer to a trade or business for purposes of section 162. The PE industry commonly takes the position that PE funds are not engaged in a trade or business and thus not subject to aggregation under section 52(b).
Build Back Better Act
The BBBA passed by the House on November 19, 2021, would have amended section 52 in various ways, including by clarifying that the term trade or business includes a trade or business described in section 469(c)(6). That section, in turn, refers to any activity for which deductions are allowed under section 212, the provision which generally allows individuals to deduct expenses incurred in the production of income. During the development of the BBBA, numerous firms noted that this revised definition would foreclose the argument that a PE fund is not engaged in a trade or business. As a result, PE funds would clearly be subject to section 52 aggregation. This change would have rippled out to the various existing Code provisions that cross-reference section 52, as well as the cross-referencing provisions elsewhere in the BBBA.
The CMT
At a high-level, the CMT requires a two-step analysis. First, which entity is an “applicable corporation”? Second, what is each applicable corporation’s relevant book income (referred to as “adjusted financial statement income” or “AFSI”) that is potentially subject to the CMT?
The first step, which involves defining an applicable corporation, incorporates the mechanics of section 52. Each version of the CMT throughout its legislative development has generally provided that for purposes of identifying an applicable corporation, if a corporation is part of an aggregated group under section 52(a) or (b), all of the AFSI of the group is attributed to that corporation.
Section 59(k)(1)(D), as proposed in the BBBA, did not provide for any adjustments to the operation of section 52. However, as described above, the amendments to section 52 in the BBBA would have explicitly treated many PE funds as engaged in a trade or business. Thus, the funds would clearly be subject to aggregation under section 52(b).
The relevant text of section 59(k)(1)(D) in the proposal unveiled by Senators Manchin and Schumer on July 27, 2022, (the July 27 proposal) generally mirrored its counterpart in the BBBA. However, the July 27 proposal would not have amended section 52. Thus, the cross-reference to section 52 would have incorporated section 52 under current law and an arguably narrower definition of a trade or business. Accordingly, the July 27 proposal would not affect the PE industry’s position that a fund is not aggregated under section 52(b).
The updated proposal released by the Senate Finance Committee on August 6, 2022, (the August 6 proposal) conformed the text of the CMT with the outcome in the BBBA by incorporating the BBBA’s changes to section 52. These adjustments would not have extended to the other provisions in the Code that cross-reference section 52; they would have applied only for purposes of identifying an applicable corporation under section 59(k). Thus, under the August 6 proposal, a PE fund would clearly be treated as engaged in a trade or business for purposes of the CMT and therefore aggregated under section 52(b).
The inclusion of a PE fund in section 52 aggregation under the BBBA and the August 6 proposal would not render the fund, a partnership, an applicable corporation. But it would ensure that the AFSI of the fund and its various portfolio companies is aggregated for purposes of determining whether the portfolio companies are applicable corporations. However, the adjustments to the operation of section 52 in the August 6 proposal were ultimately removed. As a result, the CMT in the enacted IRA captures fewer PE portfolio companies than the CMT proposed in the BBBA, at least under the industry’s interpretation of the term “trade or business.”
Considerations going forward
Policy: The significant role this issue played in the development of the IRA could invite additional attention in the future. Concerns about horizontal equity may suggest that PE portfolio companies should have the same exposure to the CMT as subsidiaries of other large, sophisticated businesses. Indeed, the enacted IRA affords the PE industry a competitive advantage over other industries in pursuing acquisitions. However, there may also be an argument that the relationship between portfolio companies is different from the relationship between subsidiaries of a large corporation. The various portfolio companies owned by a PE fund may not even know of each other’s existence and thus arguably should not be aggregated (although the same might be said about the subsidiaries of a diversified conglomerate).
Legislation: If Congress revisits this issue, it may return to the amendments to section 52 that were included in the BBBA. An alternative approach would be to adjust the operation of section 52 for specific purposes, as the August 6 proposal would have done for the CMT. In either case, the revenue estimates developed over the course of the BBBA and IRA offer a useful reference point for any future efforts at reform.
The revenue impact of amending section 52 under the approach adopted in the BBBA would depend on the effect of those amendments on the numerous provisions that cross-reference section 52. For example, section 448 permits certain small businesses to use the cash method of accounting. Similarly, section 163(j)(3) provides certain small businesses an exception to the limitation on the deductibility of business interest expense. Each of these rules defines a small business, in part, by reference to the aggregation rules of section 52. The section 52 mechanics are also incorporated in other provisions, including the R&D credit, the work opportunity credit, and the base erosion and anti-abuse tax. The Joint Committee on Taxation (JCT) estimated that the BBBA’s amendments to section 52 would raise approximately $16 billion of revenue from 2022 through 2031.
It is unclear if the JCT’s estimate included the impact of amending section 52 on the CMT. When a single tax bill includes multiple interacting provisions, the “stacking order” of the provisions — that is, the sequence in which they appear on the revenue table — generally indicates where the interaction is captured. The first provision in the revenue table typically does not incorporate the interaction, but the second provision does. Stated differently, the estimates assume that the law is changed in the order in which the provisions appear in the table. (The JCT may also include a separate line that notes the interaction.)
The stacking order in the revenue table for the BBBA would suggest that the estimate for the amendments to section 52 included the impact of those amendments on the CMT. The CMT, which was titled the “Corporate alternative minimum tax,” appeared before the amendments to section 52, which were titled “Rules relating to common control.” This sequence would usually indicate that the approximately $319 billion estimate for the CMT for 2022 through 2031 was computed against a baseline that assumed current law section 52. Accordingly, the impact of amending section 52 on the CMT would be reflected in the subsequent estimate for those section 52 amendments.
However, the impact of amending section 52 on the CMT may instead have been reflected in the estimate for the CMT. While the Senate was debating the IRA, it was disclosed that the changes to section 59(k)(1)(D) in the August 6 proposal were estimated to raise approximately $35 billion of revenue from 2022 through 2031. If this $35 billion figure was included in the estimate for the amendments to section 52, then the gross revenue raised by amending section 52 must have been offset by one or more substantial outlays to reach the net estimate of $16 billion. It is unclear which, if any, of the provisions that cross-reference section 52 might account for a revenue loss of that magnitude. Alternatively, the JCT may have included the $35 billion in the line-item for the CMT in order to more fully reflect its impact as the single largest revenue provision in the bill.
In any event, if Congress revives the amendments to section 52 from the BBBA, the revenue estimate will be computed against a new current law baseline that includes the CMT. That new baseline will also include a number of other new provisions in the IRA that cross-reference section 52, including those addressing healthcare and decarbonization. Any new estimate will also account for new information not available when the estimates for the BBBA and IRA were prepared, such as guidance or additional information about taxpayer planning.
Guidance: Treasury and the IRS may also consider addressing this issue with regulatory guidance. As described above, the term trade or business is not defined for purposes of section 52. Thus, regulations could define the term in a manner consistent with the BBBA and the August 6 proposal, or in a different manner altogether. Such an approach would be consistent with existing guidance in which the term “trade or business” is defined for a particular purpose, such as regulations issued under sections 355, 367(a), and 989.
Regulatory guidance may also revise some of the operational mechanics under section 52(b). Notably, the statute only provides, in relevant part, that “all employees of trades or business . . . which are under common control shall be treated as employed by a single employer . . .” The statute, and arguably the regulations, do not require that the controlling entity itself be engaged in a trade or business. In fact, section 52(b) does not reference the aggregation of entities at all; it only contemplates the aggregation of trades or businesses as a single employer. Thus, there is no statutory proscription against including an intermediate entity, much less a parent entity, that is not engaged in a trade or business in the aggregated group. On the contrary, the flush language of section 52(b) may suggest that all such entities be aggregated. Finally, guidance could more clearly address whether it is implementing section 52(a), section 52(b), or both.
Planning opportunities: It remains to be seen whether taxpayers outside of the PE industry can utilize the mechanics of section 52(b) to partially or fully avoid application of the CMT. For example, might a partnership be inserted as a holding company to block a chain of entities from aggregation? A holding company is often treated as engaged in the trade or business of its subsidiaries. To break from this treatment, could a taxpayer planning around the CMT seek minority investors in a partnership holding company to avail itself of the same position as the PE funds? This question may have arisen relatively recently in other contexts, as various provisions in both the Tax Cuts and Jobs Act of 2017 and the CARES Act of 2020 relied on section 52. Now, with the enactment of the IRA, both taxpayers and the government appear poised to face this issue when the CMT takes effect next year.
Please subscribe to our mailing list to receive our posts and general updates via email.
