Private Equity Firms Converting to C-Corp with Huge Upside

September 23, 2019 by Tae Kim, Esq.

The Tax Cuts and Jobs Act of 2017 (“TCJA”) signed into law in December 2017 had a far-reaching effect for every taxpayer, including businesses.

In the real estate and lending industry, one of the more popular statutory provisions within TCJA is the 20% QBI deduction for real estate investment trusts (“REITs”). The other area where it is gaining traction is the conversion of entities from partnerships to C-corporations due to the tax rate dropping from 35% to 21%. Several publicly traded private equity firms are making the jump to convert their businesses, most notably, Apollo Global Management LLC and KKR & Co LP.

C-corporation vs. Partnership tax structure

It is traditionally viewed that a limited liability company or a partnership is taxed at the member/limited partner level (single taxation). A C-corporation, on the other hand, is taxed at two levels – once at corporate level, and another at the shareholder level. Due to the double taxation structure, there is a general understanding that the partnership tax rate is lower than that of a C-corporation. In a closely held company, C-corporation tax is a disadvantage as the same shareholder is the majority or sole shareholder of the corporation – which makes little sense to elect the entity as a c-corporation and incur double taxation.

Publicly Traded Private Equity Firms (“PTPs”) – why they are making the switch

Apollo Global Management LLC and KKR & Co LP have made the jump to convert their businesses to C-corporations. While PTPs are converting to C-corporation status for a variety of reasons, the lower corporate tax rate is one of the motivating factors for the structural change.

These PTPs are traded on a national securities exchange. However, they were trading as partnerships as opposed to traditional corporations. As a result, the PTPs were undervalued and traded at a discount – the PTP structure limits the pool of potential shareholders and prevents some investors from purchasing their shares, and alienating others who are averse to the operational and tax complexities. In addition, the PTP business model carries a unique risk and distribution model – the exit of each investment made by a PTP becomes a “lump-sum” distribution which lacks consistency of distribution to investors.

However, converting to C-corp status makes sense because corporate structural changes came with numerous benefits. For one, due to conversion, PTP stocks are now index-eligible, meaning that the mutual funds, index funds, and other asset classes may now participate in the purchase of PTP shares. In addition, tax reporting became simpler for investors – K-1 issuance is no longer required. As a result of these changes, PTPs have seen an uptick in their stock prices.

Private Market Funds and Firms – what about them?

In a private market setting, the benefits of lower corporate tax rate is not as clear-cut or beneficial as it is for PTPs. However, benefits may still exist. For example, a 16% tax rate differential should be taken into serious consideration. Because the current market is experiencing yield compression due to competition, capital liquidity, and market saturation, rate of return to investors appears to be trending lower.

Primary considerations to take into account is simply math. When calculating the partnership vs. c-corporation tax rate, an issuer should analyze whether the conversion makes mathematical sense. The issuer should test various models and structures, including capital and corporate structure, ownership, and capital flow, among others. 

However, there are certain drawbacks to conversion. First, the issuer should understand that the corporate transition is a long-term (if not, permanent) commitment. It is very difficult to reconvert a c-corporation back to a partnership, as there is really no tax efficient option to make such re-conversion. There is also the potential that future tax legislation may increase the current 21% tax rate, which is a substantial risk. Lastly, there is a compliance component for the issuer once it converts from a partnership to a C-corp.

The decision to convert is based upon a balance of many factors as addressed above. However, through consultation with an accountant and/or tax attorney, a company will be able to determine whether entity conversion is the proper move.