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Clauses & Consequences: The Convergence of Private Equity Legal Agreements and Tax Interpretations

Intent vs. interpretation. Concept vs. reality. Clauses vs. practices. The push-pull issues private equity firms encounter as they lay out the financial and tax structure for portfolio company acquisitions can dramatically affect risk and return as well as operational compliance post-close.

While well-intentioned legal structuring may mitigate certain risks, their practical, day-to-day application can be challenging, deviate from intention and may be impractical to operationalize. It is important to be ever mindful of tax structuring and the related tax implications that can dramatically affect risk reduction, operational efficiencies and EBITDA improvement. Cracks at the conception stage can create wide chasms with deep philosophical gaps at the closing and beyond.

More times than not, the accounting professional team chartered with operationalizing the compliance are stymied to do so. This is because they were not privy to, nor involved in, pre-transaction construction of the tax strategy.

Intent vs. Interpretation

Weaving the legal intent, as outlined in the term sheet, into the operating agreement that governs the portfolio company’s entire lifecycle involves a skilled level of interpretation and ability to navigate its inherent vulnerabilities. In such cases, legal expertise should not be mistaken for tax expertise, and vice versa.

Because initial organizational structures can only be successful with maximum tax efficiencies, it is good business sense to appoint a third-party certified public accounting advisor to the formation advisory team from the outset. By doing so, intent and interpretation will yield start-to-finish alignment.

For example, an initial agreement may document that the cashflow, equity structure and associated payout will be based on a distribution waterfall. However, most operating agreements stop there, often failing to translate how the waterfall actually works at formation and over the life of the company. In what order are gains allocated between investors? Is there a clause hidden in an article of the operating agreement that can change how the waterfall performs? They also can address and detail “what if” scenarios related to downside issues such as business losses. In these and many other scenarios, having Withum as the third-party business advisor and advocate at the pre-transaction table creates a newfound layer of surety where legal and operational concerns merge.

Concept vs. Reality

Employing a global accounting perspective at the fund agreement inception stage also allows for a PE firm’s goals to be realized in ways not yet considered. One common method utilized by private-equity-focused CPAs is modeling.

This ideal practice effectively brings the legal document for a newly formed entity to life. In so doing, it takes the abstract and creates a data-driven roadmap for the future. As a result, modeling has the potential to reduce conflict among partners while enhancing forecasting and efficiencies.

Clauses vs. Practices

At a time when private equity lifecycles are evolving from the once-industry norm of 10 years to 15 to 20, the intent of the original agreement is susceptible to even greater fluctuations in a prolonged timeline. As the operations of the investment evolve over its lifecycle, a knowledgeable professional must keep an eye on new and changing compliance mandates. Tax accountants are typically the most-versed professionals that are in constant contact with the company to spot any lapses.

One common mistake spotted by tax accountants, particularly in the PE arena, relates to the “employee status” of a partner of the partnership. Specifically, a limited or general partner is not considered an employee of the portfolio company and is prohibited from receiving W-2 wages from the company. If that occurs, the portfolio company’s Section 125 or “cafeteria” plan will be tarnished due to the ineligible participant. When one or more ineligible participants are in a cafeteria plan, all participants lose the tax-free treatment of their benefits.

In the pre-planning phase, the engaged accountant would have the opportunity to pick up on this seemingly minor, yet impactful mistake. In turn, the CPA team has the opportunity to make a series of easy-to-incorporate recommendations. These could include the execution of Code Section 125, which allows employers to establish a tax-savings arrangement.

While it is an attorney or attorneys who shape and execute the legal foundation for a private equity fund or company, it is the third-party tax accounting team that ensures it enjoys longevity and prosperity. High-caliber CPAs at firms like Withum should be enlisted to take a seat at the table from day one. This level of inclusion assures their specialized expertise will extend to the full portfolio company lifecycle, from initial structuring in the pre-execution stages through the closure of one fund and the transition to the next transaction.

Please contact our Withum’s Private Equity Team should you have any additional questions.

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