In this summary, we cover:

  • The impact of the new tax law on C-Corps
  • What the reduced taxation means to investors
  • What to do immediately after converting your business into a C-Corp

Take-Aways

  • Trading as a C-Corp has major tax advantages both to the firm and investors
  • Not filing returns for periods before converting into a C-Corp attracts serious penalties
  • The new corporate tax rate of 21% means that companies will have more disposable income available to shareholders
  • Not all PE firms will immediately reap from converting into C-Corps. The biggest winners are those that majorly rely on management fees rather than performance fees for income
  • Tax pass-throughs may now be forced to convert into C-Corps to avoid higher taxes

Summary

The recent overhaul of the U.S Tax Code is certainly set to be a game changer in the corporate world. The 2017 amendment has seen PE business covert into C-Corporations with the first being Ares Management. And most recently, KKR followed suit by being the second PE firm to convert into a corporation. So, why exactly did they convert into a C-Corp?

We sort to find out and here’s why…

Kohlberg Kravis Roberts (KKR) is one of the highly decorated private equity firms in North America, Europe, and Asia. Having been established in 1976, the investment giant has successfully been trading on the NYSE for close to a decade now. However, beginning in July 2018, the company commences operations as a C-Corp.

The move has been taken to be partly responsible for its recent rise in share price—with a steady growth being witnessed even before the conversion came to effect. On June 4, this year, the share price of the firm closed at $22.47—up from the previous day’s $22.23. Ardent investors see this as a decent increase considering the 1.08% increase was only experienced in a span of 24 hours.

When the new tax laws slashed the corporate tax rate from 35% to 21%, converting to a C-Corp seemed like a great opportunity for KKR to take advantage of the perks attributed to such companies. Their fortunes seemed to have gotten even better as witnessed in their first quarter results. The firm surpassed Thompson Reuters’ estimates of an ENI (Entire Net Income) of 11 cents per share to hit 42 cents per share. It was while releasing the first quarter results that the corporation treated its investors to the strategic conversion plan. The move seemed to have the blessing of the investors since the process has since been concluded.

The conversion will open access to new investments in the firm boosting its investment base. Tax reports would now be simplified for investors since K-1 issuance will henceforth be unnecessary. This is as a result of the stocks now being indexed.

Also, the investors are likely to develop more interest in the shares of C-Corps resulting into higher valuation multiples.

By converting into a corporation, one of KKR’s targets was to woo potential investors. “Investors such as venture capitalists always watch out for C-Corps—which allows them to create preferred share stocks.” Further, with such investments, investors are able to get a consistent legal structure that offers an opportunity for them to compare companies side by side.

Notable is the fact that when it comes to tax evasion, this type of corporations will make this almost impossible for any perpetrators since they have tight reporting standards as compared to LLCs and partnerships.

As a word of caution, “you need to be aware of looming penalties to partners or owners of a business for failure to file tax returns of an entity before conversion into a C-Corp.” The penalty stands at $195 per month per partner—plus the outstanding taxes.

After the KKR and Ares Management conversion, many other PE firms are definitely looking to follow suit. For instance, businesses that previously operated as tax pass-throughs; such as LLCs, Partnerships, and S-Corps may find it prudent to jump ship.

In addition to the tax benefit that C-Corps will now enjoy, under the Act:

  1. The Federal rate for individuals’ ordinary incomes such as unqualified dividends and short-term capital gains previously taxed at 39.6% has now been reduced to 37%. The rate is however not fixed at 37% just yet, —it is expected to shoot back to 39.6% in 2025; well, unless it is extended or permanently passed into law. For firms such as KKR, the move is expected to ease up the tax burden on their investors.
  2. On top of the 37% tax, the Act further imposes a 3.8% tax on investment incomes for married couples with over $250,000 filing jointly and $200,000 for individuals.

KKR investors will, of course, walk away with fatter pockets since the ripple effect of the reduced tax rate may result in more disposable income which may, in turn, be distributed to investors. Investors will certainly be keeping an eye on the impact of the conversion in the second quarter results.

Firms who draw most of their income from management as compared to performance-based fees have warmed up to the conversion idea. KKR, for example, draws a decent amount of its income from management fees as compared to its counterparts such as The Carlyle Group. Further, the decision by KKR to convert into a C-Corp received a shot in the arm from other industry players including The Wall Street.

As may have been expected, Henry Kravis and George Roberts (KKR co-founders) in a joint statement, exuded confidence that the move would boost the firm’s investment base. They also alluded to the fact that this would indeed make it easier to invest in its stocks thereby creating a long-term shareholder value.

The corporation also expects to issue an annual dividend of 50 cents for every common share held. It further plans to step up its share repurchase authorization to an all-time high of $500 million.

In Q1, the firm reported after-tax earnings available for distribution at $304 million and an AUM of $176 million. Well, whether the effect of conversion will be the same for its counterparts, still remains to be seen with Ares posting a less promising figure of 28 cents per share in Q1.

Generally, the corporate sector is set to experience a major shift from the ‘usual’ earnings, capital base, tax liabilities, among other things. And without doubt, the change is bound to have a positive long-term effect.

After all is said and done, C-Corps such as “KKR will in the meantime continue to enjoy their ‘reclassification’ to improve liquidity, trading volumes, broaden investor base, and acquire more funds for future strategic acquisitions”.