Government Contracting M&A Tax Shop Talk: Is Operating Under a Full Pass-Through PE-Sponsored Platform Right for You?

At a glance:

• The main takeaway: There are a lot of benefits to operating a full pass-through tax structure, but there are some drawbacks, too. It’s important to know if the costs will outweigh the benefits before deciding to shift away from a C Corporation blocker tax structure.
• The impact on your business: Understanding the pros and cons of switching to a full pass-through tax structure and the costs associated with it is crucial to ensuring that you make the best decision for you and your firm.
• Next steps: Absorb the insights in this piece, think about your options and contact Aprio’s Government Contracting specialists to help you move forward with confidence and clarity.

Schedule a consultation with Aprio’s Government Contracting team today.

The full story:

In the past five years, there has been a significant shift among Private Equity (PE) firms that are invested in the government contracting space to move away from the traditional C Corporation blocker tax structuring to a full pass-through operating structuring arrangement.

Operating a full pass-through tax structure comes with obvious and tempting tax perks to an accreditor passive investor, including the prevention of double taxation, accommodating asset sale tax treatment upon exit and tax basis recovery built-up funded with tax distributions, but it may not be the right solution for you.

Ask yourself: is the upside worth the challenges of operating a full pass-through tax operating structure that requires added administrative costs and much higher tax incremental costs in the short run? In other words, is the juice worth the squeeze?

It is common for PE sponsors to downplay the magnitude of hidden costs associated with operating under a full pass-through tax structure. If you are a mature government contractor going through an existing event, it is expected for you to have some skin in the game and to participate via rolled-over equity contribution in the dealmaking.

Further, if you are not in the retirement phase and you are simply taking some equity off the table and expect to be part of the driving management team, depending on the PE financing and liquidity capabilities, your rolled-over participation requirements could be as high as 30 to 40%.

Take for example a government contractor with a younger legacy ownership/management team that wants to take some value off the table but expects a second bite of the apple with the future sale of the equity rolled within a 5-year post-closing period. Is operating a business model via a pass-through tax structuring ideal for you to generate three times its return? On the other hand, your PE partner will need to weigh the higher costs of financing and limited money supply to get the deal done.

When analyzing the tax structure, you need to consider the following factors:

• Do you expect to have a partial liquidity event before you exit? A partial liquidity asset sale could be costly because of double taxation under a C Corporation tax regime.

• Will your exit event mandate an asset sale structure subject to double taxation under a C Corporation blocker structure? Under the described scenario, if the buyer will be another PE, an asset purchase is likely if the price tag is above book value. On the other hand, if the most likely scenario will be a large public company (because of the magnitude of the purchase price, etc.) the deal structure should be tax indifferent.

• Will the substantial portion of the future corporate development plans be self-financed from future operational profits? The C Corporation model’s 21% flat tax rate makes it more tax efficient. The current individual tax rate can range from the effective calculated marginal rate of 29.6% (if IRC Code Sec 199A deduction applies) to a 40% effective rate when you factor in other imposed income taxes such as Medicare and/or Net Investment Tax for passive investors. Further, most full pass-through taxing structures will require tax distribution using an agreed marginal tax rate of 40 to 50% which tends to become an operational cash flow burden.

• Does your long-term budget have significant dollars assigned to maintaining a back-office infrastructure required to effectively administrate a very cumbersome and demanding tax operating structure requiring quarterly tax calculation, tax distributions, and the administration of an evolving pass-through tax system with little tax guidance? Based on our client experience, a typical emerging Government PE platform over its life cycle at a minimum will need to invest substantial time and monies to effectively administrate all the required tax compliance matters.

• For government contractors heavily engaged in providing services abroad in high-taxing foreign jurisdictions and subject to the GILTI tax regime, the GILTI high tax exception is only available to US C Corporations blocker tax structure.

• Under a full pass-through partnership taxing structure, there is a lack of flexibility involving key employee compensation systems that require additional reorganization steps that are costly to implement and administrate. For example, key personnel who hold incentive profit interest unit awards without the tax benefits of a tiered partnership structure arrangement are treated as partners for benefits and income tax reporting matters which is quite cumbersome and creates all kinds of administrative inconveniences and distractions. Further, the tiered partnership structure arrangement requires an upper and lower-tiered regarded partnership with a splitter C corporation minority member that becomes an additional administrative costs burden to you (i.e., the additional costs of preparing and maintaining books and records for three entities consisting of the upper tiered investment holding partnership, lower tiered operating partnership, and splitter C corporation minority partner).

The bottom line is that you need to understand the true costs to operate the operating tax structure and weigh in all considerations including financing constraints and attracting the limited supply of accredited investors that shrink each year the economy is not booming. Your focus should always be scaling your business and having proof of the pudding in higher EBITDA multiples with a strong backlog and mature workforce capabilities. Business objectives and financial constraints must be all mashed with tax objectives.

Ready to move forward? Schedule a consultation with Aprio’s Government Contracting team today.

Related Resources:

When Does Cost or Pricing Data Need to be Certified, and What Does That Mean?

Pass-Through Entity Tax Considerations for Government Contractors

Texas Court Addresses Flow-Through of Sales Tax Exemptions for Government Contractors