Tax Receivable Agreement Private Equity: What You Need to Know
Private equity firms are always on the lookout for smart ways to minimize their tax liabilities. One strategy that has gained popularity in recent times is the use of tax receivable agreements (TRAs). In this article, we`ll discuss what TRAs are and how they work in the context of private equity transactions.
What is a Tax Receivable Agreement?
A TRA is a contractual agreement between a seller of a company and its new owner, usually a private equity firm. The agreement aims to allocate the future tax benefits associated with pre-transaction losses or net operating losses (NOLs) to the new owner. When a business has NOLs, it means that it has accumulated tax losses that can be used to offset future taxable income.
How Does a TRA Work?
In a private equity transaction, the buyer acquires a company that has NOLs, which can be used to lower its future tax bills. The seller enters into a TRA with the buyer, where the buyer agrees to pay the seller a proportion of the tax savings generated from the use of NOLs. The TRA usually has a term of approximately 15-20 years.
For example, let`s say that a private equity firm acquires a company with $100 million in NOLs. If the buyer generates $50 million in taxable income over the next ten years, the NOLs can be used to offset that income and reduce the buyer`s tax bill. The TRA would then specify that the buyer pays a percentage, say 85%, of the tax savings to the seller over the next 15-20 years.
Why Do Private Equity Firms Use TRAs?
TRAs provide private equity firms with several benefits:
1. Reduced Tax Liability – TRAs allow private equity investors to reduce their tax liabilities by offsetting future taxable income with pre-transaction losses.
2. Increased Purchase Price – By using TRAs, private equity firms can often increase the purchase price of a company by up to 25%, resulting in a higher return on investment (ROI).
3. Improved Deal Terms – With TRAs in place, private equity firms can negotiate better deal terms with sellers who might otherwise be unwilling to sell for less than what they consider fair value.
4. Greater Efficiency – TRAs allow private equity firms to focus on acquiring companies with significant NOLs, as they can use the NOLs to offset future tax liabilities to enhance the return of investment.
Conclusion
TRAs have become an increasingly popular strategy for private equity firms looking to minimize their tax liabilities, increase purchase price, and improve deal terms. While TRAs can be complicated agreements, their benefits make them worthwhile for many private equity firms. If you are considering a private equity transaction, it`s important to work with experienced tax advisors and legal professionals to ensure that you structure the agreement to meet your specific needs.