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The Great Tax-reform Brouhaha

Contrary to what you've been hearing from almost every tax expert in the country, the Tax Reform Act may yet turn out to be a bonanza for small private companies seeking outside equity.
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EVEN BEFORE THE TAX REFORM ACT of 1986 was out of committee -- let alone amended, voted on, and signed into law -- most of the country's self-styled experts on small-business finance were already proclaiming it a disaster for private companies in search of equity. Venture capitalists sounded the alarm before congressional panels. Tax lawyers wrung their hands at special press briefings. major accounting firms held seminars for clients, staged elaborate news conferences, and rushed millions of booklets into print, all carrying the same dismal message: small private companies would be starved for outside equity under the new tax code.

These dire warnings must have come as a surprise to the owners of small private companies, most of whom had been unaware of the vast amounts of outside equity available under the old tax code. Granted, a handful had been indirect beneficiaries of the tax differential between personal income and capital gains, a gap that had helped set loose the flood of venture capital in the early 1980s. But let's face it: the vast majority of companies never saw a drop of that venture financing. For them, outside equity under the old system was, more often than not, what they could wheedle out of Aunt Millie and Uncle Fred.

At least one inveterate entrepreneur went so far as to argue that the old tax code actually discouraged outside investments in small private companies -- and that tax reform would bring in a wave of a new money. "I think this tax bill is one of the best things to happen to small business in a long time," INC. columnist Wilson Harrell told us a few months ago, when just about every other observer was coming to the opposite conclusion. "At last, the speculative money can start going where it always should have gone: to entrepreneurs who can use it to expand companies, build new ones, and create new jobs and new products.

"Look," he explained, "for the past decade or more, entrepreneurs have had to compete for outside capital under totally unfair circumstances. Instead of putting their money to work in good businesses, investors have been making ridiculous investments in money-losing tax shelters, just so they could write off two, three, four times their out-of-pocket cash. And guess who figured out all those tax-shelter schemes and made fortunes in fees in the process? The same experts who are now wringing their hands. I don't blame them. Their sun is slowly sinking in the West."

It was an intriguing argument, intriguing enough for us to take another look at the experts' predictions of doom and gloom. As it turns out, they don't bear up very well under close scrutiny.

In its most persuasive form, the worst-case scenario turns on the new tax law's treatment of capital gains for individuals, which will now be taxed at the same rate as ordinary income. If we assume that investors are in the top tax bracket, that change will mean an increase in the tax rate on capital gains from an effective rate of 20% to 28%. in order to get the same aftertax yield as before, investors will have to earn 11% more on their investments. As a result, the doomsayers argue, small companies will have a much harder time competing for investors' dollars. "Investments like bonds and common stocks are a lot more attractive than they used to be," says William Nasgovitz, president of The Milwaukee Co., a Milwaukee investment company. That's because investors can now keep more of the interest and dividends on safe securities, thereby boosting their aftertax yields. So long as you can make a decent return on, say, a Treasury issue, why would anyone choose to tie up funds for a few years in the equity of a small private company?

Some people in the venture capital community go a step further, arguing that the old capital-gains differential "is a distinct 'signal' that investment is favored," in the words of California venture capitalist Burton J. McMurtry. In the future, he fears, the signal will be jammed. That could have serious consequences, warns Stanley E. Pratt, chairman of Venture Economics Inc., a consulting and information-services firm, and publisher of Venture Capital Journal, in Wellesley Hills, Mass. Investors who want to get involved with riskier companies will flock to speculative stocks. A "trading mentality" will take over, he says, and the biggest losers will be smaller private companies, which need years -- not minutes -- to show investors a return.

Now, on the surface, this argument sounds reasonable enough, and it no doubt reflects sincere concern over the impact of tax reform on the future availability of venture capital. It is only fair to note, however, that approximately one-third of the money in the venture capital investment pool comes from such nontaxable sources as pension funds and other institutions whose investment priorities will not be directly affected by the Tax Reform Act. Beyond that, the argument has two logical flaws.

To begin with, it is wrong in suggesting that the increase in the capital-gains tax will inevitably discourage new investment. Granted, the old 20% rate is more attractive to an investor than the new 28% rate, and some deals may have to be restructured accordingly. But that doesn't mean investors are going to avoid otherwise promising investments. Besides, the new rate may not be as bad as the critics suggest. It is certainly a lot better than the effective maximum tax rate of 49.2% on capital gains that existed prior to the 1978 legislation.

Second, investors aren't necessarily going to rush into safe securities just because their aftertax yields will be greater. Many people still won't be content earning 8.25% on 25-year Treasuries or 6.1% on six-month certificates of deposit. Some investors will no doubt choose to accept the additional risk in hopes of earning 18%, 20%, 35%, or whatever.

But perhaps the most serious flaw in the doomsayers' argument is that it ignores what may be the most important aspect of the Tax Reform Act as it relates to small companies: the changes in the rules governing tax-shelter investments. Under the old rules, high-income individuals were allowed to write off tax-shelter losses (often amounting to several times their actual investments) against salary or other types of ordinary income. Under the new rules, investors with passive losses in real estate and other tax shelters cannot deduct those losses from ordinary income or even from portfolio income from stocks and bonds. The only way to take advantage of passive losses is to offset them with passive gains.

That's a very significant provision, at least from the standpoint of small private companies, because it means that investors can't offset their passive losses by investing in stocks. The gains must come from limited partnerships -- or S corporations -- where the investor does not "materially participate" in active management.

How much money are we talking about? Well, according to the latest published figures of the Internal Revenue Service, some 6 million investors in 1984 claimed total tax losses of $73 billion on limited partnerships. More than half of those losses came from real estate deals -- deals that were designed to lose money, at least initially.

It is, of course, a matter of conjecture as to what those investors will do now. Some will undoubtedly lick their wounds and hope that their money-losing investments will eventually turn the corner into profitability. Ohers may go into new real estate partnerships geared to making money or partnerships built around, say, undervalued oil wells, which are as attractive as ever. But, from an entrepreneur's perspective, the most interesting possibility is that erstwhile tax-shelter investors may start putting their money into partnerships built around small companies, an option left open by the Tax Reform Act. Indeed, some quick-thinking deal makers are already out looking for such opportunities.

Harrell himself knows of one such case involving a company he's been working for as a consultant. The company, based in North Dakota, needed $200,000 to test-market its new consumer product and (assuming the test is successful) $2 million for a national rollout. The owner had borrowed all he could from family and friends and was having trouble finding more. Then, last fall, came a call from a tax-sheler specialist, who wanted to discuss bringing in some of his clients as investors.

It turned out that the specialist, aware of the impending changes in the tax code, was actively seeking out income-oriented deals for his clients. He and the company eventually agreed to an arrangement whereby the investors will put up the $200,000 for the market test. If the test results are acceptable, his clients will then finance the rollout. In return, they will get a percentage of the gross income of the business, up to a specified amount several times their total investment. They'll also receive an option to buy the company. "The worst that can happen," says Harrell, "is that the market test fails, in which case the product wasn't going to make it to begin with, and the investors lose their initial $200,000." On the other hand, if the product does well, everybody "receives one hell of a return."

Harrell's example is not an isolated case. Last spring, Pamco Inc., which owns and operates five car washes in the Boston area, raised some $700,000 from about 30 limited partners. The new partnership will help finance the construction and operation of two new car washes over the next 24 months. The deal, moreover, is structured in a way that gives the investors significant advantages under the new tax law. The limited partners will get 90% of all taxable income, losses, and cash distributions up to a target return of 2.75 times their original $25,000 investment. This must represent an aftertax return of 15% or more. "And we're shooting for a 25% aftertax return over the life of the partnership," says Marshall B. Paisner, president of Pamco.

For the investors, it's a very attractive deal, especially in light of the company's track record over 20 years. "We have a good balance sheet and we've always shown a good return on investment," says Paisner. "Yes, we pay a bit more by raising money this way. But if we had relied on bank financing, we'd be a lot more limited in our ability to build new units."

Then there's Environmental Services Inc., a hazardous-waste cleanup company in Rancho Dominguez, Calif., which -- in conjunction with Atlantic Northern Corp. -- has raised $4 million from investors since July, much of it in anticipation of the new tax law. The company is built around a technology that allows it to treat industrial wastewater on site, thereby sparing customers the trouble and the expense of carting it away. The technology comes in the form of specially equipped trailer trucks that cost around $200,000 each. And where does the company get the money to buy the trucks? From the investors, who buy them. According to Judithe Goldberg, of Goldberg-Heyman, a Los Angeles investment-banking firm that has helped put together the deals, outside investors can expect to earn a 30% to 50% annual return on their investments, "and there are still significant profits left over for the company."

So what's going on here? It may be too soon to label all this a trend, but something is clearly happening that defies the experts' gloomy predictions. Overnight, tax reform has created a potentially huge market for income-producing deals geared toward former tax-shelter investors. Even as you read this, real esate syndicators, tax-shelter specialists, and investment bankers are scrambling to find those deals.

Their need opens up a world of possibilities for small companies. If you can provide a decent return on a partnership organized around equipment, retail outlets, new products, or the like, you may have precisely what thousands of investors want. To be sure, it remains to be seen whether real estate investors will feel comfortable putting their money into such deals. Then again, they don't have many options.

"Any business that can throw off cash is ripe," says Arnold G. Rudoff, national director of partnership analysis in the San Francisco office of Price Waterhouse. "You can almost go down the phone book and come up with ideas."

This is not to suggest, of course, that the new tax law is an unmixed blessing for small companies. Some businesses, for example, will be hurt by the law's requirement that companies with more than $5 million in sales use accrual, rather than cash-basis, accounting.

Then, too, retailers and distributors with more than $10 million in sales will be forced to capitalize their inventory at a higher cost, thereby inflating their taxable income. The law doesn't do much, either, for start-ups dependent on a new technology that may take years to unfold. They may have to look for corporate investors, who can absorb unlimited passive losses.

When all is said and done, though, tax reform does not appear to be the unmitigated disaster the experts have warned us about. Indeed, it may yet turn out to be the small-business bonanza that observers such as Harrell foresee. In any case, you probably shouldn't lose much sleep over the supposed threat to small private companies in need of outside equity -- unless, that is, you happen to be an expert.

Last updated: Dec 1, 1986




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