Key Points for M&A Activity Under the New Tax Law
By Doug Collins, CPA, Partner Nisivoccia LLP
The Tax Cuts and Jobs Act (TCJA) brings both opportunities and concerns to the planning and execution of merger & acquisition transactions. It can provide advantages to both sellers and buyers if deals are structured with a full understanding of these changes to the tax code.
The TCJA predominately impacts tax years beginning with 2018. A variety of changes—some of them temporary—have bearing on due diligence, negotiations, pricing and how transactions are structured. These include:
- Full capital expensing of qualifying assets, including 100 percent expensing of capital acquisitions
- A significant drop in the corporate tax rate to 21 percent from the previous level of 35 percent
- Removal of the corporate alternative minimum tax (AMT). The individual AMT is retained with higher exemption amounts
- Increase of long-term capital gains from carried interest to three years from previously one year
- A reduced deduction of 20 percent for qualifying pass-through income from partnerships and S Corporations
- Reduction in the value of a company’s net operating losses (NOLs)
What do you need to keep in mind as you review your clients’ M&A plans and decisions under the TCJA?
Consider the changes for pass-through entities (PTEs) and corporations
The TCJA now allows a deduction of up to 20 percent by non-corporate taxpayers of qualified business income (QBI) received from a pass-through business, such as S corporations, partnerships, LLCs and sole proprietorships.
The TCJA has put many owners of pass-through entities at a similar level of deductions to owners of C corporations. If your client is on the buyer’s side of the transaction, your client may benefit from having a pass-through entity purchase and own the business they’re acquiring. When clients are looking at current acquisitions, we must consider the impact of the tax rate changes, especially the reduced tax rates on the acquisition and how these apply based on whether it’s a C Corporation or a PTE. It’s also critical to understand if the acquisition will qualify for the section 199A deduction. There is considerable uncertainty for many types of businesses whether they will qualify for the 199A deduction.
In order to understand what’s best for a specific M&A situation, the buyers and their legal and accounting professionals need to know the long-term plans for the business, plus the implications of dividends and distributions. In the past, a PTE was almost always a preferred choice but now one has to consider if a C Corporation is the more advantageous choice. A caution about choosing a C Corporation is that if the tax rates revert to higher amounts, a subsequent conversion to a PTE has many challenges.
Take advantage of capital expensing
Businesses can now fully expense certain capital acquisitions, which can amount to a significant advantage. Bonus depreciation is set at 100 percent for properties—both new and used—placed in service after Sept. 27, 2017 and before Jan. 1, 2023. At that point, the depreciation rate begins to drop by 20 percent a year until being eliminated in 2027. Not all properties are eligible; they must have a depreciable life of 20 years or fewer and must meet the expanded definition of qualified improvement property.
In addition, the limits for Section 179 of the TCJA increased to $1 million and includes qualifying improvement property, roofs, HVACs, alarm and fire protection systems, and security systems. A cost segregation study can help your clients determine how they can benefit from these changes.
Consider assets and depreciation in partnership terminations
Previously, when a partnership interest of more than 50% was transferred, it was considered a technical termination for tax purposes. The partnership therefore had to begin its depreciation again in terms of net book value of tangible assets. The TCJA removed the technical termination rules, including having to restart the depreciation. In addition, because it also made used property eligible for depreciation, business owners may be able to include this in their M&A transactions.
This means that buyers and sellers need to look carefully at the advantages of asset sales. It also puts more emphasis on purchase price allocations within the terms of the transaction. You may also want to encourage your clients to talk to their accountants about the timing of capital expenditures related to M&A transactions if they need to expand the business infrastructure.
Understand the current value of net operating losses
The value of a company’s net operating losses (NOLs) has decreased under the TCJA. NOLs occurring in 2018 and future years can only offset up to 80 percent of taxable income and can no longer be carried back to prior years. However, they can be carried forward indefinitely.
If your clients have NOLs prior to 2018, those may be carried back two years or carried forward 20 years, and used to offset 100 percent of taxable income, just as they were before TCJA. This makes the NOLs incurred before 2018 more valuable than those arising today. These might increase the price of an M&A target; if your client is in the buyer position, they will need to perform due diligence to make sure those NOLs exist, can be monetized as expected, and can be used by the buyer. In addition, the value of NOLs arising in 2018 and later has decreased because of the new 80 percent limitation.
However, the TCJA also eliminated the corporate AMT, which can potentially change the value of a business’ NOLs to the buyer. Work with a qualified accounting professional to understand the true value on any NOLs that are included in the purchase price of a business your clients may be seeking to acquire.
Watch out for short-term carried interests
Investors wishing to take advantage of the carried interest provisions of the acquisition will now need to hold the investment for three years to get the long-term capital gains treatment. This is a change from one year in the previous tax code.
The three-year change of the TCJA applies to partnership interest in the fields of investing or in developing rental or investment real estate, cash or cash equivalents, securities, commodities, options or derivative contracts. It’s possible that this change could affect deals currently on the table because they have not been specifically exempted. That means that interest received in 2016 or 2017 and disposed of in 2018 is subject to the three-year rule rather than the previous one-year rule.
Make sure your clients are paying attention to short-term capital gains vs. long-term under the three-year requirement for any current M&A transactions.
Be aware of business interest deduction limitations
When considering leveraged buy-out acquisitions, your clients must also consider the new business interest deduction rules and limitations, and how they will impact the operations of the business. Under the TCJA, business interest deductions are limited to 30 percent of EBITDA, but additional amounts can be carried forward.
This applies to businesses with over $25 million in average annual gross revenue for the past three years, regardless of business structure (C Corporation or PTE). Real property, trade or business, may elect out of the limitation if they choose a less advantageous depreciation method. Because outstanding debt is included, highly-leveraged companies may be hard hit by this limitation to deductions for existing debt. This makes M&A transactions involving those businesses less desirable than in the past.
Prepare for limitations on 1031 Exchanges
Under the TCJA, 1031 exchanges no longer apply to personal property. This is particularly an issue when a taxpayer has real property that also includes personal property.
For example, if a client is selling a 200-unit complex and buying a 400-unit complex in a 1031 exchange, now all the personal property is taxable in that exchange. This can include office equipment and furniture, dishwashers, stoves, washers, dryers, drapes, tools and other equipment. Part of the transaction proceeds must now be allocated to personal property and reported accordingly, which can be a significant impact on real estate transactions.
Understand the value of asset purchases
Asset purchases are likely to rise in 2018 and the following years for reasons described below. However, stock purchase buyers can also benefit through tax code sections 338(h) (10) or 336(e). Qualifying taxpayers can treat a stock sale as an asset sale for tax purposes. This gives buyers the tax benefits of the immediate deduction for equipment and depreciable assets.
The TCJA not only eliminates the corporate alternative minimum tax, but it has also dropped the corporate tax rate from 35 percent to 21 percent. In addition, individual tax rates have been reduced in most brackets with a new maximum rate of 37 percent
Because of the lowered corporate and individual tax rates, sellers may be more open to selling assets—they stand to gain more than in previous years. At the same time, buyers are also attracted to asset purchases due to the tax code changes that let them immediately deduct equipment costs and depreciable assets.
Last year, small business transactions hit record highs and that momentum is expected to continue through 2018. TCJA can give buyers greater cash flow at the same time that the Small Business Administration has lowered the down payment to 10 percent (from 25 percent) for business acquisitions. Despite recent increases, interest rates are historically low. As mentioned above, the corporate tax rate was dropped to 21 percent (from 35 percent), individual tax rates have been reduced, and for the next five years, companies can expense 100 percent of expenditures on qualified property.
If your clients are considering selling, they may want to:
Clean up their financials—Consider removing nonessentials items: underperforming segments, non-operating assets, shareholder loans and minority investors. This allows buyers to focus on the core of the business.
Focus on strengths—Private business owners nearing retirement may lose the drive to grow their businesses and operate their companies as a “cash cow.” But buyers are generally interested in a company’s future potential. Achieving top dollar requires a tack-sharp sales team, a pipeline of research and development projects, well-maintained equipment and a marketing department that’s strategically positioning the company to take advantage of market changes and opportunities.
Create a tax-aware offer package—With all the changes brought by TCJA, they’ll want to make sure they offer potential buyers fixed asset registers and inventory listings, in addition to business plans and financial projections, working capital analyses, quality of earning reports and more.
Keep confidentiality in place—Before your clients give out any information or allow potential buyers to tour their facilities, remind them to work with you to require a confidentiality agreement to protect their proprietary information.
If your clients are buying, be aware that 2017 was even more of a seller’s market than 2016, with sellers realizing, on average, 99 percent of their asking price. If they’re paying top dollar for an acquisition, make sure that they’ve considered the tax changes above and are structuring the deal to put themselves in the most advantageous position for years to come.
The list above does not detail all of the changes brought by TCJA that could pertain to your M&A transactions. We recommend that you have any potential M&A transactions thoroughly examined by a qualified tax advisor.
Doug Collins, CPA, is a partner with the accounting firm of Nisivoccia LLP in Mount Arlington, New Jersey. As partner leader of the real estate group, Doug provides tax and advisory services for real estate developers and investors, as well as construction contractors. In addition, his clients include medical and professional service organizations, manufacturing businesses, long-term care facilities, employee benefit plans, client shareholders, officers and other executives and individuals. Doug can be reached at firstname.lastname@example.org.