Dealmakers are living in a brave new world of tax rules now. Many describe the recent federal income tax legislation as historic—a once-in-a-generation event—but it would also be accurate to describe it as complex, with far-reaching strategic implications for organizations that transcend the tax function. M&A is no exception. Corporate purchasers and sellers in M&A deals may be positioned to take advantage of some of the recent tax changes to improve deal value, maximize income tax savings and minimize tax liabilities.
The changes are generally effective for tax years beginning after 2017. With tax reform of this magnitude, however, it is not possible to touch on all of them, so this article will focus on the five most significant changes influencing domestic M&A transactions involving corporations. It will not address the impact of changes on international income tax matters and cross-border M&A deals, or state and local tax implications.
Five key federal income tax changes affecting corporate M&A deals in the U.S.:
#1 – TAX RATE REDUCTIONS:
Corporate tax rate reductions will impact transaction structures.
- The corporate income tax rate is permanently reduced from 35 percent to 21 percent.
- The highest individual income tax rate is reduced from 39.6 percent to 37 percent (but note that most individual provisions are set to expire in 2025).
- Owners of sole proprietorships and pass-through entities such as S corporations and partnerships who are allocated certain qualified income from their pass-through entities may obtain a deduction of up to 20 percent on this income, which effectively could reduce the highest income tax rate on this income to 29.6 percent (the deduction could land between zero and 20 percent depending on the circumstances).
- Individual tax rates on capital gains (20 percent), qualified dividend income (20 percent), and net investment income (3.8 percent) remain the same.
- The corporate alternative minimum tax is repealed, yet the ability to use minimum tax credit carry- forwards generated in 2017 and prior years has been preserved in a generous fashion. These carry- forwards may offset regular income tax liability for the years 2018 through 2020, and to the extent the credit carryforwards still exceed regular tax, 50 percent of the excess credit carryforwards are refundable for those years with the ability to obtain a 100 percent refund of whatever excess amount remains for 2021.
Purchasers should consider the choice of entity to be used in planning and holding acquisitions, and compare the tax rates that apply to each entity option. For instance, if the corporate form is chosen, the net present value benefit derived from a tax shield from the amortization of a step-up in the tax basis of intangible assets should decrease. Also, the value of tax receivable arrangements for payments for its use of tax attributes acquired from the seller would diminish due to lower tax rates.
Both purchasers and sellers should consider the potential for entity rationalization as part of a strategy for an eventual sale.
#2 – LIMITATION ON INTEREST DEDUCTIONS:
An interest deduction limitation change should influence the after-tax cost for debt-financed acquisitions of corporations. This tax rule change limits annual deductions for net business interest expense to 30 percent of the purchaser’s taxable income with adjustments.
- The amount of adjusted taxable income approximates earnings before interest, taxes, depreciation and amortization (EBITDA) before 2022, and approximates earnings before interest and taxes (EBIT) after 2021.
- EBITDA or EBIT as shown on financial statements is not the same as the amount of the adjusted taxable income because of differences between financial statement accounting and tax accounting.
- Disallowed interest deductions may be carried forward indefinitely.
- The disallowed portion of interest expense that is carried forward would be subject to potential ownership change limitations on its future use.
- The limitation does not apply to businesses with $25 million or less of gross receipts or to certain businesses engaged in agriculture, real estate, or floor plan financing interest.
The limitation of interest expense deductibility may increase taxes on corporations with substantial indebtedness or that make highly leveraged acquisitions. In an investment thesis, returns may be lower because this tax rule change could make the cost of debt more expensive on an after-tax basis. Thus, this limitation on interest deductibility could have an impact on the cost of capital. Consequently, there could be less use of leverage in some transactions. For example, if the purchaser is a private equity firm, this tax rule change might result in the use of more of its equity to finance the acquisition. This limitation on interest expense should be considered as part of the capitalization of a contemplated transaction and in modeling the value of the investment.
#3 – EXPENSING THE COST OF TANGIBLE ASSETS:
Companies will be able to fully expense certain capital expenditures, including acquisitions of used property in 2018.
- For the next five years, an immediate expensing of 100 percent of the cost of certain depreciable assets acquired and placed in service (capex) during a tax year is permitted. The assets may be new or used.
- During the five years after 2022, the expensing percentage is decreased by 20 percent per year. Acquisitions that involve a plan for capex could benefit from this opportunity. Generally, the assets that qualify for expensing include equipment and other fixed assets with a tax life of 20 years or less.
- Assets that do not qualify include:
- Intangible assets
- Real estate (a new category of 15-year improvement property is intended to be eligible for expensing. A technical correction by Congress, however, is needed to fix this omission.)
- Property located outside the U.S.
- Related party assets, so the acquired assets must be first used by the purchaser
- Underlying assets acquired in a transaction treated as a stock acquisition for tax purposes
In planning a transaction, these rules may cause a purchaser to seek an asset acquisition as the assets acquired would be available for immediate and full expensing. This assumes the expensing results in an attractive net present value after other tax factors are considered. Of course, there are many non-tax factors to weigh in deciding on the form of a transaction. The chosen transaction structure itself may influence whether expensing is available. Due diligence should be performed as to the history and nature of the assets involved to ascertain whether they qualify for expensing.
A comparison of expensing to depreciating assets for income tax purposes should be considered in tax and valuation modeling. For example, the ability to elect out of full expensing is available because depreciation could be viable in certain situations. If the target company is expected to generate a net operating loss (NOL), the expensing amount should be reduced to the extent it creates the NOL. On the other hand, for target companies with plans for significant capex, the immediate tax deductions generated by the capex could make up for deductions lost due to interest expense limitations. Finally, this expensing benefit might be particularly suitable in a carve-out transaction or the acquisition of a closely held company that has pass-through income tax status.
#4 – CHANGES AS TO THE USE OF NOL CARRYFORWARDS:
In a stock acquisition, the target company may possess NOL carryforwards. A purchaser may perceive this to be an asset to potentially reduce post-acquisition taxable income. The tax rules in effect for an NOL generated in 2017 and in prior years remain unchanged and are applicable to the carryforward of that NOL into 2018 and years following. Several changes are in effect, however, for the carryforward of NOL generated in 2018 and years following.
Key changes to the use of an NOL generated in 2018 and after:
- May not be carried back
- May be carried forward indefinitely
- Is limited to offset only 80 percent of taxable income in the future year of its use
These rule changes may impact the value of a stock acquisition for both sellers and purchasers. Often, a seller may bargain to be reimbursed for tax deductions attributable to payments made by the target or seller for transaction costs. These reimbursements may be substantial and include debt refinancing costs, a portion of investment banking fees, and compensation payments such as stock option exercises, bonuses, severance and other items. For transactions occurring in 2018 and beyond, a purchaser or seller may no longer carry back deductions that could create an NOL in the year of the transaction for a tax refund. This NOL is available only to be carried forward subject to the changes highlighted above. The 80 percent limit on use could slow the pace of the absorption of the NOL carryforward. A potentially lengthy or unknown carryforward period may pose a practical issue as to the net present value of its use or for estimating a purchase price adjustment.
Other rules place potential limitations on the use of pre-transaction NOL carryforwards in the case of ownership changes. These ownership change limitation rules remain the same and continue to present their own challenges to derive benefits from pre-transaction NOL carryforwards. Without careful modeling, the recent changes highlighted above and the ownership change limitations as to NOL use, in combination, may pose an unexpected risk of erosion of valuable tax attributes.
#5 – PUBLIC COMPANY CHANGE OF CONTROL PAYMENTS FOR EXECUTIVES:
The rule changes expand restrictions on the ability of a public company to deduct compensation of more than $1 million paid to each of certain top executives.
- The rule changes add the chief financial officer to the definition of an employee covered by the rules.
- The changes eliminate the exception for performance-based compensation, including stock options, from the definition of compensation subject to the $1 million deduction limitation. Since performance-based exceptions to this cap had been available in the past, some plans in existence in 2017 may be eligible to be grandfathered. If not, compensation related to stock option and bonus plans now are included in the determination of whether the $1 million cap has been exceeded.
- The definition of a public company has been expanded. It appears to include issuers of debt and equity, and there does not appear to be a requirement that the securities of the company be listed.
Many compensation plans contain change-of-control provisions that could result in substantial payments to the top executives of a public company. Limitations on the deductibility of compensation may come into play with a change of control and should be examined as part of the value of the transaction to both the seller and the buyer. Even if the stock of the company appears to be privately held, these restrictions unexpectedly may be applicable. Also, the golden parachute rules remain unchanged for public and non-public companies. These limitations on deductibility and potential excise taxes on executives should be considered in modeling the value and cost of the transaction.
Many of the new tax changes will impact how domestic corporate deals are structured, valued, and financed. For example, the reduction in tax rates may affect the value of a transaction. For the purchaser, lower tax rates operate to reduce the net present value benefit of certain tax deductions used to create a tax shield after an asset transaction. The immediate expensing benefit, though, for tangible assets acquired in an asset transaction could significantly improve the net present value in such a transaction. This change may make asset deals more attractive for buyers, and potentially for sellers in that sellers may enjoy a lower tax rate on their gain in asset transactions.
Limitations on the deductibility of interest expense to 30 percent of an approximation of financial statement EBITDA could significantly impact how deals are financed. These limitations could increase the income tax liability of a post-transaction corporate entity in highly leveraged deals. In certain situations, the ability to currently deduct and not depreciate capex over the next five years may offset the loss of the interest expense benefits.
The reduced corporate tax rates could lead to an increase in corporate M&A activity for two main reasons: First, lower corporate tax rates may produce more after-tax cash available for buyers to carry out acquisitions and encourage sellers to move forward with contemplated deals. Second, some deals that may have been on-hold due to the uncertainty of their tax consequences for either buyers or sellers before the tax changes were enacted may now be given the green light.
Still, the interaction of all the tax changes is more complex than ever. Careful planning and modeling is recommended to capture the value, and to understand the cost, of the tax changes related to M&A transactions.
Section 1202 can eliminate the double tax burden on C corporations entirely with proper tax planning. But buyer beware – there are hurdles, limitations, and traps galore to navigate for our clients. Section 1202 allows certain noncorporate taxpayers to exclude 50 to 100 percent of gain from the sale of “qualified small business stock” (QSBS) held for at least five years. This provision was designed to provide “relief for investors who risk their funds in . . . small businesses, many of which have difficulty attracting equity financing.” H.R. Rep. No. 103-111 (1993). QSBS includes certain stock issued after August 10, 1993, in a domestic C corporation conducting a qualified active business. Generally, the gain exclusion is 50, 75, and 100 percent for QSBS acquired after August 10, 1993, February 17, 2009, and September 27, 2010, respectively. In addition, to the extent such gain is excluded from gross income, it is now also exempt from both the individual AMT and the net investment income tax.
To the extent that bias against C corporation status remains following the reduction in the corporate income tax rate and capital gain/dividend rate, section 1202 may reverse that bias in favor of C corporations by eliminating a second level of tax for some taxpayers, while subjecting the first level of tax to an historically low 21 percent tax rate. Section 1244 allows ordinary loss treatment with respect to the stock of small business corporations. Section 1045 allows for the rollover of QSBS (sale of existing QSBS and purchase of QSBS in a different issuing corporation within 60 days). Both section 1244 and section 1045 contain their own complex set of rules that are outside the scope of this alert. Collectively, sections 1202, 1244, and 1045 are provisions that level the playing field for C corporations which have traditionally been subject to two levels of tax, thereby reducing the federal income tax law’s bias against C corporations, if certain stringent requirements can be met.
The amount of gain a shareholder may exclude from gross income upon the sale of QSBS originally issued after September 27, 2010, is limited to the greater of $10 million or 10 times the shareholder’s adjusted tax basis in the stock. The $10 million shareholder gain limitation takes into account all gain recognized from the sale of QSBS in each issuing corporation. The 10 times exclusion amount is a yearly limitation based on the shareholder’s gain from the disposition of QSBS in each issuing corporation each year.
QSBS is generally stock issued in a domestic C corporation, as opposed to a foreign corporation, an S corporation, a partnership, or an interest in a wholly-owned limited liability company treated as a disregarded entity. QSBS usually must be acquired at original issuance in exchange for money, property (other than stock), or services provided to the issuing corporation. If stock is issued in connection with the performance of services, the stock will be treated as originally issued at the time of the taxpayer’s income inclusion, including upon a section 83(b) election for restricted stock. A taxpayer must hold QSBS for more than five years before disposition to benefit from the section 1202 exclusion.
The shareholder’s holding period generally begins on the day after the date of issuance, regardless of whether the property contributed would otherwise take a tacked holding period for capital gain purposes. There are some exceptions to this limitation on tacked holding periods (e.g., certain section 351 tax-free contributions to capital and section 368 tax-free reorganizations). If QSBS is exchanged under section 351 or section 368 for non-QSBS, the amount of excludable gain is generally limited to the gain that would have been recognized at the time of that exchange (i.e., further appreciation post-transaction may not qualify).
At the time a corporation originally issues QSBS, its aggregate gross assets must not have exceeded $50 million (after giving effect to the issuance). Testing upon issuance makes for good policy, because the goal is to encourage investing when the business is still considered small enough under this definitional threshold. Still, investors will rightly hope that the value of the business appreciates beyond the $50 million threshold soon after their investment is made. It is not clear whether the step-transaction doctrine applies where multiple pre-planned investments make the value equal or exceed the $50 million threshold. Because early organizational costs may reduce aggregate gross assets and thus allow for subsequent issuances of potential QSBS, balancing taxpayer intent and economic expectations for future capital needs with the mechanical section 1202 regime creates the need to address substance over form principles and the underlying Congressional goals. Aggregate gross assets are equal to cash plus the aggregate adjusted basis of property. The adjusted basis of property contributed to a corporation in a transaction in which tax basis otherwise carries over is equal to the fair market value of that property at the time of the contribution. All corporations that are treated as part of the same parent-subsidiary controlled group under section 1563(a)(1), determined by substituting more than 50 percent for at least 80 percent, are treated as one corporation in calculating aggregate gross assets.
The issuing corporation must conduct an active qualified trade or business (active business) for substantially all of the taxpayer’s holding period in the QSBS. At least 80 percent of the corporation’s assets, by value, must be used in the active business during this period. For this purpose, the issuing corporation is deemed to own its ratable share of the subsidiary’s assets and to conduct its ratable share of a more than 50 percent, by voting power and value, owned subsidiary’s activities. Greater than 10 percent ownership of stock or securities, other than those of a more than 50 percent-owned subsidiary, will cause a corporation to fail the active business requirement. Assets used in start-up activities (e.g., R&D) are considered active business assets for these purposes. While investment assets are generally non-qualifying, those reasonably expected to be used within two years of formation in an active business or held to meet reasonable working capital needs are considered qualified assets.
An active business must be a qualified trade or business, a term defined by exclusion. A qualified trade or business is one other than: 1) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principal asset of that trade or business is the reputation or skill of at least one of its employees; 2) any banking, insurance, financing, leasing, investing, or similar business; 3) any farming business (including the business of raising or harvesting trees); 4) any business involving the production or extraction of products of a character for which a deduction is allowable under section 613 or 613A; and 5) any business of operating a hotel, motel, restaurant, or similar business. IRS guidance (e.g., PLR 201717010 and PLR 201436001) highlights the importance of analyzing the businesses’ facts and circumstances because what constitutes a qualifying business is not always clear (e.g., determining the reputation or skill of an employee is not a principal asset of the business).
For the majority of the time since 1993, the section 1202 benefits have been far less than under current law. Half of the gain was still taxed at 28 percent, which resulted in an overall effective tax rate of 14 percent. The regular capital gains tax rate was only 15 percent so the overall benefit of one percent (15 -14 percent) was minimal. Now with the 100 percent exclusion, the tax benefit is substantial. Section 1202 will now impact choice of entity determinations for some and provide traps for the unwary for others. For example, the benefit of a stock sale under section 1202 may largely be negated by the benefits of an asset sale to a buyer, particularly with increased expensing and bonus depreciation following the 2017 tax reform legislation. But as with most acquisitions of businesses, such tax factors and attributes are merely a point for purchase price negotiations. Acquirers who want basis step-ups will have to weigh the costs of doing so (e.g., those resulting from section 331 taxable liquidations) against the purchase price reductions they’ll obtain from giving sellers of QSBS the now large tax benefits of section 1202.
Warren Averett is an independent member of the BDO Alliance USA. This article was borrowed with permission from BDO USA, LLP.