Key Points for M&A Activity Under the New Tax Law

By NJSBA Staff posted 11 days ago

  
The following piece is by Doug Collins, CPA, a partner with the accounting rm of Nisivoccia LLP in Mount Arlington. As partner leader of the real estate group, he provides tax and advisory services for real estate developers and investors, as well as construction contractors. The newsletter in its entirety is available to section members. To learn more about joining a section of the NJSBA, email askthenjsba@njsba.com

The Tax Cuts and Jobs Act (TCJA) brings both opportunities and concerns to the planning and execution of merger and acquisition (M&A) 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 tempo- rary, affect 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 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 practitioners need to keep in mind as they review their 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 quali ed business income (QBI) received from a pass-through business, such as S corporations, partnerships, limited liability companies (LLCs) and sole proprietorships.

The TCJA has placed many owners of pass-through entities at a similar level of deductions as owners of C corporations. If the client is on the buyer’s side of the transaction, the client may benefit from having a pass-through entity purchase and own the business they are acquiring. When clients are looking at current acquisitions practitioners must consider the impact of the tax rate changes, especially the reduced tax rates on the acquisition, and how they apply based on whether it is a C corporation or a PTE. It is also critical to understand whether the acquisition will qualify for the Section 199A deduction. There is considerable uncertainty for many types of businesses regarding whether they will qualify for the 199A deduction.

In order to understand what is 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, as well as the implications of dividends and distributions. In the past, a PTE was almost always a preferred choice, but now one has to consider whether a C corporation is a more advantageous choice. One caution about choosing a C corporation is if the tax rates increase a subsequent conversion to a PTE presents many challenges.

Take Advantage of Capital Expensing

One significant benefit under the TCJA is that businesses can now fully expense certain capital acquisitions. 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 less 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 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 percent 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.

Therefore, 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. A practitioner may also wish to encourage 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 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 inde nitely.

If 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. This might increase the price of an M&A target. If a client is in the buyer position they will need to perform due diligence to make sure the 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’s NOLs to the buyer. Understanding the true value of any NOLs that are included in the purchase price of a business a client may be seeking to acquire is essential.

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 under the previous tax code.

The three-year change of the TCJA applies to partnership interests in the fields of investing or in developing rental or investment real estate, cash or cash equivalents, securities, commodities and options or derivative contracts. It is possible this change could affect deals currently on the table, because they have not been specifically exempted. This means 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 clients are paying attention to short-term capital gains versus 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, 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 earnings before interest, taxes, depreciation and amortization, 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 and 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 of 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 of office equipment, 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 have 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 also dropped the corporate tax rate from 35 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 lower corporate and individual tax rates, sellers may be more open to selling assets, since 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.

Conclusion

Last year, small business transactions hit record highs, and that momentum is expected to continue through 2018. The 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 clients are considering selling, they may want to:

Clean up their financials. Consider removing nonessential items such as underperforming segments, non-operating assets, shareholder loans and minority investors. This allows buyers to focus on the core strengths 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.’ However, 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 is strategically positioning the company to take advantage of market changes and opportunities.

Create a tax-aware offer package. With all the changes brought by the TCJA, sellers will want to make sure they offer potential buyers fixed asset registers and inventory lists, in addition to business plans and nancial projections, working capital analyses, quality of earnings reports and more.

Keep confidentiality in place. Before clients give out any information or allow potential buyers to tour their facilities, remind them to require a confidentiality agreement to protect their proprietary information.

If clients are buying, be aware that 2017 was even more of a seller’s market than 2016, with sellers realiz- ing, on average, 99 percent of their asking price. If they are paying top dollar for an acquisition, make sure they have considered the tax changes above and are structur- ing 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 the TCJA that could pertain to M&A transactions.

Doug Collins, CPA, is a partner with the accounting rm of Nisivoccia LLP in Mount Arlington. As partner leader of the real estate group, he provides tax and advisory services for real estate developers and investors, as well as construction contractors.

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