The Tax Cuts and Jobs Act (“TCJA”) will significantly impact merger and acquisition (“M&A”) activity. Although billed as tax reform, the TCJA did not reform or simplify the Internal Revenue Code (“Code”).
Virtually none of the provisions of the TCJA directly impact M&A transactions. Rather, the TCJA added or modified several sections of the Code that indirectly impact transaction structuring, pricing, negotiations and due diligence. Making matters more complex, some of these provisions of the TCJA are temporary.
This blog post briefly highlights several key provisions of the TCJA and the impact on M&A.
Reduced Tax Rates and 100% Expensing
The TCJA reduces the corporate tax rate from 35% to 21% (a 40% reduction) and repeals the corporate alternative minimum tax. It also reduces individual tax rates and retains the 20% capital gains tax rate, thus maintaining a tax preference for individuals selling stock, real estate or other capital assets.
The TCJA (through 2022) allows buyers of assets acquired in M&A transactions the potential to immediately expense 100% of the cost of depreciable tangible assets (e.g., equipment) in the year the transaction closes and the assets are placed in service. After 2022, the pre-TCJA “original use” requirement springs back to life, under which only the first owner of depreciable tangible assets may qualify to use immediate expensing.
These two changes to the Code clearly impact transaction structuring of M&A. Lower tax rates mean potential sellers may be more willing to sell assets, since they may end up with more money in their pockets than they would have in prior years. Likewise, buyers will likely favor asset purchases if they are able to immediately deduct the cost of equipment and other depreciable assets. The ability to immediately expense such assets without an “original use” requirement will almost certainly result in more transactions being structured as asset purchases than we saw in previous years.
Additionally, even in a stock purchase, buyers will be more motivated to negotiate for and utilize tax elections under Code Sections 338(h)(10) or 336(e) whenever possible. Taxpayers that qualify to make these elections are able to treat a stock sale transaction as if it was an asset sale for tax purposes. In doing so, buyers may obtain the tax benefits of immediately deducting the cost of equipment and other depreciable assets purchased in an M&A transaction.
Finally, lower tax rates mean sellers have less desire to structure a transaction as a “tax-free” reorganization. So, the use of these nifty provisions of the Code could very well diminish.
Under the TCJA, non-corporate taxpayers may deduct up to 20% of “qualified business income” received from a “pass-through” trade or business, such as an S corporation, partnership, LLC or sole proprietorship. This change to the Code places most owners of pass-through business entities on par with owners of C corporations who now have the benefit of the 21% top corporate income tax rate. Consequently, buyers may now be motivated to structure transactions so that a pass-through entity will purchase and own the post-transaction business assets and operations.
1031 Exchanges Are Now Limited to Real Estate
The TCJA limits Code Section 1031 to exchanges of real property. Personal property is no longer eligible for tax deferral. Taxpayers wanting to exchange real property that also includes personal property need to be keenly aware of this change to the Code. Consider a taxpayer selling a 300-unit apartment complex and buying a 450-unit apartment complex in a Code Section 1031 exchange. Under the TCJA, all of the attendant personal property (e.g., washers, dryers, dishwashers, stoves, drapes, tools, landscaping equipment, office equipment and furniture, recreation and pool equipment) is now taxable “boot” in the exchange. The taxpayer must now allocate part of the transaction proceeds to the personal property and report income accordingly. This change will significantly impact many transactions involving real estate.
Interest Deduction Limitation
The TCJA effectively limits business interest deductions to 30% of EBITDA (changing to EBIT in 2022). Disallowed amounts can be carried forward. This change will affect many debt-financed transactions and could ultimately lead to fewer highly-leveraged M&A deals. Time will tell.
The TCJA limits the use of net operating losses (“NOLs”) arising after 2017 to offset income. NOLs arising in 2018 and later years cannot be carried back to prior years and can only offset up to 80% of taxable income, but they can be carried forward indefinitely.
NOLs arising prior to 2018, however, are grandfathered in and may be used to offset income in the manner provided under pre-TCJA law—i.e., they may be carried back 2 years and used to offset 100% of taxable income.
Thus, pre-2018 NOLs are essentially more valuable than NOLs arising in 2018 and later years. The existence of pre-2018 NOLs may enhance the value of an M&A target to buyers, resulting in higher pricing and more significant due diligence to ensure the existence of the NOLs. Be aware of Code Section 382. It still may impact a buyer’s use of a target’s NOLs.
The TCJA’s changes to the federal taxation of multinational businesses is essentially triggering the “repatriation” of a significant amount of funds that had previously been earned and held overseas. Companies that are repatriating funds now have an additional “war chest” to use for business and investment purposes. It has been estimated that between $1.5 and $2 trillion dollars may be repatriated. Companies repatriating funds from overseas may choose to use those funds for M&A purposes. Thus, we are likely to see an increase in domestic M&A activity over the next several years merely as a side-effect of the repatriation of funds formerly held overseas.
We have only mentioned a few of the TCJA’s provisions that may impact M&A transactions. As has always been the case, any M&A transaction should be thoroughly analyzed by qualified tax professionals before it is structured and carried out. This is even more important with the enactment of the TCJA.
Stay tuned for more posts on the TCJA. Its broad breadth requires additional reporting.
Larry's practice focuses on tax planning and advice, tax controversy and business transactions. He regularly advises clients in structuring mergers and acquisitions, joint ventures and other business transactions.
Steve assists clients with business and tax planning matters, including business entity formation and ownership transfers, tax and compensation planning (including executive compensation matters), worker classification ...
Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "Tax Law Update for Family Law Practitioners," Oregon State Bar - Family Law Section 2019 Annual ConferenceSunriver, OR, 10.11.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationNew York, NY, 10.20.19-10.25.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," Oregon Society of Certified Public Accountants (OSCPA) 2019 Northwest Federal Tax ConferencePortland, OR, 10.28.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationSan Francisco, CA, 11.10.19–11.15.19
- "The Oregon Corporate Activity Tax," Oregon Society of Certified Public Accountants (OSCPA) 2020 OSCPA State & Local Tax ConferencePortland, OR, 1.6.20