TCJA provisions will affect many aspects of M&A transactions, including choice of entity, valuation, due diligence, and a variety of transactional tax considerations.
The Tax Cuts and Jobs Act (TCJA) made widespread changes to the U.S. Tax Code. Many of those changes will reduce the tax liabilities of taxpayers, such as lowered tax rates and enhanced business deductions. Other deductions, such as business interest expense, will now be subject to new limitations. These changes also affect many aspects of M&A transactions, including business entity selection, financing considerations, and purchase price allocation considerations.
Entity choice considerations
Historically, pass-through business entities were often preferred for M&A transactions since they only resulted in the imposition of a single level of taxation to the owners and more easily provided for increases to the tax basis of assets inside target companies. In certain circumstances, C corporations were beneficial and corporations were also utilized further up the chain of ownership as blocker entities.
The TCJA has altered the entity choice analysis due to several key changes:
The corporate tax rate has been reduced from a maximum of 35 percent to a flat 21 percent.
A new 20 percent deduction has been created for individuals and trusts with respect to qualified business income, which is generally ordinary income from trade or business activity effectively connected with the United States.
The tax brackets for individuals have been widened and the top incremental rate lowered to 37 percent.
State and local taxes, including allocations from pass-through entities, are subject to limitations at the individual and trust level, but such taxes continue to be fully deductible by C corporations.
Many changes were made to the U.S. treatment of foreign activities.
In light of these changes, it is necessary to revisit the entity choice analysis for existing structures and for future transactions. Parties on both the buy side and sell side of a transaction will need to consider whether a C corporation or a pass-through entity structure is best suited to satisfying their objectives. Making a proper determination of the ideal entity structure requires a holistic view — not only an analysis of the tax burdens on operating income, distributions, and exit transactions, but also an analysis of legal and practical business considerations, which may not have changed.
The choice of entity depends on the individual facts and circumstances of the entity and its owners.
In general, if the business will distribute significant amounts of earnings in the near future, a pass-through entity structure will likely be more beneficial. That analysis is further enhanced if the business activity is eligible for the 20 percent qualified business income deduction. Conversely, if the business intends to retain significant earnings to fund growth then the lowered corporate rate will provide meaningful benefits. Additionally, the impact of changes to the treatment of foreign business activity and state and local tax deductions can swing the analysis in a meaningful way.
Businesses should take the time to consider changes carefully before committing to a course of action. As a practical matter, it’s relatively simple to transform pass-through entities into C corporations, but it is much more difficult to transfer assets and built-in gains out of a C corporation.
When approaching M&A transactions the buyer and seller typically have divergent interests. The seller would prefer to sell corporate stock or to maximize purchase price allocations to properties generating long-term capital gains. Conversely, the buyer would prefer to purchase the underlying assets of the business (either directly or through a deemed asset transaction) and to maximize allocations to assets that offer the shortest path to cost recovery.
The TCJA has altered the positions of buyers and sellers in the following ways:
In general, the effective tax rates on operating business income has been reduced, but tax rates applicable to dividends and long-term capital gains remain unchanged.
Bonus depreciation was increased to 100 percent for new and used assets until 2022.
Business interest expense deductions are subject to new limitations.
The TCJA didn’t alter the general preferences of the parties in a transaction, but it did adjust their modeling. In particular, the potential availability of 100 percent bonus depreciation on used equipment significantly increases the preference of a buyer for an asset acquisition with large allocations of purchase price to fixed assets.
In general, if the business will distribute significant amounts of earnings in the near future, a pass-through entity structure will likely be more beneficial.
The reduction in effective tax rates on business income impacts both the buyer and seller. From the seller’s perspective, the reduced tax costs on an asset type of transaction may result in lower demands for a tax gross-up payment. On the other hand, the lower tax rates on operating income reduce the cash value of tax attributes, including amortization deductions that are acquired in an asset acquisition.
The new limitations on business interest expense deductions may also impact the cost of debt financed acquisitions. As a general proposition, those rules can result in the suspension of tax deductions until the business creates excess income or until the business is sold. In some cases, the interest might not even be deductible at all to the company but rather carry forward to buyers after an exit transaction. As a result, these limitations may increase the after-tax cost of significantly leveraged M&A transactions.
Buy-side tax due diligence
Changes made by the TCJA can also impact a buyer’s approach to conducting tax due diligence on target companies. The following items should be considered:
There is a one-time tax on the deemed repatriation of foreign earnings, for which an election can be made to pay the tax in eight installments.
Net operating losses (NOLs) are subject to new limitations, with NOL carrybacks being eliminated, removal of the expiration date for carryforwards, and a new limitation for the use of NOL carryforwards equal to 80 percent of taxable income in any year.
The enhanced bonus depreciation requires additional analysis related to fixed assets.
States may modify their laws to compensate for federal changes.
Buyers will need to understand how a target company has implemented the many changes made by the TCJA. Provisions like deemed repatriations and NOL carryforwards will require special calculations for several years to come. It will be important for buyers to understand how these items impact the amount of tax payments due currently or in the future. Has the target accounted for those changes in the information disclosed to date? Are there any concerns about improper tax positions or reporting on recently filed tax returns?
In addition, most states that have a corporate income tax start their calculation with federal taxable income. Many states among that group have already started efforts to modify their laws to make sure that not all of the federal changes will reduce state taxable income. Tax due diligence needs to account for the potential effect of changes in every state where the target is required to file an income tax return.
Tax reform changes can also impact a buyer’s approach to conducting tax due diligence on target companies.
With any change in tax law, the early days after enactment tend to be filled with more questions than answers. We’ve provided a very high-level look at how some of the provisions of the new law may affect the deal space, but there’s still considerable detail to be filled in by IRS guidance. As you consider M&A transactions in the months and years ahead, be sure you're relying on the most current information when evaluating the tax implications of a deal.