What Buy Side Investors Need to Know Today

Tax Update for Buy Side Investors

 

 

On December 22, 2017, President Donald Trump signed into law sweeping new tax legislation – The Tax Cuts and Jobs Act. The Jobs Act covers numerous areas of tax law, and certain provisions may be applicable to various buy side investors of operating businesses located in the U.S.

Not all of the below provisions may be applicable to all types of buyers, and such provisions may not be applicable on every deal. However, the below is intended to highlight certain areas that were changed by the Jobs Act that buyers should be considering in each transaction whether such change may be relevant in such deal.

There are eight areas that were changed by the Jobs Act that buyers must be aware of and consider in each of their transactions today:

1. Reduced Federal Corporate Income Tax Rates and Elimination of Corporate AMT
2. Qualified Business Income Deduction for Pass-Through Entities
3. Carried or Profits Interests
4. Limitation on Deductibility of Business Interest
5. Expensing of Certain Depreciable Property
6. Limitation on Use of Net Operating Losses
7. Tax on Foreigners of Sale of Partnership Interests
8. Self-Created Intangible Assets

 

1. Reduced Federal Corporate Income Tax Rates and Elimination of Corporate AMT

In Month 2018, the Jobs Act will:

1. Reduce the maximum U.S. federal corporate income tax rate to 21 percent from 35 percent; and
2. Result in the elimination of the corporate Alternative Minimum Tax (AMT).

The effect of these two provisions will be to reduce the federal tax costs of operating a U.S. business through a C corporation.

 

Investors that Require a C Corporation 

Certain types of investors (e.g., tax-exempt and foreign investors) generally require the use of a C corporation for investments into U.S. businesses to avoid the application of unrelated business taxable income or effectively connected income.

The changes in the Jobs Act will reduce the amount of U.S. federal income tax drag on such investments.

Investors that Do Not Require a C Corporation

For investors that do not require a C corporation for such reasons, they should not instantly convert to a C corporation to obtain the reduced lower rate.

U.S. individuals are still subject to a U.S. federal dividend tax rate on distributions out from a C corporation or capital gains tax rate on the sale of the stock of the C corporation in the maximum amount of 23.8 percent (including the Affordable Care Act 3.8 percent), which still results in a combined corporate and dividend effective tax rate of approximately 40 percent.

Given that the maximum U.S. individual income tax rate was decreased to 37 percent (with possibility of additional 3.8 percent for Affordable Care Act, depending on what type of investor for pass-through purposes), the combined U.S. tax rates of operating through a C corporation and a pass-through are similar (without taking into account the effects of qualified business income deduction to be discussed hereafter). Additionally, as there are benefits such as an increase in basis in a pass-through entity from taxable income that is not present with a C corporation, generally investing through a pass-through entity may remain to be more tax efficient depending on the facts and circumstances of each transaction.

Additional Aspects the Reduced U.S. Federal Corporate Tax Rate Impacts 

Buyers that are going to be operating through a C corporation after a purchase generally like to obtain a step-up in the income tax basis of the assets of the target, through an asset sale, or deemed asset sale for U.S. income tax purposes, and are therefore more likely to pay more for such a step-up than a stock sale. With the reduced corporate rate, comes a corresponding reduction in the value of the step-up in the income tax basis in the assets of a C corporation. This should result in the difference between what a buyer would pay for an asset sale versus a stock sale shrinking as compared to where it was under the higher rate.

Additionally, sometimes sellers are able to arrange for additional purchase price for net operating losses of the C corporation. Similarly, the amount that buyers should be willing to pay for such net operating losses should be reduced due to the reduced tax benefit associated therewith.

Buyers Attempting to Qualify for Tax-Free Treatment under Section 1202 

One area that may continue to grow with the reduced corporate income tax rate may be buyers attempting to qualify for tax-free treatment under Section 1202 of the Internal Revenue Code of 1986, as amended (the “Code”).

Under Code Section 1202, taxpayers (other than corporations) are eligible for federal tax exclusion on eligible C corporations that are held for five years or more. This exclusion generally applies to the greater of $10 million of gain from such a sale or 10 times the amount of the income tax basis of the qualified stock disposed of during the year.

There are other limitations that may limit the ability of Code Section 1202 to a taxpayer, including but not limited to:

• Certain types of business being excluded;
• The stock must be an original issuance (i.e., not purchased from a previous shareholder); and
• The value of the corporation at issuance must be less than $50 million.

 

2. Qualified Business Income Deduction for Pass-Through Entities

The Jobs Act provides for a 20 percent deduction for individual taxpayer’s qualified business income from a partnership, S corporation or sole proprietorship. Provided that such individual is subject to the new reduced 37 percent top rate for individuals, this deduction could reduce the effective U.S. federal income tax rate on such income by 7.4 percent to 29.6 percent.

 

Limitations Applicable to Business Income Deduction 

Qualified business income generally includes:

• Items that are effectively connected with a U.S. trade or business.

Qualified business income does not include:

• Any compensation income or guaranteed payments that a recipient receives from such qualified trade or business.

There are certain limitations that are applicable to this deduction. The two main limitations begin to kick in for individual taxpayers that have taxable income (in general and not just from this certain qualified trade or business) that exceeds $157,500 (or $315,000 in the case of married filing jointly).

The first limitation applies to all individuals that have taxable income in excess of the limits above. For such individuals, the deduction is limited to the greater of:

• 50 percent of the w-2 wages paid with respect to the qualified trade or business (allocated among the owners in a partnership or S corporation with more than one owner); or
• The sum of (A) 25 percent of the w-2 wages paid with respect to the qualified trade or business, plus (B) 2.5 percent of the unadjusted tax basis immediately after acquisition of all qualified property (which is generally tangible property subject to depreciation).

Additional Restrictions 

There are further restrictions if the trade or business:

• Is among any specified service trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services; or
• Whose principal asset is the reputation or skill of one or more of its employees or owners; or
• Involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.

These further restrictions would generally limit the ability of individuals with taxable income that exceeds $157,000 (or $315,000 in the case of married filing jointly) from taking all or some of the deduction.

Individuals not Eligible for Deduction 

For individuals who are receiving income from a specified service trade or business, the amount of the deduction (calculated subject to the wage limitations discussed above) is reduced by the percentage such individual’s taxable income is in excess of $157,000 (or $315,000 in the case of married filing jointly) divided by $50,000 (or $100,000 in the case of married filing jointly). Therefore, if such an individual has taxable income in excess of $207,000 (or $415,000 in the case of married filing jointly), such individual would not be eligible for any portion of the deduction.

Other Potential Deductions 

If a Buyer is intending on owning the structure pursuant to a pass-through partnership or LLC, buyers may be inclined to offer to management members bonus arrangements that provide w-2 income and therefore a greater potential deduction under this new provision rather than “profits interests” which should not result in w-2 income to the employees. Additionally, generally if an employee receives profits interest and is a k-1 partner, any “salary” earned by such employee is generally considered a “guaranteed payment” and is not treated as w-2 income.

Further, for buyers that may be individuals and eligible to own through an S corporation, this deduction may be more beneficially used through an S corporation than a partnership or LLC depending on the facts. For example, if two individuals are buying a business which will not have significant other w-2 employees, even though all of the income might be eligible for the deduction under this new provision, if the individuals have taxable income in excess of the above mentioned thresholds, and there is not significant qualified property, the w-2 wage limitation may result in none of the income being eligible for deduction.

However, if this same business were structured as an S corporation, then a portion of the income would have to be structured as a reasonable salary to the shareholders, with the remaining portion being eligible for the deduction. As a portion of the income is required to be paid as w-2 wages to the shareholders, this results in at least some portion of the additional income being eligible for the deduction.

 

3. Carried or Profits Interests

The Jobs Act has extended the holding period requirement for carried or profits interests to three years in order to qualify for long-term capital gain with respect to such carried or profits interest.

Long-Term Capital Gain 

Carried or profits interests that were not in-the-money at grant, were generally treated under prior law in a similar manner to other partnership or membership interests. Namely, the character of any underlying gain on sales of assets retained their character from the partnership level when passed on to the carried interest holder.

Therefore, if the partnership or LLC in which carried interest holder was a partner or member sold assets that had a long-term capital gain, such gain maintained its character as long-term capital gain when allocated to the carried interest holder. Any sale of the carried interest would also have generally been treated as the sale of a capital asset, resulting in long-term capital gain if such carried interest was sold after one year.

Short-Term Capital Gain

The Jobs Act still allows for the concept of a carried interest that may enable the holder of such interest to receive capital gain with respect to such interest. However, the Jobs Act has added a three year holding requirement as opposed to one year, in order for any capital gain associated therewith to be treated as long-term capital gains. Therefore, to the extent that a partnership or LLC sells a capital asset that has a holding period that is not greater than three years, the capital gain that is allocated to the carried interest holder would be treated as short-term capital gain and subject to ordinary income tax rates.

Carried Interests

This provision generally applies to carried interests that are received for services with respect to investments made with third party investors’ money. Until guidance is issued by the IRS allowing for the exception for carried interests not received with respect to investments with third party investor’s money, it is not clear how expansive this requirement will be treated.

The new provision does not apply to the tax treatment of returns on investments that are attributable to capital invested by the carried interest holder, provided that the returns on such investments are pari passu with the returns of other investors on their investments. Therefore, if a carried interest holder also invests in the transaction, only the gains associated with the carried interest portion of such person’s interest in the partnership or LLC is subject to these new rules.

Caution is Advised until IRS Provides Guidance

Currently it is not clear whether a sale of the carried interest will be subject to this requirement as well. It is possible that the IRS will treat the sale as short-term if the carried interest has been held for less than three years.

• It is also possible that the IRS could perform a look-through analysis allocating the purchase price to all of the underlying assets of the partnership or LLC, with the capital assets that do not have a greater than three year holding period being treated as short-term capital gain.

It is also not clear whether the IRS would require a carried interest to be held for three years if the underlying asset has been held for three years.

• This could arise if a person receives a carried interest later on in the cycle of an investment such that the capital assets being sold upon exit have a greater than three year holding period but the holder does not have a three year holding period in the carried interest itself.

Until such time as the IRS comes out with additional guidance on how this new provision of the Jobs Act is going to be applied, buyers should be wary of attempting to take the position that any capital gain is long-term to the extent that any of the assets or the carried interest have been held not greater than three years.

For example, under the provision:

• Corporations are not subject to this new rule without specifying that this was S or C corporations. Therefore, in late 2017, there was an influx of new corporations being set up in Delaware that were making S corporation elections that would allow the carried interest rules to not apply to such S corporations, and also not subject the carried interest to a second layer of tax at the C corporation level. The IRS has already stated that in its future guidance the exception for corporations will only apply to C corporations.

 

4. Limitation on Deductibility of Business Interest

Under the Jobs Act, business interest expense is now limited to 30 percent of the taxpayers adjusted taxable income, plus the taxpayer’s business interest income.

Adjusted Income and Limitations 

Adjusted income is defined as roughly equal to EBITDA through 2021, and is further reduced to roughly EBIT thereafter. Any interest that is disallowed is able to be carried forward and is treated as business interest expense in the following year and subject to the same test. Therefore, to the extent that the business is generating significant interest expenses in excess of income, such interest may not be deductible for numerous years.

If a business has average annual gross receipts for the three taxable years ending with the prior taxable year of $25 million or less, then this new limitation does not apply to such businesses. Additionally, if a business is conducting a real estate trade or business, then provided that it makes an election, such real estate trade or business is not subject to the limitation. In making such an election, the real estate business must use the alternative depreciation system (ADS) for reporting depreciation.

This has a slight effect in increasing the years for depreciation from:

• 39 years to 40 for nonresidential real property;
• 27.5 years to 30 years for residential real property; and
• 15 years to 20 years for qualified improvement property.

For partnerships this limitation is applied at the partnership level, and the interest expense and corresponding limitations are passed through to the partner based on the partnership’s 30 percent limitation.

Buyers will need to factor this new provision in when determining their projections for a business as well as their capital structure of debt versus equity for such purchase. Additionally, buyers need to be aware of the further reduction of the amount able to be deducted after 2021 when the base on which the 30 percent is calculated is reduced further by the amount of depreciation and amortization in the business.

 

5. Expensing of Certain Depreciable Property

A provision was added that allows for there to be 100 percent depreciation on all new business investment in qualified depreciable property (which does not include structures, real estate or intangible assets).

Previous Bonus Regimes vs. New Provision 

The 100 percent bonus depreciation lasts for property placed into service after September 27, 2017 through the end of 2022. The bonus depreciation is then phased down over the next few years by 20 percent per year, until there is no bonus depreciation for items placed into service in or after 2027.

Under previous bonus regimes, bonus depreciation generally only applied to those items that were new and placed into service and not items that were purchased, including as part of a sale. Under the new provision, the bonus appreciation now applies to qualified property that was purchased as well. This provides for additional planning opportunities for buyers to allocate more purchase price to qualified depreciable property in connection with an asset or deemed asset sale of a business. However, it should be noted that to the extent that too much bonus depreciation is taken resulting in net operating losses (NOLs) that are created, due to the limitation on NOLs to be discussed later, spreading depreciation out over a longer period may be more advantageous. Modeling should be performed to determine the correct approach.

 

6. Limitation on Use of Net Operating Losses

Pursuant to the Jobs Act, NOLs are now limited to 80 percent of the taxpayer’s income determined without regard to the NOL deduction.

Therefore, for corporations that have sufficient NOLs to offset 100 percent of their income, such corporations will still be subject to an effective tax rate of 4.2 percent and similarly situated individuals (assuming the new highest individual rate of 37 percent) would have an effective tax rate of 7.4 percent.

Additionally, NOLs are no longer able to be carried back (subject to very limited small businesses and farms), but can be forward indefinitely as opposed to just 20 years.

Losses that were incurred prior to 2018 are not subject to these new limitations and be used to fully offset taxable income of the taxpayer for years after 2018.

This limitation should factor into how much a buyer is willing to pay for any NOLs of a C corporation. Additionally, this limitation should be considered when modeling out the timing and amount of expenses to be incurred by a business. As opposed to automatically seeking to accelerate deductions into earlier years, it may be beneficial to spread out such deductions as they then can reduce taxable income in the years that they are taken without being subject to this limitation if they are carried forward as part of a NOL.

 

7. Tax on Foreigners of Sale of Partnership Interests

The Jobs Act imposed a U.S. tax on foreigners on sales of partnership interests where the partnership is engaged in a U.S. trade or business.

This was generally the IRS position until such time as a case recently overturned such IRS position. The Jobs Act codifies the prior IRS position and treats the gain from the sale of such partnerships as effectively connected income (“ECI”) subject to U.S. taxation.

In addition, from a buyer’s perspective, the Jobs Act imposes a 10 percent withholding on any amounts paid for partnership interests where the sale results in any ECI. The IRS has recently issued preliminary guidance that sets forth rules by which a seller can provide comfort to the buyer that no withholding is required.

The most likely exception is that the seller is a U.S. person. Similar to certificates provide for FIRPTA purposes, when buying a partnership or LLC interest, buyers should now require certificates from sellers stating that they are U.S. persons for purposes of the ECI withholding rules.

There are certain other ways that buyers can be excused of withholding, such as:

• Where the seller is able to provide a certificate under penalties of perjury that based on its k-1s less than 25 percent of its income from the partnership for the last three years was ECI; or
• Where the partnership is able to provide a certificate under penalties of perjury stating that less than 25 percent of the gain from the sale of the partnership’s assets would be considered ECI.

 

8. Self-Created Intangible Assets

Self-created intangible assets (e.g., self-created patents, inventions, models or designs, or secret formula or process) are now subject to taxation at ordinary income rates as opposed to capital gains rates.

Previous Bonus Regimes vs. New Provision

Generally speaking from a buyer’s perspective, allocating purchase price to one of these types of assets as opposed to goodwill or going concern should not result in a benefit to a buyer as all such assets should generally result in 15 year depreciation for the buyer. Therefore, to the extent that it is supportable, buyers may be willing to work with sellers on the allocation between such assets.