The recently passed federal tax reform act commonly, also known as the “Tax Cut and Jobs Act of 2017,” contains many provisions that will require careful analysis and rethinking to effectively negotiate all future M&A transactions. Generally, the new tax law provision changes are effective for any taxable year beginning after December 31, 2017.
It is imperative that you aware of these forthcoming significant changes and keep in mind some of the basic preliminary observations during the planning and consummation of your exit strategy. Waiting to address and negotiate these tax matters after signing the letter of intent (LOI) or another binding document could be costly and, in extreme cases, could end your deal.
Tax Reform Tax Changes Impacting Purchase Price Negotiations, Financing Trends, and Timing
For most corporate purchasers’ that are primarily US-based operations with insignificant multinational presence, the effective combined US corporate tax rate will generally drop from approximately 40% to 27%. In terms of asset sale and other stepped-up basis transaction, experts expect for the corporate purchaser party to attempt to negotiate a lower purchase price. This is because the present value of the purchase tax benefit will generally drop by approximately 30% based on a profit value calculation basis.
At minimum, the purchaser will be stingier and sharing the purchased future tax benefits with the seller party. In the context of stock sale and other carried over basis transaction, all deferred income tax liability (benefit) items will need to be scrubbed and re-valued for the tax rate structure change and the new law provision effective changes will also need to be taken into consideration. The assumption of deferred taxes will generally be embedded in the purchase price valuation negotiation process.
With respect to future private equity acquisition transactions, the 30% interest expense limitation based on EBIDAT will impact the overall selling price, flexibility, and financing term and conditions with respect to any highly leverage acquisition transaction arrangement. Lurking in the horizon, and further impacting the selling pricing and potentially delaying the consummation of future deals, is the new law change increasing the holding period to 3 years to qualify for long-term capital gain tax regime items earned via certain private equity industry preferred interest issuance awards, commonly referred as “carried interest.” The 3 year-holding provision is effective for taxable years beginning after December 31, 2017.
Lastly, because of extremely generous and mandatory tax repatriation tax provisions that will come into play for 2017 year-end financial reporting period, corporate America should be flush with more cash liquidity on the balance sheet moving forward that hopefully should spurred future acquisition activity and maintain the cost of raising capital at a relatively inexpensive level
Selling target entity with highly appreciated assets with low tax basis, such as IP/software developers and pharmaceutical companies, needs to analyze whether it could potentially be subject to a larger tax burden under an asset sale structure. In terms of a corporate asset sale transaction, generally explored by a selling target setting with large NOL carried forward attributes, any regular NOL carried forward deduction arising for taxable years beginning after December 31, 2017 will be subject to a 80% of taxable income limitation. This means that 20% of taxable purchase price could be subject to double tax.
Selling shareholders will no longer be able to seek a purchase price adjustment for NOL carried back refund opportunity for any NOL arising in taxable year beginning after December 31, 2017. Transaction bonuses and option cancellation payments will no longer be available to generate NOL carried back deduction opportunities to pre-closing taxable period. This raises the question, will the buyer party be willing to share the tax benefit of future NOL utilization?
An asset sale transaction involving an S Corporation selling target applicable for taxable years beginning after December 31, 2017 and involving the disposition of self-created intangibles consisting of patent, invention, model, design or formula, all realized net gains will be subject to ordinary income tax regime. Compared to 20% LTCG under a stock sale transaction scenario, will a purchaser party be willing to reimburse a selling owner for the additional, federal incremental tax to be incurred?
In the sale of a partnership interest, including LLC interest, the existing ordinary income look-through gain characterization provisions, commonly referred as hot asset look-through rule, will presumably expand to the inclusion of the aforementioned self-created intangibles.
Pass-Through Businesses- 20% Deduction Provision
Based on the current literal reading of the newly enacted 20% deduction provision, to calculate taxable income for pass-through business owners to be effective for taxable years commencing after December 31, 2017, and only applicable to Individual selling owners’, including trust, and estate, of certain qualifying pass-through entities not engaged in specified service businesses in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employee. Such taxpayers should be able to be able to offset 20% of all pass-through, ordinary income items including the net ordinary gain portion stemming from a taxable asset sale transaction. Please note that the IRS has been authorized to issue interpreted regulations for years involving the disposition and acquisition of a trade or business activity that could impact the current literal code section interpretation. The 20% special deduction section effectively reduces the top non-corporate federal income tax rates ordinary rate from 37% to 29.6% for qualifying pass-through business owners. All long-term capital gains items will continue to be taxed at the maximum LTCG preferential tax rate of 20%. For owners’ of non-qualifying pass-through entities, all ordinary flow-through income in the year of sale including asset sale gain will be taxed at the top graduated rate of 37%.
3.8% Net Investment Income Tax Not Repealed
The tax reform provision passed did not change the net investment income tax (NIIT) taxation regime applicable to all net investment income taxable items over certain modified adjusted gross income threshold amount. All C Corporation stock sale gain, including liquidation gain, remains subject to 3.8% NIIT. All passive, pass-through taxable income items, the owners of the pass-through entity that does not materially participate in the underlying trade or business as defined by passive law provisions. Accordingly, the net gain from the sale or liquidation of ownership interest in pass-through entity that the seller owner does not materially participate will remain subject to the 3.8% NIIT.
In the coming year we will examine more closely the interaction of all these provisions, including developments and regulation issuance guidance and share our thoughts with you. If you have any questions or need additional information, please contact your Aronson tax advisor at 301.231.6200.