On December 22, 2017, new tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Act”) was signed into law. The Act represents a major overhaul of the U.S. federal tax system and includes many new provisions, as well as significant revisions to current tax law, which will have wide ranging implications for individuals and businesses. The following is an overview of certain provisions of the Act that are relevant to private equity and M&A transactions:
Reduced Corporate Tax Rate – The Act lowers the corporate rate from a top graduated rate of 35% to a flat rate of 21%. This rate is now significantly lower than the highest federal income tax rate applicable to individuals (now 37%, plus a potential 3.8% Medicare surtax). As a result, owners (and buyers) of businesses organized as a flow-through entity may give increased consideration to converting the business to a “C” corporation. A number of factors would need to be considered, including the expected level of earnings to be distributed to the owners (rather than reinvested) and whether the business qualifies for the new 20% deduction for qualified business income, discussed below. Moreover, flow-through entities would still provide the potential benefit of owner level basis build-up for undistributed income, the ability to pass losses through to their owners (subject to various limitations), and the ability to pass through favorable long-term capital gains in a single tax structure. State income and franchise taxes to which a “C” corporation is subject can be significant and should also be considered in any choice of entity decision.
20% Deduction for Pass-Through Income – For tax years beginning after December 31, 2017 and before January 1, 2026, individuals and non-corporate taxpayers, including trusts and estates, are allowed to deduct 20% of “qualified business income” earned through partnerships, S corporations or sole proprietorships. This deduction will result in a top federal income tax rate of 29.6% on “qualified business income”, but the deduction will be subject to limitations for taxpayers having taxable income above $157,500 ($315,000 for joint filers). First, the deduction phases out entirely for certain types of businesses, such as businesses involving the performance of services in health, law, accounting, consulting or financial services fields. Second, regardless of the type of business, the deduction is subject to limitations based on the wages paid by, or wages paid plus capital invested in, the business.
Limits on Deduction of Business Interest – Businesses may not deduct net interest expense that exceeds 30% of the business’s adjusted taxable income (defined generally as EBIDTA through 2021, and EBIT thereafter). The interest disallowed can be carried forward indefinitely and allowed as a deduction to the extent of excess limitation in subsequent years. An exception is provided for small businesses. The new interest limitation could diminish the tax benefits of utilizing debt to acquire a portfolio company. Moreover, the limitation could impact the ability of “leveraged” blocker corporations to claim interest deductions.
Net Operating Loss (NOL) Limitations – For NOLs incurred after December 31, 2017, the Act eliminates the two-year carryback provisions in most cases, but allows for an indefinite carryforward to offset future income. The Act also imposes a limit on NOL deductions equal to 80% of taxable income. These limitations could adversely impact the after-tax cash flows of corporate portfolio companies and blocker corporations (which historically could carryback NOLs for a limited period, and use 100% of NOL carryforwards to shield future taxable income). On the other hand, the lower 21% corporate rate partially mitigates the adverse impact of these limitations.
Temporary 100% Expensing for Qualifying Business Assets – For certain new and used tangible property placed into service after September 27, 2017 and before January 1, 2023, businesses are allowed to immediately expense (rather than depreciate over time) 100% of the cost of the property. For most types of property, the deduction begins to phase down by 20% each year beginning in 2023, and is fully eliminated after 2026. The favorable depreciation rules should generally increase the relative tax benefit, from the buyer’s perspective, of an asset acquisition (or deemed asset acquisition resulting from, for example, a section 338(h)(10) or 336(e) election) as compared to a stock acquisition. On the other hand, sellers may be subject to a greater amount of depreciation recapture that will be taxed as ordinary income rather than capital gain. Allocations of purchase price in asset or deemed asset acquisitions will have increased importance as a result of this change in law.
Carried Interest Holding Period – In the case of carried interests issued by private equity funds, the underlying investments are subject to a new 3-year holding period to qualify for long-term capital gains treatment. Since most private equity funds have an investment horizon of longer than 3 years, this change generally should not impact fund managers. However, leveraged recapitalizations within 3 years could result in gains taxed at the higher rate, and “add-on” investments, depending on their structure, could re-start the 3 year holding period for a portion of the investment. The new 3 year holding period generally would not apply to profits interests issued to management by portfolio companies that are LLCs, or by LLCs that hold corporate portfolio companies.
Repeal of Partnership Technical Termination – The Act repeals the “technical termination” rule that provides that a partnership is considered terminated if there is a sale or exchange of 50% or more of the total interest in the partnership over any 12-month period. As a result of this change, a portfolio company organized as a partnership (or an LLC taxed as such) will no longer be able to file a “stub period” return if 50% or more of its equity is sold to a third party buyer.
International Taxation – The Act makes a number of significant changes to the U.S. taxation of foreign operations. For example, a U.S. corporation may deduct 100% of the foreign-source portion of dividends received from certain 10%-owned foreign corporations. The Act also imposes a tax on U.S. shareholders of controlled foreign corporations based on offshore profits above deemed return on tangible assets. A partially offsetting deduction is provided for U.S. shareholders that are corporations, but not other types of taxpayers. A U.S. corporation is also entitled to a new deduction for a portion of its income derived from foreign sales, leases and services. Investors in businesses with foreign subsidiaries or operations should carefully review their structures in light of the new Act.