The Impact of Tax Reform on Merger and Acquisition (M&A) Transactions

Buyers and sellers have always taken taxes and tax law into account when evaluating a potential transaction. Sellers want to make sure that the proceeds they receive, net of their tax liability, are appropriate for what they think the company is worth. Similarly, buyers want to make sure the economic return they make, after paying taxes, will justify their purchase price. Now, with provisions in the Tax Cuts and Jobs Act (TCJA) set to expire in 2025 unless lawmakers extend them, both buyers and sellers need to be even more strategic about how deals are structured.

Stock vs. Asset Deal

As a general rule of thumb, buyers want to buy assets and sellers want to sell stock. The primary reason is that buyers want to avoid any liabilities (known or unknown) that they will assume as part of the purchase of the company stock. In addition, in an asset purchase, buyers take a tax basis in the assets equal to the assigned purchase price that can be amortized or depreciated. In contrast, when acquiring company stock, the buyer’s depreciation and amortization is limited to the remaining tax net book value of the target’s assets.

A buyer’s ability to amortize and depreciate the purchase price has always been an attractive aspect of an asset purchase. The expansion of the bonus depreciation rule in the TCJA passed in 2017 made this even better. Qualified properties (generally, tangible personal property) purchased between 2018–2025, are eligible for deduction of up to 20% of QBI (qualified business income) when determining federal tax.

In addition, tax reform expanded the definition of qualified property to include most “used” property, meaning that buyers can now get an upfront deduction for the portion of the purchase price allocated to such property. However, the depreciation deduction will go away at the end of 2025 as the law stands now. 

On the flip side, Sellers generally want to sell stock to have the transaction taxed at the preferential capital gains rate. In an asset sale sellers often increase their tax liability because some of the consideration can be taxed as ordinary income rather than capital gain. Sellers of interests in partnerships and LLCs taxed as partnerships generally have a result similar to an asset sale because of special partnership look-through rules.

Most commonly, ordinary income results from the recapture of past depreciation and amortization deductions, as well as from the sale of certain assets—such as cash basis accounts receivable—that were not previously taxed because the seller used the cash basis of accounting.  The impact of the ordinary income tax rates can potentially be reduced if a business is eligible for the IRC 199A deduction (20% pass-through deduction) but the overall tax rate will still be higher. Again, this deduction is set to expire at the end of 2025 unless Congress extends it.

Read about the final regulations for the IRC 199A deduction by clicking here.

Because of the 2017 tax reforms, more businesses chose to operate as a C corporation to take advantage of:

• a lower 21% corporate tax rate (it had previously been 35%);
• the elimination of the corporate alternative minimum tax; and
• certain changes to the international tax system.

The tax benefits of selling stock are even greater for C corporation shareholders because it allows them to avoid the “double tax” of having the corporation pay tax on the asset sale proceeds in addition to the shareholders on the distribution of the sales proceeds.  

Furthermore, some sellers of eligible C corporation stock may qualify for the capital gain exclusion available under IRC 1202—not new to tax reform—that will allow them to exclude all or a portion of the gain on the sale of their stock (limited to the greater of $10 million or 10 times the adjusted basis of the stock acquired). The amount of the exclusion depends upon when the stock was acquired as follows:

• 100% for stock acquired after September 27, 2010;
• 75% for stock acquired after February 17, 2009, and before September 28, 2010; and
• 50% if acquired before February 18, 2009, and after August 10, 1993

Eligibility for the IRC 1202 exclusion depends on several factors, including how the stock is acquired, the holding period of the stock, and the type and size of business at the time of issuance of the stock. For the 50% and 75% exclusions, there is a special tax rate on the portion not excluded, as well as certain adjustments that are required for alternative minimum tax purposes.

Financing and Equity Structures

The 2017 tax reforms provided a limitation on the deductibility of business interest expense to 30 percent of adjusted taxable income. Any interest expense exceeding the threshold was disallowed but can be carried forward indefinitely until such time when it can be utilized. This limitation can significantly impact the timing of tax deductions and related cash flow, so it needs to be understood and accounted for when determining the ideal capital structure of the acquisition. 

This new limitation applies to businesses with average gross receipts over $25 million; however, taxpayers need to aggregate the gross receipts of certain related parties when determining if they are over the threshold. In addition, businesses that are considered to be tax shelters—because they allocate more than 35% of their losses to limited partners or entrepreneurs—are also subject to the interest limitation. Private equity firms and other buyers utilizing higher percentages of debt will be particularly impacted by this new limitation.

Adjusted taxable income is defined as taxable income without regard to items not related to a trade or business (i.e. investment items); any business interest expense or business interest income, net operating losses, deductions under IRC 199A, and—for years beginning before January 1, 2022—depreciation, amortization, and depletion deductions. Adjusted taxable income is similar to EBITDA, but, as noted below, the definitions in the regulations are limiting and impact taxpayers and the calculations of their interest limitations. 

The regulations under these interest limitations took an expansive view of interest and included most items treated as interest in substance or form, including:

• qualified stated interest as well as amortization of debt issuance costs;
• substitute interest payments; and
• guaranteed payments for the use of capital, etc.

Furthermore, the definition of depreciation in the regulations did not include depreciation capitalized to inventory under the Uniform Capitalization (UNICAP) rules and expensed as cost of goods sold.  Therefore, the impact to manufacturers can be significant.

One potential solution is the utilization of various classes of equity. If done properly, this can minimize the impact of the interest limitations and achieve a similar economic result for the buyer. However, care is required to ensure that the allocations and distributions are respected—and not reclassified as interest expense.

At this time, it’s unclear how deductions of interest expenses will be handled after the TCJA sunsets. You’ll have to keep an eye on what gets passed by Congress.

Timing of Transaction

Outside of the change in tax rates, the timing of a sale transaction has generally not been of significant concern when considering the tax consequences to the buyer or the seller. If anything, a seller may have seen a slight benefit when closing a sale transaction early in a year as opposed to later in the previous year to delay the timing of when estimated tax payments related to the sale were required to be paid. 

At a high level, owners of pass-through entities are allowed a deduction equal to the lesser of 20% of qualified business income or 20% of taxable income less capital gains. Generally, qualified business income is income from a trade or business, if effectively connected with the United States, other than a specified service trade or business—or a trade or business of performing services as an employee. Investment income and capital gain income (or items taxed as capital gain such as IRC 1231 gain) are not eligible for the 20% deduction.

The 199A deduction is generally limited to the greater of:

• 50% of a pass-through owner's share of the businesses W2 wages; or
• 25% of a pass-through owner's share of the businesses W2 wages, plus 2.5% of the unadjusted basis of qualified property.

To the extent that the sale of the business generates capital gain, the 199A deduction will not be relevant to the transaction. However, as discussed previously, businesses that sell assets or are treated as selling assets can have some or all of the gain from their business taxed as ordinary income. For federal purposes, the top income tax rate for ordinary income can be as high as 37% (and this could go up if new tax laws are not passed by the end of 2025). However, ordinary gain from the sale of a business can be eligible income for 199A purposes if the business income would otherwise be eligible. Depending upon the amount of ordinary income on the transaction, the impact of the deduction can be significant—lowering the top rate on that income to 29.6% if all other requirements are met. 

Because the deduction is limited in part by the wages of the business, the timing of the sale can be relevant to the overall tax rate the sellers pay on ordinary income. If, for example, the business is sold on January 1st rather than December 31st, the seller may have no W2 wages, as opposed to a full year’s worth of W2 wages to determine the W2 wage limitation. The regulations specifically address this point, providing that in the case of an acquisition or disposition of a trade or business, or a major portion thereof, where the employees become employees of the acquirer, the wages must be allocated between the buyer and seller based upon the employee wages incurred during each of their ownership periods. 

Furthermore, only property held at the close of the tax year is taken into account for determining the unadjusted basis of qualified property.  As a result, sellers need to monitor the potential ordinary income from a sale transaction and the impact of the wage and property limitations on their potential 199A deduction.

The impact of the 2017 tax reforms on businesses and their owners was significant. Now that we are a few years removed from the changes and a potential sunsetting date for lower rates and deduction eligibility is on the horizon, there is the potential for uncertainty in the years ahead. For anyone considering a transaction, it will be important to follow news out of Washington as Congress weighs taxing options.