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Mergers & Acquisitions in the New TCJA World

Discover the impact of the Tax Cuts and Jobs Act (TCJA) on mergers and acquisitions. Explore changes in tax rates, pass-through deductions, choice of entity, NOLs, depreciation, and more. #WBInsights18

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Mergers & Acquisitions in the New TCJA World

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  1. Mergers & Acquisitions in the New TCJA World Kristi Johnson, CPA Laura Berry, CPA

  2. Mergers & Acquisitions - TCJA #WBInsights18

  3. Overview – Related to Transactions • M&A Activity – Current and Prospective • Tax Rates (Corporate & Individual) • Pass-Through Deduction (QBI) Section 199A Proposed Regulations – Service Businesses • C-Corporation vs. S-Corporation Choice of Entity • Net Operating Losses (NOLs) • Depreciation • Interest Expense Limitation • Carried Interest • Partnership Technical Terminations • Self Created Intangibles • Opportunity Zones (Overview) • “Take Aways” #WBInsights18

  4. Current Market M&A Activity #WBInsights18

  5. Current Market M&A Activity #WBInsights18

  6. Tax Cuts & Jobs Act • Signed into law on December 22, 2017 • Largest major tax reform since 1986 – prior to the enactment, the US had the highest statutory tax rate in the industrialized world • Significant changes to both business and individual items – encourage growth (jobs, investment in US facilities); changes to the treatment of foreign income • Most tax provisions related to individuals expire after 2025, while most corporate tax provisions are permanent • Projected costs over the 10 year window (with offsets) – adds approximately $1 Trillion to the Deficit #WBInsights18

  7. Corporate Tax Rate • Pre-TCJA • Graduated tax rates of 15%, 25%, 34% and 35% • Personal services corporations taxed at a flat 35% • Post-TCJA beginning January 1, 2018 • PERMANENT flat tax rate of 21% • Personal service corporations included at the flat 21% #WBInsights18

  8. Individual Tax Rate Effective 2018 Highest rate reduced from 39.6% to 37% Dollar thresholds for brackets increased The 3.8% NIIT and 0.9% Medicare tax remain All individual provisions set to expire after 2025 #WBInsights18

  9. Individual Tax Rates – (Married Filing Joint) #WBInsights18

  10. Individual Tax Rates - Single #WBInsights18

  11. Pass-Through Deduction – Section 199A • Beginning in 2018 (expiring 2025) – Taxpayers who have “Qualified Business Income” (QBI) from a flow through entity (partnership, S corporation or sole proprietorship) are entitled to a deduction, up to a 20%, on Qualified Business Income (QBI) for each “Qualified Trade or Business” (QTB). • A QTB means any trade or business other than a “specified service trade or business” (SSTB) or the trade of business of performing services as an employee. • Not to include investment income • A SSTB includes the fields of law, health, consulting, brokerage services, financial 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 employees or owners. Engineering and architects are not specified service businesses. • The deductions equates to a 29.6% tax rate on the QBI if it all qualifies for the 20% deduction. • Proposed Regulations issued were very favorable for “service” businesses #WBInsights18

  12. Pass-Through Deduction – Section 199A QBI deduction is based upon the lesser of • 20% of qualified business income or • 20% of the excess of taxable income over net capital gain Then the deduction is further limited to the GREATER of: • 50% Allocable W-2 wages of the business (wage limitation) or • 25% Allocable W-2 wages of the business plus 2.5% unadjusted basis of qualified property (wage/property limitation) * Maximizing wages may prove beneficial * Consider slowing down depreciation deduction to claim the pass through deduction while available (through 2025) * No phaseouts or SSTB limitations apply if taxable income is below thresholds (next slide) #WBInsights18

  13. Pass-Through Deduction – Section 199A • Neither the limitation nor the prohibition on specified service businesses applies to a taxpayer with taxable income not exceeding $315,000 (MFJ) – but limitations are fully phased in if taxable income is in excess of $415,000 (MFJ) #WBInsights18

  14. Pass-Through Deduction Flowchart #WBInsights18

  15. Business Life Cycle #WBInsights18

  16. Flow-Through vs. C-Corporation (choice of entity)- Annual Operations #WBInsights18

  17. Flow-Through vs. C-Corporation (choice of entity)- Sale of Business Assets #WBInsights18

  18. Net Operating Losses (NOLs) • For losses arising in taxable years beginning after December 31, 2017. • NOL deduction limited to 80% of taxable income, • NOL carrybacks eliminated, and • NOLs may be carried forward indefinitely. • No change to pre-2018 NOLs • These NOLs still expire after 20 years, • Or may be carried back 2 years, • Tracking of Pre- and Post- NOLs will be necessary • Fiscal year taxpayers – look to when taxable year begins. • Net Business Losses for individuals are only able to offset $500,000 of non-business income (MFJ), any excess is a NOL. #WBInsights18

  19. Net Operating Losses (NOLs) As noted, you must now track NOLs generated before and after the effective date separately. #WBInsights18

  20. Net Operating Losses (NOLs) • Transaction costs can create NOLs, which prior to 2018, were able to be carried back 2 years and generate immediate cash flow. Under TCJA, prior to entering into a transaction, the cash flow implications must be recognized and quantified since they are only able to be carried forward and will only offset 80% of future taxable income. • The purchase price may need to be revisited or negotiated based on this limitation. #WBInsights18

  21. Effects of Ownership Changes382 limitations • Prior NOLs can be further limited if there is an “ownership change” under Section 382 – annual limitation is calculated • “Ownership change” is where there is > 50% change in the value of the stock owned by > 5% owners during the testing period (normally 3 years) • Strategize and plan for ownership changes to allow for more NOL or business interest utilization (3 years + 1 day) • Since no expiration of NOLs, beginning 2018, NOLs could potentially carry forward many years • The carry forward of business interest limitation under TCJA is subject to Section 382 #WBInsights18

  22. Depreciation – Bonus • Extended through December 31, 2026. • In effect for assets placed in service after September 27, 2017. • 100% expensing for certain qualified assets through December 31, 2022. • Now includes used equipment, as long as not previously used by the taxpayer. • Bonus phased down by 20% each year from 2023 through 2026. • May elect 50% bonus in lieu of 100% bonus during the first year ending after September 27, 2017. • On 5 or 7 year property – consider electing out of bonus if concerned about excess business loss limitations #WBInsights18

  23. Depreciation - Section 179 • Expands the definition of qualified real property to include all qualified improvement property(QIP) and certain improvements (roofs, heating, ventilation, and air-conditioning property, fire protection and alarm systems, and security systems) made to nonresidential real property. • Save Sec 179 for assets that are not bonus eligible, i.e. roofs, HVAC. • Now includes personal property included in rental real estate. • Remember Sec 179 is limited to taxable income, but can elect and carryover excess. • Phaseout threshold is increased to $2.5M #WBInsights18

  24. Bonus Depreciation – No Net Operating Loss #WBInsights18

  25. Bonus Depreciation – Net Operating Loss #WBInsights18

  26. Depreciation – QBI Deduction #WBInsights18

  27. Bonus Depreciation – QBI Deduction #WBInsights18

  28. Depreciation – QBI Deduction #WBInsights18

  29. Business Interest Expense Limitations - Sec 163(j) The deduction for business interest is limited to the sum of (1) business interest income PLUS (2) 30 percent of the adjusted taxable income (ATI) of the taxpayer for the taxable year* and (3) floor plan financing Exceptions: (1) limits do not apply to businesses with gross receipts in the 3 prior years of $25 million or less (2) any electing real property trade or business (a real property trade or business as defined in 469(c)(7)(C). *ATI is computed without regard to Business Interest Expense or Depreciation and Amortization Deductions. ATI is computed by taking into account Depreciation and Amortization Deductions after 2021. For C-corporations, the amount of any business interest expense not allowed as a deduction for any taxable year is treated as a business expense paid or accrued in the following taxable year, and may be carried forward indefinitely. The limit is first applied at the entity level for Partnerships and S-Corporations. Any carry forward for pass-through owners is subject to special rules and calculations of “excess business interest” and “excess taxable income”. As noted before, ownership changes could result in additional limitations to the business interest deduction. #WBInsights18

  30. Business Interest Expense Limitations - Sec 163(j) Investor A Investor B 50.0% 50.0% Fund I Owner B Owner A 51.0% 24.5% 24.5% $4M Loan @ 10% APR • RP LLC Historical Gross Revenues • $23,000,000 • 2016 25,000,000 • 2017 28,000,000 • 3-year average : $25,333,333 RP LLC #WBInsights18

  31. Business Interest Expense Limitations - Sec 163(j) – prior to 2022 Investor A Investor B 50.0% 50.0% Is the $400K of interest expense paid from RP LLC to Fund I Limited? Fund I Owner B Owner A 51.0% 24.5% 24.5% $400,000 Interest Paid RP LLC RP LLC 2018 Taxable Income Projection: ATI $600,000 Depreciation (150,000) Income before interest $450,000 Interest expense (no limit) (400,000) #WBInsights18

  32. Business Interest Expense Limitations - Sec 163(j) – prior to 2022 Investor A Investor B 50.0% 50.0% Yes, interest expense is limited to $180,000 Fund I Owner B Owner A 51.0% 24.5% 24.5% $400,000 Interest Paid RP LLC 2018 Taxable Income Projection: ATI $600,000 163(j) percentage x .30 163(j) limitation $180,000 RP LLC #WBInsights18

  33. Business Interest Expense Limitations - Sec 163(j) – prior to 2022 $220K x 25.5% = 56,100 C/F each Investor A Investor B $220K x 24.5% = 53,900 C/F each 50.0% 50.0% Fund I Owner B Owner A 51.0% 24.5% 24.5% $400,000 Interest Paid RP LLC 2018 Taxable Income Projection: ATI $600,000 Depreciation (150,000) Interest expense (400,000) 163(j) addback 220,000 Taxable Income $270,000 RP LLC #WBInsights18

  34. Business Interest Expense Limitations - Sec 163(j) – starting 2022 Investor A Investor B 50.0% 50.0% Yes, interest expense is limited to $135,000 Fund I Owner B Owner A 51.0% 24.5% 24.5% $400,000 Interest Paid RP LLC 2022 Taxable Income Projection: ATI before depreciation $600,000 Depreciation (150,000) ATI 450,000 163(j) percentage x .30 163(j) limitation $135,000 RP LLC #WBInsights18

  35. Business Interest Expense Limitations - Sec 163(j) – starting 2022 $265K x 25.5% = 67,575 C/F each Investor A Investor B $265K x 24.5% = 64,925 C/F each 50.0% 50.0% Fund I Owner B Owner A 51.0% 24.5% 24.5% $400,000 Interest Paid RP LLC 2022 Taxable Income Projection: ATI before depreciation $600,000 Depreciation (150,000) Interest expense (400,000) 163(j) addback 265,000 Taxable Income $315,000 RP LLC #WBInsights18

  36. Carried Interests – Sec 1061 • Partnership Interests held in connection with performances of services = Carried interest – also known as a profits interest. • Primarily intended to apply to hedge fund managers – to deny them long term capital gain treatment. • Requires a 3 year hold of the partnership interest (if the interest is sold) and the 3 year hold of the underlying assets (if the assets are sold) to obtain long-term capital gain treatment. Otherwise, short-term capital gain (taxed at same rates as ordinary income). • Applies to the holder of an “Applicable Partnership Interest” (API) • Applicable Partnership Interest - An ownership interest for which capital/profits are not commensurate with the amount of capital contributed. This is an interest acquired for services. #WBInsights18

  37. Partnership Technical Terminations • Pre-TCJA, a partnership would be deemed “terminated” if 50% or more of the total interests in the partnership capital and profits was sold or exchanged within a 12 month period. • This allowed for partnership-level elections to cease to apply and could be “reset”, certain attributes may have been lost, and the depreciation recovery periods had to be restarted. • TCJA – eliminates the technical termination rule. A partnership is terminated only if no part of any business continues to be carried on. • New elections are not required or permitted. • This could add complexity by resulting in a “straddle” taxable periods overlapping the closing date – difficult to manage tax liabilities between buyer and seller. • This should also avoid the acceleration of deferred revenue in an acquisition • This could result in additional purchase price negotiations * Books do not formally close. If this is the intended result, a revision to the structure may need to be considered up front. Who prepares the return? Buyer or seller? #WBInsights18

  38. Self Created Intangibles • Prior to TCJA – self created intangibles (patents, inventions, models/designs, or secret formula or process), if sold as part of an asset sale, were considered capital assets and subject to capital gain tax rates. • Post-TCJA, the Code was amended to exclude all of the above “self created intangibles” from the definition of a “capital asset.” • Thus, gains or losses from the sale or exchange of any of the above intangibles will no longer receive capital gain treatment (ordinary income or loss treatment). #WBInsights18

  39. Opportunity Zones • Opportunity Zones (OZs) are part of a developmental program that promotes the long-term investment in and development of low-income urban and rural real estate across the United States. • Opportunity Fund (OF) is an investment vehicle for those that would like to invest in Opportunity Zone assets. #WBInsights18

  40. Timeline of Recognition *Gain must be recognized on 12/31/2026 – no additional Step-Up following this date 5 years 180 days 7 years

  41. Opportunity Zones #WBInsights18

  42. Take-Aways • Sellers will want to still do stock deals, and Buyers will still want to asset deals • Any “tax reimbursement” related to purchase price allocation (stock versus asset deals), you need to be aware and take into account Tax Reform changes (tax rate changes, pass through deduction, self created intangibles) • Greater attention to purchase price allocations, and how it may affect cash flow in light of Tax Reform • Consider limitations related to business interest expense, if debt is being used to fund the purchase • Review for any tax opportunities that could help offset the NOL and interest expense limitations (depreciation, R&D credits) • Choice of entity will depend on several factors: qualify for 199A deduction; benefits of being a C corporation (1202 stock, cash accumulation); succession planning; potential repeal of 21% corporate tax rate • Attend Windham Brannon Webinar on OZ Funds on December 6, 2018 at 2:00 pm #WBInsights18

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