By: Len Russek, Transworld M&A Advisors
Starting in 2018, the New Tax Law will have a “yuuge” impact on middle market businesses. This is true whether you are at the point in life where it’s time to sell or if you want to grow your business by acquiring other companies.
Let’s talk first about those who want to sell their company. If this is you and you want to stop reading, all you need to know is that selling now will cost you substantially less in income taxes. You get to take more home after tax. Deductions (depreciation) that have sheltered income for you in the past at 35% to 39.5% tax rates will now be taxable (recaptured) at rates as low as 21% to 29%.
Most transactions are structured as a sale of assets which places the seller and buyer in the frustrating process of making an allocation of purchase price among the depreciable assets, working capital and intangible assets such as goodwill. This allocation process requires a formal sign-off between buyer and seller on the amount for each asset. The seller’s tax advisor then must do the math to identify the amount of depreciation recapture, taxed at ordinary income tax rates and the amount to be taxed at capital gains tax rates. While we don’t yet have the detailed IRS rules to implement the new tax law, it does seem the capital gain tax rates and ordinary income tax rates are now essentially the same, with minor differences.
So if you are on the selling side, this is about all that you need to know.
If you want to grow by acquiring other companies, your tax breaks and complexities just went way up. (Sellers, these are your buyers, so it may help you to know what they are thinking.)
The first to consider is the Capex Deduction that appears to allow a 100% write off against the buyer’s taxable income without any annual limitation for “qualified property” purchased in an M&A transaction. It’s not yet clear whether “qualified property” is limited to just depreciable assets like equipment and vehicles or if it also applies to intangible assets like patents, customer lists and goodwill. It does not seem to matter if this 100% deduction creates a Net Operating Loss for tax purposes, since these losses can be carried forward to future years, but can no longer be carried back to prior years. Sorry, you can’t get a tax refund from buying other companies.
Likewise, until we see the IRS rules for implementation we won’t know what the impacts will be for buying companies known as asset light companies such as consulting, marketing or finance companies. I doubt the Capex Deduction will be available to buyers of these types of companies, beyond the depreciable office equipment, but we’ll see.
Next for the buyer to consider is the limitation on the deductibility of the interest cost for any acquisition related debt. From the wording that I’ve seen so far, it’s not just the interest expense on the new debt for the acquisition, but the total interest expense for your company on a consolidated basis.
Interest deductibility is limited to 30% of EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) and it’s still unclear what impact the Capex Deduction will have on EBITDA. If it’s considered the same as Depreciation then it will have no impact reducing EBITDA, so let’s hope that’s how the IRS rules see it. (We need to keep in mind that EBITDA is a formal designation by accounting people and may or may not be similarly defined by the IRS.) None-the-less, any Net Operating Loss created by excess interest expense can be carried over to future years, subject to the same annual 30% of EBITDA limitation.
If your consolidated entity has annual revenues of less than $25 million you are exempt from the 30% of EBITDA limitation. So, small business transactions bought by individuals using highly levered SBA guaranteed loans appear to be exempt.
An additional issue is what impact this may have on Private Equity Groups who typically use leverage of 60% or more on each of their portfolio acquisitions. It’s unclear whether for the 30% of EBITDA limitation on interest expense deductibility they will be evaluated as a consolidated entity for all of their portfolio companies or if each portfolio company will be evaluated as separate entities. Private Equity Groups and individuals who are organized as Pass-thru entities (LLC, Sub S, Partnerships) will also have new rules on pass thru deductions. We will just have to wait for the IRS to define these rules.
Neither a Seller Nor Buyer
If you are not ready to sell your company and are not interested in growing by acquiring others, you also have benefits beyond just the tax rate reductions. The largest is the increase in the limit on Section 179 deductions to $1,000,000 per year for capital expenditures on new assets. You will be able to purchase new equipment and write it off in the year of purchase. This is the same rule that has existed in prior years with a $500,000 limit. It’s now just a larger annual limitation.
If you have international operations, there are many more changes in the new tax law that are beyond the scope of this discussion. However, the focus of the new tax law seems to be to get cash repatriated back to the United States by the large multi-national corporations and to stimulate the economy. While many of the provisions discussed above have effective periods of 5 or more years starting in 2018, the law can always be changed by Congress if it’s found to be too strong of a stimulus such that our economy goes into a high inflationary mode. For this reason, and the fact that it may take a year or so to complete a transaction, you may not want to hold off on any transactions that you might otherwise be considering. Of course, this is self serving since M&A transactions are what I do for a living.
- Len Russek, a former CPA has been a Mergers & Acquisitions advisor for over 25 years both inside large corporations and as an intermediary during which he has been involved in structuring and negotiating the sale of hundreds of businesses. Contact him at 727-894-7888 or LRussek@TransworldMA.com.