The Tax Cuts and Jobs Act, enacted on December 22, 2017, contains several provisions that significantly affect the federal income tax consequences of structures often used in domestic M&A transactions.
While some are taxpayer-favorable, others are unfavorable, compared with prior law. Buyers and sellers should carefully plan any acquisition or disposition of assets or equity interests to maximize the impact of the favorable provisions and mitigate the impact of the unfavorable provisions.
Some of the more salient Act provisions affecting M&A transactions include:
Ordinary Income on Disposition of Patents and Certain Similar Assets
The Act provides that gain on the sale of certain self-created patents, inventions, models or designs (regardless of whether patented), and secret formulas and processes is taxed at ordinary income rates and may not qualify for the preferential long-term capital gain rate, effective for dispositions after December 31, 2017.
Deduction for Qualified Business Income
The Act provides a new deduction for owners of pass-through entities (the “Pass-Through Deduction”), generally equal to 20 percent of certain domestic business income, excluding income from certain service businesses such as engineering, law and financial services, and also excluding long-term capital gains. The amount of Pass-Through Deduction is subject to certain limitations based on wages paid to employees and unadjusted tax basis of certain property. It is not clear to what extent the Pass-Through Deduction would benefit the owners of a pass-through entity that sells of all of its assets, because the conference committee has instructed the Treasury Department to provide rules applying the limitation to the Pass-Through Deduction in the year in which where the pass-through entity disposes of a major portion of a trade or business.
The Pass-Through Deduction is effective for taxable years beginning after December 31, 2017.
Temporary Full Expensing of Certain Property
The Act generally permits full expensing of certain property (for example, equipment), whether new or used, placed in service between September 28, 2017 and December 31, 2022 (or, in the case of certain longer-production property and aircraft, December 31, 2023), followed by a phase-down over the years 2023 through 2026 (or, in the case of certain longer-production property and aircraft, through 2027). This provision should increase the buyer’s federal income tax benefits of an asset sale (or a transaction treated as an asset sale for federal income tax purposes) by allowing the buyer to deduct 100 percent of the cost of the applicable property.
Treatment of Gains and Losses by Foreign Persons from the Sale of an Interest in a Partnership that is Engaged in a U.S. Trade or Business
Gain or loss from the sale or exchange of a partnership interest on or after November 27, 2017, will be subject to federal income tax at graduated income tax rates to the extent that the seller of the interest would have had income connected with a U.S. trade or business had the partnership sold its assets. The Act overturns the holding in Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (2017). In Grecian, the Tax Court held that a foreign person’s gain or loss from the sale of an interest in a partnership that is engaged in a U.S. trade or business is foreign-source income and was not subject to U.S. tax.
Withholding on the amount realized will be required with respect to sales or exchanges of partnership interests beginning after December 31, 2017.
Provisions Relevant to the Termination of S Status
S corporations that convert to C corporations within two years of the date of enactment may be able to distribute cash as a tax-free return of capital rather than as a taxable dividend. The provision is effective upon enactment.
The Act reduces the corporate income tax rate to 21 percent. This ameliorates, to some extent, the post-closing tax cost of the corporate structure resulting from the termination of S status if a portion of S corporation stock is sold to an ineligible shareholder, such as a private equity fund. The corporate income tax rate reduction is effective for taxable years beginning after December 31, 2017.
Further, any section 481(a) adjustments resulting from the termination of S status (such as a required change from the cash to accrual method of accounting) are taken into account ratably during the six-year period beginning with the year of change. The provision is effective upon enactment.
Treatment of Net Long-Term Capital Gain Relating to Profits Interests Received in Connection with the Performance of Investment Services
With certain exceptions, recipients of profits interests received in connection with the performance of services for certain investment type businesses are now potentially subject to unfavorable tax rates. Net long-term capital gain from the partnership’s sale of an asset held for three years or less is treated as short-term capital gain (taxable at ordinary income tax rates). Sales or exchanges of such profits interests are also subject to the more than three-year holding period requirement. A special rule exists for dispositions of such interests to related persons which, if applicable, treats the entire gain as short-term capital gain.
Whether a taxpayer included an amount in income upon receipt of the interest, or made a section 83(b) election with respect to such an interest, does not change the more than three-year holding period requirement.
The provision is effective for taxable years beginning after December 31, 2017.
State and Local Taxes
The Act generally does not alter the treatment of state and local taxes imposed at the entity level, for example business taxes imposed on pass-through entities, and such taxes will continue to reduce the distributive or pro-rata share of income of the owners of pass-through entities.
Business Interest Expense Limitations
Effective for tax years beginning after December 31, 2017, the Act generally limits the deductions for net interest expense to 30 percent of adjusted taxable income. Taxpayers who have less than $25 million in average gross receipts for the three years ending prior to the applicable taxable year are exempt from this limitation. The business interest expense limitation is subject to various special rules, including with respect to partnerships and limited liability companies taxed as partnerships, and motor vehicle dealers.
Repeal of Technical Termination Rule for Partnerships
The Act repeals the law that provided that a sale or exchange of 50 percent or more of the total interest in partnership capital and profits within a 12-month period caused a “technical termination.” The effects of a technical termination included the start of a new depreciation period for the partnership’s depreciable tangible assets, the need for both the terminating and new partnership to file short period tax returns, and for the new partnership to file new tax elections.
The Act applies to partnership taxable years beginning after December 31, 2017.
Loss Limitations for Non-corporate Taxpayers
For taxable years beginning after December 31, 2017 and prior to January 1, 2026, the Act limits excess business losses of non-corporate taxpayers. Excess business loss is the amount of aggregate deductions attributable to the taxpayer’s trades or business (determined without regard to the limitations imposed by this provision) reduced by (i) the aggregate gross income or gain plus (ii) $250,000 for taxpayers filing single returns ($500,000 for joint returns). The threshold amounts are indexed for inflation. Excess losses not allowed are treated as part of the taxpayer’s net operating loss carryforward.
In case of partnerships, limited liability companies classified as partnerships and S corporations, the limitation is applied at the partner or shareholder level, and takes into account the partner’s or shareholder’s distributive or pro-rata share of each item of income, gain, loss, and deduction.
Net Operating Losses (NOLs)
The Act limits deductions for NOLs arising for taxable year beginning after December 31, 2017 to 80 percent of taxable income (determined without regard to the deduction), with exceptions for certain insurance companies. The Act generally repeals the two-year carry-back of NOLs to prior taxable years, and replaces the 20-year carryover limit with an unlimited carryover period.
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