Mr. August is a nationally recognized tax lawyer who advises clients on income tax matters, including foreign taxation of U.S. businesses and U.S. taxation of foreign businesses and investors. In many instances he works with ...
This post highlights a few of the “moving pieces” affecting the structure for engaging in a merger or acquisition of a privately owned company brought about by the Tax Cuts and Jobs Act of 2017, P.L. 115-97, 12/22/2017. The reduction in the corporate income tax rate to a flat 21% will encourage business entities to evaluate whether a conversion from a pass through entity to a C or regular corporation makes sense, taking relevant foreign, if any, and state income tax issues into account. Certain sources of foreign income will, for certain domestic corporations, be subject to a maximum federal income tax rate of 13.5% or 10.5% as will be highlighted below. On the other hand, net operating losses of both corporations and individual are subject to new limitations. In general, net operating losses generated in taxable year subject to the TCJA are subject to a 20% cutback. In other words, only 80% of a NOL can be used against taxable income in a subsequent year. Subject to limited exceptions, NOLs under the TCJA ca not be carried back 2 years as before. This means the overall value of a corporate NOL for example is reduced by 20% of the gross available amount with a discounted rate for the projected absorption of the NOLs against future income. There is also new section 461(l) which applies to non-corporate taxpayers and limits the use of current NOLs to $250,000 ($500,000) for a joint return.
Below are a set of factors that the new law requires tax planners to take into account in advising clients in structuring the acquisition of a target company. The list is not intended to be all-inclusive and the comments are directed towards domestic business transactions. There obviously is much more to consider than this list of factors and in the cross-border context, the impact of the TCJA is far broader.
- Corporate Income Tax Rate Changes. Under-pre Tax Cuts and Jobs Act, corporations were subject to graduated rates of income tax that resulted in a 35% corporate rate for taxable income over $10M, with a phase out of the lower rates (surtax exemption) for taxable income over $100,000. Certain personal service corporations were subject to a maximum rate of tax at 35%. The maximum rate of a corporation’s net capital gain was also 35%. The new law reduces the corporate income tax to a flat 21% and repeals the maximum corporate tax rate on net capital gain as obsolete.
- Dividends Received Deduction. Under section 243(a), a corporation is allowed a deduction for dividends received (DRD) from other taxable domestic corporations. In general, the deduction is 70% of the dividend received. This produces a maximum rate of 10.5%. For a domestic corporation’s holding 20% or more of the stock of another C corporation, the amount of the deduction is 80% of the dividend received. Such dividends are taxed at a maximum rate of 7%. For dividends received from a member of the same affiliated group, the DRD is generally 100% of the dividend. The TCJA reduces the 70% DRD to 50% and the 80% DRD to 65%. This will yield the same tax rate as under prior law as the reduction is based on the reduced corporate income tax rate of a flat 21%. The DRD rules may influence the acquisition of a target corporation so that the purchase of stock for example results in the target corporation’s maintaining its C or regular corporation status.
- Corporate Alternative Minimum Tax (C-AMT). Prior to the JCTA corporations were subject to the C-AMT to the extent that the tentative minimum tax exceeds its regulator tax. The tentative minimum tax is computed at the rate of 20% on the AMTI in excess of $40,000 , i.e., the exemption amount, that phases out by an amount equal to 25% of the amount that the corporation's AMTI exceeds $150,000. AMTI is the taxpayer's taxable income increased by certain preference items. A corporation with average gross receipts of less than $7.5M for the prior three taxable years is exempt from the corporate minimum tax. The $7.5M million threshold is reduced to $5M for the corporation's first three-taxable year period. A major item included in the corporation’s AMT base is the “adjusted current earning (“ACE”) adjustment. The ACE adjustment is equal to 75% of the amount by which adjusted current earnings of a corporation exceed AMTI. The NOL carryover of a corporation cannot reduce the AMT base by more than 90% of the NOL. Nonrefundable business credits allowed for regular tax purposes are not allowable for C-AMT. Where a corporation is subject to the C-AMT, the amount of C-AMT is a credit for use in any subsequent tax year where the taxpayer’s regular tax liability exceeds its tentative minimum tax in such later year. The corporate AMT is repealed by the TCJA. Existing C-AMT credits are refundable for any tax year beginning after 2017 and prior to 2022 in an amount equal to 50% (100% for tax years beginning in 2021) of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability.
- Replacement of the Corporate Alternative Minimum Tax With A Base Erosion Tax Under New Section 59A. In replacing the corporate alternative minimum tax, and in response to earnings stripping enforcement efforts by members of the G-20, the U.S. independently enacted a base erosion minimum tax to prevent companies from stripping earnings out of the U.S. through payments to foreign affiliates that are deductible for U.S. tax purposes. The tax is structured as an alternative minimum tax that applies when a multinational company reduces its regular U.S. tax liability to less than a specified percentage of its taxable income, after adding back deductible base eroding payments and a percentage of tax losses claimed that were carried from another year. The “base erosion minimum tax” is 10% (5% for years beginning in 2018) of the “modified taxable income” of a subject taxpayer over an amount equal the regular tax liability reduced by applicable credits of the corporation. The rate climbs to 12.5% for taxable years beginning after 2025. The BEATs tax only applies to large C corporations. Obviously the BEATs tax will not be relevant to smaller economic concerns.
- Net Operating Losses of Corporations. A net operating loss (NOL) is allowed corporations and individuals in computing taxable income in an amount equal to the aggregate of the NOL carryovers and NOL carrybacks for that year. Under the law prior to the TCJA, the NOL deduction was not subject to the a limitation based on taxable income.
- Individual Tax Rates Modified and Reduced. The new tax rates start at 10% and increase to 37%. The net investment income tax (Obama Medicare Tax of 3.8% under section 1411) still applies. The individual alternative minimum tax is still in effect. As per section 172(b)(2), where an NOL is not used in the first year to which it is carried, the loss can be carried to a second year (with certain modifications). Prior to TCJA, generally net operating losses could be carried back two years and forward 20 years. The TCJA limits the NOL deduction for taxable years beginning in 2018 to 80% of taxable income.
- Deduction for Qualified Business Income. New section 199A allows a 20% deduction from taxable income for a taxpayer other than a corporation. An S corporation is an individual. The deduction applies at the individual S shareholder level as it does for partners in a partnership. Section 199A treats each shareholder or partner as receiving his allocable share of the items needed for computing the section 199A deduction. The deduction equals the sum of lesser of (a) the “combined qualified business income amount”and (b) 20% percent of the excess of (i) taxable income (computed without regard to Section 199A) over (ii) the sum of any “net capital gain” plus any “qualified cooperative dividends.” The second amount is the lesser of (a) 20% of the qualified cooperative dividends or (b) taxable income reduced by net capital gains. The amount determined under the formula may not exceed the taxable income reduced by the net capital gain. The combined qualified business income amount includes certain amounts with respect to each qualified trade or business. In addition, the combined qualified business income amount includes 20% of qualified REIT dividends and qualified publicly traded partnership income. The amount determined for any QBI is subject to a limitation. The limitation is the lesser of: (a) 20% of ABI or (b) the greater of (i) 50% of W-2 wages with respect to the qualified trade or business or (ii) the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis after the acquisition of “qualified property”. The unadjusted basis is the cost of the property immediately after the acquisition of the property involved and is not reduced by depreciation taken on the asset after its acquisition. The W-2 wages and qualified property apply separate as to each trade or business. For individuals whose income does not exceed a threshold amount, the 20% deduction is allowed even if the trade or business is not a QBI but is a specified service trade or business. The threshold amount is $157,500( $315,000 for a joint return) (with inflation adjustments). This rule phases out if the taxpayer’s taxable income is up to $50,000 more than the threshold amount ($100,000 or more for a joint return). Proposed regulations were recently issued under section 199A.
- Limitation on Deduction for Interest. Frequently an acquisition is a “leveraged acquisition” in which case the buyer obtains financial from institutional or private investors, including foreign institutions or investors, in acquiring a domestic corporation. One of the benefits of the financing is the ability for the acquiring corporation to deduct interest subject to whether such interest is required to be capitalized under section 263A(f) or section 461(g) or the so-called INDOPCO regulations. See also §§163(e)(5), 163(f), 267. Interest is generally deducted by a taxpayer as it is paid or accrued, depending on the taxpayer's method of accounting. Where an obligation is issued with original issue discount (“OID”), a deduction for interest is allowable over the life of the obligation on a yield to maturity basis.
(a) Investment Interest: Section 163(d). For a taxpayer other than a corporation, the interest deduction allocable to property held for investment is limited to the taxpayer’s net investment income. Disallowed interest is carried forward.
(b) Earnings Stripping: Former Section 163(j). Section 163(j) disallows the deduction for disqualified interest paid or accrued by where two threshold tests are met: (i) the obligor's debt-to-equity ratio exceeds 1.5 to 1.0 (“safe harbor” rule); and (ii) obligor’s net interest expense exceeds 50% of its adjusted taxable income, as computed. Disqualified interest includes interest paid or accrued to: (i) related parties when no Federal income tax is imposed with respect to such interest; (ii) unrelated parties in certain instances in which a related party guarantees the debt; or (iii) to a real estate investment trust (“REIT”) by a taxable REIT subsidiary of that trust. Interest amounts disallowed under these rules can be carried forward indefinitely. In addition, any excess limitation can be carried forward three years. Under TCJA, for tax years beginning after 2017, section 163(j) limits the deduction for net business interest expense to 30% of the adjusted taxable income of the business. Disallowed business interest may be carried forward indefinitely, subject to certain restrictions applicable to partnerships. Taxpayers whose average annual gross receipts for the three-tax year period ending with the earlier tax year don't exceed $25M are exempt from this restriction. The business interest limitation doesn't apply to certain regulated public utilities and electric cooperatives. Real property trades or businesses can elect out of the provision if they use the alternative depreciation system (ADS) to depreciate applicable real property used in a trade or business. Farming businesses may also elect out if they use ADS to depreciate any property used in the farming business with a recovery period of ten years or more. An exception from the limitation is also provided for interest on floor plan financing, defined as financing for the acquisition of motor vehicles, boats, or farm machinery for sale or lease and secured by that inventory. Where a tax treaty reduces the rate of tax on interest, the interest is treated as interest on which no Federal income tax is imposed to the extent of the same proportion as the rate of tax imposed without regard to the treaty, reduced by the rate of tax imposed by the treaty, bears to the rate of tax imposed without regard to the treaty. Section 163(j)(5)(B). It is important to note that the section 163(j) limitation is applied at the partnership or S corporation level. See section 163(j)(4). Unlike section 199A deductions, excess interest of a pass through entity still reduces the outside basis of each partner or shareholder in an S corporation.
- Enhanced Expensing of Tangible Personal Property. Under the law prior to the TCJA, section 168(k) provided that a taxpayer that owned “qualified property” (see below) was allowed, subject to the phase-down rules discussed below, additional depreciation at a 50% rate (bonus depreciation) in the year that the property was placed in service (with corresponding reductions in basis and, therefore, reductions of the regular depreciation deductions otherwise allowed in the placed-in-service year and in later years. The TCJA increases the bonus depreciation rate to 100% for all qualified property and cancels certain “phase-down” rules. The enhanced expensing rules may further motivate acquirers of target corporations to engage in direct asset purchases or deemed asset purchase under section 338(h)(10) or section 336(e). See also section 179.
- Excess Business Loss Disallowance Rule. Under the TCJA, new section 461(a) (TCJA §1102(a)) provides that for a tax year of a non-corporation beginning after 2017 and prior to 2026, a taxpayer’s excess business loss (EBL) is disallowed. See section 461(l)(1)(B). Such losses are carried forward and treated as part of the taxpayer’s NOL carryforward for subsequent taxable years. An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a taxable year is $250,000 (or twice the otherwise applicable threshold amount in the case of a joint return). The threshold amount is indexed for inflation. n the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner's distributive share and each S corporation shareholder's pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder. This limitation applies after application of sections 1366(d)(basis limitation ), 704(d)(basis limitation), 465 (at-risk limitation) and 468 (passive activity loss rule).