HOW WILL TRUMP’S NEW TAX LAW AFFECT M&A TRANSACTIONS?
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (“TCJA”), legislation that contains significant changes to U.S. Tax Law affecting individuals and businesses alike.
While the sweeping changes were made at many levels, there are very few changes that TCJA has made affecting future PCO M&A transactions. Below is a summary of items that may affect those contemplating selling their business. While there are some changes that will affect all taxpayers, we don’t feel as though the new tax law will negatively impact PCO M&A transactions.
However, we do feel that as a direct result of the legislation the business environment in general will be positively impacted by changing local and national economies, industry consolidation and/or loan interest rates which could have a greater impact on PCO M&A transactions.
New 20% Deduction for Qualified Business Income
Most PCO’s operate their business through a “pass-through” entity which is either a general partnership, a Limited Liability Company or an S-Corporation. If you are a sole proprietor or owner of a pass-through entity operating a “qualified trade or business,” TCJA provides a new 20% deduction for “Qualified Business Income” for taxable years beginning after December 31, 2017, and before January 1, 2026.
Although there is a buzz circulating about this great 20% deduction, such change has absolutely no tax savings in terms of an M&A transaction. The reason being that in most PCO M&A transactions, a PCO realizes capital gain income from the sale of the business which does not qualify for the 20% deduction.
C-Corporation Tax Rate Reduction
It is generally unpalatable to structure a PCO using a C-Corporation because of the double taxation problem that pass-through entities do not worry about. For most PCOs that are small family owned businesses, the worst thing to learn when entertaining a potential M&A transaction is that the PCO (as seller) has a C-Corporation holding its business and a huge tax bill to pay upon sale. The TCJA changed the corporate tax rate to a flat 21% and given the pre-2018 highest corporate rate was 35%, the reduction to 21% reduces the degree of double taxation as compared to the long-term capital gain rate of 20% (at personal level) when a pass-through entity or sole proprietor, as the case may be, was the seller.
Long Term Capital Gain Tax Rates
Although individual marginal income tax rates for individuals and C Corporations have been reduced under TCJA, no such changes have been made, upward or downward, to the long- term capital gains rate. The same rates remain at a maximum rate of 20% plus the potential extra 2.3% net investment income tax if the PCO seller is a passive investor and the capital gain exceeds a certain threshold depending on filing status as opposed to an active operator who would not be subject to the net investment tax.
Ordinary Income Tax Rates
Under prior law and current law there are 7 tax brackets. Old law ranged from 10% to 39.6% while TCJA has tax rates from 10% to 37%. Under prior law, if taxable income (married filing joint) was above $153,000 then you moved into the 28% bracket (i.e., $153K – $233K). Under current law, if you make more than $165,000 in taxable income then you are only in the 24% bracket until you reach $315,000 (then moves to 32%), whereas under prior law you would be well into the 33% bracket which starts at just $233,000 of taxable income.
In an M&A transaction many times a portion of the total consideration paid to the PCO (as seller) may be treated as ordinary income and to the extent marginal rates on ordinary income have been lowered then the overall tax burden will be less than what would have been the case prior to TCJA.
State and Local Income Tax Deductions
TCJA has adopted a maximum itemized deduction limit of $10,000 for state and local taxes (SALT). Accordingly, any state and/or local income taxes paid over the $10,000 limit from ordinary income or the gain arising from the sale of a PCO business will reduce the after-tax sale proceeds received by a seller.
Lifetime Exemption for Estate/Gift Taxes
TCJA doubled the amount that can be given away during life (gift) or at death (bequest). The new (inflation adjusted) limit is expected to be $11.2 million per person thereby allowing a married couple to be able to avoid gift/estate tax on the first $22.4 million of net worth. This can be a huge savings for those PCO owners whose companies have significant value whether selling to an outside firm and passing the proceeds on to the next generation at death or whether planning to pass a PCO firm with significant value to the next generation directly.
Accordingly, a PCO looking to shift income to the next generation prior to a sale of their business can now have greater flexibility to transfer equity in the business without fear of incurring gift tax (during lifetime) or estate tax (at death).
The Authors are the managing directors at PCO M&A Specialists (a division of PCO Bookkeepers), Daniel S. Gordon, CPA, John P. Corrigan, Esq, MBA, CPA. For more information, email us at email@example.com.
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