Despite the ongoing COVID-19 pandemic, the deal market, in many aspects, is on fire — with soaring multiples, a higher than normal volume of deals in play and private equity buyers taking a front seat. However, the pandemic has impacted transactions in critical ways, from valuations to deal timing to process. Both buyers and sellers have creatively had to navigate new uncertainties and negotiation approaches surrounding the future of the economy, COVID relief packages and potential tax changes.
While an ongoing active market means opportunity for owners of private companies of all sizes, what exactly are those opportunities, related challenges and the ultimate impact on deals?
Below are a few questions and answers to help shed light on what business owners can expect.
In the beginning, we saw an uptick in asset purchases due to uncertainty surrounding the treatment of Paycheck Protection Program (PPP) loans and interaction with employee retention tax credits that target entities, buyers or even buyer affiliates may have taken. Things started to change around October, when we were given some clarity around the steps buyers and sellers should take regarding outstanding PPP loans at the time of a transaction. This and other guidance have given buyers a chance to return to deal structures they used following the Tax Cuts and Jobs Act (TCJA).
The structure in high demand has been an equity deal that treated the transaction as a purchase of assets for tax purposes. It allows all the advantages of an equity deal for legal purposes, such as not having to re-title assets, yet allows the buyer to take enhanced bonus depreciation. That means 100% bonus depre¬ciation on new and used property. Since even used assets are ‘new to them,’ buyers can recover their purchase price faster than before.
There is a cost to the seller, which could affect their proceeds. For example, when an owner sells stock of an S Corporation, favorable capital gain tax rates are applied to any gain. However, when selling assets, a portion of that gain may be taxed at higher, ordinary gain rates. In the context of a partnership, even a sale of equity could result in some or all of the seller’s gain being taxed at ordinary gain rates. The impact of rate differentials is dependent on the purchase price allocation.
This area has become more hotly debated post- TCJA. Sellers want to allocate purchase price to assets that result in capital gain, such as goodwill, while buyers want shorter-term assets and assets for which they can take 100% bonus depreciation, such as equipment. While the latter can cause higher tax rates for the seller, buyers may be willing to pay more for assets rather than corporate stock. The trick is that buyers and sellers often will try to agree on the allo¬cation; therefore, sellers should protect themselves by ensuring the purchase agreement clearly states they can review the purchase price allocation.
Buyers who can be flexible with post-acqui¬sition tax classification, including private equity buyers, are looking at entity structures differently in light of reform. In addition to structuring deals to get a ‘step-up’ in inside asset basis, they are scrutinizing the flat C Corporation rate, individual rates and the Qualified Business Income Deduction for owners of pass-through entities. Another important area to consider is the cash needs coming out of the entity, as owners may potentially have to pay tax on distributions coming out of a corporation but not from other tax structures. There are a multitude of factors to consider regarding whether a pass-through or C Corporation entity is the right structure over the intended holding period. Modeling out each scenario is important.
Prior to the TCJA, a taxpayer could offset 100% of income with an NOL and carry it back two years and forward 20 years. The TCJA changed the rules so that NOLs could not be carried back, could only offset 80% of taxable income, but could be carried forward indefinitely. This impacted deals with C Corporation targets because of the change in offsetting income, but also because the buyer knew if losses were generated in the year of the sale due to transaction costs and compensation expenses, the seller could no longer carry back those losses.
The CARES Act of 2020 changed the NOL rules again. It temporarily allowed carrybacks and suspended the 80% limitation put in place by the TCJA. This not only impacts transactions closed after the CARES Act was enacted but also means that transactions could have taken place where purchase agreements did not contemplate carrybacks of NOLs. This could cause confusion on whether NOLs needed to be carried back to years where a C Corporation was owned by different shareholders and, if the losses were carried back, who received the benefit. If a deal is being structured to buy equity in a corporation, this is a potentially valuable attribute to consider.
Not necessarily. It’s true these new limitations have negatively impacted highly leveraged transac-tions, favored by private equity buyers, by limiting related deductions. But, disallowed interest can now be carried forward indefinitely, which potentially benefits buyers. When a target company has interest expense to carry forward but can’t use it before the acquisition occurs, the buyer may be able to use it after the deal.
Know what the buyer is looking for. What are the most important structural components of the deal? Do they want a step-up in basis or to recover the purchase price as soon as possible? Often in private equity deals, buyers want management of the target company to continue working post-transaction and to purchase or rollover equity into the buying entity. That generally causes a significant tax impact for the seller, including a potential cash flow issue if not handled appropriately during negotiations.
Also, be aware a letter of intent often will simply say ‘we want to buy the company’ and give a purchase price. It needs to state whether it will be an equity or asset sale. That’s critical to determine the tax impact and the after-tax cash proceeds a seller will receive.
Other considerations include knowing who is liable if tax is assessed upon examination, and fully vetting the many state, local and international tax concerns that can cause significant issues later on.
Do your homework and be prepared. Careful planning in advance of and throughout the trans-action can maximize your net sale price and minimize your stress.
Contact Samantha Smudz at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.
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