Question: I’m thinking of selling my rental business. I know the tax code has been changed, but I’m not sure what affects the changes might have on my sale. Any information you can provide would be appreciated.
You are correct. This year, with the enactment of the “Tax Cut and Jobs Act” (“TCJA”), the Internal Revenue Code (“IRC”) saw its most significant changes since 1986. Most rental industry participants realize the changes have been generally positive for business, but limited information has been made available regarding how those changes might affect business buyers and sellers.
Following is a short list of some of the most meaningful changes and how they are likely to impact these transactions:
- Corporate Tax Rate: The corporate tax rate – the rate charged to “C” (non-tax passthrough) entities, has been reduced from 35% to 21% for 2018 and beyond.
Coupling this reduction with: (a) IRC Section 1202, which since 2010, has enabled sellers of qualified small business stock (“QSBS”) of C-corporations having assets of less than $50 million to exclude up to $10 million of gain on original issue stock held for more than 5 years; and (b) IRC Section 1045, which allows for non-recognition of gain on sales of C-corporation equity held for more than 6 months when the proceeds are rolled over within 60 days, has prompted many business owners to consider starting or converting to C-corporations.
This may, in fact, make sense for some, but most rental operations still are going to be better off to continue as tax pass-through entities unless they intend to retain significant amounts of undistributed income. Why? Broadly speaking, because: (i) a C-corporation pays tax (now 21%) at the “entity” level; and (ii) then, upon distribution of the remaining funds to its shareholders, the income is taxed again at the “individual” level (a new top marginal rate of 37%). Pass-through entities like LLCs and S-corporations on the other hand, generate only one level of tax – at the “individual” level (discussed more below).
- Individual Tax Rates: The number of tax brackets remains unchanged at 7, but the top marginal rate (for those making over $500,000 individually; $600,000 for married filing jointly) has been reduced from 39.6% to 37%, and the brackets have been adjusted substantially. For example, the second tier remains at 35%, but its bracket has been expanded from $416,700-$470,000 to $200,001-$600,000 (combined individual and married filing jointly). Those in other brackets will generally see rate reductions in the range of 3 to 4%.
In terms of their impact on buying and selling rental companies, the effects could be substantial. The math isn’t difficult. Other things being equal, a rate reduction of 3% on sale of a business worth $10 million could yield tax savings in the range of $300,000.
Perhaps the most important of all changes is immediate expensing.
- Immediate Expensing: Perhaps the most important of all changes is immediate expensing. Buyers of the assets, rather than the equity, of targets will now be able to immediately expense 100% of their purchases of both new and used assets, excluding intangibles. This is an extraordinarily valuable write-off, and one that should not be overlooked by business sellers in negotiations. In the above referenced $10 million sale, the value of the tax write-off could be $3.7 million to the buyer in year one.
This doesn’t necessarily rule out sales of “stock” or “equity” however. IRC Section 338(h)(10) still permits parties to elect to tax acquisitions of S-corporation stock as asset purchases, and C-corporation sellers are still generally going to insist on selling equity, especially if they might be eligible for the Section 1202 exemption discussed above. For those sellers, an asset sale of $10 million could yield a total tax bill of over $5,000,000: 21% corporate tax on the sale of the assets and up to 37% individual tax on the distribution to shareholders of the remainder (versus $-0- on a sale of Section 1202 stock to the extent the resulting proceeds are retained by the corporation).
Nonetheless, because most rental companies are currently structured as “tax pass-through” entities (S-corporations, Partnerships or LLCs), for the majority of buyers and sellers of those businesses, I would expect asset acquisitions to continue to be the norm, barring the existence of critical non-transferrable seller contracts and/or intellectual property rights. Both sides should, however, be prepared to thoroughly negotiate this issue.
- New Section 199A: An entirely new IRC Section, 199A, now allows for a deduction by pass-through entities of 20% of their qualified business income; subject to certain limitations, including initial caps of $157,500 for single filers and $315,000 for joint filers, after which the deduction is phased out. Obviously, this has meaning for rental operators with respect to both their continuing business operations as well as their possible efforts to sell their businesses, particularly if they sell assets.
- Excess Business Loss Limitations: For 2018 through 2025, business losses of greater than $250,000 for individuals or $500,000 for those who are married and filing jointly in any tax year will have to be carried forward (not used as deductions from other income or to generate additional tax refunds in the current year) as “Net Operating Losses” (“NOLs”).
- NOL Carries: The rules pertaining to NOLs have also been modified. Prior to 2018, NOLs could be carried back for 2 years and carried forward for 20 years. With the exception of NOLs generated by certain farming operations and insurance companies, NOLs generated after 2017 cannot be carried back, but can be carried forward indefinitely. They are also, however, now limited to 80% of taxable income. Use of NOL carries by subsequent business buyers is further limited under IRC Section 382. Consequently, the benefits of NOLs will likely be limited for most buyers and sellers of rental businesses, but for those sellers with significant prior losses, any potential benefits should be considered and factored into the negotiation of the sale price.
- Profits (“Carried”) Interests: The much discussed, but rarely understood “carried interest” issue which enables private equity (“PE”) firms to characterize the interests they “carried” in their “applicable partnership interest” equity investments (usually 20% of profits) as long-term capital gains, which are taxed at a maximum rate of 20%, plus the 3.8% Obamacare tax, rather than at ordinary income rates, has seen the required holding period for such treatment lengthened from “over 1 year” to “over 3 years” under the new IRC Section 1061. The effect of this change on the incentives for PE firms to fund buyouts may be limited, however, as they have reportedly already devised a number of workaround strategies.
- Estate Tax Exemption: The TCJA also more than doubled the estate and gift tax exemption, increasing it to $11,200,000 for individuals and $22,400,000 for married couples (adjusted for inflation annually through 2025). On January 1, 2026, the rates are scheduled to revert to 2017 levels, adjusted for inflation. The highest marginal federal estate tax rate will remain at 40% for now. This is, of course, good news for sellers of businesses that would previously have generated proceeds in excess of the old estate tax exemption, enabling them to potentially save an additional $4,568,000 in estate taxes.
- Other Potential Issues: The preceding paragraphs identify several, but far from all, of the 2018 tax code changes that could materially impact buyers and sellers of rental businesses. Other changes that may, depending on timing and circumstances, also bear on such transactions include new withholding requirements for foreign sellers similar to the old FIRPTA provisions applicable to real estate, repatriation liabilities for foreign subsidiaries, which can generate 8 years’ worth of escalating tax liabilities for repatriated profits (now required for all periods from and after 1987); new business interest deduction limitations, and new executive compensation rules that, among other things, now require public companies to include previously excludable bonuses in determinations of deductibility.
The TCJA includes a number of business-friendly provisions, but like all prior versions of the Tax Code, it isn’t for the sleepy or easily bored. Understanding its provisions and their effects on business acquisitions and sales is a must for both buyers and sellers. Like so many things in business, the well-prepared stand to reap substantial benefits, while being less than fully prepared can be an enormously expensive mistake. Feel free to contact us if we can help.
James R. Waite is a business lawyer with over 20 years in the equipment industry. He authored the American Rental Association’s book on rental contracts, and represents equipment lessors throughout North America on a wide range of issues, including corporate law, negotiating and drafting dealership agreements, rental contracts, and buying, selling and financing businesses and their equipment. He is a veteran of the United States Air Force, has a BBA in Finance from the University of Texas at San Antonio, a Juris Doctor from St. Mary’s University, and an MBA from Northwestern University. He can be reached at (866) 582-2586, or via email at firstname.lastname@example.org.