How the new tax code can impact sales of rental businesses
QUESTION: I’m thinking of selling my rental business. I know the tax code has been changed, but I’m not sure how this might impact the sale of my business. Any information you can provide would be appreciated.
Answer: 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.
The following is a short list of some of the most meaningful changes and how they are likely to impact these transactions:
Corporate tax rates. The corporate tax rate — the rate charged to “C” non-tax passthrough entities, has been reduced from 35 percent to 21 percent for 2018 and beyond.
Coupling this reduction with 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 five years; and IRC Section 1045, which allows for non-recognition of gain on sales of C corporation equity held for more than six 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 a C corporation pays tax, now 21 percent, at the entity level and then, upon distribution of the remaining funds to its shareholders, the income is taxed again at the individual level with a new top marginal rate of 37 percent. Pass-through entities like limited liability companies (LLCs) and S corporations, on the other hand, generate only one level of tax — at the individual level.
Individual tax rates. The number of tax brackets remains unchanged at seven, but the top marginal rate for those making more than $500,000 individually or $600,000 for those married filing jointly has been reduced from 39.6 percent to 37 percent, and the brackets have been adjusted substantially. For example, the second tier remains at 35 percent, but its bracket has been expanded from between $416,700 to $470,000 to $200,001 to $600,000 for combined individual and married filing jointly. Those in other brackets will generally see rate reductions in the range of 3 to 4 percent.
In terms of the 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 percent on a sale of a business worth $10 million could yield tax savings in the range of $300,000.
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 percent 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 the first year.
This doesn’t necessarily rule out sales of stock or equity. IRC Section 338(h)(10) still permits parties to elect to tax acquisitions of S corporation stock as asset purchases, and C corporation sellers still are 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 more than $5 million — 21 percent corporate tax on the sale of the assets and an up to 37 percent 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, such as S corporations, partnerships or LLCs, for the majority of buyers and sellers of those businesses, asset acquisitions could 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.
Section 199A. An entirely new IRC Section 199A, now allows for a deduction by pass-through entities of 20 percent 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. 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 — that is 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 also have been modified. Prior to 2018, NOLs could be carried back two 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 also are now limited to 80 percent of taxable income. Use of NOL carries by subsequent business buyers is further limited under IRC Section 382. Consequently, the benefits of NOLs likely will 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 or carried interests. The much discussed, but rarely understood, carried interest issue, enables private equity (PE) firms to characterize the interests they carried in their applicable partnership interest equity investments, usually 20 percent of profits, as long-term capital gains, which are taxed at a maximum rate of 20 percent, plus the 3.8 percent Affordable Care Act tax, rather than at ordinary income rates. The required holding period for such treatment lengthened from more than one year to more than three 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 already have reportedly devised a number of workaround strategies.
Estate tax exemption. The TCJA also more than doubled the estate and gift tax exemption, increasing it to $11.2 million for individuals and $22.4 million for married couples, to be adjusted for inflation annually through 2025. On Jan. 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 percent for now. This is 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 million 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 Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) provisions applicable to real estate and repatriation liabilities for foreign subsidiaries, which can generate eight 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, 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.