The Tax Cuts and Jobs Act of 2017 contains some of the most significant changes in tax laws in more than a generation. While the full implications of the Tax Act are still coming into focus, the magnitude of these changes should cause us to reevaluate past decisions in light of changed circumstances. Current tax and market trends suggest that corporations that have in the past decided against divesting of assets or business lines should reevaluate such decisions, and may cause corporations to take a fresh look at new acquisition activity as well. Three factors stand out that justify reevaluation in light of the Tax Act.
Among other changes, the Tax Act lowered the stated tax rate for C corporations from 35% to 21%. This historic shift puts the corporate tax rate at the lowest rate in over 70 years.
The change in the tax rate has significant implications on potential C corporation sellers.
First, lower tax rates means a corporate seller will retain a greater portion of the proceeds from the divestiture of a line of business or business unit. Because less of the purchase price will be used to pay taxes, more will be retained for other purposes. All else being constant, the effective after-tax purchase price will be higher. Thus, the change in rates shifts the cost/benefit analysis directionally in favor of a “sell” decision when compared to the same decision under prior law.
Second, the lower tax rate has a secondary impact of increasing the free cash flow of many existing corporations. That “new” cash flow can be redirected for many purposes, including the direct funding of acquisitions. The higher cash flow also supports additional borrowing capacity that can be used to fund acquisitions. Though only three months have passed since the enactment of the Tax Act, most practitioners have noticed increased interest and activity in mergers and acquisitions.
Third, the Tax Act modified the provisions for so-called bonus depreciation. Bonus depreciation refers to the accelerated depreciation that is generally available for capital expenditures made in respect of depreciable property having a recovery period of 20 years or less. Over the past 15 years, bonus depreciation has been used as an economic stimulus in a variety of different tax packages. In each of those instances, however, bonus depreciation only applied to the initial user of newly employed assets. The Tax Act increases the amount of bonus depreciation allowable from 50% to 100% for property placed in service before January 1, 2023. In addition, the Tax Act extends bonus depreciation to used property, provided that such property is acquired in an arm’s-length transaction from an unrelated party. Bonus depreciation does not generally apply to intangible assets purchased as part of the acquisition of a business (such as goodwill).
The extension of bonus depreciation to cover used property may result in a tax advantage for divestiture as compared to merely continuing the operation of qualifying property, since the sale of such property will generate a depreciation deduction in the hands of the purchaser equal to the amount of the purchase price allocated to such assets. This benefit will generally support increased discounted cash flows for a purchase of plants and equipment, which will in turn justify a higher purchase price. Bonus depreciation is only be available for transactions treated as asset sales for federal income tax purposes. Such treatment typically applies to divestitures by corporations because the transaction is legally structured as an asset sale, or because asset sale treatment is deemed to occur (e.g., via a Section 338(h)(10) election). See your tax advisor to determine the most efficient structure for you, as asset-sale treatment may be detrimental for some sellers.
How long these favorable trends last is a matter of speculation. The increase in the amount of bonus depreciation is set to be reduced by 20% each year beginning in 2024 before phasing out entirely in 2027. As mentioned, however, increasing and extending bonus depreciation has frequently been used to provide fiscal stimulus in the past. On the other hand, while the corporate tax rate change is nominally permanent, Senate Democrats recently introduced a bill in that would fund infrastructure projects in part by increasing the corporate tax rate from 21% to 25%. Because the Tax Act passed without any support from the Democratic Party, it is not unreasonable to believe that, should the Democrats gain seats in the mid-term elections, some of the benefits of the Tax Act may be revisited in the future. Due to these uncertainties, it may be wise to make use of the benefits provided by the Tax Act sooner rather than later, further stimulating divestiture and acquisition activity.
