Pending Tax Law Changes Affecting The Acquisition And Sale of Businesses - March 2017

With the major political shifts in Washington, D.C., there are pending substantial changes to Federal income tax laws that will directly affect the buying and selling of businesses and the structuring of business transactions. There are proposals to reduce tax rates including capital gains rates, eliminate §1031 exchanges, allow expensing of capital investment, and eliminate the deduction of interest expenses. The completion of comprehensive tax reform legislation had been projected by Congressional leaders to be by August 2017. However, recently Senate Republican leaders have hinted that new tax legislation may take until the end of 2017. On the other hand, the Trump administration has proposed enacting tax legislation sooner than this August date under a budget reconciliation process.

We expect the President in the next 60 days to deliver detailed tax proposals to Congress. The President's stated goals of tax reform is to simplify the Internal Revenue Code, encourage more business activity in the United States, and increase the ability of U.S. based businesses to compete in the global markets.

These tax law changes could lead to an overhaul of the entire Internal Revenue Code and result in the most significant changes to the Federal tax laws in our lifetimes.

At this time there are numerous proposals being discussed by the President and Congress. Below are some of those proposed tax law changes affecting the buying and selling of businesses and capital formation.

1. What are Some of the New Income Tax Proposals Being Discussed by Congress and the President?

a. Proposed Individual Tax Rates and Elimination of Personal Deductions. There are proposals to reduce the maximum individual income tax rate to 33%, along with having only three income tax brackets (12%, 25% and 33%). Along with these proposals there have been discussions to eliminate the alternative minimum tax and most itemized deductions (Trump administration officials have announced that the residential mortgage interest deduction will not be repealed). There have also been proposals to cap the use of itemized deductions such as charitable deductions for certain high-income earners.

b. Proposed Business Tax Changes. In the business tax area there are proposals to lower the corporate tax rate to 20% or 15% (from the current 35% tax rate). There are also proposals to reduce the tax rates on the pass-through of business income (including real estate rents) from business entities such as partnerships and limited liability companies in order to equal the lower corporate tax rates. It is unclear if this new pass-through entity tax would be imposed at the entity level or at the individual level.

To offset the reduced tax revenue, any business tax rate reduction would be linked with the elimination of certain specified business tax deductions such as eliminating the interest deduction. An elimination of the interest deduction would cause businesses to effectively pay a higher tax on their income (however, such tax rate would be lower). Disallowing an interest deduction would encourage U.S. based companies to finance their business operations and their business acquisitions by using equity rather than debt.

The tax proposals have included preserving the current research and development credit.

In the business tax area, in order to offset the loss of deductions there have been proposals to allow expensing of investments in business assets in the year that the asset is acquired (rather than amortizing or depreciating an asset or capital investment over time). This proposal is to encourage businesses to invest more in facilities and machinery.

c. Proposed Changes to Capital Gains Rates. Also undergoing discussion are proposals to lower the current capital gains tax rates.

d. Proposal to Repeal §1031 Exchanges. Congressional staffers have discussed a proposal to repeal the taxpayer-favored provision of §1031 tax-deferred exchanges. The fact that President Trump may be heavily invested in real estate is no assurance that real estate tax favorable provisions such as Section 1031 or commercial mortgage interest deductions might not be eliminated in order to achieve the goal of lower tax rates. A repeal of §1031 tax-deferred exchanges would substantially reduce the number of real estate sales resulting in a decline in real estate values. Currently, there are significant lobbying efforts by the real estate industry to have Congress preserve §1031 exchanges.

e. Increase of Tax Rate for Partnership Carried Interests. It is likely that comprehensive tax reform will result in partnership and limited liability company promotional interests contained in many LLC and partnership agreements (sometimes known as "carried interests") to be taxed at higher ordinary income tax rates, rather than lower capital gain rates.

f. Discussions to Repeal the Tax Exemption on Municipal Bond Interest. There have been general discussions to eliminate the tax exemption for municipal bond interest. An elimination or even a cap on tax-exempt bond interest would reduce the value of these bonds, and would also significantly affect the ability of local and state governments and governmental districts (such as school districts) to finance construction projects. Most commentators feel that tax-exempt bond interest will be preserved. On March 9, 2017 more than a 150 members of Congress asked in a letter to the House Ways and Means Committee that municipal bond tax-exempt interest status be preserved.

g. Proposed New Tax on Imports of Foreign Goods. There has been a proposal to tax the importation of goods into the United States, although such proposals have been met with strong opposition even within the Republican Party. President Trump in his most recent remarks appears to be backing away from this import tax. This so-called "border adjustment tax" has met with strong opposition by industries that rely upon importing products from other countries (such as retail companies).

h. Foreign Earnings Proposals. For U.S. multinational companies there are proposals to exempt a U.S. tax being imposed on those companies' foreign earnings, whether those foreign earnings are held in a foreign jurisdiction or brought back to the U.S. For currently deferred foreign earnings of these U.S. multinational companies there are proposals to impose a one-time tax payable over several years to encourage these earnings to be brought back to the U.S.

i. Proposed Repeal of the 3.8% Tax on Net Investment Income. In the Republican proposals to modify the Affordable Care Act, there have been efforts to repeal the 3.8% Net Investment Income Tax. One of the many proposed Republican changes to the Affordable Care Act is to have tax credits to offset costs of higher healthcare insurance premiums.

2. How will Repeal of the Federal Estate and Gift Tax Laws Effect the Sale and Acquisition of Businesses?

With the Republicans retaining majority control of both Houses of Congress and also controlling the Presidency, there is now a serious possibility that the entire federal estate tax system will be repealed (along with the repeal of the current tax law which allows an increase in an asset's income tax basis at death). These tax changes could have a major effect on clients who desire to buy and sell their businesses.

One of President Trump's proposals has been to repeal the entire estate and generation-skipping tax system, while also repealing the current step-up in an asset's basis for income tax purposes at death. Under one Trump administration proposal, a step-up in income tax basis would be allowed for the first $10 million of assets, with asset values in excess of this $10 million base not receiving a step-up in basis. Thus, the current tax law's unlimited increase in corporate stock and partnership (and LLC membership interests) income tax basis at death may no longer occur (or may be limited) if there is repeal of the estate and gift tax laws. Under current tax laws, when either spouse dies, there is a step-up in the income tax basis of the entire community property (eliminating the entire income tax on the appreciation of community owned stock, partnership and LLC interests).

There is also an additional tax law proposal to impose at death a new capital gains tax (after certain exemptions) on appreciated assets (such as a capital gains tax on assets over $10 million in aggregate value), rather than waiting to tax the assets' appreciation until those assets are actually sold.

One proposal for this new capital gains tax at death is that there would be a $10 million exemption for married couples, and there is also a proposal to exempt farms and small businesses from this date-of-death capital gains tax.

Thus, the repeal of the federal estate tax system may be accompanied by an increase the income tax burden for buying and selling businesses.

Finally, a total repeal of the estate tax laws would be controversial with Democrats, and any repeal could be reversed by a politically changed Congress in the future.

3. What Should be changed in Documents and in Structuring Transactions for Buying and Selling a Business?

Because of these pending tax law changes you need to consider changes to documentation and deal structuring for the buying and selling of a business.

a. New Potential Tax Benefits to Buyers of Businesses. If there is permitted immediate expensing of an acquired business' assets then the buyer will want the business acquisition to be treated as an asset purchase by either a direct asset purchase or by way of a Section 338 election.

b. Lower Tax Rates will Effect Valuations of the Acquired Business. Lower tax rates will reduce the value to the buyer of tax losses or of tax credits in a business acquisition. Thus, the buyer may need to reevaluate the purchase price amount that the buyer is prepared to pay for a particular business.

c. Earn-Out Formulas. Many times the purchase price of a business is paid and based upon that businesses' after tax future earnings. If tax rates and tax deductions change then this must be factored into these earn-out formulas. Business sales with earn-out formulas should address these possible future changes to tax rates and deductions.

d. Changes to Business Acquisition Documents. In the purchase and sale agreement of the business, the seller will want to specifically disclaim any representation or warranty as to potential future tax law changes or the effect of taxes on the transaction. The parties will also want to consider whether potential future tax law changes should be a condition of going forward with the transaction and the closing.

e. Raising Capital for Business Acquisitions. If interest should cease being tax deductible then instead of financing a business acquisition with debt, the buyer may prefer to acquire the target business through an equity investment.

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