Tax reform: how buyers and sellers can benefit
The newly enacted tax act presents asset buyers, both large and small, with a new opportunity to increase post-transaction cash flow via tax savings. This opportunity results from the very generous expansion of an old rule with no prior significant relevance to asset acquisitions: bonus depreciation. Many dealmakers with tax backgrounds have heard of, or are even familiar with, the old bonus depreciation rules. Bonus depreciation came about way back in 2002 and allowed taxpayers buying certain new assets to immediately expense 50% of the purchase price in the year of acquisition. Even better, these rules cover almost all personal property including machinery, equipment, and computer software (bonus depreciation did not and does not cover real estate assets or traditional goodwill). A great rule but of almost no use to dealmakers because they only covered the asset’s “original use”, i.e., the asset’s original purchaser. Subsequent purchasers of these same assets, e.g., asset buyers in a structured acquisition transaction, need not apply.
What has changed? First off, qualified property acquired after September 27, 2017, and placed into service on or before December 31, 2022, generally will be eligible for 100% percent bonus depreciation, i.e., the property’s purchase price immediately fully deductible. Many may recall that 100% expensing was temporarily available back in late 2010 and 2011 before reverting back to 50%. That’s great. Now it’s fully deductible again.
What has really changed and why does this really matter to dealmakers large and small? The act removed the “original use” requirement that these benefits only accrue to the property’s original purchaser. That’s huge and significantly impacts deal making. A buyer in a true asset purchase or a stock sale subject to a Section 338(h)(10) election can now immediately deduct the cost of a potentially very large piece of the acquisition. That’s the buyer’s cash flow benefit all wrapped up in a bow.
How does all of this impact strategic deal making?
We know that a seller is not keen on the step-up in asset value to fair market value for personal property that’s a key component of any asset transaction. That’s because the seller pays the tax on the gain related to the step-up. Just to prove that life is a matter of perspective, the flip side of the seller’s step-up is the buyer’s higher depreciable basis. None of that is new as it has been part of the deal making landscape for some time. What is new is the buyer taking pre-transaction efforts to ensure that as many of the purchased assets qualify for the newly enacted immediate expensing.
The buyer needs to perform a detailed review of the assets that make up the deal during diligence. With detailed asset information in hand, the buyer needs to walk through a basic three-step process:
1. Which assets qualify for the new benefits? In general, most assets qualifying for bonus depreciation have a taxable 5, 7, or 15 year life. It’s entirely possible that the seller misclassified some of these assets to a life greater than 20 years which is the limit here. Reclassifying assets to the proper and lower depreciable life gives the buyer a greater benefit than may appear at first blush.
2. As with all asset acquisitions, values are very important. Nothing new here but it is now, considering #1 above, especially important to have the proper asset fair market value and the proper asset depreciation classification for US tax purposes.
3. The benefits must be properly modeled. The buyer won’t truly know the impact of the planning on their cash flow or overall taxability until proper detailed modeling occurs. How does the buyer protect these benefits? If the buyer confirms their benefits through the aforementioned three step process outlined above, the next significant step is making sure the necessary actions are part of the deal itself. As noted above, fundamentally, a seller generally does not like paying the bill on a taxable step-up in asset values. If this issue exists, this problem is usually solved via a gross-up or increase in purchase price to cover the seller’s increased tax bill. I’ve also seen it addressed by other non-tax related buyer concessions, but it depends on the deal.
Once the seller is on board, the buyer needs to take steps to support the asset valuation, allocation, and classification. The best way to do this is make it a part of the transaction’s sale purchase agreement itself. Most asset sale agreements contain a standard “agree to agree” provision where both parties state that within a given time period, usually 90 days, of the transaction date they will agree on the allocation of asset values for tax purposes. This agreed upon valuation is then reflected on their respective Form 8594 filed after the transaction.
There is a very important reason for compliance with the “agree to agree” clause noted above. There is a 2012 United States Tax Court’s case named Peco Foods, Inc., (T.C. Memo. 2012-18) where the Court disallowed a taxpayer’s changes to a purchase price allocation based on a post-acquisition cost allocation adjustment by one of the parties to the agreement. The now generally accepted Pecos rule is that once the purchase price allocation has been agreed to by both parties, the acquirer is restricted from making any changes to this allocation. However, it is also well settled that whether the parties agree to the cost allocation or not, the IRS always has the ability to amend the parties’ cost allocations whether agreed upon or not. Thus, absolute security in cost allocations remains elusive.
One rather common way to support cost allocations noting Pecos and the IRS’s continued ability to intervene, is by having a third party valuation firm provide an asset value allocation and classification study. Quite often the buyer is required to have such a study performed as part of U.S. GAAP Purchase Accounting and, although the GAAP Purchase Accounting allocation rules are not the same as tax cost allocation rules, the same firm can efficiently perform both studies. Again, the IRS can intervene under any circumstances but this does lend additional security to the allocation. Practical issues to keep in mind All of this said, the new bonus depreciation rules do phase out in time. After 2022, the bonus depreciation percentage is phased-down to 80% for property placed in service in 2023, 60% for property placed in service in 2024, 40% for property placed in service in 2025, and 20% for property placed in service in 2026. However, for deals that close between now and the end or 2022 the rules are as stated above. It is also important to note that not all states have adopted these new (or pre-existing) bonus depreciation rules. All important considerations to take into account when modeling any deal.
The bottom line is that not all deal makers I’ve seen are taking this significant new opportunity into consideration when modeling tax advantages related to an asset purchase transaction. We all know that when most deals are in the final stages of negotiation any additional benefits, tax or otherwise, can boost one buyer over another. Here, courtesy of tax reform, is a newly minted benefit to asset buyers. Enjoy.