Lower Middle Market Company Owners: 21 New Tax Law Considerations
While news stories cover aspects of the new Tax Cuts and Jobs Act applicable to the general population, the purpose of this article is to focus apolitically on selected areas of direct importance to owners/major shareholders of lower middle-market ($10 million-$250 million revenue), closely held companies.
The law was effective January 1st, 2018, excepting provisions within it specified otherwise.
Context for Discussion
There are many important changes to consider, whether the intent is to continue running the company for the foreseeable future as is, divest some equity and run it in conjunction with outside investors for another five years or so, or divest altogether. Tax considerations shouldn’t drive major decisions like that, but are always interwoven in scenarios evaluation, and ultimately, a deal’s structure.
In either case, M&A activity is set to build this year, and there are compelling market forces to consider a transaction now, rather than waiting.
These highlights, and limited discussion of implications, are provided as a discussion catalyst with your company’s accountants and a knowledgeable investment banking resource, such as Mid-Market Securities, LLC, which advises business owners on strategic as well as financial matters (e.g., achieving liquidity and diversification).
Tax information should be considered in the context of estate planning, business planning, ownership exit/succession planning, and be guided by qualified accounting and financial advisors with visibility of one’s entire personal and business financial picture.
In alliance with some of the top tax law and personal investment advisors, we lead processes for our Clients contemplating either an immediate corporate transaction, or doing so within the foreseeable future, such as:
- obtaining growth capital, and/or opportunities to supplement organic growth with strategic acquisitions or business combinations
- a partial or complete exit to achieve some liquidity and lower owners’ personal risk
Whether planning a near term event or contemplating the future, there is a compelling reason to begin a planning process as soon as possible, since advance planning and positioning enables us to maximize valuations and mitigate transactions’ tax impact.
There are too many business provisions in the thousand-page bill to summarize in such a short article, so this treatment is certainly not comprehensive of all changes relevant to middle market companies. Also, real property investment and ownership are not included.
Presumption of Owners’ Complex Financial Lives
People who have built a company to this stage typically will own a mix of real estate, investable liquid assets, and illiquid company stock. Few will be concerned only with the tax bill’s effect on income.
One particularly notable change that will affect wealthy families is a doubling of the 2018 estate tax exemption to $10.98 million for singles and $22.4 million for couples.
Implication: probably every mid-market business owner should initiate estate planning if not already done so, or meet with their advisors to contemplate warranted adjustments to their plan. The business entity must be considered part of this evaluation, including its current and potential future value.
General Effect on Affluent Individuals
A particularly controversial provision is to limit combined deductions for state and local income, sales, and property taxes to $10,000 annually, as it disproportionately affects residents of states with a state income tax and higher housing costs. Previously, the amount paid to the state was deductible from federal taxes.
Barron’s December 25 article “How the New Tax Law Affects You,” canvased tax experts for opinion and analysis. Among them was Tim Steffen, director of advanced planning at Baird Private Wealth Management, who ran various analyses for different hypothetical families around the country to understand the effect on higher-income households.
He assumed incomes ranging from $100,000 to $1 million per year, and high tax, low tax and no income tax states. “In nearly every scenario for all three states, taxable income went up under the new law, but the tax liability went down.” At income levels between $100,000 and $500,000, “his hypothetical families had the same federal tax burden regardless of whether they live in a high, low, or no-tax state, because the [new] cap on state tax deductions equalizes their situations.”
“At the $1 million income level, the loss of state tax deductions in states in which that is applicable is more likely to cause an increase in federal tax owed, under Steffen’s analysis,” but not necessarily by much. “Generally, under the new plan, the greater the wealth, the greater the tax savings. For most wealthy families, you have to look beyond just income taxes to understand their full benefit,” says Matt Gardner, a senior fellow at the non-partisan Institute for Tax and Economic Policy. 1
In other words, the Affluent will manage the hit with mitigation strategies, and wealthy people are more likely to own corporate stock, now taxed at a lower rate.
Principle Changes Applicable to Businesses and Their Owners 2,3,6
- Replacement of graduated corporate tax rates ranging from 15% to 35% with a corporate rate of 21%. This provision is permanent. 35% was one of the highest top rates levied by developed nations, and “an abomination, a carry-over from a prior century where the US was the center of the global economy and companies would do anything demanded of them, to preserve their US incorporation.” 4
- Foreign income – The U.S. has now harmonized with the rest of the world on treatment of foreign income, no longer requiring a U.S. corporation to pay the U.S. tax rate on all their global income when brought back home, after having paid the foreign country’s tax already. Now, U.S. companies will only have to pay the foreign taxes on foreign income, and be able to bring money back to the U.S. without incurring a penalizing U.S. tax. This change should have three effects, somewhat affecting the middle market:
- Repatriation of at least some of the $2+ trillion that U.S. corporations now hold overseas (at a reduced tax rate from before). That money can now be put to work domestically.
- Capital repatriation’s importance to the middle market is as a catalyst for corporate acquisitions, joint ventures and other forms of strategic investment. Effectively, this provision applies to only a few dozen large companies, and certain industries. For instance, U.S. biopharma companies comprise one-third of the top U.S. companies’ offshore cash holdings. Google’s parent company Alphabet and Apple comprise a disproportionate share of the holdings, too, but given their broad corporate venture capital strategy it’s hard to predict where their cash may go.
- Encouragement for U.S. companies to expand overseas operations, as they’ll no longer face the choice of punishing U.S. foreign income taxation or having to develop elaborate, expensive legal strategies to avert it. This change should encourage mid-market companies to initiate or expand foreign operations.
- New dis-allowance of deductions for net interest expense in excess of 30% of the business’s “adjusted taxable income,” defined as EBITDA through 2022 and EBIT thereafter. This means that the deductible dollar amount will be significantly reduced in 2023 for many businesses because EBIT is likely to be much lower than EBITDA. While this provision will increase the cost of capital, and likely reduce debt as a % of M&A financing, it is unlikely to profoundly affect lower middle market companies’ daily operations, according to an analysis by a Tax Attorney friend,5 since most don’t utilize debt to the degree that the impact would be profound.
- This limitation on deductibility of interest does not apply to small businesses that are eligible to use the cash method of accounting (i.e. with gross receipts of less than $25M).
- With respect to interest incurred by pass-through entities, with certain modifications the interest limitation is applied at the taxpayer level rather than at the entity level.
- Doubling of bonus depreciation, i.e. full and immediate expensing to 100%, for the cost of qualified tangible property acquired, and expansion of qualified assets to include used assets. Applies to assets acquired and placed in service after September 27, 2017 and before January 2, 2023. The expensing for qualified property will phase-out for property placed in service beginning January, 2023.
- Leasehold improvement property, qualified restaurant property and qualified retail improvement property are now considered “Qualified Improvement Property,” (any improvement to the interior of a building that is nonresidential real property), and the recovery period for all is now shortened to 15 years.6
- Doubling of the Section 179 expensing limit to $1 million (versus deducting purchases that would otherwise need to be depreciated), and an increase to the expensing phaseout threshold to $2.5 million. Section 179 property includes tangible personal property or certain computer software that is purchased for use in the active conduct of a trade or business, as well as certain “qualified real property.”
- Research and Development (R&D) expenses must be capitalized (rather than expensed, as currently) with amortization over 5 years (15 years for R&D conducted outside of the U.S.). Software development expenses can be amortized over 36 months.
- Non-deferral of Taxable Income beyond Financial Reporting Year – Taxable income cannot be deferred beyond the tax year that such income is recognized for reporting in audited financial statements of the taxpayer. The IRS has been granted regulatory authority to determine whether non-audited financial statements (for example, a Review or Compilation) should also be included in this book-to-tax conformity requirement.
- Conversions of S corporations to C corporations – Act has provisions to ease, if not encourage, the conversion of a S Corporation using the cash method of accounting to a C corporation using the accrual method
- Repeal of the 20% corporate Alternative Minimum Tax (AMT)
- New limits on Net Operating Loss (NOL) deductions – In 2018, NOLs will be limited to 80% of taxable income in a given year. Carryback and carryforward provisions are modified, too. This has implications for certain companies’ valuation.
- Reductions on Domestic Dividend Received Deduction (DRD), a tax deduction received by a corporation on the dividends it receives by other corporations in which it has an ownership stake. Few lower middle market companies will be affected.
- New 20% qualified business income (QBI) deduction for owners of pass-through entities – but only through 2025. The deduction will be much more helpful to small business owners than bona fide mid-market companies. Businesses entitled to the deduction include partnerships (including LLCs taxed as partnerships), publicly-traded partnerships and master limited partnerships, S corporations, real estate investment trusts, trusts and estates, and sole proprietorships, but it doesn’t apply to “Specified Service Businesses.” QBI includes all domestic business income other than investment income, reasonable compensation paid by an S corporation and guaranteed payments paid by a partnership. There are no restrictions on the deduction for taxpayers with QBI of up to $157,500 for single filers and $315,000 for those filing joint returns. The benefit is phased out over the next $50,000 of QBI for individuals, and $100,000 for joint filers. Above these amounts, there are restrictions. Most owners of these businesses will see a reduction in taxes owed.
- Elimination of the 9% Section 199 deduction (6% for certain oil and gas activities), also commonly referred to as the domestic production activities deduction or manufacturers’ deduction — effective for tax years beginning after December 31, 2017, for non-corporate taxpayers and for tax years beginning after December 31, 2018, for C corporation taxpayers
- New rule limiting like-kind exchanges to real property that is not held primarily for sale
- New tax credit for employer-paid family and medical leave — through 2019
- New limitations on excessive employee compensation
- New limitations on deductions for employee fringe benefits, such as entertainment and, in certain circumstances, meals and transportation. For decades, businesses have been able to deduct 50% of the cost of entertainment directly related to or associated with the active conduct of a business. For example, if you took a client to a nightclub after a business meeting, you could deduct 50% of the cost if strict substantiation requirements were met. But under the new law, for amounts paid or incurred after Dec. 31, 2017, there’s no deduction for such expenses.
- Gains or losses from the sale or exchange of patents, inventions, models or designs, and secret formulas or processes and held by its creator or successor will not receive capital gains treatment. Section 1221(2)(3) of the Code was amended to exclude these from the “capital asset” definition.
- Revenue recognition – The Act requires recognition no later than the year in which the income is accounted for as income on a financial statement of the type that is filed with a regulatory organization or that in a form prescribed by regulation. Taxpayers will generally recognize income earlier under this provision.
- New type of equity grant – Private companies will now have a new way for certain employees to be granted stock options and restricted stock units (RSUs). If these equity grants are structured properly, eligible employees will be able to defer income on these awards up to five years from the exercise date of options and the vesting date of RSUs.
Additional Implications and Expectations
Winners and Losers – Highly regarded New York University finance professor Dr. Aswath Damodaran has conducted extensive analysis on the new law’s likely effects on publicly traded equities, based on current knowledge. He writes “While much of the discussion about the tax reform has been about its impact on the overall economy and equity values, the bigger effect of the changes to the code will be redistributive, with some sectors gaining and other losing. Companies (sectors) that are currently paying high effective tax rates, invest large amounts in tangible (depreciable) assets and have little or no debt will benefit the most from the tax code changes. Companies (sectors) that are currently paying low effective tax rates, invest little or nothing in tangible (depreciable) assets and have high debt will be hurt the most by the tax code changes.” 4
- Sectors Benefiting Most (High effective tax rate, high capital expense, low debt-to-capital ratios): Precious metals, Transportation (Railroads), Transportation, Metals and Mining, Oilfield Services/Equipment, and Retail (General)
- Sectors Benefiting Least (Low effective tax rate, low capital expense, high debt-to-capital ratios): Hotel/Gaming, Diversified, Computer Services
Seeking advantageous ways to work the tax code to one’s favor has always existed and always will. Here are a few likely scenarios, and results.
Conversion from S corporation or LLC to C corporation – Some pass-through business entity owners will consider whether to restructure as a C corporation to take advantage of the new 21% top tier rate. Pass-through income is taxed as ordinary income, up to a 37% marginal rate under the new law, and even with the 20% deduction on some pass-through income, larger and/or more profitable company owners may find the corporate rate advantageous. Additionally, C corporations can still deduct state and local taxes, while pass-throughs cannot.7
Form a Pass-through – Some individuals with flexibility on how they claim income will consider creating a pass-through entity to receive it to claim the 20% deduction (though the prohibition against service businesses may create a barrier to many). 7
Public Equities: Higher Dividends and Stock Prices – Stock ownership will become increasingly attractive as corporations have more to pay shareholder dividends, and/or invest in corporate growth. Lower tax will increase earnings, thus making stocks more valuable.
Some companies will use part of their gain to buy back their stock, thus propping up their stock prices (reducing shares tends to build value of those available).
Mergers & Acquisitions – The new law will have two primary effects, as pertains to M&A and financing transactions:
- Will stimulate M&A and financing activity. There is broad industry consensus that the decline in M&A deal volume over the past two years was largely due to political uncertainty: first the election itself, then uncertainty surrounding tax reform. Now settled, the more favorable corporate tax rate and strong economy – how much longer? – will likely spur M&A activity and other corporate investment.
- Will necessitate deal makers to study the new law and its effects on both corporations as well as private equity investment groups. Tax considerations have always been a key element of negotiating deal structure, so now that many variables have changed, all of us in the deal community must learn the new rules and nuances.
McGavock Dickinson (Dick) Bransford is a Managing Director in San Francisco with Mid-Market Securities, LLC, an investment bank headquartered at 11 East 44th Street, 19th Floor, New York, New York 10017. Member FINRA/SIPC. He can be contacted at (415) 294-0002 or mdb @ mid-marketsecurities.com.
 Gilmore and Associates Certified Public Accountants, December 22, 2017 client letter
 Tax Cuts and Jobs Act of 2017, KMR, LLP client newsletter
 2018 Data Update 3: Taxing Questions on Value, Aswath Damodaran, January 2018. http://aswathdamodaran.blogspot.in/
 Todd Ganos, IWC Family Offices, https://toddganos.com/
 Barron’s, How the New Tax Law Affects You, December 25, 2017
Disclaimer: This article provides general information, and is not intended to constitute, and should not be construed as, legal, tax, accounting or business advice, nor does it constitute an offer to sell or to purchase securities. Rather, it is summary compilation of timely issues confronting your industry and as such does not purport to be a full recitation of the matters presented. Prior to acting upon any information set forth in this article or related to this article, you should consult independent counsel and/or more detail contained in the Source Information. The article reflects the opinion of the writer, and does not necessarily reflect the opinions of Mid-Market Securities, LLC, or its affiliates. IRS Circular 230 Disclosure: In order to comply with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax discussion contained in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.