The changes in the Tax Cuts and Jobs Act (TCJA) have drawn renewed attention to the importance of purchase price allocations for acquisitions of S corporations and partnerships.
Purchase price allocations are often required for book and tax purposes. Thus, when an acquirer purchases a target it is required to allocate the purchase price into the various assets and liabilities acquired as part of the transaction. For tax purposes, this allocation generally only applies when the assets are acquired in a so-called “tax basis step-up” transaction.
Enter the TCJA’s provision that enables companies to boost the portion of the cost of certain kinds of business property that they can immediately claim as a tax expense. The law lifts the previous rate of 50% to a rate of 100%.
Buyers will want to take advantage of this 100% capital expenditure expensing for tax purposes before it expires in a few years, because it brings immediate and substantial net present value.
But to take advantage of the 100% capex expensing, a transaction has to be structured to provide a tax basis step-up.
Tax basis step-up transactions include asset acquisitions, acquisitions of partnership (or LLC) interests, or acquisitions of S corporations with a so-called Section 338(h)(10) election. This election treats the acquisition of S corporation stock as an asset acquisition when all of the qualifications are met.
The two drivers of purchase price allocations for tax are 1) who is being taxed and 2) the tax rate. When the seller is a corporation, the corporation pays the tax at its effective federal and state tax rates.
The tax rate for corporations is the same whether the gain is capital or ordinary. Accordingly, a corporate seller is typically indifferent to the purchase price allocation.
However, when the seller is an S corporation or a partnership owned by individuals, the individuals pay the tax. When individuals pay the tax, the critical difference is whether the gain is taxed at the 20% capital gains rate or at the 37% ordinary income rate.
Because of this difference in tax rate, partnership and S corporation sellers want to allocate all of the gain to goodwill and intangibles so that they avoid the 37% tax on fixed assets (known as “depreciation recapture”). This has driven purchase price allocations for decades.
Now that buyers can currently expense the full amount allocated to fixed assets, the old paradigm has to be reassessed. Dealmakers should be considering whether a purchase price can be allocated to fixed assets above their tax basis.
The analysis is to determine whether the net present value benefit of 100% expensing to the buyer exceeds the buyer’s cost of grossing up the sellers.
With 100% expensing for tax purposes, the net present value to the buyer is the amount of purchase price allocated to fixed assets multiplied by the buyer’s tax rate (21% federal rate for corporations and 37% for individuals who own through S corporations and partnerships).
If the net present value exceeds the additional tax cost to the sellers, i.e., the difference between the 37% tax rate on fixed assets over the 20% tax rate on goodwill/intangibles, it may make sense for the buyer to pay the additional amount to the seller to step-up the fixed assets.
As an example, an S corporation is selling a division for $100, the sellers want to allocate all of the gain to goodwill and intangibles. By doing so, the entirety of the gain will be taxed at the 20% capital gains rate.
The buyer, however, wants to allocate $40 to fixed assets so it can immediately expense that $40 on its tax return. Because $40 is $30 above the $10 tax basis of the fixed assets, the $30 of gain on the fixed assets would be taxed to the sellers at the 37% rate.
The difference on the $30 being taxed at 37% versus 20% is about $5. Consequently, the sellers would want to be “grossed-up” for this additional cost.
Because the net present value to the buyer of a $30 current deduction is higher than this $5 cost, the buyer and seller can agree to allocate $40 of the purchase price to fixed assets.
That example is very simple, and the actual analysis will require consideration of other factors, including the buyer’s hold period for the assets. There may be situations where the gross-up is more or less than the net present value benefit to the buyer. As a result, these situations should be modeled to determine the best outcome for the buyer.
Another consideration is whether the business can take full advantage of the 100% expensing.
If not, where the 100% expensing amount exceeds taxable income for that year, the expensing creates a net operating loss that can be carried forward indefinitely, subject to an annual 80% limitation (a part of the recent tax code changes). If so, the value of the 100% expensing is lower.
To summarize, the new tax law has made us reconsider our paradigm for purchase price allocations for tax basis step-up transactions. It is now worth modeling whether the net present value to the buyer of an allocation of purchase price to property, plant, and equipment, which provides an immediate 100% tax deduction, is greater than the buyer’s cost to gross up the sellers.
Statements and opinions expressed herein are solely those of the author and may not coincide with those of Houlihan Lokey.
Oscar Aarts is a director and leader in Houlihan Lokey’s New York tax and financial reporting valuation practice, and Jerome Schwartzman is a director in Houlihan Lokey’s transaction advisory services practice and head of M&A tax services. Winston Shows is a vice president and member of the firm’s transaction advisory services practice, specializing in M&A tax services.