The Tax Cuts and Jobs Act (TCJA) is a comprehensive tax bill impacting all manufacturing and distribution (M&D) companies, both large and small. TCJA offers significant tax cuts and tax rate reduction for businesses, applying to both C Corporations and pass-through businesses (Partnerships/LLCs and S Corporations). Without exception, the new tax reform law also impacts private equity firms (PEFs) as they analyze their holdings.
How Tax Rate Changes Might Impact M&D Companies and PEFs
Congress initially set out to lower the tax rate on pass-through businesses, since these businesses generate jobs and impact the economy. This change, while positively impacting many businesses in the M&D industry, presents complications. TCJA offers a new 20 percent deduction for Qualified Business Income (Section 199A, referred to as QBI) to owners of pass-through businesses, but has a W-2 payroll and a property factor to consider. To the extent the trade or business meets all the requirements and qualifies for this deduction, the top tax rate drops from 37 percent to 29.6 percent.
It is important for a PEF to evaluate not only these new tax rates for the business enterprises it owns, but also for its own operations and management of its PEF. The PEF will need to evaluate each M&D business it invests in and determine what type of entity should be utilized. Some of the factors to address are:
- the projected income of the business in the coming years
- whether the business qualifies for the new 20% deduction
- the anticipated succession plan of the business
- any international and state considerations of the business
- and several other factors
It is important for the PEF to model out this entity analysis for each company it owns.
Another aspect for PEFs to be aware of relates to the timing of when a transaction closes. If a seller recognizes ordinary income from depreciation recaptured as part of a sale, this income would be entitled to the QBI deduction, but the payroll and property factors could be distorted if the sale occurs too early in the tax year. Thus, when a sale of a business is contemplated, part of the analysis should focus on the amount of the QBI deduction and how this timing might be managed to maximize this deduction.
Significant TCJA Changes with CapEx Offer Opportunities for M&D Companies and PEFs
Beyond tax savings implemented under the new QBI deduction, the tax law’s CapEx changes also provide PEFs in the M&D space with further opportunities. Two key TCJA changes for CapEx were:
- double the bonus depreciation to 100%
- permit taking bonus depreciation on used property
This change will have a significant impact on M&D businesses—as they are usually capital intensive. However, it will also play an important role in the buying and selling of businesses. Many transactions today are structured as the sale/purchase of assets, and not as a stock sale. This generally results in only one layer of tax by the seller. The buyer and seller not only negotiate the selling price of the business, but also spend time determining how this price is allocated among the various assets being sold/purchased. Before TCJA, any amounts allocated in a transaction for CapEx (personal property; not real estate) were depreciated over five to seven years, since used property was not eligible for bonus depreciation. Now under TCJA, CapEx is eligible for the 100 percent bonus depreciation and applies to used property.
Thus, PEFs may change the dynamic of how they allocate purchase price in transactions, in which they are the buyer, to maximize the up-front depreciation deductions for allocations to CapEx, and scale back on the amounts attributed to intangible assets that receive a longer 15-year shelf life amortization period. This may especially be a factor with PEF deals involving M&D businesses, due to the higher propensity of fixed assets within manufacturing companies.
Anytime there is major tax reform, there are opportunities to identify tax savings strategies and to limit the impact of tax hikes. With TCJA, this is also the case—and two areas for M&D companies and PEFs to focus on are entity selection and CapEx items. Please contact your Sikich tax advisor for assistance or with questions relating to your PEF.