How Provisions in the CARES Act May Impact M&A

On March 27^th President Trump signed the Coronavirus Aid, Relief and Economic Security Act (CARES Act). The CARES Act contains a wide range of tax and financial relief provisions, ranging from simple payroll tax relief to intricate adjustments to the calculation of depreciation on certain capital assets. This article will deal with the provisions that may impact potential M&A transactions and the operations of portfolio companies held by investors.

Increased Tax Deduction for Interest Paid

For tax years beginning in 2018, interest expense that exceeds the amount of a business’s interest income is only deductible to the extent of 30 percent of the  business’s adjusted taxable income (ATI). However, the CARES Act increases the limitation on the deductibility of interest expense from 30% to 50% for tax years beginning in 2019 and 2020.

In addition, the CARES Act allows taxpayers to elect to use their 2019 ATI in computing their 2020 taxable year interest expense limitation. The reasoning for this election is that due to the COVID-19 pandemic, taxpayers are likely to earn less income in tax year 2020 than 2019. Therefore, by allowing the use of 2019  ATI, taxpayers are likely to further increase the amount of deductible interest in 2020.

The additional allowed interest for years beginning in 2019 and 2020, will make both potential and completed transactions more attractive from a tax point of view. Consideration may even be given to short-term borrowing to use the beneficial provision of 2019 and 2020.

Accelerated Depreciation for Qualified Improvement Property

Qualified improvement property (QIP) refers to any improvements made to an interior of a nonresidential building that were completed after the building was in service.  The CARES Act corrects a technical error that occurred in the Tax Cut and Jobs Act of 2017 (TCJA). This technical correction could have a significant beneficial impact on the tax ramifications of M&A transactions.

Typically, a purchaser wants to buy the assets of a business rather than the stock of the business. That’s because the buyer can take a depreciation or amortization deduction over the useful life of certain assets. The 2017 TCJA mistakenly classified QIP as 39-year property, where the intention was to assign a 15-year useful life to QIP. The CARES Act corrects this error and QIP is now properly classified as 15-year property. The correction is retroactive to QIP placed in service after December 31, 2017,  providing businesses with opportunities to increase depreciation for 2017 and 2018, resulting in a greater after-tax return on business acquisitions.

Modification of Rules Concerning the Use of Net Operating Losses

In the simplest terms, corporate net operating losses (NOLs) are the excess of business expenses over business income in a taxable year. NOLs are typically not a factor in the negotiations between buyers and sellers in an M&A transaction because, under the tax laws, they are not easily transferable in a sale of a company. Rather, sellers may attempt to utilize their NOLs to offset the gain on the sale, or NOLs become a tax attribute to the buyer if the acquired entity has NOLs from business operations after the acquisition.

The CARES Act makes two changes with regard to the use of NOLs on the tax return of a corporation.

The first change relates to the carryforward of a NOL to a year subsequent to the year in which the NOL occurred. Before the CARES Act, NOLs that occurred in a taxable year beginning after December 31, 2017, were allowed to offset only 80 percent of a corporation’s taxable income in a subsequent year. The CARES Act provides that, in the case of a taxable year beginning before January 1, 2021, the 80 percent taxable income limit does not apply, allowing taxpayers to use NOLs to fully offset taxable income.

The second change relates to the carryback of an NOL to a year prior to the year that the NOL occurred. Before the CARES Act, carrybacks were not allowed. However, the CARES Act allows taxpayers to carryback NOLs earned in 2018, 2019, or 2020 up to five previous years. Therefore, there may be opportunities to receive refunds of prior year taxes by carrying back NOLs to prior years to offset the income of those years.

Provisions in the CARES Act Providing Relief to Portfolio Company Operations

It is beyond the scope of this article to discuss all provisions that assist and provide relief to entities during these difficult times. However, the following two provisions  aimed at maintaining employment levels, are worthy of mentioning:

• The deferral for submitting payroll taxes – Employers will be allowed a deferral for depositing the 6.2 percent Social Security tax on employee wages. The deferral applies to such payroll taxes arising from March 27^th, 2020 through December 31, 2020. Half the deferred amounts are due by December 31, 2021 and the other half by December 31, 2022.
• Employee retention credit – The CARES Act provides for an employee retention credit for wages paid from March 13, 2020 to December 31, 2020, by employers that are subject to closure or significant economic downturn due to COVID-19. The maximum credit amount is $5,000 per employee. The credit is applied against the 6.2 percent of Social Security taxes that employers are required to pay for employee wages paid. To be eligible for the retention credit in any quarter, an employer must experience in 2020 one of the two following COVID-19-related occurrences: (1) operations were fully or partially suspended on orders from a governmental authority due to COVID-19 or (2) the business experienced a 50 percent reduction in gross receipts for a calendar quarter as compared to the same calendar quarter in the prior year.

The CARES Act can have an impact on both completed and potential M&A transactions. The provisions are far-reaching, spanning from the impact on the after-tax return on transactions to the day-to-day operations of portfolio companies. In these difficult times, knowledge and utilization of the provisions of the CARES Act is essential to the businesses’ ongoing financial security.

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Lewis Taub, CPA, is a Director in the New York office of Berkowitz Pollack Brant Advisors + CPAs, where he works with entrepreneurial business, multinational and multi-state corporations on tax planning and compliance strategies. Much of his work is concerned with advising buyers and sellers on the structure of M&A transactions to optimize the tax impact.  Lewis has developed and instructed many courses on tax planning opportunities and for many years instructed tax courses as an Adjunct Professor at Fordham University’s graduate tax program. Lewis holds a master’s degree from New York University in Taxation and served on the AICPA’s S corporation technical resource committee. Contact Lewis at [email protected]