Provisions in the CARES Act that are Important in the M&A Area by Lewis Taub, CPA
Posted on April 10, 2020
On March 27, the president signed into law the Coronavirus Aid, Relief and Economic Security Act (CARES Act), which provides a wide range of tax and financial relief to businesses and individuals suffering the economic consequences of the COVID-19 pandemic. Provisions contained in the law include simple payroll tax relief and intricate adjustments to the calculation of depreciation on certain capital assets as well as measures may impact potential M&A transactions and the operations of portfolio companies held by investors.
Increased tax deduction for interest paid
The CARES act increases the limitation on the deductibility of interest expense to 50 percent of adjusted taxable income (ATI) for tax years beginning in 2019 and 2020. Previously, interest expense that exceeded the amount of a business’s interest income was only deductible to the extent of 30 percent of that business’s ATI.
In addition, the CARES Act allows taxpayers to elect to use their 2019 ATI to compute their 2020 taxable-year interest-expense limitation. The reasoning for this election is that the COVID-19 pandemic will likely result in taxpayers earning less income in 2020 than 2019. Therefore, taxpayers are likely to further increase the amount of deductible interest in 2020.
The additional allowed interest will make 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 interiors of nonresidential buildings that were completed after the buildings were put into service. The CARES Act corrects a technical contained in the Tax Cuts and Jobs Act (TCJA) that could have significant 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 because he or she can take a depreciation or amortization deduction over the useful life of certain assets. The TCJA mistakenly classified QIP as 39-year property despite the intention to assign it a 15-year useful life. Under the CARES Act, QIP placed in service after December 31, 2017, is now properly classified as 15-year property, 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 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 negotiations between buyers and sellers in M&A transactions because they are not easily transferable in the sale of a company. Rather, sellers may attempt to utilize their NOLs to offset gains on the sale, or NOLs may become a tax attribute if the acquired entities have NOLs from business operations after the acquisition.
The CARES Act makes two changes the use of NOLs on tax returns of corporations.
The first change relates to the carryforward of an NOL to a year after the one 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.4 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 permits 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 offset income in prior years.
Relief to operations of portfolio companies
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, 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 employers that are subject to closure or significant economic downturn due to COVID-19 an employee-retention credit for wages paid from March 13, 2020, to December 31, 2020, by. The maximum credit amount is $5,000 per employee. The credit is applied against the 6.2 percent of Social Security taxes employers are required to pay for employee wages paid. To be eligible for the retention credit in any quarter, an employer must experience one of the two following COVID-19-related occurrences: in 2020 (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 transaction to the day-to-day operation of portfolio companies. In these difficult times, knowledge and utilization of the provisions of the CURES Act is essential to businesses’ ongoing financial security.
Lewis Taub, CPA, is a tax director in the New York office of Berkowitz Pollack Brant Advisors + CPAs, where he works with entrepreneurial businesses and multinational and multi-state corporations on tax planning and compliance strategies. Much of his work involves advising buyers and sellers on the structure of M&A transactions to optimize the tax impact. He can be reached at 646-213-7569 or at firstname.lastname@example.org.
This article originally appeared on Axial Middle Market Review.