Mergers & Acquisitions After Tax Reform

I. Background Mergers & Acquisitions After Tax Reform Robert J. Bauer, CPA, Dopkins & Company, LLP Kelly E. Marks, Esq., Phillips Lytle LLP Gregory J. Urban, CPA, CVA, Dopkins & Company, LLP A. The Tax Cuts and Jobs Act (the Act or TCJA ) was signed into law on December 22, 2018. B. The Act made significant changes to tax rates of individuals and corporations, the U.S. international tax regime, and deductions and tax attributes that come into play when buying and selling businesses. 1. The top individual ordinary income tax rate was lowered from 39.6% to 37% for taxable years beginning after December 31, 2017 through December 31, 2025. I.R.C. 1. 2. The corporate tax rate is a flat 21% effective for taxable years beginning after December 31, 2017 (down from a top tax rate of 35%). I.R.C. 11. 3. Introduction of a pass-through deduction with respect to income from certain types of businesses held in a tax partnership, disregarded entity or sole proprietorship for taxable years beginning after December 31, 2017 through December 31, 2025. I.R.C. 199A. II. Private Company Mergers and Acquisitions Before the Act A. Deal Structure 1. Target Company as a C Corporation i. Sellers were motivated to sell stock because a sale of assets resulted in tax at the corporate and shareholder levels. Gain from the sale of stock held for more than one year would be eligible for long-term capital gains treatment and taxation at a top rate of 20%. Absent regulatory, licensing or contractual requirements, Buyers were generally motivated to acquire assets in order to get a step-up in basis in the acquired assets that could be depreciated and/or amortized. 2. Target Company as an S Corporation i. Sellers and Buyers generally have the same motivations as they would if the Target Company was a C corporation; however, S corporations afford corporate buyers the opportunity to treat an

- 2 - acquisition of at least 80% of the stock of the Target Company as an asset sale for federal income tax purposes if Sellers joined the Buyer in making an election under I.R.C. Section 338(h)(10) (a 338(h)(10) election ). i A 338(h)(10) election allows Buyer to treat a stock acquisition as such for legal purposes so as to deal with any regulatory, licensing or contractual requirements more efficiently, but an asset deal for income tax purposes so as to benefit from depreciation and amortization deductions. A 338(h)(10) election, however, usually results in adverse tax consequences to Sellers. The adverse tax consequences usually result from the difference in tax rates applied to depreciation recapture (ordinary income tax rates) versus gain from the sale of stock held for more than one year (long-term capital gains rates). Therefore, Sellers would attempt to negotiate (and would frequently receive) a tax gross-up from Buyer. That is, Buyer would cover Sellers increased tax cost associated with a 338(h)(10) election versus a straight stock deal. 3. Target Company as an I.R.C. Section 1202 Qualified Small Business i. If Target Company was a qualified small business under I.R.C. Section 1202, non-corporate Sellers had even more motivation to sell stock. I.R.C. Section 1202(a)(1) provides that the gross income of a taxpayer other than a corporation shall not include 50 percent of any gain from the sale or exchange of qualified small business stock held for more than 5 years. For qualified small business stock acquired after August 10, 1993 ( Enactment Date ) and before September 27, 2010, a taxpayer could have excluded 75% of the gain from the sale or exchange from such stock. For qualified small business stock acquired after September 27, 2010, 100% of the gain from the sale or exchange of the stock could have excluded from gross income. The amount of gain excluded with respect to qualified small business stock must not exceed the greater of (x) $10,000,000 reduced by the aggregate amount of eligible gain the taxpayer took into account in prior tax years under I.R.C. Section 1202 with respect to qualified small business stock issued by the corporation or (y) ten (10) times the aggregate adjusted basis of the qualified small business stock of the corporation the stock of which is disposed of by the taxpayer.

- 3 - i Under I.R.C. Section 1202(d), a qualified small business is defined as a domestic C corporation, which meets the following requirements: the amount of cash and aggregate adjusted basis of other assets of the corporation (or any predecessor thereof) at all times on or after the Enactment Date and before the issuance of qualified small business stock did not exceed $50,000,000; the amount of cash and aggregate adjusted basis of other assets of the corporation immediately after the issuance of qualified small business stock (determined by taking into account amounts received in the issuance) does not exceed $50,000,000; and the corporation agrees to submit such reports to the Secretary and to shareholders as may be required. I.R.C. Section 1202(d)(2)(B) provides that with respect to a corporation s assets acquired by contribution, the fair market value of the assets at the time of the contribution shall be treated as the adjusted basis. Qualified small business stock is stock of a C corporation that is originally issued after the Enactment Date and meets the following requirements: as of the date of issuance, the corporation is a qualified small business; subject to certain exceptions, the taxpayer acquired the stock at its original issue for money or other property (other than stock) or for compensation for services (other than services performed as underwriter for such stock); and during substantially all of the taxpayer s holding period for the stock, the corporation satisfies the active business requirements set forth in Section 1202(e) of the Code and the corporation is a C corporation. I.R.C. 1202(c)(1). v. The active business requirement is satisfied if at least 80 percent (by value) of the assets of such corporation are used by such corporation in the active conduct of 1 or more qualified trades or businesses, and [the] corporation is an eligible corporation. For

- 4 - purposes of this test, assets used in certain start-up activities and certain research and development activities are treated as used in the active conduct of a qualified trade or business. I.R.C. 1202(c)(2) & (e). vi. v In order to satisfy the active business requirement, a corporation must be an eligible corporation. An eligible corporation is any domestic corporation which is not a DISC or former DISC, a corporation with respect to which an election under section 936 is in effect or which has a direct or indirect subsidiary with respect to which such an election is in effect, a regulated investment company, real estate investment trust, or REMIC, [or] a cooperative. I.R.C. 1202(e)(4). Under I.R.C. Section 1202(e)(3), a qualified trade or business is any trade or business, except one of the following: any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees; any banking, insurance, financing, leasing, investing, or similar business; any farming business (including the business of raising or harvesting trees); any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A; and any business of operating a hotel, motel, restaurant, or similar business. 4. Target Company as Multi-Member LLC i. When acquiring 100% of the membership interests of an LLC taxed as a partnership, both Buyer and Sellers get the best of both worlds. Buyer is treated as acquiring the assets of the LLC and Sellers are generally treated as selling the equity of the LLC subject to some ordinary income treatment attributable to hot assets (e.g., depreciation recapture). Rev. Rul. 99-6, I.R.B. 1999-6, 6 (Feb. 8, 1999).

- 5-5. Post-Closing Target Company Structure i. Buyers rarely requested a restructuring of the Target Company (i.e., converting a corporation to an LLC) to accommodate their preferred choice of entity post-closing. Buyers would from time to time, in equity deals, request that certain unwanted assets or liabilities be spun out of the Target Company before closing. B. Allocation of Purchase Price 1. In an applicable asset acquisition, Buyer and Seller allocate the purchase price among the assets transferred using the residual allocation method. 2. The transfer is an applicable asset acquisition if Buyer determines his basis for the acquired assets wholly by reference to the consideration he pays. i. Buyer and Seller use allocated amounts to determine gain or loss and basis for transferred assets. i Buyer and Seller must use the residual allocation method to make any purchase price adjustments. Buyer and Seller must report any applicable asset acquisition. Buyer and Seller cannot challenge allocations they have agreed to, except in cases of mistake, undue influence, fraud or duress. v. Buyer and Seller must carefully identify the assets transferred to determine how best to allocate the purchase price. 3. An owner of a business who sells its assets, and Buyer who buys them, must allocate the purchase price for the business among the assets acquired. Therefore, although Buyer pays and Seller receives a single purchase price for all the assets of the business, Buyer and Seller must allocate the purchase price to each individual asset. This allocation of the purchase price determines: i. The amount of Seller's gain or loss on the transaction; i The amount of gain or loss allocated to assets that are capital assets or are treated as capital assets in determining the character of the gain or loss; and Buyer's basis in the assets acquired.

- 6-4. If the transaction is an applicable asset acquisition, Buyer and Seller must use the residual allocation method to allocate the purchase price (however, the IRS usually respects a written allocation agreement if the parties have adverse tax interests). As stated previously, an applicable asset acquisition is any transfer of assets that constitute a trade or business if Buyer s basis in the assets is determined wholly by reference to the consideration paid. (Note: applicable asset acquisitions also include transactions in which a portion of the assets is exchanged tax free in a like-kind exchange.) 5. The residual allocation method highlights the importance of identifying the various assets that can be involved in an applicable asset acquisition. These may include: i. Inventory; i Accounts receivable; Section 1231 property used in a trade or business subject to the capital gain/ordinary loss rule; Capital assets; v. Acquired intangibles; vi. v vi ix. Goodwill and going concern value; Trademarks, trade names and franchises; Patents; Copyrights; x. Covenants not to compete; xi. x Customer lists and other customer-based intangibles; and Employment contracts and other workforce-based intangibles. 6. Purchase Price Allocations i. Allocations preferred by Seller Sellers of assets usually prefer to allocate as much of the purchase price to capital assets when the tax rate on capital gains is less than the rate on other income. Similarly, favorable capital gains rates may make a Seller generally prefer allocations to Section 1231 property when the allocations can produce a net capital gain.

- 7 - A Seller also may prefer allocations to Section 1231 property when these produce a net loss, because he may deduct the loss as ordinary. Sellers also benefit from allocations to capital assets over allocations to Section 1231 assets, which produce ordinary recapture income. Generally, allocations to high-basis assets permit the Seller to receive more of the purchase price as a recovery of capital, rather than as producing gain or loss, which the Seller may not be able to use against each other or against other losses or gains. A Seller should consider the tax consequences of selling his proprietorship's assets in the context of his entire tax position. The tax aspects of other activities may affect how important it is to a Seller that the allocations with respect to the proprietorship produce a specific tax result. For example, a Seller often can offset gains from selling business assets with losses the seller recognizes on other properties. Allocations Preferred by Buyer Buyer of the assets of a proprietorship generally seeks to allocate as much purchase price as possible to property, the cost of which Buyer can recover the soonest at the least tax cost. Thus, Buyer may prefer a significant allocation to inventory, stock in trade, accounts receivable and property held for sale to customers in the ordinary course of business, to the extent Buyer expects to be able to sell the property quickly. Next, Buyer generally may prefer to allocate a purchase price to assets that Buyer may depreciate or amortize, the shorter the period the better. C. Pre-Closing Tax Indemnities/Post-Closing Tax Obligations 1. A substantial majority of private company deals provide that Sellers indemnify Buyers for all taxes due on or before the closing date of the transaction and for taxes due and owing by Sellers arising out of the transaction regardless of whether there is a breach of a representation or warranty with respect to taxes. The indemnity for taxes would generally be carved out from any indemnity basket (the threshold claim amount that must be reached before Sellers become liable for Buyers losses) but would be capped at the purchase price in the vast majority of deals. 2. In most deals, tax representations and warranties survive beyond the general survival period which is usually between 12 and 24 months. Tax

- 8 - representations and warranties typically survive for the statute of limitations plus a specified number of days. 3. Other points of negotiation include Sellers control of tax audits and voluntary disclosure proceedings and consents to settlements or closings of audits and voluntary disclosure proceedings. III. Tax Law Changes under the Act impacting Mergers and Acquisitions A. Deal Financing 1. Interest Deductibility Limitation i. The Act limited the deductibility of interest expense to 30% of adjusted taxable income. I.R.C. 163(j). i Adjusted taxable income is equal to EBITDA through December 31, 2021 and beginning January 1, 2022, adjusted taxable income is equal to EBIT. I.R.C. 163(j)(8). The limitation is determined at the entity level. I.R.C. 163(j)(4). Interest expense is calculated net of interest income. I.R.C. 163(j)(5). v. Any interest expense that is not deductible in a taxable year is carried forward. I.R.C. 163(j)(2). 2. Implications for Buyer i. Buyer may not be able to deduct interest on acquisition financing. i Buyer may owe tax even if Buyer has a loss. Buyer will need to consider cash flow implications when modeling the impact of the acquisition. 3. Increased focus on whether the following items should be classified as interest: Commitment fee Arrangement fee Market discount Origination fee Underwriting fee Call premium Structuring fee Original issue Trustee fee discount Exit fee Make whole Imputed interest payment

- 9 - Participation fee Servicing fee Factoring income Line of credit fee Attorneys fees 4. Exemptions from Interest Expense Limitation i. Small businesses ($25 million of gross receipts). I.R.C. 163(j)(3). i Auto floor financing. I.R.C. 163(j)(l)(C) & (j)(9). Agricultural, farming, and real estate business may irrevocably elect out of the interest expense deduction limitation. I.R.C. 163(j)(7)(B) & (C). - A business that elects out of the interest expense deduction limitation must use the alternative depreciation system with respect to certain property. I.R.C. 168(g)(1)(F) & (G). B. Tax Attributes 1. Net Operating Losses ( NOLs ) i. The Act amended I.R.C. Section 172 with respect to NOLs arising in fiscal years ending after December 31, 2017. i Historic NOLs will need to be tracked separately from post-2017 NOLs. For C corporations, alternative minimum tax ( AMT ) NOL carryforwards will have no impact because of the elimination of the AMT. Post-2017 NOLs may no longer be carried back to prior taxable years except for Presidentially Declared Disaster Areas. v. Post-2017 NOLs may be carried forward indefinitely. vi. Taxpayers utilization of NOLs is limited to 80% of taxable income. v The Act changed I.R.C. Section 172, not I.R.C. Section 382. vi Buyers will need to model the impact of NOL limitations and potentially slower utilization of future NOLs. 2. Fixed Asset Expensing

- 10 - i. The Act provides for 100% bonus depreciation for new and used property acquired and placed in service after September 27, 2017 until December 31, 2022. I.R.C. 168(k). i The bonus depreciation percentage decreases by 20% annually between January 1, 2024 and January 1, 2027. Taxpayers are not eligible for bonus depreciation if the purchase agreement (invoice, contract, etc.) was entered into prior to September 27, 2017. Bonus depreciation is required unless the taxpayer elects out. v. The Act included a new category called Qualified Improvement Property ( QIP ) to replace Qualified Leasehold Property, Qualified Restaurant Property, and Qualified Retail Property. vi. QIP was supposed to have 15-year life and therefore qualify for bonus depreciation. However, technical errors resulted in this provision not being enacted. Currently, QIP has a 39-year life and is not bonus depreciation eligible. Buyers will need to consider this when allocating purchase price and modeling depreciation. 3. I.R.C. Section 179 expensing amount increased to $1 million for assets placed in service after December 31, 2017. i. Phase-out threshold increased to $2.5 million. Specifically includes QIP. 4. Consider the potential negative impacts of bonus depreciation and increased expensing: i. If bonus depreciation generates an NOL carryforward, the NOL utilization is limited to 80% of future taxable income. Accelerated depreciation is recaptured on future disposals of acquired fixed assets. C. Accounting Methods 1. The Act amended the small business exception for utilizing the cash method of accounting under I.R.C. 448. i. Any business with average annual gross receipts under $25 million for the 3 prior taxable years can qualify as a small business. C-Corporations

- 11 - S-Corporations Partnerships and LLCs Sch. C Businesses Did Target Company make any of the below changes in 2018 that need to be reversed post-acquisition? Change to cash basis accounting Change to inventory Elimination of UNICAP Change to completed contract method i Whether the gross receipts is met is determined on an annual basis. The cash method will still be used if current receipts exceed $25 million if the average annual receipts for the 3-year period ending with the current year do not exceed $25 million. Entity aggregation rules apply for purposes of determining gross receipts. Controlled or affiliated entities will generally be considered as one business for purposes of this test. D. Intangible Assets 1. Before the Act, self-created intellectual property was not expressly excluded from capital asset treatment under I.R.C. Section 1221(a)(3). 2. The Act amends I.R.C. Section 1221(a)(3) to exclude the following: i. Patents, i Inventions, Models or designs (regardless of patent), Secret formulas or processes. 3. The Act also amended I.R.C. Section 1231(b)(1) to exclude self-created assets from property used in a trade or business. 4. Due to these amendments, self-created intangible assets are subject not only to ordinary income rates on recapture of any accumulated amortization, but on any gain recognized on sale or transfer of the asset.

- 12-5. Buyers and Sellers will need to consider these changes as part of future transactions. 6. Section 1235 still allows capital gain treatment for inventors and investors who sell or transfer all substantial rights to a patent. E. International Considerations 1. The Act is shifting U.S. international taxation to a quasi-territorial system. In connection with that shift, there is one-time transition tax for taxable years beginning before January 1, 2018 which effectively imposes mandatory foreign profits repatriation. The taxpayer can elect to pay the transition tax in installments over 8 years. I.R.C. 965. i. Tax is payable by any U.S. shareholder who owns 10% of the value or vote of stock of a controlled foreign corporation or a foreign corporation with at least one 10% U.S. shareholder that is a corporation. Under the new quasi-territorial system, U.S. corporate shareholders will be able to exclude dividend income from 10% (by vote or value) or greater owned foreign subsidiaries. 2. Future Considerations-Quasi Territorial System i. GILTI essentially a tax on intangible earnings. i FDII reduced tax on exports. BEAT a minimum tax on the taxable income of a corporate taxpayer and a denial of deductions for certain expense payments between related parties. 3. What is the impact of these new international rules on the Target Company? 4. What is the potential tax exposure for Buyer? F. State Conformity 1. States are decoupling at an alarming rate: i. Bonus depreciation being disallowed i Decoupling from the higher I.R.C. Section 179 amount Differing definition of interest expense State AMT may still exist

- 13 - v. I.R.C. Section 965 treatment vi. Two sets of rules old laws not gone IV. Private Company Mergers and Acquisitions After the Act A. Deal Structure 1. Because of the immediate bonus depreciation deduction available for purchases of depreciable assets, Sellers are under even greater pressure to sell assets as opposed to stock in deals involving C and S corporations. Sellers will want to surface a tax gross up at the earliest stage possible. 2. Because of the pass-through deduction, Buyers are increasingly interested in acquiring a limited liability company as opposed to a corporation. With S corporations, Buyers are regularly asking Sellers to undertake a preclosing reorganization under I.R.C. Section 368(a)(1)(F) and Rev. Rul. 2008-18, I.R.B. 2008-13 (Mar. 7, 2008), to accommodate their preferred post-closing structure. i. S corporation shareholders form a new corporation ( Newco ). i The shareholders contribute all of the stock of the S corporation to Newco. Newco makes a qualified subchapter S subsidiary election with respect to the S corporation so that the S corporation becomes a qualified subchapter S subsidiary ( QSUB ) effective as of the date of contribution. Newco forms a single member LLC which is treated as an entity disregarded from Newco for U.S. federal and state income tax purposes. v. The QSUB merges into LLC in a transaction that is disregarded for income tax purposes. vi. Buyer acquires 100% of the membership interests of LLC, which is treated as an asset acquisition for income tax purposes. 3. The Act made the 100% gain exclusion under I.R.C. Section 1202 permanent. Given this and the lower corporate tax rate, will the use of C corporations become more prevalent? B. Post-Closing Tax Indemnities/Post-Closing Tax Obligations

- 14-1. We continue to see Sellers indemnifying Buyers for pre-closing and transaction-related taxes. However, Buyers are also requesting indemnification for the I.R.C. Section 965 transition tax. i. Did the Target Company properly calculate its foreign accumulated E&P and I.R.C. Section 965 amounts? Were proper elections made related to I.R.C. Section 965? i Is the transition tax being paid on installments? 2. We continue to see tax representations and warranties survive beyond the general survival period which is usually between 12 and 24 months. Tax representation and warranty survival periods continue to primarily be the statute of limitations plus a specified number of days. 3. Buyers seem to be more aggressive in not having checks on voluntary disclosure proceedings or settlement or closing of tax audits that could impact Sellers tax indemnification obligations. C. Estate Tax Considerations 1. Before delving into the impact of U.S. estate tax changes on different types of companies and deals, it is helpful to reiterate a few points that are relevant to many M&A situations: i. Passage of TCJA is expected to increase M&A activity by eliminating uncertainty regarding the level of future tax rates for acquirers and targets, as the lack of clarity in the preceding months about the nature and timing of tax reform may have caused some deal-makers to move to the sidelines temporarily. For tax years beginning in 2018, statutory corporate income tax rates decline to 21% from 35%, while the corporate alternative minimum tax has been repealed. Reduced tax rates inherently increase target company values by providing a larger share of profits to owners. i As was detailed earlier, TCJA allows companies to expense 100% of expenditures on new and used qualified property (i.e., tangible property with a recovery period of up to 20 years, plus computer software) acquired and placed in service from September 28, 2017 through the end of 2022. By lowering near-term tax obligations through higher year-one deductibility for acquired asset costs, this provision makes the economics of some prospective acquisitions more viable for Buyers, especially in manufacturing or other equipment-intensive industries, even when Sellers negotiate for their share of raised tax shield values via higher sale prices.

- 15-2. The federal estate and gift tax exemption allows individuals a specified value of lifetime gifts and assets to pass to their beneficiaries -- estate and gift tax-free. As of 2017, the federal exemption was $5,490,000. Under the new changes, the federal estate tax exemption has been temporarily doubled. As of January 1, 2018, the exemption is now $11,180,000. With careful planning, married couples can gift up to $22,360,000 exempt from federal estate and gift taxes. In 2026, the exemption limits are scheduled to revert to 2017 limits. 3. Given the expected increase in M&A activity, it remains important to use strategic estate planning with a thorough understanding of both the federal and state exemptions so that taxpayers can benefit from the increase in M&A activity. Optimal estate planning for taxpayers who own business assets involves transferring non-controlling interests in those assets to trusts for family members, allowing the appreciation and sale proceeds to be received outside of the taxpayers taxable estate. Ideally, these transfers precede the sale or significant growth by years. Techniques to consider include: Grantor Retained Annuity Trusts (GRATS), Sales to defective grantor trusts and Restructuring of businesses to create voting and non-voting shares. These strategies have proven track records of minimizing estate taxes on heirs and transferring ownership of business assets to children and grandchildren working in the family business.