What Does the GOP Tax Reform Proposal Mean for Businesses in Transition?

by Ann Hanna

Business transition plans could be affected by proposed tax reform changes.

House Republicans recently released a sweeping tax reform bill over 400 pages long making significant changes to individual and business taxes. If passed it would be the first overhaul to our tax system in over 30 years. Legislators have made tax reform their top legislative priority and are dedicated to passing this major piece of legislation before year-end.

The bill contains extensive changes to personal, estate, transfer and international taxation issues. How will this affect business owners who may be transitioning their businesses at some point in the future? Below we address what we believe may be the most significant proposals: 

1. Corporate tax rate changes

Changes proposed are as follows:

Type of entity Proposed tax rate
C corporation Flat 20%
Personal service corporations Flat 25%
Pass-through corporations (S-corp & LLC) passive owners Flat 25%
Pass-through corporations (S-corp & LLC) active owners Using safe harbor* 30% of income at 25% and 70% income at ordinary income rate (max 39.6%) Blended top rate 35%

 * Optional return of capital method also offered which may give better results

The majority of our clients are lower and middle-market companies with active owners who are organized as S corporations or LLCs. The potential disparity in rates between C corporations and pass-through entities could cause many businesses to consider changing their structure.

If this occurs, the challenge will arise when those C corporations are sold in an asset sale. A sale of a C corporation potentially creates a higher tax liability due to the double taxation which occurs—first on corporate taxable income due to the gain on sale of assets, which is at ordinary corporate rates, and again on shareholder dividends or liquidating distributions. There does not appear to be any changes addressing this double taxation issue.

Lower tax rates for C corporations may make these entities more willing to sell assets or subsidiaries to a prospective buyer. Lower tax rates for corporations may also make corporations more useful as an acquisition vehicle, as compared to partnerships or LLCs.

2. Capital gains tax

The top question we receive as a result of the tax reform proposal is: Will the capital gains rate decline and should I delay the sale of my business? As currently proposed, top capital gain tax rates remain at 20% and the net investment income tax of 3.8% remains intact. The bill does expand the amount of capital gains that qualify for the zero and 15% brackets.

3. Non-deductibility of interest payments for corporations

The tax plan suggests limiting the corporate tax deduction for interest payments to 30% of EBITDA. On the surface, this may appear to be a fairly generous number…in a good year. However, as we all remember from the previous great recession, business profitability can be cyclical and business owners could lose interest deductions when they are most needed.

Debt plays a large role in M&A transactions and the loss of interest deductions would make companies think differently about how they structure acquisitions, especially in the private equity sector where leverage is critical. Restricting interest deductions also could make acquisitions of U.S. companies by foreign buyers somewhat less attractive because of a reduced ability to leverage the U.S. target.

4. International repatriation of cash to the U.S.

The bill proposes shifting to a system in which much of future foreign earnings could be repatriated tax-free through a 100% dividends-received deduction. There is also a suggested one-time tax on previously unrepatriated foreign earnings at 12% of cash and cash equivalents and 5% on the remainder. A lessening of the burden on repatriation of cash for U.S. tax purposes may make currently cost-prohibitive dispositions of foreign operations more likely to occur.

So what does this mean for the average middle-market business owner?

There are many business owners sitting on the sidelines hoping for lower capital gains rates. Currently there is no motivation to delay the sale of your business to capitalize on more favorable capital gains treatment. At this stage there is no change proposed which will lower the top capital gains rates.

If you are planning on a sale in the next three to 10 years, you may be faced with a decision on changing your structure to a C corporation to obtain favorable tax rates. This may present a disadvantage when it comes time for a sale as many buyers prefer an asset sale. At the very least, you lose structure flexibility.

If you are planning on future acquisitions, leverage is going to be a less favorable, riskier vehicle. If you are a seller, the risk introduced by the possible reduction in deductibility of interest may also dampen the private equity market and ability to offer premium pricing.

Finally, it appears some long-awaited relief may be coming if you have profits trapped overseas. Disposing of foreign operations may be more favorable as well.

That being said, this bill is far from a finished product and the only thing we know for certain is that the final bill will contain many changes and compromises. Our suggested current action is to talk with your CPA, tax advisors and congressmen as tax reforms provisions evolve through the process.

For more information or to better understand your options related to transitioning your business, please contact Ann Hanna, managing director & owner, at ah@taureaugroup.com or any member of the Taureau Group team at 414-465-5555.