The further in advance you start your tax planning, the more you can accomplish. Aside from the benefits you stand to gain in your yearly operating results, tax planning is also a vital way to protect business value when the time comes to sell.
One common strategy is to use favorable tax accounting methods or annual elections to defer taxes, which bolsters cash flow by reducing your tax liability. Doing so can have a significant impact on your business. These deferrals create benefits in the near-term that accumulate and then reverse, or become due, at some point in time.
If your company pursues a transaction, these deferrals will fall directly on the radar in deal negotiations—so it’s important to understand where they originate, how they work, and how to best manage them over the long term.
Creating the Deferral
Fundamentally, a tax deferral allows a business to delay paying taxes until some future period—sometimes decades later. The hope is that the company will be taxed at a lower rate in the future, or that it can at least reduce the total amount by choosing when it pays. Deferrals can be the equivalent of kicking the can down the road, and while this may create concern for conservative business owners, it often means keeping more cash in your pocket today, which can be worth the money later.
Most tax deferrals are created either through an election during the annual tax planning process or by identifying beneficial accounting methods to handle ongoing transactions. Taking advantage of tax deferrals has typically been beneficial in the high-tax environments common today. Deferring taxes into the future creates more cash flow that can be immediately reinvested into the company.
One example of a tax strategy many trucking companies have enjoyed over the years involves taking accelerated depreciation on trucks and trailers. For the past decade, the IRS allowed businesses to take bonus depreciation, which typically allowed over half the cost of a new asset to be expensed in the year of purchase. The Protecting Americans from Tax Hikes (PATH) Act of 2015 extended companies’ ability to use this benefit, with some modifications, through 2019.
Another IRS provision—Section 179 expensing—allows some businesses to expense up to $500,000 of truck and trailer purchases (along with certain other capital assets) in the year of acquisition. The PATH Act made this provision a permanent part of the US tax code. These accelerated depreciation strategies allow companies to expense most of an asset’s cost in the first three years of ownership, oftentimes in the first year.
Current tax law generally allows transportation companies to compute revenue and deduct expenses in different ways. Some trucking companies use the cash method of accounting; others choose to expense certain balance sheet items when they’re purchased, such as tires, trailer decals, and other prepaid expense items.
These tax positions leave a company with an asset on their books with little to no tax basis, resulting in a deferred tax liability, which is where carefully managing deferrals becomes important.
Managing Tax Deferrals
Some of these tax deferrals aren’t rocket science. However, owners and CFOs don’t always actively track and manage tax deferrals, which can cause trouble later. Some types of business entities (such as C corporations) are required to book tax deferrals on their balance sheet. This provides visibility into the volume of cumulative deferrals, but it doesn’t necessary result in their proper management. Other types of businesses aren’t required to book tax deferrals on their balance sheet; as a result, their tracking is often lost in the year-end shuffle.
It’s important to chart all your business tax deferrals on an annual basis and to manage them carefully. Because tax deferrals are often driven by annual decisions and elections, revisiting them annually can help you manage them appropriately to meet your cash flow needs while reducing tax. With some of these elections (less so your accounting methods), you’re free to adapt your strategy based on changes in tax laws that take place every year.
Neither generally accepted accounting principles nor the IRS require limited liability companies (LLCs) or S corporations—both increasingly popular ownership types for transportation companies—to report the total amount of the cumulative timing differences on their tax returns. Therefore, most owners of LLCs and S corporations have no idea if they owe a future tax liability or own a future tax asset at any given time. For better or worse, these deferrals often don’t become an issue until the transportation company is sold.
What Happens to a Tax Deferral in the Event of a Sale?
Sellers may be hit with a significant tax liability (or buyers may inherit one) if they don’t properly answer this question before entering into a transaction. Either way, such a discovery could significantly change the landscape of a deal negotiation. So as a buyer or seller, it’s critical to understand the financial impact of taxes on a deal so you can negotiate accordingly.
Typically, a sale can be structured to pass a deferred tax liability on to a buyer or to reverse upon sale, creating an additional tax liability for the seller. In a perfect world, a deal would be structured with both the buyer’s and seller’s interests perfectly aligned; however, this is rarely the case. More typically, where one party receives a benefit, the other party is giving up some form of consideration. This is why tax deferrals and tax structure are always included as part of a deal negotiation.
Two Sides to Every Transaction
The seller’s view. Generally speaking, taking advantage of accelerated depreciation and corresponding tax deferrals will result in a low tax basis in a fleet. When the fleet is sold, the gain results in ordinary income, which is taxed at higher rates. This is where tax deferrals reverse, resulting in a significant tax liability to the seller. Any purchase price allocated to intangible assets generally results in capital gain, which is taxed at a much lower tax rate. With this in mind, a seller will typically try to negotiate an allocation of purchase price that reduces the amount of gain allocated to the trucks and trailers and increases the portion of the gain allocated to intangible assets (more on allocation below).
The buyer’s view. Buyers rarely want to structure a transaction that results in them inheriting the seller’s tax deferrals. Because of this, deals are often structured so the seller bears the burden of the tax deferrals. This transaction structure is treated as an asset sale for tax purposes. (Note that certain elections make it possible to treat a stock sale as an asset sale for tax purposes only.) Buyers often push for a structure that steps up (or increases) the basis of the assets purchased. This basis step-up results in future tax deductions for the buyer, and it directly factors into the buyer’s anticipated return on investment and valuation of the company.
A greater step-up often results in more tax gain for the seller. This is where deal negotiations become critical. Both buyer and seller should enter the negotiation understanding the economic value each party places on the basis step-up in a transaction.
Purchase Price Allocation
Though often overlooked in planning a transaction, the purchase price amounts allocated to tangible and intangible assets taxed as part of an asset sale can have a material tax effect to both the buyer and the seller. Sellers should negotiate and agree with buyers regarding how the purchase price will be allocated prior to the close of a transaction, and the agreed-upon tax allocation should be included as part of the final purchase agreement.
Remember that agreed-upon purchase price allocations made for tax purposes may not be consistent with the acquisition accounting requirements necessary for financial statement reporting purposes. The IRS requires these allocations to be made based on asset fair market values, and it will typically honor a negotiation between two unrelated parties as to the determination of the fair value of the assets. In other words, the IRS will typically honor a purchase price allocation as long as the buyer and seller both agree on the allocation and determination of the fair value of the assets in the deal.
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Tax deferrals can be an important tool for managing cash flow; however, it’s critical they’re understood and planned properly, especially in the context of a sale.
When the time comes to cash in, get your tax advisor involved early. In doing so, you’ll be able to take steps to make the most of your tax assets and address your liabilities, prepping you for a successful and fruitful sale. To learn more, contact your Moss Adams professional.