A Refresher on the Tax Cuts and Jobs Act Federal Tax Structure: A Steadying Force on the M&A Market Amidst an Uncertain Economic Backdrop

November 30, 2023

By: David L. Corbett, CFA, Director
M. Vance Saunders, CPA, Managing Director
Downstream Energy & Convenience Retail Investment Banking Group

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The U.S. Federal Reserve has raised the benchmark federal funds rate a total of seven times in 2022 and four times so far in 2023 in an effort to combat inflation rates, which have been at a level the United States hasn’t experienced in decades. The rapid increase in the federal funds rate, which had been near zero since 2009, has understandably received substantial coverage in the media, and the impact of higher interest rates on both corporate and personal finance has also been well documented. Interest rates still remain moderate relative to longer-term averages, but the recent prolonged period of abnormally low rates have reprogrammed perspective for many people. Corporate finance theory would tell you that all else being equal, higher interest rates increase the cost of capital, which should lower valuations of businesses and likely result in reduced M&A transaction volume. Recently, this has proven to be true in many other industries; however, the market for petroleum marketing businesses has actually remained very robust. Businesses in the industry have continued to perform well despite the uncertain economic backdrop and volatility in the public equity and debt markets.

It is important to remember that a key driver of continued strength in M&A valuations, and ultimately volume, since 2018, has been tax rates that are very favorable by historical standards. Some of these favorable tax treatments are beginning to phase out, while for others there is simply uncertainty surrounding how much longer they will be in place.

The Tax Cuts and Jobs Act of 2017 (“TCJA”) was signed into law in December 2017. Due to the passage of time, it’s easy to lose sight of the fact that this extensive tax code overhaul made it more attractive to sell a business from a net proceeds perspective and also provided substantial incentives to acquire a target business from a buyer’s perspective. This issue of Capital Markets Perspective provides a refresher on some of the changes that were made to the tax code as part of the TCJA and highlights why those considering an exit in the near/medium term should keep the favorable tax treatment that currently exists top of mind when comparing the tax implications of a sale relative to historical rates or where rates may be in the future. Some of the key business friendly provisions of the TCJA are summarized below:

Reduction in the Corporate Income Tax Rate
The TCJA reduced the income tax rate for C-corporations (“C-Corps”) to a flat 21%. Prior to the TCJA, C-Corps paid income taxes on a graduated rate schedule with a top marginal federal income tax rate of 35%. The chart below provides a snapshot of the top federal corporate tax rates in the United States from 1973 – 2023 and puts into perspective how favorable the current flat 21% corporate rate is when compared to top marginal tax rates as high as 48% in the 1970’s. Unlike individuals or pass-through entities, which may pay lower tax rates on capital gains for the sale of certain classes of property, capital gains for C-Corps are generally taxed at ordinary income tax rates. As a result of the lower corporate tax rate in effect today, C-Corps retain a higher portion of their operating cash flows to either reinvest in their businesses or distribute to shareholders. When all other factors remain the same, the lower corporate tax rate allows buyers structured as a C-Corp to pay more for an acquisition, while still achieving a targeted after-tax return relative to what was possible prior to the TCJA. This factor also helps to mitigate the impact of currently prevailing higher interest rates and corresponding interest expense. While the 21% C-Corp tax rate does not have a sunset provision as part of the TCJA, the threat always remains that new tax laws could be passed, particularly given the burgeoning national debt.

Changes to Individual Income Tax Provisions
The TCJA lowered most individual income tax rates as well, including the top marginal rate from 39.6% to 37.0%. The law maintained the historical seven bracket structure, but the income thresholds were updated along with the tax rates, in most cases being favorable to the taxpayer. In 2026, based on the sunset provisions of the TCJA, individual income tax rates will revert to their 2017 levels.

Immediate Expensing for Qualifying Capital Investments
Prior to the TCJA, most property acquired in a trade or business was generally capitalized and recovered over time through annual depreciation deductions. While that construct has remained unchanged, the TCJA did include meaningful tax law changes that can significantly accelerate tax depreciation deductions.

Before the TCJA, Section 168(k) of the tax code allowed for additional first year ‘bonus depreciation’ to be deducted on certain qualifying property. Under this provision, 50% of the adjusted basis of ‘original use’ property, which was considered to be new rather than used property, could, but was not required to, be depreciated and expensed during the year in which it was acquired. An asset could qualify for this bonus depreciation under a few different tests, but the broadest and most applicable characteristic was for the property to have a MACRS (Modified Accelerated Cost Recovery System) tax depreciable life of 20 years or less. Broadly speaking, this threshold includes most tangible personal property and excludes most real property (e.g. land and buildings – although buildings for retail motor fuel outlets typically qualify as 15-year property). A retail motor fuel outlet in this context is defined as a facility that 1) is used to a substantial extent in the retail marketing of petroleum or petroleum products, whether or not it is also used to sell food or other convenience items and 2) meets any one of the following three tests: i) is not larger than 1,400 square feet, ii) 50% or more of the gross revenues generated from the property are derived from petroleum sales, and iii) 50% or more of the floor space of the property is devoted to petroleum marketing sales.

The TCJA retained the framework of Section 168(k) bonus depreciation, but also expanded it in several key ways. First, taxpayers were allowed starting in 2018 and through 2022 to deduct 100% of qualifying property and immediately expense it in the year of acquisition rather than depreciating it over multiple years. As of 2023, this provision is now in a stepdown period whereby smaller percentages of bonus depreciation can be taken in year one. The following is the schedule of year-one expensing of qualifying property over the next four years: 2023 (80%), 2024 (60%), 2025 (40%), 2026 (20%). The second key provision was that the requirement that the property must be ‘original use’ was removed, which allows complete first year expensing of qualifying assets, regardless of age, so long as it is the taxpayer’s first use of the property.

This expansion in the tax code has had important implications in the M&A marketplace, especially in the downstream energy and convenience retail sector due in part to the favorable tax treatment afforded to retail motor fuel outlets. Prior to the TCJA, the buyer in an M&A transaction, (assuming it was structured as an asset sale or a stock sale with a 338(h)(10) election), would step‐up the tax basis of the acquired assets and depreciate them over time subject to the normal depreciable life of each asset, which typically spans three to 39 years. In the case of retail motor fuel outlets, buildings are typically treated as 15-year MACRS property. Since the acquired assets were considered used (i.e. not ‘new’) under the prior tax law, no bonus depreciation was allowed. Buyers in this same situation can now immediately expense qualifying assets and potentially realize the associated tax shield well in advance of what was possible prior to the TCJA.

While the bonus depreciation provision has begun its stepdown period from the prior 100% that was in place through 2022, it remains a very favorable tax treatment for acquirors of businesses in the downstream energy and convenience store sector, which should continue to support valuations in the near term. Conversely, the currently slated elimination of bonus depreciation in 2027 could have an impact on M&A activity and valuations. While it’s possible legislation could be put in place in the interim to avoid the elimination of bonus depreciation, it is something that both sellers and buyers should have on their radar.

Qualified Business Income Deduction
Section 199A of the TCJA was designed to provide tax relief through a Qualified Business Income Deduction (“QBI”) to sole proprietorships and pass through entities such as S-Corporations that did not receive the benefit from the reduction of the federal corporate tax rate to 21%. There is quite a bit of nuance in terms of the practical application of the QBI that is beyond the intended scope of this CMP, but generally speaking, the deduction is equal to the lesser of 20% of qualified business income plus 20% of qualified real estate investment trust (“REIT”) and qualified publicly traded partnership (“PTP”) income, or 20% of taxable income, less net capital gain. QBI is the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer; however, it does not include any qualified REIT dividends or qualified PTP income. Combined QBI is the aggregate of the deductible amount for each of a taxpayer’s qualified trades or businesses plus 20% of the taxpayer’s aggregate REIT dividends and income from PTPs.

Like many provisions in the tax code, there are a number of caveats and exclusions that impact the application of the QBI provision. Fortunately, the majority of businesses in the downstream energy and convenience retail sector sit outside of the exclusions and would be likely to take advantage of the provision, subject to certain limitations. The QBI provision is currently set to expire on December 31, 2025.

Conclusion
While rising interest rates and turbulent conditions in the public equity markets have captured the lion’s share of headlines and consumed the focus of many so-called economic pundits, the fact that the corporate tax code remains extremely favorable and conducive to M&A activity is often lost. The TCJA tax code changes that have been in place since 2018 continue to serve as a very compelling reason for owners of petroleum marketing businesses that are considering a sale or divestiture to execute on a plan in the near term and capitalize on the benefits before some of those provisions sunset or are otherwise modified.

As always, readers should consult their tax, legal, and/or accounting advisors before making any decision or taking any action.

About Matrix Capital Markets Group, Inc.
Founded in 1988, Matrix Capital Markets Group, Inc. is an independent, advisory focused, privately-held investment bank headquartered in Richmond, VA, with additional offices in Baltimore, MD and New York, NY. Matrix provides merger & acquisition and financial advisory services for privately-held, private-equity owned, not-for-profit and publicly traded companies. Matrix’s advisory services include company sales, recapitalizations, capital raises of debt & equity, corporate carve outs, special situations, management buyouts, corporate valuations, and fairness opinions. Matrix serves clients in a wide range of industries, including automotive aftermarket, building products, car washes, consumer products, convenience retail, downstream energy, healthcare and industrial products. For additional information or to contact our team members, please visit www.matrixcmg.com.

Disclaimer
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