Cedric C. Fortemps, CFA, Managing Director & Principal, Stephen C. Lynch, CFA, CPA, Vice President and John C. Duni, CFA, CPA, Associate

Click here for a print-friendly PDF version

Introduction
Every strategic business decision, whether as simple as purchasing a single piece of equipment or as complex as buying or selling an entire company, involves careful analysis and the evaluation of a multitude of factors. For most businesses, one pivotal issue often stands out as one of the most difficult to assess: taxes.

The Tax Cuts & Jobs Act [1] (“TCJA”), signed into law on December 22, 2017 by President Trump, not only included broad tax cuts but was also billed as a measure to simplify certain aspects of the U.S. tax code. Unfortunately, as is often the case with tax reform, it requires many hours of research before even beginning to understand the impact of the changes on one’s business. While our objective is not to provide a comprehensive summary of this 185-page piece of legislation, our goal in this issue of the Capital Markets Perspective (“CMP”) is to identify several key provisions included within the TCJA and explore their potential impact on merger and acquisition (“M&A”) transactions in the downstream energy and convenience retail sector. Although not directly related to M&A activity, we have also included a review of the qualified business income (“QBI”) deduction in Appendix A as we believe that many readers could qualify for and benefit from this new tax provision.

While there are many facets of the TCJA, we believe changes in the following provisions could have the largest impacts on the overall M&A marketplace:
• Reduction in the corporate income tax rate,
• Immediate expensing for qualifying capital investments, and
• Limitation on the business interest expense deduction.

We will review these changes in the tax laws and demonstrate how, in our hypothetical acquisition example, a potential buyer could pay 14.7x corporate earnings before interest, taxes, depreciation, and amortization (“EBITDA”) on a transaction that, under the old tax laws, they would have only been able to pay 12.0x in order to generate the same return. Alternatively, for a seller concerned about the impact that recent or near-term increases in interest rates could have on valuations, they may find comfort in the fact that, using certain assumptions, the TCJA could allow a buyer to absorb a 250 basis point increase in interest rates yet still be able to generate the same return on this hypothetical acquisition.

Although this issue of the CMP is intended to discuss both the qualitative and quantitative impacts of certain aspects of the TCJA, it is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Readers should consult their own tax, legal, and accounting advisors before making any decision or taking any action. Moreover, certain components of the new tax reform remain vague, and it is uncertain as to how the IRS will proceed with compliance and enforcement of the new code.

[1] Officially known as: Public law no. 115-97, an Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018

Given the hurried manner in which this legislation was passed, it is possible that Congress will further revise the tax code to update the more nebulous provisions of the TCJA as well as correct some of its unintended consequences.

Base Scenario: Tax Law Prior to the Signing of the TCJA

Throughout this issue, we will use the estimated investment returns, as measured by the after-tax, levered internal rate of return (“IRR”) that may be realized on a hypothetical M&A transaction as a tool to evaluate the potential impacts of the TCJA. These calculations are largely derived from a 10-year projection model for a hypothetical acquisition of a convenience store chain that generates $10 million of corporate EBITDA. We have also assumed that corporate EBITDA grows consistently at 5.0% per year throughout the entire 10-year projection period and that all locations are owned with fee simple real estate interest. See Exhibit 1 for a summary of the other material assumptions that pertain to the underlying projection model.

The Base Scenario presented in Appendix B reflects the tax laws in effect prior to the enactment of the TCJA and forms the basis for which we will compare the effects of this recent tax reform. As can be seen in Appendix B, the IRR over the 10-year projection period in the Base Scenario is approximately 15.5%, which will be the frame of reference for the remainder of our analysis. Scenarios where the IRR is above 15.5% [2] will demonstrate that the acquirer is expected to benefit from the applicable provision of the TCJA.

In addition to the Base Scenario, we have included the following individual scenarios where we isolate the impact that the TCJA will have on future M&A transactions:
• Scenario 1: Reduction in the Corporate Income Tax Rate
• Scenario 2: Immediate Expensing for Qualifying Capital Investments
• Scenario 3: Limitation on the Business Interest Expense Deduction
• Scenario 4: Bringing it All Together – A Cumulative Evaluation of the Reviewed Provisions

Scenario 1: Reduction in the Corporate Income Tax Rate

We begin with an analysis of one of the most significant changes we will be covering, which is the reduction in the corporate income tax rate. One of the fundamental premises of the TCJA is to stimulate growth through supply-side economics. It is theorized that a reduction in corporate income taxes will increase business cash flows, which, in turn, will spark domestic investment and drive economic growth. As a result, the TCJA has reduced the corporate income tax rate for 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 tax rate of 35%.

[2] The Base Scenario IRR is 15.8% when the acquirer can fully realize all tax deductions in the year in which they are generated and is not constrained by the taxable income of the target company.

It is likely no surprise that reducing federal corporate income tax rates from 35% to 21% produces very significant benefits to C-corps. Based on our 10-year projection model, the change in federal corporate tax rates results in the IRR on the hypothetical acquisition increasing 1.7%, from 15.5% to 17.2%. We can attribute approximately one-third of the improvement in the IRR to increased annual cash flows over the course of the 10-year projection. What is not immediately apparent, however, is that two-thirds of the total improvement in the IRR comes from lower taxes due at the end of the projection period when the hypothetical investment is exited. Unlike individuals or pass-through entities, who may pay lower tax rates on capital gains for the sale of certain classes of property, capital gain items for C-corps are generally taxed at ordinary income tax rates. For this reason, the lower tax rate for C-corps as part of the TCJA may potentially spur some C-corps to sell assets and reallocate capital, which may not have otherwise been considered prior to the TCJA.

Additionally, while we will primarily focus on C-corps throughout this issue of the CMP, pass-through entities, which ‘pass through’ their business profits and losses to their owners where those items are ultimately taxed, will generally benefit from lower taxes due to the various provisions of the TCJA. Although we will not be presenting any formal calculations of IRRs for these types of entities, acquirers with a pass-through entity structure are also expected to realize improvements in returns on acquisitions due to lower overall tax rates and other beneficial changes to the tax code, such as the new depreciation tax laws that are covered in Scenario 2. The impact of the TCJA on investment returns for pass-through entities, however, is not likely to be as significant as the improvements realized by C-corps.

Scenario 2: 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 does include meaningful tax law changes that can significantly accelerate tax depreciation deductions.

Before the recent tax reform, 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% [3] 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 regular depreciable life (tax-basis) of 20 years or less. Broadly speaking, this threshold includes most tangible personal property and excludes most real property (e.g. land and buildings).

The TCJA retained the framework of Section 168(k) bonus depreciation but also expanded it in several key ways. First, taxpayers are now allowed to deduct 100% of qualifying property and immediately expense it in the year of acquisition rather than depreciating it over multiple years. Second, 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.

[3] Section 168(k) bonus depreciation rates prior to the TCJA: 2017 – 50%; 2018 – 40%; 2019 – 30%; completely phased out thereafter.

This expansion in the tax code also has important implications in the M&A marketplace, especially in the downstream energy and convenience retail sector due in part to the favorable tax treatment outlined below. 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 anywhere from three years to 39 years. Since the acquired assets were considered used (i.e. not ‘new’) under the prior tax law, no bonus depreciation was allowed. With the enactment of the TCJA, 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.

As indicated in Exhibit 3, property having a depreciable life (tax-basis) of 20 years or less still qualifies for bonus depreciation under Section 168(k). This threshold is important because it captures the substantial majority of retail facilities owned by convenience retailers and petroleum marketers under a special provision [4] designating ‘retail motor fuels outlets’ as 15-year property instead of longer-lived property. While this was a pre-existing concept prior to the TCJA, the current Internal Revenue Code does not define this term, but fortunately, IRS Publication 946 provides additional detail, which is further summarized in Exhibit 4.

In the context of an M&A transaction involving a convenience and gas retailer, such as our example, most, if not all, of the acquired tangible personal property and buildings should qualify for immediate expensing through Section 168(k) bonus depreciation under the TCJA. Notable exceptions to this include land, which is not depreciated, and goodwill, which is amortized on a straight-line basis over a 15-year period.

By expensing the full cost of all equipment and buildings in the year of acquisition, a significant amount of depreciation expense results. In fact, the depreciation deduction is so large that it creates a net operating loss (“NOL”) of over $55 million in our example if we are looking at this transaction on a stand-alone basis where taxable income from the acquirer’s other operations is not considered. Fortunately, this NOL can be carried forward to offset future taxable income; however, under another, separate provision of the TCJA, taxpayers are now limited in their ability to use an NOL to shield taxable income in future years. While we will not be going into great detail about the new NOL tax laws, the modifications under the TCJA include: (i) elimination of the 2-year carryback provision, (ii) extension of the 20-year carryforward provision into perpetuity, and (iii) limiting the NOL deduction to 80% of pre-NOL taxable income. Our projection model has not been designed to isolate the impact of the changes in the NOL carryback and carryforward periods, but it does, however, allow us to model in the impact of only being able to shield 80% of pre-NOL taxable income in future tax years as opposed to 100%, which was possible prior to the TCJA.

In comparing the ability to use the amended 168(k) bonus depreciation deduction, although on a constrained basis as we are limiting the deduction to the target’s income, while also taking the new NOL tax laws into account (Scenario 2a), one can see in Exhibit 3 that the IRR modestly declined by 0.1% to 15.4% versus the Base Scenario’s IRR of 15.5%. One might have expected a larger, and likely positive, change between these two scenarios since we are now expensing 100% of the acquired buildings and equipment in the first year rather than over the course or five, seven, or even 15 years. The primary reasons for the slight decline in the IRR can be attributed to two factors: (i) in this example, the bonus depreciation tax shield realized in Years 2 – 10 is limited due to the new NOL tax laws; and (ii) having a lower basis in the assets at the end of the projection period, which increases taxes on gains when the investment is exited.

In our stand-alone example, while the buyer has the technical ability to fully expense qualifying property in the first year of the acquisition, in practice, it can take multiple years in order to fully realize the benefits of this deduction. In fact, once the new NOL limits are considered, the net, post-NOL depreciation tax shield is less advantageous during the earlier years of the projection period compared to the annual depreciation deductions the acquirer could take if they elected not to deduct the new Section 168(k) bonus depreciation, which, as we previously stated, they can choose not to do. Exhibit 5 compares the depreciation tax shield between the Base Scenario and the current scenario, after factoring how the ultimate depreciation deduction flows through the resulting NOL. By comparing the shape of each curve, one can see that the tax reform has reduced Scenario 2a’s depreciation tax shield during Years 2 – 6 compared to the Base Scenario if the buyer elects to deduct the Section 168(k) bonus depreciation and its tax deductions are limited to the taxable income of the target alone. Also apparent, however, is that the opposite of this occurs during Years 7 – 10 as the NOL in Scenario 2a provides a tax shield that would otherwise be realized over many more years in the Base Scenario.

The above discussion assumes this acquisition is made on a stand-alone basis, which may very well be the case, but once we remove this restriction and operate under the assumption that the acquirer has sufficient taxable income from other operations from which to deduct the large first-year bonus depreciation, we get a much more beneficial impact on returns. If this is the case, the acquirer could deduct the full $60 million of bonus depreciation during the first year rather than being limited to only $5.3 million, with the remainder creating an NOL when this is viewed on an independent, stand-alone basis. If the full bonus depreciation can be realized during the first year (Scenario 2b), the difference in the IRR versus the Base Scenario, as can be seen in Exhibit 3, is now positive and increases by 3.7% to 19.6%. Ultimately, the acquirer’s ability to realize this new bonus depreciation is likely between these two sub-scenarios, as it greatly depends on the amount of taxable income it has from other existing operations.

If the acquirer elects to deduct Section 168(k) bonus depreciation, it can receive a large tax benefit on the front end, but, consequently, additional taxes would result on the back-end when the associated assets are sold. Since this property was fully depreciated in the first year, it will have a basis of zero in all subsequent years. This has little to no effect in most periods, but it does result in a substantially higher tax bill in Year 10 when our hypothetical investment is liquidated. As return metrics are rooted in the time-value of money, they are sensitive to the timing of the cash flows. While paying higher taxes when these assets are sold can appear to be a negative consequence, this is more than offset by receiving the benefits of this bonus depreciation in the earlier years of the projection period.

We have spent a considerable amount of time covering the background and potential benefits of the new bonus depreciation tax laws under the TCJA, but there are some limiting factors to address as well. Primarily, this provision should be seen as temporary until it is further extended. While 100% expensing is available through 2022, the bonus depreciation percentage does step-down between 2023 and 2026 and is fully eliminated by 2027. It is far too early to determine whether Congress will extend this tax provision or modify the step-down schedule, so taxpayers should be abundantly aware of these tax laws and their associated phase-outs and limitations when evaluating M&A transactions or performing more routine capital budgeting exercises.

Although separate from the new Section 168(k) bonus depreciation we have just outlined, the TCJA also expanded another form of immediate expensing of capital assets under Section 179. Under the TCJA, the annual expense limitation under this provision has been increased to $1 million from $510,000, and will be indexed for inflation for tax years beginning after December 31, 2018. Our projection model does not incorporate Section 179 depreciation given the significance of Section 168(k) bonus depreciation within the model, but businesses should be cognizant of the fact that Section 179 expensing has also been expanded as part of the TCJA.

Scenario 3: Limitation on the Business Interest Expense Deduction
Businesses have long-enjoyed the ability to fully deduct interest incurred on their indebtedness. Whether the debt was obtained to fund an expansion, recapitalize the organization, or as part of an M&A transaction, debt capital has historically received favorable tax treatment compared to equity capital, and despite some negative changes as part of TCJA, that still largely remains the case. These changes are especially important to consider today because after a decade of low interest rates, businesses now carry a record amount of debt on their balance sheets [5].

Many provisions of the TCJA are favorable to businesses, but unfortunately, the new limit on the deductibility of interest expense is not. For tax years beginning after December 31, 2017, the interest expense deduction is limited to interest income plus 30% of adjusted taxable income (“ATI”). While the definition of ATI is lengthy, most taxpayers can consider it to be roughly synonymous with corporate EBITDA. This limitation becomes exacerbated for tax years beginning on or after January 1, 2022, where the limitation adjusts to 30% of interest income plus what approximates earnings before interest and taxes (“EBIT”).

It is important to remember that an entity’s pre-tax cost of debt and the amount of debt financing used have a profound effect on the impact of this new limitation. The IRR in Scenario 3, which contemplates the limited deductibility of interest expense under the TCJA, declined by 0.6% from 15.5% to 14.9%. Our proposed transaction assumes the transaction is funded with 35% equity and 65% debt with a pre-tax cost of debt of 6%. We have provided a sensitivity table in Exhibit 7 that shows the difference in IRRs when using varying assumptions related to the acquirer’s debt financing. When increasing the assumptions used for the debt financing percentage or the pre-tax cost of debt, this deduction limitation can become far more consequential. For example, after increasing the acquisition debt to 75% of the total transaction value, which may be possible for real estate-heavy transactions, the disparity between the two scenarios becomes more significant with a decline in the IRR of 1.1%, from 15.5% to 14.4%.

While a blanket exemption exists for businesses with gross receipts of $25 million or less, a ‘real property trade or business’, which includes businesses involved in real property development, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage, may irrevocably elect out of this interest expense deduction limitation. However, the downside of doing so is that it likely prohibits the entity from taking Section 168(k) bonus depreciation. Businesses within the downstream energy and convenience retail sector that have separate real estate holding companies should understand how the exclusions for a real property trade or business may impact – either positively or negatively – the particular tax situations of these entities. While this exclusion is just one example that may initially appear to be beneficial, it should ultimately be considered comprehensively along with other provisions of the TCJA.

Scenario 4: Bringing it all Together – A Cumulative Evaluation of the Reviewed Provisions

Now that we have examined each provision and the associated impacts they individually have on an acquirer’s return on a hypothetical M&A transaction, one may wonder what the cumulative effect is when all of these provisions are considered at the same time. Unfortunately, it’s not as simple as adding up the various incremental changes in each scenario’s IRR since, once all of the provisions are considered, they impact one another. As seen in Exhibit 8, when considering the combined effect of all three provisions on a stand-alone basis, the IRR over the 10-year holding period becomes 17.0%, which is an increase of 1.5% over the Base Scenario IRR of 15.5%. Additionally, if we remove the restriction of the M&A transaction being viewed on a stand-alone basis and assume Section 168(k) bonus depreciation can be fully utilized as a tax shield in Year 1, similar to the approach in Scenario 2b, the difference in IRRs compared to the Base Scenario widens 3.3%, from 15.8% to 19.1%.

The next logical question one may ask is: what are the implications of these improvements on the M&A marketplace? One viewpoint is that potential buyers could, in essence, pass the cumulative effect of these benefits through to sellers in the form of increased purchase consideration. Mechanically speaking, our projection model indicates that post-TCJA acquisition purchase prices could increase between approximately 10% and 22% while still delivering the same IRR that could have been achieved prior to this tax reform. The lower end of this range is when an M&A opportunity is considered strictly on a stand-alone basis, while the higher end of this range is achieved when this restriction is removed and the buyer’s first-year depreciation deduction is not limited in any way. For example, a buyer with the ability to use the maximum benefit of the Section 168(k) bonus depreciation deduction in Year 1 and an IRR hurdle rate equal to that of our Base Scenario (15.8%) could justify paying 14.7x corporate EBITDA as opposed to 12.0x corporate EBITDA due to benefits derived from the TCJA provisions addressed in this issue of the CMP.

We will need to see more transactions completed in 2018 and beyond with the new tax laws being fully considered to determine if buyers are passing along any of the TCJA’s benefits to sellers. However, we believe the benefits provided by this tax reform should certainly help protect buyers from the risk of rising interest rates, which appears imminent as of the date of this publication. With the Federal Reserve increasing its benchmark interest rate, the Federal Funds Rate, twice within the last six months and signaling additional future rate increases, the pre-tax cost of debt financing for most buyers will likely experience increases in the near- to medium-term. When
comparing the Base Scenario versus the cumulative effects of the TCJA, the pre-tax cost of debt in our projection model can rise between 1.5% and 2.5%, depending on the buyer’s ability to realize the bonus depreciation tax shield, before this scenario is at parity with the Base Scenario. While not all future rate increases can be absorbed, we believe the effect of higher interest rates can be partially offset by the more mechanical benefits stemming from the TCJA reviewed herein.

Concluding Thoughts
The select provisions we have examined in this CMP are just a few pieces of the overall puzzle regarding this recent tax reform. Examples of some other factors that may partially dictate the overall impact of the TCJA include changes in the cost of capital, shifts in overall valuations as businesses likely generate higher on-going, after-tax cash flows after this tax reform, and uncertainly regarding future tax changes and/or extensions of some of the TCJA’s temporary provisions.

Although the substantial majority of this issue of the CMP has focused on the impact of the TCJA from the lens of a buyer, the new law certainly also benefits sellers involved in M&A transactions. While the magnitude of these improvements greatly depends on the seller’s legal structure and tax status, the TCJA has lowered tax rates across the board, which will likely result in sellers receiving a greater amount of after-tax proceeds from the sale of their business. Another beneficial improvement for sellers structured as a pass-through entity is that certain transaction-related taxable gains could qualify for the new QBI deduction. We have provided additional information on the QBI deduction in Appendix A, but in summary, after-tax proceeds for pass-through entities could be significantly improved under this new provision of the TCJA.

The TCJA is likely to receive much attention over the coming months and years as it is debated whether this legislation has achieved its overall goals or not. Before that, however, taxpayers and tax practitioners must wade through the myriad of changes brought forth by this tax reform to determine the total impact on their own tax situation or to those of their clients. Overall, while there are many what-ifs and variables to consider, some of which are favorable while others are not, we believe the TCJA will prove to be a net positive for the M&A marketplace and for both buyers and sellers alike.

Disclaimer
The contents of this publication are presented for informational purposes only by Matrix Capital Markets Group, Inc. and MCMG Capital Advisors, Inc. (“Matrix”), and nothing contained herein is an offer to sell or a solicitation to purchase any of the securities discussed. The contents of this publication are presented for informational purposes only. While Matrix believes the information presented in this publication is accurate, this publication is provided “AS IS” and without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranty of merchantability, fitness for a particular purpose, or non‐infringement. Matrix assumes no responsibility for errors or omissions in this Presentation or other documents which may be contained in, referenced, or linked to this publication. Any recipient of this publication is expressly responsible to seek out its own professional advice with respect to the information contained herein.

Matrix’s Downstream Energy & Convenience Retail Group is recognized as the national leader in providing transactional advisory services to companies in the downstream energy and multi‐site retail sectors.

Appendix A
Deduction of Qualified Business Income (QBI) for Pass-Through Entities

Since many of our clients’ businesses are structured as pass-through entities, we would be remiss if we did not provide a brief summary regarding the new deduction of qualified business income (“QBI”) for certain pass-through entities. Overall, the QBI deduction was included as part of the Tax Cuts & Jobs Act to maintain the relative tax difference between pass-through entities and C-corps, the latter of which received a sizable tax cut through this new tax reform.

What Are the Basics of This New Deduction?
Owners of pass-through entities such as partnerships, subchapter S corporations, and sole proprietorships can potentially receive a deduction in the amount of 20% of QBI. As currently drafted, this deduction is available for tax years beginning on or after January 1, 2018 and expires for tax years beginning after December 31, 2025.

What is Qualified Business Income?
Before discussing the specific mechanics of the deduction, we need to define exactly what constitutes QBI. QBI is generally defined as the net amount of income, gain, deductions, and losses with respect to a U.S. trade or business. Excluded from the calculation are: W-2 wages the owners earn as employees of the business, guaranteed payments to partners/shareholders, and any investment-related gains or losses such as capital gains, interest, and dividends.

As noted above, QBI does not include investment-related items such as capital gains or losses. Initially, this seems to limit the ability for taxpayers to apply this deduction to gains realized in certain situations such as the sale of a capital asset, operating division, or even an entire company. Despite that, it appears as though pass-through entities may have the ability to consider some of the gains recognized in these situations as QBI and thus receive a deduction of up to 20% on these items. Not all taxes due upon the sale of business property could be considered QBI, but the depreciation recapture component of the overall gain could fit this definition. While this appears somewhat limited in scope, this type of gain may be significant for certain low-basis property. Since the associated language is vague, lacks corresponding detail from the IRS, and has yet to be tested, taxpayers are highly encouraged to seek guidance from a tax professional before considering this interpretation of QBI.

What Types of Businesses Qualify?
Like many provisions in the tax code, there are caveats and exclusions for nearly everything. In the case of QBI, not all pass-through entities are treated equally for determining the amount of the deduction. In order to receive more favorable tax treatment under this provision, one must first determine that the pass-through entity is not considered a specified service business (“SSB”).

SSBs generally include any trade or business involving the performance of services in the fields of health, law, 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 one or more of its employees or owners. While this appears to be intended to capture many professional service businesses, many feel the boundaries of this language are unclear. Fortunately, we expect the significant majority of pass-through entities operating within the downstream energy and convenience retail sector to fall comfortably outside the definition of a SSB per the TCJA.

While we have discussed SSBs and non-SSBs, there is also a third pass-through entity classification that can qualify for the QBI deduction. Under this new provision, qualifying income from REIT dividends and income from qualified
publicly traded partnerships (“PTP”) is also eligible for the QBI deduction. While this could be an afterthought for some, an important takeaway from this is that entities structured as master limited partnerships (“MLP”) are considered to be a PTP; thus, distributions paid to their limited partners or investors that would otherwise be taxed at ordinary income rates will now qualify for the 20% QBI deduction.

What Limitations May Exist?
As shown below, the classification of one’s pass-through entity and taxable income level can dictate a great deal concerning QBI deduction eligibility. The thresholds for single taxpayers as well as those filing married filing jointly (“MFJ”) have been presented below, but for simplicity, we will reference the thresholds for MFJ taxpayers and only non-SSBs given their relevance to our analysis.

As can be seen in the above summary, three ranges of taxable income exist. Taxpayers in the first tier, with taxable income less than $315,000 (MFJ), are eligible for the full 20% QBI deduction regardless of how their pass-through entity is classified. However, once taxable income increases beyond $315,000 (MFJ), one’s QBI deductibility starts to become more complicated.

For discussion purposes, it is easier to jump to the third taxable income range, which includes individuals with taxable income above $415,000 (MFJ). Non-SSBs are eligible for the full 20% QBI deduction but are limited to the greater of two tests, which, on a simplified basis, are: (i) 50% of W-2 wages or (ii) 25% of W-2 wages plus 2.5% of the unadjusted basis of all qualified property. Assuming a pass-through entity has a sufficiently large labor force and/or broad enough asset base, its owners should generally receive a large portion of the QBI deduction, if not the full 20%. For non-SSB taxpayers that can deduct the full 20% QBI deduction, their effective top marginal tax rate on their pass-through entity income is 29.6%.

The two limitations mentioned above regarding the extent of the QBI deduction allow certain types of companies in the downstream energy and convenience retail sector to be able to realize the full deduction more so than others. The limitations show preference to those companies that are more labor and capital intensive (e.g. an owner and operator of a convenience store chain) as compared to those that are more asset and operationally light (e.g. a fuels distributor with a limited asset base). This is not to say that these leaner companies will receive no benefit from this new tax provision, but rather, the ability to receive the full QBI deduction may be more difficult to achieve.

Taxpayers whose taxable income falls between $315,000 and $415,000 will find themselves in the second income range as indicated in the preceding summary table. While a series of complicated formulas dictate the ultimate outcome, the mechanics are rather simple. Within this range, owners of non-SSBs will gradually start to phase in the limitations outlined above.

Lastly, it is important to note that there does not appear to be a limitation on the QBI deduction associated with qualifying REIT dividends and PTP income, at least in isolation. There are many additional rules to consider that could ultimately limit one’s QBI deduction, but as those potential limitations are highly individualized, we have not considered them for this high-level overview.

Final Thoughts
The QBI deduction has already generated a large amount of confusion among business owners. Much of this is due to how quickly the legislation was drafted and the resulting gaps, inconsistencies, and unintended consequences of the enacted language. While our discussion has only provided a broad summary of several key components of the new QBI deduction, there are many more layers and intricacies embedded within this new tax law. As always, readers should consult their own tax, legal, and/or accounting advisors before making any decision or taking any action.

Appendix B – Projection Models

Securities offered by MCMG Capital Advisors, Inc., an affiliate of Matrix Capital Markets Group, Inc., Member FINRA & SIPC
Copyright © 2018 Matrix Capital Markets Group, Inc. All rights reserved.