The CARES Act: Tax implications for transactions and private-equity-owned portfolio companies

The federal government recently enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act as part of its ongoing effort to help businesses and individuals weather the economic storm caused by COVID-19. The new law focuses on helping businesses keep more cash on hand by allowing them to utilize tax losses more quickly, claim additional tax deductions, earn new tax credits, and defer tax payments. The CARES Act changes have their biggest impact in the 2019 and 2020 tax years, but certain provisions could modify tax returns for several additional prior years.

Private equity firms should focus their CARES Act implementation efforts in two areas:

1. Making sure that portfolio companies take full advantage of the assistance that the CARES Act tax changes offer, and
2. Managing the impact of tax adjustments in past, present, and future years on the transactions.

Here’s a look at how some of the key provisions affect portfolio company tax liabilities and transactions.

Utilization of net operating losses (NOLs)

The CARES Act accelerates the use of NOLs by:

1. Allowing taxpayers to carry NOLs created in 2018, 2019, or 2020 back to the five years preceding the loss year.
2. Removing the 80% limitation on the use of NOLs for tax years before 2021.

Portfolio company impact

• Portfolio companies should work with their tax professionals to review NOL carryback opportunities. The IRS has released guidance for taxpayers claiming NOL carrybacks as a result of the CARES Act.
• In general, it’s advantageous to carryback NOLs. However, there are some tax provisions that can mitigate or eliminate the benefits of an NOL carryback. The qualified business income deduction, global intangible low-taxed income, and the base erosion anti-abuse tax are just a few of the provisions that can make an NOL carryback less attractive.
• To the extent it’s disadvantageous to carryback NOLs, an irrevocable election to forgo the carryback can be made.

Transaction impact

• Purchase agreements from 2018 and 2019 should be reviewed to determine the appropriate recipient of any refunds generated from NOLs carried back from those tax years. If NOLs were originally carried forward in accordance with the law at the time, the value to the buyer may be reduced when the seller obtains the benefit of the carryback. Buyers may also be responsible for amending any returns filed since the transaction that utilized the carryforward. Buyers may want to negotiate an adjustment to reflect the lost benefit of the carryforward as well as the payment of any professional fees incurred to determine the amounts and file the amended returns.
• Stock deals often generate NOLs in the year of the transaction due to short periods and the recognition of transaction costs inside the target. Parties to transactions in 2020 should factor in the value of NOLs based on how much of the NOL remains after carrybacks and the usability of NOLs in 2021 and beyond (once CARES Act provisions expire), as well as any, Section 382 limitations that will continue to apply in change in ownership scenarios.

Increased business expense limitations

The Tax Cuts and Jobs Act of 2017 (TCJA) imposed a limit on the business interest expense beginning in 2018. The CARES Act generally increases the TCJA limitation from 30% of ATI (adjusted taxable income) to 50% of ATI for 2019 and 2020.

This increase will not apply to partnerships in 2019. Instead, partnerships will apply the limitation using 30% of ATI for 2019, and any corresponding excess business interest expense (EBIE) is subject to a special rule at the partner level. Affected partners will be able to deduct 50% of such EBIE in 2020. The remaining 50% of EBIE will be subject to the normal carryforward rules. A partner may elect out of that special rule relating to EBIE allocated by the partnership in 2019. Partnerships will be eligible to utilize the increased limitation based on 50% of ATI in 2020.

Portfolio company impact

• Overall, this change will benefit businesses by permitting them to deduct more interest expenses from taxable income.
• The rules permit taxpayers to use their 2019 ATI to calculate the interest limitation on their 2020 tax returns if it provides a better result. This will allow businesses that were more profitable during 2019 than 2020 to further increase their business interest expense deductions in 2020.
• IRS is expected to issue guidance on the interest expense limitation shortly. Portfolio companies should consult with their tax advisors to evaluate whether the application of these regulations to their 2019 tax year could increase ATI for 2019, which could then be utilized in 2020 as well.

Transaction impact

• Upon exit from a partnership, EBIE is added to outside basis to reduce overall gain on the sale of the partnership interest. However, the reduction in gain may be a reduction to capital gain versus ordinary income.  With the ability to deduct additional current year interest and 50% of EBIE in 2020, those potential capital deductions upon sale may become ordinary deductions during operations.
• EBIE in a C corporation is transferred to a buyer in a stock sale and is subject to Section 382 limitations. Buyers may be reluctant to place a value on EBIE at the time of the stock sale due to the uncertainty that EBIE will be freed up in future years. After the CARES Act, the “lost” value in EBIE at close should be reduced.

Qualified improvement property (technical correction)

The CARES Act fixed a drafting error in the bonus depreciation provisions of the TCJA. Qualified improvement property is now eligible for both 100% bonus depreciation and a 15-year recovery period if bonus depreciation isn’t claimed. The TCJA failed to include qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property among the assets eligible for bonus depreciation, despite an apparent intention to do so. As a result, this property has generally been depreciated over a much longer 39-year recovery period without the benefit of bonus depreciation since the TCJA became law. This correction is also retroactive to the enactment of the TCJA.

Portfolio company impact

• Portfolio companies should work with their tax advisors to determine whether opportunities exist to claim additional bonus depreciation for all relevant years, whether on original returns, amended returns, or through changes in accounting method.
• 100% bonus depreciation on qualified improvement property will often generate significantly higher depreciation deductions, which may in turn lead to NOLs. See the previous discussion for more on how the CARES Act makes such losses even more valuable due to new loss carryback rules.

Transaction impact

• Purchase agreements from completed transactions should be reviewed to determine the appropriate recipient of any refunds generated from this technical correction.  The parties should also consider the mechanism used to adjust this item on tax returns that have already been filed. 
• Consider specifying in purchase agreements which party will receive tax refunds for pre-close periods that aren’t amended until after closing. The recipient of the benefit is likely the party which should bear the professional fees for amended tax return or changes in accounting methods.

Deferral of employer payroll tax and self-employment taxes

The CARES Act allows certain employers to defer the deposit of the employer’s portion of the 6.2% Social Security tax for the remainder of the 2020 calendar year. The deferral applies to any amounts not yet deposited as of March 27, 2020. 50% of the deferred taxes are due by Dec. 31, 2021, while the remainder must be paid by Dec. 31, 2022. If a company reporting on a calendar-year tax basis takes advantage of the full deferral period and does not pay any of the deferred portion of the payroll taxes until sometime after Sept. 15, 2021, the company will not be able to deduct the payroll taxes until the time of payment.

Portfolio company impact

• Portfolio companies should work closely with their payroll tax providers to determine eligible deferral amounts. Employers should also keep in mind that this is, in effect, a 33-month interest-free loan. For many businesses, it will result in a significant liability that will have to be repaid before the end of 2022.

Transaction impact

• For transactions closing before Dec. 31, 2022, the agreement will need to specify which party will repay any deferred payroll tax liability. This may result in an adjustment to purchase price, especially in equity transactions. It’s also possible that future regulations may limit the ability of parties to transfer this liability.
• To the extent sellers in an asset sale claim the deduction at close, it would be treated as an ordinary deduction that may offset ordinary income triggered by the sale. This could potentially impact payments that buyers are making for incremental taxes.
• Adjustments to EBITDA may be needed to the extent that the deferred payroll tax liability isn’t expensed for book purposes because payroll taxes will be different than normal operations.

Employer tax credits for employee retention

The CARES Act created a refundable payroll tax credit designed to help employers continue to pay employees when operations were curtailed or halted by COVID-19 restrictions. The credit is equal to 50% of eligible wages, including healthcare expenses, paid to employees. Eligible wages are limited to $10,000 per employee, leading to a maximum credit of $5,000 per employee. For employers with more than 100 employees, only wages that are paid to employees who didn’t provide services as a result of either eligibility event described below are eligible for the credit. Qualified wages are limited to those paid after March 12, 2020. Wages included in the employee retention credit aren’t allowed to be included in certain other employment-related credits. In addition, taxpayers taking advantage of a covered loan under section 7(a) of the Small Business Act such as the Payment Protection Program are not eligible for this credit.

To be eligible for the credit, an employer must be either:

1. Carrying on a trade or business during 2020, or
2. A section 501(c) organization are entitled to the credit.

In addition, the eligible entity must be affected by COVID-19, which can be demonstrated in one of two ways:

1. The operation of the employer’s business must be partially or fully suspended due to government orders which limit commerce, travel, or group meetings due to COVID-19, or
2. The gross receipts of the business in the quarter must have declined to less than 50% of the gross receipts from the same quarter in the prior year.

An entity whose eligibility is based on a full or partial suspension of operations will remain eligible only until it’s no longer suspended. The definition of “partially suspended” is not provided in the CARES Act. The IRS has issued frequently asked questions providing that the term includes circumstances where “the operation can still continue to operate but not at its normal capacity.” Given the broad reach of many state orders that have been issued, it’s possible that most businesses would qualify as partially suspended under future guidance.

For the gross receipts test, a business remains eligible through the quarter in which gross receipts exceed 80% of the gross receipts from the same quarter in the prior year (but in no cases can this extend beyond Dec. 31, 2020). Quarterly gross receipts are not something that most businesses are ordinarily required to measure for income tax purposes. Additional accounting and tax procedures may be required to determine the amount of gross receipts in the relevant quarters of both 2019 and 2020. Further, an entity won’t know whether it will fall below the 50% threshold until the quarter is complete, so it may have to delay the application of the credit unless it also qualifies as fully or partially suspended during the quarter.

Cash flow from the credit

The retention credit is a refundable payroll tax credit. An employer is permitted to retain payroll taxes and withholdings up to the amount of the credit in order to keep cash on hand when wages are paid. An employer is permitted to retain any amounts that would otherwise be due to the federal government, including:

• Employee and employer share of social security taxes,
• Employee and employer share of Medicare taxes, and
• Employee Federal income tax withholding.

The retained amounts can be related to any wages paid for the period and do not need to relate to the qualified wages.

To the extent that there are not enough withholdings to cover the full amount of the credit, the employer can either (1) wait until the end of the quarter and request a cash refund with its quarterly payroll tax return or (2) file Form 7200 to obtain an advance refund for the credit. Form 7200 can be filed as late as the end of the month following the end of the quarter, but can also be filed multiple times during the quarter in order to obtain refunds more contemporaneously with when the qualified wages are paid. The IRS has indicated that it expects to process refund claims within about 2 weeks, but specific details have not yet been provided.

The IRS has issued Notice 2020-22 providing that an employer will not be subject to any failure to deposit penalties with respect to payroll taxes retained in an amount equal to the anticipated credit. It isn’t clear how this penalty relief will apply in situations where an employer miscalculates the available credit or where it loses its eligibility at a later date.

In any case, the credit is reported and reconciled on each quarterly payroll tax filing. The IRS has indicated that reporting for the credit will begin with the second quarter payroll tax filings, so it’s not yet clear how the credit will be reported for wages paid form March 12, 2020 through March 31, 2020.

Portfolio company impact

• Portfolio companies should consider whether the possible assessment of failure-to-deposit penalties on any required credit repayments would be mitigated by requesting advance payments of credits rather than retaining payroll taxes. Employers that lack good data to calculate credits or that are at a high risk of becoming disqualified may also consider accessing the credit by requesting refunds on quarterly payroll tax filings to avoid the imposition of penalties.
• These employer tax credits should also be evaluated in conjunction with other credit opportunities that were created by the Families First Coronavirus Response Act.

Transaction impact

• Buyers will need to determine if the target company is eligible for the credit pre- and post-transaction and if EBITDA will need to be adjusted during the quality of earnings analysis as historical payroll tax expense may not reflect payroll tax expense after the credit period. Additional payroll tax due diligence may be warranted to the extent sellers have taken these payroll tax credits to determine if there are any potential exposures relating to either qualifications or calculation of the credit.
• The tax credit is expected to be included in taxable income. Buyers might perceive this as phantom income if the seller’s received the economic benefit of the credit. Negotiating the impact of the income into the purchase agreement may be important to the overall economics.

Changes for excess business losses from pass-through and businesses reported on Schedules C, E, and F

The CARES Act suspends the application of this loss limitation until 2021 and makes other technical corrections.

Portfolio company impact

• Portfolio companies that operate as pass-through entities may have a tax loss that was subject to this limitation for the taxpayer’s 2018 or 2019 tax years. The taxpayer may be required to amend tax returns in order to claim the excess business losses and make any other corresponding adjustments. Taken together with the NOL rules described above, this provision will provide individual taxpayers with a much greater ability to utilize business losses and obtain tax refunds.

Corporate AMT credits

The alternative minimum tax (AMT) for corporations was eliminated for tax years after 2017 under the TCJA. Corporations could claim 50% of any unused AMT credit carryforwards as a refundable credit for 2018, 2019, and 2020, with any excess being fully refundable in 2021. The CARES Act amends this rule and allows any excess credits to be fully refundable in 2019. In addition, corporations can elect to claim the full AMT credit refund in 2018.

Portfolio company impact

• Like other aspects of the CARES Act, this change provides corporations with faster access to a tax attribute. It also may require corporations to amend tax returns.

Transaction impact

• Purchase agreements from 2018 and 2019 should be reviewed to determine the appropriate recipient of this benefit in the event a C corporation was sold or purchased with this tax attribute.

Understanding the full impact of the CARES Act

The changes made by the CARES Act stretch beyond just the tax function. Provisions in the new law will affect labor relations and human resources rules in ways that may still affect the value of a target going forward. For answers to specific questions about the impact of these changes on your business, please contact your Plante Moran advisor.