Manufacturing and Distribution Group Newsletter – Fall 2020
Mark A. Thomson, Seamus M. Donoghue
Now May Be the Right Time to Acquire a Business
MARK THOMSON, CPA
The COVID-19 pandemic has resulted in financial losses for many businesses, including manufacturers. As a result, some owners may be looking for an exit strategy. In this uncertain market, some investors see opportunity. For those who are able, now can be a good time to acquire a distressed business with an eye to turning a profit. Here is some guidance on this strategy to help you avoid potential pitfalls.
Looking at the long term
While turnaround acquisitions can yield significant long-term rewards, acquiring a troubled target can also pose greater risks than buying a financially sound business. The keys are choosing a company with fixable problems and having a detailed plan to address them. Due diligence and spending time understanding the business’ targets will be critical to successfully integrating them into your existing company.
Look for a company with hidden value, such as untapped market opportunities, poor leadership and excessive costs. Also, consider cost-saving or revenue-building synergies with other businesses that the buyer owns. Be sure to assess whether these opportunities exceed acquisition risks and potentially provide ample financial benefits.
Doing your homework
Successful turnaround acquisitions start by understanding the target company’s core business — specifically, its profit drivers and roadblocks. Without a clear understanding, you may misread the company’s financial statements, misjudge its financial condition and, ultimately, devise an ineffective course of rehabilitative action. This is why many successful turnarounds are conducted by corporate buyers in the same industry as the sellers or by investors (such as private equity funds) that specialize in a particular sector.
During the due diligence phase, pinpoint the source of your target’s distress, such as excessive fixed costs, decreased demand for products and services or overwhelming debt. Then determine what, if any, corrective measures can be taken. Do not be surprised to find hidden liabilities — such as pending legal actions or deferred tax liabilities — beyond those you already know about.
You also may find potential sources of value, such as tax breaks or proprietary technologies. Benchmarking the company’s performance with its industry peers’ can help reveal where the potential for profit lies.
Managing cash flow
Before completing a transaction, determine what products drive revenue growth and which costs hinder profitability. Does it make sense to divest the business of unprofitable products, services, subsidiaries, divisions or real estate? Should you cut staff?
Implementing a longer-term cash-management plan and developing a forecast based on receipts and disbursements is also critical. This allows the buyer to understand what capital is needed to support the transaction. Cost-saving and revenue-generating opportunities, such as excessive overtime pay, high utility bills and unbilled services, can be achieved with a strong cash-management plan and a thorough evaluation of accounting controls and procedures.
Reliable due diligence hinges on whether the target company’s accounting and reporting systems can produce the appropriate data. If these systems do not accurately capture all transactions and list all assets and liabilities, a potential buyer will not be able to track progress and fully pursue growth opportunities or respond to potential problems.
Related Read: Cash Flows: Thinking Ahead
Structuring the deal
When buying a business, the parties can structure the deal as a sale of either assets or stock. Buyers generally prefer asset deals, which allow them to select the most desirable items from the company’s balance sheet. In addition, the buyer receives a step-up in basis on the acquired assets, which lowers future tax obligations. And the buyer negotiates new contracts, licenses, titles and permits.
On the other hand, sellers typically prefer to sell stock, not assets. Selling stock simplifies the deal and tax obligations are usually lower for the seller.
However, stock sales may be riskier for buyers because the business continues to operate, uninterrupted, and the buyer takes on all debts and legal obligations. In a stock sale, the buyer also inherits the seller’s existing depreciation schedules and tax basis in the company’s assets.
Another important decision is whether to pay cash for the transaction, borrow funds or set up a structure that pays a portion at closing and includes an earn-out provision that is based on future performance. In today’s COVID-19 environment, buyers should be careful to understand the full capital commitment needed.
Developing a plan
Current market conditions make business acquisitions both tempting and tricky. Consult your ORBA CPA to help develop a strategic plan that minimizes potential risks and maximizes your long-term value.
For more information, contact Mark Thomson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing & Distribution Group.
First-Year Bonus Depreciation and Sec. 179 Expensing: Beware the Pitfalls
SEAMUS DONOGHUE, CPA, MST
Many manufacturers are eligible for tax write-offs for certain equipment purchases and building improvements. These write-offs can do wonders for a manufacturer’s cash flow, but whether to claim them is not always an easy decision. In some cases, there are advantages to the regular depreciation rules. It is critical to look at the big picture and develop a strategy that aligns with your company’s overall tax-planning objectives.
Taxpayers can elect to use the 100% bonus depreciation or the Section 179 expensing election to deduct the full cost of eligible property upfront in the year it is placed in service. Alternatively, they may spread depreciation deductions over several years or decades, depending on how the asset is classified under the tax code. Note that 100% bonus depreciation is available for property placed in service through 2022. Then, allowable bonus depreciation will be phased down to 80% for property placed in service in 2023, 60% in 2024, 40% in 2025 and 20% in 2026. After 2026, bonus depreciation will no longer be available.
Related Read: Why Wait to Deduct Your Purchases? Turbocharge Tax Deductions With Bonus Depreciation and Sec. 179
In March 2020, a technical correction made by the Coronavirus Aid, Relief, and Economic Security (CARES) Act expanded the reach of bonus depreciation. Under the Act, qualified improvement property (QIP), which includes many interior improvements to commercial buildings, is eligible for 100% bonus depreciation retroactively to 2018. So, taxpayers that placed QIP in service in 2018 and 2019 may have an opportunity to claim bonus depreciation by amending their returns for those years. If bonus depreciation is not claimed, QIP is generally depreciable on a straight-line basis over 15 years.
Sec. 179 also allows taxpayers to fully deduct the cost of eligible property, but the maximum deduction in a given year is $1 million (adjusted for inflation), and the deduction is gradually phased out once a taxpayer’s qualifying expenditures exceed $2.5 million (also adjusted for inflation).
While 100% first-year bonus depreciation or Sec. 179 expensing can significantly lower your company’s taxable income, it is not always a smart move.
Here are three examples of situations where it may be preferable to forgo bonus depreciation or Sec. 179 expensing:
- You are Planning to Sell QIP
If you have invested heavily in building improvements that are eligible for bonus depreciation as QIP, you may be stepping into a tax trap by writing it off if you plan to sell the building in the near future. That is because your gain on the sale — up to the amount of bonus depreciation or Sec. 179 deductions you have claimed — will be treated as “recaptured” depreciation that is taxable at ordinary income tax rates as high as 37%. On the other hand, if you deduct the cost of QIP under regular depreciation rules (generally, over 15 years), any long-term gain attributable to those deductions will be taxable at a top rate of 25% if the building is sold.
Related Read: What You Need to Know About the CARES Act and Qualified Improvement Property
- You are Eligible for the “Pass-Through” Deduction
This deduction allows eligible business owners to deduct up to 20% of their qualified business income (QBI) from certain pass-through entities, such as partnerships, limited liability companies or sole proprietorships. The deduction, which is available through 2025, cannot exceed 20% of an owner’s taxable income, excluding net capital gains (several other restrictions apply).
Claiming bonus depreciation or Sec. 179 deductions reduces your taxable income, which may deprive you of an opportunity to maximize QBI deductions. And since the QBI deduction is scheduled to expire in 2025, it makes sense to take advantage of it while you can.
- Depreciation Deductions Will be More Valuable in the Future
The value of a deduction is based on its ability to reduce your tax bill. If you think your tax rate will go up in the coming years, either because you believe Congress will increase rates or you expect to be in a higher bracket, depreciation write-offs may be worth more in future years than they are now.
Timing is everything
Keep in mind that forgoing bonus depreciation or Sec. 179 deductions only affects the timing of those deductions. You will still have an opportunity to write off the full cost of eligible assets over a longer time period. Your ORBA tax advisor can analyze how these write-offs interact with other tax benefits and determine the optimal strategy for your company’s situation.
Sidebar: Can you deduct the cost of your website?
There was a time when websites were nothing more than “online brochures.” But today, they are indispensable tools that many manufacturers use for critical business functions, including marketing and advertising, communications, supply chain management and e-commerce. Websites are especially important in the COVID-19 environment, as manufacturers rely more heavily on virtual rather than in-person interactions.
Developing an effective website can require a significant investment, but are those costs deductible for federal tax purposes? The IRS has not published any website-specific guidance, but general guidance on the tax treatment of hardware and software is instructive.
Servers and other hardware used to maintain a website are treated like other computer equipment, which is typically depreciable over five years. But it may be possible to deduct 100% of the cost in year one if you qualify for bonus depreciation or the Section 179 expensing election.
Off-the-shelf software is generally amortizable over 36 months. Like hardware, however, it may also be eligible for bonus depreciation or Sec. 179 expensing. Internally developed software is typically amortized over 36 months, but, in some cases, it may be written off more quickly. For example, if your website is used primarily for advertising, it may be possible to deduct software development costs currently as “ordinary and necessary business expenses.” And certain development costs may qualify as deductible research expenses.
- Other Options
If you engage a vendor to set up and operate your website, the payments are likely deductible business expenses. If your business is new, you will be eligible to deduct up to $5,000 in start-up expenses, including website costs, in year one.
The tax treatment of your website depends on your company’s circumstances. Be sure to consult with your ORBA tax advisor.
For more information, contact Seamus Donoghue at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group.
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