Perhaps the single most important day in the life of any closely held business is the day on which it is sold. The occasion will often mark the culmination of years of effort on the part of its owners.

The business may have succeeded to the point that its competitors seek to acquire it in furtherance of their own expansion plans; alternatively, private equity investors may view it as a positive addition to their portfolio of growth companies.

On the flip side, the owners of the business may not have adequately planned for their own succession; consequently, they may view the business as a “wasting asset” that has to be monetized sooner rather than later.

Worse still, the business may be failing and the owners want to recover as much of their investment as possible.

In any of the foregoing scenarios, the tax consequences arising from the disposition of the business will greatly affect the net economic result for its owners.

The following outlines a number of provisions included in the recently enacted Tax Cuts and Jobs Act[1] that should be of interest to owners of a closely held business that are considering the sale of the business, as well as to the potential buyers of the business.

Corporate Tax Rate

In general, the individual owner of a C corporation, or of an S corporation that is subject to the built-in gains tax, would prefer to sell his stock to a buyer – and thereby incur only a single level of federal income tax, at the favorable 20% capital gain rate[2] – rather than cause the corporation to sell its assets.

An asset sale generally results in two levels of tax: (a) to the corporation based upon the gain recognized by the corporation on the disposition of its assets; and (b)(i) to the shareholder of a C corporation upon his receipt of the after-tax proceeds in liquidation of the corporation, or (ii) to the shareholder of an S corporation under the applicable flow-through rules.

Prior to the Act, the maximum federal corporate tax rate was set at 35%; thus, the combined effective maximum rate for the corporation and shareholder was just over 50% (assuming the sale generated only capital gain).

The Act reduced the federal corporate tax rate to a flat 21%; consequently, the combined maximum federal rate has been reduced to 39.8%.

From the tax perspective of a seller, the reduced corporate rate will make asset deals[3] less expensive. For the buyer that agrees to gross-up the seller for the additional tax arising out of an asset deal (as opposed to a stock deal), the immediate out-of-pocket cost of doing so is also reduced.

Individual Ordinary Income Rate

The Act reduced the rate at which the ordinary income recognized by an individual is taxed, from 39.6% to 37%.[4]

In the case of an S corporation shareholder, or of an individual member of an LLC taxable as a pass-through entity[5], any ordinary income generated on the sale of the corporate assets – for example, depreciation recapture[6] – will be taxed at the reduced rate.

Any interest that is paid by a buyer to a seller in respect of a deferred payment of purchase price – i.e., an installment sale – or that is imputed to the seller[7], as in the case of an earn-out, will be taxable at the reduced rate for ordinary income.

Similarly, if the seller or its owners continue to hold the real estate on which the business operates, the rental income paid by the buyer will be subject to tax at this reduced rate.

Finally, any compensation paid to the owners, either as consultants or employees, or in respect of a non-compete, will be taxable at the reduced rate.

Self-Created Intangibles

The Act amended the Code to exclude a patent, invention, model or design (whether or not patented), and a secret formula or process which is held either by the taxpayer who created the property, or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created), from the definition of a “capital asset.”

Thus, gains or losses from the sale or exchange of any of the above intangibles will no longer receive capital gain treatment.


Prior to the Act, the net operating losses (“NOLs”) for a taxable year could be carried back two years and forward 20 years. The Act eliminates the carryback and allows the NOLs to be carried forward indefinitely, though it also limits the carryover deduction for a taxable year to 80% of the taxpayer’s taxable income for such year.

The Act did not change the rule that limits a target corporation’s ability to utilize its NOLs after a significant change in the ownership of its stock.[8] However, the Act’s elimination of the “NOL-20-year-carryover-limit” reduces the impact of the “change-in-ownership-loss-limitation” rule on a buyer of the target’s stock; even though the annual limitation imposed by the rule will continue to apply, the NOL will not expire unused after twenty years – rather, it will continue to be carried over until it is exhausted.

At the same time, however, the Act’s limitation of the carryover deduction for a taxable year, to 80% of the corporation’s taxable income, may impair a target’s ability to offset some of the gain recognized on the sale of its assets.

Interest Deduction Limit

The Act generally limits the deduction for business interest incurred or paid by a business for any taxable year to 30% of the business’s adjusted taxable income for such year.[9] Any interest deduction disallowed under this rule is carried forward indefinitely.

In the case of a buyer that will incur indebtedness to purchase a target company – for example, by borrowing the funds, or by issuing a promissory note as part of the consideration for the acquisition – this limitation on its ability to deduct the interest charged or imputed in respect of such indebtedness could make the acquisition more expensive from an economic perspective.[10]

Immediate Expensing

Prior to the Act, an additional first-year depreciation deduction was allowed in an amount equal to 50% of the adjusted basis of qualified property acquired and placed in service before January 1, 2020. Property qualifying for the additional first-year depreciation deduction had to meet requirements; for example, it had to be tangible personal property, certain computer software, or qualified improvement property. Moreover, the “original use” of the property had to commence with the taxpayer.

The Act, extended and modified the additional first-year depreciation deduction for qualifying property through 2026. It also increased the 50% allowance to 100% for property placed in service after September 27, 2017, and before January 1, 2023.[11]

It also removed the requirement that the original use of the qualifying property had to commence with the taxpayer. Thus, the provision applies to purchases of used as well as new items; in other words, the additional first-year depreciation deduction is now allowed for newly acquired used property.

The additional first-year depreciation deduction applies only to property that was not used by the taxpayer prior to the acquisition, and that was purchased in an arm’s-length transaction. It does not apply to property acquired in a nontaxable exchange such as a reorganization, or to property acquired from certain related persons, including a related entity (for example, from a person who controls, is controlled by, or is under common control with, the taxpayer).

Thus, a buyer will be permitted to immediately deduct the cost of acquiring “used” qualifying property[12] from a target business, thereby recovering what may be a not insignificant portion of its purchase price, and reducing the overall cost of the acquisition.


Query whether the owners of an S corporation (or of another target that is treated as a pass-through entity for tax purposes) will be allowed to claim the 20% deduction based on qualified business income in determining their tax liability from the sale of the assets of the business. Stated differently, and assuming that the owner’s income for the taxable year is derived entirely from the operation and sale of a single business, will the gain from the sale be included in determining the amount of the deduction?

It appears not. The definition of “qualified business income” excludes items of gain even where they are effectively connected with the conduct of a qualified trade or business; this would cover any capital gain arising from the sale of assets used in the trade or business. Moreover, it appears that the presence of such gain in an amount in excess of the taxable income of the business for the year of the sale (exclusive of the gain) would disallow any such deduction to the taxpayer.[13]

What Does It All Mean?

It remains to be seen whether these changes will influence the structure of M&A transactions. After all, most buyers would prefer to cherry-pick the target assets to be acquired and to assume only certain liabilities; they will consider a stock deal only if necessary. The reduction in the corporate tax rate will likely reinforce that fundamental principle, and may cause certain corporate sellers and their shareholders to be more amenable to an asset deal.

However, the pricing of an M&A transaction will likely be affected by the reduced corporate tax rate, by the limitation on a buyer’s deduction of acquisition interest, and by a buyer’s ability to immediately expense a portion of the purchase price. Each of these factors should be considered by a buyer in evaluating its acquisition of a target, the amount the buyer can offer in consideration, and its ability to finance the acquisition.

Only time and experience will tell.

As was mentioned in an earlier post, the Act was introduced on November 2, 2017, was enacted on December 22, 2017 – without the benefit of meaningful hearings and of input from tax professionals – and became effective on January 1, 2018 (just three weeks ago). The Congress is already discussing technical corrections, and the tax bar is asking for guidance from the IRS. Much remains to be discovered.

Stay tuned.

[1] Pub. L. 115-97 (the “Act”).

[2] The shareholder of a C corp, or of an S corp in which he does not materially participate, will also incur the additional 3.8% surtax on net investment income.

[3] Including sales of stock that are treated as asset sales for tax purposes under Sec. 338(h)(10) or Sec. 336(e) of the Code.

[4] The rate may be greater if the 3.8% surtax also applies to the item of income in question; for example, interest income.

[5] For example, a partnership.

[6] Sec. 1245 of the Code.

[7] Sec. 1274 of the Code.

[8] Code Sec. 382.

[9] In general, before 2022, the limitation is tied to EBITDA; thereafter, it is tied to EBIT.

[10] In general, the limitation does not apply to a corporation if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million.

[11] The allowance is thereafter reduced, and phased out, through 2026.

[12] This should cover both actual and deemed acquisitions of assets (as under a Sec. 338(h)(10) election).

[13] Although the underlying basis for the result is not discussed in the Congressional committee reports, it is likely attributable to favorable capital gain rate that applies to the individual owners of a pass-through entity.