How Private Equity companies are using new CARES Act tax rules to help pay for the acquisition of distressed companies
Structured properly can fund a significant % of the acquisition price
The CARES Act (or the Coronavirus Aid, Relief and Economic Security Act) was passes in March 2020 at a whopping cost of $2.2 trillion dollars. The aim was to help businesses suffering from the economic fallout brought on by sweeping lockdowns impacting all four corners of the country.
As with most government packages of this size, there is buried treasure lobbied into the bill by those who are close to Washington. Little known, an adjustment was made to section 269 of the US tax code allowing private equity funds to acquire distressed companies funded, in large part, by tax rebates.
What is different and how would this even work? Well, it’s complicated but let’s take a look at a simplistic example…
Prior to the passing of the CARES act, any distressed company with a booked Net Operating Loss (NOL) acquired by a PE Fund, could only use the tax benefits generated by the NOL, in the year of the acquisition. Thus the potential tax refund was quite limited. The IRS was wise to these tactics in the past (& without quoting too much dry tax laws) passed codes 269 & 382. CARES kind of blows the door wide open.
Briefly, code 269 states strictly that NOL’s can't be used if corporation is solely purchased for sake of federal tax avoidance, while 382 put major limitations on the amount of those refunds. While not impossible, prior to CARES, to get through 269 & minimize the limitation of 382, the new laws are providing a lot of free liquidity to funds by creating 3 distinct ways to generate funds for acquisitions. Add to this, the NOL carrybacks are now 5 years, instead of just within the existing year of the acquisition.
The 3 distinct ways are as follows…
The use of “Transaction Tax Deductions” (or TTD’s)
Structure the deal as an add-on asset acquisition
Benefit from the deductibility of acquisition debt
Okay, so not sure what this means yet? Let’s go through an example…
PE Fund acquires ABC Inc for $100K
Structured as an asset acquisition using all debt in transaction
ABC was a profitable company prior to 2020, earning $10K per year
TTD’s - to sell the company, ABC Inc paid $10K in advisory & investment banker fees.
Asset Deduction - it was deemed that ABC Inc had $20K in “qualified properties” eligible for 100% immediate expensing.
Interest Deduction - IRS, under the new laws, allow 50% of 2019 income (or $5K) to be the maximum amount deducted for acquisition interest costs. With a $100K price @ 5% interest, the PE Fund is already at the maximum and can enjoy the total amount as an NOL generator.
With 2020 taxable income at $0, combined with the 3 distinct ways to generate funds, the fund is now able to apply $35K of NOL’s to the last 5 years of taxable income. At a 35% tax rate ($35K x 35%), $12.5K in tax refunds are generated and used to pay down ABC shareholders for the $100K acquisition.
A more distressed company might have allowed the PE Fund to use tax refunds to pay more than just 12.5%. We are working on a deal where the PE Fund will enjoy a 50% reduction in purchase price using these methodologies. If you are looking at buying distressed businesses, now is the time based on supply and ability to finance via tax refunds. Who knows how long this window will stay open?