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New Immediate Expensing Rules and NOL Limitations in the Mergers & Acquisition Context: A Planning Opportunity or Trap for the Unwary?

06.15.2018

The “Tax Cuts and Jobs Act” (the “Act”)[1] amended Section 168(k) of the Internal Revenue Code to allow taxpayers to immediately depreciate or expense 100% of the cost of new and acquired qualified property[2] placed in service between September 27, 2017 and January 1, 2023.[3] In addition to increasing “bonus depreciation” from 50% to 100%, the Act makes “acquired property” eligible for immediate expensing. Previously, Section 168(k) allowed 50% bonus depreciation for property first used in that tax year, which meant that bonus depreciation was generally limited to new property. However, the broader definition of “acquired property” in the revised Section 168(k) only requires that the property be acquired in an arms-length transaction and not previously used by the taxpayer to qualify for bonus depreciation.[4] This change allows used qualified property to be immediately expensed when purchased and placed into service. In the mergers and acquisitions context, it creates an even stronger incentive for purchasers of businesses to pursue “asset deals”[5] and negotiate to allocate as much of the purchase price as possible to qualified property to take advantage of the new immediate expensing rules.

However, there are nuances for purchasers of businesses to consider before electing to immediately expense acquired qualified property.

For instance, the Act makes net operating losses (“NOLs”) more difficult to use, which may impact the advisability of electing to immediately expense acquired qualified property. NOLs are the excess of deductions over gross income in a taxable year. Previously, NOLs could be used to offset 100% of the income in those tax years and could generally be “carried back” to prior tax years for up to two years and “carried over” into future tax years for up to twenty years. However, the Act’s revisions to Section 172 generally eliminate NOL carry back to previous tax years and limit the amount of NOLs that may be deducted in a single year to the lesser of the available NOL carryover or 80% of the taxpayer’s pre-NOL deduction taxable income.

Although the Act now allows NOLs to be carried over indefinitely into future tax years, the new limitations are potentially important in the context of immediately expensing acquired qualified property when a business is acquired in an asset deal. For example, assume a business acquires qualified property of another business for $10 million and that the business generates $2 million of annual taxable income each year prior to any deductions related to the $10 million purchase of qualified property. If the taxpayer elects to immediately expense this acquired qualified property, $2 million would be deducted in year 0 and an $8 million NOL would be created. The new NOL limitations would not allow this NOL to be carried back to previous years, and would only allow 80% of future year taxable income to be sheltered by NOLs that are carried over, meaning the business in this example could only shelter $1.6 million of its annual taxable income until the carried over NOL is exhausted, which would occur equally over years 1 through 5.

Following the enactment of the Act, taxpayers may still elect out of bonus depreciation for any class of qualifying property placed in service during the tax year.[6] Now assume that in the same transaction, the taxpayer (i) elected out of bonus depreciation for qualifying property totaling $4 million (assume they are 5-year assets and that straight-line depreciation is elected with depreciation beginning in year 1 for this example) and (ii) immediately expensed only $6 million of the acquired qualified property. This would would create a $4 million NOL instead of an $8 million NOL. The following tables demonstrate why in this scenario the taxpayer could achieve a more efficient tax result by not immediately expensing all of the acquired qualified property.

Immediate Expensing of $10 Million

  Income Prior
to NOL
/Deductions
Deduction / Depreciation NOL Used Taxable Income After NOL / Deductions NOL Carryover
Year 0 $2,000,000 $2,000,000 $0 $0 $8,000,000
Year 1 $2,000,000 $0 $1,600,000 $400,000 $6,400,000
Year 2 $2,000,000 $0 $1,600,000 $400,000 $4,800,000
Year 3 $2,000,000 $0 $1,600,000 $400,000 $3,200,000
Year 4 $2,000,000 $0 $1,600,000 $400,000 $1,600,000
Year 5 $2,000,000 $0 $1,600,000 $400,000 $0

Immediate Expensing of $6 Million and Straight-Line 5-Year Depreciation of $4 Million 

  Income Prior
to NOL /Deductions
Deduction / Depreciation NOL Used Taxable Income After NOL / Deductions NOL Carryover
Year 0 $2,000,000 $2,000,000 $0 $0 $4,000,000
Year 1 $2,000,000 $800,000 $960,000 $240,000 $3,040,000
Year 2 $2,000,000 $800,000 $960,000 $240,000 $2,080,000
Year 3 $2,000,000 $800,000 $960,000 $240,000 $1,120,000
Year 4 $2,000,000 $800,000 $960,000 $240,000 $160,000
Year 5 $2,000,000 $800,000 $160,000 $1,040,000 $0


Although the taxpayer would ultimately recognize $2 million of taxable income in either example, by not immediately expensing the full $10 million, the taxpayer would be able to decrease its taxable income by $160,000 in Years 1-4 and effectively defer this $640,000 of taxable income to Year 5.

In short, purchasers of businesses should be careful not to be overly aggressive when immediately expensing acquired qualified property in light of the new NOL limitations, which could lead to a counterintuitive result where immediately expensing acquired qualified property does not lead to the most efficient long-term tax results.

We continue to analyze the Act’s impact. Please contact one of the authors or your regular Koley Jessen contact with any questions.


[1] The “Tax Cuts and Jobs Act” is the the name commonly given to: An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, P.L. 115-97.

[2] “Qualified property” is generally defined as (i) tangible personal property with a recovery period of 20 years or less under current law, (ii) certain computer software, and (iii) property used in qualified film, television and theatrical productions.

[3] For property placed in service after January 1, 2023, the percentage allowed as bonus depreciation is reduced by 20% every two years until it is phased out completely for property placed in service after January 1, 2027.

[4] I.R.C. § 168(k)(2)(E)(ii).

[5] “Asset deals” refers to transaction structures that allow the purchaser to step-up the tax basis of business assets acquired. Examples include a transaction structured as an asset purchase, the purchase of the equity of an entity that is treated as a “disregarded entity” (such as a single member limited liability company that has not made a “check the box” election to be taxed as an association or qualified subchapter S subsidiary), qualified stock purchases for which a Section 338(h)(10) election to treat the qualified stock purchase as a deemed asset purchase has been made, and qualified stock dispositions for which a Section 336(e) election to treat the qualified stock disposition as a deemed asset sale has been made.

[6] I.R.C. § 168(k)(7).

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