Tax Cuts & Job Act Implications for Small Business Investments Companies

Polsinelli PC. In California, Polsinelli LLP
Tax Cuts & Jobs Act Implications for
the SBIC Industry
Presented by Polsinelli PC & BKD
June 6, 2018
1

real challenges. real answers. sm
2
Presenters
Bill Sanders
Shareholder and
Practice Chair of
the Tax Group
(Kansas City)
Philip Feigen
Shareholder and
Practice Chair of the
Banking and Financial
Institutions Group
(Washington, D.C.)
Rick Klahsen
Regional Tax Director
BKD

3
Overview of the Major Tax Act Provisions
Affecting the SBIC Industry
 Rate Reductions including Choice of Entity
 Qualified Business Income (“QBI”) Deduction
 Interest Expense Deduction Limitation
 Changes to Depreciation and Expensing
 NOL Limitations
 Limitation on Deductibility of State Taxes
 Further Limits on Deductibility for Meals, Entertainment
and Employee Parking
 Choice of Entity – To be a Flow-Through or not to be a
Flow-Through – That is the question

4
Rate Reductions
 37% Top Individual Rate (40.8% including net
investment income tax)
• Prior maximum was up to 45%
 29.6% Effective Rate on Business Income From Pass-
Throughs Eligible for Full 20% Deduction
 21% C Corporation Tax Rate Reduced to Flat 21%
• Qualified Dividends still subject to shareholder
level tax of up to 23.8%
• Overall effective federal tax rate of 39.8% for
earnings if distributed (down from 50%)
 23.8% Capital Gains Tax Rate Did Not Change

5
Qualified Business Income (“QBI”)
Deduction
 20% deduction for flow-through income
 Limited to the greater of:
– 50% of W-2/wages paid or
– 25% of W-2/wages paid plus 2.5% of the cost of
tangible depreciable property for qualifying
businesses
 Subject to certain limitations and phase-outs
 Aggregation issues

6
Qualified Business Income (“QBI”)
Deduction , cont’d
 Allows individual taxpayers to deduct 20% of
domestic “qualified business income” (QBI) from a
partnership, S corporation, or sole proprietorship
(“qualified businesses”) subject to certain limitations
and thresholds.
 “Qualified businesses” do not include “specified
service trade or businesses” (accounting, law,
health, several other professions, service
businesses related to investing, and financial
services) but engineering and architecture trades
are not excluded.

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Interest Expense Deduction Limitation
 Across the board limitations on the deductibility of
business interest expense.
 Real property and farming trades or businesses can
make an irrevocable election out of the business
interest deduction limitation. These businesses must
then use the alternative depreciation system to
depreciate property with a recovery period of 10
years or more.

8
Interest Expense Deduction
Limitation, cont’d
 In common parlance, this limitation is described as
limiting the deduction of net interest expense to the
extent of 30% of “adjusted taxable income” where:
– For the first four years, “adjusted taxable income” is
EBITDA (computed on a tax basis); and
– Later, “adjusted taxable income” is 30% of EBIT.
 Only applies where average annual gross receipts for
prior 3 years exceed $25 million
 Limit is recalculated every year, so a bad year can get
worse fast.

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Immediate Expense Deduction and
Section 179
 Immediate expensing of tangible property placed in
service between September 27, 2017 through 2022.
 5 year phase-out: 80% expensing in 2023, 60% in 2024,
etc.
 Applies to new and used property so long as it is
purchaser’s first use of the property.
 Applies to tangible property with 20 year depreciation or
less.
– Cost segregation worth more
– Asset purchases more valuable
– Purchase price allocations more important

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Section 179, cont’d
 There were four categories of improvements to the interior of
nonresidential buildings: leasehold improvements, retail
improvement property, restaurant property, and qualified
improvement property.
 Now, there is only one general definition, “qualified improvement
property.”
– Includes most interior improvements made after real property is placed
in service
– Supposed to get 15 year depreciation, but may have been inadvertently
left out.
– Qualified improvement property: normal is 15 years, ADS should be 20
years, but may have been erroneously omitted. Result unclear.
 Error means property could be subject to lengthy depreciation, and
could also disqualify this property from immediate expensing.

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Section 179, cont’d
 Prior law allowed immediate deduction of $510,000 in
purchases of qualified property in 2017, so long as total
purchases did not exceed $2,030,000
– Qualified property is tangible personal property (not
real estate, except as described below)
 New Law increases the deduction to $1,000,000 with
purchase limit of $2,500,000 (both indexed for inflation)
 Includes Qualified Improvement Property, roofs, HVAC,
fire and security

12
NOL Limitations
 Corporate net operating loss carrybacks are eliminated.
 Net operating losses carryforward indefinitely but are
limited to 80% of taxable income.
 Technical Correction Possible:
– The new 80% deduction limit is effective for losses arising
in tax years beginning after Dec. 31, 2017 but the Tax Act
made the changes to carrybacks and carryforwards
effective for tax years ending after that date.
– For fiscal year companies with 2017 taxable years ending
after Dec. 31, 2017, this results in an unexpected problem
if they have incurred significant losses they were hoping to
carryback.

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Limitation on Deductibility of State Taxes
 Individuals are limited to state and local tax
deductions at $10,000 (property plus choice of
income or sales taxes, as under old law).
 Taxable entities are not subject to these
limitations.
 Implications for flow through state and local
income taxes.

14
Limitation on Deductibility of State Taxes, cont’d
 State Tax Deductions Limited to $10,000
– Worse for Blue States
 Ranking of States by Income and Property Tax Per
Capita
Top 10
1. CT - 5053
2. NY - 4789
3. NJ - 4544
4. MA - 4214
5. VT - 3472
6. RI - 3458
7. CA - 3376
8. MN - 3300
9. IL - 3244
10. OR - 3164
Bottom 10
1. TN - 876
2. NV - 953
3. FL - 1184
4. AL - 1209
5. SD - 1301
6. WA - 1364
7. NM - 1393
8. OK - 1455
9. LA - 1478
10. MS - 1512

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Limitation on Deductibility of State Taxes, cont’d
Compliments of the Tax Foundation © TaxFoundation

16
Further Limits on Deductibility for Meals,
Entertainment and Employee Parking
 No deduction for entertainment expenses
 Meals provided for convenience of
employer are now only 50% deductible
even if excludible from employees’ gross
income as de minimis fringe benefits
 Employee parking costs no longer
deductible

17
Choice of Entity – To be an S or not to be
an S – That is the question
 Historical role of Flow-Throughs and C corporations
in the SBIC Industry
 Cumulative Impact of New Tax Law Changes on the
Choice of Entity
 Analysis and Case Study of a Portfolio Operating
Business and its Decision on Conversion
 The 10 year Hang Over Effect of Converting From
an S corporation to a C corporation
 Washington and the Dilemma of Future Uncertainty

18
Historical Role of Flow-Throughs and C
Corporations in the SBIC Industry
 Significance of portfolio entity type not as relevant if
investment is debt rather than equity (including
options/warrants)
 Equity investments in flow-through entities
– Generally more tax efficient due to single level tax
– Requires tax distributions
– Gap has closed due to rate changes
– Complication for Tax Exempt Fund Investors – use of
blocker C corporations (including limitations due to 25% /
50% ownership rules – UBIT)

19
Cumulative Impact of New Tax Law
Changes on the Choice of Entity
 Historically, the tax code has been biased
toward operating in pass-through form, but the
Tax Act significantly reduced the disparity in
effective tax rates.

20
Changes on the Choice of Entity, cont’d
 Examples of businesses that may want to incorporate:
– Businesses that reinvest most of their earnings. Corporate tax
rate is now 21% whereas pass-through income is taxed at 29.6%
to owner if a full QBI deduction is available, and 37% if no
deduction is available.
 E.g., assets light and labor light businesses; high tech
business
– Business whose shares may qualify as Section 1202 “Qualified
Small Business Stock”
– Businesses that can make use of nonqualified deferred
compensation.
– C Corporations with foreign sales or who own foreign
subsidiaries.

21
 CAVEAT: Once a business chooses to incorporate,
changing back to pass-through form may cause gain
recognition.
– Corporation to partnership (legal partnership or LLC taxed as
partnership): Gain recognized as if assets sold at fair value.
– C Corporation to S Corporation:
– All shareholders must be eligible shareholders.
– One class of stock rule.
– Corporate tax is levied on asset sales within 5 years of the
election to the extent that unrealized built-in gains existed on the
election date.
– Accumulated earnings remain subject to double tax.

22
 Examples of businesses that may wish to be organized
in or remain in pass-through form:
– Businesses that distribute most of their earnings. Effective federal tax
rate to corporate shareholders is 39.8% whereas pass-through effective
rate is 29.6% if a full QBI deduction is available. (E.g., asset intensive
and labor intensive businesses.)
– If no QBI deduction is available, individual rate is 37%, which is still ~
3% lower than effective rate to shareholders, assuming NII tax doesn’t
apply – otherwise rates are about the same (39.8% vs. 40.8%).
– Certain heavily leveraged businesses because it is easier for pass-
throughs (e.g., partnerships) to work around the new limitation on
interest deductions.
– S Corporations with foreign subsidiaries can avoid immediate inclusion
of tax deferred foreign earnings.

23
Section 1202
 21% Corporate Tax Rate – 40% Rate Reduction
 Lower C Corp Rate Opportunity – Choice of Entity
 Lower C Corp Rate Opportunity: Qualified Small Business
Stock
– QSBS is C corp stock
• Issued after 1993
• Company value is less than $50 million up through
stock issuance
• Must be active trade or business
• Must be held for 5 years
• Doesn’t work for service businesses or real estate
– Up to 100% Gain Exclusion

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Corporation S corporation Corporation S corporation
Business income 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$
Shareholder salary (250,000) (250,000) (250,000) (250,000)
Pass-through business deduction - - - - - - (150,000)
State income tax (entity level) (45,000) - - (45,000) - -
Taxable income 705,000 750,000 705,000 600,000
State income tax (shareholder level) (15,000) (60,000) (15,000) (60,000)
Federal income tax on business income (239,700) (271,049) (148,050) (214,830)
Federal income tax on shareholder salary (66,178) (66,178) (41,773) (41,773)
Tax on distribution to owner (110,741) - - (132,554) - -
Total tax (476,619) (397,227) (382,377) (316,603)
Net cash to owner 523,381$ 602,773$ 617,623$ 683,397$
Combined federal & state effective tax rate 47.66% 39.72% 38.24% 31.66%
Previous tax law TCJA
Example 1: Effective Tax Rate Before & After the TCJA

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Business income 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$
Pass-through business deduction - - - - - - - -
Taxable income 705,000 750,000 705,000 750,000
Total tax (476,619) (397,227) (382,377) (372,103)
Net cash to owner 523,381$ 602,773$ 617,623$ 627,897$
Combined federal & state effective tax rate 47.66% 39.72% 38.24% 37.21%

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Business income 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$
Pass-through business deduction - - - - - - - -
Taxable income 705,000 750,000 705,000 750,000
Total tax (476,619) (397,227) (382,377) (372,103)
Net cash to owner 347,200 602,773 405,425 627,897
Net cash retained in business 232,650 - - 278,475 - -
Total net cash after taxes 579,850$ 602,773$ 683,900$ 627,897
Effective tax rate (federal and state) 65.28% 39.72% 31.61% 37.21%

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The 10 year Hang Over Effect of Converting
to a C Corporation
 S corporation to C corporation
– General five year prohibition against re-electing S
corporation status
 C corporation to S corporation
– Five year built in gains period
 S corporation to C corporation to S corporation
– General five year prohibition against re-electing S
corporation status followed by five year built in gains
period

28
Washington and the
Dilemma of Future Uncertainty
 New OMB tax jurisdiction
 Pending tax rulemakings
 Tax reform 2.0?

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A Few Key Points
 Choice of Entity is now more complicated – certain provisions
of the tax bill favor corporate form, like the flat 21% tax rate
and desire to reinvest profits, while others, such as the 20%
deduction of qualified business income and distribution of
profits, favor pass-throughs.
 M&A is likely to accelerate, and asset sales will be more
important because of new rule allowing immediate expensing
of tangible asset purchases.
 New provisions will require careful planning and coordination
– new limit on interest deductions, 20% deduction from
taxable income of pass-through businesses, new depreciation
and immediate expensing rules, etc.

30
Questions
Bill Sanders
Shareholder and
Practice Chair of
the Tax Group
(Kansas City)
Philip Feigen
Shareholder and
Practice Chair of the
Banking and Financial
Institutions Group
(Washington, D.C.)
Rick Klahsen
Regional Tax Director
BKD

Polsinelli provides this material for informational purposes only. The material
provided herein is general and is not intended to be legal advice. Nothing
herein should be relied upon or used without consulting a lawyer to consider
your specific circumstances, possible changes to applicable laws, rules and
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Polsinelli is very proud of the results we obtain for our clients, but you should
know that past results do not guarantee future results; that every case is
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is an important decision and should not be based solely upon advertisements.
© 2018 Polsinelli PC. In California, Polsinelli LLP.
Polsinelli is a registered mark of Polsinelli PC

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