Sec. 174(d) in M&As: Risks and opportunities

Editor: Mark Heroux, J.D.

Changes made to Sec. 174 under the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, may be among the most taxpayer-unfavorable tax provisions in recent memory. Taxpayers from a wide range of industries face the challenges of these law changes that took effect beginning with tax year 2022. The consequences have been apparent nowhere more than in merger and acquisition (M&A) transactions.

As is often the case, however, opportunities for strategic planning around Sec. 174 have developed. Implications of Sec. 174 will continue to evolve as additional guidance is released, but in the interim, taxpayers and advisers should focus on understanding the risks and maximizing the benefits of Sec. 174 when involved in M&A transactions.

Understanding the changes to Sec. 174

Prior to the TCJA’s enactment, Sec. 174 allowed for domestic research and experimental (R&E) expenditures to be expensed when incurred. Sec. 174(a), as amended, now disallows immediate expensing and requires domestic expenses to be capitalized and amortized over a five-year recovery period. Foreign expenses are required to be capitalized and amortized over a 15-year recovery period, creating additional complexity.

While these provisions are unfavorable to taxpayers, perhaps the most detrimental one is Sec. 174(d), which prevents taxpayers from accelerating the capitalized Sec. 174 costs in the event associated property is “disposed, retired, or abandoned” during the recovery period. Further, as if to dispel any doubt, the provision further specifies that for the unrecovered costs, “such amortization deduction shall continue with respect to such expenditures.” The law’s direct language makes it clear that the Sec. 174 costs cannot be accelerated. Its difficulty and rigidness have become apparent to any practitioner involved in transaction planning involving R&E expenditures.

Potential effects of Sec. 174(d) in asset and stock sales

Asset sale: In a transaction treated as an asset sale, including transactions that are elected to be treated as asset sales, Sec. 174(d) leaves clear practical impediments to recovering the capitalized R&E costs. The fact that Sec. 174(d) clearly states amortization deductions shall continue begs the question of whether these capitalized costs can be recovered as basis in an asset sale. Assuming they are not recovered as basis, then a taxpayer is left with potentially years of deductions. For certain taxpayers without other income, these deductions could become worthless.

Without proper planning, taxpayers in an asset sale can be left with an increased tax burden. Working with their advisers, these taxpayers may benefit from designing alternative transaction structures. Earnouts or other deferred compensation can be an option for a seller to consider to fully use the deductions still being amortized under the Sec. 174 recovery period.

Modeling these alternatives with interest components or increased future payments can leave a seller whole from a purchase-price perspective and can be used against the Sec. 174 deductions, creating a more tax-efficient transaction. Not every purchaser will desire an installment sale structure, but for those that do, this can be an effective solution. Taxpayers need to be prepared for this option if they want to maximize after-tax returns in an asset sale.

In an asset sale where a legal entity remains on the seller side post-transaction, a complete liquidation could occur after the sale. The interplay in a liquidation of a corporation under Sec. 332 or partnership under Sec. 731 remains an issue. Which section should take precedence and how Sec. 174 costs should be treated in such circumstances remains an open issue. Taxpayers will have to consider their specific facts, and IRS guidance likely will be needed.

Asset sale with rollover: An asset sale with rollover can further complicate Sec. 174(d)’s impact. The capitalized Sec. 174 costs likely remain with the seller. However, taxpayers should ensure that the buyer and seller agree on how these costs will be treated, and purchase agreements should contain specific provisions on the treatment of the costs so there is no doubt about how they will be treated. Lack of specific language in a purchase agreement can leave the buyer and seller with different understandings of the treatment and lead to post-closing differences.

Rollover equity in a flowthrough entity can be a successful planning technique as well. Assuming the rollover entity will receive positive taxable income post-acquisition, previously capitalized Sec. 174 costs can offset future taxable income. Significant modeling needs to be done to ensure capitalized Sec. 174 costs will be fully utilized. The rollover needs to be significant enough to offset the capitalized costs that are deducted over the following years. Further, taxpayers need to understand that the modeling relies heavily on forecasted income and the assumption that the buyer will be successful in meeting forecasts.

Stock sale: A traditional corporate stock sale in which the buyer does not receive a step-up in basis leaves a clearer picture of how Sec. 174(d) should be handled. As the underlying assets are not sold, the recovery through amortization deductions under Sec. 174 continues, as is the case with other assets held by the corporation that have a carryover basis. While Sec. 338(h)(10) elections are an option, they should be considered with additional scrutiny, as the issues presented for asset sales would apply and may make the election less accretive than it would have been under the past Sec. 174 regime. Further, in a stock sale, the unrecovered tax benefits of Sec. 174 can be significant to a buyer and in certain circumstances may be more valuable than the step-up received in an asset sale. The accelerated recovery period of five versus 15 years for purchased Sec. 197 assets may leave the Sec. 338(h)(10) election as less accretive, and it needs to be modeled appropriately.

Sellers need to understand the underlying tax value of their business more than ever. Sellers preferring a stock sale often have had significant deferred tax liabilities, making a stock sale less attractive for buyers. However, the significant deferred deductions created by Sec. 174 can flip the issue entirely, where sellers may have both a valuable company and net tax assets that should be considered appropriately in the purchase price. Sellers often think of tax as a drawback to them, but in certain industries, Sec. 174 may create a significant tax asset they should consider when selling their business.

Opportunities in M&As

As with any complex provision of the Code, the complexity can provide opportunities for planning and structuring both within the confines of the Code and in deal structuring. All parties in a transaction need to be prepared to handle the challenges presented by Sec. 174(d); however, sellers in particular need to be prepared in order to prevent losing deductions or benefits. Taxpayers considering selling their business have multiple pitfalls to avoid.

Before engaging in a transaction, sellers should plan their approach to Sec. 174(d) accordingly. Considering their preference for the transaction structure ahead of time can leave sellers in a stronger negotiating position and lead to a more advantageous transaction. Sellers may find their business has an increased tax value from Sec. 174 that they did not anticipate. With tax assets, sellers can potentially negotiate gross-up payments or other terms to maximize value. Further modeling Sec. 174 in different transaction structures can yield unexpected results and can lead further to value creation.

Buyers need to be cognizant of the challenges that Sec. 174 creates as well. Sophisticated buyers will find value in capitalized Sec. 174 costs and can attempt to structure transactions to have minimized future tax burdens. Basis step-ups may be less valuable than they were historically, particularly in the software and technology industry. Buyers also may be able to use a stock sale in a more tax-efficient way than prior to the changes to Sec. 174. Further, buyers should spend additional time scrutinizing Sec 174 costs during due diligence to ensure realizable tax benefits from the capitalized costs.

Concerns about retroactive changes

Of all the concerns around Sec. 174, perhaps the one top-of-mind for sellers involves potential retroactive changes to Sec. 174. As of the time of this writing, several proposed bills in Congress would amend Sec. 174 to restore prior expensing treatment (see, e.g., H.R. 2673, the American Innovation and R&D Competitiveness Act of 2023). Unfortunately, a “hope for the best/plan for the worst” mentality needs to be taken.

Sellers can protect themselves and structure purchase agreements to ensure that the benefits of unrecovered Sec. 174 costs remain with them. Sellers should ensure that purchase agreements explicitly provide them the benefit of any retroactive law changes. Further, sellers should consider additional purchase agreement provisions around rights to amend tax returns for any retroactive changes to Sec. 174. While the potential for changes to Sec. 174 wanes with time, many sellers hold out hope that they will be able to recover the additional tax burden created by the law change.

While there are plenty of reasons to view Sec. 174(d) as an unfavorable provision, there are significant opportunities for well-planned transactions to recover the initial negative tax impact of the capitalization of these expenses. Taxpayers contemplating a sale should plan for Sec. 174 and the desired outcomes ahead of going to market and be prepared to present both the tax detriments and benefits to purchasers. Transactions without proper planning can lead to less accretive deals and in certain circumstances permanently lost deductions.

Editor Notes

Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.

For additional information about these items, contact Heroux at mark.heroux@bakertilly.com.

Contributors are members of or associated with Baker Tilley US, LLP.